A surprise rally in the riskiest corporate debt comes with a warning: $7 billion of shorts.

That’s the amount of short interest traders have amassed in the two largest junk bond exchange-traded funds, the iShares iBoxx High Yield Corporate Bond ETF and SPDR Bloomberg Barclays High Yield Bond ETF, according to S3 Partners. The bets have climbed 18% in the past 30 days, rising at the fastest pace since April when the collapse of US regional lenders sparked fears of a wider credit crunch.

The rush for hedges shows enduring skepticism over the health of heavily indebted companies in an uncertain economy, and it belies demand for risk that’s pushed the yield premiums on US junk bonds to their lowest since the Federal Reserve kicked off a series of aggressive rate increases in April 2022.

On the surface, investors are showing confidence that companies will keep defaults at bay as inflation eases and central banks engineer economic soft landings. The shift in mood in July has been swift: The spread above Treasury bond yields that investors demand to hold US junk debt has narrowed more than 100 basis points to about 370 basis points since the start of May, paving the way for a borrowing spree.

Yet even with optimism growing that the Fed is almost done raising rates, many in the market remain unconvinced, and that explains the rapid pace of short-selling alongside the surge in demand for high-yield debt.

“There is going to be a big pick-up in defaults. I don’t need a crystal ball for that — it’s happening and it’s happening even absent a recession and it will grow,” hedge fund manager Boaz Weinstein said in an interview with Bloomberg TV last week. “There are risks for sure to the markets and to the economy, because this is not just derivative traders playing games.”

Weinstein, the founder of Saba Capital Management, has been preparing for a credit crunch since trouble erupted in US banks in March.

Companies will soon need to refinance debts they secured during the pandemic when central banks slashed rates to near zero to keep economies afloat. Moody’s Investors Service warns the rate of speculative-grade defaults worldwide is expected to hit 5.1% next year, up from 3.8% in the 12 months ended in June.

Though junk bonds have been one of the best-performing segments of fixed-income markets this year, funds that invest in the securities have seen outflows even as fixed income overall has been a preferred asset class for investors. US high-yield ETFs have seen net outflows of $5.6 billion in 2023, while US bond ETFs overall have taken in more than $110 billion.

Still, Peter Tchir of Academy Securities argues that the risks may be overblown, and in the meantime, hedging a market in the throes of a rally is expensive. For one thing, a speculator who borrows ETFs to short them has to pay the lender the dividends that the lender is missing out on. 

“I actually like high yield. I think high yield is healthy here,” Tchir said. “People seem to forget how costly it is to be short. Look at the dividend yield and the cost to borrow shares. It is a slow bleed but a bleed nonetheless.”

Junk bonds also have a track record of outperformance immediately following recessions. They recorded their best-ever year in 2009 just after the financial crisis with the Bloomberg US Corporate High Yield Bond Index climbing 58% for the year.

George Curtis, a portfolio manager at TwentyFour Asset Management, sees the rally as an opportune moment to cut his junk bond exposure rather than amass an outright short.

“We have been selling into the strength,” Curtis said. “We don’t expect spreads to tighten much from here, they could go wider even. It probably makes sense for the short base to increase given how quickly spreads have tightened.”

This article was provided by Bloomberg News.