How to Short Bonds – A Guide

Bonds are primarily used for income generation, given their fixed structure and immutable nature. However, bond prices are impacted by various market factors, and are tradeable on the secondary market. 

The existence of the secondary bond market – and financial derivatives like CFDs – paves the way for investors to apply short selling strategies on the bond markets, potentially reaping returns during bond market downturns.

In this article, we will explore how to short bonds, along with an explanation of what bonds are and how the bond market works. 

What are bonds?

Bonds are a class of tradable securities based on debt. They are used by organisations such as governments, municipalities and corporations to raise funds for their various activities. 

In simple terms, bonds are loans that have a predetermined maturity date and fixed interest payments. 

The issuer of the bond (the borrower) promises to repay the loan (represented by the face value of the bond) to the bondholder (the lender) on the day the bond matures. 

The bondholder is also entitled to a fixed interest payment per year, which is paid out at specified intervals – commonly half-yearly. 

What types of bonds are there? ^[1] 

There are multiple types of bonds, and they may be classified as follows. 

Government or sovereign bonds

These are bonds issued and backed by governments of various countries. Usually regarded as the safest types of bonds with lowest risk of defaults, although not all government bonds are equal in quality.

Among the most popular government bonds are Treasuries, issued and backed by the U.S. government. Investors may choose from 

• Treasury bonds, with long-term tenures of 20 or 30 years
• Treasury notes, with short to medium tenures of 2, 3, 5, 7 or 10 years, and
• Treasury bills, which have maturity of one year or less. Treasury bills also do not pay out interest, but are instead sold at a discount to the face value. 

Municipal bonds

Municipal bonds are issued by local government or authorities such as states, cities, special-purpose districts, publicly owned airports and seaports, and other government-owned entities. They are issued when such organisations are seeking funds to pursue various projects. 

One advantage of municipal bonds is their tax-exempt or tax-advantaged status, depending on the legal framework governing the territories of the bond issuers. 

Corporate bonds

Bonds issued by companies and corporate entities are known as corporate bonds. These are issued mainly to help fund operations, such as expansions, or to increase manufacturing capacity. 

Corporate bonds may be classified into two types, depending on their quality. The first is “investment grade” bonds, which are evaluated by rating agencies such as Moody’s to have a low risk of default. This usually means that the companies issuing investment grade bonds have a proven track record and strong fundamentals. 

The second type is “junk bonds”, or “high-yield bonds”. These are corporate bonds that rating agencies regard as having a higher risk of default, due to weakness or issues in the bond issuer. To make up for the higher risk of default, junk bonds offer a higher interest rate to attract investors with higher risk appetites. 

Understanding the bond market ^[2]

The bond market may be further split into two levels – the primary market and the secondary market.

In the primary market, bonds are sold to investors directly by the bond issuer. The primary market holds “new issue” bonds that have not been held by other investors before. 

The secondary market is where previously issued bonds are bought and sold. Here, transactions take place between different investors, usually with an online brokerage as intermediary between the two parties. 

What is short selling? ^[3]

Short selling (aka “shorting”, or “going short”) is a trading strategy that allows investors to potentially profit during a market downturn. By going short on a position, an investor reaps a profit when the price of the underlying asset goes down.

This is opposite to going long on an asset or security, which furnishes a profit when the price goes up. 

Short selling is a little more complicated than going long. Instead of buying a security at a low price and selling it for a higher price – pocketing the difference as profit –, shorting involves selling borrowed shares of the security at its current price. 

When the price drops to a certain level, the short seller buys back the security from the market at the lower price to repay what was borrowed, pocketing the difference as profit.

Can you short bonds?

The simple answer is yes, you can short bonds. However, investors may not borrow a bond to make a short trade, and return the bond once the trade is complete. 

Instead, investors wishing to execute short-selling strategies in the bond markets may do so via derivatives such as contracts-for-differences (CFDs).

How to short bonds – two ways ^[4]

Bond Contracts-for-Difference (CFDs)

Bond CFDs offer trading opportunities on bond prices without requiring ownership of the underlying bonds. This allows investors to potentially profit if bond prices move in the direction they predicted (and conversely, incur losses if prices move against their predictions) – all without the need to hold the bonds themselves.

Significantly, CFDs enable investors to take a short position, allowing them to bet against the bond market without requiring ownership of the bond. When an investor shorts bond CFDs, they are speculating that the price of the underlying bond will decrease, potentially earning higher returns as the price continues to decline.

Inverse bond ETFs

Another way to short bonds is to invest in inverse bond ETFs. 

As their name suggests, inverse bond ETFs generate a positive return for every negative return in the underlying, which in this case is the bond market. In other words, the prices of inverse bond ETFs move in the opposite direction to bond prices.

Hence, another way to short the bond market is to go long on an inverse bond ETF; doing so will furnish gains during a bond market downturn.

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