Next recession: Gundlach explains problems with corporate bond market

The junk-bond market will run into trouble when the next economic downturn hits, according to Jeffrey Gundlach, the CEO of DoubleLine Capital.During a recent discussion with clients and media, Gundlach said the US economy is not as healthy as many believe, and explained why corporate bonds will face trouble at the next recession. Visit Business Insider's homepage for more stories.Jeffrey Gundlach is worried about debt. Whether it's ballooning US government debt or student loans, the DoubleLine Capital CEO sees worrying trends across markets. But it's the $8 trillion corporate-debt market that is poised to face a reckoning when the next economic recession hits, said Gundlach, who's also nicknamed Wall Street's bond king.Post-financial crisis, the market was juiced by zero interest rates and historically low yields on safer bonds like Treasuries. And according the Federal Reserve's semiannual report released Monday, leveraged lending in the US jumped by one-fifth to $1.1 trillion in 2018, crossing its pre-crisis peak.“The corporate-bond market will really have problems when you see negative GDP,” Gundlach said Tuesday at a media and client event in New York.The simple reason, he said, is a concept previously espoused by Berkshire Hathaway CEO Warren Buffett: You don't see who's swimming naked in the ocean until the tide goes out. In other words, weak companies appear to be doing just fine until adverse circumstances expose their hidden flaws. “It's kind of a nude beach out there,” Gundlach said. Read more: A $369 billion investor lays out how the private-equity boom is supercharging a major risk in the stock marketHe is specifically watching the levels of leverage being taken on by companies at the lower end of the investment-grade spectrum, as well as firms with junk status. Such bonds offer investors higher yields than their safer counterparts in return for the greater risk.While non-investment-grade bonds are perpetually a cause for concern, Gundlach flagged the cohort of BBB-rated companies that are a hair away from being downgraded. Last year, the weakest of these investment-grade bonds constituted a record 40% of the entire market for the first time. Gundlach also cited research published by Morgan Stanley last August that said 45% of the investment-grade universe would be rated as junk if leverage was the only criteria being used. This share was 30% in early 2017 and just 8% in 2011.The ratings agencies are not entirely to blame for downplaying the risk stemming from leverage, although their processes are not without flaws, Gundlach said.“Rating agencies have been known to listen to reassuring statements with sympathetic ears about actions that will be taken at some future date to correct these leverage ratios,” he said. “But if there's a downturn in the economy, you can't fix these problems.”Responding to those who believe the economy is far from a downturn, Gundlach pointed to the Citi Economic Data Change Index, which tracks releases relative to their one-year history.The series has “absolutely cratered” since the beginning of 2018 and serves as a good leading indicator for changes in GDP, he said. If indeed the index is sending a negative signal about the economy, there's no hope of avoiding a wave of downgrades, Gundlach said.