Time to Diversify in the Face of Interest Rate Risk?

Let’s talk about bonds—more specifically, shorting bonds. Frankly, I’m mystified why there’s not more discussion about how shorting bonds can offer investors potential diversification when interest rates rise.

I think we can all agree that the great Bond Bull that started pawing the ground more than three decades ago is dying. To pick a benchmark, rates on 10-year U.S. Treasuries have declined from a record 14.59% in 1982 to around 2.75% today, give or take a few basis points. Even if rates stay the same or go lower, the best that bonds can provide in that scenario is a safe haven for cash, but little income. If rates go higher—a much more likely scenario in the months ahead as the economy continues to recover—bondholders may suffer.

Higher rates aren’t all bad. Pension funds trying to find 8% returns to fund their liabilities would welcome them. However, rising rates wreak havoc on bond prices. As a general rule of thumb, a fund that has a duration of 4.5 years—in effect, a metric derived from how long it takes for a bond to mature—will lose 4.5% of its value for every 1% rise in rates. A rate rise of 2% would cause a 9% decline in the bond fund’s value. This hypothetical example simplifies a rather complex concept and ignores other factors that affect bond prices such as credit quality or coupon rate; nevertheless, duration is an important measure.

That brings me to long-short bond (also called long-short fixed income) funds. They are designed to potentially minimize interest rate risk if interest rates rise, but also to potentially generate returns if they don’t. As investment vehicles go, long-short fixed income funds fall in the category of “liquid alternatives,” combining the key attributes of both mutual funds and hedge funds. That is, they offer an efficient way to buy and sell shares on a daily basis like a mutual fund—that’s the “liquid” part—with the investment tool kit of a hedge fund—that’s the “alternative” part.

Shorting bonds is not something investors should try for themselves. To carry out the short element in a long-short fixed income strategy takes a manager in the most complex part of our industry. First, shorting is always risky—the upside is always limited, while the downside on an uncovered short is infinite.

Second, the process of directly shorting a bond is not easy. Since shorting a security typically means having to find someone to lend it to you, the process is made difficult when the underlying security is thinly traded. While the bond market is enormous and liquid, that doesn’t mean the market in a particular bond is deep—just ask anyone who has tried to find a buyer for a bond at the “market” price. Imagine how much harder it would be to find an owner willing to lend a specific bond for a short sale.