Learn How to Bet Against the Bond Market
There is no shortage of ways to invest in bonds – including mutual funds, exchange-traded fund, and individual bonds – but how does one go about betting against the bond market? It’s a question many investors are asking given all of the talks about a “bubble” in the bond market.
There are two different ways investors can go about this, but be careful: the occasions when bonds fall in price for an extended period have been few and far between in the past 30-plus years. Betting against the market, therefore, requires a tolerance for risk, the ability to absorb a loss, and – perhaps most important – outstanding timing.
Inverse Bond ETFs
With that said, the easiest way for individual investors to position for a downturn in bond prices is by using “inverse ETFs,” or exchange-traded funds that take short positions in bonds. Inverse ETFs rise in price when bond prices fall, and a decline in value when bond prices rise. (A “short position” is when an investor sells a security her or she does not own, hoping to buy it back later at a lower price and thereby pocket the difference. In other words, it’s the technical term for “betting against”).
The current crop of inverse ETFs provides investors with the ability to position for a downturn in U.S. Treasuries, Treasury Inflation-Protected Securities (TIPS), corporate bonds, high-yield bonds, and even Japanese government bonds. In addition, investors can choose ETFs that will rise two or three times the inverse of the daily performance of certain bond market segments. For instance, if the underlying investment fell 1% in a given day, the two-times inverse ETF would rise 2%.
While these funds can provide short-term traders with opportunities, over time they tend to deliver performance far from their stated two- or three-times objective. A quick example: in a single day, an inverse Treasury ETF might lose 2% if the market rises 1%.
Over a month, the return might be -6% (not -4%) on a 2% loss for the market. In a year, an investor may see a -26% (not -20%) loss in a 10% downturn in the market. This is only a hypothetical, but it illustrates the divergence that can occur over time. This is the most important reason why the leveraged inverse funds shouldn’t be considered long-term investments. In short, be wary: these funds are high-risk in nature, and losses can mount quickly if you bet wrong.
Investors also have the option of investing in mutual funds that move inversely to the bond market, such as Guggenheim Inverse Government Long Bond Strategy (ticker: RYAQX) or ProFunds Rising Rates Opportunity ProFund (RRPIX). While both funds accomplish the same goal as the ETFs mentioned above, using a mutual fund instead of an ETF deprives the investors of being able to buy or sell the fund at any point during the trading day. Instead, transactions are only allowed once a day at a set, closing prices.
The two funds also carry hefty expense ratios (1.74% and 1.65%, respectively) making them more expensive than the ETF alternatives.
Selling ETFs Short
Investors whose brokerage accounts allow them to use margin can also conduct their own short sales using ETFs that track the bond market. In a short sale, an investor borrows shares of a stock or ETF that he or she doesn’t already own, and then sells the borrowed shares with the intention of buying them back at a later date.
If the shares fall in price, the investor can buy them back in at a lower price, thereby pocketing the difference. If the shares rise, the investor must buy them back in at a higher price than that he or she originally sold them, incurring a loss. By selling a fund short, the investor can generate returns that are the opposite of the performance of the ETF.
The benefit of doing a short-sale with a long fund, rather than simply buying an inverse ETF, is that the investors realized return will track more closely to the actual inverse performance of the underlying investment. (Again, inverse ETFs only deliver the expected return in single calendar days; over longer periods their returns deviate significantly from the result an investor might anticipate based on the fund’s objective).
Futures and Options
This is the realm of the most sophisticated investors and those with the greatest ability to absorb a loss. For those who hold an account with a commodity futures broker, it’s possible to trade futures contracts on Treasury bonds and notes of varying maturities. As with a stock or an ETF, an investor can sell a bond contract short in the hopes that its price will fall. The risks are substantial since small moves in the underlying security are magnified significantly in the movement of the related futures contract.
It’s also possible for individual investors to buy options contracts– or more specifically, bearish puts – on bond ETFs that have options available. Options trade on the major bond ETFs, such as those that in Treasuries, corporate, and high yield bonds, so there is a way to use options to play the direction of all of the important segments of the market.
Keep in mind, however: options require investors to be correct not just in the direction of the underlying security, but also in the timing in which the move takes place. Options are also extremely risky, and they can – and do – go to zero and saddle unfortunate traders with 100% losses. Suffice it to say, this is the “deep end of the pool,” and not an area in which novice investors should try to make money.
Hedging Your Portfolio
Betting against the market is unlikely to work over the long term, but it can provide investors with a way to “hedge” their portfolios – or in other words, to protect against short-term losses. For example, someone with a $100,000 bond portfolio could take a short-term, $50,000 position in inverse ETFs – or other investments that move in the opposite direction of the market – to limit the impact of a market downturn.
The problem, of course, is that if the investor is wrong and the market does not-in-fact go down, the hedge itself loses money and takes away from the long-term wealth accumulation that the investor was trying to accomplish in the first place. Again, this is the type of move that only the most sophisticated investor would consider.
The Bottom Line
There’s no shortage of ways that an investor can attempt to profit from a downturn in the bond market, and many veteran investors do indeed use these techniques profitably. But for the majority of investors, the road to wealth is well-known: diversify, stay focused on your long-term goals, and stay away from high-risk strategies. If you are indeed considering a way to profit from market weakness, be sure you understand the risks of such a move.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Be sure to consult investment and tax professionals before you invest.