* Managers bet LTRO will avert worst of debt crisis
* Favour short-dated, high-yield bonds where fundamentals improved
* Some shorting longer-dated, investment grade bonds
By Laurence Fletcher
LONDON, Feb 27 Hedge funds have been snapping up European sub-investment grade bonds this year, industry insiders said, betting the European Central Bank's cash boost to bolster the region's banks will improve the finances of firms on poor credit ratings.
Like many assets, junk bonds have been rallying since the ECB's long-term refinancing operations (LTRO) in December, which flooded markets with 489 billion euros ($658 billion) of cheap cash to try and head off a second credit crunch.
Hedge funds have been prominent amongst the buyers, attracted by the high yields on offer when real yields on short and medium-term government bonds in developed markets are low or sometimes negative.
"Credit managers are saying very pragmatically that short-duration, high-yield paper with a reasonable credit quality that matures or is callable very soon (is attractive)," said one London-based fund of funds manager who spoke on condition of anonymity.
"With interest rates near zero and spreads still reasonably high, they're gobbling it up."
The Merrill Lynch Euro high yield index fell 14 percent from its 2011 peak in May to its October trough as worries over Europe's deepening debt crisis pushed investors to cut their bets and shun risk.
Since then, however, the index has rebounded to around its May levels, fuelled by the growing belief among some hedge funds and other investors that the ECB's actions mean the euro zone is past the worst of its debt crisis.
"So many people sold so much European credit on real fears. A lot of things have got way out of whack," said one U.S.-based credit hedge fund manager who declined to be named.
"The LTRO has really helped. There were going to be problems, banks weren't going to be able to fund themselves (otherwise)," added the manager, who expects "a relatively muted year" for defaults and who has been buying bonds with yields from 5-11 percent.
Tim Beck, senior analyst at fund of funds firm Stenham Advisors, agreed that a number of long-short credit managers are now long high-yield bonds. "The feeling is that the tail risk with Europe is much reduced," he said.
The ECB holds its second three-year LTRO auction on Wednesday. Banks were forecast to take 492 billion euros in a Reuters poll.
Managers have bought junk bonds on attractive yields and then gone short longer-dated, investment grade bonds where yields are lower and where they think ratings could still be vulnerable.
"Funds are seeing returns for holding high-yield bonds," said Teresa Heitsenrether, head of prime brokerage, EMEA at JPMorgan.
"People are looking at the fundamentals. Balance sheets are generally healthier than they were, so investment managers may consider lower credit quality alternatives than they have done previously."
While the high yield index has rebounded to around its May levels, the Merrill Lynch Investment Grade index is 6.1 percent above May's levels.
The U.S.-based credit hedge fund manager said he is short some investment grade bonds on tight spreads as a tail hedge for his portfolio. "We want to protect the portfolio in a situation when things get a lot worse," he said.
"They're short longer-dated paper, which ostensibly has a higher credit quality but is trading at a tighter spread and is sensitive to an interest rate move," said the London-based fund of funds manager.
"It's an odd anomaly right now. They're not necessarily thinking that the investment grade companies are going to go bust, just that they're trading very, very tight. It's also doesn't cost very much (to put on)."