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Is Short Selling U.S. Treasury Bonds a Good Idea?

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By Kalen Smith and edited by Paul Khoo

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:

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 demands for

bonds in general.

Here are some reasons

why you may want to

short sell a bond:

Interest rates are likely to increase

Historically, interest rates are low. 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. 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. Interest rates may rise if the Fed is convinced that US recovery is sustainable. The Fed’s have been under a lot of pressure to drive inflation to avoid stagflation and deflation. This may drive interest rates up further over the long-run. In other words, treasury bond price values will decline if interest rates stay where they are or if they increase. Either way, this creates a good opportunity for investors to establish a short position on long dated US Treasury Bond.

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.

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2 How do you Short Sell a

Bond?

Why would you short sell a Bond?

Is Short Selling U.S. Treasury Bonds a Good Idea?

Special Issue

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2 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.

Source: US Treasury, Barclay Capital, JP Morgan, FactSet, 31 March 2015

FOMC PROJECTS GRADUAL HIKE

PRICE IMPACT OF A 1% RISE / FALL IN INTEREST RATES ON U.S. TREASURIES

Source: Federal Reserve, FactSet, J.P. Morgan Asset Management. Market expectations are the federal funds rates priced into the fed futures market as of the date of the March 2015 FOMC meeting. *Forecasts of 17 Federal Open Market Committee (FOMC) participants,

midpoints of central tendency except for federal funds rate which is a median estimate. Data are as of March 31, 2015.

Note: By shorting U.S. Treasury 30 years, a 1% rise in yield would generate a return of +18.6%

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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. With Fed has stopped the bond buying program, as part of their tapering plan, is an example of reduced demand for US Treasury Bonds. Institutional and foreign support of U.S. Treasuries is declining soon. 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 bearish on long-dated U.S. Treasuries and bonds.

Higher rates in the U.S. will be one of the driving forces behind a strong U.S. Dollar

Federal Reserve continues to accommodative monetary stance to ensure the U.S. economy growth is sustainable, and hence running the risk of inflation may skyrocket over in the long-run. The president of the Fed Bank of St Louis said in March 2015 the central bank risks being “behind the curve” on inflation if it doesn’t raise its benchmark interest rate from near zero soon (Bloomberg, 28 Apr 2015) 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 will be driving interest higher over time.

“While short selling bonds is an appropriate strategy for many investors, it’s important to keep in mind the potential risk for longer than expected rates hike by the Fed.”

For Anyone Concerned at Bond Rout, Don’t Say You Weren’t Warned

by Wes Goodman

After analysts got it wrong last year, bonds are doing what forecasters expected in 2015 -- plunging. Byron Wien at Blackstone Group LP says there are more losses to come. At the end of 2014, Wall Street’s forecasters predicted 2015 would be a disastrous year for benchmark Treasuries. With Federal Reserve Chair Janet Yellen poised to raise interest rates for the first time in almost a decade, prognosticators were convinced yields had to rise. The latest Bloomberg surveys of economists suggests the selling isn’t over. Analysts don’t have a great track record. Almost everyone who foresaw a selloff in 2014 as the Fed ended its bond-buying program was caught by surprise as a tumbling inflation rate pushed Treasuries higher. They’re proving to be correct this time around, with Treasuries plunging 2.2 percent since the start of April, based on data compiled by Bloomberg. German 10-year yields have surged to 0.72 percent from 0.05 percent last month. “Yields are going to go higher,” said John Gorman, head of dollar interest-rate trading for Asia and the Pacific at Nomura Holdings Inc. in Tokyo. “People are coming to terms with the fact that the Fed is going to raise sometime toward the end of this year. The economy is in an upward trend.” Nomura is one of the 22 primary dealers that trade directly with the Fed. Benchmark U.S. 10-year yields were little changed at 2.29 percent as of 6:49 a.m. in London, according to Bloomberg Bond Trader prices. They have risen from this year’s low of 1.64 percent in January. The price of the 2.125 percent note due in May 2025 was 98 18/32.

Forecasts Trimmed At the start of 2015, the Bloomberg surveys projected the yield would surge to 3 percent by year-end. Though economists have reduced the figure, they still see it climbing to 2.41 percent, based on the responses, with the most recent given the heaviest weightings.

The Fed will probably raise borrowing costs in September as the economy improves, said Wien, the vice chairman at New York-based Blackstone, which specializes in alternative investments such as private equity and real estate. “Interest rates are going up, and I’ve thought that for a long time,” he said this week in an interview with Bloomberg. “I don’t think they’re going up a lot.”

A surge in yields like the one under way now is cause for bondholders to give thanks that their investments make interest payments. If U.S. 10-year yields rise to 2.41 percent by Dec. 31 as projected, an investor who bought today would break even as the coupon payments offset the drop in price, data compiled by Bloomberg show. 03

PAUL SINGER

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FAMOUS Investors

JOINING THE CALL

WARREN BUFFET

BILL ACKMAN

BILL GROSS

“If I had an easy way, in a non-risk way of shorting a whole lot of 30-year bonds, I’d do it. But I think that

bonds are very overvalued, I’ll put it that way”.

Self-made billionaire, investor, philanthropist, CEO of Berkshire Hathaway with total assets over USD 520 billion

“I don’t like fixed income as a category, particularly at today’s interest rates”.

Founder and Chief Executive Officer of Pershing Square Capital Management LP with total assets of USD 18 billion

“The bull market ‘supercycle’ for bonds is ending and credit-based oxygen is running out. I acknowledged

that my call for the end of the bond rally in both February and April of 2013 were too early.

“Today, six and a half years after the collapse of Lehman, there is a Bigger Short cooking -

long term claims on paper money i.e. Bonds.

Founder and CEO of Elliott Management Corp with total assets of US$23 billion

Source: News Article from www.bloomberg.com, Buffet and Gross Agree: Slump in 30-Year Bonds Makes Good Sense, 4 May 2015

Source: News Article from www.bloomberg.com, Buffet and Ackman Hate U.S. Bonds and the Losses are Piling Up, 6 May 2015

Source: News Article from www.bloomberg.com, Bill Gross: The Bull Market ‘Super Cycle’ is Nearing its End, 4 May 2015

Financial Manager and Author, Cofounder and Co-Chief Investment Officer of Pacific Investment Management LLC Company (PIMCO) with total assets of USD 1.59 trillion

Source: News Article from www.cnbc.com, Paul Singer: This is the new ‘big short’, 28 May 2015

Growing discontent with how low yields have gotten, and the sense that it can’t last too much longer with an economy that’s showing signs of life.

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:

1. 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. This is the simplest

way for investors to leverage on a

rising yield environment.

2. 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.

3. 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.

4. 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.

5. 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.

How do you short sell a bond?

Proshares Ultrashort 20+ Year US Treasury ETF (TBT)

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Proshares Short 20+ Year US Treasury ETF (TBF)

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“The concept of short-selling Treasuries is an idea that many investors have started seriously considering in recent months.”

Source: This article was originally extracted from www.moneycrashers.com and www.bloomberg.com

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