In a recent article by Barry Habib, (see below) he describes how large investors can take advantage of the current interest rate environment. Is there a way for individual investors to make such a carry trade?
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"While the Fed's end of the MBS purchase program and eventual selling of MBS - along with an almost certain move higher in Treasury yields - all tell us that mortgage rates are headed higher, there is another important element that could have an even greater influence in moving yields higher and prices lower throughout the Bond market. It's called an unwinding of the "carry trade." The low interest rate environment in the US has provided fertile ground for the carry trade, where large investors can borrow at very low rates, and leverage into higher yields, resulting in huge returns.
Let's take an example: An investor wishes to purchase $1M in Mortgage Bonds yielding 4.5%. This would provide $45,000 as an annual return. In order to make the purchase, the investor puts up only 10% of $1M, or $100,000 in cash - and borrows the other $900,000 at the Fed Funds Rate + 2%, for example - which would be a borrowing cost of 2.25% or $20,250. This investor receives a $45,000 return, but subtracts a $20,250 cost to borrow $900,000 - leaving them with a net return of $24,750. Remember, the investor needed only to invest 10% of the $1M purchase - or $100,000 in cash. This gives the investor a whopping 24.75% return on their investment in a boring little old Mortgage Bond. And of course, this "carry trade" can be used in other securities as well.
While the investor understands that there are always market risks at play - the juicy 24.75% yield cushion gives them much added comfort to stay in the trade. But the biggest risk for the investor is if their borrowing costs - which are based on the Fed Funds Rate - were to rise."