High Yield

If you invested in high yield bonds in December 2008--when they were selling for 55 cents on the dollar--and you held onto them until now, you participated in one of the strongest performing segments of the market's recovery over the last two years. That's that steep upwards jag in the yellow line on the right end of the chart above.

In 2009 the high yield index gained 57.5%, it gained another 15.2% last year and has already added an additional 3.7% in the first two months of this year. A good chunk of that performance has been driven by the economic and market recovery, but since late summer, with QE2 keeping interest rates depressed, it's also been driven by investors' search for yield in the market.

This has been great news for issuers. You can also see in the chart above what's happened to high yield spreads during the same period. The blue line is the amount over the prevailing Treasury rate that companies have to pay when they're selling new bonds in the market. It's not quite at record lows today, but given where underlying Treasury rates sit, issuers are doing just fine. Unsurprisingly, they've been active--the first two months of this year saw record deal flow of $9.8 billion in the riskiest segment of the market--CCC-rated bonds.

And deals have had all sorts of bells and whistles on them--they're covenant lite and some have PIK toggles--that allow issuers to issue new bonds instead of making interest payments, if they hit a bump in the road. Use of proceeds? In many instances, payment of dividends to private equity owners. All of these features are vintage pre-crisis, and, to use good market-speak, are signs that the high yield market may be getting a bit "frothy". Especially in the context of the last two years' market performance.

So I wasn't particularly surprised on Tuesday to see the headline Move to Synthetic Junk Bonds on the front page of the Financial Times' Markets section. What I expected to follow was an article on how anxious investors are finding clever ways to short the high yield market. What I found instead was one that offered up a generally bullish investor outlook on the economy--leading to the expectation that bond default rates will remain low--and that aforementioned search for yield as reasons for the uptick in demand for Credit Default Swap (CDS) derivatives in the high yield market.

The instruments described by the article--tranches of exposure to CDS Indices--aren't new. But in the wake of the financial crisis, their use is just re-emerging. For now, the market is tiny. According to the FT, at the end of February the net notional exposure on all CDS tranches--investment grade and high yield--was $5.9 billion--a mere drop in the multi-trillion dollar bucket of global financial markets.

My take away from learning about the resurfacing of these instruments was multi-faceted. First, that the market is so small, and yet the FT was able to spot it is, to me, an indicator of improving transparency in the derivatives market. Derivatives are traded over the counter. They are right now the subject of intense regulatory debate. In response, players in the market are moving to make information on their structure and trading more readily publicly available. Three years ago it's doubtful the public would have known these deals were being struck at this stage in the market's development.

Second, while I appreciated the optimistic perspective on the investor interest in the instruments, there are two sides to trades like these--the bullish and the bearish one. Given the froth in the high yield market today, I was surprised that the FT didn't address the bearish indicator--for the high yield market and, for some investors, perhaps, for the economy as a whole--that their resurfacing just now also represents.

Finally, I have mixed feelings about the instruments. Credit default swaps serve a real purpose. They allow investors to take that bearish stance in the bond market, where shorting bonds is difficult to do, and also to strip away interest rate risk, to trade on credit risk alone. I believe there's market value in both of those roles. Yet, when you layer a derivative on top of a derivative, as these instruments do, it's questionable to me where the real value lies. And we've seen how they can amplify value destruction, when underlying assets go badly wrong.

For now, on balance, I'm sanguine about the instruments themselves. There's enormous value in the FT having flagged them early. That regulators are paying attention to derivatives puts inside players on best behavior. Media attention intensifies that positive pressure. Curiosity has been piqued, and I expect we'll see more about them in the coming months--potentially from the swaps and derivatives industry itself. As for the high yield market? I'd take the bearish side of the trade.

You can learn more about Markit, the organization that licenses and runs the CDS Indices underlying the tranches described by the FT here. The Depository Trust and Clearing Corporation (DTCC) now publishes weekly CDS market updates. You can find them here. And for a great overview of Credit Default Swaps basics, the International Swaps and Derivatives Association, DTCC and Markit have created The ISDA CDS Market Place, which is here.