Must-know: Are short Interest spikes actually bullish indicators?

Market Realist

Will investors prefer investment grade over high yield in 2014? (Part 7 of 7)

(Continued from Part 6)

Why the short interest ratio may actually be a bullish indicator

Sudden spikes in the short interest ratio could lead to sudden increases in the price for the ETF shorted. This is called a “short squeeze,” and it occurs because if too many investors expect the price to fall, the security oversells and the resultant demand as short sellers scramble to cover short positions to replace the borrowed security could lead to price increases instead of decreases as expected, resulting in losses for the short seller since the shares need to be purchased at a higher price.

The current short interest ratios (or SIR) are at record levels for both JNK and HYG. The SIR for JNK increased to 7.051x on February 28, 2014—the highest in the ETF’s history, since its inception in November 2007, while the SIR for HYG increased to 7.746x on the same date, its third-highest level ever. The short interest, or the number of shares of a security or ETF that have been sold short by short sellers, increased to ~25.9 million on February 28, 2014, for JNK and ~30.2 million on February 14, 2014, for HYG—an all-time high.

Over 20% of shares outstanding have been sold short for HYG as of February 28, 2014. Also, the lower number of shares outstanding in HYG (~144 million) make it more vulnerable to sudden price spikes than JNK, which has about 248.8 million outstanding shares. This situation could be another example of the contrarian behavior that bond markets exhibited in 2014, and bond prices for both JNK and HYG could rally instead.

Contrarian behavior in U.S. fixed income markets

Following the Fed’s taper announcement in December 2013, financial markets expected yields on fixed income securities to increase and bond prices to decline. Yet bond prices rallied instead. From December 18, 2013, to March 24, 2014, we saw increases in prices for fixed income ETFs.

  1. The price of the iShares 20+ Year Treasury Bond ETF (TLT) increased 6.7%.
  2. The price of the Vanguard Total Bond Market ETF (BND) increased 1.1%.
  3. The price of the iShares Barclays MBS Fixed-Rate Bond Fund (MBB), which tracks the Barclays Capital U.S. MBS Index (a measure of the performance of the investment-grade fixed-rate mortgage-backed pass-through securities of GNMA, FNMA, and FHLMC) increased 1.4%.

Price increases in debt securities have largely been attributed to flight-to-safety flows from emerging and frontier markets. Once the taper was announced on December 18, financial markets anticipated that liquidity would dry up as the Fed tapered its monthly asset purchase program. Investors preferred to put their money in safer Treasuries rather than riskier emerging and frontier markets. An increase in risk perceptions usually leads investors to shift their money to safer assets—in this case, U.S. debt (TLT) and equity securities (OEF).

Secondly, the economic data releases in January and February also raised questions about the strength of the recovery. Those may in part be due to adverse weather, but markets were skeptical. A recovery would mean that the economic stimulus currently in place may be removed sooner than anticipated. This would raise interest rates and reduce bond prices, other factors remaining constant. So investor demand for U.S. fixed income securities was strong—particularly for Treasuries.

Shares in both HYG and JNK could be oversold, and the prices of these ETFs could rally instead as short-sellers scramble to purchase securities they had borrowed earlier to sell short on expectations of price declines.

To learn more about investing in fixed income securities, see the Market Realist series Credit spreads: A fixed income investor’s must-know guide.

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