How Carry Can Help (or Hurt) Your Pension

(March 15, 2013) — Investors staying away from bonds due to their current nominal yields may be missing out on significant outperformance while pension fund liabilities would grow due to the same underlying cause, an investment consultant has warned.

“Carry”, the action of just holding an asset in a portfolio over time, can have a significant effect on its return, according to a new paper from London-based consulting firm Redington.

In a paper entitled “Rolldown and Carry: Low Yields Do Not Mean Unattractive Returns” the firm explains how investors can make returns significantly above Libor by using what is inherent in holding even very low-yielding bonds. 

“Since 2002, 10 year Japanese government bonds have yielded only 1.22% per annum; this does not sound like an attractive asset by any traditional measure,” the authors said.

However, their total returns exceeded yields by almost 1.00% per annum over this same period with a volatility of 3.88%, equating to a return of LIBOR +1.86%. In terms of risk-adjusted returns, this made JGBs a very attractive investment, even though their yield was low.

“If, for example, they were leveraged such that their volatility was 10%, then Japanese government bonds would have delivered LIBOR +5.06%,” the authors said. “While some of their excess return was generated by further declines in interest rates, much of it was generated by what is known as carry, as rates were already low and stayed low over the period.”

On the flipside, many investors fail to take into account the effect carry has on liabilities.

“From a risk management perspective, carry is an important factor and should be reviewed and measured as part of a pension scheme’s overall risk analysis and its assessment of current hedging levels,” the authors said. “While interest rates have seemingly moved in only one direction over the past several years, it is not surprising that some schemes have taken the decision to wait for higher levels before implementing LDI, but the 2.5% of annual carry cost is a very expensive price to pay for the privilege of waiting.”

For the full paper, click here.