Title:   An Emerging Credit Risk with Contagion Potential — When Managers Need to Make Room
Show:    Paulo Macro (Substack) — paid
Guest:   Paulo Macro ("Cloudbear")
Date:    2025-DEC-19
URL:     https://paulomacro.substack.com/p/an-emerging-credit-risk-with-contagion
Length:  written post (no timestamps)
Note:    Back-filled post (processed 2026-JUL-07). A credit note building on Michael W. Green's (Simplify) work on why high-yield spreads are historically tight: Paulo's twist is that the catalyst to break the tightness may be a supply shock — an ORCL downgrade from IG (BBB neg) to BB+ that would grow the ~$1.7T HY market by ~6% overnight, forcing HY managers to "make room." Body reproduced for personal study; Substack chrome (like/restack counts, Share/Previous/Next) removed.

Most of you know I'm not much of a credit guy, but something has been gnawing at me over the past week as a possible red flag so throwing this out there fully expecting peals of laughter. I would welcome hearing back from credit readers in particular on this.

This past Sunday, Michael W. Green of Simplify wrote on why high yield (HY) spreads have remained so tight. I find much of what Green writes to be thought provoking, and I would encourage you to have a look at his substack here. I trust he won't mind I reproduce some of his comments, because i think this is very important, and… well… I have a few thoughts:

Giving Credit Where Credit is Due — What the Heck is Keeping Spreads so Tight?

After the briefest of interludes in October and November, credit spreads for cash high yield bonds have again returned to their tightest levels in history. This is occurring despite a surge in realized bankruptcies in the month of November (thin blue line) to the highest non-recessionary levels in history. My models of credit spreads suggest they should be approaching 600bps versus the current levels of 275bps (6%ile versus all history).

Cash spreads are very tight as issuance in high yield has been weak while demand for cash high yield (actual bonds) has been strong. Higher interest rates combined with the growth of private credit and limited interest deductibility for highly levered companies (2017 tax reform limited deductibility of interest expense to 30% of EBIT [operating profit]) has resulted in companies both unwilling and unable to raise their interest expense by refinancing 2020-2021 era low coupon paper. Meanwhile, the higher secondary market yields have resulted in increased cash flow to high yield funds, driving additional demand. Similar to the lead-in to the GFC, spreads are artificially tight while economic conditions are increasingly precarious.

Of course, there's more to the story. My visit to New York last week included a chat with David Meneret, one of the smartest credit investors I know. David shared with me his analysis of the high yield CDS (credit default swaps) market which has been running with a consistent positive basis to high yield cash. This means "long high yield" synthetically via short high yield CDS delivers significant excess returns:

The basis for high yield CDS is traditionally negative because (1) unlike high yield cash bonds, financing the purchase of CDS as protection is easily levered, and (2) insurance trades at a premium. It has turned positive as the shortage of secondary market paper (also occurred in Q4-2018), combined with strong cash flows to high yield, and competition from private credit has pushed cash bonds tighter.

A fund that chooses to leverage exposure to high yield by SELLING high yield CDS can generate extraordinary returns:

Eye-popping indeed. And David points out that this trade is absolutely in play. He identified a single high-yield hedge fund, launched in 2021, with roughly $12B in AUM, that has taken this to the extreme. On his estimates, this fund is levered between 10-15x into a synthetic high yield position, suggesting they represent between 12-20% of the entire high yield market. At that degree of leverage, a 200bps widening of high yield spreads would wipe out the fund. As a reminder, Ralph Cioffi's Bear Stearns High Grade Credit Opportunities Fund was 10x levered in 2007. Got popcorn?

Mike is flagging that the tight supply/demand of HY cash bonds is resulting in a divergence vs deteriorating credit conditions (bankruptcies). HY fund managers receive more income from higher post-Covid coupons to reinvest since rates went up, but HY issuance has not grown much due to the rise of alternative funding sources in private credit. Excess investor demand vs supply in HY is keeping spreads so tight that HY credit insurance (CDS) is trading cheaper/wider than the cash bonds, when historically the opposite should be the case (in part because CDS is easier to leverage). We'll come back on this last point at the end and have a little fun.

