Gundlach Talks to Aston
An Interview with DoubleLine’s Jeffrey Gundlach
(This is Part I of the recent interview between Aston CEO Stuart Bilton and Jeffrey Gundlach, Co-founder and CEO of DoubleLine Capital and portfolio manager of the ASTON/DoubleLine Core Plus Fixed Income Fund.)
Mr. Bilton: Jeffrey, the name DoubleLine is a metaphor for lines you should not cross when investing. What lines are you currently afraid to cross?
Mr. Gundlach: At DoubleLine, we always try to ensure that we understand the risks we are taking and to avoid the risks for which the potential return is likely to be inadequate. For example, there are times when ideas become too popular and investors don’t understand the risks of an asset. Today the biggest area of unrecognized risk is low volatility. Consider the measures of market volatility, the VIX index on the S&P 500 or the MOVE index on bonds: both are at multiyear lows. Yet we see investors betting against a rise in volatility. We believe this is very dangerous because when volatility has been low – which has been the case for the last few years – then the premium for writing options gets lower, at a time when the odds of volatility going lower still become virtually nonexistent and the odds of it rising significantly keep increasing. The VIX rarely drops below 10 for any length of time, and it is currently at 11.4. An investor assuming that the VIX is going lower might perhaps make 6%, but when volatility picks up, and it will – it’s just a question of when, not if – then the VIX could reach 20, 30 or 40. Therefore we have a return that’s probably one fifth of the size of the risk being taken. That is what DoubleLine tries to avoid investment positions that have poor asymmetrical risk/return trade-offs.
In fixed income, we are concerned about the high-yield bond market where, at this point in time, there seems to be an under appreciation of risk. Perhaps this complacency stems from 2013: high-yield bonds went up a little in price while other segments of the bond market fell. But high-yield bonds do have interest rate as well as default risk, especially in the wake of recent spread compression. I think a lot of investors have been lulled into complacency about high-yield bonds as they chase yield. One of the sectors we have underweighted more this year has been high-yield bonds where we think too many of them are priced for perfection.
Mr. Bilton: What about Emerging Markets?
Mr. Gundlach: Emerging markets did poorly last year. In fact, it was a most unusual year: high-yield bonds did quite well while emerging markets were sharply to moderately negative. We entered 2014 looking for stronger returns from emerging markets debt, and it has been among the top-performing sectors year to date. We believe that the risk/return trade-off for emerging market debt is going to continue to be favorable partly because of the need for pension plans to find long-maturity assets to populate their portfolios. Pension plans are shifting from stocks into bonds because last year their funding status improved dramatically as their liabilities, which are present-valued by interest rates on “A” corporate bonds, went down in value (yields rose) and their assets generally went up. Many pension plans had a 20 percentage point improvement in funding status. It means that corporate pension plans are likely to increase fixed income assets to immunize their asset/liability mismatch. In fact, we’ve already seen plenty of evidence of this shift in allocation. US-denominated emerging markets debt is the perfect vehicle to do this. While short-term volatility is always at hand in emerging markets debt, the long-term fundamentals are very favorable. These countries enjoy natural resources, population growth, better debt-to-GDP ratios than exist in developed markets, and improving budget deficits. This provides a long-term asset that matches almost perfectly with a long-term liability with a yield that is a few hundred basis points higher than traditional fixed-income. So I think emerging market debt will probably do well in the second half of 2014 just as it did in the first half; just be sure it is US dollar-denominated.
Mr. Bilton: Are you still concerned about developed market debt, particularly European?
Mr. Gundlach: European debt is remarkably unattractive with a German Bund (bond) yielding 1% less than equivalent US government bonds. French bonds even yield something like 80 basis points less than the US, despite a French banking system that can never resist a poor credit. Then there is the European periphery (Spain, Italy, and Greece) where the economic systems are in a shambles; yet there was a day recently when Spanish 10 year bonds yielded less than the equivalent US bonds. So US government bonds actually have a good relative value compared to other developed market bonds. The main argument for Euro zone bonds has been one of real interest rates. With Europe in a deflationary trend, it is argued that yields should be low because disinflation means their real interest rates are actually high. The problem with this argument for a US investor is that the CPI in a specific country is relevant only if you live in that country. The fact that Spain has a negative inflation rate makes their real interest rate look attractive, but that’s irrelevant to a US investor living in the US buying goods and services here.
