Carried Away With Junk

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."

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