Junk-Bond Anxiety Grows as Traders Buy Up Bearish Puts

U.S. options traders are bracing for more losses in junk bonds.

Demand for protection against declines has pushed the number of outstanding puts on the iShares iBoxx $ High Yield Corporate Bond exchange-traded fund to five for each call, up from a ratio of 1.6 at the start of 2014, data compiled by Bloomberg show. The eight contracts on the fund with the highest ownership are all bearish.

Investors are turning skeptical on the five-year bull market in speculative debt amid concern the gains have gone on too long and that violence in the Middle East and Ukraine will boost demand for safer assets. Speculation that the Federal Reserve will raise interest rates within the next year is also supporting demand for put options, often used as a hedge because their value rises when the ETF (HYG) falls.

“Sometimes when an asset class gets to be expensive, you don’t need a catalyst,” Alan Higgins, who helps oversee about $48 billion as U.K. chief investment officer at Coutts & Co. in London, said by phone. “It’s simply that the value is not there.”

Conflicts erupting in Iraq, Israel and Ukraine have led investors to bail out of riskier assets. A record $7.1 billion was withdrawn from high-yield funds in the week ended Aug. 6, accelerating a flight that started last month and bringing net outflows to $9.75 billion this year, according to data provider Lipper.

Rotating Out

Junk-bond prices fell 1.3 percent in July, the first monthly decline since last August, according to Bank of America Merrill Lynch U.S. High Yield Index. The securities are still up 146 percent since the end of 2008, when the Fed lowered its short-term interest-rate target to almost zero to spur the economy out of the worst recession since the Great Depression.

“This asset class is getting rotated out of,” Michael Purves, chief global strategist and head of equity derivatives research at Weeden & Co. in Greenwich, Connecticut, said by phone on Aug. 8. “If Treasuries are proven to stay at these levels and credit spreads potentially widen out, it could be exposed to further disintegration.”

Traders have tripled holdings of bearish options on the junk bond ETF this year, while ownership of bullish contracts stayed about the same, data compiled by Bloomberg show. Put open interest is at a record 494,000, compared with 96,000 for calls.

Fundamentally OK

Puts expiring in September with strike prices of $90 and $92 have the highest open interest. The ETF was little changed at $93.41 yesterday.

U.S. companies have plenty of cash to repay bondholders and many have refinanced their debt to lower the cost, according to Thomas Chow, a money manager at Philadelphia-based Delaware Investments. Moody’s Investors Service expects the global default rate for speculative-grade debt to finish this year at 2.2 percent, below its long-term average of 4.7 percent, according to an Aug. 11 report by the ratings firm.

“The days of worrying about survival and accessing the capital markets are long behind us,” Chow said by phone. His firm oversees about $190 billion. “When you look at these companies fundamentally, they look OK.”

Fed Funds

Investors may be underestimating the pace at which the Fed will raise interest rates over the next two years, Jeffrey Lacker, president of the Fed Bank of Richmond, said in an Aug. 1 interview. The Fed funds rate won’t rise above 0.5 percent until the third quarter of next year, according to the median economist forecast from a Bloomberg survey.

Ten-year U.S. Treasuries yield 2.45 percent, near the lowest level in more than a year. High-yield bonds, or debt rated below BBB- by Standard & Poor’s and lower than Baa3 by Moody’s Investors Service, pay 6.13 percent, Bank of America Merrill Lynch data show.

The extra yield investors demand to hold high-risk company bonds rather than government securities has risen 59 basis points since June 30 to 412 basis points through Aug. 11.

Investors who buy options on the junk bond ETF often use the securities as a hedge for a broader portfolio, according to Todd Salamone, senior vice president of research at Schaeffer’s Investment Research.

Implied volatility, a measure of options demand, for the high-yield ETF has climbed 34 percent in the past month, according to three-month data compiled by Bloomberg. On Aug. 1, the cost of options on the high-yield ETF reached the most expensive since 2011 relative to contracts on the iShares 20+ Year Treasury Bond ETF.

“Regardless of if this is via speculative positions or increased hedging, there is definitely more nervousness,” Salamone said in an Aug. 11 phone interview from Cincinnati.

To contact the reporters on this story: Callie Bost in New York at cbost2@bloomberg.net; Inyoung Hwang in London at ihwang7@bloomberg.net

To contact the editors responsible for this story: Lynn Thomasson at lthomasson@bloomberg.net Jeff Sutherland

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