Positive Carry is an investment approach made more known as the “Yen carry trade” during a period when Bank of Japan (BOJ) kept lowering its interest rate. Investors borrowed cheap in Yen and invested elsewhere for higher returns. The over-riding principle is that if you can earn a return higher than the cost of funds, it is justified to borrow/leverage. It is also not without risks. Leverage is an amplifier, profits and losses do get magnified. But here’s a write up on it covering an example as well as the risks associated with pulling off this debt financing move.
It (Positive Carry) is also not without risks.
First and foremost, there are many ways to do positive carry. A property investor who rents out property and collects more monthly rental than the monthly mortgage commitment, is in essence pulling off a positive carry.
But let us look at a specific example in detail. Keppel Infrastructure Trust (A7RU) listed on the Singapore Stock Exchange.
Distribution yield 7.2% (as indicated above) is higher than say a nominal 2.88% cost of funds (using an assumption).
Using 1st June 2018 Friday’s closing price of $0.51, based on 50% borrowing let us look at the numbers.
Paying for 20,000 shares of it will cost $10,200 without slippage costs (brokerage, clearing fee etc) and 50% borrowing means the positive carry investor only puts in half which is $5100.
Now the 2.88% needs to be divided by 365days and compounded back to give an effective rate of 2.92%, which when applied on $5100 of borrowings, the estimated yearly cost of funds is $149.01.
20,000 shares ought to yield $744 ($0.0372 x 20,000) if all goes according to plan, resulting in a positive carry of $594.99 ($744 – $149.01).
In fact, this counter currently pays dividend quarterly ($0.0093 x 20000 = $186) which will exceed the yearly borrowing costs already!
$594.99 as a percentage of $5100 invested capital gives an estimated return of 11.67%.
3 key risks to watch for in positive carry.
Asset Price Volatility – asset prices do vary and capital gains/losses get magnified because leverage is involved. In the case above, the table shows the capital balance for unwinding the positive carry at various price levels. Unwinding positive carry involves disposing the asset and returning the borrowed capital.
Dividend Policy Changes – future cash flows from the asset is not, guaranteed and cast in stone. Depending on economic/market/business circumstances, projected future cash flows may not be able to cover the cost of funds which will render the positive carry ineffective.
Finance Rate Changes – the cost of funds is also not fixed and may rise to the point whereby cash flows from the asset cannot cover, which will also render the positive carry ineffective.
There is no free lunch at the end of the day. Manage these 3 risks well and the payoff will be good. Nonetheless, it is good to always keep a lookout on how to pull off this approach! Essentially as long as there is reasonable expectation of generating a consistent return higher than the cost of funds, it can be done. Once implemented and found to be ineffective, don’t forget to unwind!