Why We're Moving DoubleLine Total Return Bond Fund's Rating to Neutral

In our analysis published today, we assigned  DoubleLine Total Return Bond (DBLTX) a Morningstar Analyst Rating of Neutral. The following Q&A explains the rationale supporting the Neutral rating and key questions we would seek to satisfactorily answer in order to recommend the strategy.  

Q: Why is DoubleLine Total Return Bond rated Neutral, and what does that mean?

A: We assigned a Neutral rating because we have a mixed view of the fund. We respect the skill and experience of its manager, Jeffrey Gundlach, who has amassed an impressive record here and at previous charge  TCW Total Return Bond (TGLMX). We also think the fund is priced competitively--fees on its institutional share class are below the category norm. This explains the Positive ratings we have assigned to the People, Performance, and Price pillars. However, we still have questions about the prudence and repeatability of the fund’s process and the extent to which its advisor, DoubleLine Capital Management, is demonstrating its commitment to shareholder interests. This explains the Neutral ratings we have assigned to the Process and Parent pillars. Taken together, the fund’s Neutral rating means we do not have enough conviction to recommend it.

Q: What are key questions you have about the fund’s process and the firm’s advisor?

A: This is a fairly sophisticated mortgage strategy. Therefore, it is important to assess how management is assembling the portfolio and balancing the risks therein. For instance, Gundlach has historically talked about offsetting the risk in the fund’s high-quality and rate-sensitive agency mortgage portfolio with its more credit-sensitive nonagency residential mortgage-backed securities portfolio. As the nonagency RMBS market has shrunk and prices have recovered, how has portfolio construction evolved? In addition, given Gundlach’s centrality to the fund’s success and considering the firm’s asset growth, it is essential to evaluate stewardship issues such as succession planning and the advisor’s approach to managing capacity. We have not been able to satisfactorily answer these questions using publicly available sources of information. DoubleLine has repeatedly declined our requests for information.

Q: Do you always need access to a firm in order to conduct your research and assign a rating?

A: No. Access to a firm is not a compulsory part of our research process. However, when we are evaluating sophisticated bond strategies like DoubleLine Total Return Bond, publicly available information often does not suffice. This is not a failing of DoubleLine’s, per se, but rather reflects the fact that disclosure and reporting practices have not kept pace with financial innovation. In addition, firms do not ordinarily publicly disclose information on a range of topics including the details of succession planning or capacity management. Given this, we routinely conduct interviews with fund managers to better assess portfolio construction, risk management, key performance drivers, and firm stewardship, among other issues. What we ask are the kinds of basic due diligence questions that all other managers answer and that any fiduciary, whose interests we're trying to represent, has a responsibility to ascertain.

Q: You’d previously said the fund was Not Ratable. What changed?

A: We revisited our decision to assign a Not Ratable designation to the fund. We originally assigned Not Ratable to the fund in July 2014 and reaffirmed it in July 2015. However, upon further review, we think it makes more sense to assign a rating to the fund that reflects what we know rather than, in effect, withhold a rating absent complete information. Leveraging the analysis we have conducted and considering the unanswered questions that remain about the fund’s process and DoubleLine’s stewardship, we do not have enough conviction in the fund to recommend it. We feel that the Neutral rating we have assigned better conveys that view than Not Ratable, hence the change.

Q: How did you arrive at the Not Ratable designation in the first place?

A: We initiated the fund's rating at Neutral in 2011 and conducted a due diligence visit in April 2012. Shortly thereafter, DoubleLine denied us further access to the firm’s personnel and subsequently declined repeated requests for information. For a period of time, we left the fund’s Neutral rating in place, leveraging extensive research we had conducted up to that point. However, after several years had gone by without additional information from, or substantive contact with, DoubleLine, we determined that we lacked sufficient information to fully and fairly assess the fund’s process or stewardship practices. That prompted the change to Not Ratable in July 2014, a rating we reaffirmed in July 2015.  

