The $8 Trillion Dollar Ticking Time Bomb
What will trigger the next market crash?
Jeffrey Gundlach, often referred to as the “Bond King”, shared his thoughts on this matter recently during a brief television interview.
“The U.S. Deficit and the National Debt are totally out of control” Mr. Gundlach proclaimed.
We should share his concern, but Donald Trump would like you to think that this is the greatest economy in the history of the world despite the fact that GDP in 2018 was positive as a result of government spending and a 6% increase in the National Debt.
However Mr. Trump is merely following in the footsteps of his predecessors. Economic growth the last 5 years, going all the way back to the start of Obama’s 2nd term, has been positive only because of an increase in the National Debt.
Although Trump is infamous for his love affair with debt, the expansion of the Federal Debt during his administration is the lowest of the last three presidents.
…and although government debt levels are a serious concern in the bigger picture, the Corporate Bond Market is what should really be keeping investors up at night.
As Gundlach mentions, “the Corporate Bond Market is much worse today than in 2006…it’s triple the size”.
That is just the beginning. The number of BBB rated bonds is now bigger than the junk bond market.
In investment grade bonds, there is a range of ratings from AAA (the safest and highest rating) to BBB which is the lowest rating for “investment grade” bonds.
Triple-B rated bonds are also just a notch above the classification of “junk” or high-yield bonds which begins with a BB rating.
The growth in this sector has also outpaced both investment grade and junk bonds, with the majority of the BBB growth, more than 40%, coming from banks.
This could be big trouble amid the next economic downturn since many of these securities would most likely see their credit ratings slashed.
Why would a credit downgrade matter so much to the triple B’s?
As noted in a recent “Market Watch” article
“Many institutional investors, such as insurers and pension funds, are barred from owning sub investment-grade debt, so money managers would have to dump their holdings of these fallen angels, leading to a sharp fall in their bond prices.”
As the price of a bond drops, the yield (interest rate) increases, which would make servicing the debt more expensive.
“Market Watch” points out in a separate article why this would be a big concern for markets right now.
“$3.5 trillion of bonds expected to come due in the next three years from high-yield and investment-grade issuers, the so-called maturity wall, firms may have to roll over their debts when interest rates are much higher, or even during a recession.”
The downgrade would also impact the stock market.
“The Street” notes that – “companies often slash their dividends when faced with a potential downgrade to junk status to shore up their creditworthiness. Or they sell assets to pay off debt, a move that often sends stock prices tanking.”
This dividend adjustment or asset sale is to generate the liquidity the company needs to pay the higher debt-service … but how will they find buyers, and what price?
Liquidity is already an issue and it will become even more scarce in a downturn.
Later in the interview Gundlach states that 45% of the current 8 trillion corporate bond market could be downgraded to junk during the next recession based on current leverage ratios (amount of capital a company has that comes from debt).
This type of corporate fall-out would far exceeds what we experienced occurred during the subprime mortgage meltdown, which ultimately triggered the Great Recession.
Gundach was asked … “what’s the spark” which he confidently replies “a recession … the economy is in such bad shape to withstand a downturn” … and with the national debt exploding despite some of the best GDP in years, “the economy is not in any kind of condition for the government to come to the rescue.”
The only option, which he hints at as the video fades out, is if the central banks use what he refers to as “wickedly extraordinary policies” such as those used by the ECB (European Central Bank) and the BOJ (Bank of Japan).
The central banks in these countries resorted to various forms of stimulus that could be considered as QE (Quantitative Easing) on steroids.
Should the U.S. be forced to take similar drastic measures as a result of a crumbling $8 Trillion dollar Corporate Bond Market, it would lead to an even bigger national debt and stagflation (inflation with no economic growth).
In addition to the net-effects, this type of policy response would be hard to reverse without a total economic collapse.
Therefore, the U.S. could end-up like Japan which has been trapped in stagflation for more than 30 years (referred to as the “lost decades”).
Here is the video interview with Jeff Gundlach. Share your thoughts in the comments below.