Celebrating Short-Sellers

Just 13 trading sessions ago on April 17th, the yield on the German 10-year government bond, or bund, fell to less than 0.05 percent.

Given that a third of all non-US bonds issued worldwide had a negative yield, the question wasn’t whether the yield on bunds would go lower, but how far into negative territory they would go.  Unfortunately, I didn’t have the right tools to make a chart, so I’ve provided a link here.

Of course things could change from here, but in almost no time, the yield on the 10-year bund has shot up to 0.51 percent – a massive yield change in a short period of time.

It should be old news that when interest rates go up/down on bonds, the prices on those bonds fall/rise.  The longer the term, or duration, of a bond, the more the price is affected by the yield.

As it’s probably obvious from the flurry of articles that I’ve written on the topic of negative yields, I find this pretty fascinating.  Long into the future, when I’m an old-timer doddering around the office talking about the olden days, I think negative bond yields will be one of my big topics: ‘Young fella, I remember when you had to pay interest just to get your money back safely.’

One of the interesting aspects of negative bond yields that we were talking about yesterday is that you can get paid to short-sell them.  Now you may be trying to remember what short selling means, so here’s a quick summary:

If you think a security is going to go up, you simply buy that security.  If you think a security is going to fall in value, you have to do the opposite, or sell it.  The part that people struggle with is that you don’t have to own a security to sell it.

Instead, you borrow the security from someone who does own it in exchange for some interest and then sell it.  If the price drops as you hoped, then you can return the security that you borrowed along with that interest and you’ve made a little money.

For example, assume that ABC Corporation is trading for $100 and you think it’s going to fall dramatically.  You go to your broker, borrow $100 shares from someone who owns the stock, sell it in the market and wait for the bad news.  If you did this with 100 shares, you’d have $10,000 in your brokerage account as proceeds from the sale.

Let’s assume that you’re right and the stock falls to $50.  You can buy the stock for $5,000, return the shares to your broker along with $1 in interest in exchange for borrowing the stock.  You bought something for $5,000 that you sold for $10,000 – just not in the usual order.  But still, you’ve got $4,999 in your account when you had zero before.

Let’s say you get it wrong, though and the stock doubles.  You still have $10,000 in your account from the sale, but now the person you borrowed the stock from wants it back, but it’s going to cost you $20,000 to buy it back.  Now the trade has cost you $10,000 plus the interest you had to pay for the privilege of borrowing.

When you are short a security, you have to pay the interest and dividends to the person that bought it from you – after all, the owner is entitled to that payment.

Now, here’s the rub: if the security that you are borrowing has a negative yield, you actually get paid interest instead of having to pay it out.  If the negative yield is high enough, it will cover the amount of interest that you have to pay to borrow the security from the owner.

In short, you’ve got unlimited borrowing capacity that finances itself – what a deal!

Former bond king Bill Gross called German bunds ‘the short of a lifetime’ and so far, he’s right.  We don’t short securities, so this doesn’t affect us directly, but it’s a useful example of why we want short-sellers in the market.

Often times, particularly in the 2008 financial crisis, short-sellers were criticized for profiting from losses.  Then and now, I think they play an important role in the financial system: rooting out fraud in companies like Enron, providing liquidity, and now, helping put a zero bound on interest rates.

Rates can go lower and stay negative for long periods, but it’s a positive to have natural market forces helping the system stay somewhat closer to equilibrium.


PS – At the end of one of my articles about negative interest rates, I said that I was hoping to take out a mortgage where the bank pays me.  I was just kidding, but it turns out that in some European countries that’s a real issue.

Sometimes, mortgages are tied to other interest rates like LIBOR plus 0.25 percent.  Well, if LIBOR goes to -0.75 percent, that means that the rate on the mortgage is -0.50 percent so the bank has to pay the borrower.

As you might expect, banks didn’t think about that when drafting the agreements, but didn’t want to pay the borrowers either, so people are heading to court to resolve the problem.  What a world!