Q: Why doesn’t Not Ratable fit anymore?

A: As mentioned, in general we believe we can better serve investors by assigning a rating that reflects what we know than withholding a rating absent complete information. For a time, we felt that Not Ratable usefully fit the circumstances--namely, a temporary lack of information prevented us from fully and fairly assessing the DoubleLine fund’s investment merits. As time passed and DoubleLine’s stance became clearer, we questioned whether Not Ratable was the best fit. Absent additional information, we concluded that we do not know enough about the strategy or the firm’s stewardship plans and practices to recommend the fund, explaining the Neutral rating we assigned.

Q: Do you rate other strategies like this one? If so, can’t you leverage that knowledge to rate this fund?      

A: We research and rate a variety of mortgage-focused funds. These include funds that follow a relatively plain-vanilla approach that emphasizes agency-backed mortgage pass-throughs as well as those that invest heavily in credit-sensitive nonagency mortgage bonds backed by residential or commercial mortgage loans. Meanwhile, some invest in more-complex securitized structures that carve up the cash flows of the underlying pool of loans, while other absolute-return-oriented mortgage funds have the ability to go long and short. While mortgage funds share certain traits in common, even seemingly similar strategies can exhibit strikingly different risk and reward profiles. This can reflect variations in the way managers select mortgage securities, which depends on the inputs being used to evaluate a given mortgage pool or tranche, as well as differences in particular mortgage sectors being emphasized. For these reasons, while some analysis can be leveraged, we still believe it is important to evaluate each strategy on its own, so as to incorporate its unique attributes into the assessment we are making.

Q: How long have you been covering the DoubleLine fund or other funds that its manager ran in the past?

A: We have been covering the DoubleLine fund since 2010 and covered Gundlach’s previous charge, TCW Total Return Bond, since 2002. In the 1990s, we also covered the closed-end TCW Dean Witter Term Trusts that Gundlach comanaged with his current DoubleLine colleague, Phil Barach.

Q: How have your views evolved over that time?

A: We have consistently praised Gundlach’s skill and experience over time, extending to our most recent analysis of the DoubleLine fund. In fact, we nominated him several times for some of the highest honors we bestow, including Morningstar Fund Manager of the Year and Morningstar Fund Manager of the Decade. We also highly recommended his previous charge, TCW Total Return Bond, which was a longtime Analyst Pick (the precursor to our current Gold rating). When Gundlach left TCW and formed DoubleLine, we were enthused about his and his firm’s prospects. However, at the time we initiated the fund’s rating at Neutral in 2011, we had become concerned about the risks presented by a sizable stake in esoteric mortgage-backed securities that the fund had taken. While those risks did not materialize and the fund’s performance has since been excellent, it was shortly after that initial rating that DoubleLine denied us further access to the firm’s personnel and declined subsequent requests for additional information.     

Q: The fund’s performance has been excellent. Isn’t that enough to earn your recommendation?

A: No, it is not. While past performance can yield insights into a strategy’s risk and return profile and help to corroborate or dispel conclusions drawn about the process and how it is implemented, it is not a divining rod. That is why we evaluate other factors that we believe are more-predictive of future returns--the People, Process, Parent, and Price Pillar ratings mentioned above. We do not feel we can really evaluate a fund’s merits--that is, understand it--if we are not looking beyond past performance, something we have consistently sought to do in covering the DoubleLine fund.

Q: What additional information are you seeking? What would you ask if DoubleLine granted you access to firm personnel again?

