Big Investors Lead Bets Against Junk Bonds

Junk or Jewels? The Lowdown on High-Yield Bonds
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Some of the world's most sophisticated credit investors have been ramping up their bets against junk bonds even as retail investors have been pouring money into the asset class.

The list of junk-bond bears includes GSO, the credit arm of Blackstone; Apollo Global Management; Centerbridge Partners; Oaktree Capital; and a host of credit and so-called "macro" hedge funds, according to executives familiar with the firms' investment activities.

These investors began paring their junk-bond holdings during late 2012. In more recent weeks, some have been taking short positions in the market, betting that the price of junk bonds will decline and their yields will go up.

(Read More: How the Fed Is Pushing Investors to Buy Junk Bonds)

The pessimism of the big alternative investment firms has been stoked by the recent ravenous retail appetite for junk bonds. During 2012 and the early days of 2013, massive inflows into funds buying these securities led to a narrowing of the spreads between the interest rates on junk bonds and those on Treasury securities.

As the spreads came in, many of the big funds looked to get out, fearing that junk bond prices could suffer in any economic scenario. If the economy deteriorates, the rising probability of default could cause spreads to widen. If the economy improves, yields would rise – and prices fall – for all manner of fixed-income securities.

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"To be long fixed income – and particularly high yield – doesn't make a lot of sense," said a senior executive in the credit arm for a major New York alternative investment firm. "If you miscalculate on either side you lose. You lose if things are bad and there is a sell-off and you lose if things are better and there is a sell-off. The balance beam is very narrow."

(Read More: Asia's Junk Bond Rally Near Exhaustion)

To position itself for higher rates, GSO, for example, has moved money from fixed-rate bonds, mostly of the higher-yield variety, into senior secured bank loans, which have floating rates and re-price every 90 days. In addition it is shortening the maturity of the debt it holds and holding more cash, according to Steve Schwarzman, founder of Blackstone.

In recent days, retail investors have begun to display similar signs of caution. In the week ending February 6, investors pulled $1.2 billion from junk-bond funds and put $1.3 billion into funds buying floating rate corporate loans. Spreads between junk bonds and Treasury securities have also begun to widen.

(Read More: Why 10-Year Notes Could Suffer a Dramatic Sell-Off)

Big funds are particularly fearful that a reversal in the junk bond market could be faster in this cycle than in past ones. While issuance has boomed, there are fewer big banks and those that exist have pared back their securities portfolios, meaning they have less capacity to buy bonds and support the market in a crisis.