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Carry On

07.11.2017

books on library shelf

With the Federal Reserve contributing to the recent flattening of the US yield curve by raising the fed funds rate on June 14th, it’s time again to round up the usual leveraged investment suspects like mortgage REITs, closed-end funds, and 3X ETFs. These investment vehicles utilize leverage to drive much of their economics. So, when short-term interests rate rise, these investor groups often see their economic prospects hurt by higher financing costs, which is manifested in the form of reduced or negative "carry" (i.e., the differential between an asset’s yield and its financing costs). However, this time we need to include another investor group in the impacted leveraged mix: corporate defined benefit (DB) pension plans. What? Aren’t pensions typically underfunded by 20 or more percent, which means they are inherently short US interest rates, benefiting when rates rise? Well, yes and no. Some corporate pensions have utilized leverage to hedge their liabilities, potentially presenting a carry issue for them too. Will the continued curve flattening lead to potential de-leveraging among pensions? Let’s see.

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