What Is Negative Carry?
Negative carry occurs when the cost to hold an asset or position exceeds the income that asset generates during the holding period. In plain terms: you are paying more to finance or maintain an investment than you are receiving in interest, dividends, rent or other income. Investors accept negative carry only when they expect capital gains, tax benefits, or some other payoff to more than offset the ongoing carrying cost (Investopedia).
Key takeaways
– Negative carry = carrying cost − income yield. If positive, the position is losing money on a cash-flow basis.
– Common in leveraged investments: borrowing to buy bonds, holding rental real estate, certain forex positions, and some short-sale strategies.
– Investors tolerate negative carry when they expect capital appreciation, favorable exchange-rate moves, tax advantages, or strategic hedges.
– Important risks: funding-cost changes, margin calls, liquidity stress and the possibility that expected capital gains never materialize. (Investopedia; NBER)
How negative carry works (simple formula and interpretation)
– Basic formula: Negative carry (%) = Cost of financing (%) − Income yield (%).
Example: borrow at 6% to buy a bond that yields 4% → negative carry = 6% − 4% = 2% (you lose 2% per year on cash flow unless the bond’s price rises). (Investopedia)
– Note: this calculation ignores capital gains or losses. A negative carry position can still be profitable overall if capital appreciation exceeds the carry cost. (Investopedia)
Concrete examples
1) Bonds and leveraged purchases
– Scenario: an investor borrows at 6% to buy a bond paying a 4% coupon. On a cash-flow basis the investor pays 2% annually to hold the bond. If interest rates fall and the bond price rises, capital gains might offset or exceed the 2% negative carry. If rates rise or stay flat and the bond is held to maturity at par, the investor realizes a negative return. (Investopedia; RBA)
2) Real estate (owner-occupied and rented)
– Owner-occupied: many homeowners experience negative carry in the early years of a mortgage because interest payments exceed principal paydown; upkeep and insurance add costs. Owners accept this expecting house-price appreciation or nonfinancial benefits. (Investopedia; Congressional Research Service)
– Rental property: rental income can be less than expenses (mortgage interest, maintenance, taxes). Tax deductions (e.g., deductible interest) can reduce the effective cost, making the holding feasible until capital gains accrue. Tax benefits depend on jurisdiction. (Investopedia; IRS)
3) Forex (negative carry pairs)
– Reverse of the classic carry trade: borrow in a high-yield currency and invest in a lower-yield currency. The interest-rate differential produces negative carry, so a trader only does this if they expect the low-rate currency to appreciate relative to the funding currency enough to cover the interest cost. Success requires exchange-rate moves that offset the negative carry. (Investopedia; NBER)
4) Banks and lending
– A bank can experience negative carry if the return it earns on a loan is below its cost of funds. That compresses margins and profitability. (IMF)
5) Short selling and market-neutral strategies
– Short positions can generate negative carry via borrow fees, dividend payments on borrowed stock, or other costs. In hedged or market-neutral strategies, the short leg’s carry expense can create a negative-carry component that must be offset elsewhere. (Investopedia; Federal Register)
Special considerations and risks
– Funding-cost risk: If your funding rate increases (variable-rate loans, margin requirements), negative carry worsens. Conversely, decreasing funding rates can reduce or reverse the carry.
– Capital-gains dependency: Negative carry strategies rely on the timing and magnitude of expected price moves; if those moves fail to materialize, losses accumulate.
– Liquidity and margin calls: Leverage magnifies the risk of forced liquidation if adverse moves trigger margin calls. (NBER)
– Correlation risk: Expected gains must be uncorrelated or sufficiently strong relative to funding-cost shocks.
– Tax treatment: Deductibility of interest or other tax effects can materially change the economic cost of carry; tax rules vary by jurisdiction and over time. (IRS)
– Opportunity cost: Capital devoted to a negative-carry position could be deployed elsewhere for positive carry or lower-risk return.
– Measurement: Carry calculations often exclude expected capital gains, so evaluate total expected return (income + expected price change − carry costs). (Investopedia)
Practical steps for investors considering negative-carry positions
1) Define the investment thesis and horizon
– Be explicit: are you seeking capital appreciation, exchange-rate gains, tax benefits, or a hedge? Set a realistic time horizon consistent with the thesis.
2) Quantify the carry and the break-even point
– Compute negative carry: financing cost − income yield.
– Compute the required capital gain (absolute and annualized) needed to offset the carry over your expected holding period. Example: if negative carry is 2% annually and you plan to hold 3 years, you need >6% cumulative gain (plus transaction costs) to break even on cash flow.
3) Stress-test scenarios
– Run best/worst/base cases for: funding-cost increases, slower-than-expected price appreciation, adverse exchange-rate moves, and liquidity shocks (margin calls). Include transaction costs and taxes.
4) Incorporate taxes and regulatory effects
– Determine whether interest or other carrying costs are tax-deductible and how that affects the net carry. Check local tax rules and potential future changes. (IRS)
5) Use hedges or limit exposure
– Consider partial hedges (options, swaps) to protect against large adverse price moves. Set stop-loss or position-size limits to cap potential losses from prolonged negative carry.
6) Monitor funding and liquidity
– Regularly review funding sources and their terms. Avoid mismatches (long assets financed with very short-term borrowing), which can create rollover risk.
7) Consider alternatives and opportunity costs
– Compare expected risk-adjusted returns versus alternative uses of capital (holding cash, positive-carry investments, or less leveraged strategies).
8) Manage operational and counterparty risks
– For forex and derivatives, ensure counterparty credit, settlement procedures and margining are understood. For short sales, account for borrow availability and recall risk.
9) Document exit strategy and triggers
– Define explicit exit conditions: target price, max drawdown, time limit, or a change in the thesis (e.g., funding rate shift). Having rules reduces emotional decisions under stress.
10) Keep records and review outcomes
– Track realized carry costs, actual capital gains/losses, tax impacts and whether the thesis held. Use lessons learned to refine future decisions.
Example calculation (bond):
– Buy a bond yielding 4% financed at 6% (annual rates). Negative carry = 6% − 4% = 2%. If you pay transaction costs equal to 0.5% the first year, your first-year net cash-flow loss = 2.5% (plus any price change). If you expect the bond’s price to rise 5% in a year, your net return after carry and transaction costs = 5% − 2.5% = 2.5%.
When negative carry can make sense
– You expect a significant capital gain (rate drops, house price appreciation, currency appreciation).
– You need a hedge: paying carry to hold a protective position can be justified to reduce larger potential losses elsewhere.
– Tax advantages or strategic business reasons (e.g., controlling an asset or operational benefits) offset the cash-flow cost. (Investopedia; IRS)
Further reading and sources
– Investopedia — “Negative Carry” (source URL provided by user)
– 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”
– Reserve Bank of Australia — “Bonds and the Yield Curve”
– Daniel, Kent, Hodrick, and Lu — “The Carry Trade: Risks and Drawdowns.” National Bureau of Economic Research, Working Paper No. 20433 (2014)
– Internal Revenue Service — “Topic No. 505, Interest Expense”
– Federal Register — “Short Position and Short Activity Reporting by Institutional Investment Managers”
Bottom line
Negative carry is a deliberate acceptance of ongoing cash-flow losses in exchange for an anticipated payoff (capital gains, tax benefits, strategic hedging). It can be a valid tactic, but it raises distinct funding, liquidity and timing risks. Before entering a negative-carry trade, quantify the carry, stress-test scenarios, incorporate taxes and liquidity, set strict position limits and define a clear exit plan.