Where Gundlach's Core Fund Is Placing Its Bets

Ryan Leggio: Switching gears to risk assets, your mutual fund by prospectus can invest up to a third of its assets in non-investment-grade securities. Two questions there, why did you feel the need for that type of latitude and are you investing in any non-investment-grade securities right now?

Jeffrey Gundlach: Yes. You are talking about the Total Return Fund and that has had historically and continues to have a mortgage-backed security concentration bias, and over half of the portfolio is invested in non-guaranteed mortgage-backed securities. And we felt a need to have that one-third below-investment-grade, because a lot of these securities are already downgraded to that level and probably many more will be downgraded; ultimately a lot of that market is going to a D rating.

That doesn't mean that it's a disaster of investment; it means you are not going to get a 100 cents back. Even if you get 99 cents back on the dollar, it will have a D rating. We think that that part of the market is very attractive. We are very expert at analyzing and making a lot of money in it, and so want to make sure the fund could have a decent sector exposure to non-agency downgraded market.

Leggio: In the Core Fund, where you sit around a lot of very, very smart experienced sector managers and specialists, you get to really see where the opportunities are and aren't really all over the world. And for investors today and for you, where are the best opportunities? Is it in the mortgage-backed market or is it somewhere else?

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Gundlach: To the extent one is taking credit risk, it seems to us that the non-guaranteed mortgage market really substantially dominates. So in the Core Fund, we do have 20% of the assets in non-guaranteed mortgage credit, and a lot of that is below investment grade again.

In an unusual setup for us, we have zero, below investment grade corporate credit. We think that if you are going to take that type of credit risk, you should take it in mortgages. There are times in the past when our core strategy had 25% non-investment-grade corporate bonds. So, it's not at all that we are averse to using them, it's just that the risk-reward setup isn't good.

We also have zero currency risk, which is unusual. Often we would own the yen bonds or euro bonds. I do think that the dollar had a huge rally from the fourth quarter of last year and may be a little weak in the near term, but I think the biggest move that's coming in the near term is for the dollar to continue to rally against eurozone problems.

So we have an unusual setup in the Core Fund. Lots of Treasury credit--Ginnie Mae credit. Non-investment-grade mortgages. A little bit of emerging-markets debt, but no currency risk, no below-investment-grade corporates, and we have about 15% in defensive investment grade corporate credit in United States.

Leggio: You were asked at the end of your speech at the Morningstar Investment Conference about municipal bonds, and you answered pretty favorably, in general, for those. I guess the question is, are you investing in any municipal bonds, in any of your funds right now? And if not, at what point would the attractiveness be just too much to bear, and you would invest in some municipal securities?

Gundlach: We do not own any municipal bonds in the Total Return Fund or the Core Fund presently. My attitude about munis keeps bouncing around between – an awareness of the attractiveness on a pre-tax basis, on a tax equivalent basis, and yet the undeniably bad trends in municipal finance.

When I look at the statistics just in the last two weeks since I gave my keynote, some warning signals are popping up for me in terms of foreign ownership of munis, bank ownership of munis. If there is a bubble that is in the fixed income market, and maybe in the muni market in terms of demand, I don't think munis are about to collapse in the near term, but I am watching very carefully.

I think they would have to be a significantly cheaper than they are today for them to make sense within the context of my mutual funds.

Leggio: Looking at your two funds, the Core Fund and the Total Return Fund, how does the yield-to-maturity look on those two funds right now, stacking them up? And then what type of interest rate exposure are you taking on those two funds generally speaking?

Gundlach: The Total Return Fund will almost always have a higher dividend. It's really an income fund and over time has had really premium dividends and continues to. If you look at the most recent dividends, it's very high because we are earning that thanks to the mix of the assets in the fund. It generally is set up to have a lower interest rate exposure.

So we're actually running a duration of under three in the Total Return Fund. The Core Fund is really more of a capital allocation fund. It's more of a one-stop shopping, call it more traditional bond fund, that is looking to avoid risk, and then be in a position to redeploy capital after markets significantly re-price it down and offer opportunity.

So for example, I think the below-investment-grade corporate market is going to have substantial price declines in the next 18 months. At that point, we'd move in there and try to make money. So the idea there is to make more capital gains and be more indifferent to income.

Also in the Core Fund, we express more fully the macro views. So if deflation actually is going to be the near-term concern, which is what I think, the Total Return Fund will probably, while interest rates are falling, do less well than the Core Fund, which is really set up to express a more directional view on macroeconomic deflation.

The Total Return Fund is more balanced in that regard. It has Treasuries, which should do well – Treasury credit, which should do well for deflation, but the non-guaranteed mortgages are really a pretty good place to be for a stronger economy and more inflationary outlook.

Leggio: So for an investor, who is sitting back, doesn't really understand, really maybe even what you are buying, except for, okay, these are bonds, they pay me a coupon, I am not taking a lot of interest rate risk on either fund, which one should investors own in your opinion or should they own a little of both?

Gundlach: Well, it's really dependent on the usage. For the income investor, the Total Return Fund is the clear choice. It's designed for high-income flow and certainly is delivering that today, but it's mortgage-concentrated. Another use for the Total Return Fund would be if someone wants to think of tactical opportunities in the mortgage market that would be a place to express that opinion.

The Core Fund is more of a one-stop shopping fund. We are going to move the money around for you based upon our judgments. We hope to make capital gains, and we more fully express the diversified view of the market in the Core Fund. So it's really a more for long-term capital gain and income and more of a one-stop shopping approach.

Leggio: So PIMCO Total Return is, kind of, an 800-pound gorilla in the fixed-income mutual fund market. Do you view the Core Fund then as the natural competitor to Bill Gross' PIMCO Total Return?

Gundlach: Yes. It is more similar in terms of the way that the strategy is attempting to succeed. The [DoubleLine] Total Return Fund has had very, very competitive returns, but it is mortgage-concentrated and more income-oriented, and so it's not as direct a comparison to something like a PIMCO fund as the [DoubleLine] Core Fund would be.