Wall Street’s biggest credit brokers are for the first time using exchange-traded funds as a way to wager that junk bonds are overvalued.

Bank of America Corp. traders who helped dealers move $1.5 trillion of credit-default swaps index contracts last year began offering clients the ability to trade blocks of bond ETF shares in February, according to three people familiar with the trading and an e-mail sent to customers. Shares borrowed to make bearish bets on State Street Corp.’s $12 billion speculative-grade bond ETF soared to a record 11.5 percent of the total outstanding on March 1, up from 4 percent at year-end.

Federal Reserve Governor Jeremy Stein warned last month that he was seeing “a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit,” with four years of central bank stimulus pushing investors toward the riskiest securities and compressing junk-bond yields to a record low 6.4 percent on March 15. Buyers who reaped gains of 125 percent the past four years are now souring on the debt.

“As the high-yield ETF market has grown, we’ve seen institutional investors using high-yield ETFs to build portfolios and manage risk,” said Matthew Tucker, head of iShares fixed-income strategy for BlackRock Inc., the world’s biggest money manager, in San Francisco. “They’ve been looking for ways to both go long the high-yield market and hedge against losses.”

Rate Bets

As the number of borrowed shares in the two biggest speculative-grade bond ETFs almost doubled last month, the net amount of credit swaps tied to a benchmark index of junk-rated companies increased 10 percent, Markit Group Ltd. and Depository Trust & Clearing Corp. data show.

Unlike credit swaps, which typically only allow investors to wager on corporate creditworthiness and trade off exchanges in privately negotiated transactions, ETFs also fluctuate with interest rates and trade like stocks.

“To the extent that investors want to hedge both their credit risk and their interest-rate risk, selling the ETFs can make sense,” said Eric Gross, a credit strategist at Barclays Plc in New York. Swap indexes are “still the most liquid way to hedge high-yield credit, but it has essentially zero exposure to rates,” he said.

BlackRock Fund

The volume of shares on loan from BlackRock’s $15.4 billion junk-bond ETF, the biggest of its kind, soared to 20.9 million on March 7, or 13 percent of the total outstanding that day, according to Markit and Bloomberg data. That’s up from 0.3 percent on March 9, 2012, and 7 percent at year-end.

Elsewhere in credit markets, the cost of insuring European bank bonds against default jumped to the highest in two weeks after Cyprus imposed an unprecedented levy on bank savings to help finance its international bailout.

Traders are betting the tax makes it more likely European authorities will force senior bank bondholders, who rank alongside depositors as the last to lose out when debt is impaired, to share the burden of financial-system rescues.

The Markit iTraxx Financial Index of credit-default swaps insuring the senior bonds of 25 lenders and insurers climbed 15 basis points to 158, the biggest jump in cost since Italy’s inconclusive election three weeks ago.

Credit-default swaps typically fall as investor confidence improves and rise as it deteriorates. Contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a swap protecting $10 million of debt.

Spread Narrows

The extra yield investors demand to hold corporate bonds globally rather than government debentures declined for the second week.

Spreads on bonds from the U.S. to Europe and Asia tightened 1 basis point to 143 basis points, or 1.43 percentage points, in the period ended March 15, according to Bank of America Merrill Lynch’s Global Corporate index, which reached 142 on Jan. 10, the least since April 2010. Yields fell to 2.62 percent from 2.68 percent on March 8.

The Barclays Global Aggregate Corporate Index has lost 0.2 percent this month, bringing the decline this year to 1.19 percent.

Bonds of Fairfield, Conn.-based General Electric Co. were the most actively traded dollar-denominated corporate securities by dealers last week, accounting for 3.6 percent of the volume of trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Bond Sales

A $3 billion offering by GlaxoSmithKline Plc led $104.4 billion of corporate bond sales worldwide last week, following $93.6 billion in the period ended March 8, Bloomberg data show.

In its first dollar-denominated sale since May, Glaxo, the U.K.’s largest drugmaker, sold bonds that included $1.25 billion each of 0.7 percent, three-year notes yielding 35 basis points more than similar-maturity Treasuries and 2.8 percent, 10-year securities at a relative yield of 90 basis points, Bloomberg data show.

