"There Is No Corner To Hide": $100 Billion Fund Manager Warns Credit Rout Is Just Starting

One day after Jeff Gundlach warned in his latest webcast that much more pain is coming for the corporate bond market, echoing a similar warning made just hours earlier by Scott Minerd, who cautioned that "the selloff in GE is not an isolated event. More investment grade credits to follow. The slide and collapse in investment grade debt has begun"...

... it was the turn of another fund manager to join the growing chorus of warnings about the coming credit rout.

Jason Shoup, head of global credit strategy at Legal & General Investment Management America which manages $186 billion including $100 billion in fixed income, told Bloomberg that rising rates, fading stimulus, weaker earnings and a coming tide of rating downgrades means that the worst year for investment grade in a decade is just the start of the bond slump and align to ensure that 2019 will be a tough year for US corporate credit.

"It just feels like a much more risky proposition than it did a year ago," Shoup told Bloomberg in a phone interview: "There really is no corner in which you can obviously hide."

While the fixed income manager expects a modest rebound in high grade bonds if issuance slows, Asian investors stop selling and stock markets stabilize, Shoup still sees next year as "dicey."

"I wouldn’t be surprised if the second half of 2019 really poses some significant challenges and could result in wider spreads," Shoup said. "Without that central bank support and transitioning off the fiscal stimulus, our long-term outlook for investment grade is definitely on the more bearish side over the last two to three years."

Courtesy of Bloomberg, here are some more highlights from the interview:

Slowing Growth

  • As the Federal Reserve reduces its balance sheet and higher rates weigh, the economic boost from U.S. tax cuts should fade, Shoup said.
  • “The contribution of fiscal stimulus to growth has to slow. It’s not like we’re going to do another tax cut on the same order of magnitude that we once got,” he said.
  • That will slow growth -- possibly by at least 1 percentage point after the second quarter -- which along with rising input costs fueled by trade wars, should have a negative impact on corporate profits.

Downgrade Risk

  • That could mean billions of dollars in BBB rated bonds will be cut to junk.
  • “The concern is that companies can get behind on that deleveraging path and if profits really do slow meaningfully over the next 12 to 18 months, you would think that more and more of those companies are going to get behind and be subject to potential downgrade risk or at least repricing risk,” Shoup said.
  • As General Electric Co. trades more like high yield, Anheuser-Busch is also a concern, Shoup said.
  • “If Anheuser-Busch loses its Moody’s rating -- which we think is likely -- do we get a repeat of GE, in terms of Anheuser-Busch? At the moment I would say Asia has been selling GE risk but has been willing to buy Anheuser-Busch risk, so it seems less likely,” Shoup said.

Liquidity Wildcard

  • Shoup said he expects less liquidity in the market will cause more volatility.
  • Secondary liquidity is worse than it was during the last big credit sell-off at the beginning of 2016. The shape of the yield curve has made dealers reluctant to hold bonds because of the negative carry, just as foreigners may be becoming more reluctant to buy, according to Shoup.
  • “Asia and the foreign bid has been such an important component to demand in the credit markets in the last few years. Any sniff that they’re going to turn into a seller of a certain name has this potential to trade an exaggerated move wider,” he said.

Diamonds in the Rough

  • Shoup said he sees potential opportunities in energy pipeline and financial sector bonds. Temporary increases in leverage by Master Limited Partnerships, so that holding companies can buy out operating units, make those bonds attractive, he said.
  • “The Williams, the Energy Transfer Partners -- those are companies that trade on the riskier side in terms of spread and we think that that will continue to outperform,” Shoup said, adding that his firm has a strong conviction about the trade.
  • Legal & General also likes banks, particularly after they failed to issue new debt following earnings. Shoup said he is “cautious” on the pharmaceutical sector, and is awaiting more mergers and acquisitions.
  • Underscoring its defensive positioning, Legal & General has a higher than average allocation to cash and Treasuries, he said.