Distress in high-yield corporate debt will continue in 2016

As US Treasury bond yields rise 150 basis points as Wall Street prices in a yield to worst well above nine per cent.

I was fascinated by high-yield debt ever since I first heard Michael Milken, then the maestro of Drexel Burham Lambert's junk bond trading empire from its Rodeo Drive, Beverly Hills office, speak at Wharton. Milken was then hailed as America's greatest financier since J.P. Morgan, the creator of the junk bond new issuance that was the high-octane fuel for Wall Street's merger arbitrageurs, hostile takeover and leveraged buyout kings and asset strippers, the Wharton MBA whose bonus alone was $560 million.
A year later, Milken was in Club Fed, Burnham was kaput and merger mania in deep freeze as daisy chain of junk bond financed deals culminated in Chapter 11. Morgan's words haunted me then as they haunt me now: "Liquidity is like a cab on a rainy night in New York. It disappears when you need it the most".
The Third Avenue Credit Focused Fund froze investor redemption and precipitated panic in a high-yield debt market braced for a tsunami of energy debt defaults in 2016 as West Texas hedges end. The sector has lost its credibility after years of balance sheet leverage, go go financing and shrunken profits for high risk issuers even outside energy.
As US Treasury bond yields rise 150 basis points as Wall Street prices in a yield to worst well above nine per cent. This means the two major high-yield debt index fund are still a short on any strength.
This is not the time or place to bottom-fish despite ostensibly fat coupons/spreads as default rates will continue to rise while dealer banks (thank you, Volcker, Dodd and Barney Frank!) refuse to commit capital to the embattled secondary market.
This means risk premia in high yield debt will continue to spike on Wall Street in 2016 mainly in oilfield services, drillers, media, metals/mining cable/satellites, Macau gaming and even wireless telecom. Lucidus Capital demonstrates that the liquidation of high-yield credit hedge funds will continue.
I can well envisage the current high yield debt bear market as the worst since the 2008 meltdown after the failure of Lehman and the 1991 crash that followed Drexel's closure and Milken's arrest for insider trading. No asset allocator in his right mind would allocate to high yield and private debt as investor redemptions surge while dealer bid/ask spreads widen to the size of a Patton tank. Historically, bloodbaths in high-yield debt have presaged recessions in America as unerringly as an inverted US Treasury debt yield curve.
This was the case in 1990, 2001 and 2008-09. Credit spreads have widened since mid-2014 even while US economic data momentum has accelerated. The high-yield debt market is the victim of a classic "liquidity shock" created by the regulatory excesses of the post-Dodd Frank, Volcker Rule, Basle Three world. Sure, the pain is focused on energy/mining but contagion can easily spread to the debt netherworld of Wall Street, just as it spread to equity when Third Avenue unnerved global risk assets.
Defaults will continue to rise in 2016 and could well peak at five per cent, meaning spreads have significant room to widen even from current levels. Despite juicy eight per cent yields, I do squat in this toxic asset class. Far easier to replicate these yields selling expensive put options on momentum darlings in the Chicago Board Options Exchange.
Who said fairy tales do not exist in emerging markets? City of Kiev bonds rose from 40 to 90 after the IMF's Ukraine debt restructuring even though Putin's proxy war still rages in the Donbass. Yet I was saddened that Gulf-based NRI private client investors lost at least $50 million as Private Bankerji lured them into Brazil OAS bonds, now in default with the chairman in jail. Once again, the blind lead their trusting lambs to the slaughter after fleecing them with exploitative fees. Brazil, Turkey and South Africa tell me that the sovereign credit rating cycle will turn ugly in 2016. I see a Venezuelan default as inevitable. Hot money will force a Turkish bank debt crisis. The cost of refinancing external debt will surge.
Dr Janet Yellen tells me 100 basis points of monetary tightening will happen in 2016 from the FOMC dot plot. This is nightmare for Third World debt, crude oil, Hong Kong/GCC property and offshore sovereign junk credit. Get real. Get out.

market view