How To Profit From The Coming High Yield Meltdown

The credit cycle has finally turned: one can see it everywhere – from the rapidly deteriorating corporate fundamentals, to the recent surge in defaults and downgrades, to the tightening lending standards, to the most obvious – sliding asset prices. Nowhere is the bursting of the credit bubble more obvious than in the spread between junk spreads and the equity market,

Yes, equities may not have gotten the memo yet, but they will, as will all other skeptics once they read Ellington Management’s analysis laying out all the telltale signs that showcase the turning of the credit cycle.

What does that mean for investors? Conveniently the very same Ellington, which recently did a remarkable job of explaining why the credit party is now over, has proceeded to layout how to profit from the upcoming credit turmoil.

Here it the answer:

Given the fundamental factors in place that should support the demand for housing, we believe the eect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”

Ben Bernanke, May 200

For my own part, I did not see and did not appreciate what the risks were with securitization, the credit ratings agencies, the shadow banking system, the SIVs – I didn’t see any of that coming until it happened.”

Janet Yellen, November 2010

Complacency today about the risks of contagion from the weakest segments of high yield to the rest of the corporate credit markets is strongly reminiscent of the complacency about contagion risks from subprime in mid-2007. At that time, investors and regulators realized that the sharp increase in subprime delinquency rates was an issue, but believed that losses would be contained to that sector. Even though housing leverage was at all-time highs and home prices had peaked a year prior, markets did not believe that other sectors were at risk. Today, with corporate leverage ratios at all-time highs and a year after corporate profits have peaked,markets are again largely ignoring the risks of contagion from the most distressed sectors of high yield to the rest of the corporate credit sector.