Will this man be right about next crisis?

Wed, 22 Apr Pre-Open

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If a man can see what most other men cannot, then that man must be a man of wisdom. Billionaire Jeffrey Gundlach, CEO of DoubleLine Capital, did just that during the last decade. To his credit, he was one of the very few smart men who correctly predicted the US subprime crisis. And it is not for no reason that he is sometimes called the king of the bond markets.

So when such a man has something important to say, we like to be all ears.

Gundlach is of the view that the next financial crisis will be in junk bonds. It may not be immediate; it could take a year or two to manifest.

First let's understand what junk bonds are and why they have gained so much prominence. To put it simply, junk bonds are fixed income instruments that offer high yields because they have a high risk of default.

Why do investors get attracted to junk bonds?

The reason is that they offer much higher yields in comparison to other safer bonds. In the aftermath of the financial crisis and the Great Recession that followed in the previous decade, the Federal Reserve slashed interest rates to near-zero levels. So investors who were looking for regular income would get peanuts if they put their money in safe bonds. It is little wonder then that junk bonds have gained a lot of popularity over the last five years.

Why does Gundlach think the next big crisis will be in junk bonds?

In search of higher yields, investors have pumped in heavily into junk bonds. Now, there are two key developments in the offing that could impact the junk bond market. One, the US central bank is expected to start raising interest rates later this year or early next year. Two, a total of about US$ 600 billion worth junk bonds are set to mature in 2018 and 2019.

With rising interest rates and the expected bond maturities, many companies may have trouble refinancing their debt. If defaults are high, it may cause investors to panic and look for a quick exit from the junk bond market.

In a fragile financial system, it takes little for a panic to transform into a full-fledged crisis. So Gundlach may indeed be right in warning us about the next crisis.

One may say that the US junk bond market may not have anything to do with the Indian economy and the stock markets directly. But if the crisis usurps other parts of the global financial system and becomes a widespread crisis, the generous flood of liquidity in India could see a temporary reversal. While it could hurt short term investors heavily, for long term investors such periods of panic and crisis are the best time to pick up solid long term investments.