Watch Out for a Doubling of Junk Defaults, Warns Gundlach

Jeffrey Gundlach (photo courtesy of DoubleLine Capital)

Junk bond defaults may double soon, according to Jeffrey Gundlach, dubbed the Bond King. And that’s despite Federal Reserve efforts to prop up high-yield issues.

“There is room to go on the upside” with default rates, he warned on a webcast sponsored by his firm, DoubleLine Capital. The protracted recession will put highly indebted companies with junk ratings under increasing pressure, he reasoned.

The title of his program was “Hey Kid, Want Some Candy?” Implication: Some bond investors are enticed by the sweet (relatively speaking) payouts of junk bonds, but that won’t be healthy for them in the long run.

The Fed has pumped more money into the economic system, but that hasn’t erased “economic fundamentals,” he cautioned. Many junk issues are overpriced amid investor euphoria, he said. Thus, recovery rates—the portion of a defaulted bond’s face value that investors may actually recoup in a restructuring—will be lousy, he added. “There are many junk bonds that are priced today, or certainly were a week ago, at levels in excess of the recovery rate should they default,” he said.

Right now, the portion of US junk issues that aren’t paying interest has been steadily rising, hitting 8% last month, says Moody’s Investors Service. Defaults are up from 4.2% at the end of 2019 and 4.4% right before the coronavirus began spreading in the US in March.

Nevertheless, yield-starved investors have flocked to buy the speculative-grade paper. Last month, the US high-yield market expanded $1.36 trillion, up 15% from 12 months earlier, as the result of new issuance and also demotions from investment grade.

The Fed has pledged to buy these new arrivals to junk-land, known as “fallen angels,” as well as to purchase exchange-traded funds (ETFs) dedicated to junk. Although the central bank has said it won’t go for older junk, and hasn’t bought that much high-yield anyway, the halo effect of its intervention has reassured investors about the entire speculative-grade spectrum.

Right now, half of investment-grade corporate debt is at the category’s lowest rung, BBB. If 50% of that were to be downgraded to junk, this would magnify the risk for junk investors, Gundlach argued. In the Great Recession, junk defaults topped out at around 12%.

Gundlach criticized the Fed’s campaign to bolster risky assets such as junk bonds. That, along with federal government stimulus spending, has prompted what he termed as unsustainable corporate borrowing binges. “It’s foolhardy to believe that one can have this kind of a shock to an economy and it just gets healed through a one-shot deal” from Washington, he said.