Negative carry in investing refers to a situation where the cost of holding an investment, including expenses, interest, or financing charges, exceeds the income or return generated from that investment. Calculating this can help you avoid costly investment mistakes and identify opportunities to take advantage of potential increases in asset value when borrowing money to invest. Here’s what you should know.
Working with a financial advisor can help you identify investment opportunities that align with the goals of your portfolio.
How Negative Carry Works
In the case of bonds, negative carry occurs when the interest payable on borrowed funds to purchase the bond surpasses the bond’s yield.
Forex trading, comparatively, presents a scenario of negative carry when the interest rate of the currency being bought is less than the one being sold.
Factors such as interest rates and market volatility can influence negative carry. An increase in interest rates, for instance, can increase borrowing costs and push investors into a negative carry situation. Market volatility, affecting the asset’s price and subsequently its yield, can also contribute to negative carry.
Real Investing Examples of Negative Carry
Negative carry happens anytime the cost of holding or financing an investment is higher than your return. So, if you borrow money to invest in an asset, and the interest paid on the borrowed funds is higher than the income generated by your investment, you will have a negative carry.
Here’s a simplified example:
Let’s say you borrow $100,000 at an interest rate of 6% per year to invest in a bond that yields only 4% per year. In this case, the negative carry would be the difference between the cost of borrowing (6%) and the return on the investment (4%). The negative carry in this scenario would be 2% (6% – 4%).
- Investment return: 4%
- Borrowing cost: -6%
- Negative carry: -2%
In this situation, the investor is losing money on the cost of borrowing when compared with the income generated by the investment, so it might not make sense to make this investment unless you have research that supports an expected increase in value.
Benefits of the Negative Carry Strategy
Despite the initial losses, negative carry can possibly lead to financial gains if the asset appreciates in value sufficiently to cover the cost.
A negative carry can also prove beneficial in a bullish market, where asset prices are expected to rise. And, investors could accept a negative carry in anticipation of potential capital gains to offset initial losses.
One common example: An investor might endure a negative carry on a property in the short term because they anticipate that the property’s value will increase over time and ultimately yielding a profit.
Risks of Using the Negative Carry Strategy
Taking on higher costs of holding or financing an investment with a negative carry strategy involves several risks that investors should carefully consider:
- Losses and erosion of capital: The most apparent risk is the potential for financial losses. If the costs associated with holding an investment (such as interest expenses) consistently exceed the returns generated by the investment, it can erode capital over time.
- Market risk: Negative carry strategies often involve investments that are subject to market fluctuations. Changes in interest rates, market conditions or economic factors can impact the returns on the investment, potentially exacerbating the negative carry and leading to increased losses.
- Liquidity risk: Negative carry positions may be harder to exit, especially if market conditions worsen or if the investment is illiquid. This can lead to difficulties in selling the asset at a favorable price, potentially amplifying losses.
- Interest rate risk: Negative carry often involves borrowing at one interest rate and investing in assets with a different rate of return. Changes in interest rates can impact the cost of financing and the returns on the investment, affecting the overall profitability of the strategy.
Investors should carefully assess their risk tolerance, market conditions and the specific details of their negative carry strategy before implementing such an approach. You may also want to seek advice from financial professionals to ensure a thorough understanding of the associated risks and potential consequences.
A negative carry strategy could benefit investors when they anticipate potential long-term gains or market opportunities, which include certain hedging or speculative scenarios. But this strategy can also put you at risk for sustained losses or diminished returns if the costs of holding the investment consistently exceed the returns generated over time.
Tips for Investing
- A financial advisor is an expert who can help you identify and invest in the assets that can help you reach your long-term financial goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- You can use an investment calculator to help you estimate how your portfolio could grow and what it might return over time.
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