FLASH UPDATE: Alarm Bells are Ringing, High Yield is Overheated

Alarm Bells are Ringing, High Yield is Overheated

• “As a percentage of advanced economies, total credit – including corporate, government and consumer debt – is 30% higher than it was in 2007.  I don’t think the economy is recovering at all.  We have in the American economy a slowdown,” said Marc Faber. 

• “All the risky things that were happening back in ’06 and ‘07 are back again to the same level, if not more. So we are in the beginning of a credit bubble…,” said Nouriel Roubini. 

• “The last time junk bonds were overvalued by this much for this long was in mid-2008, just before Lehman collapsed and the financial crisis took hold,” said Marty Fridson.

• “I find it difficult to love a 4.0% yield in junk bonds while hating a 4.0% yield in Treasurys,” said Jeffrey Gundlach.

We have been discussing the extreme overvaluation of the corporate high yield bond market for several quarters now.  We have been pragmatic the entire time, understanding that the current environment is still awash with liquidity from the Fed.  We continuously question our thesis, as part of our process.  As we continue down the path of identifying mispriced, over-levered and vulnerable credits, we conduct market surveillance and listen to what other successful investors think.  Look at the quotes above.  Read them forward and backward, google “high yield bubble” yourself, they (we) are not alone... 

We are as convinced as ever that being short specific credits in this fully-heated credit environment, at levels where there is no upside for the bonds, is not only the right direction, but also an extraordinary opportunity.  The cost to be short today is historically cheap and argument to be short is as strong as ever. 

March and April were very difficult months for hedge fund managers, and I suspect that May will also prove to be challenging.  As correlations of hedge funds continue to rise, there are many investors that we have spoken to over the last year that have made asset allocation shifts in their respective portfolios to minimize the impact of an isolated burst in the current high yield bubble.  We applaud that forward thinking, and suggest that it is now time to be aggressive.  Build short positions in high yield credit now, while yields are compressed, prices are high, spreads are tight and overall interest rates are low.  Once the market loses its bid, free-falling high yield bonds will be hard to take advantage of.  Break the glass now, while you are still able. 

Happy Mother's Day to all of the Mothers out there.  Enjoy your Sunday and celebrate all that is good in life.  

Richard Travia

Director of Research