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Traders Short Junk-Bond ETFs as Gains Top 100%: Credit Markets

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Traders Short Junk-Bond ETFs as Gains Top 100%
A trader works on the floor of the New York Stock Exchange (NYSE) in New York. Photographer: Jin Lee/Bloomberg

March 18 (Bloomberg) -- Wall Street’s biggest credit brokers are for the first time using exchange-traded funds as a way to wager that junk bonds are overvalued.

Bank of America Corp. traders who helped dealers move $1.5 trillion of credit-default swaps index contracts last year began offering clients the ability to trade blocks of bond ETF shares in February, according to three people familiar with the trading and an e-mail sent to customers. Shares borrowed to make bearish bets on State Street Corp.’s $12 billion speculative-grade bond ETF soared to a record 11.5 percent of the total outstanding on March 1, up from 4 percent at year-end.

Federal Reserve Governor Jeremy Stein warned last month that he was seeing “a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit,” with four years of central bank stimulus pushing investors toward the riskiest securities and compressing junk-bond yields to a record low 6.4 percent on March 15. Buyers who reaped gains of 125 percent the past four years are now souring on the debt.

“As the high-yield ETF market has grown, we’ve seen institutional investors using high-yield ETFs to build portfolios and manage risk,” said Matthew Tucker, head of iShares fixed-income strategy for BlackRock Inc., the world’s biggest money manager, in San Francisco. “They’ve been looking for ways to both go long the high-yield market and hedge against losses.”

Rate Bets

As the number of borrowed shares in the two biggest speculative-grade bond ETFs almost doubled last month, the net amount of credit swaps tied to a benchmark index of junk-rated companies increased 10 percent, Markit Group Ltd. and Depository Trust & Clearing Corp. data show.

Unlike credit swaps, which typically only allow investors to wager on corporate creditworthiness and trade off exchanges in privately negotiated transactions, ETFs also fluctuate with interest rates and trade like stocks.

“To the extent that investors want to hedge both their credit risk and their interest-rate risk, selling the ETFs can make sense,” said Eric Gross, a credit strategist at Barclays Plc in New York. Swap indexes are “still the most liquid way to hedge high-yield credit, but it has essentially zero exposure to rates,” he said.

BlackRock Fund

The volume of shares on loan from BlackRock’s $15.4 billion junk-bond ETF, the biggest of its kind, soared to 20.9 million on March 7, or 13 percent of the total outstanding that day, according to Markit and Bloomberg data. That’s up from 0.3 percent on March 9, 2012, and 7 percent at year-end.

Elsewhere in credit markets, the cost of insuring European bank bonds against default jumped the most in almost three weeks after Cyprus imposed an unprecedented levy on bank savings to help finance its international bailout. Chesapeake Energy Corp. is planning to issue $2.3 billion of bonds to fund a tender offer and repay debt.

Traders are betting Cyprus’s tax makes it more likely European authorities will force senior bank bondholders, who rank alongside depositors as the last to lose out when debt is impaired, to share the burden of financial-system rescues.

The Markit iTraxx Financial Index of credit swaps insuring the senior bonds of 25 lenders and insurers climbed 10.2 basis points to a mid-price of 153 basis points as of 3:17 p.m. in London, the biggest jump since climbing 17.3 on Feb. 26 after Italy’s inconclusive election, according to prices compiled by Bloomberg.

U.S. Benchmark

In the U.S., the Markit CDX North American Investment Grade Index increased 1.3 to 80. The benchmark fell to 78.3 on March 14, the lowest since January 2010.

Credit swaps typically rise as investor confidence deteriorates and fall as it improves. Contracts 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 swap protecting $10 million of debt.

Bonds of New York-based Morgan Stanley are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 3.8 percent of the volume of trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Chesapeake Offering

Chesapeake, the U.S. natural gas producer that’s selling as much as $7 billion in assets this year to plug a cash shortfall, may issue senior notes due in March 2016, June 2021 and March 2023 as soon as today, according to a person familiar with the transaction. The bonds may be rated Ba3 by Moody’s Investors Service.

Proceeds will be used to fund a tender offer for Chesapeake’s 7.625 percent securities due 2013 and its 6.875 percent debentures maturing in 2018, the Oklahoma City-based company said today in a statement. It will also use proceeds to redeem its 6.775 percent notes due 2019 and repay its revolving bank credit facility.

