If you think bonds are going to fall – make a trade.

We have advocated a long term, diversified approach as the investing methodology that will produce the best results for the majority of your portfolio for a long time. However, mixing some shorter term positions, options strategies and even a few speculative bets into your portfolio can often have the affect of improving your overall returns and reducing portfolio volatility.

The current bond market environment in California is the perfect example of why investors need to be thinking about investing strategies beyond a generic buy-and-hold methodology.

The economy has been in a tug-of-war between the threats and serious risks of deflation and the disadvantages of high inflation. The extraordinary deficits planned by the U.S. and other State Governments and the massive intervention in the U.S. treasuries market by the Fed has made the problem worse.

This has been done to fight deflation but has shifted investor expectations more towards high inflation and potential defaults over the next several quarters.

Savvy traders observing this shift towards inflation expectations and higher default rates are likely getting their inflation-based investing plans ready to deploy. When traders talk about opportunities in a market like that they will often mention short bonds or treasuries positions.

A short bonds position has the potential to produce big profits during high inflationary periods but how does a individual trader do any of that within their regular stock account?

Shorting an actual bond is complicated and probably outside the scope or interest of most individual traders. However, shorting a bond ETF could accomplish the same thing with a lot less hassle.

As bond prices drop (due to inflation or risk of default) bond ETFs will also decline in value. There are many bond ETFs to choose from but the iShares 7-10 year treasury bond fund (IEF) is an ideal instrument for this short strategy.

However, what if you are not even interested in the complexity of shorting a stock? There are even easier ways to take advantage of a decline in bond prices by buying a short bond ETF. That means that the ETF itself is investing in short bonds and by buying the ETF you will profit when bond prices drop.

There is a leveraged ETF that has become very popular as a way to execute this strategy called the ProShares Ultra-short 7-10 year treasury ETF (PST).

There are some inherent risks in shorting bonds that you should be aware of.

1. Bonds are mean-reverting, which means that they don’t “trend” for long periods of time. This makes your holding period fairly short term.
2. Leveraged positions using margin and leveraged ETFs include higher costs.
3. Leveraged funds will underperform in the long run because they lose some of the benefits of compounding.

You will notice that the disadvantages of this strategy mostly concern the fact that a short bond strategy is a short-term strategy. Short term trading costs more and is more difficult than longer term investing. However, when faced with an extraordinary market and an evolving economic environment, looking outside the long-term box for new opportunities can be quite attractive.