Positive carry occurs when the yield or income generated from a security exceeds the cost of financing the purchase of that security. This situation typically involves borrowing money at a lower interest rate to invest in a security that has a higher return.
For example, consider a fixed-income bond that yields 10% annually. If this bond is purchased with a loan that bears 8% annual interest, the investor experiences a positive carry because the return on the investment (10%) is greater than the cost of borrowing (8%).
Here is a mathematical representation for better understanding:
In the given example, the positive carry would be:
Types of Positive Carry Instruments
- Bonds: Frequently used in positive carry strategies. Bonds often provide predictable returns, making them ideal for leveraging with lower-cost debt.
- Real Estate: When rental income exceeds the mortgage payment and other costs, positive carry exists.
- Forex Trading: In currency markets, when an investor borrows in a currency with a low-interest rate to invest in a currency with a higher interest rate.
- Securities Lending: Lending securities to generate additional income, provided the yield on the lent securities surpasses the cost incurred by borrowing them.
Special Considerations
- Interest Rate Risk: Fluctuations in interest rates can affect the carry. If borrowing costs increase or the yield on the security decreases, positive carry can turn negative.
- Credit Risk: The risk that the issuer of a bond or any instrument may default, impacting returns.
- Market Conditions: Positive carry is more achievable in stable or predictable markets.
Historical Context
Historically, positive carry has been utilized by investors and financial institutions to hedge investments and enhance returns. During periods of low-interest rates, the strategy becomes particularly attractive and more prevalent among investors seeking to exploit the spread between borrowing costs and investment yields.
Examples
- Bond Investment: A corporate bond yielding 6% purchased with a personal loan at 4% interest rate results in a positive carry of:$$ 6\% - 4\% = 2\% $$
- Real Estate: A property generating $5,000 per month in rental income while incurring $3,500 in mortgage and maintenance costs demonstrates a positive carry of:$$ \$5,000 - \$3,500 = \$1,500 \text{ monthly} $$
Comparison to Negative Carry
The opposite of positive carry is negative carry, a situation where the cost of financing exceeds the yield on the investment. For instance, if the same bond yielding 6% was purchased with a loan bearing 8% interest, the investor would experience a negative carry of:
Related Terms
- Carry Trade: An investment strategy where an investor borrows funds at a low-interest rate to invest in an asset expected to provide a higher return.
- Yield Spread: The difference between yields on different bonds or debt instruments, significant in determining carry.
- Leverage: Using borrowed capital for investment, amplifying both potential gains and losses.
FAQs
Can positive carry guarantee profits?
Is positive carry the same as arbitrage?
How does inflation impact positive carry?
References
- Mankiw, N. G. (2019). Principles of Economics. Cengage Learning.
- Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments. McGraw-Hill Education.
- Shreve, S. E. (2004). Stochastic Calculus for Finance II: Continuous-Time Models. Springer.
Summary
Positive carry is a fundamental financial concept where the return on an investment surpasses the cost of financing the purchase of that investment. It is commonly applied in bonds, real estate, and currency markets and plays a critical role in portfolio management and investment strategies. However, investors must be mindful of risks such as interest rate fluctuations and market conditions to successfully leverage positive carry.
