One Man’s Opinion: Will Junk Bond Defaults Go Up If Oil Remains At Current Levels?

ManThe US economy would certainly not witness a 2008-style recession despite the recent sell-out in the junk-bond market, said Jeffery Gundlach, co-founder and CEO of DoubleLine Capital.

The crises that started in 2008 are rare and seldom repeat themselves. It was probably and hopefully an once-in-a-lifetime event. Nevertheless, the condition in the junk-bond market is disconcerting though, but it’s really centered on commodity prices as opposed to financial leverage, which was the case in 2008.

Low commodity and oil prices are problematic for the junk-bond market because there’s a substantial fraction that is associated with materials, mining and energy. Increasingly, as oil stays where it is now, investors will find junk-bond markets populated with greater shares of these types of sub-sectors because the investment-grade bonds that were rated BBB are likely to get downgraded.

So, junk-bonds are really troubled because oil is probably not going higher based simply on inventory data. The inventory data of oil are so high, particularly in the US where they remain so high compared to where they were even a year ago, which were inventory levels that were sufficient to break the camel’s back with the price of oil and send it into a tailspin.

So, it’s very unlikely that oil’s going to go higher and if it stays where it is, junk-bond defaults are almost certain to go up. So, this is the problem with the junk-bond market. The cost of corporate-borrowing has gone up this year; 10-year Treasury rates are up a little bit, investment-grade corporate bond spreads have widened moderately and junk bond spreads have widened substantially this year. Corporate borrowing costs are important in a buy-back kind of stock market environment, he noted.

Asked if he owns any junk bonds and at what point prices become attractive, Gundlach said DoubleLine slashed its junk-bond holdings in the middle of the current year by over two-thirds and own a few junk bonds in its portfolio now.

DoubleLine would start buying them when prices start to go down every single day, particularly after some capitulation in the DD-rated bonds. DoubleLine is also worried about the redemption cycle that’s going to come with hedge funds suffering large redemptions.

Thankfully, Third Avenue didn’t happen a month ago because markets were right in the teeth of a huge redemption cycle probably for credit hedge funds right at the end of the year while the Fed’s raising interest rates. It would have been a perfect storm for a debacle, but that has been pushed forward since the window of redemptions is closed for most hedge funds.

But there are reasons to believe the credit hedge funds are down very significantly. So, if investors are leveraged one-time and if they are worried about getting wiped out, markets will witness big redemptions. That pressure is likely to remain in the junk bond market for some months to come, he concluded.

You can watch the video here.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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