Volatility reduction - short selling of corporate bonds

[y1980]

hello
I would like to slightly reduce the volatility in my portfolio (100% stocks), for this I considered entering a short position on a fund that holds corporate bonds.
What do you think of this strategy?

I could not simulate in 'Portfolio Visualizer' in 'Monte Carlo' tool, because they do not support short position.
Thank you very much for the help

[muffins14]

Why would this reduce your volatility?

[ScubaHogg]

If you don’t want the volatility of a 100% stock portfolio my suggestion is not to hold a 100% stock portfolio.

I can’t even begin to process the risks associated with short selling corporate bonds. Especially in a world that appears* to be one of declining interest rates

*but I acknowledge interest rate movements are basically unpredictable

[gavinsiu]

May be you can explain how this would work? I would think you may be able to use stock options for insurance at the cost of returns, but I am not sure how a short position on corporate bond would help.

Note that if you can't explain it, you probably shouldn't do it. This is not a criticism of your knowledge but that a strategy that you can't explain shouldn't be executed.

[y1980]

Why would this reduce your volatility?

Because when companies go down, their bonds go down with them.

[y1980]

May be you can explain how this would work? I would think you may be able to use stock options for insurance at the cost of returns, but I am not sure how a short position on corporate bond would help.

Note that if you can't explain it, you probably shouldn't do it. This is not a criticism of your knowledge but that a strategy that you can't explain shouldn't be executed.

You are right of course, I should have explained that in the opening post.

I assume so because when companies fall, their bond prices fall as well.
Of course, I would love to find a way to validate this assumption scientifically, or by simulations based on historical data.

[rkhusky]

May be you can explain how this would work? I would think you may be able to use stock options for insurance at the cost of returns, but I am not sure how a short position on corporate bond would help.

Note that if you can't explain it, you probably shouldn't do it. This is not a criticism of your knowledge but that a strategy that you can't explain shouldn't be executed.

You are right of course, I should have explained that in the opening post.

I assume so because when companies fall, their bond prices fall as well.
Of course, I would love to find a way to validate this assumption scientifically, or by simulations based on historical data.

Not clear to me why that would be so. Bond returns are largely uncorrelated to stock returns.

If you want to reduce volatility, add bonds to your portfolio. Short treasuries or MM would reduce volatility the most.

[gavinsiu]

You are right of course, I should have explained that in the opening post.

I assume so because when companies fall, their bond prices fall as well.
Of course, I would love to find a way to validate this assumption scientifically, or by simulations based on historical data.

I have to admit that my knowledge is lacking in this area, but it probably won't work. First, one issue is that the group of companies n a corporate bond fund is likely not to be in the same group of companies in the the stock fund, so it wouldn't be feasible. You might be able to do this with individual stock and bonds, but the volatility of investing in the stock directly would be greater than a mutual fund.

[y1980]

May be you can explain how this would work? I would think you may be able to use stock options for insurance at the cost of returns, but I am not sure how a short position on corporate bond would help.

Note that if you can't explain it, you probably shouldn't do it. This is not a criticism of your knowledge but that a strategy that you can't explain shouldn't be executed.

You are right of course, I should have explained that in the opening post.

I assume so because when companies fall, their bond prices fall as well.
Of course, I would love to find a way to validate this assumption scientifically, or by simulations based on historical data.

Not clear to me why that would be so. Bond returns are largely uncorrelated to stock returns.

If you want to reduce volatility, add bonds to your portfolio. Short treasuries or MM would reduce volatility the most.

The price of the bond stems from the strength of the company. If the company's price has fallen, its bond will probably be priced at a lower price as well.
I prefer to do this by shorting a corporate bond, because in my estimation it has a higher correlation to the stock price than a government bond.
I am looking for a way how to find past data on this topic.

[rkhusky]

May be you can explain how this would work? I would think you may be able to use stock options for insurance at the cost of returns, but I am not sure how a short position on corporate bond would help.

Note that if you can't explain it, you probably shouldn't do it. This is not a criticism of your knowledge but that a strategy that you can't explain shouldn't be executed.

You are right of course, I should have explained that in the opening post.

I assume so because when companies fall, their bond prices fall as well.
Of course, I would love to find a way to validate this assumption scientifically, or by simulations based on historical data.

Not clear to me why that would be so. Bond returns are largely uncorrelated to stock returns.

If you want to reduce volatility, add bonds to your portfolio. Short treasuries or MM would reduce volatility the most.

