What Is a Negative Carry?
A negative carry is a term used to describe a scenario in which the yield generated on some type of futures position is less than the costs associated with arranging that position. This situation can develop when the security or asset purchased fails to generate the returns that were originally anticipated. As a result, the buyer or investor does not earn any profit from the investment, but ends up losing money instead at the time the futures position matures.
One of the easiest ways to understand how a negative carry develops is to consider the purchase of a bond issue that is structured with a floating or variable rate of interest. The investor borrows the money to purchase the bond at a fixed rate of interest that he or she believes will ultimately be covered by the returns generated by the bond. The perception is based on predictions that the average rate of interest will in fact increase significantly over the life of that bond. Instead, the average rate actually slips below and remains lower than the fixed rate the investor is paying on the loan used to finance the bond purchase. As a result, a negative carry develops, meaning that once the bond reaches its maturity date and the principal and accrued interest is delivered to the investor, it will not be sufficient to offset the overall cost of the loan financing.
There are other situations in which a negative carry may be experienced. Financial institutions that grant loans may find that the interest income earned from a given loan is not enough to cover all the costs associated with granting and managing that loan, resulting in what is known as a negative cost of carry. In like manner, a borrower may purchase real estate with the intention of making improvements and selling the property at a profit, only to find that the market will not accommodate a sale price sufficient to offset the combination of the principal and interest used to buy the property initially, and the cost of improvements. Generally, a negative carry develops whenever the amount of resources expended to enter into an investment fails to be completely covered by the returns generated by that investment.
Avoiding a negative carry on any investment opportunity is important to the success of just about any type of business deal. Investors want to make sure that any investment will provide a yield that exceeds the total resources expended in securing and maintaining an asset. In like manner, banks and other financial institutions will set interest rates and other fees so that the chances of losing money on a loan that is paid in full by the borrower are extremely low.
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