Gundlach’s Credit Trade Suggests the Coronavirus Rout Is Real

(Bloomberg Opinion) -- For better or worse, the latest developments from the coronavirus outbreak have focused a lot of investor attention on the U.S. stock market. That makes sense, given that the S&P 500 Index set a record high just a week ago but then fell more than 2.5% in consecutive sessions for the first time since 2015; President Donald Trump and aide Larry Kudlow are suggesting that investors buy the dip.

The $16.7 trillion U.S. Treasuries market doesn’t offer much guidance on whether the swift risk-off reaction is justified. As I wrote earlier this week, no record is safe in the world’s biggest bond market with so much uncertainty about how the coronavirus will dent the global economy. But just as important, Treasuries have been rallying for more than a year, even as equities soared, in no small part because of longer-term concerns about global growth, inflation and the limitations of developed-market monetary policy near the lower bound of interest rates. It shouldn’t be all that shocking that the benchmark 10-year yield touched 1.31% on Tuesday, a new low.

What, then, can investors use to gauge risk tolerance in markets? I’d suggest corporate bonds, which offer some clues that there’s more pain ahead.

Just like stocks, the credit markets reached unprecedented levels toward the end of 2019. On Dec. 18, the difference between double-B and triple-B corporate bond yields fell to just 38 basis points, the smallest on record. That meant investors were hardly differentiating between securities rated below investment-grade — otherwise known as junk — and those that still maintained investment-grade quality. I asked at the time: What does a junk bond even mean anymore?

I wasn’t the only one shaking my head at that spread. Jeffrey Gundlach, DoubleLine Capital’s chief investment officer, highlighted the phenomenon during his annual “Just Markets” webcast last month, calling double-B corporate debt “one of the worst investments in the bond market.”

“I think you’re much better off owning triple-B — I don’t even like triple-B — but I don’t like double-B corporate bonds,” he said on Jan. 7. Just to hammer home the point, he added: “Stay away from double-B corporates is my message.”

Any trader who heeded that advice has won big in the past several weeks. The spread between double-B and triple-B bonds is now 127 basis points, the widest in more than six months. It jumped 19 basis points on Tuesday, 22 basis points on Monday and 21 basis points on Jan. 27, three days dominated by investor angst over the spread of the coronavirus. The only other comparable moves in the past year came in August, when U.S. recession fears peaked.

Gundlach called the widening since December “a big crack in risk asset confidence” in a Twitter post on Monday.

Charts with a left and right Y-axis are often imperfect, but comparing that yield spread to the S&P 500 since the end of 2017 shows a tight fit, especially during bouts of risk-aversion like the final months of 2018 and in August 2019. Corporate bonds retreated from their extremes at a much sharper pace than U.S. equities this time around, which isn’t entirely out of the ordinary but supports the idea that the steep drop in stocks wasn’t just a short-term blip.

Now, as I’ve noted before, some technical factors are at play in corporate-bond indexes. For example, part of the reason the yield spread between double-B and triple-B bonds narrowed so much in 2019 was because triple-B duration rose while double-B duration dropped by the most on record. The duration of the double-B index spiked higher earlier this month, which, all else equal, would tend to widen the spread, though it didn’t appear to do so.

Also of note: Debt from Kraft Heinz Co., EQM Midstream Partners LP and EQT Corp. remains in the triple-B index for now, even though the ratings of all three companies were cut to junk recently. Again, in theory, bonds from “fallen angels” would have higher yields than before the downgrades, which would narrow the spread between double-Bs and triple-Bs. All told, it’s probably safe to conclude that these factors are small enough and slow-moving enough that they don’t alter short-term spread movements very much.

As of Feb. 24, the option-adjusted spread on double-B bonds has jumped to 2.62 percentage points from 1.82 percentage points to start the year, while the spread on triple-Bs is up to 1.35 percentage points from 1.2 percentage points. For some context, those spreads reached 3.65 percentage points and 1.68 percentage points, respectively, during the height of the December 2018 market squeeze. That suggests the high-yield market in particular could be in store for further pain if sentiment doesn’t turn around soon.

As for the U.S. investment-grade market, companies aren’t taking any chances with new deals, even with Treasury yields setting record lows. Bloomberg News’s Michael Gambale reported that at least four issuers stood down on Tuesday, marking the first two-day break to start a week since July 1 and July 2.(1)That’s hardly a vote of confidence from the C-suite on the state of the financial markets.

The follow-through from stocks to credit is worth watching in the coming days and weeks. As much as traders like to quip that the Federal Reserve is most concerned about the S&P 500, or as much as they use Treasury yields to estimate how many interest-rate cuts are “priced in” for the year, ultimately a lack of market access for companies that need it is a truly perilous situation.

Recall that December 2018 marked the first month in 10 years with no speculative-grade bond sales. The Fed quickly pivoted in January 2019 — but what if looser monetary policy isn’t as effective this time around? Lower short-term interest rates mean relatively little in comparison to the Centers for Disease Control and Prevention telling Americans to prepare for significant disruptions of daily life if the coronavirus outbreak begins to spread locally in the U.S., deeming it “not a matter of if, but a question of when, this will exactly happen.”

Without a drastic shift in what’s known about the coronavirus, corporate-bond buyers may need to take a similar approach. It no longer seems a matter of if, but of when, spreads widen further in the riskiest corners of the debt markets.

(1) He excluded the December holidays and the typical two-week summer hiatus in late August in this analysis.

To contact the author of this story: Brian Chappatta at bchappatta1@bloomberg.net

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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