Bond traders take bearish action on junk Stocks have scaled record highs, house prices are rebounding smartly and all the while bond yields remain low. Something is clearly wrong with this picture and it's no surprise that fear of interest rate risk in the form of a sudden surge in bond yields is a topic of conversation across the market. Robust jobs data on Friday duly sent 10-year Treasury yields to a new high for the year above 2 per cent. Recent speeches by Federal Reserve officials have addressed the topic of frothy credit markets, courtesy of their extraordinary monetary policy, while there are signs that some bond investors are taking action. As money keeps flowing into junk bond funds, the FT reported that short interest on exchange traded funds for the sector run by BlackRock and State Street this week hit their highest level since October 2007. This bearish play comes after average yields on junk debt plumbed a record low of 5.61 per cent earlier this year. With the average price of junk bonds around $105, there is limited scope for improvement as the debt can be called by companies, should prices rise further and be replaced with lower yielding bonds. The bullish argument for junk is that you can earn a higher yield than other bonds in the coming year of a slowly growing economy, continued Fed bond buying and a low corporate default rate. Certainly the brave may stretch towards triple-C rated companies with their current average yield of 9.1 per cent but this part of the junk market contains many of the leveraged buyout deals that marked the peak of the previous credit boom. While it makes sense to steer clear of that area, the fact that shorting activity for the overall junk market is rising suggests the risk/reward equation is shifting among some investors, notably hedge funds who like the flexibility of ETFs. Selling junk bond ETFs enable investors to protect their portfolios from the adverse consequences of higher interest rates, which move inversely to prices. But they also provide speculative investors with a high-powered tool to jump on any emerging big momentum trade, potentially destabilising financial markets. Retail investors have flocked to ETFs, seeing them as a way to own a diverse pool of assets bundled into a security that trades like an equity with a quoted price on an exchange. All well and good, but dislocations can occur between the price of an ETF and the assets that it follows, just as we saw during the credit crisis with sophisticated derivative structures. This has not escaped the attention of Jeremy Stein, a Fed governor, who issued a stark warning last month: "If relatively illiquid junk bonds or leveraged loans are held by open-end investment vehicles such as mutual funds or by exchange traded funds, and if investors in these vehicles seek to withdraw at the first sign of trouble, then this demandable equity will have the same fire-sale-generating properties as short-term debt." The trigger for a major dislocation across interest rate markets, led by junk bonds and ETFs, looms once the economy shows signs of stronger momentum thanks to the Fed's current interest rate suppression. Under quantitative easing, the Fed wants low rates to boost housing, equities and by extension the broad economy. But the danger of artificially low borrowing costs is that investors load up on debt, fuelling excessive speculation while others stretch for yield in racier areas of the market. Late last week, Ben Bernanke spoke about long-term interest rates. He sought to soothe worries about the prospect of higher long-term bond yields and the risk that a sharp rise will inflict capital losses on bond holders and financial institutions as was the case in 1994. Unlike that period of intense bond market turmoil, Mr Bernanke argued that the central bank now provides far more clarity about its policy intentions and could delay selling mortgage bonds purchased via QE to stem any sharp rise in rates. Should the current rally in equities be vindicated by a much stronger economy later this year, a far greater test of the central bank's powers potentially looms in the form of ETFs and aggressively orientated hedge funds.