How to bet against government bonds

If the government bond bubble is about to burst how can investors cash in?

A number of leading fund managers believe a dangerous bubble has formed in government bonds in the UK and US. This has whetted the appetite of bold investors who wonder if they can make money betting that the price of government bonds, known as gilts in this country, will fall.

The classic way of making money from correctly forecasting that something will fall in price called shorting. Traditionally, shorting - the practice of borrowing an asset in order to sell it for a profit when the price falls - has been the preserve of wealthy or institutional investors, not something that most private investors should consider. This is no longer necessarily the case, but, as we explain, it remains a high risk strategy.

The case against bonds

Bonds are IOUs issued by governments and companies when they wish to borrow money from investors. Bonds from governments go by different names: gilts in the UK, treasuries in the US and bunds in Germany, for example. Because bonds pay a fixed level of interest (or coupon, the amount depending on the credit worthiness of the issuer) they can be seen as an attractive defensive asset to hold in times of uncertainty or recession, when shares in companies can do badly.

The problem is that government bond prices have soared not just because of investor fears of a slip back into recession (the infamous 'double dip'), although that has been a factor. The bigger factor has been both the UK and the US governments spending huge sums buying back gilts and treasuries as a way of pumping money into their ailing economies (the 'quantitative easing' you often hear about). This has artificially inflated the price of government bonds, although to what extent is unclear.

Last week yields (the amount of interest paid as a proportion of the price) of UK and US government bonds fell to an all-time low of around 3% as the central banks on both sides of the Atlantic hinted that a second wave of QE (or bond buying) might be needed to tide over their economies.

This has prompted several prominent fund managers to argue that at some point QE will either be stopped or markets will become scared at the level of UK and US expenditure (or indebtedness). Either way the price of government bonds will collapse.

Professionals with negative views include William Littlewood (pictured), manager of the Artemis Strategic Assets fund which has the largest short position on government bonds since it launched. Philip Gibbs, manager of the Jupiter Absolute Return fund, said that investors will steer clear of government bonds if there is a slow down which will ensure a significant drop from their current highs. However, Ian Spreadbury manager of the Fidelity Strategic Bond fund, cautioned now is not the time to bet against bonds. 

What are your options?

Pure short selling is an expensive and bureaucratic process and tends only to be done by professionals handling large sums of money. However, there are a few ways of replicating short selling without physically borrowing and selling assets. These are still high risk and investors have to decide if they want to try it themselves or invest their money with a fund manager who shares their views.

1) Exchange traded fund (ETF)

The recently launched db x-trackers uk gilts short daily exchange traded fund (ETF) moves in the opposite direction to an index which tracks UK government bonds. So, if you think that gilts will fall, perhaps as a result of an expectation that interest rates will rise and make the fixed coupon from government bonds look unattractive, you would buy this ETF. If gilts do fall, its value will rise.

Manooj Mistry, UK head of db x-trackers, said that this was the only short bond ETF currently available on the London Stock Exchange. Only £5 million has been invested so far. 'When we see upward interest rate movements we will see inflows coming into this ETF,' he said.

Private investors can buy this ETF from execution-only brokers but Mistry warned it was specifically aimed at sophisticated investors who like to day trade when there is a clear trend. He said it was not for inexperienced investors as compounded returns meant an investor's money could be at risk if left in the fund for more than a day.