Junk-Bond Bears Squeezed With Fed Unleashing QE3: Credit Markets

U.S. Federal Reserve Chairman Ben S. Bernanke
Ben S. Bernanke, chairman of the U.S. Federal Reserve. Photographer: Andrew Harrer/Bloomberg

Ben S. Bernanke is sending junk-bond bears into hiding.

The number of shares borrowed to bet against State Street Corp.’s exchange-traded high-yield bond fund has plunged 49 percent since Aug. 30, pushing its price to a 15-month high, according to data compiled by Markit Group Ltd. The most distressed securities are outperforming the highest speculative-grade tier this month by the most since February, Bank of America Merrill Lynch index data show.

The Federal Reserve’s third round of quantitative easing to stimulate the economy is leading junk-bond buyers to accept the lowest yields ever as they seek a reprieve from a fourth year of near-zero interest rates. Even as the pace of earnings growth for speculative-grade companies slows and credit-ratings cuts accelerate, research firm EPFR Global says investors have shifted six times more cash this year than all of 2011 into funds that buy the debt.

“Shorts have pulled back from the market,” said James Lee, the senior high-yield analyst at Bethesda, Maryland-based Calvert Investment Management Inc., which oversees about $12 billion. Investors are thinking “the chances that a landmine is going to hit the portfolio are probably pretty low.”

Short Sales

Shares of State Street’s SPDR Barclays Capital High Yield Bond ETF that investors borrowed, a practice commonly used for short sales, dropped to 6.76 million on Sept. 12 from 13.14 million shares on Aug. 30, Markit data show. That’s 22 percent below the daily average since the end of May.

In a short sale, traders sell borrowed stock in a bet they can profit from price declines.

Investors are curbing bearish bets as Fed Chairman Bernanke enlarges his supply of unconventional tools to attack unemployment stuck above 8 percent since February 2009. The central bank said yesterday it will expand its holdings of long-term securities with open-ended purchases of $40 billion of mortgage debt a month and will probably hold the federal funds rate near zero “at least through mid-2015.”

Even as corporate ratings downgrades outpace upgrades for the first time since 2009, according to Standard and Poor’s, distressed securities, or those closest to default in the eyes of debt investors, have returned 3 percent this month. That’s 1.9 percentage points more than bonds one tier below investment grade, Bank of America Merrill Lynch index data show. The average speculative-grade yield dropped to a record 7.1 percent on Sept. 12 from 8.3 percent in June.


“You should not be long high-yield,” said Peter Troob, founder of credit hedge fund Troob Capital Management. “High yield is an oxymoron. There is nothing high about it.”

Elsewhere in credit markets, a measure of relative yields on Fannie Mae and Freddie Mac mortgage securities that guide U.S. home-loan rates tumbled to the lowest on record after the Fed move. A Bloomberg index of yields on Fannie Mae-guaranteed mortgage bonds trading closest to face value fell about 5 basis points to 89 basis points, or 0.89 percentage point, higher than an average of five- and 10-year Treasury rates as of 9:45 a.m. in New York. That’s the narrowest spread since at least 1984.

The cost of protecting corporate debt from default in the U.S. fell, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, declining 2.4 basis points to a mid-price of 83.3 basis points as of 11:30 a.m. in New York, according to prices compiled by Bloomberg.

Swap Spreads

That’s the lowest level on an intraday basis since March 2011 for the measure, which typically declines as investor confidence improves and rises 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.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, declined 1.7 basis points to 12.05 basis points, the lowest since March 2010, as of 11:31 a.m. in New York. The gauge narrows when investors favor assets such as company debentures and widens when they seek the perceived safety of government securities.

Bonds of Cablevision Systems Corp. are the most actively traded dollar-denominated corporate securities by dealers today, with 94 trades of $1 million or more as of 11:33 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The company sold $750 million of 5.875 percent, 10-year notes yesterday.

BlackRock’s ETF

The number of borrowed shares on BlackRock Inc.’s junk-bond ETF dropped to 6.65 million as of Sept. 12, 11 percent below the daily average since the end of May, Markit data show. BlackRock’s fund, the biggest of its kind, owns $16.27 billion of corporate securities, up from $10.4 billion at year-end, data compiled by Bloomberg show.

Bonds held by State Street’s junk ETF, the second-largest, have climbed $3.4 billion since December to $12.25 billion, the data show. ETFs are listed on exchanges and brokered like stocks, unlike mutual funds, whose shares are priced once daily.

Bets against the junk-bond market also are declining after European Central Bank President Mario Draghi pledged in July to do “whatever it takes” to save the euro from the region’s fiscal crisis. Draghi announced an agreement on Sept. 6 for an unlimited bond-buying program to lower borrowing costs in the region and fight speculation of a currency breakup.

‘Bubble Levels’

“The Fed and ECB actions have created a lot of liquidity and cash in the market,” said James Serhant, senior vice president and head of high-yield fixed income at Hartford Investment Management Co. in Hartford, Connecticut. “If you sit on the cash long enough and returns lag, you get a little hot under the collar.”

Junk-bond funds globally have reported $52.4 billion of deposits this year through Aug. 29 compared with $8.3 billion in 2011 and $31.5 billion in 2010, as measured by Cambridge, Massachusetts-based EPFR.

Flows into credit funds “in some respect are reaching bubble levels, never before breached in history,” Bank of America Corp. strategists led by Oleg Melentyev in New York wrote in an Aug. 14 report.

Yields Plunge

Yields on speculative-grade corporate debt, which have averaged 10.2 percent since 1993, have plunged from as high as 23 percent at the peak of the credit-market seizure in 2008, after the bankruptcy of Lehman Brothers Holdings Inc. sent investors fleeing the market.

For the 360 speculative-grade companies that had reported second-quarter results at the time of the Bank of America report last month, earnings growth slowed to 1.2 percent from “high single digits” in previous quarters.

That and a slowdown in sales gains “suggest corporate issuers are dealing with both noticeable slower revenue growth environment coupled with inability to immediately cut the costs to fully protect their margins,” the Bank of America strategists wrote.

Moody’s global speculative-grade default rate was 3 percent in August from 1.8 percent a year ago, according to a Sept. 10 report. S&P has downgraded 220 speculative-grade U.S. companies this year, 44 more borrowers than the credit-ratings company upgraded. It’s the first year since 2009 that downgrades have outpaced upgrades.

“We’re past the peak of credit quality, but that’s not to say we’re in a rapid deterioration mode,” said Diane Vazza, the head of S&P’s global fixed-income research.

Growth in the U.S. will improve to as much as 3 percent next year and as much as 3.8 percent in 2014, from upper estimates of 2.8 percent and 3.5 percent in the Fed’s previous forecasts.

While Troob said it makes sense to wager against the bonds at current levels, he said, “This isn’t a today trade, it is six months to a year from now.”

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