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Move to 'Synthetic' US Junk Bonds

Demand is growing for "synthetic" financial instruments that enable investors to take positions in the US junk bond market without owning the underlying securities.

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Jan Mammey | Stock4B | Getty Images

The instruments, created by using credit derivatives on junk bond or high-yield indices, resemble transactions linked to US mortgages that proliferated before the financial crisis.

The collapse of these synthetic mortgage-backed collateralized debt obligations when mortgages turned sour was a big feature of the crisis.

Exposure to such instruments proved toxic for the banks and investors that bought them, causing hundreds of billions of dollars of losses, and substantial profits for hedge funds that sold them.

Now, hedge fundsare buying the riskiest parts of instruments linked to bonds. This demand reflects more bullish views on the US economy, which investors believe will translate into lower corporate defaults.

"We see much interest in synthetic high yield, more than we would have predicted just a few months ago," said Sivan Mahadevan, managing director at Morgan Stanley.

Synthetic junk bonds have been in the market before. Similar investments, called collateralized bond obligations, blew up after corporate defaults unexpectedly soared when the telecoms bubble burst in the early 2000s.

The move into junk bond derivatives also reflects the plunge in yields on actual bonds to record lows. "With the Federal Reserve providing liquidity, default rates low and yields falling, the synthetic market is a way to increase returns," said a derivatives trader at another US bank. "Investors are looking to take credit risk."

The derivatives are sold as "tranches" that represent different slices of default risk in an index of high-yield bondscompiled by Markit called "CDX".

The exact level of activity is hard to pin down. The Depository Trust & Clearing Corp, which compiles credit derivative data, says the net notional exposure in all credit default swap tranches on February 25 was $5.9 billion, up from $5.4 billion four weeks earlier. It does not make public how much of this is in junk bond or other tranches.

There are differences between the current junk bond derivatives and the pre-crisis mortgage structures, dealers said. Banks' pre-crisis off-balance- sheet investment vehicles are now defunct, limiting the investor base. Second, the tranches are linked to one, standardized index, rather than tailor-made.