Some investors have placed a huge bet against U.S. high-yield corporate bonds. Unfortunately, it's also a bet against U.S. Federal Reserve policy, which breaks a very important investing tenet: Never fight the Fed.
Almost 13 million shares of the iShares IBoxx High Yield Corporate Bond Fund (HYG) have been sold short (borrowed and then sold in the open market with the hope of buying the shares back at a lower price) after the fund jumped 9.5 per cent in the latter half of 2012. The thinking is that high-yield corporate bonds have rallied too far, too quickly and are poised for a major sell-off. The bond market in general is, according to a number of pundits, ready to collapse after years of record asset inflows.
But the short sellers in the corporate bond market have forgotten about QE3, the U.S. Federal Reserve's $85-billion (U.S.) per month asset buying program. This chart shows the historic pattern where spreads (the difference between high-yield bond yields and ten-year Treasury bonds) decline as money-supply growth increases. When the Fed force-feeds money into the financial system as it is doing now, high-yield bond prices rise, and yields fall. The current trend – where the growth rate of the U.S. money supply is rising while high-yield spreads decline – is clear from August 2012.
So the big wager against high-yield bonds is likely misplaced. The Fed is expected to continue its asset buying program until at least the fall of 2013 and this should support high-yield bond yields close to current levels. If this is the case, the short seller pain will be increased by having to pay the HYG's six and a half per cent yield for as long as they remain short. This may set up for a short squeeze at some point in 2013 as short sellers rush to flatten their positions by buying the stock back. The result would be a sharp, if temporary, rise in HYG units.