Sept. 17 (bloomberg) - Exchange-traded funds are poised to overtake credit derivatives by year-end as a way to speculate on junk bonds.
The value of corporate securities held by the five-largest junk ETFs almost doubled in the past year to a record $31.4 billion, while the net amount of protection bought or sold on the debt using the two current credit-default swaps indexes declined 3 per cent to $35 billion, data compiled by Bloomberg show. The ETFs are growing at an average 5.2 per cent monthly pace this year, which would put assets at more than $36.5 billion by December 31.
Trading in credit swaps has slowed as the market faces regulation for the first time under the Dodd-Frank Act, potentially making them harder and costlier to buy and sell. The growth of junk-bond ETFs, which are listed on exchanges and brokered like stocks, has accelerated since their inception in 2007 as investors seek a faster and cheaper way to trade debt.
“Product innovation is often the answer to regulatory change and I don’t think it’s any coincidence that we’ve seen this explosion of interest in fixed-income ETFs just at the point at which CDS as a product and asset class comes under pressure,” Will Rhode, director of fixed-income at research firm Tabb Group LLC, said in a telephone interview.
Gaining influence
Junk-bond ETFs, which have attracted 25 per cent of high- yield fund inflows since 2010 as measured by EPFR Global, are gaining influence in a market where both securities and their derivatives are generally traded off exchanges.
Even investors seeking to hedge against losses on the securities have started using ETFs, with the number of shares borrowed to bet against one run by State Street Corp. surging almost three-fold from the end of 2011.
Credit swaps, created in the 1990s as a means for lenders to protect against losses on corporate debt, gained popularity in the past decade as a way to wager on gains without actually owning bonds or loans.
With the Federal Reserve saying last week it will probably hold its interest-rate target near zero through at least mid-2015 and conduct a third round of bond purchases to stimulate the economy, investors are gravitating toward the funds to boost returns as demand for default protection diminishes.
Spreads shrink
Elsewhere in credit markets, the extra yield investors demand to hold corporate bonds globally rather than government debt narrowed for a second week, reaching the lowest level in 13 months. The cost of protecting company obligations from default in the US fell to the lowest in 18 months. Leveraged loan prices reached the highest levels since February 2011.
Relative yields on company bonds from the US to Europe and Asia tightened 10 basis points last week to 173 basis points, or 1.73 percentage points, according to Bank of America Merrill Lynch’s Global Broad Market Corporate index. That’s the least since August 2, 2011, for spreads, which have contracted from a more than four-month high of 236 on June 1. Yields rose to 2.907 percent from 2.903 percent on September 7.
The Barclays Global Aggregate Corporate Index has gained 0.86 percent this month, bringing returns for the year to 8.5 percent.
The Markit CDX North America Investment-Grade index declined 10 basis points last week to a mid-price of 83 basis points, according to prices compiled by Bloomberg. That’s the biggest drop since the period ended December 23 and the lowest level since March 3, 2011.
London swaps
In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings plunged 7.9 to 118.2. In the Asia- Pacific region, the Markit iTraxx Asia index of 40 investment- grade borrowers outside Japan dropped 3 to 112.5 as of 8:24 a.m. in Hong Kong, Royal Bank of Scotland Group Plc prices show.
The indexes typically fall as investor confidence improves and rise as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million.
Bonds of New York-based Morgan Stanley were the most actively traded dollar-denominated corporate securities by dealers last week, with 727 trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
A five-part $4 billion offering from Walgreen Co. led borrowers selling $115.5 billion of bonds globally, compared with $111.6 billion in the period ended Sept. 7, Bloomberg data show. Weekly sales had averaged $72.8 billion this year.
Leveraged loans
A $1.2 billion portion of Walgreen’s 3.1 percent, 10-year notes rose 1.3 cents from the issue price on Sept. 10 to 101.16 cents on the dollar at week’s end, Trace data show.
The S&P/LSTA US Leveraged Loan 100 Index climbed 0.59 cent to 96.16 cents on the dollar, the highest level since February 23, 2011. The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, has climbed from 91.8 on June 5, the lowest in almost five months.
Leveraged loans and high-yield bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- at S&P.
In emerging markets, spreads narrowed 19.3 basis points to 282.5 basis points, the least since April 8, 2011, JPMorgan Chase & Co.’s EMBI Global index shows. The gauge has tightened from this year’s high of 441 on Jan. 13.