A: Portfolio Construction:

• An important part of the investment team’s historical success has been its ability to balance exposure to sectors with different risk and return profiles. Beyond noting shifts in the portfolio's broad sector weightings, what is the rationale behind the team's portfolio construction decisions and how have they evolved? For instance, how is the team balancing the economic, valuation, and prepayment characteristics of its nonagency RMBS cash flows against the same factors in its agency mortgage holdings, particularly after several years of strong returns for the nonagency sector?
• As the nonagency RMBS market has shrunk and nonagency RMBS have declined as a percentage of the fund’s total assets, the team has turned toward other types of securitized credit, including asset-backed securities, collateralized loan obligations, and commercial mortgage-backed securities. Are those positions primarily being used as substitutes for the declining nonagency stake in the portfolio’s previous barbell structure or are there other factors driving the investment thesis?
• Are the fundamental differences between nonagency RMBS and these other securitized credit markets, such as those surrounding security structure and underlying collateral, sufficient to require a rethinking or retooling of the strategy?
• The fund’s exposure to mortgage derivatives has remained low since late 2012. Why was the allocation reduced here but still sizable in the closed-end fund DoubleLine Opportunistic Credit (DBL) (26% in agency inverse floaters and 24% in agency inverse IO/IO as of April 2016)? Is it possible that allocation could grow again in the future and under what circumstances? What notional principal exposure does the fund’s current exposure to mortgage derivatives represent, and what role do they play in the portfolio?
• Would the team consider adding other credit-sensitive sectors to the portfolio in lieu of nonagency RMBS, such as emerging-markets debt? 
• Digging beneath the fund’s reported effective duration, how is the team balancing the interest-rate sensitivity of various segments of the portfolio and what does that mean for the fund’s overall interest-rate sensitivity? 

 

Security Selection:

• The fundamental analysis driving bottom-up security selection could potentially represent a sustainable advantage. With that in mind:

o   What fundamental traits are the team emphasizing in its nonagency RMBS stake, such as collateral profile, geography, servicer behavior, potential to benefit from legal settlements, seniority in the capital structure?

o   Why has the composition of the fund’s nonagency RMBS stake shifted more toward subprime in the past 18 months, and what parts of the subprime market offer the best opportunities, in the team’s view?

o   When nonagency RMBS were priced at sizable discounts to par value in the aftermath of the financial crisis, the team stress-tested individual holdings using Draconian assumptions regarding borrower delinquency and home price values. How have the team’s stress-testing assumptions changed following a period of recovery? What are the greatest risks to these positions in the current environment?

o   How important is continued home price appreciation for the performance of the fund’s nonagency RMBS positions?

o   What are the characteristics of the fund’s stake in agency collateralized mortgage obligations, and how have these changed?

• The fund’s exposure to ABS, CMBS, and CLOs has grown. With that in mind:

o   What factors drive security selection in these sectors?  

o   Under what circumstances would the team consider investing further down in the capital structure in any of these areas?

o   What factors does the team consider in conducting loan-level analysis of the underlying commercial real estate portfolios?

o   Regarding CLOs:

§  How does the team balance its analysis of the underlying corporate debt with structural protections of the security? In other words, does the team need to have a positive view of each of the underlying credits in order to invest or will it rely on the structural seniority of the tranche to protect its investment?

§  Does it avoid CLOs with heavy exposure to less desirable industries?

§  What criteria does the team consider when evaluating the competency of a CLO manager? Are there certain managers the team will avoid?

§  How does the team assess the liquidity of individual CLO positions?

§   Why would the team choose to invest in CLOs managed by one firm versus another?

o   How does valuation factor into bottom-up security selection in these areas?  

• As the system for financing mortgages in the United States evolves, what are the investment team’s views on relatively new RMBS securitized credit sectors, such as new-issue nonperforming loan securitizations, single-family rental securitizations, and agency credit risk transfer bonds? What are the team’s views on the European ABS market?

 

Risk Management:

• How is risk control integrated into the management of the fund? What checks and balances are in place? How has this evolved over time?
  • What quantitative tools are available for monitoring risk?
  • What type of stress-testing and scenario analysis is conducted on individual positions and at the portfolio level?
  • What tools or processes are used to manage liquidity risk? How does the team account for liquidity risk in evaluating securities and in its relative value assessment?
  • What are the reporting lines for the firm’s chief risk officer and other risk management staff?
  • What elements are in place to protect the independence of risk management from being influenced by the interests of investment managers?

