In an environment with potential for rate reduction, bonds can be a great way to hedge. Conversely, as the FED rate hike looms, the temptation to short bonds intensifies.
Since the housing market crash and with continued slow growth until now, the federal interest rates have been held at historic lows. Given this unprecedented economic environment, anticipation of hikes has increased. In the minutes of the FED meeting Wednesday (11/23/2016) attendees urged a rate hike, "to preserve credibility." Many see economic improvements such as a stronger housing market as signs that a hike at the next FED meeting, December 13th, is likely.
Imagine you sell a 10 year loan at 3% annual interest, and suddenly rates drop to 1%. Your original 3% loan will now fetch far more than the security's underlying principle. This is because individuals on the secondary market who want to lend their money will be keen to earn the larger interest amount over the term of that bond.
Hiking the rate will have an inverse effect to the situation described above. So how can smart investors behave accordingly? One possibility - Borrow (aka short sell) bonds or bond ETFs such as TLT, AGG, or MBB while these instruments still offer undesirable returns, in anticipation of a hike in the coming months. The idea being, such low rate vehicles could be purchased to cover the short at a discount once the cost to borrow is increased. In other words, holding loans for pennies on the dollar is about to become very cumbersome, in this authors opinion.
Alternatively, savvy options traders might buy puts in those same instruments listed above, in order to limit their downside risk while still gaining exposure to the bond market short outlook.
Caution should be advised in contemplating such a strategy, as this hike has been anticipated for some time, and as such bond markets may have already priced in this potential value drop to some extent, depending on how much the federal interest rate is adjusted. Additionally, though signs are strong that the hike is coming sooner rather than later, the FED may surprise and hold off until next year to begin throwing on the economic breaks, and raising rates.
In the long term, should the FED increase lending rates, bonds are likely to become more attractive especially for the novice investor, institutional entities, and pensioners that require a consistent cash flow.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in TLT, BOND, AGG over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.