US junk bonds are expensive given the deteriorating performance of many high-yield corporations, and buying credit derivatives on individual companies can be the best way to bet against the debt, according to Barclays Plc strategists.
(Bloomberg) — US junk bonds are expensive given the deteriorating performance of many high-yield corporations, and buying credit derivatives on individual companies can be the best way to bet against the debt, according to Barclays Plc strategists.
Risk premiums, or spreads, on junk bonds averaged about 3.85 percentage points on Tuesday, close to the lowest level of the year and below the average of the last decade of 4.3 percentage points. In times of market turmoil, high-yield spreads can reach 7 percentage points or higher.
Meanwhile, corporate earnings show that key measures of income are falling relative to interest expenses, among other signs of deteriorating performance, Barclays strategists wrote earlier this year. The Federal Reserve is signaling that interest rates may stay higher for longer than many market participants had expected, which is broadly weighing on bond yields now.
That combination of deteriorating corporate performance plus low risk premiums means it makes sense to look at betting against high yield now, strategists led by Bradley Rogoff wrote in a note dated Aug. 18. Spreads might not widen much between now and September, according to Barclays, which makes it hard to short junk bonds through, for example, repo trades.
But there are companies rated in the BB and B range where the cost of using derivatives to protect their debt against default is less than the spreads on their bonds, known as a negative basis. That implies that credit default swaps for some corporations are too cheap, and there’s an opportunity to add hedges, or just bet against junk debt, relatively cheaply, the Barclays strategists wrote.
For example, buying five-year credit default swaps on MGM Resorts International, a casino operator, costs about 2.33 percent a year, or 233 basis points. Its bonds due in October 2028, with a 4.75% coupon, recently traded at a yield-to-worst of about 7%, and a z-spread of around 290 basis points.
Entering these trades has become easier, because single-name credit default swap liquidity is improving, at least for some names. Credit-default swap volume for single high-yield names in the Markit CDX North America High Yield Index is 41% higher than last year, Barclays strategist Jigar Patel wrote earlier in August, while those in the investment grade index increased 62%.
While an investor might be tempted to just buy protection on the Markit CDX North American High Yield Index, index swaps are expensive now relative to the Bloomberg US Corporate High Yield Bond index. The CDX index, which is skewed toward BB rated credits, hasn’t benefited as much as the cash index from gains in lower-rated junk, according to Barclays.
Junk bond sales have been relatively light this year, which is one factor that has helped keep risk premiums low for many issuers. But some investors can see the argument for betting against junk bonds.
“You are seeing a deterioration in high frequency data, from consumers to default rates, and there’s a reasonable argument that earnings peaked and things get more challenging from here,” said Christian Hoffmann, a portfolio manager at Thornburg Investment Management Inc. “If you are putting on a CDS trade, you can get decent liquidity in hopes spread widen.”
Thornburg doesn’t take short positions within its funds, Hoffmann said.
Barclays recommends the trade idea for the following bonds and companies:
Xerox and Charter Communications declined to comment. Bombardier, Beazer, MGM and Vistra didn’t respond to requests for comment.
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