Dispersion should manifest in potential fallen angel credits that are likely to proliferate

Duncan Sankey

Portfolio director and head of credit research Cheyne Capital

IG and crossover names present a compelling alternative to shorting HY credit

It’s been a torrid time for short credit. Over a decade’s worth of unprecedented monetary accommodation provided not merely a fig leaf, but a whole forest behind which all manner of corporates could conceal the nakedness of their business strategies.

Event risk in the form of cash-rich PE managers and activists chasing sleepy (ie, conservatively financed) investment-grade names provided the only real meat for would-be short sellers of credit and, however diligently they screened for candidates, this often meant paying away a lot of carry in the hope of hitting pay dirt. Paradoxically, the one definitive event that drove all spreads wider nobody saw coming.

But things are looking up. Aggressive central bank hikes and quantitative tightening (from balance sheet roll-off) will drive up financing costs and dry up liquidity, exposing business models ill-suited to a period of economic contraction. So far, the attendant dispersion in credit spreads has only really been evident among the weakest names, which is consistent with a recent assertion by Moody’s that a 300 basis points rise in rates from 2021 levels would render the interest burden untenable for half of B3-rated companies.

Moreover, it was the weakest credits that were the main beneficiaries of over $300 billion of US CLO issuance over the past couple of years. A wave of downgrades threatens to engorge the triple C exposure of CLOs, which, JP Morgan notes, has risen 73bp to 4.66% across 106 managers in the last quarter alone. Since triple C exposure is usually capped at 7.5%, the willingness of CLO managers to absorb single-B and triple C refinancing is open to question. So shorting weak HY names should be like shooting fish in a barrel?

Shorting individual HY names is not easy

High yield bonds tend to be small, discrete issues that are elusive and expensive to borrow; the interest on the cash from selling the security short may well not cover the cost of financing. Moreover, most deep junk HY names do not benefit from active CDS contracts through which a short risk position can be easily established by buying protection on the name.

A would-be short seller of single-name B or triple C risk therefore must have a high level of conviction that the trade will pay off over a relatively short time-frame, in which case the downside will likely already be in the price. The alternative would be a total return swap on a basket of leveraged loans; this is a less surgical approach, but makes sense in the context of a general decompression between B/CCC and higher-rated credit.

IG offers a different opportunity set. The lack of spread dispersion in the “belly” of the credit market (single-As, triple Bs and more robust double Bs) bespeaks a cohort that currently enjoys strong margins, manageable leverage and coverage, and limited refinancing risk.

However, in the absence of central bank support, it is reasonable to expect increasing dispersion in IG in the context of at best flaccid economic growth, coupled with the impact on margins and cashflows of wage inflation, higher-friction supply chains and the replacement of just-in-time with just-in-case; in this scenario there will be winners and losers. Also, while EU IG spreads may already appear to discount bad news (at mid-70th percentile on a 10-year retrospective), the period of comparison is one in which easy money kept spreads tight. Dispersion should manifest in potential fallen angel credits (IG credits on the cusp of junk), whose count rose for the first time in almost two years in Q3 last year and which are likely to proliferate.

IG and crossover should therefore provide a more fertile ground for traditional, actively managed long-short credit strategies. Moreover, these names are more likely to be traded in the CDS market, which enjoys superior liquidity to that of bonds.

Buying protection is also relatively unconstrained in terms of maturity, whereas the choice of maturity when shorting a cash bond is limited by the availability of a bond issue at a given maturity point. Finally, the challenges of financing a short in a cash bond apply to potential “fallen angels” as well as spec-grade credits. CDS gives a simple and efficient vehicle for expressing long and short credit views and, along with fundamental research, should form a key part of the long-short toolbox.

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Global credit funds & CLO's

February 2023 | Issue 252

Published in London & New York.