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Beware the Corporate Debt Time Bomb

It is a veritable law of finance and economics that as a bull market drags on, lenders loosen their standards. At the same time, investors desperate for yield tend to look for opportunities ever further down the capital stack.

This means that many investors are seeking (and obtaining) exposure to lower-quality debt, which can leave them seriously exposed in the event of a cyclical downturn.

While this is a widely cited and understood historical pattern, investors have shown a remarkable willingness to believe that "it's different this time." That could mean trouble for many investors.

Dancing near the edge

As I discussed in an article for GuruFocus last month, corporate credit standards have been falling precipitously. This has worrying implications for the late market cycle since investors seeking higher yields find themselves with greater exposure to debt at the cusp of losing investment-grade status. A downturn could cause painful ripples across the space. In August, investment strategist John Mauldin discussed the potential consequences of such an episode:

"I expect liquidity in these below-investment-grade bonds to disappear quickly in the next financial crisis. We got a small hint of how this will look in the December 2015 meltdown of Third Avenue Focused Credit Fund, which had to suspend redemptions and then spend two years liquidating its assets."

A rout in the bond market could see mass downgrades, forcing many investment managers, such as pension funds and large mutual funds, to dump their holdings.

Playing with fire

A crisis may not be quite so imminent. In a comment response to my December article, GuruFocus user Dirt2642 pointed made an important observation about the current behavior of high-yield debt:

"I watch the CCC and B indexes (ICE BofAML US High Yield) at the St Louis Fed. They show yields both trending down which means there is no present danger, probably due to the FEDs non-QE4. But they can turn quite quickly if liquidity dries up as high yield is the last place that Fed liquidity sloshes into, and the first place that it drains out of."

The Federal Reserve has certainly been pulling out all the stops in recent months in an effort to keep the bull market chugging along, as I discussed earlier this month. A review of the latest St. Louis Fed and Bank of America (BC) data shows that the immediate danger is still at bay.

Yet, even a slight shock could reverse that trend in short order.

Delving too deep

Even the most staid and conservative investors and allocators have been getting sucked increasingly into the dangerous yield-hunting spiral of the late bull market.

Many of the largest pension funds have begun to delve worryingly deep into corporate debt exposure. Most distressing of all is their growing exposure to private credit, as Bloomberg reported last month:

"In a recent survey of firms managing nearly $400 billion in private-credit strategies, nearly 90% said they expect pension funds to up their allocations over the next three years. The Ohio Police & Fire Pension Fund said this month that it was cutting its high-yield exposure as it moves toward a 5% target for private debt. And in its most recent financial statement, the Teachers' Retirement System of the State of Illinois said it "continues increasing exposures to private debt opportunities," even as it retreats from fixed income broadly."

Private credit is corporate debt that is far less liquid than tradable bonds, and far more prone to trouble in the event of a recession. These are companies offering higher yield in exchange for laxer standards and less liquidity.

Living dangerously

On Dec. 4, Jeffrey Gundlach, the legendary bond investor who famously predicted the subprime lending crash, warned investors to steer clear of corporate debt:

"Corporate bond exposure should be at absolute minimum levels right now."

Anyone with exposure to this asset class could face trouble in the event of an economic downturn or serious market correction. Large allocators will be especially vulnerable.

Investors should be paying very close attention to what their pension fund managers are doing with their money. The desperate search for yield could end up costing retirees dearly.

Disclosure: No positions.

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This article first appeared on GuruFocus.