This got me thinking about what could be a catalyst to change all this, and it occurred to me that maybe investors are looking in the wrong place in worrying about defaults and bankruptcies as a catalyst. If flow and supply/demand is at the heart of the tightness in spreads, than perhaps the problem would be a sudden flow imbalance the other way.

Here is where things get interesting. Supply can certainly grow from issuance, and demand can fall from outflows driven by risk aversion. But supply can also grow by IG issuers getting downgraded to HY. "Sent down to the minor leagues," as ball players would say…

Notice where the growth in corporate bond issuance has been over the past ~15 years — it's all A and BBB, while the HY space has not really grown thanks to private credit's crowding out:

Source: Apollo

But there is one situation in particular that has my attention (I'm sure it's no big deal because nothing ever happens). We have all seen a version of this chart too many times by now:

Source: PauloMacro via Bloomberg

But I decided to look. It turns out both S&P and Moody's have ORCL rated at BBB with a negative outlook:

Source: Bloomberg

Is ORCL debt trading like HY and worthy of a downgrade? It's easy to conclude that because HY is trading at a ~2.8% spread while 5yr ORCL debt trades at a 1.62% spread that therefore ORCL is not HY and shouldn't be downgraded (or how HY CDX=320 but ORCL is 'only' 154). But this misses the point that we need to look at the next rung down… the BB level — the highest rung of HY. BB trades at a 1.74% spread… and that's actually getting pretty close to where ORCL is trading:

Source: Bloomberg

And while ORCL CDS trades 154, the HY BB CDX Index is trading around 115:

Source: Bloomberg

The recently issued ORCL 30Y bond is trading 275bps over Treasuries… this is definitely getting into BB territory:

Source: Bloomberg

Why my focus on ORCL? Besides the fact that it has captivated the media and run away with the Jump the Shark narrative in AI hyperscaler spend, apparently ORCL has $101bn of outstanding bonds (plus another $3bn in loans — not shown):

Source: Bloomberg

Imagine for a moment if $101bn of ORCL debt were to be downgraded to BB+. The entire HY bond market is $1.7T. This means the HY market would grow by 6% overnight.

Remember when I wrote about IPOs as a 'tell' for corrections and bear markets in When IPOs Forewarn Market Rollovers? The premise was that when supply begins to overwhelm demand in ECM and the recent vintage IPOs don't move off buyside ECM books fast enough, the buyside has to "make room" by selling something else, and this creates the effect of IPOs rolling over from the 'pop' and eventually breaking price at faster intervals. A downgrade of ORCL would have a similar effect, but on a much larger scale. HY managers would need to make a lot of room, and flows are procyclical as we know. Could investor inflows continue to be counted on in an environment where spreads are breaking wider? Probably not, at least not for a while.

One last thing — I have no idea how to verify this last part of Mike's note, but what he writes seems plausible. I mean, crazy things happen in credit… if the JPM Whale went out on a limb in IG, why not a hedge fund in HY?

Eye-popping indeed. And David points out that this trade is absolutely in play. He identified a single high-yield hedge fund, launched in 2021, with roughly $12B in AUM, that has taken this to the extreme. On his estimates, this fund is levered between 10-15x into a synthetic high yield position, suggesting they represent between 12-20% of the entire high yield market. At that degree of leverage, a 200bps widening of high yield spreads would wipe out the fund. As a reminder, Ralph Cioffi's Bear Stearns High Grade Credit Opportunities Fund was 10x levered in 2007. Got popcorn?

It got me curious, and that's when I stumbled across this bro who runs this giant fund here named after a parrot. Have a read of both.

Making sure I have it straight: when Covid hit in 2020, a 29yr old 'wunderkind' crushed it at Credit Suisse (it's always CS isn't it)… in junk bonds (clearly by being long, since the blowout lasted a few weeks)… and his post-college career basically would have begun in 2013 onward, so at 35 he hasn't experienced a market environment that doesn't feature spread compression other than for maybe a month. He gives interviews "while wearing a Mickey Mouse t-shirt saying 'It's all going to be okay.'" And he might be levered 10-15x on $12bn, making him possibly as big as 20% of the high yield market at a time when the high yield space might grow by 6% at any moment from an ORCL downgrade.

I look forward to hearing what my credit friends have to say about this.

As always…stay frosty. Kind regards,

Paulo aka Cloudbear