If you think a market is going to strengthen, you are a bull. If pessimism dominates your outlook, then Goldilocks might be visiting your house. A bull market in bond yields is a bear market in bond prices. You can therefore profitably invest in financial instruments or funds that increase in value when interest rates rise. You can also short-sell bonds by borrowing bond fund shares, selling them and replacing them later at what you hope are lower prices. In either case, you’ll profit from the current economic condition.
Price versus Yield
The annual yield of a bond is its yearly interest payments divided by its price. As prices go in one direction, yields must go in the other. For example, suppose you purchase a 10-year, $10,000 bond with an annual yield of 5 percent, the prevailing rate at the time of the purchase. After a while, prevailing bond rates might climb to 7 percent, in which case the value of your bond declines to $9,100. If you have an inkling that bond yields are about to rise, you could chart a conservative course by selling your bond and parking the proceeds in a money market account. You can also invest in alternatives that are more aggressive.
Play One -- Options on Interest Rates
Options exchanges, such as the Chicago Board Options Exchange, offer products tied directly to interest rates. For example, if you feel interest rates are going to rise, you can purchase call options on the TYX index, which ties to the yield of the 30-year bonds most recently auctioned by the U.S. Treasury. A call option can give the buyer the right to buy an underlying asset at a preset price -- the strike price -- on or before an expiration date. However, index calls are cash settled and do not involve purchase of an underlying asset. Rather, they are cash bets that pay off when the index rises above the strike price. From the CBOE’s example, you could purchase a three-month TYX call with a strike price of $62.50, representing an interest rate of 6.25 percent. The call might cost $150 but would grab a profit if the TYX index rises above $64 before expiration. If your call reaches $67.50, it is worth $500, netting you a cash profit of $350.
Play Two -- Shorting Bond Exchange-Traded Funds
You can capitalize on falling bond prices by shorting bond exchange-traded funds. As noted earlier, you profit by a short sale when you can repurchase replacement shares at a lower price. Bond ETFs are stock shares backed by a basket of bonds. You can borrow bond ETF shares from your broker and sell them on the stock exchange. You will eventually have to buy replacement ETF shares and return them to the lender. Your profit or loss is equal to the proceeds from selling the borrowed shares minus the purchase cost of the replacement shares. Shorting bond ETFs is much easier than trying to borrow and short individual bonds, and ETF shares are more liquid -- easier to sell -- than specific bonds. Alternatively, you might buy a put option on a bond ETF; the option will profit if bond prices fall. Puts resemble calls, except they allow you to sell rather than buy the underlying asset at the strike price -- a bearish strategy.
Play Three -- Ultrashort Bond ETFs
For the stouthearted, ultrashort bond ETFs can be your path to glory or a roller coaster to hell. These ETFs are inverse funds. Using futures and options, they provide a return opposite that of their target indexes. If bond prices fall, these ETFs rise. Additionally, they are geared to give you double or triple the inverse return. For example, an ultrashort ETF based on an index of 7- to 10-year Treasury notes will rise 2 percent for each 1 percent decline in the index. Ultrashort bond funds are volatile and have relatively high expense ratios, often in the vicinity of 1 percent. Study these carefully before investing; they can be a white-knuckle ride.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.