"Can someone help me understand the downside of always rolling contracts into the highest-carry treasuries between 2-yrs, 3-ys, and 5yrs? It's been mentioned positively in this thread, but I'm sensing some kind of market-timing catch (i.e. the 2-year carry is higher than 5-year carry right now because the market foresees more yield-inversion at that point of the curve)"skierincolorado wrote: ↑Tue Jul 19, 2022 9:39 amThat should be captured. For example let's say the equilibrium rate is 2% and the market is betting we will rall to that rate in 2 years. Let's say the FF rate is 1.5% the whole time for simplicity. Would we earn more by holding 100k of 5 year bonds with initial rate of 3% or 250k of 2 year bonds with initial yield of 2.5%? With the 2 year bonds we net 1% of 250k or 2.5k. With the 5 year bonds we net 1.5% of 100k, or 1.5k. But we also would see a capital appreciation of our 5 year bonds of 3k for total profit of 4.5k.LazyOverthinker wrote: ↑Tue Jul 19, 2022 3:20 amOk, that makes sense. Does that same market-logic apply if we replace our 5-year treasuries with 60% more "duration-matched" 2-year treasuries?
In other words: even if we agree with the market's bet on 5-year rates, are we properly compensated for giving up the chance to hold 60% more-total "0.65% carry" treasuries?
Essentially I'm wondering if leveraged investors have a "bet against beta" advantage by being able to adapt total $ exposure, or if that is captured in the market's foresight.
This example illustrates how the bond with higher carry per unit duration can easily have lower returns. Of course if this were actually the market expectation it would easily be arbitraged out of existence and would not happen in the first place.
Bet against beta is separate from this. In an efficient market there would be no advantage to investing in shorter durations with highe carry per unit risk even with leverage because the expected return above the risk free rate would be the same per unit of risk. So it would not matter which duration you leveraged or what the carry was. Higher carry per unit of risk would simply be a reflection of a duration that was expected to benefit less from expected rate changes. BAB is separate from this and causes there to be more return per unit of risk at shorter durations historically. But higher carry per unit risk, on its face, is not evidence of BAB or greater expected return above the risk free rate per unit risk.
It's possible that part of the higher carry of the 2 year is BAB but the majority is certainly that the market expects the 5 to benefit more from future rate changes (more on a per unit risk basis). The 5 year should capture most or all of BAB which is really about terrible risk adjusted returns beyond 10 years.
There are papers that show a significant excess return of "carry on the yield curve" investing. (There are other papers that say it's no actionable. I have not analyzed those papers yet.)
https://www.cfainstitute.org/en/researc ... 19-1628552
http://wp.lancs.ac.uk/fofi2018/files/20 ... tens-1.pdf
If true, one should be able to overlay a carry strategy over mHFEA by switching to the 2/3/5/7 or 3/5/7/10, etc. futures contract which has the highest carry. Of course everything is duration-adjusted, because you don't want to change your duration exposure. I think "carry" would be yield minus financing rate, or yield + current rolldown return - financing rate.
Of course it's not as simplistic as thinking you can pocket the entire difference between the current carries. Part of the difference reflects market expectations of rolldown and changes in rolldown returns, yield curve movements, etc. But there are significant excess returns as per the paper.
On another note, if you look at the current yield curve, the 10y point (TN) seems to be the absolute loser (in terms of yield i.e. for future expected returns), and I have a bit of a hard time reconciling this with the SOFR curve. treasury 7y is at ca. 3.13%, 10y is at ca. 3.02% i.e. below the 10y. But SOFR futures are in a range of 96.9 and 96.65 between 2029 and 2031, implying 3.1% - 3.35% future short-term rates in the 7-10 year range. The SOFR is the short-term interest rate forecast plus the term premium; per expectations theory, the treasury curve should be the average over the SOFR curve between now and the time in question, i.e. x-year treasury rate = average of short-term rates over the next x years + term premium, shouldn't it? So how can the 10-year treasury be below the 7-year, all the while the SOFR futures for the 7-10y period are above both the 7y and the 10y treasury?
Am I misunderstanding the relation between SOFR/LIBOR futures and the treasury yield curve?