Ahead Of A Fed Move, A Cash Cow Runs Dry

Like a tightrope walker on a suddenly windy day, the bond market is trying to get back to solid ground after a heady period of high profits made from cheap money and a tactic known as the carry trade. Hedge funds, bond dealers, and commercial banks borrow at, or near, the 1% overnight rate set by the Federal Reserve and then invest the money in multiyear notes and bonds that yield much more.

Over the past 18 months a carry trade into 10-year U.S. Treasuries has typically earned 3% on the investment over a year -- a huge payoff on a multimillion-dollar deal. The profits were even juicier for those venturing into higher-yielding mortgage-backed securities, corporate bonds, and emerging-market debt.

But such trades began to unravel in mid-March when bond prices started to fall. Since then, the price of the 10-year note, for example, has plunged some 8% -- more than twice what the carry traders expect to pocket over a year. As a result, some traders are starting to cut their losses by selling Treasuries -- adding to the downward pressure on bond prices -- and repaying their loans.

The specter of these losses has given the bond market -- and the Federal Reserve -- the jitters. Many people remember the trouble in 1994, the last time rising interest rates torpedoed carry trades on a large scale. Then, the turmoil fueled a debt crisis in Mexico, led to the default of Orange County, Calif., which had a big carry trade, and contributed to the demise of bond dealer Kidder, Peabody & Co. and some hedge funds. As portfolios were liquidated that year, the bond market suffered some of its worst losses on record.

Adding to the anxiety now is that no one really knows exactly how big and widespread the carry trades are, how many remain to be unwound, and whether any major players are sitting on big losses. The available evidence, however, suggests that lately the trade has been bigger than ever because borrowings by bond dealers and bond purchases by hedge funds reached record levels before the sell-off began. Says James T. Swanson, chief investment strategist at MFS Investment Management: "The carry trade was on in a big way." Variations of it spread far and wide, with investors borrowing dollars cheaply to buy everything from Australian government bonds to Russian corporate debt.

Now some of the carry trades appear to be unwinding, though "in bits and pieces," says Swanson. Selling by leveraged players has helped push up the yields on 10-year Treasuries from 3.68% on March 17 to 4.80% on May 12. Jack Malvey, global chief fixed income strategist at Lehman Brothers Inc. (LEH ) says the unwinding has also contributed to losses in markets for corporate junk bonds, mortgage-backed securities, stocks, non-oil commodities, and emerging market debt. In a single day, May 7, yields on Brazilian bonds jumped 1.52 percentage points as the unexpectedly strong jobs report in the U.S. increased the likelihood of higher short-term rates.

So far, no firms have 'fessed up to big losses. Malvey believes they remember the lessons of 1994 and are being cautious. That may be so, but until they have unwound most of their carry trades, the transition to higher interest rates will be perilous for them -- and delicate for the Fed, which is now promising that increases will be "measured."

By David Henry in New York

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