In emerging markets, relative yields widened 8.6 basis points to 287.5 basis points, according to JPMorgan Chase & Co.’s EMBI Global index. The measure reached 245 on Jan. 3, the least since April 2010.

Relative yields on dollar-denominated junk bonds have contracted 13.4 percentage points since 2008, when the Fed began purchasing bonds and holding benchmark borrowing costs from zero to 0.25 percent to rescue the world’s biggest economy from the credit crisis.

Facing Erosion

The notes have declined 0.5 cent to an average 105.4 cents on the dollar from the record high of 105.9 cents in January, Bank of America Merrill Lynch index data show. They traded as low as 58.8 cents in March 2009.

“Most bonds are trading at a pretty high premium and could face significant price erosion,” Natalie Trevithick, who oversees $35 billion as head of investment-grade debt at Los Angeles-based Payden & Rygel, said in a telephone interview.

Average modified duration, a gauge of debt’s sensitivity to increasing interest rates, climbed to 4.98 on Jan. 3, the highest level since October 2007. Investors yanked $418 million from high-yield bond funds last week, JPMorgan data show.

The Fed’s Stein warned that the junk-debt market may be overheating in a Feb. 7 speech in St. Louis. If so, “it does not bode well for the expected returns to junk-bond and leveraged-loan investors,” he said. Rising rates are a “medium risk” to corporate-bond ETFs, Fitch Ratings analysts wrote in a Dec. 19 report.

ETF Trades

U.S. life insurance companies, which hold $2.1 trillion of corporate bonds, and hedge funds, which may experience magnified losses because of their use of leverage, or borrowed money, face similar potential challenges, the analysts wrote.

Bank of America’s Kavi Gupta offered trades of about $30 million in BlackRock’s junk-bond ETF shares in an e-mail listing securities available for sale to clients last month, according to a copy of the message obtained by Bloomberg News. The credit- swaps index trader also offered trades in about $20 million of shares from State Street’s fund, according to the note.

February was the first time that Bank of America’s swaps traders started trading blocks of ETF shares, according to the three people familiar with trading in the market, who asked not to be identified since the trades aren’t public. Zia Ahmed, a spokesman for Bank of America, declined to comment.

‘More Volatile’

“High-yield ETFs tend to be more volatile than the underlying broad market,” said Jason Rosiak, head of portfolio management at Newport Beach, California-based Pacific Asset Management, the Pacific Life Insurance Co. affiliate that oversees about $3.2 billion. “It’s a new tool due to their size and liquidity.”

In the two weeks after junk-bond yields reached a record low on Jan. 25, prices on BlackRock’s iShares iBoxx High Yield ETF shares declined 1.95 percent. That’s 0.8 percentage point more than the 1.18 percent loss on the Bank of America Merrill Lynch U.S. High Yield Index during the same period and 1.14 percentage points more than the 0.8 percent decline in the price of the Markit CDX North American High Yield credit-swaps index, data compiled by Bloomberg show.

The ETF rose 0.81 percent in the next two weeks, compared with a 0.18 percent return on bonds in the Bank of America Merrill Lynch index and a 0.56 percent price gain on the swaps benchmark.

Option Surge

The net amount of credit swaps outstanding on the most recent version of the Markit CDX high-yield index increased about 10 percent in the month ended March 1 to $25.5 billion, according to Depository Trust & Clearing data. That compares with a 135 percent increase in shares on loan for State Street’s junk-bond ETF in the period and a 62 percent rise in borrowed shares for BlackRock’s fund, Markit data show.

The number of bearish options on BlackRock’s $15.4 billion junk-bond fund rose to a record after yields dropped to an all- time low and companies sold more of the debt than ever before.

Outstanding puts giving the right to sell the iShares iBoxx High Yield Corporate Bond Fund rose to 456,910 on March 7, almost 10 times the total of calls to buy. The number of bearish contracts has more than doubled since the Jan. 18 options expiration and reached an all-time high last month.

“We’ve seen increasing availability of ETF shares for borrowing and selling short as a hedging vehicle,” BlackRock’s Tucker said.