Analysts have begun to attribute declining US bond yields to the relative value argument; I think this has some merit. This is the sixth year in a row when the US was supposed to reach escape velocity in GDP – we were going to go from a 2% to a 3% real GDP growth rate. Then, of course, the first quarter 2014’s numbers came out and GDP keeps getting revised down. It is likely that first quarter’s GDP will show a negative of 2% or worse. [Editor’s note: after this interview with Mr. Gundlach, the U.S. Department of Commerce reported first quarter GDP contracted at an annual rate of -2.9%.] This is remarkable; before the first release of the GDP number, the consensus estimate was for 2.6% growth, and now it is significantly negative, which will be one of the biggest misses in history. We are beginning to see – true to form for the past half a dozen years – growth forecasts for the year being revised down as we move deeper into the year. That’s the reason the bond market has done better than most people expected.
Mr. Bilton: Last year when we spoke, you were one of the few people who were not anticipating a major bear market in bonds in the U.S. The analyst community seems to be coming around to that perspective. Do you still hold that point of view?
Mr. Gundlach: Yes. When interest rates started to move higher last year and once they got above 2.35% on the US 10-year Treasury bond, it was quite clear they would get up into the high twos. Then the question was whether the 10-year was going to stop in the high twos or very low threes or go higher. I didn’t believe that we were looking at a secularly higher interest rate trend, but rather a repricing that was caused by some special circumstances in the summertime. As it turned out, the 10-year hit its high exactly on December 31, 2013. It reached 3.03% and then dropped all the way down to 2.4%, which is about where it started from in May of 2013. So year-over-year there’s been virtually no change in the US 10-year bond. With the conditions that we have in the market for the rest of the year, we are looking at a range that is probably a bit lower than the range of last year, so perhaps 2.2% to 2.8% on the 10 year. The market seems to love the 2.6% area – right in the middle of the range. So that’s what we’re expecting.
The argument for higher interest rates has a lot to do with the decline in bond purchases driven by the Federal Reserve’s taper of its quantitative easing program. We are now experiencing the third reduction in that program or other forms of stimulus, and each time the bond market has rallied. So I find the taper argument for higher rates unpersuasive. The Federal Reserve has already reduced monthly purchases from $85 billion to $35 billion with little or no impact on bond markets; I don’t believe that the taper is the main driver in bond prices. Instead the key variable seems to be relative value. We can expect higher interest rates only when we get improved economic growth, which is unlikely in the near-term. I don’t think bond yields are going to rise much this year.
Assuming quantitative easing drops toward zero, there has understandably been a lot of talk that the stage is being set for short-term interest rates to rise to 2% on the federal funds rate. The market has begun to anticipate that the first hundred of the 200 basis points expected increase will begin next year, with the second 100 basis points increase occurring in 2016; and then the funds rate will stay at 2% for a very long time. I doubt that this will happen; I don’t believe that the Federal Reserve is going to raise interest rates until there’s some real reason to raise rates. If the reason is a strong economy, interest rates could rise faster than people think. It is interesting that the market’s perspective on when rates will hit 1% and 2% has not changed in the last few years. What has changed in recent months is the market’s interpretation of when the fed funds rate will get to 4%; it used to be 2017 and now the yield curve suggests that the consensus viewpoint is we won’t reach 4% until 2021. I don’t agree. I think the fed funds rate will be either 4% in two years or zero in two years, one or the other. I’m not sure which, but I don’t think the rate will be 2%. If there’s enough logic to raise them to 2% then there will be enough logic for the Fed to raise it to 4%.
Mr. Bilton: What would you say to an investor who is afraid of bonds because he or she expects interest rates to rise?
