DEFINITION of Negative Carry
Negative carry is a situation in which the cost of holding a security exceeds the income earned. A negative carry situation is typically undesirable because it means the investor is losing money as long as the principal value of the investment remains the same (or falls). This is important when positions are financed by debt.
A negative carry investment can be a security (such as a bond), real estate (such as a rental property), or a business. Even banks can experience negative carry if the income earned from a loan is less than the bank's cost of funds. This is also called negative cost of carry.
BREAKING DOWN Negative Carry
Any investment that costs more to hold than it returns in payments can result in negative carry. Again, this does not include any capital gains or losses that might occur when the asset is sold or matures.
For example, an investor may borrow money at 6% interest to invest in a bond paying a 4% yield. In this case, the investor has a negative carry of 2% and is actually spending money to own the bond. If the bond was purchased at par or above and held to maturity, the investor will have a negative return. However, if the bond was bought at a discount and/or interest rates fall, the capital appreciation when the bond is sold or matures can overcome the loss from negative carry.
Another way the investment can offer a positive return is if the cost of funding is tax deductible and/or the investment itself is a tax-free security, such as a municipal bond. The higher the investor's tax bracket, the better the chance that favorable tax treatment will overcome negative carry.
While borrowing to invest is the typical reason for negative carry (where the carry cost is the interest), short selling can also create a negative carry situation. One example would be in a market neutral strategy where a short position in a security is matched against a long position in another.
Investors in the foreign exchange markets can also have a negative carry trade, called a negative carry pair. Borrowing money in a currency with high interest rates and then investing in assets denominated in a lower interest rate currency will create the negative carry. However, if the value of the higher-yielding currency declines relative to the lower-yielding currency, then the favorable shift in exchange rates can create profits that more than offset the negative carry.