Avoiding the damage of a corporate bond meltdown

Default rates on corporate bonds hit a 25-year low last year. Meanwhile, the extra yield paid by junk bonds over the rates of ultra-safe U.S. Treasury securities, the yield premium, hit an all-time low this year. And now you have some investors pointing to similarities between lax underwriting standards for subprime mortgages and the easy credit terms available to leveraged buyout borrowers. With the economy slowing and long-term interest rates ticking up, companies that borrowed too much will have trouble repaying their debt.

“The tide is going out and all the wreckage at the bottom of the sea is about to show up,” Jeffrey Gundlach, manager of the TCW Total Return Bond Fund, warned the other day after his speech at the Morningstar conference.

What’s an investor to do? You can certainly pare your holdings of junk bond or related funds. “You’ve got to avoid high yield at the moment,” says Herb Morgan, president and chief investment officer at Efficient Market Advisors in Del Mar, California. But that’s not always possible. You may have junk bonds mixed into a broader fund or perhaps even own a few corporate issues directly. Sometimes selling would create a painful tax bill. So the next question is how to hedge.

There’s still not much out there for individual investors. Hedge funds and other big players go to the over-the-counter derivatives market to trade what are called credit default swaps. But regular folk can’t get in to that market. As I mentioned back in April, Rydex does have a mutual fund now that takes a short position against high yield debt using credit default swaps. The Rydex Inverse High Yield Strategy Fund trades under the symbol RYILX.

For more sophisticated investors, the Chicago Mercantile Exchange has started trading a futures contracts based on an index of 50 credit default swaps. And the Chicago Board Options Exchange has listed options on credit default swaps for five individual companies, including General Motors and Ford Motor Company, that could be used to hedge individual bond holdings. Efficient Market’s Morgan, an exchange-traded fund specialists, says a third strategy is to sell short the new Barclays iBoxx $ High Yield Corporate Bond ETF, which trades under the symbol HYG. Still, if interest rates came down overall, that move might backfire even if junk bonds underperformed.

A more hedge-like move might be to sell HYG short while buying an ETF of a similar maturity of Treasury bonds. Gary Gordon, a financial advisor and president of Pacific Park Financial, offers the trade of going long the iShares Lehman 7-10 Year Treasury Bond Fund (IEF) and short the iShares Goldman Sachs Corporate Bond (LQD) or the iBoxx iShares fund. Actually, Gary blogged an even more detailed answer after he got my question. The blogosphere strikes again.