The price of the bond stems from the strength of the company. If the company's price has fallen, its bond will probably be priced at a lower price as well.
I prefer to do this by shorting a corporate bond, because in my estimation it has a higher correlation to the stock price than a government bond.
I am looking for a way how to find past data on this topic.

Not likely, unless the company is in danger of bankruptcy and defaulting on its contractual obligations.

Bond prices rise and fall on overall interest rate changes. If the bond ratings change significantly, there may be an effect on price.

[y1980]

You are right of course, I should have explained that in the opening post.

I assume so because when companies fall, their bond prices fall as well.
Of course, I would love to find a way to validate this assumption scientifically, or by simulations based on historical data.

I have to admit that my knowledge is lacking in this area, but it probably won't work. First, one issue is that the group of companies n a corporate bond fund is likely not to be in the same group of companies in the the stock fund, so it wouldn't be feasible. You might be able to do this with individual stock and bonds, but the volatility of investing in the stock directly would be greater than a mutual fund.

I'm not going to own individual stocks or bonds. The intention is to hold a mutual fund of a large stock index, and at the same time hold a short position in a mutual fund of corporate bonds.

[rkhusky]

You can download prices of funds from Yahoo. Open the files in a spreadsheet and you should be able to compute the correlation. Use the price column, not the adjusted price column because the latter is total return and includes dividends. Most analyses that compute the correlation between stocks and bonds use total return.

[gavinsiu]

I'm not going to own individual stocks or bonds. The intention is to hold a mutual fund of a large stock index, and at the same time hold a short position in a mutual fund of corporate bonds.

If you examine the corporate bond's top holding with the top holding in stock, you will find that they are typically not the same. You would be attempting to hedge apple by shorting oranges. Difference company in different sectors probably rise and fall in an unrelated manner.

[ScubaHogg]

The price of the bond stems from the strength of the company. If the company's price has fallen, its bond will probably be priced at a lower price as well.
I prefer to do this by shorting a corporate bond, because in my estimation it has a higher correlation to the stock price than a government bond.
I am looking for a way how to find past data on this topic.

But I'm assuming you are trying to short a broad based set of corporate bonds and not shorting individual companies' bonds? So it's

a) all the companies start failing (thereby helping your short bonds), in which case equities will fall as well

b) interest rates fall, but this will raise the price of the corporate bonds (and you are short, so this hurts)

c) interest rates rise, which will hurt bond prices (and help you). But this has an unclear affect on equities

d) probably a million other things that I can't think of all of which will have a complicated relationship on the correlation of corporate bond/equity returns

Show me in this graph where being short would have helped significantly? Maybe in 2022? But being short long duration treasuries probably would have helped more

https://legacy.portfoliovisualizer.com/ ... BeJ3Yt5VgA

It might help if you say why you think this will work?

Here's another link showing that corporate bonds had a much higher correlation with equities than long term treasuries. Why do you think it'll be different going forward?

https://legacy.portfoliovisualizer.com/ ... dTy1E8AwsD

[BrooklynInvest]

So you'd long, say, the S&P and then short a fund that has corporate bonds from the S&P companies (give or take) in it?

One, since bonds and stocks are generally negatively correlated aren't both of these now moving in the same direction?

Two, even leaving falling rates aside, wouldn't you be paying the coupons for all those bonds? How exactly does that help you? Granted, you may have reduced portfolio volatility in dollar terms, but only because you'd have fewer dollars.

What am I missing?

[alex_686]

Why would this reduce your volatility?

Because when companies go down, their bonds go down with them.

So 3 big points here.

When you short a stock/fund/bond you need to pay the dividends/coupons. So this would be a expensive form of protection.

During times of economic crisis 2 things happen. Credit spreads increase so prices go down. So point to you. However the Federal Reserve and Treasury pump in cash to the system, causing bond rates to fall. So a point away from you.

A more correct answer would be for you to enter a CDX IG (investment grade credit swap index) or CDX HY (junk bonds). This would be a pure credit play. The problem here is that relationships are weak between equities and credit spreads.

The real answer is to add bonds. Maybe do something with options. Maybe tilt towards Low Beta and Quality factors.

[Tyler Aspect]

Just sell stocks if you think your stock allocation is too high. Do not try to make something easy into a complicated activity.

[muffins14]

Owning treasury bonds seems like a much better solution here.

Ideally you want to own investments with a positive expected value for their return.

Just add some treasury bonds like intermediate term treasuries: VGIT

[gavinsiu]

I feel like OP is attempting to implement a long short strategy without the massive expertise to implement a long short strategy. Long short strategy are often employed by hedge fund. I don't know how long short works (other than at a rudimentary level), but in a contest where 5 hedge fund were pitted against the S&P 500 for 10 years, none were able to match the S&P 500's return. I am skeptical that this will work, especially hedge fund has high fees.

