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The end of the carry trade — Part 2

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“The carry trade” is used to describe an investment technique based on using leverage to generate returns from low-risk investments

The carry trade happens when an investor squeezes a higher return out of an investment using leverage. As we’ve seen in Part 1, using leverage (in other words, borrowed money) increases the rate of return on equity. Say an investor buys a mortgage-backed security (MBS) yielding 2.7% and invests all cash. The return on that investment is a little more than 2.7% if you take into account the re-invested monthly coupon payments. If the investor borrows enough to buy another MBS, the rate of return is 5.4% less the interest on the half that was borrowed. The chart above shows the returns under further leverage scenarios. But what if the bond market rallies? Throw in a few points of capital gains and you’re suddenly looking at low double-digit returns. Of course, you don’t need to invest only in MBS—any “safe” asset will do. Investors will lever up high-grade corporate bonds, European sovereign debt, Treasuries—pretty much anything whose return of principal is almost guaranteed.

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The other use for the carry trade is unofficially bank rehab. It’s an easy way for the banks to re-liquefy, by sitting in Treasuries, taking very little risk, and slowly disposing (or writing down) their problem assets. The yen carry trade was an attempt to help re-liquefy the Japanese banks, and it was a way for the U.S. banks to work their way out of problem assets. The yen carry trade was even done in the late ’80s and early ’90s, as the savings and loan crisis caused junk bonds to sell off to bargain basement values and blew holes in the balance sheets of the S&Ls (savings and loan associations) as well as some big commercial banks.

The end of the carry trade — Part 3

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