US Videos

Gundlach: Cycle of Default Not Over

Eric Jacobson

Jacobson: Let me change gears then and ask you a little bit about kind of where we are today in the market relative to the last couple years. They who are familiar with the story of your fund that you ran at TCW know that you were a very big user of agency mortgage securities for many years, and that going into the crisis, one of the big successes that you had was shifting gears, recognizing the value in non-agency mortgages.

Maybe talk a little bit about how things went this year for that market. I know you can't really predict where things will be when you are up and running with a public fund, but kind of a take us up to today in terms of the value there, what you see, and if there is more gas in that tank, if you will.

Gundlach: Yeah. The markets have certainly changed many times in the past couple of years. They have changed very dramatically since the bottom in March, which I was fortunate enough to basically signal in a call that I did on my mutual fund. That call was called "You're Too Bearish," and that was done March 12, because my idea was that as bad as things seemed, a rally was overdue, and a significant one.

The way I framed it was I said it will be a rally that is too big to look past. If you miss that rally, you'll be in a very painful place, and you get in that horrible situation where you don't know what to do, because you still feel the same way, but you're scared about the price movement.

We did have agency securities dominate our funds going into the credit crisis. We had very high government credit in all of our strategies. This is one of the reasons for the successful record.

And as you point out, when the non-agency market collapsed along with other credit, not only did we see that as an opportunity, but beyond that, we had the team with by far the greatest resources in terms of personnel, and in terms of systems, in terms of experience in managing mortgages of all stripes.

Read Full Transcript

So not only were we able to capitalize on the beta of non-agency mortgage and credit during that period--let's just sort of broadly frame it as being from November of '08 into maybe April of '09...

Jacobson: And just to clarify for our viewers, beta meaning sort of a--I don't know how you want to define it.

Gundlach: The index fund. I always use beta as a word that means index fund. So if you just want the beta, it means, well, you just buy an index fund. And sure, you would have done well in credit on an index fund basis if you bought anytime in that window that I just referenced.

But our team also has tremendous alpha generation, or excess return above an index fund. We saw that in the agency market for many years. For the non-agency market, it was really very inefficiently priced.

And with the number of people that we have in the systems--we have something like 50 people that work on non-agency mortgage credit during the appropriate moments, so we are able to sort through and sift through. And we had some very big ideas about what parts of the market to avoid, like option pay arms, like subprime of any type, like second liens, and stick to the highest quality.

And so we managed also to understand the prepayment dynamics that were changing during the year. With much to many investors' surprise, there was a prepayment spike in the prime non-agency mortgage market that we talked about and benefited tremendously from during 2009.

Now if I look at the market, I say first of all, the agency pass-through market that is being supported by the U.S. government, I would go so far as to say it may never have looked richer than it looks today relative to Treasuries and the absolute yields. You're looking at a market now that has extraordinarily bad-looking future price performance. If rates go up, the prices will drop pretty heavily. And if interest rates fall, there is not much upside on those securities.

For that type of bad idea in an investment portfolio, usually, you get a lot of excess cash flow yield, and you're not getting much today because of the prices.

So an index fund or a beta approach to agency mortgages is probably about as unattractive as it's ever been, and I speak with 25 years experience in this market at a pretty high level.

The non-agency market has also rallied a lot. It's basically hovering near its highs, as are all credit markets at this point. And frankly I think new investments into credit risk are not a very good idea.

I think that as we move into 2010, as investment committees meet and portfolio managers think about their roadmap for success in 2010, I think it's likely that investors and asset pools are going to say, "I don't think that we should be loading up on risk." The pricing is not what it was, and the markets are starting to look a little bit shaky as the economy is being a little bit less responsive than a lot of people were hoping for.

I deeply believe that this cycle of default is not over. This is one of the reasons why I went out on a limb in September and talked about the coming dollar rally, and I put out that the dollar has rallied substantially above any price that it has been at since that date.

So anybody that is in non-dollar is now losing money, and I think that that's going to get much worse. I think the dollar is going to rally substantially more from where it is, because of the positioning against it, and the enormous short covering that will take place once the carry trade, at zero interests being deployed into these other markets, starts to unwind, and I think it will unwind.

As investors start to experience losses, they will accelerate their unwinding and we will get this, I think, fairly sharp move up in the dollar and down in risk. That could be a buying opportunity for a risk that emerges in the first half of 2010. In fact, I think one should be on the lookout for that.

But for now, we have actually been moving systematically away from risk. In Core Plus, we now have 72% of the portfolio strategy in government credit again. That's very high. We were down something like 40%. So we have made a big move there. And in TGLMX, I was up at about 50% non-agency bonds at the bottom of the market, and we were systematically letting that go down. In fact, I was targeting that to a level that is lower than what it was when I left TCW.

So I'm not sure what's happening with TGLMX. Certainly, I think that the investors hired my team, and I think that our team is more than happy to serve as fiduciary for these clients' assets. We are big investors in all of our funds ourselves, are the principals of DoubleLine, and we are willing to be cooperative in any way to see that those assets make it to the team that developed the results. And the clients obviously voted for with their wallets.