Shorting Mortgage Bonds: A Risky Bet On Interest Rates

Shorting a bond is a way to profit from a declining security by selling it without owning it. In the context of the housing market, shorting involves speculating that the price of houses will fall. This can be done by trading alternative assets such as real estate investment trusts (REITs) or shares in companies within the industry. While there is no direct way to short the housing market, investors can use derivative products such as CFDs and spread bets to open a short position. Shorting the housing market is essentially placing a bet against it, and if the market fails, the investor wins. This strategy played a significant role in the 2008 financial crisis, where banks bundled mortgage IOUs into bonds, leading to a vicious cycle of investment losses and contributing to the collapse of the economy.

Shorting the housing market

There is no direct way to short the housing market. Therefore, investors and traders will trade alternative assets such as real estate investment trusts (REITs) or shares in companies within the industry. REITs are companies that buy income-producing real estate. Shorting a REIT involves finding a broker willing to loan you the shares, then selling them at the market price. If the share price falls, you can buy them back at a lower price and return them to the broker, profiting from the difference.

Another way to short the housing market is by investing in exchange-traded funds (ETFs). These are instruments that track a basket of assets, such as a stock index, the shares of companies involved in the housing market, or REITs. By opening a position to sell an ETF, you are speculating that its price will decline. There are also ETFs specifically made for shorting purposes, known as inverse ETFs – the price of these assets rises as the underlying market falls in price.

Short-selling mortgage-backed securities

Short-selling is a way to profit from a declining security, such as a stock or a bond, by selling it without owning it. Investors expecting a bear market will often enter a short position by selling a borrowed security at the current market price, hoping to buy it back at a lower price. When it comes to bonds, investors are concerned with future bond yields, the determining factor of bond prices. As interest rates jump, bond prices tend to fall, and vice versa. Therefore, a person anticipating interest rate hikes might look to make a short sale.

Mortgage-backed securities (MBS) are investments that represent claims on the money generated by pools of mortgage loans. These securities are created by bundling together many mortgages and selling shares of the resulting pool to investors. This process is known as securitization. MBSs are asset-backed securities formed by pooling together mortgages. The investor who buys an MBS is essentially lending money to homebuyers. Bonds securitizing mortgages are usually treated as a separate class, termed residential; another class is commercial, depending on whether the underlying asset is mortgages owned by borrowers or assets for commercial purposes.

Short-selling MBSs would involve the same process as short-selling any other security. An investor would borrow MBSs and sell them on the market, hoping to buy them back at a lower price. However, it is important to note that short-selling can be riskier than simply shorting stocks. It can be difficult to predict if and when a market crash will happen, making it challenging to know when to open a short position. Many traders and investors perform technical and fundamental analyses to identify possible turning points in the market.

Additionally, MBSs can be complex instruments, and it is crucial to understand how they work and the associated risks. For example, MBS spreads—the difference between interest rates sellers must pay investors and 10-year Treasurys—can impact the compensation investors expect. MBSs may also carry prepayment risk, where the investor receives money from mortgage prepayments but then needs to reinvest it at a lower interest rate.

Shorting mortgage bonds with credit default swaps

Shorting a mortgage bond involves taking a bet that the price of a bond will go lower. This can be done by borrowing a bond and selling it, with the hope of buying it back at a lower price.

In the case of speculation, investors are betting on the credit quality of the reference entity. Credit default swaps are sold to investors to mitigate the risks of underlying asset defaults. They were highly used in the past to reduce the risks of investing in mortgage-backed securities and fixed-income products, which contributed to the financial crisis of 2007-2008.

In the movie The Big Short, the characters short mortgage bonds by buying credit default swaps. This is an insurance contract that pays out if the CDO it insures defaults on a certain proportion of its underlying mortgages.

Shorting the housing market with real estate investment trusts

Shorting the housing market is the practice of taking a position to sell an asset with the view that real estate will fall in value. This enables traders to hedge their exposure to the market and profit from the decline. Since there is no way to directly short the housing market, investors and traders will trade alternative assets such as real estate investment trusts (REITs) or shares in companies within the industry.

REITs are companies that buy income-producing real estate assets. They are classified as publicly traded companies, meaning real estate investors can either buy and sell shares of a REIT itself or invest in an exchange-traded fund (ETF).

There are also ETFs specifically made for shorting purposes, known as inverse ETFs – the price of these assets rises as the underlying market falls in price. If you wanted to short-sell the housing market, you would do so by going long or ‘buying’ an inverse ETF, as the tracker is inherently short-selling the market. This means that any bearish investors and traders can immediately get exposure to a declining housing market.

Short-selling in the real estate market works similarly to short-selling stocks. A short seller borrows stocks from a broker in order to sell them, and buys them back after prices fall. Similarly, in the real estate market, investors can borrow REITs or real estate ETFs and sell them in the market, hoping to buy them back at a lower price.

It is important to note that shorting the housing market can be risky and complex. It is difficult to predict if and when a market crash will happen, which can make knowing when to open a short position difficult. As such, it is important to perform thorough research and analysis before entering into any short-selling transactions.

Inverse bond ETFs

Another example of an inverse bond ETF is the ProShares Short High Yield (ARCA: SJB), which seeks the inverse of the daily price performance of the Markit iBoxx $ Liquid High Yield Index, also known as "junk bonds." SJB's expense ratio is 0.95%, and the fund held around $273 million in assets as of April 2023. Inverse/Short High Yield Bond ETFs seek to provide the opposite daily or monthly return of high-yield or junk bond prices. These ETFs use futures contracts to gain exposure and provide a synthetic short position in junk bonds.

Overall, inverse bond ETFs can be a useful tool for investors looking to profit from a decline in bond prices caused by rising interest rates. However, it is important to carefully consider the underlying bond indices, liquidity, expense ratios, and other risks associated with these complex financial products.

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