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Carry strategy applied to Fixed Income market

Updated: Dec 4, 2023

One of the best-known investment methods within the bond and money markets is the carry strategy, which mainly belongs to experienced traders. In the following article, we will focus on the characteristics of this strategy and their application in fixed-income financial instruments, i.e. where interest rates are fixed during underwriting and remain so throughout the life of the security.

Carry Trade refers to:

The expression of one of the many investment strategies that can be implemented on the international financial markets. This practice aims at maximizing the exposure to benefits associated with holding an investment, exploiting advantages such as the difference in interest rates of different currencies in different geographical areas around the world. In fact, this strategy follows this reasoning: the investor decides to take out loans in countries where interest rates are low, to reinvest them in financial instruments denominated in other currencies that allow returns higher than the cost of financing. The profit derives precisely from the difference between the return on the investment and the cost of financing, i.e. the difference between the different interest rates. For this practice to be profitable and not too risky, it is necessary that the chosen currencies enjoy a stable rate over time and low volatility; since any loss on the currency exchange could reduce the gains or even make them nill.

To further reduce the risk of such a transaction, the financial instruments favored by practitioners of this strategy are low-risk instruments such as government bonds. It was very convenient, for example, to borrow in the Japanese currency, given the low interest rates on the yen. Investments made with borrowed Japanese capital were used more in emerging stock markets and in the high-yield bonds of the US, New Zealand, Australia and the UK. The relative stability of the USD-JPY exchange rate in recent years has made carry trade operations profitable, based on borrowing in yen, subsequently converting yen into foreign currencies, and investing the resulting capital in government bonds, or other risk-free financial instruments, which yield 3% or more. Once the government bond expired, the money was converted from foreign currency back into yen and used to repay the debt incurred in Japan.

Risks associated with the carry trade

The volatility of the currency rate is one of the most important risks in a carry strategy. As a result, before engaging in currency trading on the Forex market, it is crucial to consider other factors as well. For instance, with a market correction, i.e. a sudden decline of 10% or greater in assets’ prices or financial markets, the investor may lose money.

An investor can understand if trading in certain pairs is a wise choice for him by taking a look at the directional bias of the pairs he is considering. He can still lose capital while gaining on interest if the carry trade pair decreases in percentage more than the interest rate increases. Despite the fact that he is profiting from the interest rate disparity, this could result in a larger net loss. Additionally, since these transactions are frequently done with a lot of leverage, even a little shift in exchange rates can result in significant losses if the position is not properly hedged.

Going long on the currency with the highest yield and short on the currency with the lowest yield is not the only approach to a successful carry trading strategy. The direction that interest rates will take in the future is more significant than the interest rate's current level. For instance, if the US central bank raises interest rates while the Australian central bank has finished tightening, the US currency may appreciate against the Australian dollar. Additionally, carry trades only succeed when the markets are optimistic or complacent. Investors may close their carry trades as a result of uncertainty and concern.

Interest rate fluctuations represent a significant threat to carry trades since they may turn a deal that had once a great potential for a profitable return into a bad investment that loses a large amount of money. Carry trades are intended to be long-term investments, and the value of the currency can both increase and decrease. For Forex traders, this is a danger because they can suffer financial loss as a result. There are risks associated with carry trades for forex traders since no foreign currency is entirely stable and because of foreign exchange rate changes. Forex traders need to perform their research and understand the hazards. Additionally, they need to never put more money on the line than they cannot afford to lose.

We contend that these high profits from currency carry trades might be viewed as a form of risk-compensation. According to finance theories, risk-averse agents would seek currencies that can hedge against this risk because investors are worried about factors influencing the evolution of investment possibilities and want to protect themselves against unanticipated changes (innovations) in market volatility. We investigate whether the returns on currency portfolios can be rationalized by the sensitivity of excess returns to the risk of global foreign exchange volatility in a standard asset-pricing framework. In periods of unexpectedly high volatility, when low interest rate currencies offer a hedge by delivering positive returns, we find that high interest rate currencies are negatively correlated with innovations in global foreign currency volatility and, as a result, produce low returns.

Carry strategy and yield curve

In its simplest form, a carry strategy in the fixed-income market can be implemented by taking advantage of the difference in interest rates. It is indeed an example of arbitrage, where the easiest example can be found in financial institutions borrowing money from depositors at low interest rates and then in turn lend these funds out to borrowers at higher rates. The profit in this case would be in the interest rate differential.

