What Is Negative Carry?

What Is Negative Carry?

Let me explain negative carry to you directly: it's a situation where the cost of holding an investment or security is higher than the income you earn from it while you hold it. As a professional portfolio manager, I find negative carry trades or investments generally undesirable because they mean you're losing money as long as the principal value stays the same or drops. That said, many investors and professionals like me regularly get into these positions when we expect a big payoff from holding the investment over time.

You can contrast negative carry with positive carry, where the income exceeds the costs.

Key Takeaways

Here's what you need to know: negative carry is when holding investments costs you more than they bring in over a short-term horizon. There are plenty of reasons to hold onto such an investment, but they all boil down to expecting capital gains down the line. And remember, negative carry can show up in a wide variety of investments.

How Negative Carry Works

Any investment that costs more to hold than it returns in payments can lead to negative carry. This could be a securities position like bonds, stocks, futures, or forex, or even real estate such as a rental property, or a business. Even banks face negative carry if the income from a loan is less than their cost of funds—we call this the negative cost of carry.

This doesn't factor in any capital gains from selling or maturing the asset. Those anticipated gains are usually the main reason we initiate and hold negative carry investments.

Examples of Negative Carry

Let's look at real estate first. Owning a home is a negative carry investment for most homeowners who live in it as their primary residence. The monthly interest on a typical mortgage exceeds what accrues to the principal for the first half of the term. Upkeep costs add to the financial burden. But since house prices tend to rise over time, many homeowners like you might see some capital gain after owning for a few years.

Borrowing and Lending

In the professional world, you might borrow money at 6% interest to invest in a bond paying 4% yield. That gives you a negative carry of 2%, meaning you're spending money to own the bond. The only reason to do this is if the bond was bought at a discount to expected future prices. If bought at par or above and held to maturity, you'll have a negative return. But if bond prices rise due to falling interest rates, your capital gains could outweigh the negative carry loss.

Forex Markets

In forex markets, you can have a negative carry trade, known as a negative carry pair. This involves borrowing in a high-interest currency and investing in a lower-interest one, creating negative carry. If the higher-yielding currency declines relative to the lower one, the exchange rate shift can generate profits that offset the negative carry. This is the reverse of the popular carry trade strategy.

You'd only start this trade if you believe the low-interest currency will appreciate against the high-interest one. Then, when you reverse the trade—selling what you bought and repaying the debt—you pocket the gain, which needs to exceed the interest costs for the whole thing to succeed.

Special Considerations

One reason to buy into negative carry is for tax benefits. Suppose you buy a condo and rent it out, but after expenses, the rental income is $50 less than monthly costs. If the interest is tax-deductible, you might save $150 on taxes monthly, allowing you to hold it long enough for capital gains. Tax laws vary and can change, potentially increasing the carry cost.

While borrowing to invest is the usual cause of negative carry due to interest, short selling can also create it. For example, in a market-neutral strategy, a short position matched against a long one can result in negative carry.