Billionaire investor David Einhorn breaks down why he just started shorting the US credit market

David Einhorn, the billionaire president and founder of Greenlight Capital, revealed in his latest investor letter that he recently started shorting US corporate credit.

He detailed the reasoning behind his call, pointing at the rapid expansion of corporate debt and lackadaisical analysis on the part of rating agencies.

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David Einhorn has earned the attention of the investment community.

The billionaire president and founder of Greenlight Capital, which oversees $2.5 billion, garnered his reputation through an array of prescient market calls and double-digit returns. And over time, he's managed to stay one step ahead of the market.

Einhorn revealed his latest big market call in his second-quarter investor letter, telling clients he has opened a new short position against both investment-grade and high-yield corporate credit — an area he says has been looking frothy.

“Over the last few years, corporate debt has expanded dramatically, while covenant packages and other bond-holder protections have weakened considerably,” Einhorn relayed.

In other words, as debt issuance has grown, credit quality has deteriorated.

Also notable is that this explosion of corporate debt — which sits near a record — has occurred even as the economy has slowed. This has been enabled by the Federal Reserve's willingness to keep interest rates low in an attempt to stimulate conditions.

In fact, the central bank just eased monetary conditions further this week, cutting its benchmark lending rate for the first time since 2008. That accommodation has, in turn, enabled the unabated swell of low-quality debt.

But, in Einhorn's eyes, the Fed is far from the only culpable party. He also finds fault with the agencies tasked with assessing the creditworthiness of debt.

“Rating agencies have been complacent and allowed debt/EBITDA and debt/equity ratios to deteriorate without a corresponding reduction in credit ratings,” he said.

If this all sounds familar, that's because a similar scenario played out around the last financial crisis. Back then, lackadaisical agency analysis led to a swath of essentially worthless mortgage-backed securities being touted at the highest investment grade.

When that endeavor went south, those betting against those securities made out well — or at least softened the blow of other financial damage. It's what Einhorn is hoping to do with his credit short.

One final appealing aspect of his new bet is how inexpensive it is.

“Finally, credit spreads are approaching historical tights, such that the cost of betting against corporate credit is quite low,” Einhorn said in the letter.

As for the express purpose of his short-credit wager, Einhorn says it's more of a hedge than a directional bet. He's using it in order to offset some of the long-equity risk present in his portfolio. Given equities are trading at all-time highs and the market is considered to be late-cycle, the maneuver seems timely.

“We have a fair amount of cyclical risk in our equity portfolio (which we added to by buying CC), and believe shorting corporate credit, in addition to having attractive standalone asymmetric risk-reward characteristics, provides a hedge to our long equity portfolio,” Einhorn concluded.