Carry trades and credit trades – the completion is heating up

Carry trades have caused vast sums of money to pour into the FX markets. Why have all of these flows come in the last few years? There have been other times when the interest rate spread differential has actually been greater, so the gains from these trades would have been better. What makes this time unique and what could cause a change back to another environment.

A closer look across markets may suggest that the investors in these trades have a very broad perspective of their investment alternatives. They look for the best interest rate opportunities around the globe, although they may have a home or domestic bias. The reason for moving into FX carry trades over the last few years may be due to the tight spreads in corporate debt markets. Spreads have been tight in traditional debt markets, so these investors have gravitated to other debt alternatives. The same can be said for yield curves. As the curves flattened in home markets, there was search for better alternatives across foreign markets.

One of the basic principals for the foreign exchange markets is that if you hedge your foreign bond exposure you will get the same returns as a domestic bond which has the same rating as the sovereign debt of the country you invested in. You buy double-A country risk and hedge the currency exposure, you will get a double-A corporate spread. 

You are able to get further gains if you take on the currency risk component. Of course, you take on the currency risk which don't have in the domestic bond market. You can also look for a cheap funding source, but you then take on more currency risk and the interest rate risk of the funding currency. Nevertheless, at some point, the currency and funding risk may be viewed as manageable relative to the domestic corporate spread alternative.

Similar to the corporate spread story, if the domestic yield curve is relatively flat, financing will take on a geographic dimension. Find the lowest funding source in another country. You can borrow in the low yielding currency and buy the high-yield to fund a purchase of a longer-term asset. 

The choice of making a carry trade will be based on the relative opportunities in other markets. If corporate spreads increase and there is not a corresponding increase in the relative yields across countries, then the opportunity to receive gains in domestic markets increases and the money is less likely to flow to offshore markets. There is not a repricing of risk but a shifting in the relative gains in trading domestic versus foreign assets.

This comparison of alternatives becomes clear when you look at the risks of each trade. In the FX market, you have three levels of risk to worry about. There is the interest rate risk in the high yielding currency, the interest rate in the funding or low-yielding currency and the exchange rate. In the corporate spread market, there is the spread itself and the movement in the underlying Treasuries. The dimensions of risk are lower.

With higher yields in domestic credit markets, there will be a flow of funds out of the carry market and into the domestic credit markets. It is not a function of something happening to the currency markets other than there are better alternatives with fewer dimensions of risk in the domestic markets.