High valuations, a buildup of corporate leverage, and some risky behavior are leaving some bond fund managers with a pessimistic outlook for the current economic cycle.

Investors need to shorten up on duration, lighten up on riskier assets, and have liquidity on hand so that when the market turns, they can take advantage of distressed assets, with one fund manager saying the current situation feels “a lot like 2007.”

“When the cycle turns, every asset class that requires liquidity with some form of risk will go through the meat grinder. Intermediate Treasuries will make money,” said Laird Landmann, group managing director, co-director fixed income, at TCW.

He spoke on Thursday as part of a fixed income panel at the Morningstar Investment Conference in Chicago.

Michael Collins, managing director, senior portfolio manager at PGIM Fixed Income, said after the Federal Reserve paused hiking rates this year, the markets talked themselves into a Goldilocks environment of low inflation and easy central bank monetary policy.

“The problem is when you’re pricing in nirvana, watch out. You have to be careful because things will come out of the blue to surprise you,” he said.

Sonali Pier, portfolio manager at PIMCO, agreed. With valuations high, any risks are a concern, especially with trade disputes between the US and China currently rattling markets.

Landmann said risky behavior is rising. He noted when IBM bought cloud computing company Red Hat for $34 billion in cash in October, it raised IBM’s leverage considerably, but the ratings agencies only cut IBM’s grade by one notch.

“Rating agencies are taking a pass on leverage…. This is like 2007. Same thing was done in subprime [mortgages]. It’s just a different debt cycle,” he said.

Landmann also pointed to asset-backed securities deals like a February consumer loan securitization deal from Social Finance which has a higher amount of subprime loans. “We’re seeing a lot more stupid pet tricks out there,” he said, referencing a skit from former late-night TV host David Letterman.

The Federal Reserve has done a good job of hiking interest rates and reducing their balance sheet to respond aggressively when a recession comes, Collins said.

“The problem is they’re the only game in town. The fiscal side is out because of the tax cuts. The Fed will cut rates, issue forward guidance. They will do more QE. QE is now a tool in the tool kit of all central banks. But the Fed in good shape, all things being said,” Collins said.

All three said investors should either have liquidity on hand now or hold instruments that can easily be turned liquid to prepare for when the rate cycle starts to turn.

“Given where valuations are today, have the flexibility build a portfolio where you can step in to provide capital when other things are selling off,” Pier said.

December’s sell off was a small warning sign of how markets might act when the cycle turns, and investors should take time now to review their portfolios.

“Look at your funds to see how much liquidity is there. When the cycle turns, whether in two years or next month, how will the funds position themselves? Do you own Treasuries, some cash, have agencies, CMBS holdings you can quickly monetize to a new opportunity set? Don’t overweight duration,” Landmann said.

Market participants are still trying to be optimistic and used the Fed pivot “to keep the music playing,” he said.

He’s not convinced the global central banks have better knowledge and analytical abilities to read economic conditions than anyone else’s views, especially since information is readily available. “This isn’t like the 1980s. They’re like a blind men hitting butterflies with a cane. They can’t figure out how to get inflation going, if they do get it going, they won’t know how to stop it. It’s not a science,” he said.

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Tags: Bonds, Laird Landmann, Michael Collins, Morningstar, PIMCO, TCW, Treasuries