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Carried Away With Junk

Emma Trincal

A popular hedge fund trade in which a long position in junk bonds is paired with a short sale of Treasuries has been lighting up the rails this year, but some think the train has left the station.

The tactic is a version of the "carry trade," which in its most basic form involves borrowing money at low short-term rates and lending it at higher long-term ones. Bonds act like loans in such a trade, with interest collected on the long position and paid out on the short sale. In this version, differing risk is substituted for differing maturities.

All things being equal, a trader holding this position "clips the coupon," or collects the spread between the higher interest rate he earns on the junk and the lower rate he pays to the owner of the Treasury. He's protected from price swings, albeit imperfectly. If interest rates rise, the value of his junk bonds goes down while the value of his bearish bet on Treasuries rises (although maybe not as fast).

The main risk in such a trade comes from the higher vulnerability of junk bonds to default. For some time, it has been a risk hedge funds have been willing to live with.

"You hope the default is not going to be too high. It's like standing in front of a train and hoping that the train doesn't roll over you," says Philippe Burke, founder of Apache Capital Management, a New York-based hedge fund. "All of a sudden, people start dumping the junk bonds. Everybody buys Treasuries and you are short Treasuries. You get slaughtered."

"A lot of hedge funds are doing the carry trade," says James Melcher, founder of Balestra Capital Management and a fervent critic of the strategy. "The problem with the carry trade is that a lot of morons are doing it because it's easy to do. All you do is cross your fingers."

Burke gives the following simplified example. An investor buys junk bonds and gets a cash flow of 10% from the coupons. He shorts a Treasury yielding 5% as a hedge. His net profit (or "net carry") is 5%. But junk bonds are by definition risky and a portion of his holdings is going to default. If he buys 100 of those bonds at one dollar each and five of them go bankrupt, he loses 5%. The trader is then flat on the year.

"He can only hope that the default rate is not going to exceed 5%," Burke says. So long as the default rate remains lower than the expected net, the trade remains positive. To be worthwhile, however, it has to return more than the money market, which is around 4%. Hence, the carry trade works better when interest rates are low.

Once a trader takes this position, its overall value goes up as the yield spread between junk bonds and the Treasuries narrows. The owner continues to harvest the difference between the securities' two yields that he locked in when he put the trade on. He's also profiting from one of two things implied by the narrowing yield: a higher price on the junk bond or a lower price on the Treasury (which he's short).

That's made the trade a winner this year. At Dec. 6, the Merrill Lynch US High Yield Master II Index was yielding 368 basis points above Treasuries. That's down from a spread of 419 basis points in April around the time of General Motors'(GM Quote - Cramer on GM - Stock Picks) debt downgrade.

Spreads could even further tighten in January, says Lorraine Spurge, a high yield portfolio manager at Post Advisory Group, a firm that manages $8 billion in high-yield long/only and hedge funds. She refers to what is called the "January effect." During that month, corporations are not issuing much paper as they end their fiscal year. At the same time, demand is high with institutional investors making their first allocations for the New Year.

Spurge says that with a default rate below 2%, this year is healthier for junk bonds than it has ever been, citing a 4%-5% default rate as the median. "There are a little bit more defaults in auto and airlines, but people feel very confident in companies," she says.

But while hedge funds continue to amass high-yield bonds, others believe that the carry trade junk party is over.

The first and most obvious reason for that is the fact that rates rose from 1% to 4% in the past 18 months. When rates are higher, the chase for higher-yield bonds may not be worth the risk.

"The risk/reward of the junk bond vs. Treasury trade is lousy right now," says Burke. Returns have collapsed and too many people are chasing too little yield, he says. "The best conditions for the carry trade are when you just had a big crash; everybody is putting money in Treasuries, everybody is scared to death; and junk bonds are very yieldy," he notes.

Another problem is the migration of funds to a more traditional carry trade that involves shorting near-term instruments to finance longer-term ones. "I see a lot of curve trading among hedge funds right now," says Doug Frigon, institutional bond salesman at San Francisco-based broker dealer Stone & Youngberg, whose clients are hedge fund managers. The trade usually consists of buying 10- or 30-year Treasury bonds and shorting the two-year government bond. The bet is that bonds will appreciate in price.

Others believe a "negative" carry is a better option at this stage.

"We're short junk bonds and long Treasuries. We're doing the exact opposite of what a couple of thousand hedge funds are doing," says Melcher. "If there is distress, junk bonds will decrease in price and people will buy Treasuries. Holders of junk bonds will look for an exit and will get killed," he says. He uses this "reverse carry" as a protection against bad times.

"If we're going through some financial crisis, junk bonds are going to go down very much and Treasuries will go up sharply. That's what happened in 1998. In 1998, I did not have a hedge fund yet, but I was prepared. I was long treasuries and short junk bonds and I was up 60%," says Melcher.

"The carry trade has been going on for a while. It's a spread trade. But spreads have narrowed. Not just junk bonds but all credit spreads," says David Kotok, a bond manager at Cumberland Advisors. "This reverse trade makes sense to me. I would do it if I were a hedge fund."