Several readers have requested a discussion of positive carry and the ride down the yield curve.I will assume a par bond of $1mm and no accrued interest.
I will use the approximately the same set of facts I used in my closing commentary yesterday. That is, the current 2 year note with a 2 5/8 coupon.
I will use a term repo rate to September 30th of 1.60 percent.
The repo begins on June 2 and matures on September 30. That looks to be 121 days.
So the repo calculation is( $1mm X .016 ) divided by 360 days times 121 days. That works out to $5377 and means that if you own the bond and financed the bond for the 121 day period at 1.60 percent you had a cost of $5377.
However, as the owner of the bond you are accruing that 2.625 percent coupon over that same period. So you earned ($1,000,000 X..02625) divided by 365 times 121 day. That works out to $8702 accrued interest for the 121 days.
$8702 minus $5377 equals $3325 of POSITIVE CARRY for each $1 million bonds.
For purposes of this discussion and simplicity I am going to arbitrarily reduce the $3325 to $3125. That is because bonds trade in increments of $312.50 per million bonds. So my arbitrary $3125 is equal to 10/32 on the $1mm par bonds.
That 1/32 increment has a value in basis points of yield. The yield value of that 1/32 increment is 1.7 basis points. So in my example the 10/32 is equal to 17 basis points. So, ceteris paribus, if I buy the bond today at a yield of 2.625 percent (par) and finance it under the set of circumstances presented here, I have a cushion of 17 basis points. So if the yield on the bond on Sept 30 is approximately 2.79 percent I have a break even transaction. There is one more step to complete the analysis.
There is one other consideration and that is the steepness of the yield curve.
Over the term of this transaction the note that we own will slide down the curve and finish as a 20 month note rather than the 24 month note at which it began. We assume that the shape of the yield curve will be the same at the end of the 120 day repo as it is at the start. At the close of business yesterday that 4 months was worth about 12 basis points. So all other things being equal the 2.625 yield today will be approximately a 2.50 percent yield on September 30.
I add those 12 basis points of yield to the 17 basis points which I earned in the financing leg of the transaction and my breakeven is now 29 basis points.
So under that set of assumptions I can buy the 2 year note today at 2.625 percent and breakeven on September 30th if the yield on the 2 year note is less than 2.915 percent. (2.625 plus the 29 basis point cushion).
If you believe that the FOMC is about to embark on a policy of serial tightenings, that is a very bad trade. If you think that the Federal Reserve is on hold and that the funds rate will be 2 percent for the rest of our natural lives it is a fair bet. And if you believe that we are in the midst of a protracted slowdown and that the FOMC will be forced to cut rates again sooner rather than later then it is a great bet.