Gundlach’s Warning to Corporate Bond Investors
Corporate bonds offer incredibly poor prospects under any scenario, according to Jeffrey Gundlach. If rates rise, prices will drop quickly because their durations are between 7 and 10 years. Falling rates are no better, he said, because they would be accompanied by a bear market in stocks with effects that would extend to corporate bonds.
Gundlach is the founder and chief investment officer of Los Angeles-based DoubleLine Capital. He spoke via a webcast with investors on November 13. The focus of his talk was DoubleLine’s core and flexible fixed-income mutual funds, DFLEX and DBFLX. The slides from his presentation are available here.
The problem facing the corporate bond market is excessive debt and an oversupply of bonds. There is a lot of leverage among corporations, Gundlach said, which can be seen in “massive increases” in the size of the investment-grade market and a deterioration in the quality of debt. Spreads are tight, according to Gundlach, but are “tighter than you think, because quality has been systematically going down” in the covenants that are offered by corporate issuers.
“Spreads and debt levels are out of sync with one another,” Gundlach said.
That dichotomy is illustrated in the graph below. The shaded area depicts leverage (the corporate debt-to-GDP ratio) and the black line is the option-adjusted spread between high-yield (junk) and Treasury bonds. The two moved in sync from 1994 until 2013, after which leverage increased without a similar increase in spreads.
As a result, both corporate and high-yield bonds are at or close to their most extreme levels of overvaluation historically, based on DoubleLine’s proprietary methodology. That methodology looks at the spreads of those bonds relative to similar-risk Treasury bonds; those spreads are approximately two standard deviations above their normal level.
The BBB-rated market, which has the lowest rated corporate bonds, is two-times bigger than the high-yield market. If those bonds are downgraded to junk, Gundlach said, it will “flood” the high-yield market.