Mon, 12 Sep 2011
Investors would lose money in munis if interest rates rise, and on the flip side, could also lose money if a souring economy worsens an already dire fiscal situation, says the Doubleline manager.
Stipp: I wanted to touch a bit on the municipal bond market. You had mentioned your outlook, your bearish outlook for that market earlier this year. You also had mentioned as part of that, though, that you were standing ready to pick up some of those pieces after they fell.
I'm interested in knowing what signals are you looking for, how bad are you expecting it to fall, and when would you start buying munis? When would you feel like now is the time to be entering that market?
Gundlach: I think the most important thing for investors to think about with the muni market is to recognize that there's two ways to lose, and I don't think that's well appreciated. When Meredith Whitney came out with her big default call in the fourth quarter, suddenly the world became focused on the potential for default-based downward pricing, but munis--and let's talk about long munis now, not real short stuff, but the long-dated munis. There's actually two ways to lose, which is what the problem is. They have interest rate risk. So, if interest rates are to rise with a better economy, you're going to lose money in the short-term mark-to-market and an opportunity cost, because the prices will drop with rising interest rates.
On the other hand, if Treasury interest rates fall, well, what's going to happen is, you're going to have an already dire fiscal situation at the state and municipal level just get that much worse. So, for rising interest rates, you lose money in munis on duration or interest rate risk, and for a bad economy, you lose money because the default problem really flares up with lower Treasury yields. So, the only way you can win in munis is with the current environment sustaining, which means 3.50 plus or minus on the 10-year, subpar growth, but still growing economy.
The good news for the muni market is that's precisely what's been happening, and in the months ahead, the DoubleLine view is, that's going to continue to happen, but ultimately that can't go on. It's not sustainable. You can't have no volatility in the economy or interest rates. They have to break out one way or the other, and when they do, muni prices will fall.
My way of thinking about it is the long-dated munis--and I am using Cal GOs, one of the biggest markets and most liquid markets--the long ones, the ones that were issued at the top of the market at a 100 cents on the dollar fell all the way down to the mid-70s at the lows of the market in January. My view is that those bonds will probably drop down, when the volatility comes, to around 60 cents on the dollar, which would mean a yield that's a 150 basis points or so higher than what we saw at the lows in January.
At that level, not only is it an attractive yield, and you do have attractive constitutional protection there, but you also are protected for some other nasty things that could happen. For example, taxation. ... Munis could potentially be taxed. I know that that's heretical thinking to some people, but these are governments, federal, state, municipal, that are absolutely dying for cash as we see with the budget talks that are going on in Washington, D.C., and there must be a solution, and taxing is certainly going to be part of the solution, and I am not saying it must happened, but it could happen that way.
It really is interesting with this budget debate in Washington, because here what they are looking for, they are having such a hard time finding just $60 billion or $75 billion in budget cuts, and everybody knows that there is $1.6 trillion of federal deficit, so there is a long road ahead of us in terms of rhetoric and market-moving news, volatility, that investors should be watching out for.
Stipp: Jeffrey Gundlach, happy anniversary to your DoubleLine Total Return Fund. Thank you for calling me today and for your insights.
Gundlach: Thanks, Jason. I enjoyed it. Anytime.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.