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

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

Trading in credit swaps has slowed as the market faces regulation for the first time under the Dodd-Frank Act, potentially making them harder and costlier to buy and sell. The growth of junk-bond ETFs, which are listed on exchanges and brokered like stocks, has accelerated since their inception in 2007 as investors seek a faster and cheaper way to trade debt.

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

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

Even investors seeking to hedge against losses on the securities have started using ETFs, with the number of shares borrowed to bet against one run by State Street Corp. surging almost three-fold from the end of 2011.

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

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

Nordea, Getty

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

The Markit CDX North America Investment-Grade index, a credit-swaps benchmark tied to the debt of 125 companies in the U.S. and Canada, rose from an 18 month low, climbing 0.9 basis point to 83.9 basis points as of 11:10 a.m. in New York. The index ended last week at 83 basis points, the lowest since March 2011.

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

The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit swaps 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 contract protecting $10 million.

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

Nordea may sell subordinated notes as soon as today, according to a person familiar with the transaction. The offering will be of benchmark 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 points more than similar-maturity Treasuries, according to data compiled by Bloomberg. The bonds traded at 105 cents on the dollar to yield 4.18 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 with knowledge of the transaction, who asked not to be identified because the information is private.

Barclays Plc, JPMorgan Chase & Co., Royal Bank of Canada, Credit Suisse Group AG and Goldman Sachs Group Inc. are arranging the 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 CDX high-yield credit swaps index have declined 20.2 percent from last year, when an escalating European debt crisis sent debt investors rushing to protect against losses, Barclays analysts led by Bradley Rogoff wrote in a Sept. 14 report. The firm cited data from the Depository Trust & Clearing Corp., which runs a central credit-swaps repository.

The declines, they said, have resulted in part from regulations being written to comply with the 2010 Dodd-Frank Act, which will require most swaps to be processed by clearinghouses and traded on exchanges or electronic systems after the contracts complicated efforts to resolve the financial crisis four years ago. The rules will increase costs for both banks and money managers in the market.

“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 part because a lot of traditional money managers have never fully embraced the derivatives, according to Peter Tchir, founder of New York-based macro strategy firm TF Market Advisors.

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

ETF assets and shares outstanding have surged at the same time that dealer inventories of the underlying bonds shrink to the lowest in more than a decade, making it more difficult for money managers to trade the debt.

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

Pitched 'A Lot'

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

The funds are more appealing than credit swaps to investment firms that haven't set up legal protocols to trade the privately negotiated contracts with banks or are restricted from trading the derivatives, Davis said.

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

Junk-bond investors have been emboldened by default rates below historical averages. The global speculative-grade default rate as measured by Moody's Investors Service was 3 percent in August from 1.8 percent a year ago, according to a Sept. 10 report. That compares with a historic average of 4.8 percent in Moody's data going back to 1983.

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

For investors not sold on the junk-bond rally ETFs also provide an alternative for betting against the market. The shares are easier to borrow than corporate bonds for use in short sales, in which traders sell borrowed stock in a bet they can profit from price declines.

The number of borrowed shares of State Street's SPDR Barclays Capital High Yield Bond ETF climbed to a record 13.1 million on Aug. 30 from 4.75 million at the end of 2011, according to Markit Group Ltd. The amount eased to 6.76 million on Sept. 12 as speculation the Fed would unleash another round of stimulus caused bearish 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 fund returning 11.2 percent, Bloomberg data show.

Holdings in BlackRock Inc.'s iShares iBoxx High Yield Corporate Bond Fund, the largest, surged 60 percent to $17 billion, returning 9.9 percent in 2012. That compares with average gains of 12.6 percent in Bank of America Merrill Lynch's US High Yield Master II Index.

London Whale

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

Bruno Iksil, who became known as the London Whale because the size of his bets grew so large, fueled price disparities between the derivatives benchmarks and the price of contracts on companies within the indexes, market participants familiar with the trades said at the time.

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

“When you're seeing big divergences in indexes from their constituents, maybe that's being driven by someone who's not a credit investor, maybe it's an equity guy,” he said in a telephone interview. “That's what worries people. Those indices can get whippy that are not necessarily driven by cash corporate bonds.”

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ETFs Playing Bigger Role in Junk-Bond Market

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