LEVERAGED FINANCE NEWS: Currency Swaps Saddle HY with Risk

Date: 31-Oct-2011

There isn’t nearly as much risk in the high yield bond market as there was before the financial crisis, when private equity firms were borrowing huge sums to purchase companies at peak valuations. And yields on junk bond are attractive enough that many investors don’t feel the need to juice returns by purchasing them with borrowed money.

Nevertheless, there are underappreciated pockets of leverage that have the potential to produce price swings. This became apparent last month, when a big move in the Brazilian real caused Japanese investors to yank their money out of so-called double-decker funds, which invest in U.S. high yield bonds, among other things, but also use currency swaps in order to capitalize on economic growth in the currency’s country of origin. For many of them, the real is the currency of choice.

Data from Lipper shows that Japanese investors yanked $348 million from double-decker funds during the month of September, when a 15% decline in the Brazilian currency against the yen hit returns.

“With a general lack of leverage in credit markets, the double-decker funds are the most concerning potential unwind in leveraged finance, despite only representing approximately 3% of the high yield bond market,” said Bradley Rogoff, an analyst with Barclays Capital.

While they’ve only been around since early 2009, double-decker funds have become increasingly popular with Japanese investors, making up approximately 17.5% of all Japanese open-end stock investment trusts, according to Lipper.

“When you have things occur like a 15% currency move in one month, even though $4 billion to $5 billion of high yield probably trades every day, in order to trade that much high yield, the price is going to have to move,” Rogoff said in a telephone interview with Leverage Finance News.

The fluctuation in the real and its effect on double-decker fund flows may prove to be short-lived; as the real has bounced against the yen this past week on news of a potential debt deal in the European Union. However, there’s a real potential for future currency moves to negatively impact the U.S. high yield bond market. “In particular, if losses in the currency swap are significant enough, fund managers will be forced to sell the underlying high yield assets to raise cash, compounding overall losses,” Rogoff wrote in a Sept. 30 report.

Not all double-decker funds are linked to the real. The Australian dollar, which has been less volatile than the real, is also a popular choice. However, Rogoff thinks these funds may be more inclined to hedge their bets in the future by linking to a basket of currencies. “You can use any type of growth currency in a double-decker fund. If anything, the last month or so has shown that to pick just one currency to lever up is probably not the best thing to do,” he said. “The sales pitch from retail banks is probably going to be more compelling with a basket approach going forward.”

Double-decker funds aren’t the only way foreign investors hold U.S. high yield bonds; offshore funds now comprise between 6% and 9% of the more than $1 trillion in outstanding high yield debt on the market, according to Barclays. Double-decker funds aren’t the only potential source of volatility in the high-yield bond market. Anders Maxwell, managing director with Peter J. Solomon Co., said that other elements, such as exchange-traded high yield bond funds, also pose potential threats to market stability.

ETFs could create volatility because they trade throughout the day on stock exchanges, unlike mutual funds, which can only be bought or redeemed once a day from fund management companies. When investors stampede into these ETFs, the sponsors must quickly purchase the constituent bonds to create new shares; likewise, when investors head for the doors en masse, sponsors must sell the bonds held in ETF shares to raise cash. Just 15% of all assets in high yield bond funds are in ETFs, but these exchange-traded vehicles often account for a disproportionate amount of total fund flows.

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