Carried Away With Junk

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."