Here is a video covering the ins and outs of shorting bonds. The longer text version is below the video.
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It is very difficult to make money shorting bonds. The reason why is because you have to cover two costs before you make any money on your short position:
- When shorting a bond or a stock, you have to borrow the security and pay interest on that loan.
- You also have to pay the interest on the bond to the bondholder who you borrowed the bond from.
Unless you are trading very large amounts of money, you are going to pay in the neighborhood of 7% in margin costs for borrowing the bond. Assuming the bond has a 5% coupon, and you hold the short position for 1 year, then the bond has to fall in value by 12% before you make any money. Most bonds are less volatile than stocks so 12% would be a very large move.
So are you out of luck if you want to short a bond? No. This can be accomplished with bond ETFs. You can learn more about this here.
Don’t know what shorting is?
Normally when people think about investing, they think about buying a specific investment, and profiting from the increase in its value, interest, or dividend payments made by the investment (or some combination of these). What many investors do not know however, is that through a technique known as “short selling,” you can also profit when a security falls in value.
What is Short Selling?
When a trader sells a security short, what they are technically doing is borrowing the security from another trader, and selling the borrowed security. If the price of the borrowed security falls in value like the trader is anticipating, then he can go into the market and buy the security back after the price has fallen for a price that is less than he received when he sold it. He can then return the security to the original owner, and pocket the difference between the price where he sold it, and the price where he bought it back.
Microsoft stock is trading at $50 a share and you think it should be valued at closer to $40 a share. You therefore sell 100 Shares of Microsoft short at $50 per share. Your broker finds 100 shares of Microsoft for you to borrow to execute the short sale, and your account is credited with $5000 ($50 X 100 Shares). A month later, Microsoft falls to $40 like you expected, and you close your short trade by buying the 100 shares back at $40. (a total cost to you of $4000).
As you are able to return the same 100 shares that you borrowed and sold for $5000, for a price of $4000, you have made a profit (minus any transaction fees) of $1000 on this trade.
With today’s electronic trading platforms, executing a short trade is as simple as buying or “going long” a security. From a practical standpoint however, there are some additional factors the short seller must consider:
- When you short a bond or stock you do so on margin, which means you have to pay interest on the money you use in the short trade. Margin rates currently average around 7% at the average broker.
- You are responsible for making any dividend or interest payments the security makes while you are holding it. So for example if you short a bond, then you have to pay any interest which accrues while you are short the bond.