How The 'New Bond King' Is Investing

Tim Begany's picture

Thursday, February 12, 2015 - 12:00pm

by Tim Begany

 

We expect the stock market to show occasional volatility, but even the staid bond market has been delivering some jolts recently.

 

Rising bond price volatility reflects the growing concern about the timing, frequency and magnitude of upcoming interest rate hikes by the Federal Reserve. The risk of loss of principal has rarely been higher, especially for income investors that have boosted their exposure to high-yield corporate debt and other riskier types of bonds, in search of better returns.

 

With global political and economic turmoil apt to worsen, investors are understandably looking to the world's leading money managers for insight into how best to navigate increasingly choppy markets. In the fixed-income arena, you might want to keep a close eye on 55-year-old Jeffrey Gundlach, CEO of Los Angeles-based DoubleLine Capital.

 

Gundlach is widely seen as the new "bond king," replacing Bill Gross. That bond fund manager -- and bond market prognosticator -- had often been seen as the "Warren Buffett of bonds." The passing of the torch to Gundlach occurred after Gross stepped down as chief investment officer of the Pacific Investment Management Company (PIMCO), a firm he co-founded in 1971.

 

DoubleLine, which Gundlach co-founded in 2009 after a stellar career with the TCW Family of Funds, offers a number of foreign and domestic stock and bond investments. However, the flagship fixed-income offering is the DoubleLine Total Return Bond I (NYSE: DBLTX), an intermediate-term bond fund with total assets of $44 billion.

 

Over the years, Gundlach has proven especially adept at finding value in mortgage-backed securities, and it's still his focus with DBLTX. This does put him at odds with most peers, who retain portfolios that are more evenly across the bond market. However, Gundlach's unconventional approach has translated to strong outperformance for DBLTX, just as it did when he worked for TCW.

 

DBLTX was launched in April 2010, so it lacks a five-year record yet. But it has beaten 91% of its peers over the past three years. The fund delivered more than 4.9% annually during that time, well ahead of the category average of 3.4% and the overall bond market's 2.8% rate of return.

 

Its yield is currently 4.6%, nearly twice the yield of the typical fund tracking the Barclays U.S. Aggregate Bond Index. This index is the most commonly used proxy for the overall U.S. bond market, and it's the performance benchmark for DBLTX.

 

When selecting investments, Gundlach favors two bond types: highly-rated government agency and non-agency residential mortgage-backed securities.

 

Agency residential mortgage-backed securities, which make up 47% of fund assets, are debt issued by government-sponsored enterprises like the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).

 

Non-agency residential mortgage-backed securities are bonds containing residential mortgages purchased from lenders.

 

The bonds in this fund have outperformed the pack because of their strong credit quality, relatively large coupons (commonly in the 3.5%-to-5.5% range) and long payment periods. Such features are highly desirable to fixed-income investors, so these bonds have seen their prices rise at a substantial rate in addition to providing an attractive income stream.

 

DBLTX allocates 23% of assets to non-agency residential mortgage-backed securities. Also commonly known as "private label" residential mortgage-backed securities, these bonds are issued by private firms like Citigroup, Inc. (NYSE: C), Wells Fargo & Co. (NYSE: WFC) and JPMorgan Chase & Co. (NYSE: JPM), among many others. They're riskier because there's no guarantee the government will cover the interest and principal for issuers who go bust due to widespread mortgage defaults.

 

Mortgage-backed securities issued by Fannie Mae and Freddie Mac aren't formally guaranteed either, but they're still considered safer because there's an implied guarantee. That is, the bond market believes the government will always bail them out in an emergency, as it did after the 2008 financial crisis.

 

Since there's no government backing, private label residential mortgage-backed securities tend to have somewhat higher coupons than agency issues. They've also enhanced fund performance simply by being much scarcer, mainly because far fewer private label offerings have occurred since the financial crisis.

 

Indeed, the market for these bonds is still shrinking, helping to boost the value of the ones that are available -- even when other credit-sensitive assets decline, according to DoubleLine.

 

To help limit default risk, DBLTX heavily stresses investment-grade debt, which makes up 75% assets and typically carries a triple-A rating. Moreover, the fund is 11% in cash, and its overall level of interest rate sensitivity is nearly 50% less than the broader bond market.

 

A 5% allocation to U.S. Treasurys should benefit returns if Gundlach is correct in predicting further declines in yields in 2015, a scenario that would mean yet another year of solid gains for Treasurys.

 

Risks To Consider: DBLTX doesn't take excessive credit risk, but it does hold about three times the concentration of mortgage-backed securities as the typical intermediate-term bond fund. Such a bold bet could backfire if there was another major housing downturn.

 

Action To Take -- > Jeffrey Gundlach's approach to the bond market is unconventional, but it's well worth considering -- especially now that the United States is finally starting to see substantial wage growth. Higher wages should further stimulate the housing market, which is DBLXT's main focus.

 

Although the minimum initial investment of $100,000 for regular taxable accounts could be a deterrent, you can get started in an IRA for $5,000. There's also an N share class with initial minimums of $2,000 and $500, respectively, for regular accounts and IRAs. However, N shares have a somewhat higher expense ratio of 0.7%, versus 0.4% for the I shares, as well as a 0.25% 12-b-1 fee.

 

Another alternative to the bond market is to invest in reliable dividend payers. In fact, my colleague Nathan Slaughter just released a new report that details how I'm locking in a paycheck of $16,200 for every $100,000 I invest... and our dividends keep growing... sometimes overtaking our original stock price. Invest like this and it just might change the way you think about investing forever. To access the report, click here.

 

Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.