Low-Interest Environment: Short Bonds for Cheap Capital?
In the latest episode of the podcast Masters in Business (Spotify, Bloomberg), Bill Miller makes a thought-provoking comment. When pressed on the low-interest environment, he suggested a strategy of selling treasuries short and investing the proceeds in the S&P 500.
This made me think about mortgages. A mortgage loan is healthy debt. A mortgage is predictable. The monthly payments are known. The total cost is known. A mortgage is accessible. It is a practical way to access low-cost capital, especially given the tax benefits. Given these characteristics, maintaining a balance on mortgage loans — and finding better use for excess cash elsewhere — seems to be a reasonable strategy.
Treasuries have many of the same characteristics.
Is there an opportunity to access cheap capital by shorting treasuries?
All-time lows
The chart below shows the history of the 10-year treasury yield dating back to 1962. After a rapid rise to a peak in the 1980’s, the yield has been on a secular decline, hitting all-time lows.
The 10-year treasury yields 0.64%.
Shorter-term treasuries yield even lower rates, with the 1-year, 3-year, and 5-year treasuries yielding 0.14%, 0.18%, and 0.29%, respectively.
Treasuries vs. equities
Stocks and bonds are two of the most widely used and accessible asset classes. Comparing their yields provides a valuable perspective.
The S&P 500 currently yields 1.85%, almost 3 times the yield on the 10-year treasury.
This is a rare phenomena. Dating back to 1970, the following chart shows the difference between the S&P 500 dividend yield and the 10-year treasury yield. This had never occurred before the global financial crisis.
Focusing in on the most recent decade, the following graph amplifies the recent divergence.
The current situation appears to be stretched far beyond the natural mean.
Cost of capital
Given the low rates, there may be an opportunity to access to cheap capital, significantly below the cost of alternatives.
A margin loan is a common way to access capital. Depending on the broker, margin rates vary from attractive to wildly expensive. Margin rates for the popular brokerage firm Charles Schwab range between 6.575%-8.325%.
Interactive Brokers provides more competitive rates, 2.6% for IBKR Lite accounts and 0.75–1.6% for IBKR Pro accounts.
Although these margin loans are nearly guaranteed, being backed by the assets, the rates are significantly above the benchmark.
Treasury yields are also significantly lower than the cost of a mortgage loan. Recently hitting all-time lows, mortgage rates are hovering around 2.98%. In direct comparison, the 30-year treasury yields less than half at a meager 1.33%.
In a short sale, the yield on the instrument would become the cost.
Shorting treasury bonds is effectively a way of borrowing money at cheaper rates. Moving along the yield curve, an investor has various choices of maturities with costs below 1%.
Shorting treasuries
Investors typically bet against stocks or bonds because they believe the underlying asset will decline in price. There are various methods to build a position against treasuries or bonds. Some instruments, such as put options and futures, must be purchased for a premium. They require capital upfront and only benefit in the case of a decline in value of the underlying asset.
Different than put options or future contracts, a short sale transaction allows an investor to borrow shares and sell them. The proceeds of the sale are deposited in the investor’s account and available for use.
This strategy does not require — nor particularly expect — a decline in value. Instead of betting against the underlying asset, an investor can accept the known and predictable low costs of the underlying treasuries.
Unfortunately, treasuries can not be directly sold short. There are, however, many bond and treasury ETFs available, tracking various benchmarks.
iShares’ SHY ETF is one example.
The iShares 1–3 Year Treasury Bond ETF seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities between one and three years.
With a 0.16% average yield to maturity and effective duration of 1.85 years, SHY seems to be a suitable candidate.
Risks
Bonds, including treasuries, operate on a fixed schedule. Holding until maturity leverages this predictability and eliminates some risk.
The market, however, is constantly taking into account any changes to the environment, repricing bonds with every trade. The market price of the a bond is likely to vary up until maturity.
Given that investors are unable to directly sell treasuries short and that ETFs typically bring in newly issued bonds resulting in rolling maturities, investors must consider potential price variation and any associated downside risk.
What if the market moves in the opposite direction, stretching to even further extremes? What is the downside risk?
A short sale can technically have unlimited cost, as the underlying asset can increase in price indefinitely.
Fortunately, short-term bonds exhibit low volatility.
The chart below shows the price of SHY going back to the early 2000’s. Although the chart appears volatile, the difference from the lows in 2006 and the highs in 2020 is under a meager 9%.
An investor who had sold short 100 shares of SHY at the lows of 2006 for roughly $7,940, would owe roughly $8,650 at the highs of 2020. In this worst-case scenario, the average cost per year over these 14 years would have been roughly $50, or 0.65%. This cost may also have tax benefits, offsetting capital gains or claimed as a capital loss.
The past is not necessarily indicative of the future. While the market may be stretched in a particular direction — near-zero rates today — and over time is likely to revert to the mean, nothing is certain. Market trends may continue for long periods of time.
It is worth noting that the above time period exhibited dramatic change, beginning from the peak leading up to the global financial crisis and ending in the coronavirus pandemic. During this change, SHY moved under 9%. This volatility is remarkably low.
Similarly worth noting is the opportunity of the instrument moving in the opposite direction. If the price of SHY were to decline over time, this capital would not only be free capital, but would actually result in a profit.
If the proceeds from the short sale of bonds are used to invest in equities, the is another potential risk: the correlation between bonds and equities. Bonds, typically seen as a safe haven, may increase in price as equities sell off. While this is not always the case, this action would decrease the value of both the short sale of treasuries as well as the long position in equities. The slow-moving nature and low-volatility of short-term treasuries should allow sufficient time for any necessary adjustments.
Closing
The proposed idea of short selling bonds for cheap access to capital does not necessarily seek to profit from a decline in value. Rather, the key idea is to expand access to cheap and predictable capital for better use.
The relationship between treasury yields and market dividend yields is bound to revert to the mean over the long-term.
For particular investors, a strategy of selling treasuries short and investing in favorable companies may be an attractive way to build wealth over a sufficiently long time horizon.
