With: Scott Minerd, Guggenheim Partners Global CIO, Portfolio Manager, Litman Gregory Masters High Income Alternatives Fund
Date: November 14, 2019
Jack Chee: Let’s talk about fundamentals and that type of downgrade of the lower rung of investment-grade into high-yield.
Scott Minerd: Sure.
If we pull up Slide Number 10 – that’s it – this is the history of credit spreads. We can see the backup we got last year in credit toward the end of the year here in the blue line. That’s the most pronounced. Then we see what really –
When you look at it in perspective, it’s a really relative modest retracement. But what’s interesting is, if you went back and looked at the energy meltdown in 2015/2016, that didn’t even result in a recession. We got nowhere near those kinds of levels in the backup last year.
We don’t even need a recession to have a massive widening in credit spreads. When you look at this chart and see how much room to the downside we have, the asymmetry between the downside opportunity in credit in terms of spread-tightening and its increase, I mean – it’s just startling.
If we go to the next slide – 11 – the fundamental problem we’re concerned about is what I like to say, “The gross-debt-to-GDP (gross domestic product).” A lot of people focus on the net-debt-to-GDP. That’s not near the highs, yet.
But the reason I don’t like net-debt-to-GDP is unless you think we’re going to have corporate socialism, the large cash balances on Corporate America’s balance sheets are concentrated in about a dozen companies.
So unless we think that Apple is going to just rain money down on somebody else, and give them money when they’re in trouble, the real issue is the gross-debt-to-GDP.
This is sitting at record highs. When you consider that today in the investment-grade market for the first time ever, more than 50% of all the outstanding investment-grade debt is rated triple-B – our estimates, if we have a mild recession – equivalent to what we had back in 2000 or 2001 –
If we use that as a corollary experience, that resulted in about a 15% migration from investment-grade to below-investment-grade. That would be the equivalent of a trillion dollars.
To put that into perspective, the entire high-yield bond market today is about a trillion dollars.
The dislocation that’s going to happen when this occurs –
First off, I don’t think Litman Gregory would be the first people to step in or the first firm to suddenly recommend that people get overweight high-yield. Because they’ll recognize how bad it can be.
But I can tell you that other people who have reached for yield – and I’ve got to tell you, the insurance industry is like ground-zero. We have a lot of insurance clients. We get a lot of pressure from our clients to increase our allocation to triple-B bonds, because the whole industry is doing it.
Once this thing starts to slide, people aren’t going to be putting more money into high-yield bonds in the mutual funds. They’re going to be going in the other direction.
The amount of capital it’s going to take to absorb all of this debt is mind-numbing, relative to the size of the market. Now, people say, “Well,” they point to all kinds of other things. The thing that I think is the most realistic assessment I hear is, there are about $2 trillion today in commitments to fund private-equity.
Some of the smarter private-equity firms out there will say, “Hey. This qualifies. Let’s step in and buy some of this distressed debt.” But remember, the kinds of returns they’re looking for are 15% or 20%. They’re not where triple-B bonds today yield less-than 4% and all kinds of stuff.
The other interesting thing here is, I think there’s going to be a peculiar opportunity to this downgrade cycle relative to others. That is the number of investment-grade corporate issuers who have long-duration bonds – like ATT. I’m going to stay away from utilities, because we’re pretty negative on utilities.
These people who issued a lot of debt and it gets downgraded to below-investment-grade – those long-duration bonds don’t really have a real home.
The high-yield market is sort of an under-10-year market. Where this long-duration high-yield debt’s going to go is going to be a real question. I would say don’t be surprised if it ends up in your portfolio.
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Audience: If we avoided recession by lowering interest rates this year, won’t that just make the recession worse when it gets here?
Scott Minerd: Yes. You’re a man after my own heart. This is one of the things that I wrote about last year when we started to talk about Indian Summer. If the Fed (Federal Reserve) were to try to address the issues that we’ve identified, which is the overleverage of Corporate America, really – that’s ground-zero. It’s not going to be housing. It’s not going to be –
The last crisis is never where the next one comes.
Corporate America. Even the Fed is concerned about this. Yes. Yes, reviving the animal spirits, which I think we’re in the midst of doing is leading to things like the potential LBO (leveraged buyout) of Walgreens. That is in their own words – is it Schwartzman or Leon Black – I can’t remember which one –
It’s a reach. The amount of debt they’re going to have to issue to do this. Yes. It’s going to be worse. This is one of the debates we have around the table in New York at the Fed. Not many people agree with me that we would be better off to allow the business cycle to run its natural course rather than building up excesses into the future. Unless we would have some sort of policy-response on the fiscal side to address the shortages of labor and other things, which are ultimately going to be the things that make the Fed have to kill the expansion.