The U.S. bond market has enjoyed a strong bull run over the past few years as the Federal Reserve has lowered interest rates to historic low levels. The price of bonds, which react inversely to changes in interest rates, have recently come under pressure as market participants anticipate that the central bank will soon indicate they will begin to raise the target rate.
Traditionally considered lower-risk investments than stocks, bond prices may fall dramatically depending on how much and how quickly interest rates rise. As a result, savvy investors might consider selling short the U.S. bond market and profit from an anticipated bear market. A short position in bonds also has the potential to generate high returns during inflationary periods. How does an individual gain short exposure to bonds within their regular brokerage account?
Key Takeaways
- Going short the bond market means that an investor or trader suspects that bond prices will fall, and wishes to take advantage of that bearish sentiment—for instance, if interest rates are expected to rise.
- Derivatives contracts on bonds, such as futures and options, provide one way to short the bond market, or to hedge an existing long position from a downturn.
- Inverse bond ETFs and mutual funds are another way to diversify a short bond position and benefit from professional portfolio management.
Bond Market Definition
Going Short
Going ‘short’ indicates that an investor believes that prices will drop and therefore will profit if they can buy back their position at a lower price. Going ‘long’ would indicate the opposite and that an investor believes prices will rise and so buys that asset. Many individual investors do not have the ability to go short an actual bond. To do so would require locating an existing holder of that bond and then borrowing it from them in order to sell it in the market. The borrowing involved may include the use of leverage, and if the price of the bond increases instead of falling, the investor has the potential for large losses.
Fortunately, there are a number of ways that the average investor can gain short exposure to the bond market without having to sell short any actual bonds.
Hedging Strategies
Before answering the question of how to profit from a drop in bond prices, it is useful to address how to hedge existing bond positions against price drops for those who do not want to or are restricted from taking short positions. For such owners of bond portfolios, duration management may be appropriate. Longer maturity bonds are more sensitive to interest rate changes, and by selling those bonds from within the portfolio to buy short-term bonds, the impact of such a rate increase will be less severe.
Some bond portfolios need to hold long-duration bonds due to their mandate. These investors can use derivatives to hedge their positions without selling any bonds.
Say an investor has a diversified bond portfolio worth $1,000,000 with a duration of seven years and is restricted from selling them in order to buy shorter-term bonds. An appropriate futures contract exists on a broad index that closely resembles the investor’s portfolio, which has a duration of five and a half years and is trading in the market at $130,000 per contract. The investor wants to reduce their duration to zero for the time being in anticipation of a sharp rise in interest rates. They would sell [(0 – 7)/5.5 x 1,000,000/130,000)] = 9.79 ≈ 10 futures contracts (fractional amounts must be rounded to the nearest whole number of contracts to trade). If interest rates were to rise 170 basis points (1.7%) without the hedge the investor would lose ($1,000,000 x 7 x .017) = $119,000. With the hedge, their bond position would still fall by that amount, but the short futures position would gain (10 x $130,000 x 5.5 x .017) = $121,550. In this case, the investor actually gains $2,550, a negligible (0.25%) result due to the rounding error in the number of contracts.
Options contracts can also be used in lieu of futures. Buying a put on the bond market gives the investor the right to sell bonds at a specified price at some point in the future no matter where the market is at that time. As prices fall, this right becomes more valuable and the price of the put option increases. If the prices of bonds rise instead, the option will become less valuable and may eventually expire worthless. A protective put will effectively create a lower bound. The investor cannot lose any more money below this price even if the market continues to drop. An option strategy has the benefit of protecting the downside while allowing the investor to participate in any upside appreciation, whereas a futures hedge will not. Buying a put option, however, can be expensive as the investor must pay the option’s premium in order to obtain it.
Shorting Strategies
Derivatives can also be used to gain pure short exposure to bond markets. Selling futures contracts, buying put options, or selling call options ’naked‘ (when the investor does not already own the underlying bonds) are all ways to do so. These naked derivative positions, however, can be very risky and require leverage. Many individual investors, while able to use derivative instruments to hedge existing positions, are unable to trade them naked.
Instead, the easiest way for an individual investor to short bonds is by using an inverse, or short ETF. These securities trade on stock markets and can be bought and sold throughout the trading day in any typical brokerage account. Being inverse, these ETFs earn a positive return for every negative return of the underlying; their price moves in the opposite direction of the underlying. By owning the short ETF, the investor is actually long those shares while having short exposure to the bond market, therefore eliminating restrictions on short selling or margin.
Some short ETFs are also leveraged or geared. This means that they will return a multiple in the opposite direction of that of the underlying. For example, a 2x inverse ETF would return +2% for every -1% returned by the underlying.
Short and leveraged ETFs are typically designed for short-term holding. These instruments risk losing value over time due to attrition with the underlying holdings, even with the purpose of hedging. The holder of these ETFs may realize losses if the bond market remains flat over a longer-than-expected period.
There are a variety of short bond ETFs to choose from. The following table is just a sample of the most popular such ETFs.
In addition to ETFs, there are a number of mutual funds that specialize in short bond positions.
The Bottom Line
Interest rates cannot remain close to zero forever. The specter of rising interest rates or inflation is a negative signal to bond markets and can result in falling prices. Investors can employ strategies to hedge their exposure through duration management or through the use of derivative securities.
Those seeking to gain actual short exposure and profit from declining bond prices can use naked derivative strategies or purchase inverse bond ETFs, which are the most accessible option for individual investors. Short ETFs can be purchased inside a typical brokerage account and will rise in price as bond prices fall.