Carry in the linker

The IIB launched on 4th June offers a positive carry (over the repo rate of 7.25%) over the next three months. The cumulative carry profile is shown in figure 1. As can be seen, carry decreases during July, before rising sharply in August.

Carry is the extra interest income earned from a fixed income instrument over the cost of borrowing funds needed to invest in the security.

Unlike conventional nominal government securities, carry in inflation-linked bonds varies with spot inflation. As discussed in one of our previous notes  (estimating the real yield for the IIB at the auction on 4-June-2013), inflation experiences seasonal fluctuation throughout the year.  In certain months the monthly inflation rate may also be negative. Given that the inflation-linked bond principal accretes in line with the inflation index, its carry also varies with inflation.

The typical way of estimating carry from a Government security is to work out the forward yield for a forward date (using the borrowing rate) and subtract the spot real yield from it. The difference is the carry (in bp) offered by the security over that period.

For the IIB 1.44% GS 2023, since we know the inflation numbers until April, 2013, we can work out its forward yield (and therefore carry) over the next three months. I have worked out the daily carry in the bond and show on a cumulative basis in chart 1. (I have assumed the cost of borrowing to be 7.25%, which is the current repo rate)

As can be seen the carry profile increases up until end of June after which it decreases until end of July. This decrease is because of the negative monthly inflation (realized) between February and March 2013. Thereafter there is a sharp increase in carry because of the +0.5% monthly inflation seen in April.

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