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Russ Kinnel's Day 2 Wrap-Up

Russel Kinnel
Christine Benz

Christine Benz: Hi, I'm Christine Benz from Morningstar. I'm here at the Morningstar Investment Conference. I'm joined by Morningstar director of manager research, Russ Kinnel. He's been at the conference for the past couple of days, culling some themes, and one theme that he has said has come out loud and clear today is corporate indebtedness. He's here to discuss it with us today. 

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's talk about this. You attended a bond session earlier today and you said that among the fixed-income managers, Laird Landmann, for example, from TCW MetWest, said that it feels a little like 2007 in terms of companies gorging on debt. Let's talk about why corporations are doing that. I assume that they think that yields are low and it's time to lock in debt. Is that the idea?

Kinnel: That's right. It's cheap to borrow right now, but also you have a strong economy, so if you borrow, you can probably put that money to good use in your business or a stock buyback, I suppose as well. But that's right. Corporations have been boring quite a lot, and it's got some pessimism from bond managers, like Laird Landmann because of it.

Benz: Sonali Pier, you said, echoed a similar sentiment over corporate indebtedness. It seems to me that the most worrisome part of the bond market in this case would be some of the lower rated corporates, those that are on shaky footing. Were those the ones that they're most concerned about?

Kinnel: Partly. One of the areas of concern is the BBB, so the lowest rung of investment grade, because that area has just exploded. There's a huge amount, and of course one of the worries is, well you're only downgrade away from being junk, and then obviously there's a dislocation when bonds move into junk status. There's a lot of worry about that. 

But Sonali had a positive point as well, which is that so far, we've been seeing many more upgrades than downgrades lately in that space. There's some worries there, there's worry about the spreads versus Treasuries being rather tight, but on the other hand, the current trend is positive. I think the message we're hearing from bond managers is right now things look really great, but conversely, that also worries them that there's so much optimism out there, that we have a lot of signs that we could be closer to the end of this cycle.

Benz: One point I know that our colleague Sarah Bush made a little while ago was that there was concern about the floating rate market maybe being a particular pocket of concern. Did that come up in the discussion today?

Kinnel: Yeah. We heard definitely a lot of concerns about floating rates. It's an area that's grown a lot. But again, one element is, right now, companies can afford to pay a lot of debt. But that would obviously change if interest rates rose on the bank loan side, because that means their interest rates would be going up, and that might force them to change the way they were doing business. Or obviously if they're really under pressure, could force them to get them downgraded and cause them more trouble. That's definitely an area of concern.

Benz: That's the fixed-income perspective. You noted that debt also came up in an equity session, where Charlie Dreifus from Royce special equity noted that some of the most indebted companies had really outperformed and that has driven undervaluation, potential opportunity, right? In the less heavily leveraged, higher quality companies.

Kinnel: That's right. Charlie Dreifus is a real stickler for accounting, really likes clean balance sheets. Clean balance sheets, among other things, means low debt levels. And so, when highly debted companies do better, Charlie's not happy, and we heard that from Charlie as well as the other panelists, Amy Zhang and David Green of Hotchkis & Wiley. They're all concerned with the high levels of debt. It was pointed out that corporate debt is about 45% of GDP, which is a very high level. And again, right now it's fairly manageable because you have a strong economy and you have a low cost to service that. But obviously both those things could change.

Benz: Let's discuss what investors should do with this information, if anything. We are 10 years plus into a bull market. What sorts of adjustments should investors be thinking about at this juncture?

Kinnel: I would start by saying most bond managers are almost permanently pessimistic. It's sort of the nature of the beast that unlike stocks, which have unlimited upside, bonds, especially high-quality bonds, have rather limited upside but huge downside. It pays for them to be wary and think more about the downside than the upside. That's part of the reason for that tone. 

But I think, to me it strikes a sobering tone just maybe that there's risks out there in the bond and the stock market. If they're right about maybe the economy being vulnerable and bond markets being vulnerable, then that goes double for equities, because of course generally when the economy slows down, if you have a recession, equities get hit much worse than bonds. 

To me it's just a note of caution that things are going well on a lot of areas, but that also means that we're fairly vulnerable when prices of bonds and stocks are really high, it doesn't take a big shock to upset the system.

Benz: Take a closer look at the lower quality piece of your fixed-income portfolio. And then also potentially revisit your equity exposure if you haven't checked lately. Chances are it's maybe higher than your target.

Kinnel: That's right. The returns we've had in the last few years can't go on forever. Think about defense or at least rebalance. It doesn't mean hide in a cave and put all your money into gold bars. I think it's just a little pessimism is probably a good thing at this point.

Benz: Russ, thank you so much for being here to share your perspective.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.