Gundlach: Expect More Downside on Credit Spreads

Jason Stipp: Moving to a conversation that you had with Morningstar last fall, you mentioned, at that time, given the run ups that we'd seen in the market, that credit risk looked very overpriced at that point. You said that there was something like a 50% run-up with hardly any change in fundamentals. Given that we have seen some repricing of risk recently, how are valuations looking for credit risk now? Is is more attractive now? Or are things maybe just getting back to a more reasonable level?

Jeffrey Gundlach: Well, they certainly have gotten cheaper. There's been a really bloody sell-off, here in the month of May, in the below-investment-grade corporate bond market, basically erasing all of the incremental performance. Treasury bonds actually, year to date, have outperformed non-investment-grade government bonds, thanks to that sell-off. Actually, in the first quarter, the fundamentals underneath the corporate economy were surprising on the upside, and there was a lot of talk about that, and that is what has propelled the S&P 500 to briefly go above 1,200.

It seems that, in the wake of that, we saw record corporate bond issuance. Broke all records, even the '06, '07 records, as money was pouring into high-yield funds, and investors were looking for some sort of yield, to escape from zero percent interest rates.

Unfortunately, as usually happens during those large issuance periods, the covenants protecting investors eroded very quickly, and I would say almost shockingly, back to the levels of sort of '06 and '07 type of debt origination, which will ultimately sow the seeds for weaker, for bigger, default problems, and weaker performance. Maybe not in the near term, but in the quarters ahead.

So it seems that the valuations are more reasonable, but I'm looking for more downside on credit spreads. Meaning that they should widen and underperform U.S. Treasuries, probably for the rest of this year.