FLASH UPDATE: Let's Keep Inflating that HY Bubble!

Let's Keep Inflating that HY Bubble!

Inflows…Tepid Growth…Yield Compression…Spread Tightening…New Issuance…Low Defaults…QE…Can-Kicking…

What do all of these things have in common?  They are all features of the current fully-heated high yield market that I hope will continue, for now.  I am crossing my fingers and toes, rubbing my lucky rabbit’s foot, holding my special four-leaf clover close to my heart, avoiding ladders, mirrors, black cats, and cracks in the sidewalk…

We think that there are significant reasons to be skeptical of the high yield market’s ability to hold up.  That being said, we want to accumulate as many ugly, highly-levered, negative free cash flow generating, falling EBITDA, bottom-dwelling, vulnerable credits as possible at prices above par and call values. 

A unique feature in the high yield market is that many bonds can be callable.  This feature gives the issuer the privilege to redeem the bond at some point (or several points) before reaching maturity, typically at a premium to par.  In more normal, less bubbly, times, these callable bonds offer a higher coupon to investors to compensate for this ‘option’.  In falling interest rate environments, companies can use this feature to ‘call-in’ previously issued debt and to refinance it at a lower interest rate.

This callable feature is key, in our opinion, to creating true mathematical asymmetry in a short high yield strategy.  Some of the most vulnerable B & CCC rated high yield bonds are trading at prices above their call-values.  This means that between now and the call date, the upside from a price perspective is likely severely limited and constrained.  Combine the notion of call-ability with today’s low absolute yields (negative cost of carry) and you have a mechanism where one can wait for certain negative catalysts or events to occur in specific securities.  So for now, let’s keep that bubble inflated. 

Richard Travia
Director of Research