Traders Prepare for Death of a Junk Rally
Many traders don't trust the rally in riskier debt right now, and some are plotting ways to bet against it.
The credit cycle seems to be souring, with corporate earnings generally weakening, and central bankers are seemingly more desperate. Yet riskier corporate debt is surging again, especially U.S. junk debt tied to energy companies, which has experienced a record 16 percent rally so far in March. That's fueled a 4 percent gain in the broader high-yield market, the biggest monthly gain since 2011.
These returns have been so impressive that some traders, who don't believe they can possibly last, are plotting ways to quickly short-sell it. And this time, they want to truly cash in, unlike the end of last year, when some were appropriately bearish but failed to execute their views well enough to make big money.
The problem with short-selling actual corporate bonds is that it's time-consuming and potentially expensive. So many investors make wagers using derivatives instead, particularly indexes that rise and fall alongside the perceived creditworthiness of a group of companies.
But the main such U.S. high-yield index failed to sufficiently track the market's 6.4 percent swoon in the last five months of 2015 because it was pegged to a smaller proportion of energy companies. That has since changed, with Markit's main U.S. high-yield credit-default swaps index undergoing a transformation. The latest version, which started trading Monday, has a 16 percent allocation to energy and materials companies, up 3 percentage points from the last incarnation, according to Morgan Stanley analysts led by Vishwas Patkar and Adam Richmond.
This is an even greater exposure to these commodities-related companies than the broader high-yield bond market. And it comes just in time for some expected destruction in riskier credit.
Many analysts, including those at UBS Wealth Management and Morgan Stanley, think the gains have gotten ahead of themselves. Barclays analysts don't think the commodities rally can last. This matters greatly to the world of U.S. corporate debt, which has moved pretty much in tandem with oil prices in recent months.
After all, the underpinnings of the latest gains in risky oil and gas debt feel somewhat flimsy. Oil prices have increased a bit and everyone feels a little better about the world, perhaps because central banks keep adding stimulus to the growing heap of policy measures aimed at igniting growth.
Some energy-related company bonds have already started losing steam. Continental Resources bonds maturing in 2022 have fallen to 82.5 cents on the dollar from 92.7 cents 11 days ago, while Oasis Petroleum debt coming due in 2022 has dropped about 70 cents from 80 cents in the period, Finra's Trace data show.
Many investors have been eagerly awaiting a credit reversal. Now they may be working with a sharpened tool to take advantage of it.
To contact the author of this story:
Lisa Abramowicz in New York at email@example.com
To contact the editor responsible for this story:
Daniel Niemi at firstname.lastname@example.org