I agree with muffins14 that the simplest way to reduce volatility is to add treasury bonds. When the stock market crash, there is a tendency for investor to escape into treasury. If you back test, you can see that from 2000-2008, which had a unusually large number of market crashes, treasury increase in value when the market crash, reducing your losses from stock or roughly doing what the OP wants. However, in 2022, bond failed to do that big time. The techique only works some of the times.

There is a price to be paid though. Adding bonds will reduce long term return and you need to add enough bonds to make a difference.

[Rocky Mtn Man]

Why not just short the broad market? Buy SPY puts or sell calls.

https://www.optionseducation.org/strate ... cured-call

https://www.optionseducation.org/strate ... arried-put

[y1980]

Just sell stocks if you think your stock allocation is too high. Do not try to make something easy into a complicated activity.

taxes.

[BitTooAggressive]

May be you can explain how this would work? I would think you may be able to use stock options for insurance at the cost of returns, but I am not sure how a short position on corporate bond would help.

Note that if you can't explain it, you probably shouldn't do it. This is not a criticism of your knowledge but that a strategy that you can't explain shouldn't be executed.

You are right of course, I should have explained that in the opening post.

I assume so because when companies fall, their bond prices fall as well.
Of course, I would love to find a way to validate this assumption scientifically, or by simulations based on historical data.

Not clear to me why that would be so. Bond returns are largely uncorrelated to stock returns.

If you want to reduce volatility, add bonds to your portfolio. Short treasuries or MM would reduce volatility the most.

The price of the bond stems from the strength of the company. If the company's price has fallen, its bond will probably be priced at a lower price as well.
I prefer to do this by shorting a corporate bond, because in my estimation it has a higher correlation to the stock price than a government bond.
I am looking for a way how to find past data on this topic.

Correlation is a lousy and often misused metric. It totally ignores magnitude and is a historical measure that may not hold in the future because it may have no cause effect but might be historical happenstance.

[gavinsiu]

Just sell stocks if you think your stock allocation is too high. Do not try to make something easy into a complicated activity.

taxes.

You think short selling doesn't result in taxes?

[Tamalak]

Why would this reduce your volatility?

Because when companies go down, their bonds go down with them.

It would make even more sense to enter a short position on STOCKS to reduce volatility on stocks, since stocks are 100% correlated with themselves (and so you would get a perfect negative correlation with a short on stocks)

But thinking this far exposes the idea as silly. You're just cancelling out your own investment. Instead of a 80% stock position and a 20% short position, a 60% stock and 40% money market position would have the same volatility protection and far better returns.

[Tyler Aspect]

When you have a individual stock based portfolio, some of your stocks will have a pattern of climbing corporate fortune, followed by declining corporate fortune. Selling individual stocks to harvest profit is what you should be doing. Waiting too long can turn your profit into loss. It is only the Bobleheads style broadly diversified index funds can you afford to hold until retirement.

It is too often that trying to save taxes result in losses 10 or 100 times the cost of the taxes.

[alex_686]

Just sell stocks if you think your stock allocation is too high. Do not try to make something easy into a complicated activity.

taxes.

Don't let the tail wag the dog.

There are not many good options here other than selling. Shorting corporate bonds isn't one a good option.

You could try to delay taxes. However the more you delay the more complex your portfolio and taxes will be. I can make a solid case for the use of options. There are some interesting options if you are willing to leverage up your portfolio, but the answers here are complex and may not necessarily lower your volatility and your taxes could become exotic.

[BitTooAggressive]

Why would this reduce your volatility?

Because when companies go down, their bonds go down with them.

It would make even more sense to enter a short position on STOCKS to reduce volatility on stocks, since stocks are 100% correlated with themselves (and so you would get a perfect negative correlation with a short on stocks)

But thinking this far exposes the idea as silly. You're just cancelling out your own investment. Instead of a 80% stock position and a 20% short position, a 60% stock and 40% money market position would have the same volatility protection and far better returns.

It makes no sense at all. But it’s their money so ..

[alex_686]

It makes no sense at all. But it’s their money so ..

No, it has a nugget of truth to it. That is the problem, there is only a nugget. I have worked with Credit Default Swaps, which is the exact slice that the OP wants. The problem is that the credit spread increase when the stock go down only in some scenarios. Not others. The situation for a single company is complex. For a basket of securities it is worse.

It is a hedge, just a very loose poor one. And using a corporate bond fund it is a very expense way to hedge.