 

Performance: 

• What have been the main drivers of the fund’s performance to date, and how have they changed over time?
• What are the team’s return expectations for different sectors in the fund from here on?
• Given the fund’s current positioning, what is the team’s base-case expectation for how the fund will perform?
• What potential scenarios is the team looking at that would cause the fund to underperform or outperform that base case? 
• Under what scenario would the fund experience negative returns?

 

Capacity:

• TCW Total Return Bond surpassed $1 billion in net assets in early 2008 and had climbed above $11 billion by the time Gundlach left the firm in late 2009. DoubleLine Total Return Bond now has over $60 billion in assets, and the firm has at least $100 billion in assets under management. Has the size of the assets that DoubleLine is now managing had an impact on its process?
• What does DoubleLine consider to be the capacity of this strategy in its current configuration? What does the firm consider to be the limiting factors in that evaluation?
• Does the fund’s size present challenges for security selection in certain areas of the market where liquidity is not as deep as the highly liquid agency pass-through market, such as more-esoteric agency CMO structures?
• Has the fund’s asset growth influenced its reduced allocation to nonagency RMBS?
• DoubleLine has issued commentary indicating that the fund’s ABS exposure is unlikely to become a major portion of its securitized credit exposure, in part because of the relatively small size of that market. Does the team anticipate growing the allocations to CLOs and CMBS, and, if so, does the fund’s size present any challenges to accomplishing that?

 

Stewardship:

• DoubleLine appears to have begun to address key-man risk and succession planning by naming Jeff Sherman, one of the firm's portfolio managers and a member of the executive management team, as deputy CIO in early June 2016. Sherman previously worked at TCW. We would like to know more about Sherman's duties at TCW and DoubleLine, how they have evolved, and, in particular, the following:

o   Why was Sherman chosen for the role? What unique or complementary skills does he bring to it?

o   What new responsibilities will he assume in the short, medium, and long term?

• Succession planning and ability to recruit, develop, and retain investment talent:

o   Is DoubleLine’s investment staff full, or does the firm have research holes to fill?

o   How does DoubleLine recruit new analysts? What are the tenures of the analysts at the firm?

o   What has turnover been like among the investment staff?

o   What does career pathing look like at DoubleLine?

o   It has proved difficult for other boutique firms to move past the founder. Has the firm’s leadership thought about what it might do to make that eventual transition successful?

o   Who challenges Gundlach the most? How can the firm ensure that the next generation of senior leadership is not just deferring to Gundlach?

o   Who has equity ownership in the firm, and how is it determined?

o   Do only active employees (other than Oaktree) have equity in the firm? What happens when they retire or leave the firm?

o   Is there a long-term plan to transfer ownership from Gundlach to others?

o   What is Oaktree Capital’s exit strategy?

• Product development and distribution:

o   Why is it important for DoubleLine to offer equity strategies? Whose decision was it to offer equity funds?

o   How did the firm go about building out its equity lineup and the infrastructure to support it? What has happened since? What did the firm learn, and would it have done anything differently?

o   What is the process for launching new funds? What factors are taken into account in deciding whether or not to add product offerings?

o   Is there an effort to actively diversify the firm’s business mix (both by asset class and distribution channel), and how does it intend to go about that?

• Compliance:

o   DoubleLine’s chief compliance officer and general counsel are one and the same. Is there a plan to separate the roles?

o   What does the compliance function look like at DoubleLine? Have resources dedicated to compliance grown with assets?

o   Has there been any recent contact with the SEC? What, if any, deficiencies did it find, and how did the firm address them?

• Fee Philosophy:

o   What is DoubleLine’s approach to fee-setting?

o   Why are there no management-fee breakpoints on Total Return, in particular?

o   Why has the firm recouped past waived fees?

Miriam Sjoblom, Director, Fixed Income Ratings, contributed to this column.