Short Selling Corporate Bonds is very risky. Here’s a better alternative

Short selling corporate bonds has speculative appeal for quick gains, but it’s a big gamble. Invest in high-quality blue-chip stocks instead to make money over the long term.

Corporate bonds carry widely varied levels of risk. Some of them are almost as safe as government bonds and offer only slightly higher yields. Other corporate bonds are far riskier, but may not offer enough extra interest to offset that risk. Among medium-risk corporate bonds, high yields may signal danger rather than a bargain. You risk capital losses as bond prices fall along with the share price of the underlying bond issuer.

The price of some low-quality, high-yield corporate bonds—often called junk bonds— may rise as a company’s prospects improve, particularly in a growing economy. But that’s far from certain.

We think investors should avoid trying to make money by short selling corporate bonds.

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Stop losing money on short selling corporate bonds when the price rises

Short selling is when you borrow stock—or a corporate bond—from a broker and then sell it. However, you eventually have to buy back the stock (or bond) on the market, to return it to its owner. If the stock falls in price while you are “short,” you can buy it back at a lower price. You have then made a profit. But if the stock rises in price, then you must buy it back at a higher price than you sold it, and you lose money.

Short selling is pure speculation. It’s what a mathematician calls a “negative sum game” since the winners have to outguess the losers by a large enough factor to pay associated costs. It doesn’t enjoy any of the advantages of conservative investing. Then, too, the returns are upside down. When you buy stocks, gains are theoretically unlimited and the most you can lose is 100%. When you sell short, your maximum gain is 100% (if the stock you’ve shorted goes to zero). But a short seller’s potential losses are limitless.

Profitable short selling requires superhuman timing, and the inevitable mistakes can be super expensive for investors.

As a general rule, we advise against short selling much as we advise against options trading, leverage, currency speculation and bond trading. In all these activities, it’s a rare investor who makes enough profit to compensate for the risk involved.

If you want to own bonds, then hold short-term bonds

As a general rule, the safest bonds are issued by or guaranteed by the federal government. Next come provincial issues or bonds with provincial guarantees.

As mentioned earlier, corporate bonds are far riskier than government bonds, and the risk varies widely. Some corporates are almost as safe as government bonds and offer only slightly higher yields. Some corporates are far riskier and offer far higher yields.

Bond enthusiasts acknowledge that bonds are vulnerable to inflation. But they claim that bonds make up for their inflation risk by providing a hedge against deflation (that is, a widespread drop in commodity prices and the cost of living).

That’s a theoretical advantage, but it’s of negligible value. Under today’s fiat-money system, which lets central banks create new money out of nothing, inflation is about 100 times more likely than deflation. When governments get deeply indebted, as many are these days, they usually inflate their way out of their debt problems. That is, they pursue policies that spur inflation.

That’s why we haven’t recommended bonds for a number of years.

If you want to hold individual bonds, we recommend holding only short-term bonds, with terms of three years or less to maturity. These expose you to less risk of capital losses if interest rates rise. (Bond prices and interest rates are inversely linked. When interest rates go up, bond prices go down.)

We will continue to stay out of longer-term bonds and instead focus on well-established, dividend-paying stocks that meet our Successful Investor criteria. They expose your purchasing power to less long-term risk than bonds, they provide higher current yields, and they offer a hedge against inflation. It’s an easy choice for Successful Investors.

Put more focus on blue chip stocks than on fixed-income investments like corporate bonds for long-term success

To succeed in the long term, we think you should find the best blue chip stocks to buy, and then hold on to them.

Most of these stocks will have an established business and a history of sales gains, plus some earnings, if not dividends. To put it more simply: these stocks have a clear business plan that seems to be working.

We feel most investors should hold a substantial portion of their investment portfolios in securities from blue chip companies. Some of these stocks should offer good “value”—that is, they should trade at reasonable multiples of their earnings, cash flow, book value and so on. Others could have above-average growth prospects, compared to alternative investments.

We recommend using our three-part Successful Investor philosophy to maximize your stock market returns

  1. Invest mainly in well-established, mostly dividend-paying companies;
  2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
  3. Downplay or avoid stocks in the broker/media limelight.

What appeal does short selling corporate bonds have for you?


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