Bonds are often considered to be fairly safe investments, but their trading prices can endure as much fluctuation and volatility as stocks. As a result, it has become increasingly popular to take advantage of the opportunity to short sell bonds.
But what exactly causes the value of bonds to decrease and how can one go about short selling a specific bond or class of bonds?
Let’s explore these areas in greater depth below.
Why Would You Short Sell a Bond?
You short sell a bond for the same reason you short sell a stock – because you think it will decline in value. Many bonds provide a fixed income, which is one reason why they’re an attractive investment. But the value of that income, and hence the bond itself, is affected by current interest rates, inflation, the company guaranteeing the bond, and demand for bonds in general.
Here are some reasons why you may want to short sell a bond:
- Interest rates are likely to increase. When interest rates increase, the value of existing bonds decline. This is because investors will be able to get a better interest rate purchasing a new bond.
- Inflation increases. The real rate of return on a bond is the difference between the interest it pays and inflation. If inflation increases, bonds will become less attractive since their interest rates do not account for inflation.
- Bonds are more likely to default. When a lender is at risk of defaulting on a bond, the demand for that bond goes down significantly. The price of bonds is fixed by supply and demand just like any other asset. You can follow Standard & Poor’s (the S&P) regarding changes in the credit rating of various bonds and news on whether or not a bond is expected to default. For example, Bill Gross, a famous bond trader, is currently short-selling U.S. Treasuries because he and other analysts believe the U.S. government is at a relatively high risk of default.
- Institutional and foreign demand for bonds is declining. Most bonds are sold to large institutions and foreign governments. When these organizations have less interest in purchasing bonds due to declining yields or higher perceived risk, the value of those bonds can decrease dramatically.
While short selling bonds is an appropriate strategy for many investors, it’s important to keep in mind the potential risk for large losses. If the underlying bonds increase significantly in price, the loss can be significantly high. Therefore, it’s important to employ a technique to mitigate loss, such as predetermining an exit point, if the market doesn’t move in the direction you expect.
How Do You Short Sell a Bond?
Generally, you can’t short sell a bond directly through your broker the same way you would a stock. However, there are other ways to conduct such a trade:
- Short a bond exchange-traded fund (ETF). An ETF is a fund that specializes in groups of assets, the value of which moves in tandem with the underlying securities. Many ETFs specialize in specific bond classes, such as 7-10 year Treasuries. Brokers will usually let you place short orders on ETFs just like any other security.
- ETF put options. Put options exist for some bond ETFs just like they do for stocks and other securities. A put option affords you the opportunity to sell the ETF at a pre-determined price should the ETF decline in value. These options will have a specified time period within which you must exercise them. Purchasing a put option is one way to mitigate potential losses; if the value of the bond fund increases, your losses are limited to the purchase price of the put.
- Treasury put options. You can also purchase put options on specific Treasuries, which affords you the opportunity to sell at a specified price before the expiration date. For example, you can purchase put options on the 5-Year Treasury Yield.
- Bond futures. Futures are another alternative. As the seller (“short position”) in a bond futures contract, you agree with the buyer (“long position”) to issue the bonds at a future, specified date for a price agreed upon now. Thus, if you expect the price of bonds to fall, you can make immense profits by entering into bond futures contracts as the seller. By doing so, you lock in current bond prices, and then buy the actual bonds at the future, lower prices when you must provide the buyer with the bonds at the agreed-upon date. This strategy can result in large losses if the bonds increase in price, however.
- Put bonds. Some individual bonds can be acquired with a put option and are known as “put bonds.” With this option, the holder can exercise and force the issuer to repurchase the bond at some point over the lifetime of the bond. Usually, this valuable “put feature” will require the investor to sacrifice a portion of the bond yield. This option offers investors the stability of bond investments while also providing an exit strategy should the bond’s price decrease significantly in value.
Is Now a Good Time to Short Sell Treasuries?
The concept of short-selling Treasuries is an idea that many investors have started seriously considering in recent months. Here are some reasons why you may want to consider shorting Treasuries:
- Historically low interest rates. Many investors are getting frustrated that interest rates on Treasuries are now at about a quarter of a percent. Fewer investors are willing to tolerate such dismal returns and either aren’t buying or are selling their holdings.
- Interest rates may rise if the Fed stops the quantitative easing program. The Fed’s have been under a lot of pressure to cease driving up the price of inflation. If they stop printing money with their quantitative easing program, they will be unable to purchase new Treasuries. This may drive interest rates up further. In other words, treasury values may decline if interest rates stay where they are or if they increase. Either way, this creates a good opportunity for investors who want to sell short.
- Diminishing value of the U.S. dollar. If the Federal Reserve continues to print more money to save the U.S. economy, the rate of inflation may skyrocket. The price of gas has already increased to over $4.00 a gallon, largely due to the declining value of the dollar. As the dollar loses value, investors become more anxious about investing in U.S. Treasuries. Also, many nations are discussing removing the dollar as the world reserve currency, which would cause serious ramifications for U.S. Treasuries.
- Institutional and foreign support of U.S. Treasuries is declining. China is the largest single holder of U.S. Treasuries, holding approximately 8% of all U.S. debt, and has been selling its holdings. Bill Gross, the manager of the largest bond fund in the country, and Warren Buffet, another legendary investor, are both shorting U.S. Treasuries. Other countries are starting to unload U.S. debt as well. This is a widespread indication that faith in the U.S. government as a lender is at an all-time low.
- Fear that the U.S. government will default on its loans for the first time ever. The S&P is threatening to take away the U.S. government’s AAA bond rating. Many are terrified that as the U.S. is on its way to reaching $15 trillion in debt (i.e. national debt ceiling), it will not possibly be able to make all of its payments.
Do You Want to Bet Against Your Country?
There are serious implications for short selling U.S. Treasuries. The biggest point of contention is that when you short sell Treasuries, you contribute to their decline. As an individual, you may not have much influence over the market. But as a member of a group shorting U.S. Treasuries, you may influence the behavior of that market and negatively impact our country’s credit.
Do you want your profit to rely on the downfall of this country? Or do you feel that amidst the economic crisis this represents a lifeboat-opportunity to escape intact? As a matter of principle and ethics, this is one aspect investors should consider before they engage in this type of trading.
The value of United States Treasuries is in serious question right now, which raises the controversial idea of selling them short. Short selling could be a lucrative strategy for individuals, but if done en masse, may negatively impact our nation’s ability to recover.
Moreover, it can be a high-risk strategy, with the potential for large losses if selling bond futures, or shorting bond ETFs. Consider where you stand on the issue, and if and how it makes sense for you to proceed.