‘Meant to work’
Trading volumes in the current version of the Markit CDX high-yield credit swaps index have declined 20.2 per cent from last year, when an escalating European debt crisis sent debt investors rushing to protect against losses, Barclays analysts led by Bradley Rogoff wrote in a September 14 report. The firm cited data from the Depository Trust & Clearing Corp., which runs a central credit-swaps repository.
The declines, they said, have resulted in part from regulations being written to comply with the 2010 Dodd-Frank Act, which will require most swaps to be processed by clearinghouses and traded on exchanges or electronic systems after the contracts complicated efforts to resolve the financial crisis four years ago. The rules will increase costs for both banks and money managers in the market.
“This is the way in which financial markets are meant to work; adapt to change through innovation,” Tabb’s Rhode said.
ETFs may eclipse credit-swaps indexes in debt markets in part because a lot of traditional money managers have never fully embraced the derivatives, according to Peter Tchir, founder of New York-based macro strategy firm TF Market Advisors.
CDS disappointment
“They’ve always looked for an alternative and been really disappointed with CDS,” he said in a telephone interview.
ETF assets and shares outstanding have surged at the same time that dealer inventories of the underlying bonds shrink to the lowest in more than a decade, making it more difficult for money managers to trade the debt.
Holdings of corporate securities by the 21 primary dealers that trade directly with the Fed have shrunk 81 percent to $43.8 billion as of September 5 from the peak of $235 billion in 2007, according to data from the central bank.
“I’ve definitely had it pitched to me a lot” as an alternative to holding cash reserves, Nancy Davis, director of derivatives at New York-based AllianceBernstein LP, which manages $230 billion of fixed-income assets, said of high-yield bond ETFs in a telephone interview.
Default rates
The funds are more appealing than credit swaps to investment firms that haven’t set up legal protocols to trade the privately negotiated contracts with banks or are restricted from trading the derivatives, Davis said.
“They either have cash positions or they’re completely invested in cash bonds, which aren’t always very liquid,” she said.
Junk-bond investors have been emboldened by default rates below historical averages. Moody’s global speculative-grade default rate was 3 per cent in August from 1.8 per cent a year ago, according to a September 10 report. That compares with a historic average of 4.8 per cent in Moody’s data going back to 1983.
“The rate of default has remained remarkably steady,” Albert Metz, managing director of Moody’s Credit Policy Research, said in the note. “As credit spreads continue to narrow slightly, our forecast remains fairly benign” at 3.1 per cent by year-end and 3 per cent in August 2013, he wrote.
BlackRock ETF
For investors not sold on the junk-bond rally ETFs also provide an alternative for betting against the market. The shares are easier to borrow than corporate bonds for use in short sales, in which traders sell borrowed stock in a bet they can profit from price declines.
The number of borrowed shares of State Street’s SPDR Barclays Capital High Yield Bond ETF climbed to a record 13.1 million on August 30 from 4.75 million at the end of 2011, according to Markit Group Ltd. The amount eased to 6.76 million on September 12 as speculation the Fed would unleash another round of stimulus caused bearish investors to reverse bets.
Corporate holdings in the ETF, the second-largest of its kind, climbed 43 per cent this year to $12.7 billion, with the fund returning 11.2 per cent, Bloomberg data show.
Holdings in BlackRock Inc.’s iShares iBoxx High Yield Corporate Bond Fund, the largest, surged 60 percent to $17 billion, returning 9.9 per cent in 2012. That compares with average gains of 12.6 per cent in Bank of America Merrill Lynch’s US High Yield Master II Index.
London whale
Investors seeking a hedge against junk-bond losses also were pushed to ETFs earlier this year after trades by a JPMorgan trader distorted prices in credit-swaps indexes.
Bruno Iksil, who became known as the London Whale because the size of his bets grew so large, fueled price disparities between the derivatives benchmarks and the price of contracts on companies within the indexes, market participants familiar with the trades said at the time.
Such dislocations unique to credit derivatives may scare away investors, according to Stephen Antczak, Citigroup Inc.’s New York-based head of US credit strategy.
“When you’re seeing big divergences in indexes from their constituents, maybe that’s being driven by someone who’s not a credit investor, maybe it’s an equity guy,” he said in a telephone interview. “That’s what worries people. Those indices can get whippy that are not necessarily driven by cash corporate bonds.”
