betting on rates going down using bonds

Question

There is a strategy that I am thinking of and would love to know about downsides: people buy/sell bonds to have a guaranteed return if held to maturity. But they also buy to take a directional view on rates moves? Assume I want to bet on rates go down a year from now, so I buy a 10y bond today, then a year from now if I am right then if the rates went down, my bond appreciated more than it would otherwise and I would sell it and realize the profit. Yes I did not realize the book yield over 10 years but I got a good return on the price. What would I do with the money once sold bond? I would not reinvest it at lower rates, I would start looking for assets generating higher yield a year from now. At least for that year I would have generated higher yield than what I bough this at. What is wrong with this strategy?

Answer 1

What you described is, indeed, the essence of what a simple bond-shorting strategy would look like. (As for what follows, normal caveats apply that this shouldn't be construed as investment advice, and it is not making a formal trading recommendation.)

Let's just recap some basics to be on the same page before covering the rest of your question. Because interest rates are directly related to asset prices, a bond with a fixed-rate coupon will invariably decline in value when market interest rates rise. To put some numbers around it, let's consider a hypothetical risk-less bond with a face value of $1,000, one year remaining to maturity, and a fixed annual coupon of 5.125%. Before today's Fed meeting, it might have been trading at par (100 cents on the dollar), but after the FOMC announced it would be increasing its Fed Funds target range by 25 basis points from 5.00-5.25% to 5.25-5.00%, its value would be expected to decline. With the new mid-point rate increasing from 5.125% to 5.375%, the intrinsic value of the interest cashflows from our bond are now lower (why receive $5.125/$100 of value when a new bond might pay you $5.375 on the same amount?). As such, the value of our bond post-Fed meeting will have dropped from $1,000.00 to $9,976.28. If I lost you on the math, google "bond math" or try this link here (https://larkresearch.com/fixed-income-index/bond-math-basics/).

Now, let's tackle the rest of your question. While some do invest in bonds intending to hold them to maturity, many do not. The way they make money is akin to how one might make money on a stock: collect interest payments (much like dividends) and then realize a profit by selling it later at a higher price, whether that's because rates have decreased or the issuer's creditworthiness has improved, causing the bond to appreciate. Others may engage in short selling seeking either to profit from higher rates or from expected deterioration in the issuer's credit profile or prospects.

As for downsides to the strategy you suggested, they are similar to if you were to short a stock. First you would have to borrow the underlying security through your broker, then pay the trade fee (if any) to sell it and again when you repurchase it. All the while, you would have to pay for the cost of the borrowed security (it has to come from somewhere) and potentially post collateral (thereby incurring an opportunity cost on foregone interest or higher returns elsewhere). The other downside is interest-rate risk: as I laid out above, asset prices are inversely related to interest rates, and they become even more sensitive to changes in rates the longer their maturities are (this concept is called duration).

If your aim is primarily to profit from falling interest rates (i.e., you want to be short rates), there are better investment products directly tailored to this sort of trading strategy, namely interest-rate derivatives. Among those to consider (and simplest to understand) would be interest-rate futures, which by selling, could help you to create a short-rates position. Alternatively, you could use a mix of put/call options, which might minimize your downside risk if your directional bet on interest rates proved wrong. In both cases, you could likely achieve the same pay-off as the bond trade you initially proposed but much more efficiently, as your cost of collateral would be much lower (this is because you're not directly transacting in the bond, which has a much larger $1,000 face value, whereas the derivative contracts would each be worth a fraction of this while offering the same notional exposure of the bond).

Hopefully this is detailed enough to answer your question but not so elaborate to cause you to get lost in the details.