What Is Negative Carry?
Negative carry is a condition in which the cost of holding an investment or security exceeds the income earned from it. This is often seen as undesirable by professional portfolio managers because it means the investment loses money as long as the principal value remains the same or decreases. However, many investors accept negative carry in anticipation of significant capital gains over time.
Negative carry stands in contrast to positive carry.
Key Takeaways
- Negative carry is when the cost of holding investments surpasses the income they generate in the short term.
- Investors often tolerate negative carry in hopes of future capital gains.
- A variety of investments, such as bonds, forex, real estate, and stocks, can exhibit negative carry.
How Negative Carry Works
Negative carry occurs whenever the cost of holding an investment surpasses its earnings from payments. This can happen with securities like bonds, stocks, futures, and forex positions, as well as real estate and business investments. For example, a bank might experience negative carry if the income from a loan is less than its cost of funds, which means it operates with negative cost of carry.
Importantly, this evaluation excludes any potential capital gains. Investors might endure periods of negative carry because they anticipate selling the asset at a higher price later.
Real-Estate: An Illustrative Example
Owning a primary residence typically involves negative carry, as the monthly mortgage interest payments often outweigh the principal accrued, especially during the early years of the loan. Maintenance costs add financial burden as well. Yet, property values generally rise over time, enabling homeowners to net significant capital gains if they hold the property long enough.
Borrowing and Lending: The Professional Angle
Consider an investor who borrows money at 6% interest to purchase a bond yielding 4%. This results in a 2% negative carry, meaning the investor spends more to maintain the bond than it earns. The only rationale for this investment would be the expectation that the bond price will rise enough to compensate for the negative carry. If the bond appreciates in value due to falling interest rates, the resulting capital gains could more than cover the initial losses.
Exploring the Forex Market
Negative carry is also present in forex markets, sometimes referred to as a negative carry pair. This involves borrowing money in a high-interest-rate currency to invest in lower-interest-rate assets. Investors seek to profit from shifts in exchange rates, expecting the investment currency to appreciate against the borrowing currency. Successful execution requires that profits from the favorable exchange rate shifts outpace the cost of the interest payments on borrowed funds.
The Appeal of Tax Benefits
Negative carry investments are sometimes pursued for their tax benefits. For example, if an investor buys a rental property and the rental income is slightly less than the monthly expenses, the investment would have negative carry. However, if the interest payments on the loan are tax-deductible, the investor could save money on taxes, making it worthwhile to maintain the investment until capital gains are realized. Tax regulations can influence the appeal and feasibility of such strategies.
Special Considerations
Borrowing to invest traditionally results in negative carry when the borrow cost exceeds the return. Nonetheless, strategies like short selling can also produce negative carry. In a market-neutral strategy, negative carry may arise if returns from long positions do not fully cover the costs of short positions, yet the strategy aims for overall profitability through balanced exposure.
Related Terms: positive carry, yield, cost of borrow, capital gains, short selling, market neutral strategy.
References
- International Monetary Fund. “Banks: At the Heart of the Matter”.
- Consumer Financial Protection Bureau. “How Does Paying Down a Mortgage Work?”
- Congressional Research Service. “The Exclusion of Capital Gains for Owner-Occupied Housing”. Page 2.
- Reserve bank of Australia. “Bonds and the Yield Curve”.
- Daniel, Kent, Hodrick, Robert, and Lu, Zhongjin. “The Carry Trade: Risks and Drawdowns”. National Bureau of Economic Research ,no 20433, August 2014, pp. 2-5.
- Internal Revenue Service. “Topic No. 505, Interest Expense”.
- Federal Register. “Short Position and Short Activity Reporting by Institutional Investment Managers”.
