A $14 billion hedge fund is sounding the alarm on distress in the retail sector

A $14 billion hedge fund firm is predicting pain for retail and other sectors.

Canyon Capital Advisors, a Los Angeles-based hedge fund set up Joshua Friedman and Mitchell Julis, said in a January letter to investors that a number of sectors would feel the effects of tightening financial conditions.

The Federal Reserve's easing program, called quantitative easing, "cushioned many companies from the impact of broader business conditions by extending them a lifeline of low cost financing," Canyon wrote. But this "volatility-suppressing effect" should recede with the program's end and the Fed's move to push up interest rates, the firm added.

"There are a number of levered industries undergoing significant transformation that are likely to be more vulnerable going forward," the report said.

In particular, the fund is focused on the retail industry, according to the letter. More than a quarter (27%) of high yield retailer bonds are trading at distressed levels, Canyon said. That suggests the market is pricing in some kind of reorganization or bankruptcy.

"Changes in consumption patters have put tremendous pressure on legacy retail business models," the Los Angeles-based hedge fund said in the letter. "Some of these companies have a reason to exist and will restructure their balance sheets; others will liquidate."

Per Canyon, other sectors that could struggle include:

• Health care - High yield "health care bonds are trading wider than the broader [high yield] market for the first time in nearly a decade... There was only one default among [high yield] health care companies in 2016, but over 15% of the sector now trades at distressed levels."
• Media - "[P]olicy shifts, M&A, and technological disintermediation are resulting in significant changes to businesses and balance sheets. Encroachment by new entrants with lower costs of capital and different motivations (whether tech giants like Amazon or Apple, or blue chip communications companies like AT&T) is putting pressure on legacy media companies, many of which are highly leveraged."
• Energy - "While the period of most acute distress may have passed, this is a sector undergoing a disruptive transition in both supply and demand dynamics and, in turn, corporate balance sheets. Accordingly, we expect there to be routine mispricing of risk and return in this area for the foreseeable future."

Canyon also wrote that the equity and credit markets are likely fully priced.

Canyon managed $14.2 billion in hedge fund assets as of mid-year 2016, according to the HFI Billion Dollar Club ranking. The Los Angeles-based hedge fund firm managed about $9 billion in its Value Realization fund at the start of this year, the letter said.

The Canyon Value Realization Fund, L.P. gained about 2 % net of fees for the fourth quarter of 2016, bringing the estimated return for 2016 to about 9%. Year to date through February 3, the fund was up an estimated 2.2% net of fees, according to the letter.

A Canyon media rep declined to comment. ValueWalk earlier reported on the letter.