Should You Sell Junk Bonds Before All the Hedge Funds Do?

According to Bloomberg, hedge funds have amassed the greatest share of the $1.2 trillion U.S. junk-bond market since the credit crisis, raising concerns that bets with borrowed cash will accelerate losses if and when the Federal Reserve stops printing record amounts of money. The funds, which as we pointed out typically use leverage to bolster returns, hold as much as 23% of outstanding dollar-denominated high-yield bonds, up from as much as 18% last year and the highest since 2008, according to Barclays. Credit hedge funds have boosted assets by 89% since 2008, outpacing the 66% growth of the junk market, data from Hedge Fund Research and Bank of America Merrill Lynch indexes show.

The problem is that there could be a junk-bond debacle that could truly threaten the financial system if all the selling starts around the same time. What happens when mass selling starts is that the bids on the bonds start to drop. The funds then mark their holdings to the market as the bids drop, and then come the margin calls. If they have used other junk-bond debt as collateral for their margin, the whole unraveling starts to feed on itself.

The Bank of America U.S. High Yield Index plunged 2.6% in June, more than stocks and Treasuries, after Fed Chairman Ben Bernanke said the central bank could start slowing its $85 billion of monthly asset purchases if the economy showed sustained improvement. In the four years before then, the debt posted average annual returns of 16.1% as buyers sought a reprieve from record-low bond yields.

The good news this time around is that even as funds that use borrowed money grab a bigger proportion of the market, leverage in the system is less than it was leading up to the crisis as banks boost debt-to-equity ratios. Credit hedge funds are also, on average, using less leverage, according to Barclay’s Bradley Rogoff. It always is unnerving when investors hear “it’s different this time,” but the margin call tsunami that engulfed Wall Street in the fall of 2008 was burned in to hedge funds’ memories.

The reason that hedge funds are in the junk-bond market is the same reason that retail investors have dedicated money to the asset class. People are willing to take a higher level of risk to achieve higher yields. The Federal Reserve may have done stock investors a great service by keeping interest rates at record lows, but they have punished fixed income investors, especially those who focus on ultra-safe certificates of deposit.

One positive thing is that some Wall Street analysts think that hedge funds may sometimes be acting as buffers against price swings fueled by redemptions from mutual funds and exchange traded funds, helping to fill a void left by banks that have reduced holdings of riskier assets in the face of new regulations. This is extremely helpful, as there is much less liquidity in the junk-bond market, and many of the individual issues are very small.

So what can a retail investor who has moved capital to the junk-bond market do? If you own quality funds, ones run by quality managers, you likely will be reasonably safe in the event of a sell-off. If you own junk bonds via a mutual fund or an exchange traded fund, look to reinvest your monthly or quarterly dividends. This acts as a dollar-cost averaging mechanism that helps you buy fewer shares if the price is high and more if the price drops.

Hedge funds use a host of very sophisticated strategies to generate top returns for their investors. While using large amounts of leverage and margin is hardly the most sophisticated strategy in the hedge fund arsenal, it is one of the most widely used. It also the one that tends to exacerbate sell-offs massively. It stands to reason that hedge fund managers see the end of the Federal Reserve’s low interest rate landscape. It also stands to reason they will sell in front of the interest rate increases, not the moment the first one goes into effect.