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Successfully shorting bonds requires a very careful analysis of prevailing market conditions in order to correctly identify bonds that are likely to underperform, and it requires careful timing so as to reap the greatest benefits from making this identification. A short position in bonds also requires careful attention to the interest rates attached to the bonds under consideration. The right financial instruments should also be selected to facilitate the short selling of bonds. In some cases, this will entail the actual short sale of bonds, while in others it will involve short selling bond-based exchange traded funds, or ETFs.
As with any short sale, shorting bonds is in essence a negative bet, a bet against the value of an asset. Any bond whose price is likely to fall, and on which the interest rate will therefore increase, is a good candidate for short selling. Careful market analysis can sometimes reveal corporations or nations whose debt will likely soon be under pressure or which will soon face additional obstacles to borrowing. Sovereign debt is often a good candidate for short sales, as these securities are widely held and usually actively traded and because information about the economic conditions that impact nations as a whole is widely available. Bond rating can sometimes be a useful indicator of bond quality, but this information is usually already priced into the market.
Interest rates are a crucial factor to consider when thinking about shorting bonds. When shorting stocks, an investor is only liable for the eventual rise or fall in the price of the stock that he has borrowed to short. When shorting a bond, however, an investor must plan to cover the ongoing interest produced by the bond, and pay that interest to the original bond owner. The role of interest in shorting bonds tends to favor short sales of bonds whose values are likely to collapse sooner rather than later. Long-term short sales of bonds can be very expensive propositions, as can shorting high-yield bonds.
A useful alternative approach to the direct short sale of bonds is the short sale of shares in ETFs based on bonds. Since ETFs can be bought and sold as stocks, the short sale of these securities is an easy way for investors to effectively short bonds without needing to enter into the somewhat more complicated arrangements needed to actually short bonds directly. This method of shorting bonds allows for good but not always perfect investment targeting. The sovereign debt of most nations can be accessed by trading in ETFs, but the debt of individual corporations or states is not always accessible, and investors who follow this approach may need to short a whole category of debt.
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