jonathan: from new york city, i'm jonathan ferro. with 30 minutes dedicated to fixed income. this is "bloomberg real yield." ♪ jonathan: coming up, increasing leverage in a rising rate environment. injecting a little pain into investment grade credit. the transatlantic spread widens. how will committed to gradual hikes, mario draghi going nowhere fast. and pricing in political risk. looking ahead at a string of key elections in emerging markets. we begin with the big issue, corporate america boosting leverage. >> right now, it is still pretty

attractive to borrow. you have seen a pretty meaningful upsurge in sizable deals. companies are raising $20 billion, $30 billion, $40 billion of money at one go. >> increased leverage on balance sheets is absolutely a risk. i think a lot of companies are much more healthy in thinking through how much risk they want to take, how much debt they actually need. so, it is definitely an area of concern. >> the economy is on a very strong growth track, no question, and that does support leverage. the question is, and it always happened in the past because economies are indeed cyclical. when do you hit a tipping point, where is the tipping point? and i think that goes back to this whole elephant in the room, the trade wars. that is the thing that could cause a tipping point. jonathan: a full house around the table here in new york today. i am pleased to say, with me is jim keenan, oksana aronov, and krishna memani. krishna, i want to begin with

you and bring up the subject of what's happening in credit at the moment. investment grades wider. big m&a story in there. high yield has stayed tight. what is your thought on what is happening at the moment? krishna: investment grade is quite wide relative to the beginning of the year, almost 35 basis points. that is very significant. the reason i think is one, issuance has been far more robust than in the investment grade market. and two, the core buyers of investment grade credit, which is overseas investors, have been missing in action. that combination has put us in a bit of a pickle. high yield, on the other hand, the technical side, is in much better shape. fundamentals are really good,

altogether holding nicely. jonathan: jim keenan, anything to worry about? quite clearly, there are companies out there that will leverage in the balance sheet. we see that reflected in investment grade. is there a worry for you? jim: yeah, i agree with krishna with regards to the widening of ig versus high yield. take a step back, i don't think you are seeing, from the leverage you are seeing in the corporate space, something that people should be worried about from an economic perspective. certainly it is creating more risk at the lower risk quality of the investment grade space as they start to put more leverage on their balance sheet, and you see a big boom in bbb leverage because of where that yields and spreads are an m&a activities. that is more idiosyncratic. they will create some technicals, you are seeing that in investment grade. if there are downgrades, that would filter into the high-yield market. but from an economic perspective, the economy is still strong, earnings are strong, and that is why you are seeing support at the high-yield level. jonathan: and we have consensus around the table, oksana? oksana: i'm always here to create dissonance. i would agree certainly that we have seen widening. investment grade is one of the worst performing parts of the fixed income market this year, down almost 4%.

it is really being affected by three major factors. m&a activity, we have seen these numbers. repatriation is another big one. many of those funds were held overseas in investment grade-type investments. so, there is excess supply coming in there. and as krishna mentioned, less demand from overseas investment. the interesting thing about it, too, is that currently about 14% of the investment grade space has over four times leverage. and roughly, you know, when you look at the bbb part of investment grade, which is the lowest string, there is four times the volume there than high-yield. which historically, that ratio is about two. if you think about a downgrades cycle, that raises the question of, can high yields start to absorb? at what point does that bleed into high-yield given that overhead has gotten so big? jonathan: is that something you

are starting to position for, or just something you are thinking about? oksana: generally, our position right now is quite conservative. we see a lot of these tipping points across different markets, and valuations do not have enough room in them for the kinds of uncertainties that are happening out there. whether we talk about the yield curve, tariffs, all of these things can go a couple of different ways, but either way they go, it will create volatility for the market. so we believe being conservatively positioned here matters. and conservatively positioned for us means having liquidity at the ready. jonathan: here is a question for you. a lot of people would say go up in credit quality. what is going up in credit quality actually, when you go from high yield to investment grade? in some respect, that is where it has become less quality. oksana: what has it done for you

