Riskier Bonds Becoming Less Desirable

DoubleLine Capital is cutting its holdings of the riskiest tier of investment-grade bonds as a defensive move, as it braces for bond yields to gyrate and for high borrowing costs to potentially weigh on corporate earnings.

The $95 billion asset manager is broadly positive about high-grade debt but is selling BBB rated bonds and staying away from small regional lenders hit by the troubled commercial real estate sector, said Robert Cohen, head of global developed credit at DoubleLine. He’s instead boosting his cash position to tactically take advantage of volatility over the next several months.

“I don’t think rate volatility is over,” Cohen said in an telephone interview. “We have tight spreads, so there’s not a lot of room for error. If rate volatility continues, I think spread volatility might pick up.”

Cohen said he isn’t expecting the U.S. to fall into a recession, with the Federal Reserve signaling it’s not in a hurry to cut rates. He also said it’s quite likely that inflation oscillates at elevated levels of around 2.5 percent to 3 percent. The Fed will likely get less restrictive—probably cutting 100 basis points (bps) on the back half of the year—but it wont be able to cut more dramatically, he added.

“The Fed is not going to be able to be very aggressive with rate cuts,” he said.

Corporate credit and stock markets have continued to show signs of strength, which has fueled a rally in bond spreads. But there are flashes of weakness, according to Cohen. Borrowing costs have been elevated for more than a year, which has created pressures in the economy. The commercial real estate market is in turmoil, leading economic indicators have been weak, and layoffs at large corporations continue.

“It’s certainly possible that even though we haven’t felt really any significant effect, maybe the effects are just so delayed that they come at a later date,” he said.

The average high-grade bond spread is hovering around its lowest point since the start of 2022. Meanwhile, the difference between spreads on BBB rated debt—the lowest tier of investment grade—and BB rated debt, the highest-quality junk, is about 0.8 percentage points, according to data compiled by Bloomberg. That’s down from 1.5 percentage points on October 27. A tighter gap between spreads in the two tiers often reflects less investor concern about credit risk.

Cohen says he has been underweight on longer-term investment-grade debt, as he sees more spread volatility risk for that part of the curve.

“In the no-recession scenario, you are likely to see long rates sell off more than intermediate and short rates,” he said. “If anything, short rates will rally a bit. And so you have some duration exposure on the long end and, quite simply, the credit curve is inverted.”

DoubleLine is still constructive on investment grade bonds, given strong earnings, issuers broadly de-levering, a credit ratings upgrade cycle, attractive yields, and strong demand for the asset class, he said.

“The yield and duration profile continues to be better than it was,” said Cohen. “There is still pretty strong demand for credit and that is creating a technical tailwind to the market.”

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