Junk-Bond Traders Pile Onto Hedges Amid Fed After Rally

With the Federal Reserve getting ready to boost interest rates, investors are adding hedges to junk bonds as they grow ever more expensive versus stocks.

There haven’t been this many bearish options on an exchange-traded fund tracking high-yield debt in almost a year, relative to bullish contracts, according to data compiled by Bloomberg. Puts protecting against a 4.3 percent decline in the ETF by June had the largest ownership, the data show.

Fixed-income investors with money to spend have been piling into junk bonds for years, sending their yields close to a record. Marathon Asset Management LP say prices will fall as the Fed starts raising rates, while defaults will probably increase as underwriting standards weaken.

“People are over-exposed to junk bonds, so they may have to hedge part of it after seeing good gains,” said Pierre Mouton, who helps oversee $8 billion at Notz, Stucki & Cie. in Geneva. “High-yield bonds may suffer in the short term, should long-term U.S. government yields go up. The U.S. economic numbers are very good.”

Five years of stimulus by central banks has helped speculative-grade bonds return 144 percent from the end of 2008. Outstanding junk securities tracked by a Bank of America Merrill Lynch index have surged to about $2 trillion worldwide from less than $1 trillion in March 2009.

Junk-bond investors are accepting payouts that are 0.74 percentage point lower than the earnings yield on the Standard & Poor’s 500 Index. Historically, debt rated below investment grade has yielded an average 4.2 percentage points more than stocks since March 1995.

Bearish Bets

There were 322,418 outstanding puts giving the right to sell the iShares iBoxx $ High Yield Corporate Bond ETF on May 5, compared with 73,736 calls, data compiled by Bloomberg show. The put-to-call ratio climbed to 6.35-to-1 on May 1.

Investors have withdrawn money from the fund, the biggest junk-bond ETF, each month since November, according to the data.

Leveraged loans and junk bonds are forms of high-yield, high-risk debt that carry ratings of less than Baa3 by Moody’s Investors Service and below BBB- at S&P. Investors of speculative-grade debt take on the risk of not getting their money back should the company default, therefore demanding higher yields.

Fed Stimulus

The Fed began trimming its monthly bond purchases in January, and Chair Janet Yellen said on March 19 that the central bank’s stimulus program could end this fall and benchmark interest rates may rise about six months later.

The Federal Open Market Committee in March scrapped a pledge to keep its key interest rate low at least as long as unemployment exceeds 6.5 percent, instead adopting a broader range of data as a guide. A report last week showed employers boosted payrolls in April by the most in two years, sending the jobless rate to 6.3 percent.

As a result of the Fed’s policies, companies owned by private-equity firms are piling more junk debt onto the companies they own, adding to concern among regulators that excesses are emerging. Some of the least-creditworthy companies are even selling notes that may pay interest with more debt.

U.S. junk bonds still offer investors good returns, according to Coutts & Co.’s Alan Higgins. The debt yields 6.03 percent, compared with 3.10 percent for securities rated above Ba1 by Moody’s Investors Service and higher than BB+ by S&P, according to Bank of America Merrill Lynch index data.

Goldilocks Situation

“It’s a nice Goldilocks situation,” Higgins, who helps manage about $50 billion as chief investment officer for the U.K. at Coutts, said by phone. “You have decent enough growth, strong enough earnings that are good for high-yield bonds, but not so strong that rates are going to rise dramatically or quickly. It’s not a time to be an aggressive buyer, but the spreads are moderately attractive.”

Even after short sales on the high-yield ETF surged to a record this year, the market kept on rallying. The volume of borrowed shares on the fund, usually used for short selling, soared to an all-time high of almost $3.6 billion on March 31, according to data compiled by Bloomberg. The ETF has gained 1.2 percent this year.

Bank of America Merrill Lynch’s MOVE Index, based on prices of over-the-counter options on Treasuries maturing in two to 30 years, climbed 6 percent to 58.67 yesterday. The Chicago Board Options Exchange Volatility Index, the gauge of Standard & Poor’s 500 Index derivatives costs known as the VIX, slipped 0.1 percent to 13.78 at 10:04 a.m. in New York today.

Open Interest

Among the 10 most-owned options on the high-yield fund, eight were bearish. June $90 puts and June $91 puts had the largest open interest, data compiled by Bloomberg show.

Bearish contracts cost 8.4 points more than bullish ones, more than the one-year average of 7.3, according to the data.

While corporate debt may still offer some good investment options, the risks related to junk bonds outweigh the potential compensation, according to Kevin Caron, a market strategist at Stifel Nicolaus & Co.

“I’m not surprised to see the put-call ratio looking the way it does,” Caron said in an interview from Florham Park, New Jersey. His company oversees about $160 billion. “We’ve been a little underweight high-yield in portfolios. We want to make sure we’re well paid to take on the risk.”

Before it's here, it's on the Bloomberg Terminal.