Exchange-traded funds are poised to overtake credit derivativesby year-end as a way to speculate on junk bonds.

The value of corporate securities held by the five-largest junkETFs almost doubled in the past year, to a record $31.4 billion,while the net amount of protection bought or sold on the debt usingthe two current credit-default swaps indexes declined 3 percent to$35 billion, data compiled by Bloomberg show. The ETFs are growingat an average 5.2 percent monthly pace this year, which would putassets at more than $36.5 billion by Dec. 31.

Trading in credit swaps has slowed as the market facesregulation for the first time under the Dodd-Frank Act, potentiallymaking them harder and costlier to buy and sell. The growth ofjunk-bond ETFs, which are listed on exchanges and brokered likestocks, has accelerated since their inception in 2007 as investorsseek a faster and cheaper way to trade debt.

“Product innovation is often the answer to regulatory change andI don't think it's any coincidence that we've seen this explosionof interest in fixed-income ETFs just at the point at which CDS asa product and asset class comes under pressure,” Will Rhode,director of fixed-income at research firm Tabb Group LLC, said in atelephone interview.

Junk-bond ETFs, which have attracted 25 percent of high-yieldfund inflows since 2010 as measured by EPFR Global, are gaininginfluence in a market where both securities and their derivativesare generally traded off exchanges.

Even investors seeking to hedge against losses on the securitieshave started using ETFs, with the number of shares borrowed to betagainst one run by State Street Corp. surging almost three-foldfrom the end of 2011.

Credit swaps, created in the 1990s as a means for lenders toprotect against losses on corporate debt, gained popularity in thepast decade as a way to wager on gains without actually owningbonds or loans.

With the Federal Reserve saying last week it will probably holdits interest-rate target near zero through at least mid-2015 andconduct a third round of bond purchases to stimulate the economy,investors are gravitating toward the funds to boost returns asdemand for default protection diminishes.

Nordea, Getty

Elsewhere in credit markets, Nordea Bank AB, the Nordic region'slargest lender, is planning its first offering in more than 16months of dollar-denominated, 10-year bonds. Getty Images Inc., thephoto archive, is said to be seeking $1.85 billion in loans to backits buyout by Carlyle Group LP.

The Markit CDX North America Investment-Grade index, acredit-swaps benchmark tied to the debt of 125 companies in theU.S. and Canada, rose from an 18 month low, climbing 0.9 basispoint to 83.9 basis points as of 11:10 a.m. in New York. The indexended last week at 83 basis points, the lowest since March2011.

In London, the Markit iTraxx Europe Index of 125 companies withinvestment-grade ratings increased 2 to 120.2.

The indexes typically rise as investor confidence deterioratesand fall as it improves. Credit swaps pay the buyer face value if aborrower fails to meet its obligations, less the value of thedefaulted debt. A basis point equals $1,000 annually on a contractprotecting $10 million.

Bonds of Caracas-based Petroleos de Venezuela SA, or PDVSA, arethe most actively traded dollar-denominated corporate securities bydealers today, with 36 trades of $1 million or more as of 11:13a.m. in New York, according to Trace, the bond-price reportingsystem of the Financial Industry Regulatory Authority.

Nordea may sell subordinated notes as soon as today, accordingto a person familiar with the transaction. The offering will be ofbenchmark size, typically at least $500 million.

The bank last issued 10-year dollar debt in May 2011, selling$1.25 billion of 4.875 percent securities to yield 180 basis pointsmore than similar-maturity Treasuries, according to data compiledby Bloomberg. The bonds traded at 105 cents on the dollar to yield4.18 percent on Aug. 13, Trace data show.

Getty's financing will include a $1.7 billion term loan B and a$150 million revolving line of credit, according to a person withknowledge of the transaction, who asked not to be identifiedbecause the information is private.

Barclays Plc, JPMorgan Chase & Co., Royal Bank of Canada,Credit Suisse Group AG and Goldman Sachs Group Inc. are arrangingthe financing and will host a lender meeting Sept. 19 at 2:30 p.m.in New York, the person said.

'Meant to Work'

Trading volumes in the current version of the Markit CDXhigh-yield credit swaps index have declined 20.2 percent from lastyear, when an escalating European debt crisis sent debt investorsrushing to protect against losses, Barclays analysts led by BradleyRogoff wrote in a Sept. 14 report. The firm cited data from theDepository Trust & Clearing Corp., which runs a centralcredit-swaps repository.

