Avoiding Credit Risk in an Uncertain Recovery

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I’m Ignacio Sosa. I’m the director of international relationship management at DoubleLine Capital in Los Angeles.

What are the biggest risks of the corporate bond market in the coming year? Well, there’s several. Number one, there’s just an enormous amount of corporate debt out there. You’re talking record, trillion-dollar levels of corporate debt. The fact that it’s widely owned and that probably half of the universe of investment grade corporate debt is just barely investment grade, would cause concern that in a prolonged kind of recessionary environment, a lot of these corporate names will not continue to be investment grade. And so we’ve been saying this for quite some time, but now we’re in a situation where the downturn in the economy has been extremely sudden and is generating levels of distress not seen since the Great Depression — never mind the Great Recession: the Great Depression.

And so it’s a very sudden change in the outlook for the American economy and very few companies were set up to deal with it. We would be very cautious with a investment grade corporate debt, especially since these prices to us appear artificially inflated by a government program which provides really very little by way of credit enhancement. In other words, it really doesn’t impact the underlying credit worthiness of corporate borrowers, but it does provide liquidity in the market because there’s somebody who’s buying them and that is the special purpose company that the New York Fed and the Treasury have put together. But that doesn’t mean that the underlying risk of these corporate bonds has improved. In fact, it’s getting worse by the day. We think investment grade corporates are sectors you want to stay away from, and that you should be focused on those sectors if the Fed is not supporting them, because those are more accurately priced — and those are primarily securitized credit instruments.

What is our firm doing in terms of avoiding some of the pitfalls that we see going forward in the fixed income markets? For one thing, we don’t think this is a good time to take on excessive interest-rate risk. Clearly the Federal Reserve doesn’t want medium- and longer-term bond yields to go up substantially in the near term. So at the same time, the federal government is producing multi-trillion-dollar deficits the likes of which we haven’t seen since World War II. This is really not the time to be taking on what we call duration. You don’t want to have bonds with long maturity in this environment because you simply don’t get paid for them. I think you also want to avoid investment grade corporate debt in general because the prices are artificially propped up. And we have absolutely no idea how a large swath of this market is going to perform.

We don’t know how long the recovery is going to take. When will people go back to shopping? When will people go back to eating in restaurants, getting a haircut, et cetera? We think it’s going to be longer than the market consensus. We don’t see a V-shaped recovery; we don’t even see a U-shaped recovery. It’s going to be much longer. Even as places start opening up, you can see that you are a store owner and you have 10 employees or a restaurant owner, and you have 20 employees, you’re not going to hire all these people back on day one. You’re going to hire a few of them and see how it goes. And until you start seeing business go back to normal, which could take months if not years, you’re not going to go back to the levels of employment that we had, say, in January or February of 2020.