ETFs Lure Bearish Bets as JPMorgan Spoils Swaps: Credit Markets

ETFs Lure Bearish Bets as JPMorgan Spoils Swaps
The offices of JPMorgan Chase & Co. in the business and financial district of Canary Wharf in London. Photographer: Simon Dawson/Bloomberg

Distortions in credit-default swaps prices fueled by JPMorgan Chase & Co. trader Bruno Iksil are pushing investors to exchange-traded funds to make bearish bets on junk bonds.

Traders sold short an unprecedented 6.86 million shares of BlackRock Inc.’s $15.1 billion iShares iBoxx High Yield Corporate Bond Fund at the end of April, about 4 percent of the biggest junk-bond ETF’s outstanding shares, according to data compiled by Bloomberg. That’s up more than three-fold from the low this year in mid-February. About 12.6 million shares of State Street’s junk-bond ETF, the second-largest, were sold short, up from 7.78 million shares in March.

Investors are seeking a more effective hedge against falling debt prices as the cost to protect against declines using swaps exceeded relative yields on the debt by the most in three years, Barclays Plc data show. Market participants have blamed trades by Iksil for disrupting prices in the credit-swaps market, typically investors’ first choice for hedging.

“The ETFs were able to maintain a closer correlation to the cash index” than swaps, UBS AG strategists led by George Bory said in a May 22 report. “It is quite likely that this came about as a result of recently publicized outsized trades in” credit-swaps indexes, they said.

Fast and Discreet

Fixed-income ETFs allow anyone from banks to retirees fast and discreet access to speculative-grade bonds without directly owning them. Unlike mutual funds, whose shares are priced once daily, ETFs are listed on exchanges and are bought and sold like stocks. As trading has increased in the funds, the cost to borrow shares in order to sell them short has dropped, the UBS analysts said.

The volume of short selling in the three-biggest junk-bond ETFs has increased 92 percent since the beginning of March, according to the UBS analysts.

“If the CDS market were functioning normally, then that would be the easiest way” to hedge, said Sabur Moini, a money manager who helps oversee about $2.5 billion of high-yield assets at Los Angeles-based Payden & Rygel.

Elsewhere in credit markets, United Technologies Corp. is planning a six-part, $10 billion debt offering to help finance its $16.5 billion acquisition of Goodrich Corp. The market for corporate borrowing via commercial paper increased to more than $1 trillion outstanding for the first time this year, and a gauge of U.S. corporate credit risk fell for a second day.

Swap Spreads Fall

The U.S. two-year interest-rate swap spread, a measure of debt market stress, fell 1.5 basis point to 33.25 basis points as of 11:45 a.m. in New York. The gauge, which reached a four-month high of 39.13 on May 15, narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.

The Markit CDX North America Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, dropped 0.9 basis point to a mid-price of 117.4, according to prices compiled by Bloomberg. The index has dropped from a five-month high of 123.4 on May 18.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings declined 6.4 to 174.5.

The indexes typically fall as investor confidence improves and rise as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

United Technologies Sale

United Technologies will offer floating-rate securities due in 2013 and 2015, as well as three-, five-, 10- and 30-year fixed-rate notes, the maker of Sikorsky helicopters and Pratt & Whitney engines said in a regulatory filing. The offering, the company’s first in more than two years, consists of $10 billion of senior unsecured notes, Fitch Ratings said in a statement.

The aerospace and building-systems company will use proceeds to help fund its acquisition of Charlotte, North Carolina-based supplier Goodrich that is expected to close mid-year, Hartford, Connecticut-based United Technologies said in the filing. Proceeds may also be used for general corporate purposes.

The seasonally adjusted amount of U.S. commercial paper rose $14.9 billion to $1.009 trillion in the week ended yesterday, the Federal Reserve said today on its website. That’s the highest level since $1.03 trillion on Sept. 21, while the fourth straight weekly increase is the longest streak since the period ended Feb. 8.

Ford Most Active

Bonds of Dearborn, Michigan-based Ford, the automaker lifted to investment grade by Moody’s Investors Service this week, were the most actively traded dollar-denominated corporate securities by dealers, with 52 trades of $1 million or more as of 11:32 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Exchange-traded funds are luring bigger investors as they account for a greater portion of the high-yield debt market. ETFs have attracted $6.5 billion in 2012, accounting for 28 percent of all flows into the debt during the period, according to JPMorgan analysts led by Peter Acciavatti in New York.

High-yield, high-risk, or junk bonds and leveraged loans are graded below Baa3 by Moody’s and lower than BBB- at Standard & Poor’s and Fitch.

The three biggest U.S. junk-bond ETFs hold $25.6 billion of debt, compared with $43.6 billion of all corporate securities with maturities greater than a year held by the 21 primary dealers authorized to trade directly with the Federal Reserve.

ETFs Morph

“It’s morphed into more of an institutional tool,” said Bonnie Baha, head of global developed credit at DoubleLine Capital LP in Los Angeles, which oversees $34 billion. “The whole idea of investing in a corporate bond is, ‘Are you going to get your money back?’ Now it’s not just, ‘Are you going to get your money back?’ but ‘Are you going to get your money out?’”

BlackRock’s fund has lost 2.5 percent this month, compared with 2.1 percent loss on the iBoxx Liquid High Yield Index, which it seeks to replicate, or a 0.4 percentage point difference, Bloomberg-compiled data show.

Short-selling accelerated as the gap between a benchmark credit-default swaps index tied to junk bonds and relative yields on the debt soared to 85 basis points last week, the highest in three years, Barclays strategists said in a May 22 presentation to clients.

Iksil Trades

“We believe part of this short position reflects large scale institutional hedging by means of the ETFs rather than the at the time heavily technically distorted CDX indices,” the UBS analysts wrote, referring to trades by JPMorgan’s chief investment office.

Bloomberg News first reported April 5 that JPMorgan’s Iksil, a trader in the bank’s chief investment office, had amassed positions that were so large he was driving price moves in the $10 trillion market for credit swaps indexes tied to corporate creditworthiness.

The bets roiled price relationships that affected instruments used to hedge hundreds of billions of dollars of fixed-income holdings, market participants, who asked not to be identified because they weren’t authorized to discuss the activity, said at the time.

Some of the positions included bearish bets on high-yield bonds, the market participants said.

‘Closer Correlation’

JPMorgan Chief Executive Officer Jamie Dimon hosted a conference call May 10 to disclose what he called “egregious” and “self-inflicted” mistakes in the chief investment office, which manages a $381.7 billion portfolio for the biggest U.S. bank by assets. The loss occurred in London under multiple traders, according to an executive at the bank, who spoke on the condition of anonymity.

Aware of the market-distorting trades, dealers “relied instead on the ETFs to more accurately hedge trading books as the ETFs were able to maintain a closer correlation to the cash index,” the UBS strategists said in the note this week.

High-yield bonds in the U.S. have dropped 1.34 percent this month as concern mounts that Greece will exit from the euro. That’s the biggest loss since November, Bank of America Merrill Lynch index data show.

Investors have been drawn to junk-bond ETFs as a way to short the debt as ETF shares are exchanged in greater volumes.

“The bigger and more liquid it is, the easier to short, the cheaper to short,” Payden & Rygel’s Moini said. “It’s difficult to do it with high-yield cash bonds. In the cash market it’s always been sort of difficult and expensive.”

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