this year, going up in credit quality? that is something i've been saying for a while. higher credit quality is no longer synonymous necessarily with safety, in the classic sense of the word, given that we are going through this cycle right now of potentially higher rates. and by the way, that is nothing to do with what the fed is doing in terms of the amount of hikes, just has to do with supply and demand. jonathan: i can hear krishna. krishna: please give me an opportunity. [laughter] krishna: the point is, in the short-term, when you have economic conditions relatively robust, quality does not do much for you especially when rates are rising from the absolute return standpoint. in this year, on the exit return bases as well. having said that, think about it, if you hit a recession in 2019, 2020, and you are planning, positioning for that recession, upgrade makes a lot

of sense. in that scenario, given the amount of leverage we are talking about, high-yield will have a far worse time than we have had in investment grade so far. jonathan: the explanation would be that you see more credit risk, and it would not be a duration story. at the moment, it is a duration risk story, which is why high-yield has outperformed investment grade. jim: i was going to say, from an economic perspective, there are a fair amount of balances of risk. right? some of this is, where in the curve are you? investment grade, as you look at 10/30 spreads, they are starting to widen out here. we are at a point where inflation is starting to be a question in the economy. at the same time, everyone is worried about where we are in the economic cycle, maturity of the business cycle. they are worried about the downside. one thing that you see right now is up in quality means going

into senior secured bank loan risks. right? bank loans have done so well, from a vol adjusted basis, they have done incredibly well because it is at the top of the stack of corporate earnings. that is why it's done well relative to investment grade or high-yield. oksana: it is hard to argue for going up in quality with a curve as flat as it is today. because you are not really getting much of a compensation by taking on more duration risk, which is what would ultimately be the saving grace in a recessionary environment. right? so, the curve has gotten so flat, you can earn 2% and then the pickup for going further out is so minimal, but your duration risk you are taking on is so major. so, the question for investors is, whether you expect and believe that there is an imminent recession, or if you believe the economic data, the policies of this administration, including tariffs, which is ultimately inflationary, frankly, whether all of those things are good for bonds, or if it is an environment in which cash could outperform bonds.

krishna: i think, let's not conflate duration risk with credit risk. those are two different levers, and you can move both of them. so, if you want a short duration and credit risk, you could buy loans, as jim was suggesting. on the other hand, if you wanted real duration risk, you can buy long treasuries. so, i think conflating the two from a portfolio-construction standpoint does not really make much sense. in today's environment, jim is right. i think loans relative to high-yield and perhaps mortgages or treasuries relative to high-grade is the safety trade today. jonathan: and is that going back to where you want to sit on the capital structure? krishna: absolutely. credit risk on loans is meaningfully lower than it is on the high-yield, and especially when you compare spreads. that makes the case more compelling.

investment-grade spreads are widen, but relative to mortgages, for example, they are not extraordinarily wide. jonathan: let's get a trade from you, jim, to wrap this up. where would you be putting money right now? where do you go? jim: yeah, as of right now, we still prefer the loan market. secured loans, tranches, things like that. i don't think you are getting paid in the risk to go down in quality in the capital structure. i think there is value in the high-yield market, but talking about broad terms, we still like loans, finding opportunity in investment-grade or in the high-yield market. jonathan: jim keenan is sticking with me alongside oksana aronov as well as krishna memani. coming up on the program, the auction block. two of the biggest offerings in 2018. a lot more on that in just a moment. this is "bloomberg real yield." ♪

♪ jonathan: i'm jonathan ferro. this is "bloomberg real yield." we want to head to the auction block.

this week, we got the second and third largest u.s. corporate debt sales of the year. first up, bayer racking up more than $50 billion in a sale. it also sold nearly $6 billion in a euro bond offering, helping to finance an acquisition of monsanto. bayer was then topped by walmart, who sold bonds to help fund its investment in flip kart. in sovereigns, a $5 billion sale of 30 year tips. indirect bidders bought 81%, the largest share they have taken ever for that maturity. still with me is jim keenan from blackrock, oksana aronov from jpmorgan, and krishna memani. oksana, i want to begin with you and talk about what we are seeing in rates. the story with the ecb and the fed, they are worlds apart in terms of their guidance for interest rates. how do you expect that story to evolve in coming months?

