Junk Bonds Have Gone From Risky And Rewarding To Just Plain Risky. So Should You Bet Against Them?

Reda Farran

9 months ago6:12 mins

Junk Bonds Have Gone From Risky And Rewarding To Just Plain Risky. So Should You Bet Against Them?

What’s going on here?

One man’s trash is another man’s treasure, and junk bonds have promised untold riches over the last twelve months. Now, though, some of the world’s biggest hedge funds seem to have smelled a rat, and they’ve taken their biggest short position on junk bonds since 2008…

What does this mean?

To understand why hedge funds are so anti-junk bonds, we need to rewind a bit.

Last year, central banks all over the world responded to the pandemic-induced economic commotion by slashing interest rates and embarking on massive bond-buying sprees. That pushed down yields in safe corners of the bond market – government and investment-grade corporate bonds – to really low levels. So it’s no surprise that yield-hungry investors have been turning to the higher returns of junk bonds: those issued by companies more at risk of defaulting, and which offer a higher reward to win investors over.

Trouble is, that influx of new investors pushed yields of junk bonds down to below 4% for the first time ever earlier this year.

The average yield on US junk bonds is at an all-time low (Source: Bloomberg)
The average yield on US junk bonds is at an all-time low (Source: Bloomberg)

What's more, the spread – the extra yield on top of government bond yields – on the riskiest kind of junk bonds (those rated “CCC”) dropped below 5% last month. We’ve only seen that twice in the last two decades: the years leading up to the 2008 financial crisis, and right before the dotcom bubble burst.

Spreads on CCC-rated bonds are flashing a warning sign (Source: Bloomberg)
Spreads on CCC-rated bonds are flashing a warning sign (Source: Bloomberg)

Those lower borrowing costs have encouraged more and more risky companies to borrow money via the bond market, with junk-rated companies issuing a record amount of bonds last month. That’s pushing overall company indebtedness to new highs, making them vulnerable to any snag in the economic recovery that’d impact their ability to pay back lenders.

And that’s not the only risk to the junk bond market. If central banks start reversing – or are even seen to be thinking about reversing – the support measures they implemented during the pandemic, bond yields could shoot up and their prices could collapse. And while the US central bank maintains it isn’t ready to raise rates or slow down bond purchases just yet, investors are betting that it’ll have no choice later this year if the economy starts to overheat.

That brings us to hedge funds: they’ve noted that the rewards of junk bonds are slipping and their risks are mounting, and they’re going all in against them.

Why should I care?

Put simply, hedge funds might be onto something.

Junk bonds could well be headed for trouble, and you might want to bet against them yourself – either by outright shorting junk bond ETFs, or buying put options on them. One of the biggest and most popular in the US is the iShares iBoxx $ High Yield Corporate Bond ETF (ticker: HYG), or iShares € High Yield Corp Bond UCITS ETF (ticker: IHYG) in Europe.

And here’s the thing: the all-time low of junk bond yields means shorting them has an attractive asymmetry in terms of its risk and reward. See, the HYG ETF has a 4% dividend yield, which means you stand to lose around 4% a year by shorting the ETF. That’s putting aside changes in the ETF’s price which – outside of big downside shocks – are quite small: HYG’s price is up just 6% versus where it was five years ago.

But if you turn out to be right and the junk bond market falls apart, your reward could be a lot higher than 4%. HYG’s price, for example, collapsed 22% during the pandemic-induced market turmoil last year, and experienced a peak-to-trough drop of more than 40% during the 2007-08 financial crisis. So junk bond investors are right about one thing: one man’s trash really is another man’s treasure.

Key takeaways

  • The valuation levels of risky corporate debt – or junk bonds – are starting to look really stretched, with the average yield hitting a record low earlier this year.
  • The junk bond market could be headed for trouble if the economic recovery hits a snag, or if central banks start reversing their pandemic support measures.
  • Hedge funds are betting big against junk bonds, and you can join them by shorting junk bond ETFs in a trade that has an attractive asymmetry in terms of its risk and reward.

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