Shorting bonds requires careful analysis of market conditions, timing, and interest rates. Shorting bond-based ETFs is an alternative approach that allows for easier targeting, but may not provide access to all types of debt. Sovereign debt is often a good candidate for short selling.
Successful shorting of bonds requires very careful analysis of prevailing market conditions to correctly identify bonds that are likely to underperform, and requires careful timing to reap the greatest benefits from making this identification. A short bond position also requires careful attention to the interest rates associated with the bonds under consideration. The correct financial instruments must also be selected to facilitate shorting bonds. In some cases, this will involve the actual short sale of bonds, while in others it will involve the short sale of bond-based exchange-traded funds, or ETFs.
As with any short sale, shorting bonds is, in essence, a negative bet, a bet against the value of an asset. Any bond whose price is likely to fall, and on which the interest rate will rise, is a good candidate for short selling. A careful analysis of the market can sometimes reveal corporations or nations whose debt is likely to be under pressure or will soon face additional hurdles in obtaining loans. Sovereign debt is often a good candidate for short selling because these securities are widely held and generally actively traded and because information about economic conditions affecting nations as a whole is widely available. Bond ratings can sometimes be a useful indicator of bond quality, but this information is usually already priced in the market.
Interest rates are a crucial factor to consider when thinking about shorting bonds. When shorting shares, an investor is only responsible for the eventual increase or decrease in the price of the shares that he has lent to short. However, when shorting a bond, an investor must plan to cover the ongoing interest produced by the bond and pay that interest back to the original owner of the bond. The role of interest in shorting bonds tends to favor short sales of bonds whose values are likely to crash sooner rather than later. Shorting long-term bonds can be very expensive propositions, as can shorting high-yield bonds.
A useful alternative approach to outright shorting bonds is shorting shares in bond-based ETFs. Since ETFs can be bought and sold like stocks, shorting these securities is an easy way for investors to cash-short bonds without needing to enter into the somewhat more complicated agreements required to actually short the bonds directly. . This bond shorting method allows for good but not always perfect investment targeting. Sovereign debt from most nations is accessible through ETF trading, but debt from individual corporations or states is not always accessible, and investors following this approach may need to reduce an entire category of debt.
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