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Worsening risk, new investors and the absent canary

There have been plenty of compelling reasons to go short credit as an asset class this year. Investment-grade corporates are under threat from leveraged takeover by huge private equity funds; at the lower end of the credit spectrum, the easy availability of cheap credit even to risky B-rated borrowers has stretched leverage ratios to unsustainable levels.

Over the summer, rising rates threatened to drain liquidity and easy money from the financial markets. Now, as the year ends, economists are fixated on the horrible US housing market and debating whether the economic landing will be hard or soft.

It’s all bad news for credit... and yet.

And yet, credit spreads have ground in all year. Why? Because most investment-grade corporates are in very rude financial health. Profits are strong, spending on capex or M&A has not risen at an alarming rate, cash and liquidity is high. Investors and lenders want to put on assets.

So it is important to remember, though, that the day of reckoning has not been averted: it has merely been delayed. Even though shorting credit this year has generally been a costly mistake, with spreads now once again at or close to historically tight levels, valuations rich, the economic outlook uncertain, announced M&A and LBO volumes rising, the only thing harder to be than a credit bear is a credit bull.

When the inevitable blow-ups come, common sense would suggest that it will be the weaker, more highly leveraged credits that explode first, especially if the economic slowdown is worse than expected, earnings decline sharply and equity markets turn volatile and weak.

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