Junk-bond investors are rushing to hedge against a reversal in the market’s biggest rally in seven years, just as the Federal Reserve considers when to raise interest rates.
The action can be seen in the derivatives markets, where increasing amounts of put options on the largest junk bond exchange-traded fund are trading. Puts give investors the right to sell the underlying securities at a set price over a specific time period and are generally considered indicators of bearish sentiment.
A total of $4.8 billion of options in the iShares iBoxx High Yield Corporate Bond ETF traded last week, the highest volume since the week of June 27 after Britain voted to leave the European Union, according to data provided by BlackRock Inc. Of the 565,000 options contracts that changed hands, more than 85 percent were puts, according to Bloomberg data. By comparison, put options have accounted for about 64 percent of the total options trading in the ETF this year, Bloomberg data show.
The fund, which is known by the ticker HYG and has $15.2 billion in assets, has also experienced $1.3 billion in redemptions since Sept. 9.
The spike in options volume comes ahead of the two-day central bank meeting that ends Sept. 21. Futures traders are now pricing in just an 20 percent likelihood that the Fed will lift rates.
With trading conditions deteriorating as dealers pull back from making markets amid increasing volatility, combined with the typically illiquid nature of junk bonds, investors are seeking cheaper ways to take on credit exposure and hedge it. That’s why trading in ETF options is so appealing.
Investors already have become skittish on signs that global central banks may turn off the spigot, according to a Sept. 15 report from Adrian Helfert at Amundi Smith Breeden. The broad selloff on Sept. 9 that preceded last week’s volatile trading was “simply the withdrawal symptoms of an addict unaccustomed to being denied his fix,” Helfert wrote in the report.
“The good news is that economy is now likely strong enough to allow the markets and companies to kick their dependence on a Fed whose accommodative stance now threatens to disable normal function,” he wrote.
But that hasn’t prevented investors from turning increasingly bearish about a junk-bond market that has delivered 14 percent gains this year. Short interest in HYG, which is a measure of the amount of shares borrowed to wager against the underlying securities, surged to a record $4.9 billion as of Sept. 15, according to estimates from financial analytics firm S3 Partners.
“If the high-yield default rate or Fed Funds rate increases, short sellers are poised to win big, but the cost in keeping their positions is getting more expensive,” Ihor Dusaniwsky, head of research at S3, said in an interview. “Shorts continued to build their positions as the probability of a fed funds rate increase diminished.”