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Short interest in high yield bond ETFs at historical high

High Yield Bond ETFs Short Interest 2013-03-13Enlarge GraphShort interest ratio in high yield bond ETFs is at historical highs for HYG and JNK.

Short interest refers to the number of shares on loan to short sellers, in other words, the number of shares shorted. It is generally quoted as a percent of the total number of outstanding shares for a particular stock. For a quick explanation of short selling, please scroll down.

Short interest can serve as a gauge of investors sentiment and it is most useful when big changes in short interest occur. As of March 11, over 8% of the shares in HYG and JNK were on loan to short sellers, according to Markit data.

Short interest should not be confused with short interest ratio (i.e. days to cover ratio), which is a multiple defined by the number of shares shorted divided by the trailing 30-day daily trading volume. In other words, it is the number of days it would take a short sellers to buy back their shorted positions. The short interest ratio for both HYG and JNK has also been increasing in past months and it is currently at approximately 5x, meaning that at the current daily trading volumes, it would take five days to buy back all the shares necessary to cover the shorts.

Investors in HYG and JNK should beware of the situation and understand that the short interest points to a more likely downside than upside scenario in the short term. On the other hand, given the massive recent issuance and the amount of high yield bonds accumulated by funds over 2012 and 2013, it may also be the case that funds are simply buying insurance for their positions that are too large to sell. Shorting HYG or JNK can serve as a hedge for existing bonds in a fund’s portfolio and effectively can lock-in the gains. Nonetheless the message seems clear: the market is signaling that upside is limited in high yield bonds, though keep in mind that until high yield bonds do fall, HYG and JNK will continue to earn interest income of approximately 5%.

Short selling basics

Short selling is a method by which investors can profit from the falling price of a stock. The way it works is as follows:

  1. Identify a stock that is likely to fall in value
  2. Borrow the stock from an investor that owns the stock
  3. Sell the stock to the market
  4. Buy the stock back from the market (ideally after it drops in price)
  5. Return the stock to the lender of the stock (referred to as covering)

While it may sound complicated for investors unfamiliar with shorting, the trading platform takes care of steps two, three and five. From the investor’s perspective, it’s just as easy as buying a stock but instead of profiting from a rise in price, the profit comes from a fall in price (or a loss if the price increases). The profit comes from selling the stock at a high price and then buying it back at a lower price.

Short interest can therefore work as a contrarian indicator of the investor sentiment of a stock. As a stock rises in price, its short-term interest usually rises as more investors start to feel the stock is overpriced and is more likely to fall in price rather than increase. The problem with shorting is that a rising tide raises all ships, so if the market is very bullish, an individual stock may increase in price regardless of the negatives associated with the individual company. For this reason, shorting is not recommended for inexperienced investors.