How the ‘carry cushion’ can change your fixed income conversations

The threat of rising interest rates and the impact on Global Fixed Interest (GFI) returns continues to be a topical question for Zenith’s adviser clients. With the US Federal Reserve (Fed) progressing along its interest rate hiking cycle, the bond bears are predicting the end of the bond bull market.

With the Fed hiking rates the question remains, should investors rotate out of global bonds and into cash or term deposits? Is this a sensible capital preservation strategy?  At Zenith, we are more sanguine on the outlook for global bonds, preferring to focus on the structure and fundamentals of the underlying bond markets.

In our experience, the naïve approach of extrapolating potential losses from rate hikes (or movements in long bond yields) and benchmark duration, fails to consider the efficiency of bond markets, the importance of carry in GFI returns and the role of active management in protecting portfolios against capital losses. Any decision to move out of bonds based on interest rate fears alone fails to consider the full picture.

In Zenith’s opinion, while there is the prospect of global bonds delivering flat returns in the short-term, any such periods would be offset by a more attractive environment over the medium-term.

The Efficiency of the Global Bond Markets

The relationship between global monetary policies and long bond yields changes over time and as such are inherently difficult to forecast. Based on Zenith’s research, bond yields are driven by a combination of expectations for inflation, output growth and the anticipated path of monetary policy actions. Inflation expectations (including shifts in expectations) exhibit the highest influence over long bond yields, and ultimately the performance of global bonds.

With the US Fed hiking interest rates five times since December 2015, the impact on bond returns has been de minimis. To illustrate this, for the two years ending 31 December 2017, the Barclays Global Aggregate Index $A Hedged has returned 4.5% p.a. When monetary policy is implemented in a transparent and predictable manner, the bond market tends to respond in a measured manner.

The Predictability of Central Monetary Authorities

Post the Global Financial Crisis (GFC), Zenith has observed significant improvements in the level of transparency from the respective monetary authorities, particularly the Fed. This manifests across a range of mediums including the narratives included in the Federal Open Market Committee policy statements and more sentiment-based measures such as the Fed Funds Dot Plot. This represents the projections of the 16 members of the FOMC on where the Fed funds rate should be at the end of the upcoming calendar years, as well as the long run i.e. the peak for the Fed funds rate once the Fed has finished normalising policy.

The following chart is the latest Fed Funds dot plot (released March 2018).

Based on the chart, the majority of FOMC members expect the Fed funds rate to range between 2.0% and 2.5% by the end of 2018 i.e. indicating further three rate hikes (assuming the current target range of 1.5% to 1.75%).

Consistent with this forward guidance, market participants have priced in the majority of these rate hikes in futures and swap markets. To illustrate this, we reference the Fed Fund Futures contract which is a widely followed instrument that reflects the markets expectations of the probability of the Fed changing monetary policy at a particular meeting. The following chart illustrates the Fed Fund Futures Contract as at 21 March 2018.

Based on the chart above, the market has already priced in between two and three rate rises for 2018 and further cuts in 2019.

Zenith believes that most of the interest rate hikes are already priced into bond markets, which should see any subsequent hikes having a measured impact on bond yields. In our opinion, bond market volatility is more closely linked to surprises i.e. around inflation data, jobs growth, risk aversion, as opposed to the actual increase itself.

To highlight the effectiveness of the Fed’s ability to guide the market, the following table outlines the yields on US Ten-Year Treasuries at the beginning and end of each month, where the Federal Open Market Committee (FOMC) increased the Target Federal Funds Rate.

Rate Hike17 Dec 1515 Dec 1616 MAR 1715 JUN 1714 DEC 1721 MAR 18
FOMC Target Federal Funds Rate/Range0.25% to 0.50%0.50% to 0.75%0.75% to 1.00%1.00% to 1.25%1.25% to 1.50%1.50% to 1.75%
% Change0.25%0.25%0.25%0.25%0.25%0.25%
US 10-Year Treasury Yield at Start of Month2.27%2.45%2.39%2.30%2.41%2.86%
US 10-Year Treasury Yield at End of Month1.92%2.47%2.29%2.30%2.71%2.74%

The Importance of Carry to GFI Returns

The concept of ‘carry’ is an important component of GFI returns and generally under-recognised by investors. Carry extends beyond the traditional metrics of running yield and yield-to-maturity, to include other forms of return such as Roll Down and Option Adjusted Spread return. An appropriately skilled manager can deploy a range of strategies to maximise the carry benefits of a portfolio, ultimately cushioning the effects of interest rate volatility. Some of the additional sources of carry include:

Roll Down: With a normal sloping yield curve (i.e. positively sloped), buying longer dated bonds (government and/or corporate) with a focus on the steepest part of the curve means that investors can profit from both the coupon payment and capital appreciation, as bonds increase in value as they move towards maturity. This effect is referred to as rolling down the yield curve.

Spread or Option-Adjusted Spread (OAS) - A structural feature of certain bonds is a ‘call’ feature which allows bonds to be called back by the issuer when interest rates are favourable.  Given this optionality, investors generally demand a higher spread to invest in callable bonds. As time passes, investors earn this option premium which is categorised as OAS premium. A highly skilled manager can structure a GFI portfolio to maximise the OAS return, through more granular understanding of call and prepayment risks.

Notional Funding Return

Incremental returns can be achieved from expressing bond or duration positions via futures instead of cash bonds. Given only an initial margin (expressed as a percentage of the face value of the contract) is posted at trade inception, the surplus cash can be invested in cash/cash like instruments, earning additional returns for the fund.

Zenith highlights that carry (or income) is the most important component of GFI returns over the long-term, particularly relative to interest rate volatility or credit spread movements. To illustrate this, the following chart disaggregates the return of the Barclays Global Aggregate AUD Hedged Index into an income return (i.e. carry/coupon) and a non-income component i.e. price return (capital gains, mark-to-market movements etc.).

The Role of Active Management in Protecting Against Rising Interest Rates

With the expectation of rising interest rates over the short to medium-term, the role of active management is important in preserving capital and controlling volatility. A skilled GFI fund manager can structure a portfolio that cushions the impact of rising bond yields and at the same time, profit from a richer opportunity set i.e. steeper yield curves, cross-market opportunities etc.

This can be achieved via a fund’s duration positioning i.e. lower effective duration relative to the benchmark, yield curve positioning, i.e. structuring steepening trades which results in underweight positions in the long end of the curve, relative to benchmark weightings and via investing in inflation-linked securities i.e. Treasury Inflation Protected Securities.


Zenith highlights that the risk of rising interest rates has cast a shadow over global bond markets for the past couple of years. With the Fed hiking six times since December 2015, the impact on bond yields has been marginal – for example, US Treasury 10-year bond yields have widened from 2.3% to 2.8% over this period. Zenith firmly believes that the cushioning effects of carry, coupled with the ability of active management to protect capital, should mitigate the impact of a protracted US hiking cycle. Further, if global bond yields were to aggressively widen, the medium-term outlook for the asset class would be highly attractive, more than offsetting any short-term weakness.

Rodney Sebire
Head of Alternatives Research & Global Fixed Income

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