oksana: it seems like they are a couple years apart. it seems like the ecb is where the fed was a couple years ago in terms of guiding toward the end of its bond purchasing program. i mean, the ecb continues to guide. the end of the program is on track for the end of the year, and with over $8 trillion in negative yielding debt, it is unclear where the demand for those bonds will come from. we got a taste of that here in the u.s., and the fed is not even yet in net negative liquidity mode yet. and there is a lot of focus, i think, way too much focus and way too much noise around how many more hikes the fed will do this year, what will happen with the flatness of the yield curve, etc. i think the most important thing that is happening in the bond market, happening with rates right now, is the reduction of the fed's balance sheet.

that is the big kahuna. certainly, the supply-demand imbalance of that is creating, along with other large-demand providers stepping away, such as sovereign buyers, russia not one of the largest, but there was a just this week that they reduced their treasury holdings by $50 billion. china and japan are holding less. banks are becoming less regulated, which means they will provide less support for that part of the market. so, everything from that 10-year in point of the curve will continue to struggle and move higher, not in a straight line, but it's hard to imagine a scenario in which the 10-year goes back to the high 1's. jonathan: krishna, let's bring in the picture she is talking about. basically, quantitative tightening from quantitative

easing for several years. and you can go through the balance sheet of the federal reserve, add in the boj and european central bank, and you get to the back half of this year, that things start to get quite interesting. what are the implications for markets from essentially that chart, when the ecb stops buying, and the fed's balance sheet rolls off more aggressively? krishna: i think trying to figure out the direction of rates based on just that supply and demand picture, i think just not right for the following reason. at the end of the day, in economic terms, you get to an equilibrium. and interest rates are a determinant of something that comes out of reaching that equilibrium, rather than supply and demand getting you there. what that means is it depends on what your expectations are with respect to the economy. so, the ecb may not be buying bonds anymore, but if the european economy continues to slow down the way it is, then the implications are very, very different.

the same applies for the fed as well. that is, the u.s. economy is accelerating going into the second half. and as long as it continues to do that, i think rates probably continue to rise as a result. but if that is not the case, i think things will revert back. jonathan: let me stress test that argument. if the ecb was not in the game, do economic conditions exist to justify the german curve to be negative out six years? krishna: well, ecb is in the game, so that is life and, if the sun was not there, how would the day look like? central banks have an enormous influence from a policy standpoint on where rates are. and ecb is in play because ecb wants to support the economy. so, i don't think you can take it out, and arrive at at some natural rate of interest rates. jonathan: oksana, i'm guessing from the way you are sitting, you are more worried about what is happening in europe than krishna is? oksana: yes, and here is why. you cannot discount what the ecb has done. the ecb has created, essentially, a completely artificially priced asset class in europe. and the reason i said that it feels in europe as it is in the u.s. a couple of years ago is because asset class is diving us around what it is going to do. the markets were dismissing it, continuing to price based on the sentiment that the fed would back off. jonathan: yeah.

oksana: and that is what is happening in europe. i just spent a week with investors in europe, and that is the sense you get. investors are generally discounting for now that the ecb will really end this bond buying program by the end of the year, and move toward normalization. and i think once that sentiment is even out, or starts to move out, you are going to see significant movement because what are rates, academically speaking? it is the short-term rate plus the rate of inflation, plus some sort of long-term premium. and that does not, even in europe, get us to a -30 rate on the german five-year. jonathan: jim keenan, just to bring into the conversation, away from rates in europe and towards high-yield, if it is hard to justify economically-speaking on its own, hypothetically speaking, what is happening with german rates, even harder to say what is happening in the corporate bond market in europe. and you just get the feeling that the corporate bond market is kind of in a little bit of trouble going into next year perhaps. when you get the handoff from the ecb, for the fundamentals, it is hard to justify where high-yield europe has been. jim: yeah, and i may step in and think about it totally different. with regards to quantitative tightening versus quantitative

easing, this is a global picture. no doubt coming out of the 2015-2016 commodity cycle, where you had enormous stimulus coming into the market, the business cycle is maturing, central banks are starting to remove policy, and you are seeing tightening. i think that policy is becoming far more localized than we have seen over the last 10 years, so you will see variations of asset prices and returns between regions. but there is no doubt when you look at the economic picture in europe, there is more volatility. it is not as stable as what you see in the u.s. and so, you don't have the same kind of backdrop or support from the economic picture right now which is why you still need the central bank to be more accommodative than what you are seeing in the u.s. jonathan: in terms of rates for the ecb, looks like they will be for a longer time. jim keenan from blackrock sticking with me along oksana aronov from jp asset management and krishna memani from

