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More Carry Trade Rhetoric

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Today's Wall Street Journal's Personal section describes a common carry trade, one almost everyone has on. It recommends not paying down a 6% mortgage, but instead buying bonds with the money.

It goes over the example where a 6% mortgage should be looked at as a source of funds. The cost of those funds after-tax is 4.5% (assuming you are in the 25% tax bracket: 6% times 1 minus 25%). It recommends using those funds to buy say California municipal bonds that pay 5% tax free. You thus earn .5% (50 basis points) of "free" money.

Nothing in life is free of course. Once again the cost is RISK, normally ignored until it happens. So what is the risk in this trade? Is California going to default on their bonds?

California bonds are rated Baa1/BBB by the bond rating agencies. This translates into roughly a 2% risk that California will default on their debt.

So let's ask ourselves, is this a good trade? Even if I buy $250,000 of bonds by taking out a mortgage on my house, I will only earn $1,250 per year, hardly enough of an amount to change anyone's life style. I have a 2% risk of California defaulting on the bonds. This doesn't sound like much, but the problem is that if it occurs, I lose everything. Because I am borrowing the money to buy the bonds, I cannot afford to take a 70% loss on the California bonds (assuming a 30% recovery rate). I will no longer in all probability be able to make my mortgage payments and the bank will foreclose on my house.

So for a small amount of money per year am I going to risk everything, no matter how small that risk is? This is called "being short tail risk" or being exposed in a major way to a very small risk.

It is normally not a good idea at all in trading or investing to be short tail risk, especially if you are not really getting paid for it.
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No positions in stocks mentioned.

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