I enjoy following financial markets and implementing investment ideas in which I am confident will perform as expected. Recently, I have become bearish on bond prices. I am bearish on bond prices because interest rates are low and are expected to begin rising in mid-2015. Bond yields will rise as interest rates rise, which also means bond prices fall (i.e. bond yields and prices have an inverse relationship). As a result, I am thinking of ways that I can trade on this perspective. According to the Wall Street Journal, “If you expect lower returns from an asset class than it has provided historically, such as lower returns from bonds, then the math, and probably logic, would tell you to lighten up on bonds”. In order to lighten up on bonds, I would need to sell any bonds that I own. However, I do not own any bonds so I have considered shorting bonds instead through an exchange-traded fund (ETF) such as ProShares UltraShort Lehman 20+ Year Treasury.
Although this investment logic might be right, I have made a mistake by not having any exposure to bonds in the first place. According to the Wall Street Journal, “To be clear, the solution is not to eliminate bonds from your portfolio because they will still provide the very important diversifying benefit of cushioning your portfolio if the market should pull back”. Diversification is an important part of asset allocation to protect against the random walk of financial markets. For example, eliminating my exposure to bonds and only being exposed to stocks puts me at extreme risk of loss if the stock market declines. According to Burton Malkiel, “But note that even though correlations between markets have risen, they are still far from perfectly correlated, and broad diversification will still tend to reduce the volatility of a portfolio” (212). With my portfolio consisting of 100% large cap United States equities, I am subject to a significant amount of volatility. By adding some exposure to bonds, I might be able to reduce the volatility of my portfolio.
Despite my bearish view on bond prices, there are still ways for me to invest in bonds and gain benefits from diversification. My bearish view on bonds is due to interest-rate risk. In this case, increasing interest rates will push down bond prices. If I wanted to still purchase bonds in order to gain some exposure, then I could purchase bonds with short maturities. The shorter the maturity of a bond, the less it is subject to interest rate risk. This can be seen in the yield curve, which has a positive slope as maturities increase. Although the prices short term bonds will still fall as rates rise, there will still be benefits from diversification.
In addition to interest-rate risk, bonds are also subject to default risk that arises when a debtor fails to pay back the creditor. If a debtor is thought to have a high risk of default, then that debtor is charged a default risk premium and charged a higher rate of interest. If I wanted to still purchase bonds in order to gain some exposure, then I could purchase bonds with a higher risk of default. This is another way to still own bonds and decrease interest rate risk. In addition, there will be benefits from diversification.