Life After Citi: Shorting High Yield Bonds

The sheer quantum of bad news due in forthcoming months forms a compelling basis to continue seeking substantively misaligned asset classes in the marketplace. As it is becoming evident that government intervention is rapidly destroying traditional valuation premises in the financial sector, the challenge today is to identify opportunities which will not draw the attention of Washington lawmakers and regulators, for bailout purposes, for many months into 2009.

The recommendation to short high-yield bond ETFs (HYG, EFT, EFR and JFR, depending upon risk-appetite) at or around Monday’s levels is founded on the following three premises. Firstly, despite the fact that the 5-year CDX index (HY-11) spread has widened from 925 to 1550 basis points since early October, the bulk of the high-yield spectrum continues to trade on yields which reflect, comparatively, near-investment-grade ratings which, in turn, have already proven to be inadequate and misleading. Secondly, even the 1550bps level does not fully incorporate the real prospect of additional negativity in default risk perceptions (i.e. credit default swap spreads) as more data on the domestic and global economy enters the public domain over the holiday stretch and in the first quarter of next year.

Finally, the liquidation risk on high-yield debt has risen appreciably in recent weeks; in numerous instances, despite nominal quotes on trader screens, there are no buyers at all. Last week’s meltdown in the commercial mortgage-backed securities (CMBS) market represented only a preliminary (and shocking) insight into an oft-ignored corporate sector which probably needs a Fed-managed funding facility more than Wall Street’s elite institutions; a facility it will not get, at least in the foreseeable future.

For that matter, in view of the irrelevance or inapplicability of ratings, investment-grade ETFs (e.g. LQD) are also creating valid short propositions for investors with a 6-month time horizon. Though the 5-year CDX index (IG-11) spread has widened appreciably this month (last at 270 bps), the outlook remains essentially bearish; spread levels in excess of 400-450 bps are firmly within the realm of reality.

For example, the current spread for highly-rated General Electric (GE) 2013 is 405 basis points, despite the company accessing the Fed’s commercial paper facility and the FDIC’s guarantee program. American Express (AXP) 2013, still being rated in the relatively lower investment-grade category, is being quoted around 670 basis points. Look for a near-term widening (in spreads) of 25% for both issuers.

As the Wall Street Journal specifies on its websites, corporate spreads sometimes mirror and sometimes anticipate share price movements, and the somewhat bullish tone in corporate bonds this week is certainly a result of the remarkable advances in the Dow and S&P500.

But, by and large, the debt matrix, in America and abroad, is still unaffected by the new yield-spread pricing realities which are slowly filtering through the lending environment. Thus far, the focus has been on the slide in benchmark rates. But, from this point forward, the downside play on benchmark rates is limited, at least for US$-denominated loans; a Fed Funds rate of 0.40% has already been priced by the debt markets.

On the other hand, several new corporate loans are now being priced in a “non-traditional” manner: i.e. a benchmark rate (usually Libor) plus the cost of funds, plus the spread on default risk insurance, plus upfront fees. When (not if) this revised, and logical, methodology gathers momentum, short positions, entered this week, in both investment-grade (supposedly) and high-yield ETFs will yield significantly above-average returns. A similarly attractive trade would be to short a liquid, emerging market high-yield-bond ETF, if such an ETF is available.

Disclosure: Author holds a short position in HYG

Comments

[User 306329:]

You may be right on price, but you will lose the distribution yield if you are short - you have to pay it to the person you borrow the ETF from to short. So the price has to fall about 15% annualised just to breakeven.

2008 Nov 25 04:49 AM

[Scott F:]

Where do you find the borrow for your short position?

2008 Nov 25 05:22 AM

[Toeser:]

I never say never, and you could be right, but it seems a little late in the cycle to initiate these short positions. Plus, after reading an opinion on a possible building short bubble, I checked the stats of numerous weak stocks. Based upon what I saw, a "short bubble" is a real possibility. We could see some pretty violent upside moves if this thing ever starts to unwind in earnest.

2008 Nov 25 07:45 AM

[cma:]

The author has just discovered a short in high yield bonds after the spread over Treasuries has widened to historically high levels. He is about 6 months late to the party. Also, junk bond yields imply default rates higher than in 1933.

2008 Nov 25 03:24 PM

[cma:]

"bulk of the high-yield spectrum continues to trade on yields which reflect, comparatively, near-investment-grade rating".
What world is he living in. High-yields bonds are showing a 20% current yield, hardly reflecting "near-investment-grade rating."
His other methodological error (one he made with Russian equities) is that when the message of two markets (CDX Indexand real yields) are contradictory, CDX index will always be the more accurate predictor. History has shown this to be invalid.

2008 Nov 25 03:28 PM

[jepittman:]

This article strikes me as little more than 'pumping your position' which in fairness is widely done in all venues. I am certainly not a high yield expert and it is likely the author is better informed than me in this specialty. Yet, as others posting replys above have already stated, I am left feeling skeptical that shorting an asset class at record low prices is an intelligent suggestion. I vividly recall people enthusiastically recommending JDS Uniphase at $125 a share at what turned out to be the virtual top of the dot com bubble. Now these lower grade bonds may very well have further to fall but I think I will sit out this trade.

2008 Nov 25 05:28 PM

[Augustus:]

The factor that is driving the price of the low grade bond sector is the deleveraging of the hedgies. They had a pretty good trade going of borow short and cheap from the banks and lend longer and higher to the companies / buy bank loans. That is unwinding with a real crash as the hedge funds have to sell. It is driving the yields through the roof. As noted by someone else, the priced in default rates are unlikely to be hit in the real world future. I would rather look for a bottom pretty soon and look to get long in this sector. Why buy shares when you can lock in near 20% yields on the debt?

2008 Nov 26 05:43 AM