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Shorting Junk Bonds using CDSes


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The junk bond market is obviously overpriced. On the other hand as Chou's semi-annual report points out CDS spreads are low.


How can we bet on junk bond defaults? Using CDSes. This product from ProShares was recently introduced it appears exactly for this purpose:




I believe there are several similar etfs in europe. I feel like it might be nice to bet against North American junk bonds and also perhaps EU sovereigns which are also spectacularly expensive. Not sure though to short EU bonds.

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I'm not totally convinced that high yield is overpriced, and Chou describes it as fair valued in his letter. Nor does CDX.HY (the sole position of this ETF) seem unusually cheap in a technical sense. The discount of the index to the constituent CDS contracts is pretty close to zero and the basis between cash bonds and CDS is also in its normal range. So I'm guessing Chou would say CDX.HY is fair valued as well.


Chou's letter seems to talk about CDS on US Treasuries but that's a more esoteric product which is sentiment driven (similar to VIX in that the relationship to actual underlying economic activity is not very clear) - I don't think CDS on high yield bonds is an analogous position.

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From Chou's letter:

Non-Investment (or High Yield) grade debt securities

Some prices for non-investment grade bonds do not reflect the risks inherent in these securities. A company can float 10-year non-investment grade bonds with a coupon of 5.5% and investors will buy them at 100 cents on the dollar. Just a few years ago, a similar bond would be trading for 60 cents or less. In fact, there is a good chance that these debt securities may now be overvalued, and that the possibility of a large, permanent loss of capital is extremely high.


Chou seems to argue both ways. My feeling is that he isn't really sure. But your right that the CDS bet seems to be more about betting on risk than on junk bonds.

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