BOND TRADING STRATEGIES SERIES
Mastering Carry Roll-Down with Leverage
A Guide to Enhanced Returns in DeFi
Introduction
Welcome to the concluding chapter of our Bond Trading Strategies series on Secured Finance. We’ve explored strategies like Carry Trade and Yield Tenor Spread with Leverage, and now we introduce Carry Roll-Down — a unique strategy that stands out with its gradual, time-focused methodology. Although it can’t be simulated on our testnet due to its long-term nature, Carry Roll-Down offers an intriguing perspective on bond trading, especially for those with a strategic, patient approach to investment.
What is Carry Roll-Down?
Carry Roll-Down is a sophisticated bond trading strategy that exploits the shape of the yield curve. A typical, upward-sloping yield curve environment involves purchasing bonds that are further to maturity at a higher yield (lower price) with the expectation that their price will increase as they approach maturity. This strategy hinges on the ‘roll down’ effect on the yield curve, where bonds move to a lower yield (and higher price) area as they get closer to maturity.
Understanding Carry Roll-Down
This strategy is particularly effective in a typical upward-sloping yield curve scenario. Traders focus on longer-term bonds, anticipating an increase in value as these bonds ‘roll down’ the yield curve towards a shorter-term, lower-yield position. For instance, a zero-coupon bond bought with a one-year maturity at a higher yield will gradually move to a 6-month maturity position on the curve, typically characterized by a lower yield, thus increasing in value.
Understanding the Simple Carry Roll-Down Effect
Before we delve into the intricacies of leveraged Carry Roll-Down strategy, it’s essential to grasp the fundamental principles of the Carry Roll-Down effect in bond trading.
Imagine a scenario where the yield for a two-year bond is set at 5%, and a one-year bond offers a 3% yield. By lending $1,000 at an annual rate of 5% for two years, you’re looking at a future value (FV) of $1,102.5, calculated as 1,000 x 1.05 x 1.05.
Now, let’s fast forward one year, assuming the yield curve remains unchanged. The recalibration of your investment’s value, with the one-year APR still at 3%, would be approximately $1,070.4, calculated by discounting the two-year future value (1102.5) by the one-year rate (1.03). Unwinding this position after one year would yield a gain of $70.4, which is a substantial 7.04% return, outperforming the simple one-year 3% yield. This additional 4% gain exemplifies the Carry Roll-Down effect.
Carry Roll-Down with Leverage in Action on Secured Finance
Let’s see how leverage amplifies the Carry Roll-Down strategy:
- Yield Curve Analysis
Start with an in-depth analysis of the yield curve to identify discrepancies in bond yields over different maturities. For instance, if a one-year zero-coupon bond yields 3%, and a two-year bond offers 5%, there’s potential for strategic investment. - Strategic Lending
Acquire a $1,000 zero-coupon bond with a two-year maturity. Anticipate the future value of this bond, given its 5% annual yield, to be $1,102.5 (1,000 x 1.05 x 1.05). - Leveraged Borrowing and Investment
Leverage the bond by borrowing $800 at a one-year interest rate of 3%, reducing your net capital employed to $200 ($1,000 — $800). Be mindful of the liquidation threshold at 80% LTV; borrowing $800 would be on the cusp of triggering liquidation. - Carry Roll Effect
As a year passes, your two-year bond aligns with the one-year yield, effectively transforming into a bond with a one-year maturity. Assuming stable yield curves, the bond’s value recalibrates to approximately $1,070.4 (1102.5 / 1.03). - Repayment of Borrowed Funds
After one year, repay the borrowed $800, which now amounts to $824 (800 x 1.03). - Position Closure and Profit Calculation
Conclude the year by selling the bond for $1,070.4 and repaying your $824 obligation. This leaves a profit of $246.4, a significant improvement over the simple accrued value of $206 (200 x 1.03), without the need to wait two full years. - Assessing the Returns
With an initial outlay of $200, this strategy nets you a profit of $46.4, translating into an annualized return of 23.2%. This demonstrates the power of leveraging in the Carry Roll-Down strategy.
This additional profit of $40.4 (246.4–206) is the essence of the Carry Roll-Down, a technique frequently employed by leveraged funds for enhanced returns.
Pros and Cons of Carry Roll-Down
Pros:
- Strategic Gains: Utilize the yield curve dynamics to secure profits over a shorter period.
- Flexibility: This strategy can be advantageous in different yield curve scenarios, adapting to market shifts.
Cons:
- Market Sensitivity: The strategy’s success is closely tied to the stability of the yield curve.
- Timing Challenges: Requires precision in timing the closure of positions to maximize gains.
Disclaimer
The strategies discussed herein are intended for educational purposes and are not to be construed as financial advice. While you can practice risk-free on our testnet, real stakes apply on the mainnet. Fixed rates on Secured Finance remove interest rate risk, yet market price risks remain. Always conduct comprehensive due diligence.
Conclusion
Carry Roll-Down offers a distinct, strategic path for bond trading on Secured Finance. Different from immediate execution strategies, it leverages yield curve dynamics, creating opportunities to amplify returns through careful planning and timing. As always, we advocate for a well-informed approach and thorough risk assessment before participating in Carry Roll-Down trading on the Secured Finance platform.
Step-by-Step Guide Series
DeFi Apps Onboarding Guide
This guide will walk you through the steps you need to take to start using DeFi apps. You’ll learn how to set up your MetaMask wallet, connect it to DeFi apps, and get test ETH from Sepolia faucets.
Secured Finance User Guide
This guide offers a concise walkthrough of the platform, covering key aspects from preparing test tokens and managing collateral to executing transactions. It also delves into advanced trading strategies that are unique to Secured Finance.
