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Hedging rising rates: it’s all about the carry

With interest rates in developed nations remaining near historically low levels, here’s a look at what investors can do to get their portfolios ready for any future hikes.

In the latter half of 2018, there were growing concerns that the low interest-rate environment might change soon, with central banks becoming more hawkish in their rhetoric on future base rates. At that time, we thought bond investors might worry that sharply rising interest rates might affect their portfolios. We therefore started to build a backtesting framework to construct a variety of systematic ‘payer swaps’ strategies – whereby you lock into paying a fixed interest rate for a set period of time in exchange for receiving floating interest rates – in an attempt to help investors optimise their rising-rates hedging programme.

As specialists in quantitative analysis, or ‘quants’, we believe more in systematic strategies as it is very challenging to consistently time the market. Indeed, investors did not anticipate that the market sentiment had changed quickly towards the end of last year. And while it now again seems that rates are going to be lower for even longer, we feel that we should still share our findings as the predictions could be wrong again.

A negative carry trade

Interest-rate curves are usually upward sloping, which means owners of payer swaps usually suffer losses as time passes (known as negative carry). The chart below shows the average steepness of the yield curve over the past 10 years.

Average yield curves over the past 10 years

Carry is defined as the P&L resulting from the passage of time, assuming that the shape of the yield curve remains unchanged

Why is paying carry bad for performance?

In recent decades, there has been a phenomenon commonly known as ‘forward rate bias’ which has seen predictions of future rate rises hardly materialise over time. This is shown in the next chart. This has led to a frustrating time for owners of payer swaps, with the carry cost not historically balanced by rising yields.

UK base rate and market forward rates

The carry versus convexity conundrum

To counter this, certain segments of interest-rate curves can be flat and offer the possibility of reducing the negative carry effect, or even achieving a positive carry as time passes.

Taking the EUR swap curve in the first chart as an example, two potential approaches would lead to a much less negative carry as time progresses: a 20-year spot-starting swap, in which you lock the paying period from the start date; and a 10y10y forward-starting swap, in which you lock the paying period starting in 10 years’ time for the next 10 years. These could enable investors to manage an environment where rates take time to increase.

Unfortunately, such strategies offer less convexity – convexity being the non-linear relationship between price and large interest-rate movements. All else being equal, the higher the convexity, the higher the returns payer swaps make if interest rates rise. Hence, these will offer less protection for immediate and large increases in interest rates, as shown in this final chart.

P&L of swaps following yield-curve shocks

Investors, then, face a conundrum when it comes to rising-rates hedging:

  • Looking to minimise the negative carry effect if there is limited visibility on timing, but this comes at the cost of reduced protection for large and immediate increases in interest rates.
  • Going for convexity if the investor expects an imminent increase in interest rates to seek to maximise portfolio protection.

While markets move in cycles and multiple indicators could reflect a shift in the environment, it is very challenging to consistently time markets. Hence, we focus on systematic investment strategies that could be beneficial for investors who have limited visibility on timing.

In our next blog, we will introduce our backtest framework and a case study to compare different systematic hedging strategies.