Why Jeff Gundlach Is Very Scared of High-Grade Corporate Bonds

Jeffrey Gundlach

Photographer: Scott Eells/Bloomberg

Money manager Bonnie Baha can’t think of a worse time to be buying the bonds of America’s blue-chip companies.

They’re yielding about the least ever, with the average dipping under 2.9 percent this month. Prices of the debt are more sensitive to interest-rate increases than at any time in the past 20 years, just as the Federal Reserve considers raising them. And now the fortress balance sheets that companies built in response to the 2008 credit crisis are being eroded, with executives increasingly eager to borrow cheaply to satisfy shareholders starved of revenue growth in a sluggish economy.

“In my 30-year career, it’s one of the most unattractive risk-return propositions that I’ve seen,” said Baha, who helps manage $73 billion as the director of global developed credit at Jeffrey Gundlach’s DoubleLine Capital in Los Angeles.

Those warning signs help explain why BlackRock Inc.’s Rick Rieder is buying less of the debt and DoubleLine founder Gundlach and Baha have been paring holdings for the past 18 months in their core fixed-income fund. The securities have gained just 0.56 percent more than Treasuries this year. That’s after a negative 0.04 percent in 2014, meaning that the only gains for the year came from declining interest rates.

Rate Risk

“There isn’t a lot of value” in investment-grade corporates, Rieder, who oversees more than $700 billion as BlackRock’s chief investment officer for fixed-income, said Thursday in an interview. “We have a higher level of interest-rate risk than we’ve ever had before and people have to be sensitive to it.”

Gundlach said in an investor webcast on Tuesday that the firm is largely avoiding the debt and instead likes municipal bonds because of their high yields relative to other parts of the fixed-income market.

After more than six years of short-term interest rates near zero and a net $1.2 trillion of investor cash placed into bond funds, the investment-grade corporate bond market has ballooned to $4.8 trillion, according to a Bank of America Merrill Lynch index. A measure of the debt’s sensitivity to interest-rate changes, expressed in years, reached a record 7.16 this month, from 5.9 at the start of 2009.

Corporate Health

Average yields on U.S. corporate bonds have fallen to 2.94 percent, below the 10-year average of 4.68 percent.

One of the most comforting signs for buyers of the debt has been the prudent policies maintained by companies during much of the past six years. Treasurers hoarded cash and tightened spending, cutting the net debt to earnings ratio for companies in the Standard & Poor’s 500 index to the lowest in 24 years.

Some in the market are beginning to sound the alarm that companies have been letting their conservative policies slip as activist stock investors push them to boost share prices. The allure of record-low borrowing costs for even the lowest-rated issuers is encouraging them to pay for it by leveraging their balance sheets.

“There’s no reason for treasurers not to do buybacks or pay dividends at these rates,” Citigroup Inc. credit strategist Stephen Antczak said in a telephone interview.

Rising Activism

After the net debt of S&P 500 companies fell to 1.63 percent of an earnings measure in the three months ending Sept. 30, the lowest since at least 1991, it has climbed for two straight quarters to 1.68 percent, data compiled by Bloomberg show. It’s still about half of the 3.4 percent ratio at the end of 2008.

Much of the debt has gone to fund the more than $2.2 trillion of shares that Citigroup says companies globally have bought back since 2011. And Moody’s Investors Service said in a report last month that investment-grade companies are spending more of their cash on shareholder rewards than at any time since 2007.

One factor fueling this trend is the rise in shareholder activism. There have been 54 cases of activists targeting companies across 14 non-financial industries so far this year, up from 43 a year ago, according to a report this week from analysts at Moody’s. That’s “rarely good news for bond investors,” the analysts wrote.

The credit ratings of Monsanto Co., the world’s largest seed company, were cut two levels by Moody’s last year after it announced plans for $10 billion of share buybacks, which it planned to help fund by raising its leverage to 1.5 times its earnings. The plan would “significantly weaken” the company’s credit metrics, Moody’s said.

Monsanto Bonds

Monsanto has since sold $3.4 billion of bonds, including $800 million this week, at least in part to funds the buybacks.

“This is about our continued confidence in the long-term growth outlook for our business and is simply the continuation of our capital allocation strategy in these favorable debt markets,” Billy Brennan, a spokesman for St. Louis-based Monsanto, said in an e-mailed statement.

The longest-maturity debt sold this week, $500 million of 3.95 percent bonds due in 2045, declined to 98.9 on Thursday, according to Trace, the Financial Industry Regulatory Authority’s bond-price reporting system.

“It’s an awful time to be an investment-grade bondholder,” David Sherman, founder of New York-based Cohanzick Management LLC, which manages $1.6 billion, said in a telephone interview.

Cohanzick started a new fund last year focusing on selling short investment-grade bonds and buying stock to reap the rewards of share buybacks. Among companies Cohanzick has targeted is Gap Inc., where new chief executive Art Peck unveiled a $1 billion share buyback less than a month after taking the helm of the struggling retailer in February. Sherman expects the company to issue debt to fund the buybacks. Liz Nunan, a spokeswoman for Gap in San Francisco, declined to comment.

Few Alternatives

Despite lower returns and deteriorating credit quality, many bondholders have been gobbling up the debt because of a lack of alternative investment options.

“Credit as a whole looks more compelling than other asset classes right now,” Antczak said. “The risks here are longer-term.”

Many fund managers feel they have little choice but to keep buying bonds as central banks globally flood their financial systems with cash, pushing investors into riskier assets.

“Central banks have pushed investors out the risk spectrum, to the benefit of companies,” said Scott Carmack, a money manager at Portland, Oregon-based Leader Capital Corp., which oversees $1.5 billion in fixed-income assets. “Investors take what is given to them, it’s shoved down their throat and they smile and take it because there is nowhere else to get yield.”

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