Here's Why You Should Toss Ackman's Bond Reveal in the Junk Bin

Pershing Square Capital Management's Bill Ackman on Wednesday morning revealed that his hedge fund was short high-yield bonds. The highly-levered businesses will struggle, because it will take time for the economy to reopen, Ackman said in a CNBC interview, adding that the Federal Reserve's bond buying wasn't going to save these kinds of companies. I, too, am very cautious on junk bonds, but I also caution readers against following Ackman's trade here. Here are my three big reasons why shorting junk bonds isn't a great trade. 1. High-Yield Is a Momentum Market This might seem strange to those who haven't looked into it. For more people, it is more intuitive to think you should be buying credit, when the yields are high, and selling it when the yields fall. Really it is the opposite. To illustrate, I ran an extremely simplistic simulation of a momentum trading strategy vs. a value strategy using the Barclays High-Yield index from 2000 until now. In the momentum strategy, I buy the index every time the yield spread (i.e., the gap in yield between junk and Treasury bonds) was below its 50-day simple moving average. In the value strategy, I do the opposite, buying when the yield has been rising and therefore the bonds are cheaper. Results? The momentum strategy makes 11.3% annualized over this 20-year period. The value strategy loses 3.5%. So why does such a simple strategy work? It is because when times are good, junk bonds earn you a solid yield. You only take losses when the market is trying to price in higher defaults. If you play high-yield using momentum, you basically own it when the market thinks times are good and are selling in the early days of trying to price in higher defaults. Sure sometimes you spin your wheels trading head fakes, but on average, that's the right way to think about credit. Own it when things are good, get out of the way when things are bad. So this is the first reason not to short the broad junk bond market. Right now it has the momentum. Odds are good that it will at least earn a positive return in the coming months. 2. Defaults Are Usually Already Priced In To make money shorting bonds, you can't just bet that more defaults are coming. You have to bet that more defaults are coming than are already priced in. In other words, there are always a set of companies that are on edge. The current price of those bonds reflect the recovery in bankruptcy. You won't make any money betting that such a company is going to go under. Right now, credit derivatives suggest that there will be a bit more than 15% in defaults in the next couple of years. That's already a very high rate. During 2008 to 2009, about 17% of high-yield bonds defaulted, according to Moody's. Could the default rate be even worse than 2008 to 2009? Sure. But fair to say, that isn't a slam dunk. If you are shorting the whole high-yield market, you are making a bigger bet than just defaults are going to accelerate from here. That's already priced in. You need to be betting on an extended recession. 3. Time Is Against You Anytime you short a bond, time is not on your side. Every day, the underlying bonds within your trade earn interest. You essentially owe that interest. This is implicitly true, even if you use derivatives to access your trade. That doesn't change the underlying fundamentals of bond returns. Right now, exchange-traded funds like the iShares iBoxx High Yield Corporate Bond fund , yield about 5%. That is even before you consider the cost of borrowing the shares. This constant erosion of your position makes timing extremely important. The longer it takes for your short position to work, you are falling ever further behind. Every day you aren't right, you are wrong. Now let's consider these three points together. Since junk bonds are a momentum market, I'd argue that spreads are just too tight isn't a good thesis. Since a lot of defaults are already priced in, more defaults are coming isn't a good thesis. And since time is against you, saying eventually the economy will turn weaker again isn't a good thesis. I hope you can see why this is a tougher bet than it might seem. Finally: Ackman May Be Actually Making a Different Bet Lastly, let's bear in mind that hedge fund guys in general are cagey about the bets they are making. All Ackman said in the interview was that Pershing was short a high-yield index. That could mean a lot of things. He could be short an ETF like HYG or the SPDR Barclays Capital High Yield Bond fund . He could be using options on credit indexes, which might give a payoff on larger changes in junk bond prices. He could be using more complicated swaps that give him something like exposure to the first 15% of losses in the High Yield CDX index. He also might view the high-yield short as a hedge against his long stock positions, and doesn't mind if he loses a little money. In the same interview, he said his fund was 98% long and that he wasn't short any stocks. I don't know which of these Ackman is doing, but they all represent different bets. Just saying hey, Ackman is a smart guy, let's do what he's doing also isn't a good thesis. You don't actually know what exactly he's doing. Now, it isn't that I'm bullish on junk bonds, but a short isn't a good idea. I actually don't love high-yield here myself. I do think all the easy money has been made, and there's certainly a risk that the market has underpriced economic risks. I've argued that economic uncertainty is the highest it has been any time in my career. High-yield is a market where downside risk is more acute than upside opportunity. I think if you want to make a bullish economic bet, there's a better payoff in value stocks than in junk bonds. I just don't think a short makes a lot of sense. The odds are that give a horizon of six to 18 months, junk bonds as a whole are unlikely to post an outright negative return, and even if they do, it will probably be small. I don't love being long, but I hate being short.

Here's Why You Should Toss Ackman's Bond Reveal in the Junk Bin

The Pershing Square founder's talk on CNBC of shorting high-yield bonds should be taken with a grain of salt.

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