Carry Trades
Understanding carry trades in the JGB market
Carry Trades
What is a Carry Trade?
A carry trade is one of the most fundamental strategies in fixed income markets. At its core, it involves holding a bond to earn the yield (carry) while financing that position at a lower rate. The profit comes from the spread between what you earn on the bond and what you pay to fund it.
In the JGB market, a typical carry trade might involve:
- Buying a 10-year JGB yielding 1.0%
- Financing the purchase via repo market at 0.1%
- Earning the spread of 90 basis points (0.9%)
The beauty of carry trades is that they can generate positive returns even if interest rates don’t move—as long as the yield curve maintains its typical upward slope and financing costs remain stable.
The Roll-Down Effect (ロールダウン効果)
One of the most important but often misunderstood components of carry trades is the roll-down effect (also called the rolling effect). This refers to the capital gain that accrues simply from the passage of time when the yield curve is upward sloping.
How Roll-Down Works
Consider this example:
- Today: You buy a 10-year JGB at 1.0% yield
- One year later: Your bond is now a 9-year JGB
- If the yield curve is unchanged: 9-year bonds yield 0.85%
Since your bond now has a shorter maturity and sits at a different point on the yield curve, its yield has decreased from 1.0% to 0.85%. When yields fall, bond prices rise—this is your roll-down gain.
\(\text{Price Gain from Roll-Down} \approx \text{Duration} \times \text{Yield Change}\) \(\approx 9 \times (1.0\% - 0.85\%) = 9 \times 0.15\% \approx 1.35\%\)
This 1.35% capital gain is in addition to the coupon income you earned over the year.
Why Roll-Down Occurs
The roll-down effect exists because:
- Yield curves are typically upward sloping (longer bonds have higher yields)
- Bonds automatically “roll down” the curve as time passes
- Duration decreases over time for fixed-rate bonds
For a 10-year JGB, the duration is approximately 10. After holding it for one year, it becomes a 9-year bond with a duration of approximately 9. The bond’s interest rate risk has automatically decreased, which is a valuable property—especially for long-term investors like life insurance companies.
Total Return Components
The total return from a carry trade consists of three components:
\[\text{Total Return} = \text{Coupon Income} + \text{Roll-Down Gain} + \text{Rate Change Impact} - \text{Financing Cost}\]Let’s break these down:
1. Coupon Income
The fixed interest payment you receive. For a 1.0% coupon bond held for one year, this is simply 1.0%.
2. Roll-Down Gain
The price appreciation from moving down the yield curve (as explained above). This is predictable if the curve shape remains stable.
3. Rate Change Impact
This is the unpredictable component. If interest rates rise across the curve, you’ll experience capital losses. If they fall, you’ll see additional gains beyond roll-down.
4. Financing Cost
The cost of funding your position, typically through repo markets. This reduces your net carry.
When Carry Trades Work Best
Carry trades are most attractive under these conditions:
- Steep yield curves: Greater slope means larger roll-down effects
- Stable or falling interest rates: Minimizes the risk of capital losses from rate increases
- Low financing costs: Wider spread between bond yield and repo rate
- Positive carry environment: When longer-dated bonds yield more than short-term funding costs
Carry vs. Total Return Perspective
It’s crucial to understand the difference between:
- Carry (narrow definition): Just the yield spread over financing cost
- Total return (broad definition): Includes roll-down, rate changes, and all other factors
In JGB markets, practitioners often use “carry” to refer to the expected return assuming no change in the yield curve, which implicitly includes the roll-down effect. This is sometimes called the carry-adjusted return or carry-roll return.
Risks in Carry Trades
While carry trades can seem like “free money” when yield curves are steep, they carry several risks:
Interest Rate Risk
If rates rise sharply, the capital loss can overwhelm the carry income. For example, if 10-year yields rise by 0.5% (50bp), a duration-10 bond would lose approximately 5% in value—far more than typical annual carry.
Curve Flattening Risk
If the yield curve flattens (long-term rates fall relative to short-term rates), the roll-down effect diminishes or disappears entirely.
Financing Risk
If repo rates spike unexpectedly, your financing costs increase, squeezing your carry spread.
Liquidity Risk
In times of market stress, you may not be able to exit positions at fair prices, or repo funding may become unavailable.
Practical Example: JGB Carry Trade
Let’s walk through a realistic scenario:
Setup (January 2024):
- Buy ¥1 billion face value of 10-year JGB #362 yielding 0.80%
- Finance via 3-month repo at 0.10%
- Hold for 3 months
Income Components:
- Coupon income: ¥1bn × 0.80% × (3/12) = ¥2 million
- Financing cost: ¥1bn × 0.10% × (3/12) = ¥250,000
- Net carry: ¥1.75 million
Roll-Down Component (assuming stable curve):
- Bond is now 9.75-year maturity instead of 10-year
- If 9.75yr yield is 0.78% vs. original 0.80%
- Price gain ≈ 9.75 duration × 0.02% = 0.195%
- Capital gain: ¥1bn × 0.195% = ¥1.95 million
Total 3-month return: ¥1.75m + ¥1.95m = ¥3.7 million (0.37%)
Annualized return: 0.37% × 4 = 1.48% (assuming no rate changes)
This example shows how roll-down can actually exceed the carry income itself when yield curves are positively sloped.
Roll-Down as a Cushion
An important practical application: roll-down provides a buffer against rate increases.
Using our example above, even if 10-year yields rose by 2 basis points over the quarter (from 0.80% to 0.82%), the roll-down effect (2bp decrease from curve position) would roughly offset the capital loss from the parallel rate increase. The bond still earns its carry income.
This is why JGB investors in a steep curve environment can tolerate small rate increases while still generating positive returns.
Relationship to Other Strategies
Carry trades form the foundation for many other JGB strategies:
- Curve trades explicitly position for roll-down at different points on the curve
- Butterfly trades can enhance roll-down by optimizing curve positioning
- Basis trades compare carry-roll in cash bonds vs. futures contracts
Understanding carry and roll-down is essential before moving to these more sophisticated strategies.