Gundlach: Short-Term Potential in Long Government Credit

Ryan Leggio: Hi, I'm Ryan Leggio. I'm a mutual fund analyst at Morningstar. We are here in Los Angeles at DoubleLine, and with me today is Jeffrey Gundlach, the portfolio manager of DoubleLine Total Return. He is a former Morningstar Manager of the Year and a finalist for Morningstar's Manager of the Decade.

Jeffrey, thanks so much for joining us.

Jeffrey Gundlach: Thanks for coming in today, Ryan.

Leggio: Well, it has been about two weeks since your keynote address at the Morningstar Investment Conference, and we really wanted to follow-up on some of the large issues that you raised for investors, and one of the big ones was the deflationary concerns that you have because of the economy. How are those concerns really playing out in the two mutual funds that you help run?

Gundlach: Well, we have a bias for the short to immediate term to favor government credit. And I know that a lot of investors think that yields are low, and they are low, and a lot of people entering the year thought yields were low. But the fact is that the inflation rate is basically non-existent and commodity prices have been dropping for the past couple of years, and basically investors are starved for income, safe income, not risky income and that leads investors out the yield curve to government bonds.

So we have been investing in long-term government credit in the Total Return Fund for about half of the portfolio. What I mean there is its Ginnie Mae type of credit, but it's out about 10 to 15 years. So it's long. And in the Core mutual fund that I manage, we have about 62% of the fund in government credit Treasuries and Ginnie Mae.

So those are the areas that will benefit in the short term from growing awareness of the lack of inflation risk and the true risk of deflation in the economy.

Leggio: So as we are speaking today in July, the 10-year Treasury is right around 3%. And I guess the question for a lot of investors who may not be buying your fund, but are taking your advice in buying some government credit is at what point are the yield so low that no matter what kind of concerns are out there, they are really not being compensated for the risks they are taking on?

Gundlach: It's really a matter of investment horizon. I'd say that at the 2.98%, 10-year Treasury yield, where we are today, that for a buy-and-hold investor you are almost there. I mean, you are almost at that yield where it doesn't make any sense.

However, I do believe that the 10-year Treasury yield is going to drop to 2.5% or even 2%, which means if that happens over a six-month timeframe, you are talking about a six-month return of somewhere between 6% and 10%. Year-to-date long-term Treasuries are up almost 15% in the first half of the year.

So it's really a short-term capital gain concept as opposed to a buy-and-hold concept. Once you get down to 2.5% or lower, I think even the short-term capital gain piece of it starts to lose its attractiveness.

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Leggio: What is the likelihood of really a stagflationary environment like the late '70s, where we get very tepid economic growth and very, very high inflation for investors?

Gundlach: I think that in the near term, the stagflation case is very difficult to support. Simply because the inflation case in any form is difficult to support, given the contraction of the money supply, given what's happening with commodity prices, the stock market, real estate, the fact that people are really more hoarding cash than they are looking to borrow money and spend cash. It's more of a deflationary case.

I think it's possible we run into an inflationary outcome or a stagflationary outcome, but only if there is some sort of a deflation awareness-based crisis first that the government has to start seriously responding to a societal demand to engineer, really engineer inflation.

Right now, the society seems to fear inflation, more than they'd be rooting for inflation. That would only change with the deflationary kind of debt crisis. Unfortunately, I think the base case is we are going to get one.

Leggio: And so, if there is big inflation, maybe years in front of us or rising interest rates or a combination of both, how would you be able to position the funds to be able to really weather that storm, which really hasn't hit fixed-income investors at all, since the late '80s, since rates have been falling really continuously for a few decades now?

Gundlach: The best fixed-income investment for an inflationary environment is credit that is priced at a discount that will start to benefit from a greater inflation system in a certain sense. The non-guaranteed mortgage market is probably the best place for that. When you are buying securities at $0.50 or $0.60 on the dollar, the reason that they are at such a low price is people expect lots of defaults and very poor recovery rates when the loans are sold out in the market.

If there is inflation, I think you have to believe that housing would experience some inflation, too, and especially if we're talking about a powerful inflationary case, and then defaults would go way down and also recovery rates should by assumption go up.

So these securities at $0.50 or $0.60 on the dollar should go up at least for the first significant move-up in inflation, and therefore, provide very good hedging. And that's why we use a significant piece of the Total Return Fund in precisely those securities. Not that we are predicting that, but we have the risk balanced out versus the potential for inflation down the road. Deflation is kind of the problem today.