I want to suggest a bunch of caution against shorting bonds (or tips).
The 30yr yield is 3.5%, so you make −3.5% per year from that.
You earn the cash rate on the capital freed up from the shorts, which is 3.8% in interactive brokers.
If you’re right that the real interest rate will rise 2% over 20 years, and average duration is 20 years, then you make +40% over 20 years – roughly 2% per year.
If you buy an ETF, maybe you lose 0.4% in fees.
So you end up with a +1.9% expected return per year.
This would have a third of the volatility of stocks, so you could leverage it several times, but then you’d need to pay the margin cost of ~4%.
So it doesn’t seem like an amazing trade in terms of expected returns (if I’ve estimated this correctly.
It gets worse if you consider correlations – if we go into a recession, yields might fall 1-2%, which would mean you lose 20-40%, and you make those losses at the worst possible time – when everything else is going down.
In addition, a neutral portfolio is something like 50% equity, 20% real assets and 30% bonds, so that should be our prior, and then you’d want to make a bayesian update away from there based on your inside view.
In effect, in your portfolio optimizer, you could set the expected returns of long bonds to be say 1.5% rather than 3.5%. My guess is that would spit out having say 0-10% bonds rather than 30%, but not actively shorting them.
Tldr my guess is that most investors (if they believe the thesis) should just underweight bonds rather than actively short them.
I want to suggest a bunch of caution against shorting bonds (or tips).
The 30yr yield is 3.5%, so you make −3.5% per year from that.
You earn the cash rate on the capital freed up from the shorts, which is 3.8% in interactive brokers.
If you’re right that the real interest rate will rise 2% over 20 years, and average duration is 20 years, then you make +40% over 20 years – roughly 2% per year.
If you buy an ETF, maybe you lose 0.4% in fees.
So you end up with a +1.9% expected return per year.
I think the calculation you’ve done here is −3.5% + 3.8% + 2% − 0.4%
This doesn’t quite make sense. The first rate you are talking about is the yield on a 30y bond. The second rate (should be) the overnight repo. What you should actually look at is the average overnight repo over 30y. The 30y SOFR swap is ~2.9% which would be a more relevant comparison to your 30y.
A simpler way to think about all of this would be to have some number for losses on fees (“shorting fees” ie your repo costs + ETF fees if you execute via an ETF) and some number for return from being right (change in real rates * duration).
I would agree (roughly) with your calculations if this happens gradually over 20y. If the market is about to realise this overnight, then you wil make 40% overnight. This is what they are advocating for. (Maybe not overnight, but over a shorter time horizon than you are implying).
(Either way I agree with you that shorting bonds is a terrible strategy to implement just based on this post)
I’m really confused where any of those numbers have come from for using futures? (But yes, the expected return with low leverage is not spectacular for 2% move in rates).
I want to suggest a bunch of caution against shorting bonds (or tips).
The 30yr yield is 3.5%, so you make −3.5% per year from that.
You earn the cash rate on the capital freed up from the shorts, which is 3.8% in interactive brokers.
If you’re right that the real interest rate will rise 2% over 20 years, and average duration is 20 years, then you make +40% over 20 years – roughly 2% per year.
If you buy an ETF, maybe you lose 0.4% in fees.
So you end up with a +1.9% expected return per year.
This would have a third of the volatility of stocks, so you could leverage it several times, but then you’d need to pay the margin cost of ~4%.
So it doesn’t seem like an amazing trade in terms of expected returns (if I’ve estimated this correctly.
It gets worse if you consider correlations – if we go into a recession, yields might fall 1-2%, which would mean you lose 20-40%, and you make those losses at the worst possible time – when everything else is going down.
In addition, a neutral portfolio is something like 50% equity, 20% real assets and 30% bonds, so that should be our prior, and then you’d want to make a bayesian update away from there based on your inside view.
In effect, in your portfolio optimizer, you could set the expected returns of long bonds to be say 1.5% rather than 3.5%. My guess is that would spit out having say 0-10% bonds rather than 30%, but not actively shorting them.
Tldr my guess is that most investors (if they believe the thesis) should just underweight bonds rather than actively short them.
I’d be very keen to hear more comments on this.
I think the calculation you’ve done here is −3.5% + 3.8% + 2% − 0.4%
This doesn’t quite make sense. The first rate you are talking about is the yield on a 30y bond. The second rate (should be) the overnight repo. What you should actually look at is the average overnight repo over 30y. The 30y SOFR swap is ~2.9% which would be a more relevant comparison to your 30y.
A simpler way to think about all of this would be to have some number for losses on fees (“shorting fees” ie your repo costs + ETF fees if you execute via an ETF) and some number for return from being right (change in real rates * duration).
I would agree (roughly) with your calculations if this happens gradually over 20y. If the market is about to realise this overnight, then you wil make 40% overnight. This is what they are advocating for. (Maybe not overnight, but over a shorter time horizon than you are implying).
(Either way I agree with you that shorting bonds is a terrible strategy to implement just based on this post)
Thanks that makes sense.
So if you implemented this with a future, you’d end up with −3.5% + 2.9% + rerating return = −0.6% + rerating.
With a 2% p.a. re-rating return over 20 years, the expected return is +1.4%, minus any fees & trade management costs.
If it happens over only 5 years, then +7.4%.
I’m really confused where any of those numbers have come from for using futures? (But yes, the expected return with low leverage is not spectacular for 2% move in rates).