oppenheimer funds. it in the markets, let's get you a check on where treasuries have been. the two-year yield has been remarkably stable over the last couple of months. around 2.55. unchanged on the week. and the 30 year yield coming up a basis point. the 10 year coming in a basis point. not a whole lot of action considering the news that we have had over the last few weeks. still ahead, the final spread, featuring elections in turkey. e.m. is next. this is "bloomberg real yield." ♪

♪ jonathan: i'm jonathan ferro. this is "bloomberg real yield." it is time for the final spread. coming up over the next week, this weekend, we get the election out of turkey. don't forget, next weekend, we have the mexican election as well. plus, we will get another round of u.s. economic data and the second leg of the u.s. bank stress tests.

also, there will be closely watched seven-year treasury auctions taking place, too. still with me is jim keenan, oksana aronov, and krishna memani. krishna, i just want to wrap up with some final thoughts on e.m. going into the mexican election. a string of elections in emerging markets through the back end of this year. are you still positive on emerging markets? krishna: yes. we have been positive and wrong, but we are sticking with that position. i think the underlying thesis was driven by the fact that economic growth in emerging markets is relatively stable, and the dollar cannot strengthen. what has happened is the dollar has strengthened. i think it some point, the demand for capital to fund the u.s. deficit will bear on the dollar, and that will be the turn that we are waiting for. valuations in emerging markets have actually improved a lot, so we are sticking with that position. jonathan: didn't we see that fx-related move to the deficit last year? are we seeing enough of that? krishna: well, we saw a little bit of that, but we were not counting on the budget deal last year. jonathan: right. krishna: the deficit picture has certainly deteriorated. in that environment, for the dollar to strengthen meaningfully and sustain itself, i think, is unlikely. jonathan: oksana, will remind

me, negative and right on emerging markets. what is next? oksana: all the reasons remain for why we were negative going into 2018. the fed is normalizing, and all of the protectionism around the world, stronger dollar. none of these things will be constructive for e.m. at these prices particularly. jonathan: ok. oksana: when i hear, as krishna said, that there is still positive sentiment around e.m., i struggle to understand what sort of price appreciation can you get from a better pricing of 290 basis points over treasuries? so, fundamentals are strong in many parts of the market, we don't argue with that. it is just hard to understand where that price appreciation will come from as the fed continues to tighten and do all the things it is doing, and protectionism continues to roll around the world. and my final point on that is we have not yet seen technicals really hurt that part of the market.

we have not seen a significant amount of outflows. technicals can do very bad things to the market, as we learned with high-yield in 2015 and early 2016, where fundamentals were really limited to just the energy part of the market, but everything fell out of bed. that has not happened yet. jonathan: krishna, really quickly, what's the upside? krishna: when we say we like e.m., it is e.m. fx and local rates, not credit spreads. just to be clear. jonathan: to wrap things up, a quick fire round. three questions, really short answers if you can. you know how this works. first question for you, have we seen the tights for the year in u.s. investment grade? jim: no. oksana: no. krishna: no. jonathan: have we seen the wide on a 10 year treasury versus bunds? jim: no. oksana: no. krishna: no. jonathan: world cup winner. e.m. or dm? [laughter]

jim: not the united states. oksana: do i really have to? jonathan: indulge me. oksana: i will go with e.m. jonathan: there you go. krishna? krishna: i will go with e.m. jonathan: trying to ask americans about football. jim keenan, krishna memani, oksana aronov. i'm not doing that again. that does it for us from new york. we will see you next friday at 1:00 p.m. new york time. 6:00 p.m. in london. this was "bloomberg real yield." this is bloomberg tv. ♪ jason: welcome to bloomberg

businessweek. i am jason kelly at bloomberg headquarters in new york. a big show for you this week. we start in london where we explore that city's future as a financial hub given the backdrop of brexit. we go to south carolina where we talk to the although ceo about the new plant there. what it means for that state's economy and for volvo's chinese owner. we start with the big story of