The junk-bond bonanza that’s doubled the market to almost $2 trillion since the credit crisis has Jeffrey Gundlach heading toward the exit.
Less than 12 months after saying the Federal Reserve’s stimulus and a plunge in defaults would support the market for speculative-grade debt for another four years, the head of DoubleLine Capital LP is trimming its allocations. With borrowing costs for the least-creditworthy companies approaching a record low, junk bonds no longer provide enough of a buffer from rising Treasury yields as the Fed scales back its bond buying, said Gundlach, whose firm oversees $49 billion.
“They’ve squeezed all the toothpaste out of the tube,” the bond manager said in a telephone interview from Los Angeles. “There is interest-rate risk that’s just being masked by fund flows holding up the prices of junk bonds.”
Without that money moving in, he said, “if they start to suffer losses, you really wonder who’s going to buy them.”
Junk bonds, which have returned 148% since the end of 2008, are showing signs of froth as five years of easy-money policies by central banks caused investors to pour unprecedented amounts of money into the high-yield market. That’s helped push the amount of junk bonds worldwide to $1.97 trillion from less than $1 trillion in March 2009, Bank of America Merrill Lynch index data show.
DoubleLine cut its allocation to speculative-grade debt in its $1.8 billion Core Fixed Income Fund to 3% at the end of last month, compared with the firm’s expected average of 10%, said Gundlach, who last April predicted “junk bonds will do OK” for the next four years. The fund has outperformed 90% of its peers in the past three years, a period during which yields on junk bonds globally reached a record-low 5.94% last year, according to data compiled by Bloomberg.
Improvements in the job market and economy spurred the Federal Open Market Committee to trim monthly bond purchases by $10 billion in each of its past two meetings. The central bank in January reduced its bond buying to $65 billion.
Investors have deposited more than $27 billion into U.S. funds that buy junk bonds since 2009, according to TrimTabs Investment Research. Even after the inflows slowed last year to the weakest pace during that period, they’ve bounced back this year. After pulling $1.2 billion out in December and January, investors have since funneled $1.4 billion back into the funds, the data show.
“The market’s very rich, valuations are lackluster and there’s very little margin for error,” said Edinburgh-based Steve Logan, the head of high-yield at Scottish Widows Investment Partnership, which manages about $242 billion. “We’ve lightened up, taken profits. Yields and cash prices on the asset class haven’t anywhere much to go now.”
The global market for speculative-grade debt, rated below Baa3 by Moody’s Investors Service and BBB- at Standard & Poor’s, is poised to surpass $2 trillion in a matter of weeks, according to the Bank of America Merrill Lynch Global High Yield Index. That gauge, started Dec. 31, 1997, took 12 years to reach $1 trillion.
Junk-rated companies have issued $59 billion this year, after a record $380.2 billion last year, according to data compiled by Bloomberg.
“When things are rollicking and the market is permitting low-quality issuers to issue debt, that’s when you need a lot of caution,” Howard Marks, the founder and chairman of Oaktree Capital Group LLC, the world’s largest distressed-debt fund, said Feb. 28 in a telephone interview. “We know which way the tide is going, and we know it won’t go that way forever, but we never know when it will turn.”
The speculative-grade global default rate is forecast to reach 2.1% in December, down from 2.9% at the end of 2013, according to a Moody’s note March 7. Default rates in Europe will fall to 5.2% next year, from 5.9% at the end of 2013, according to S&P.
At the same time, investors are demanding fewer protections. A measure of covenants on speculative-grade debt in North America were at weakest level in at least three years last month, Moody’s said in a March 11 report. A gauge of covenant quality that increases as investor protections deteriorate climbed to 4.36 last month from 3.84 in January, reversing three months of improvement. The ratings firm measures covenants on a scale of 1 to 5.
“The seeds of the high-yield demise are being sown with some lax underwriting,” said Anthony Valeri, a market strategist in San Diego with LPL Financial Corp. “But that probably won’t be a problem in the form of higher defaults until late this year.”
Yields on dollar-denominated debt rated CCC or below have fallen to 9.7% through yesterday, Bank of America Merrill Lynch index data show. That’s 3.7 percentage points below than the average of the past decade, the data show.
Buyers demanded 3.78 percentage points more than similar- maturity Treasuries to own U.S. junk bonds on March 5, the least since 2007, the data show. That’s not enough, according to Martin Fridson, chief executive officer of FridsonVision LLC, a New York research firm specializing in high-yield debt.
“We’re at an extreme over-valuation,” he said in a telephone interview. “When you’re not compensated adequately for the risk, you do tend to get punished for it. If the Fed is still sufficiently energetic about it, they could keep it at an over-valuation through all of 2014.”
–With assistance from Sridhar Natarajan in New York and John Glover in London.