The company said in a March 15 statement that it would pursue a federal lawsuit to confirm that a redemption of the $1.3 billion of March 2019 notes, sold during its last offering in February 2012, wouldn’t require a so-called make-whole penalty, triggering a $400 million payment to noteholders.

Relative yields on dollar-denominated junk bonds have contracted 13.4 percentage points since 2008, when the Fed began purchasing bonds and holding benchmark borrowing costs from zero to 0.25 percent to rescue the world’s biggest economy from the credit crisis.

Facing Erosion

The notes have declined 0.5 cent to an average 105.4 cents on the dollar from the record high of 105.9 cents in January, Bank of America Merrill Lynch index data show. They traded as low as 58.8 cents in March 2009.

“Most bonds are trading at a pretty high premium and could face significant price erosion,” Natalie Trevithick, who oversees $35 billion as head of investment-grade debt at Los Angeles-based Payden & Rygel, said in a telephone interview.

Average modified duration, a gauge of debt’s sensitivity to increasing interest rates, climbed to 4.98 on Jan. 3, the highest level since October 2007. Investors yanked $418 million from high-yield bond funds last week, JPMorgan data show.

The Fed’s Stein warned that the junk-debt market may be overheating in a Feb. 7 speech in St. Louis. If so, “it does not bode well for the expected returns to junk-bond and leveraged-loan investors,” he said. Rising rates are a “medium risk” to corporate-bond ETFs, Fitch Ratings analysts wrote in a Dec. 19 report.

ETF Trades

U.S. life insurance companies, which hold $2.1 trillion of corporate bonds, and hedge funds, which may experience magnified losses because of their use of leverage, or borrowed money, face similar potential challenges, the analysts wrote.

Bank of America’s Kavi Gupta offered trades of about $30 million in BlackRock’s junk-bond ETF shares in an e-mail listing securities available for sale to clients last month, according to a copy of the message obtained by Bloomberg News. The credit-swaps index trader also offered trades in about $20 million of shares from State Street’s fund, according to the note.

February was the first time that Bank of America’s swaps traders started trading blocks of ETF shares, according to the three people familiar with trading in the market, who asked not to be identified since the trades aren’t public. Zia Ahmed, a spokesman for Bank of America, declined to comment.

‘More Volatile’

“High-yield ETFs tend to be more volatile than the underlying broad market,” said Jason Rosiak, head of portfolio management at Newport Beach, California-based Pacific Asset Management, the Pacific Life Insurance Co. affiliate that oversees about $3.2 billion. “It’s a new tool due to their size and liquidity.”

In the two weeks after junk-bond yields reached a record low on Jan. 25, prices on BlackRock’s iShares iBoxx High Yield ETF shares declined 1.95 percent. That’s 0.8 percentage point more than the 1.18 percent loss on the Bank of America Merrill Lynch U.S. High Yield Index during the same period and 1.14 percentage points more than the 0.8 percent decline in the price of the Markit CDX North American High Yield credit-swaps index, data compiled by Bloomberg show.

The ETF rose 0.81 percent in the next two weeks, compared with a 0.18 percent return on bonds in the Bank of America Merrill Lynch index and a 0.56 percent price gain on the swaps benchmark.

Option Surge

The net amount of credit swaps outstanding on the most recent version of the Markit CDX high-yield index increased about 10 percent in the month ended March 1 to $25.5 billion, according to Depository Trust & Clearing data. That compares with a 135 percent increase in shares on loan for State Street’s junk-bond ETF in the period and a 62 percent rise in borrowed shares for BlackRock’s fund, Markit data show.

The number of bearish options on BlackRock’s $15.4 billion junk-bond fund rose to a record after yields dropped to an all-time low and companies sold more of the debt than ever before.

Outstanding puts giving the right to sell the iShares iBoxx High Yield Corporate Bond Fund rose to 456,910 on March 7, almost 10 times the total of calls to buy. The number of bearish contracts has more than doubled since the Jan. 18 options expiration and reached an all-time high last month.

“We’ve seen increasing availability of ETF shares for borrowing and selling short as a hedging vehicle,” BlackRock’s Tucker said.

To contact the reporters on this story: Lisa Abramowicz in New York at labramowicz@bloomberg.net; Mary Childs in New York at mchilds5@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net

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