Mr. Gundlach: If that is really your fear, then you should think about what rising interest rates could mean for all of your investments and then make changes depending on your level of conviction. I certainly think we could see a very different interest rate world six or seven years from now. It could be very different, but that doesn’t mean it will happen tomorrow. That said, if you believe a cycle of rising interest rates is imminent, then you should move into lower interest rate risk funds. The trick is to do that while recognizing that you are taking a different kind of risk, not the least of which is lower current income. We’ve started some funds for the rate rising interest rate crowd. I don’t endorse them much because I don’t share that point of view, but I’m not going to argue. We have diversified our offerings to include products, including low duration and floating rate strategies, that work in that environment.
Mr. Bilton: Does it bother you that the Federal Reserve will own 40% - 50% of longer-term US government bonds outstanding and a similarly large amount of mortgage-backed securities?
Mr. Gundlach: No, it doesn’t bother me at all. Interestingly, the recent reduction in bond buying (the “taper”) has been similar to the reduction in bond issuance. The budget deficit is lower and the housing market is slow in terms of activity. Plus refinancing activity is very muted. So there will be very little pressure on markets from issuance in the next year or two. This will change a few years out, but for the next couple of years the finances of the federal government are in the eye of the hurricane. Unfortunately, by 2017 or 2018, federal finances start to deteriorate again because of entitlement programs. One of the longer-term issues is that the central banks – the Fed, the Bank of Japan and the People’s Bank of China as well as the Middle Eastern sovereign wealth funds – own a lot of U.S. Treasury bonds outstanding; combined it’s around 80%. So markets are concerned about the possibility of a mass selling of bonds by central banks. That concern is understandable, but I think such an outcome is a very low probability, particularly for the Federal Reserve. The Fed will not sell Treasury bonds unless something extraordinary occurs. If Fed officials were to start discussing selling a couple of trillion dollars of Treasury bonds, they know such rhetoric would spook the market. They will not pursue such a change in policy without a lot of thoughtfulness and consideration. So the Fed is not going to sell Treasury bonds in the near future. What will be interesting is 10 years from now, assuming the Fed has ended quantitative easing, because the Treasury will actually have to roll over all of these bonds to actual buyers at exactly the same time that we will be in crisis with the federal budget deficit because of Social Security, Medicaid, Medicare and Obamacare. So we could have a scenario where the Fed may be forced to be the buyer of the bonds they roll over 10 years from now. But who knows? Too much can happen over that timeframe. It’s just one of those things you put on your calendar to start worrying about in 2020.
Mr. Bilton: Do you still like a core plus bond strategy?
Mr. Gundlach: I love core plus; sometimes I think we should rename it because there is a little bit of history. In the 1990s when the word “core” started to be used, the idea in the asset management industry was to build what amounted to an enhanced index product. That is why it was called core. The idea was that this would be a one-stop shop for bond portfolio management that would never invest far from the index. But what is so attractive about owning an enhanced index fund and a pro rata share of all debt outstanding? It seems to me that if you buy a pro rata share of everything in the market, then you are just the market. So core plus was born to evolve away from core, and the plus was meant to suggest that it was less of an enhanced index fund and more of an active management product. Today, I believe, owning a fixed income index fund is really unattractive. It means you are forced to own a larger pro rata share of a market simply because some entity is being profligate in the amount of debt it is issuing. I think it’s a much better idea to be almost anti-core. Realistically, it would be much better to avoid sectors or companies with massive borrowing, and then only buy credits with modest borrowing because they’re almost certainly a better credit risk. So the more I think about it, an index bond fund is almost 180° from perhaps what an investor should do.
(Part II of this interview is scheduled to appear on July 31, 2014.)
The views and information discussed represent opinion and an assessment of market conditions at a specific point in time that are subject to change. It should not be relied upon as a recommendation to buy and sell particular securities or markets in general. Investing involves risks and possible loss of principal. Aston Asset Management does not accept any liability for losses either direct or consequential caused by the use of this information.