While credit markets 'tightness' had been proclaimed as a pillar of support for the bull thesis by many still clinging to hope, that is no longer the case.
While longer-term, credit spreads remain extremely compressed, in the short-term, high yield bond markets have started to crack notably wider...
Cash bonds appear to be outperforming (not widening as much) but this is due to managers, such as Aberdeen's Luke Hickmane, preferring to use the considerably more liquid ETF and CDS markets to hedge before unwinding underlying cash positions.
Additionally, we note that Hickman is shunning exchange-traded bond funds, fearing a "blowout" in the passive space within the next two years.
“If you’ve been in the market long enough to remember past blowouts, you know that liquidity is key,” Hickmore said...
“High-yield credit and emerging-market ETFs won’t be well placed to handle a liquidity crunch.”
And, as that fear of a liquidity crunch leaks from cash markets to the ETF, it is the CDS markets that have become a more popular hedging tool for professionals in recent weeks.
Hickman is not alone in his fear of a "blowout" as DoubleLine CEO Jeffrey Gundlach explained in a recent interview - the time to get out of corporate bonds is now... (via CityWire)
Alex Steger (AS): Given your outlook, where markets are at the moment and where we are in the cycle, how are you positioned in your Total Return fund?
Jeffrey Gundlach (JG): We’re pretty much defensive. There's two things you have to worry about in fixed income investing.
First is interest rate risk, which clearly has not been a positive now for a couple of years. You've not made money by price gains, you've actually had price declines. So you want to position yourself so that you're not so exposed to these price declines. If you take a look at like our Total Return fund, it's doing very very well since the bottom in rates and very well this year because of its defensive positioning.
Then the other thing you have to worry about is how much credit risk do you want. And I would argue that this is not a time to have a much of that either. So you need to be defensive against credit as well. So you're doubly defensive right now in the bond market and that shows up in our funds. Some funds have more credit than others, because of the nature of their mandate. Our Total Return fund, for example, never has any corporate bonds.
So we are doing extremely well, because the corporate bond market is suffering. But it's only beginning. The corporate bond market is going to get much worse when the next recession comes.
It's not worth trying to wait for that last ounce of return, or extra yield from the corporate bond market. Because the old phrase is: You're picking up dimes in front of a steamroller.
Your chance of making big money incrementally in corporate bonds is virtually non-existent. And when it goes bad, it's going to go bad in a way that you'll lose substantially.
So it's probably better to forego a little bit of extra yield in the near term, knowing that you'll get a much better opportunity some quarters or a couple years down the road.
AS: And how severe do you think that recession will be?
JG: I just think that there's already, for what is supposedly a good economy, there's a lot of discontent socially and economically, and it will just get worse when there's a recession. So I think it will fan the flames of social unrest. And that's a little bit negative.
And one look at where corporate leverage is, it's clear that as risk 'normalizes' in credit markets that spreads are set to blow dramatically wider...
Additionally, Gundlach highlighted another potentially systemic problem that many are ignoring... Gundlach tweeted:
"DB stock price now solidly below 10 & at multi-decade low. Down massively last 5 years. Not getting enough attention in the financial media."
And while that is showing up in the stocks of the the Globally most systemically important banks...
Investors are not asking the question: why?