The declines, they said, have resulted in part from regulationsbeing written to comply with the 2010 Dodd-Frank Act, which willrequire most swaps to be processed by clearinghouses and traded onexchanges or electronic systems after the contracts complicatedefforts to resolve the financial crisis four years ago. The ruleswill increase costs for both banks and money managers in themarket.

“This is the way in which financial markets are meant to work;adapt to change through innovation,” Tabb's Rhode said.

ETFs may eclipse credit-swaps indexes in debt markets in partbecause a lot of traditional money managers have never fullyembraced the derivatives, according to Peter Tchir, founder of NewYork-based macro strategy firm TF Market Advisors.

“They've always looked for an alternative and been reallydisappointed with CDS,” he said in a telephone interview.

ETF assets and shares outstanding have surged at the same timethat dealer inventories of the underlying bonds shrink to thelowest in more than a decade, making it more difficult for moneymanagers to trade the debt.

Holdings of corporate securities by the 21 primary dealers thattrade directly with the Fed have shrunk 81 percent to $43.8 billionas of Sept. 5 from the peak of $235 billion in 2007, according todata from the central bank.

Pitched 'A Lot'

“I've definitely had it pitched to me a lot” as an alternativeto holding cash reserves, Nancy Davis, director of derivatives atNew York-based AllianceBernstein LP, which manages $230 billion offixed-income assets, said of high-yield bond ETFs in a telephoneinterview.

The funds are more appealing than credit swaps to investmentfirms that haven't set up legal protocols to trade the privatelynegotiated contracts with banks or are restricted from trading thederivatives, Davis said.

“They either have cash positions or they're completely investedin cash bonds, which aren't always very liquid,” she said.

Junk-bond investors have been emboldened by default rates belowhistorical averages. The global speculative-grade default rate asmeasured by Moody's Investors Service was 3 percent in August from1.8 percent a year ago, according to a Sept. 10 report. Thatcompares with a historic average of 4.8 percent in Moody's datagoing back to 1983.

“The rate of default has remained remarkably steady,” AlbertMetz, managing director of Moody's Credit Policy Research, said inthe note. “As credit spreads continue to narrow slightly, ourforecast remains fairly benign” at 3.1 percent by year-end and 3percent in August 2013, he wrote.

For investors not sold on the junk-bond rally ETFs also providean alternative for betting against the market. The shares areeasier to borrow than corporate bonds for use in short sales, inwhich traders sell borrowed stock in a bet they can profit fromprice declines.

The number of borrowed shares of State Street's SPDR BarclaysCapital High Yield Bond ETF climbed to a record 13.1 million onAug. 30 from 4.75 million at the end of 2011, according to MarkitGroup Ltd. The amount eased to 6.76 million on Sept. 12 asspeculation the Fed would unleash another round of stimulus causedbearish investors to reverse bets.

Corporate holdings in the ETF, the second-largest of its kind,climbed 43 percent this year to $12.7 billion, with the fundreturning 11.2 percent, Bloomberg data show.

Holdings in BlackRock Inc.'s iShares iBoxx High Yield CorporateBond Fund, the largest, surged 60 percent to $17 billion, returning9.9 percent in 2012. That compares with average gains of 12.6percent in Bank of America Merrill Lynch's US High Yield Master IIIndex.

London Whale

Investors seeking a hedge against junk-bond losses also werepushed to ETFs earlier this year after trades by a JPMorgan traderdistorted prices in credit-swaps indexes.

Bruno Iksil, who became known as the London Whale because thesize of his bets grew so large, fueled price disparities betweenthe derivatives benchmarks and the price of contracts on companieswithin the indexes, market participants familiar with the tradessaid at the time.

Such dislocations unique to credit derivatives may scare awayinvestors, according to Stephen Antczak, Citigroup Inc.'s NewYork-based head of U.S. credit strategy.

“When you're seeing big divergences in indexes from theirconstituents, maybe that's being driven by someone who's not acredit investor, maybe it's an equity guy,” he said in a telephoneinterview. “That's what worries people. Those indices can getwhippy that are not necessarily driven by cash corporatebonds.”

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