David Vs. Goliath: Einhorn Takes On The US Corporate Debt Bubble

David Einhorn has an IDEA!

The billionaire-wonder-boy-turned-pitiable-underdog has managed something of a comeback in 2019, with his flagship up 18% through June and now, according to his most recent investor letter, David is going to short investment grade and high yield credit.

If you ask Einhorn, shorting credit amid an ongoing, nosebleed rally, is a good way to hedge Greenlight’s stock exposure. Mercifully, it’s not all about cushioning the downside on his equity book. Rather, there’s a fundamental thesis here too.

Specifically, David says “rating agencies have been complacent and allowed debt/Ebitda and debt/equity ratios to deteriorate without a corresponding reduction in credit ratings”.

He also cites the fact that this is the longest expansion in US history, which presumably means the cycle is going to turn sooner or later. After all, one can’t really call something a “cycle” if it never turns, right? “We are a decade into an economic recovery and there are signs the economy may be slowing”, Einhorn wrote to investors.

To be sure, things do look awfully stretched on some metrics, but in a world where defaults are tamped down by artificially suppressed borrowing costs, it’s not clear whether the case against credit is as strong as it might be otherwise. Indeed, Deutsche Bank released a length study on this very topic back in April.

Read more on credit in a world of structurally lower defaults 

Last year, the “BBB apocalypse” story was all the rage, but for all the fearmongering in Q4, the “fallen angel” doomsday never came calling. Spreads have come back in and, indeed, this has been a banner year for credit, thanks in no small part to the reinvigorated hunt for yield. Here’s a simple view:

And here’s a complete breakdown across the spectrum:

(Goldman)

But Einhorn argues that the cost of taking positions against the market is now “quite low” given tighter spreads. Additionally, it’s worth noting that if the cycle ever does turn (or maybe “if the cycle is ever allowed to turn” is better), a dearth of liquidity will likely exacerbate any selloff.

“The US corporate bond market has near tripled in size since the GFC due to QE/lower yields encouraging companies to issue and high demand for fixed income and spread product, thus providing a captive pool of capital”, Deutsche Bank’s Jim Reid wrote earlier this year, adding that “regulation has ensured dealers/market-makers have less and less ability to warehouse risk”.

(Deutsche Bank)

That disconnect between the street’s capacity/willingness to lend its balance sheet in a pinch and the massive pile of outstanding corporate debt has the potential to be extremely problematic in a fire sale scenario.

Here’s the thing, though. Betting against corporate credit right now is, in many respects, tantamount to betting against central banks at a time when policymakers are redoubling their efforts to extend the cycle and push investors into risky assets. And to the extent Einhorn is hoping to see the liquidity mismatch described above exposed, he’d hardly be the first person to sit around waiting on that black swan.

None of this is to say that corporate credit isn’t a bubble – it probably is. But when it comes to betting against bubbles, Einhorn’s recent track record is somewhat dubious.

Still, we wish him the best of luck. “We’re all counting on you”.