An investor's guide to sovereign risk for pricing bond returns (Part 7 of 10)
International investors look to profit from differences in exchange rates and interest rates across countries. Countries offering higher interest rates attract more investors while countries offering low interest rates attract more borrowers.
The difference in interest rates should be reflected in the forward currency exchange rates. Countries with relatively higher interest rates should have forward exchange rates that are expected to appreciate and vice-versa. However, this doesn’t usually work out. It leads to speculative opportunities for traders that are betting on a directional swing in interest rates and currencies.
What does “carry trade” mean?
This strategy of profiting from interest rate differentials in known as the carry trade. An investor borrows in a low interest currency, only to shift it to a country offering higher interest rates in the local currency for a specified period.
When the investment matures, the investor re-converts the funds to the currency in that the loan was borrowed from and pays off the lender. The investor would be able to profit from the interest rate differential only if the lending currency didn’t appreciate more than the interest rate differential over the interim.
Japan (EWJ) was considered a safe bet for carry trades for many years. Its interest rate was low compared to other developed market currencies. This made it cheaper to borrow in yen.
The Bank of Japan also kept its currency, the Japanese yen, artificially low in order to benefit Japanese exporters like Toyota (TM), Sony (SNE), and Honda.
Higher exports relative to imports lead to the current account or balance of payments (or BoP) surplus. This normally leads to currency appreciation. However, because of the BoP intervention, forward Japanese yen rates were kept low.
Similarly, the U.S. dollar (UUP) has also created opportunities for carry trades with other currencies. The Fed funds rate has been kept artificially low as a result of the monetary stimulus after the financial crisis and Great Recession in 2008.
In such cases, the sovereign debt (EMB) spread may not be a true reflection of fundamentals.
In the next part, we’ll compare the returns performance of these and other sovereign bond exchange-traded funds (or ETFs) including those invested in U.S. Treasuries.
Browse this series on Market Realist: