Open a Junk-Bond ETF’s Kimono to See a Lot of Expensive Shorts

Hedge funds dislike junk bonds so much that they’re willing to pay 48 times more to short the debt using exchange-traded funds than at the end of last year.

A prime example is BlackRock Inc.’s $12.4 billion fund that trades under the ticker HYG, which allows traders to borrow a certain proportion of shares to wager that prices will decline. The daily cost for financing such activity was $342,000 a day in the week ended Aug. 5, up from $7,000 at the end of December, according to DataLend, which tracks securities lending.

This shows a couple of things. First, that traders have really hated high-yield debt ETFs in recent weeks. And second, that ETFs, often thought of as tools for individual investors, are increasingly dominated by a hedge-fund type crowd, particularly in less-traded asset classes like junk bonds.

“It seems like maybe these ETFs are acting as canaries in a coal mine for possibly a broader selloff,” said Chris Benedict, director and lead analyst of DataLend. While the cost to make bearish wagers against the funds has declined a bit, “demand is still very, very strong.”

While it’s unclear what exactly spurred the July selloff that led to a 1.3 percent decline in dollar-denominated junk bonds, it certainly had to do with concern that yields had fallen too much. They reached a record low of 5.69 percent in June and Federal Reserve Chair Janet Yellen said she was seeing signs of froth there.

Debt Rebounds

So when the geopolitical backdrop worsened with escalating conflicts in Gaza and Ukraine, it seemed unreasonable to accept such little compensation for owning speculative-grade notes.

Hedge funds and other institutions turned to ETFs to pile onto a bet against the bonds. While BlackRock’s iShares iBoxx $ High Yield Corporate Bond fund has been one of the most popular ways to wager against the junk-bond market, other funds are being used in similar manners.

Traders were spending about $157,000 a day earlier this month to finance share lending activities on State Street Corp.’s $9.2 billion fund that trades as JNK, according to DataLend. About 93 percent of that fund’s shares that were eligible for shorting activities were on loan.

Expensive Wagers

The junk-bond market needs to really tank to make these expensive wagers worthwhile. It’s getting more costly to borrow ETF shares at the same time that the debt has still delivered a

5.2 percent return this year, including coupon payments, according to Bank of America Merrill Lynch index data.

In August, the notes have been rebounding, gaining 0.95 percent as investors plow back into the debt they abandoned a few weeks ago. BlackRock’s fund is up 2.3 percent this month and State Street’s has returned 2.2 percent.

So even though there are more and more bears in the twilight of the Fed’s unprecedented stimulus program, they’re probably feeling some pain right now. It’s not easy to fight the Fed, even when the central bank is trying to fade out.

Let’s see how long traders can last clinging to these expensive wagers.

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