Shorting Global Bonds

Sentiment around the world has started to turn on bonds and resulted in a growing number of well-informed individuals calling for investors to short global bonds. Shorting is the act of borrowing a security from a broker with the promise to return it at a later date. The investor making the short hopes to buy to sell it in the market for a high price and buy it back at a lower price. He is essentially predicting a decline in the price of the security.

On the topic of global bonds, well-known commentators such as Marc Faber have called shorting global bonds the short of the century. Nassim Taleb, author of the excellent book The Black Swan, and a one-time trader himself, said that “every single human should short US Treasury bonds”. Another investor worth listening to is Jim Rogers, famous for starting the Quantum Fund with George Soros. He said he is shorting bonds (and buying sugar, interestingly enough).

Doug Kass, familiar to those who watch CNBC, summed it up quite nicely when he recently said, “A once-in-a-generation short opportunity might now be occurring in the fixed-income markets. My experience is that the magnitude of Thursday's [Feb 4^th] price rise is the sort of occurrence that ends an asset class's move. It is the essence of the anti-implosion trade and a statement that, among other things, oil will not remain under $50 a barrel and that, at some point in the near future, order will return to the world's markets.”

When government or large companies wish to raise money, they can do so by issuing bonds. Various bonds are issued at different interest rates (usually based on the underlying risk) and various redemption periods. The interest rate is determined largely by the risk appetite of the market, but also supply and demand.

One of the reasons that some many are calling for investors to short bonds is that the borrowing requirement at the government level of developed economies has risen sharply. Government spending is increasing while tax collections are down, resulting in the need for government to borrow more money. This difference is often referred to as the deficit.

This is a growing problem because spending has and is expected to continue to outlast revenues. It’s quite obvious that spending cannot continue indefinitely while revenues do not climb. According to the Congressional Budget Office, for the current year the US faces a deficit of US$1.55 trillion (10.6% of GDP), and US$1.3 trillion (8.3% of GDP) for the 2011 financial year. This deficit has to be financed in some way, and government bonds are the preferred vehicle (the other option is to raise taxes, which often proves somewhat unpopular with voters).

As the supply of bonds and debt increases, the theory is that investors will demand higher interest rates to carry that debt. Where yields rise, existing lenders suffer capital losses. Conversely as interest rates decline existing lenders enjoy capital gains.

Therefore the conclusion for all intents and purposes is that interest rate yields should rise in the future to take into account the increased supply of government debt. If this is the case, then there warrants sufficient evidence to engage in a trade to sell bonds short at current yields and buy then when the yield increases (price declines).

Naturally this is no foolproof get rich quick scheme, which is why personally and in my business I’d never undertake this trade. The reason is that US Treasury bonds are a “safe haven asset”, and investors flock to them during times of economic or political turmoil. This was evident in 2008 and the past week, when yields came down and bond investors made a profit, despite the underlying fundamentals. Hence I caution anyone who intends to make this trade, and highlight it in this article purely for interest purposes (pardon the pun).

There are several ways an investor can effectively gain exposure to this trend. The first is obviously to short bonds. However it’s somewhat difficult for the average investor to gain short exposure to bonds, so I’d suggest two alternates:

Short Bond ETFs: As described above, shorting an actual bond is complicated. The next best option is to short a bond ETF. When bond prices decline, the value of bond ETFs will also drop in value. There are many bond ETFs to choose from.

Buy Short Bond ETFs: There is another alternate way to take advantage of a decline in bond prices, by purchasing a short bond ETF. An ETF of this sort invests in short bonds, and works somewhat similarly to a mutual fund.