Carry and rolldown: the hidden cost of waiting to hedge

It may seem counterintuitive, but it is possible to invest in low yielding assets and generate attractive excess returns.

Consider, for example, Japanese Government Bonds (JGBs). Since 2002, 10 year JGBs have yielded a measly 1.22% p.a., but their total returns exceeded yields by almost 1.00% p.a. with a volatility of just 3.88%. This equated to a return of LIBOR +1.86% per year and in risk adjusted terms, this made JGBs very attractive assets indeed. If, for example, they were leveraged such that their volatility was 10% (as a risk parity manager would), then JGBs would have delivered a mouth-watering LIBOR +5.06% p.a. While some of their excess return resulted from further, small declines in interest rates, much of it was generated by what is known as carry, as JPY rates were already low and stayed low over this period.

In a fixed income portfolio, carry is defined as the mark-to-market that results, assuming that nothing changes in the market except for the passage of time. Carry is a function of the shape of the interest rate curve. When the curve is upwardly sloping, as it is currently, the market is implying that interest rates are expected to rise in the future. If the expected rises occur and forward rates are realised, then carry will be zero. If the expected rises, on the other hand, do not materialise and forward rates are not realised, then carry will result and depending on the steepness of the curve, it can be significant.

Within the context of UK LDI, an interesting question to ask is whether carry can have the same impact here as it has in Japan over the past ten years. Our current situation certainly shares similarities; banks are deleveraging, economic growth is weak, and gilt yields are “low”. And, not surprisingly, carry in the GBP interest rate markets is similarly high.

In today’s market environment, most pension scheme liabilities will grow due to carry, even if interest rates do not fall further. Using the current interest rate curve, a typical pension scheme liability profile would grow on the order of 2.5% per year as a result of carry. If the current interest rate environment persists for the next three years, this means that liabilities would have grown by almost 8% simply through the passage of time (service accrual and benefit disbursements notwithstanding). Unless a scheme is hedged, this would represent a significant cost to its funding level.

Up to now, LDI strategies have mostly been assessed against a backdrop of declining, not static, interest rates. Given this, it is not surprising that one of the most common push-backs on LDI as a strategy is a view that pension schemes should wait for rates to return to higher levels before hedging.

Interest rates will eventually rise, but the 2.5% in annual carry cost, aka potential funding level erosion, is a very expensive price to pay for the privilege of waiting.

Below is a chart showing the spot and forward curves (click to enlarge)

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