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Jeffrey Gundlach discusses 'the biggest risk' he sees in the market

Bond king Jeffrey Gundlach warns that ballooning debt levels could be a source of problems for the markets and the economy should a recession hit.

“The biggest risk – and it may not materialize for a little while longer — when the next recession comes, there's going to be a lot of turmoil because the corporate bond market is extraordinarily leveraged,” Gundlach said on Yahoo Finance’s “The Final Round.”

[Full transcript of Jeffrey Gundlach’s appearance on The Final Round]

Citing a study conducted by Morgan Stanley, Gundlach noted that if you were to use leverage ratios alone — and he characterized leverage ratios as the “most important” variable when rating debt — 45% of the investment grade bond market would actually be rated junk.

In addition to turmoil in the corporate debt market, Gundlach warned of potential problems in the market for U.S. government debt.

“Extraordinary national debt problem”

“Also during the next recession, we’re going to have an extraordinary national debt problem because the national debt is growing at a very rapid rate already,” he said, emphasizing that the debt is climbing despite the U.S. economy growing at a healthy clip.

“Larry Kudlow and the president, they keep telling me that it's the best economy ever,” Gundlach added. “I know that they know that they're being hyperbolic. But it is a growing economy.”

That national debt surpassed $22 trillion for the first time this week. Gundlach previously made a case that the U.S. economy is on a “suicide mission” by raising the deficit and interest rates simultaneously. For now, the Federal Reserve has paused on rate hikes, but the ballooning debt problem persists.

“If we’re growing [debt] at 6% of GDP, which is what we’re really growing at in terms of national debt during fiscal 2018, during a 3% real economy, then what’s the debt going to grow by during a recession?” he said. “Well typically, the debt-to-GDP ratio goes up about four percentage points during a recession. So it suggests the national debt would grow at around a 10% annual rate if we go into a normal average type of recession. That’s obviously a really big problem.”

“That looming problem on the horizon”

Companies (and governments) that carry a lot of debt face challenges when their existing debt comes due and they have to refinance in what’s rising interest rate environment.

“There's also tons of bonds maturing,” Gundlach said. “The corporate bond market has $700 billion of bonds maturing this year. That's a significant number. In future years, we're going to have lots of high yield bonds, bank loans, and of course, the Treasury's quantitative tightening program is issuance of bonds that were never floated during the deficits of the past.”

So, as these debtors clamor for new financing in the debt markets, they also face the fact that the Federal Reserve is no longer buying up billions of dollars worth of bonds. This means there is less demand in the bond market, which pushes interest rates even higher.

“I think those are the things in the longer term that are the big risks,” he said. “And the short-term risks sometimes don't really matter. It's really what's the big problem.”

“The real key, I think, is to think about that looming problem on the horizon with the next recession.”

Gundlach is the founder of DoubleLine Capital, which oversees $121 billion in assets.

Sam Ro contributed to this story.

Julia La Roche is a finance reporter at Yahoo Finance. Follow her on Twitter.