Individual traders tend to concentrate on the stock market. To a limited extent you will also see individuals in the commodity and currency market as well. Although these markets are complicated, the basic fundamentals aren’t that hard to understand. If you have ever run a household budget or been responsible for P&L in a business then you understand the basic forces that drive prices in those markets up or down.

Bonds, however, are an entirely different matter. Although many investors have bond holdings in their portfolio they are usually in the form of managed funds. Bonds, are extremely complicated and don’t really act a whole lot like the kind of debt small business owners or families hold, which is why most investors rely on specialist fund-managers for their fixed-income investments.

If you feel confused by bonds, don’t feel bad — most professional investors don’t understand them either. This is one of many reasons why crafty bankers were able to hide poor quality bonds from the ratings agencies prior to the 2008 collapse. What we really need is an opportunity that is attractive enough to be worth the effort to dig into the guts of how bonds are priced.

Fortunately, there is an emerging bearish opportunity in the iShares High Yield Bond ETF (HYG) that we really like and it is worth the explanation. Interest rates are coiling for a breakout, and it doesn’t really matter which way they move. If rates change quickly in the short term, high-yield bonds are going to take a big hit. With uncertainty building in Washington, this seems like a fairly safe bet.

Why Bonds Drop When Interest Rates Rise

A bond’s price has an inverse relationship to yields (or interest rates). If rates rise, a bond’s price will fall to match the new market yields. If rates fall, a bond’s price will rise to match the new higher market yields. This relationship is fairly linear for Treasury bonds and investment-grade debt. However, it is a little variable when you analyze the so-called “high yield bonds”, which is why they lag their investment-grade peers a little. For example, you can see in the next chart that the investment-grade bond ETF, iShares Barclays Aggregate Bond Fund (AGG), dropped two weeks before HYG did when rates started to rise in May.

Currently, the two indexed ETFs are diverging with investment-grade bonds forming lower lows while high-yield bonds form higher lows. This isn’t uncommon and is usually a bearish indicator. The same thing happened over the two quarters prior to the May 2013 collapse.

High-yield bonds lag the performance of investment-grade debt for two reasons:

First, high-yield bonds are initially a little less sensitive to changes in interest rates. This is because they already have such a high yield. A bond’s sensitivity to interest rate changes is known as its “duration” which may sound weird because it doesn’t have anything to do with how long the bond has until maturity. Treasury bonds and high-quality corporate debt are more sensitive to interest rate changes because they have a higher duration.

Rates started to rise in May 2013 and that is bad for investment-grade debt but not as bad for high-yield bonds (at least not at first). However, the benefits high-yield bond investors enjoy in a rising interest rate environment only lasts for a while. It runs out of steam when rates rise above certain benchmarks or if volatility picks up.

Second, high yield bonds are more often ‘callable.’ The company that issued them can call them back. They would do that if they could issue new bonds at lower interest rates. That is frustrating for high-yield bond investors so they discount the value of that “call option” out of the bond’s value. This is one of the reasons why HYG dropped like a rock in the second quarter of 2012 while interest rates were falling. Companies were able to call in their bonds and issue new debt at lower rates. That new debt is not as profitable for investors so bond funds like HYG drop.

In fact, you can calculate a high yield bond’s price with the following formula…

Callable Bond’s Price = Non-Callable Bond’s Price – Value of Call Option

Click to Enlarge The formula above can be used to think about the impact of volatility on a bond’s price. Just like a stock option will rise in value when volatility rises, the call portion of the high-yield bond’s price will rise when traders are expecting more volatility in the yield environment. Ironically, despite an initial spike in yield volatility earlier this month, it has calmed down a little and reached support again and is just starting to bounce higher again. You can see that in the chart below.

We expect volatility to spike again like it did last May at this same level. Support is intact and regardless of your own personal political leanings, doesn’t it seem reasonable that bond yields are likely to become more volatile in the short term?

If expected volatility rises, high-yield bonds will drop in value because the call portion of the bond’s price increases in value (remember, the call portion of the bond’s price is a negative number). If interest rates really do rise, high yield bond prices will fall further because they are more likely to have that call exercised.

But what if interest rates fall? Wouldn’t you expect high-yield bonds to rise with investment-grade debt? Aye, there’s the rub — falling interest rates can increase volatility and the price of those embedded calls rise in value. What HYG needs to maintain its current price is a very mellow interest rate environment that is trending flat or very slowly up or down. The Fed was able to accommodate those needs until May when hints of a “Taper” and fiscal shenanigans in Washington disrupted the environment.

If yields rise too fast, HYG will fall because the high-yield bond’s duration will kick in and drive prices lower to match market yields. We already have a leading signal from investment-grade debt that the bullish trend is very weak. If yields fall too fast, HYG will fall in value because the embedded call option will rise in value as volatility expectations increase. This can lead to further declines if those bonds are then called. The only route out of this mess is if interest rates trend very, very calmly — not very likely!

Recommendation

Hopefully this has been an opportunity to learn a little more about bond-pricing. You can now be the life of the party!

We recommend shorting HYG at $90.50 or lower on a break of its current support trendline. This could be triggered by one or two of the different factors we have discussed in the article, but it is simplified in the price.

For option traders we recommend buying to open the at-the-money December puts on HYG when the price breaks support.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here.

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