EnvisionCap.com: Forbes Article - How to Short Junk Bonds

How to Short Junk Bonds

Marilyn Cohen, Forbes Magazine, 9.05.05

There's a new way to bet on a decline in the high-yield market. And it's a good bet: Junk is way overpriced.

Remember West Side Story? Just as they say in the musical, "There's a rumble coming." The Sharks and the Jets in this case are junk bond bears and bulls. Retail investors have been exiting junk mutual funds (so far this year removing $7.93 billion, or 6% of the funds' assets, according to AMG Data Services), but hedge funds have kept buying junk, more than offsetting the mutual fund outflow. For once the retail folks are the smart ones.

I have been warning for some time that high-yield bonds are not worth the risk (see my Jan. 10 column). Unfortunately, if you heeded my warning then, you have left money on the table thus far in 2005. The high-yield market has gone from overvalued to extremely overvalued.

But the hedge funds won't continue their merry chase of junk prices forever. Junk is badly overpriced and overdue for a fall. The spread between a speculative-grade junk bond, one rated B2, and Treasurys is just 3.25 percentage points. That's not a lot of compensation for the risk of owning junk. The cumulative default rate over ten years for this grade of bond is 44.5%, according to Moody's. To be sure, you will be collecting a yield for the remaining 55.5% on a hypothetical portfolio over the ten years, but that would scarcely make you whole. If the long-running recovery stumbles, defaults will be worse than you see in these historical averages. In the late 1990s, even before the recession, defaults began increasing.

It used to be that the only way to deal with an overpriced junk market was to get out. Now you can do better than that. You can buy a fund that, in effect, has a short position in junk bonds. That fund is the open-end, no-load Access Flex Bear High Yield Fund, managed by ProFund Advisors. The opportunity doesn't come cheap: Minimum purchase is $15,000, and fees are a bit high at 1.45% of assets annually. Avoid the Service Class shares offered through your financial adviser since they will cost you an extra 1% in fees.

The fund does not generally short junk bonds, nor does it do any fundamental research. Instead, it seeks inverse exposure to the high-yield market through a creature called the credit default swap (CDS). This is a derivative for institutional players, a form of insurance against defaults. When junk prices rise (and yields drop), CDS prices fall because high-yield bonds seem less likely to default. When junk prices dip, CDS issues appreciate.

Member banks that are part of the CDS Index consortium are all the major brokers from Goldman Sachs to Merrill Lynch, from J.P. Morgan Chase to Deutsche Bank. CDS supply is plentiful, meaning Access Flex Bear doesn't have to worry about liquidity. The credit default swap market itself is humongous; global credit derivatives have a notional value of $8.42 trillion, a good chunk from swaps, according to the International Swaps and Derivatives Association.

Access Flex Bear buys these CDS instruments for a basket of 100 junk bonds. If defaults rise, high-yield prices will erode, spreads will widen between junk and Treasurys, and the value of the Access Flex Bear fund will climb. Since junk is still doing well, the fund is down 4% from its late-April launch.

While the ProFund family has $7 billion in assets, the fledgling Access Flex Bear fund is a peanut, with $30 million. Still, it is growing fast, with $1 million per day in new money. The long-needed ability to short high-yield is certain to catch on quickly.

Up to now the closest you could come to a junk-shorting portfolio has been a handful of funds that bet on a decline in Treasury prices, which have a loose relationship with junk since overall rates affect them both. Rising Rates Opportunity ProFund uses derivatives to track the inverse of Treasury prices. Begun in mid-2002, Rising Rates has amassed a respectable (for a newbie) $650 million in assets, despite a not cheap 1.42% in expenses and an uninspiring 7.26% year-to-date loss amid continuing low yields.

The Access Flex Bear High Yield Fund enables you to hedge your traditional high-yield fund during a market descent or just outright bet on a decline in junk bond prices and a rise in their default rate. While buying and holding is usually a good strategy, don't hang on to this fund; use it only when you think junk is overvalued and ready for a correction.

If I think this fund is such a hot idea, then why haven't the leading mutual fund companies caught on? They're too large and too enamored of their own bullish funds, I suspect. Short-selling is not a way to win a popularity contest on Wall Street.

I am hoping that we will soon see exchange-traded funds that take short positions in the junk market. As ETFs, they will be liquid and likely cheap--well below 1%.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed-income money manager and author of The Bond Bible. Find past columns at www.forbes.com/cohen.