In general, the “carry factor” (or “level”) is defined as the (positive) difference between two yields of the same curve, clearly at different maturities. In an upward-sloping yield curve environment, the difference would be positive if we subtract the yield of the shorter maturity bond from the longer maturity one. As the yield curve is not a straight line the carry is not always the same along the curve. Indeed, medium-term bonds would be the ones with the higher carry in the case of a concave curve, while longer-term bonds would be more profitable in terms of carry when the slope of the curve is convex. In this scenario, an investor would go short on the short term (thus borrowing money at the lower rate) and long on the long or medium term (thus investing money at the higher rate).

One can argue that yield curves are not always upward-sloping, as was the case of the UK in early 2007, when 10-year bonds were yielding 4.8% while the financing rate (3m rate) was 5.0%. The carry was negative (-0.2%), so a carry strategy would have held a short position in UK 10-year bonds and a long position on the short-term maturity.

The strategy described so far could seem to be relatively easy to implement, only based on observing the slope of the yield curve. However, the main assumption when calculating the carry and therefore implementing the strategy is that the yield curve remains fixed throughout the life of the investment. This is hard to see in practice, and a portfolio constructed for implementing a carry strategy has to be rebalanced with a frequency that depends on how much and how often the yield curve moves. It is straightforward to imagine that in periods of high volatility, rebalancing the portfolio more frequently leads the trader to pay higher transaction costs and thus reducing the overall performance.

It is also worth mentioning that besides the determinants of the movements of the yield curve (such as supply and demand for money, central bank policies or inflation), we are assuming the non-possibility of default of the issuer. Especially when entering long in long-term maturity bonds, the probability of default of the issuer cannot be ignored, and in the case of the event there is indeed the risk of losing a big part of the portfolio value.

One last consideration has to be made on the actual macro and fixed income scenario. With the FED that is increasing rates at a frequency never seen before and the ECB that is following this process, one would say that with such an upward-sloping curve a carry strategy is the natural and profitable consequence. However, we have to keep in mind that interest rates cannot remain at this level for a long period of time, as many studies and experts in the field are scared of a recession. In both cases, with lower interest rates the carry (defined as the difference in yields) would be reduced, and in the case of a recession the yield curve could invert its slope, thus producing great losses for strategies implemented under the upward-sloping curve scenario.

Does it work?

The returns depend on many different factors, such as the base currency, the market where it is applied, and how it is hedged or not. Some papers show that a dollar neutral strategy (where it is invested the same amount long and short without accounting for volatility) earns on average 2% more than an equally weighted dollar carry strategy.

Some of you may believe that performing a carry trade in an emerging market should be more profitable than the U.S. stock market, due to the higher risk. However, this is not the case and the Sharpe ratio for the U.S. stocks is almost five times higher than the one for the carry returns, after 2010. During the same period even the risk-free rate has performed better than the dollar carry strategy.

Talking about the effect of the choice of the base currency data shows that Dollar-based carry trades are worse than the Euro-based and the Yen-based. Even the Sharpe ratio for the Euro-based is double the one for the Dollar-based.

Last consideration we want to make is that regardless of the carry strategy adopted, if the strategy is hedged it will perform worse than an unhedged strategy. Why is that? Probably this is an effect of investing in the emerging markets, which have a higher volatility and imply a higher options premium.

How to invest in carry strategies?

To invest with a carry strategy it is not essential to perform it on your own, there are many different indices that replicate the performance of a well-defined strategy. Now we briefly explain how 3 of these indices work.

  1. Societe Generale G10 Carry Index: “aims to provide an exposure to the performance of a carry strategy on the G10 currencies (EUR, JPY, GBP, CHF, AUD, NZD, CAD, SEK and NOK) vs USD. The Index is composed of a basket of SG indices replicating a systematic roll of FX forwards. The allocation of the Index is systematically adjusted on a monthly basis according to a proprietary model based on an implied rates differential ranking. The top 3 ranking currencies with the highest carry signal are chosen to be equally invested in the long position and the bottom 3 ranking currencies with the lowest carry signal are chosen to be equally invested in the short position.” (source: )

  2. Barclays G10 Carry Index: “The index applies the carry trade strategy to a pool of G10 currencies which include USD, EUR, JPY, CAD, CHF, GBP, AUD, NZD, NOK and SEK. The index is composed of 10 cash-settled currency forward agreements, one for each index constituent currency, as well as a Hedged US dollar Overnight Index.” (source: )

  3. HFRX Risk Premia Currency Carry Index: “seek to profit from the forward-rate bias in FX using a variety of methods.” (source: )


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