How to Short Bonds

If you think bonds are going to fall – make a trade.

We have advocated a long term, diversified approach as the investing methodology that will produce the best results for the majority of your portfolio for a long time. However, mixing some shorter term positions, options strategies and even a few speculative bets into your portfolio can often have the affect of improving your overall returns and reducing portfolio volatility.

The current bond market environment in California is the perfect example of why investors need to be thinking about investing strategies beyond a generic buy-and-hold methodology.

The economy has been in a tug-of-war between the threats and serious risks of deflation and the disadvantages of high inflation. The extraordinary deficits planned by the U.S. and other State Governments and the massive intervention in the U.S. treasuries market by the Fed has made the problem worse.

This has been done to fight deflation but has shifted investor expectations more towards high inflation and potential defaults over the next several quarters.

Savvy traders observing this shift towards inflation expectations and higher default rates are likely getting their inflation-based investing plans ready to deploy. When traders talk about opportunities in a market like that they will often mention short bonds or treasuries positions.

A short bonds position has the potential to produce big profits during high inflationary periods but how does a individual trader do any of that within their regular stock account?

Shorting an actual bond is complicated and probably outside the scope or interest of most individual traders. However, shorting a bond ETF could accomplish the same thing with a lot less hassle.

As bond prices drop (due to inflation or risk of default) bond ETFs will also decline in value. There are many bond ETFs to choose from but the iShares 7-10 year treasury bond fund (IEF) is an ideal instrument for this short strategy.

However, what if you are not even interested in the complexity of shorting a stock? There are even easier ways to take advantage of a decline in bond prices by buying a short bond ETF. That means that the ETF itself is investing in short bonds and by buying the ETF you will profit when bond prices drop.

There is a leveraged ETF that has become very popular as a way to execute this strategy called the ProShares Ultra-short 7-10 year treasury ETF (PST).

There are some inherent risks in shorting bonds that you should be aware of.

1. Bonds are mean-reverting, which means that they don’t “trend” for long periods of time. This makes your holding period fairly short term.
2. Leveraged positions using margin and leveraged ETFs include higher costs.
3. Leveraged funds will underperform in the long run because they lose some of the benefits of compounding.

You will notice that the disadvantages of this strategy mostly concern the fact that a short bond strategy is a short-term strategy. Short term trading costs more and is more difficult than longer term investing. However, when faced with an extraordinary market and an evolving economic environment, looking outside the long-term box for new opportunities can be quite attractive.

Disclosures

This article is produced by Learning Markets, LLC. The materials presented are being provided to you for educational purposes only. The content was created and is being presented by employees or representatives of Learning Markets, LLC. The information presented or discussed is not a recommendation or an offer of, or solicitation of an offer by Learning Markets or its affiliates to buy, sell or hold any security or other financial product or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances and your investment objectives. Learning Markets and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.

Any specific securities, or types of securities, used as examples are for demonstration purposes only. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security or type of security.

Investors should consider the investment objectives, charges, expense, and unique risk profile of an Exchange Traded Fund (ETF) carefully before investing. Leveraged and Inverse ETFs may not be suitable for all investors and may increase exposure to volatility through the use of leverage, short sales of securities, derivatives and other complex investment strategies. These funds’ performance will likely be significantly different than their benchmark over periods of more than one day, and their performance over time may in fact trend opposite of their benchmark. Investors should monitor these holdings, consistent with their strategies, as frequently as daily. A prospectus contains this and other information about the ETF and should be obtained from the issuer. The prospectus should be read carefully before investing.

Investors should consider the investment objectives, risks, charges, and expenses of mutual fund carefully before investing. Mutual funds are subject to market fluctuation including the potential for loss of principal. A prospectus contains this and other information about the fund and is available from the issuer. The prospectus should be read carefully before investing.

Options involve risk and are not suitable for all investors. Detailed information on the risks associated with options can be found by downloading the Characteristics and Risks of Standardized Options and Supplements (PDF) from The Options Clearing Corporation, or by calling the Options Clearing Corporation at 1-888-OPTIONS.