This Bond Strategy Has Been Unloved For Decades. Now, It’s Making a Comeback.
Owning fixed income securities has worked well for so long in a falling-rate environment that people have almost found “shorting bonds scary,” argues Kathryn Kaminski of AlphaSimplex.
Shorting bonds hasn’t been a popular trading strategy for 40 years. That was a savvy decision, given the steady decline in interest rates, which makes bonds more valuable. In that scenario, it’s generally better to own bonds than to bet their prices will fall.
But a rising-rate environment may change everything investors have learned over the last few decades. In 2022, the central bank raised rates aggressively to curb high inflation, a move that caused significant losses for fixed income investors with long positions. Short sellers, however, might benefit from the rate-hiking cycle as bond prices drop, according to AlphaSimplex, a $9.4 billion investment management affiliate of Natixis. MIT Professor Andrew Lo founded AlphaSimplex in 1999 and was a senior advisor until December 2021.
In a new paper, researchers at AlphaSimplex set out the evidence for a successful bond shorting strategy.
They studied the performance of long and short positions in trend-following strategies, one of the few that consistently shorts bonds, between 1970 and 2022. Trend following tends to go long when prices are moving upward and go short otherwise; the strategy has acted as an indicator of when investors should be long or short bonds. Based on the peak and trough of interest rates, the researchers divided the time frame into three segments: 1970-1982 (rising rates), 1982-2020 (falling rates), and 2021-2022 (rising rates). They found long positions in the trend-following strategy delivered better returns when interest rates fell, while short positions earned more when interest rates rose.
In the first half of 2022, for example, the return for being net short — meaning the value of short positions is greater than that of long positions — on fixed income was “highly positive.” In contrast, the average return of short positions in fixed income was negative from 1990 to 2021, a period when rates were falling.
The researchers also found that trend-following signals have been consistent with interest rate movements. From 1982 to 2021, for example, investors had a net long exposure to fixed income 71 percent of the time. From 1970 to 1982, investors were net short in fixed income 64 percent of the time, according to the research.
“During the last 40 years, trend signals are almost always long, and they tend to do better in performance when long,” Kathryn Kaminski, chief research strategist at AlphaSimplex, told II in an email. The outperformance of long positions lasted for such an extended period of time that investors “find shorting bonds scary as it usually didn’t work.” But the data from 1970 to 1982 proved that shorting bonds may work well in a rising-rate environment, she added.
Rising interest rates are not the only factor driving the outperformance of short positions on bonds. An inverted yield curve, where short-term bonds yield more than long-term ones, also affects the returns of short sellers. In periods when there was an inverted yield curve between 1970 to 1982, the average daily return was about 7 basis points for short sellers and a 6 basis point loss for those who took long positions, according to the paper. The researchers noted that the current yield curve is largely flat but has slightly inverted for brief periods — a signal that shorting bonds may bring good returns.
“When we are in a rising rate environment, it can be preferable to take short positions—unless we see higher rates and a steep yield curve, when it may be preferable to be long despite a rising rate environment,” the researchers concluded.