New Junk-Bond Derivatives Are Hot as Traders Get Creative

When it gets tough to maneuver in the junk-bond market, traders can either give up or get creative. Many of them are opting for creativity these days.

There’s been a surge in demand for a relatively new index of derivatives that aims to replicate the risk and return of high-yield bonds. As volatility soars to the most in more than a year, trading in a total-return swaps index reached a record $4 billion in September from almost nothing in May, according to data compiled by Morgan Stanley.

The demand is in part coming from fund managers who are looking for ways to be agile as individual investors become more fickle, pulling money out and then putting it back in, said Sivan Mahadevan, a credit strategist at Morgan Stanley in New York.

For example, investors have yanked $24 billion from high-yield bond mutual funds this year, with sentiment turning particularly sour in the three months ended Sept. 30, data compiled by Wells Fargo & Co. show. Yet they poured $2.5 billion into the funds in the week ended Oct. 29.

Managing Volatility

Investors also face a harder environment to maneuver in. The volume of dollar-denominated junk bonds outstanding has swelled 81 percent since 2008, but the market’s structure hasn’t evolved much. It still consists of thousands of individual bonds governed by unique documents, traded much the way they were a decade ago.

“Market fragmentation and liquidity constraints in a large part of the bond market make managing fund-flow volatility particularly challenging,” Mahadevan wrote in an Oct. 27 report.

The concern is that after six years of near-zero interest rates from the Federal Reserve and a largely one-way trade into bonds, a reversal of that demand will cause debt values to plunge as there won’t be many willing and available buyers on the other side.

So it’s no wonder investors are turning to derivatives to quickly adjust their holdings in a market that policy makers have said looks like a bubble.

Standardized Contracts

Here’s how the total-return swaps work: An investor pays a fee to a counterparty, who promises to deliver the equivalent of the total gains on a specified basket of debt. If the debt gains value, the bullish investor receives income without having to own the underlying security. If the debt loses, the investor will have to make the counterparty whole.

Since corporate bonds can be hard to find, investors are gravitating toward the derivatives, which have a standardized contract and can be created by dealers. They also allow money managers to express bullish or bearish views on the direction of the entire market.

“The environment this summer created a lot more interest and demand for total-return swaps,” Mahadevan said.

Volumes in an index of the swaps tied to high-yield bonds are now approaching trading in the two-biggest junk-debt exchange-traded funds, Morgan Stanley analysts wrote in the Oct. 27 report. The ETFs have also become popular as an easy way to bet on the market in the last few years.

Jumpy Traders

The bottom line is that debt traders are jumpy and feeling uncommitted to the direction of yields, especially as central banks start diverging from one another. The Fed ended its bond-buying program last month while European and Japanese central banks are adding to their easy-money policies.

The uneasiness could be seen in returns. U.S. high-yield bonds lost 1.3 percent in July, gained 1.5 percent in August, then lost 2.1 percent the following month, Bank of America Merrill Lynch index data show.

Of course, investors still want to make money, and using an instrument that’s inherently leveraged is a way to magnify gains, as long as you make the right picks.

The irony is that the more traders use derivatives, the more they’ll likely exacerbate volatility going forward. It means the shadow world of debt is prospering and that moves in benchmark rates may have a much bigger ripple effect.

So in the short run, traders are preparing to move more quickly. In the long run, their creativity may cause more pain on the way out.

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