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Shorting Junk Loans Just Got Easier as New Derivatives Unveiled

Wall Street has turned to financial engineering to solve one of junk-debt investors’ biggest problems: They can’t make wagers quickly enough in these illiquid markets where trades are completed over the phone.

Banks are again resorting to derivatives to make it easier to place bullish and bearish bets amid a credit boom, allowing traders to amplify their profits or losses on debt rated below investment grade.

In the latest innovation in this push, the biggest lenders are creating total-return swaps that seek to mimic the risk and reward tied to high-yield loans. JPMorgan Chase & Co. created a total-return swap based on Markit Group Ltd.’s iBoxx USD Liquid Leveraged Loan Index in March, the first of its kind, according to Markit.

“The loan market needs tools” to make it easier for buyers to slip in and out, Morgan Stanley (MS) analysts led by Sivan Mahadevan wrote in a July 11 report. “A maturing credit cycle and a deterioration in the quality of new issuance has led to a debate about loan valuations going forward.”

Translation: There are a lot of investors out there who are considering going short.

Loan Outflows

The $750 billion U.S. speculative-grade loan market has ballooned since the 2008 financial crisis as the Federal Reserve’s easy-money policies fueled demand for higher-yielding debt investments. There’s growing concern among regulators and investors that underwriting standards have weakened too much and low yields aren’t sufficiently compensating for that growing risk.

After funneling record volumes of cash into leveraged loans last year, mutual-fund investors have been souring on the debt as they received fewer and fewer protections against losses in the case of defaults. They started paring cash in April, breaking a 95-week streak of deposits, and have pulled $645 million from such funds this month through July 16, according to Wells Fargo & Co. (WFC) data.

Total-return swaps on bond indexes are poised to reach about $10 billion this year, mainly focused on high-yield securities, according to the Morgan Stanley analysts. Similar wagers tied to loans may be even more popular since there are few alternatives, they said.

Going Short

Here’s how the derivatives work: an investor pays a fee to a counterparty, who promises to deliver the equivalent of the total gains on a specified basket of debt. If the debt gains value, the bullish investor receives income without having to own the underlying loan. If the debt loses, the investor will have to make the counterparty whole.

Some smaller investors aren’t in a position to buy junk-rated loans and may want to go long through such a synthetic wager, according to the Morgan Stanley analysts.

“On the short side, a general lack of alternatives to short the market should encourage interest from macro investors” and managers of dedicated loan funds, the analysts wrote.

Brian Marchiony, a spokesman for New York-based JPMorgan, declined to comment.

The expansion of total-return swaps indexes follows the rapid rise of corporate-debt exchange-traded funds, and builds on the more-commonly used credit-default swap indexes that emerged before the financial crisis.

These new swaps don’t have the “tracking errors” of ETFs, which have also become difficult to borrow to go short, the Morgan Stanley analysts wrote in the report. Previous attempts at creating a tool for loan investors to hedge, most notably the LCDX index, largely faltered, and liquidity in the benchmark “has all but disappeared,” they wrote.

So, Wall Street’s trying to fill in the gaps. The question is whether the latest innovations will help prevent losses when the tide turns, or add to them.

To contact the reporter on this story: Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editors responsible for this story: Shannon D. Harrington at sharrington6@bloomberg.net Caroline Salas Gage

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