Sat 10-20-18 BigPic: The Bond King Speaks: Doubleline CEO Jeffrey Gundlach Offers His Best Investing Advice
Oct
14, 2018,8:30
am
The
Bond King Speaks: Doubleline CEO Jeffrey Gundlach Offers His Best Investing
Advice
I help investors think differently about finance & the stock
market.
I spoke with Jeffrey Gundlach on
Thursday afternoon during a particularly fraught time in the global
marketplace. 10-year Treasury rates had been rising and a stock market sell-off accelerated as the Dow
lost 1300 points over the previous two sessions.
Gundlach, founder and CEO
of Doubleline
Capital ($123 billion in Assets Under Management), doesn’t give
many print interviews anymore but current market
conditions must have encouraged him to share his thoughts with me. Gundlach is
known as “The Bond King,” but as you can tell from this exclusive interview,
his knowledge is broad-based and he is well aware of the macro investing environment.
In this extensive
conversation, we discussed a wide-ranging variety of topics, including:
· his
thoughts on a possible recession and where he thinks interest rates are heading
· the
difference between active and passive bond funds
· how he
adds value for his clients and the process he goes through when analyzing an
investment opportunity
· why
emerging markets debt may be appealing
Towards the end of our
talk, I asked him for his best investment advice and his favorite book on
investing. His answers may surprise you.
Karl Kaufman: Do
you think there could be a recessionary swing in the market because of interest
rates moving too fast?
Jeffrey Gundlach: There
are no signs of that yet. We have developed over a dozen forward-looking
recession warning indicators: things like year-over-year leading economic
indicators that always fall below zero before the recession comes. Right now
they’re at 6.4% year-over-year, miles away from a recessionary signal.
Junk bond spreads are
nowhere near widening enough to signal the recession and unemployment rates
just hit a new low. Obviously, not recessionary. PMI surveys are
at multi-year if not decade highs, small business confidence broke the record,
etc. All of these things should be deteriorating very sharply to create the
potential for a recession warning.
Maybe it’ll start
happening next month, I don’t know. Right now, it’s not in the data.
The thing that’s getting
the most alarming is that the stock market has become completely unhinged.
That’s not good, obviously, for confidence, right?
Kaufman: What’s
going on with the yield curve and where do you think interest rates are heading?
Gundlach: The
Fed’s going to raise interest rates in December unless something really bad
happens to the stock market.
It seems quite likely
that the 30-year will be headed towards 4% in the not too distant future and
that would mean a steeper yield curve. The movement now in the long end has
been occurring faster than the changes in the perception of the Fed, which
hasn’t changed much. The long end is going up by 50 basis points in a month,
which is a pretty quick annual rate and will probably continue as long as we have this situation
with moving higher rates.
Rates in other parts of
the world, Germany in particular, are ridiculously low relative to the
economic reality. On the CPI, year over year, Germany is almost exactly the same as
the United States.
Yet their rate is at 55
basis points [0.55%] and ours is at 3.15% or so. There’s a lot of room for
German rates to go higher in case the ECB stops pegging it at this ridiculous rate of
negative 180 basis points less than the inflationary rate.
There are two ways
for things to go wrong, meaning bond yields go higher. Both of them seem to be
at least plausible in the short term, if not the base case. One is U.S. nominal
GDP could go up, which is happening and is going to happen again in
the third quarter. Nominal GDP is an important factor in the 10-year
Treasury. Also, German yields can go higher — they have over the past two
years, though not aggressively.
The U.S. 10-year has an
uncanny tendency to find itself at the average of U.S. nominal GDP and the
German 10-year yield. Right now, U.S. nominal GDP is at 5.4. We think we know
it’s going to 5.75 once the data for the third quarter are announced.
So we might be seeing
5.75 nominal and 55 basis points of German 10-years, not even assuming that
goes up. Add those two together, you get 6.3. Divide by 2, you get 3.15. Voila,
that’s exactly where the 10-year is today.
Those are the two things
that we need to be thinking about: nominal GDP of the United States and German
10-years are going to drive rates higher for 10-year treasury yields.
Kaufman: What
is the neutral interest rate that the Fed is talking about? Why can’t they
agree on what it is?
Gundlach: Let’s
just look at the most important voice of the Fed, chairman Jay Powell. He said
that there’s a long way to go to the neutral rate, which is weird because, in
their statement, they dropped the word accommodative. When referring to the Fed
funds rate now, it seems to me you’re either accommodative, neutral or
restricted.
If the chairperson says
we have a long way to go to neutral, it sounds to me like you’re not
restrictive, and you’re not neutral, which means you’re accommodative. They
seem to have a little challenge with their communication. They say on one side
of their mouth they’re not at neutral, yet on the other side, they drop
the word accommodative.
Clearly, there are
studies on what the so-called neutral rate is and how you get to it. Most of
those suggest the neutral rate is somewhere between two and a half and
three or maybe two and a half to three and a quarter. So clearly we’re
below that. The Fed says we’re not accommodative, but it seems like we are.
Kaufman: Is
there a certain bond category that you think is ripe for outperforming?
Gundlach: As
long as there’s not a recession, bank loans will be the top performer in the
fixed-income sector. The Fed’s raising rates, interest rates are going to rise
and bank loansfloat. They float over LIBOR and
they’re now paying five and a half, heading to 6% without any interest rate
risk. If the Fed keeps raising rates, their yields will go higher.
The problem with bank
loans is that they’re less liquid and will be difficult to sell if you try to
head to the exit when the economy seems to be rolling over. So you have to get
in front of it.
We do a formal
disciplined analysis of all recession indicators and hold a weekly macro
meeting to discuss if anything is changing. We think we can see forward as
much as a year. If there are no signs of a recession, then bank loans
are okay.
Things can deteriorate
quickly, though, and what you thought was a clear signal for a year might turn
into only four or five months. That’s still good enough. It just can’t be four
or five days because then that’s too late.
We like something that’s
off the run that you won’t find in the bond index: infrastructure bonds, which
are a small but rapidly growing category. These are bonds that invest in
the debt of airports and energy projects where there’s a big income stream
underneath them. For that reason, they’re securitized to a large extent and
certainly much safer than unsecured credit in the corporate bond market.
Not only are they safer,
but they also yield more, which is always a good thing. They’re all
investment-grade, they’re all dollar-denominated and they’re shorter maturity than
corporate bonds. More yield with shorter maturity and more safety —
how are you going to go wrong?
We use it as a surrogate
for corporate bonds because they will tend to rise and fall together. We think
infrastructure bonds will continue to deliver higher returns and even higher
risk-adjusted return. But it’s not that common of an asset category.
Right now, we sort of
like emerging market debt. We’re not getting involved with real trouble
spots — you might succeed mightily in Argentina or Turkey — but
we’re trying to do it in a lower-risk fashion.
Emerging markets have
suffered from the dollar having risen earlier this year. We believe the dollar
is going to go down. The fact that the dollar is starting to fall again
enforces that view. When the dollar goes down, you’re going to be better off in
emerging markets.
Kaufman: There’s
been a lot of publicity about the outflow of money from
active management to passive management. Why does
active management work better for a bond fund as opposed to an equity
fund?
Gundlach: On
the fixed-income side, active bond managers have by and large outperformed the
intermediate-term bond benchmark, the Barclays Bloomberg Aggregate Bond Index
(the “Agg”).
What helps the active
manager to outperform the index is that it’s quite possible in bonds to do
things very differently from what’s in the traditional bond indexes. The Agg
has no foreign bonds, certainly no emerging markets bonds, no
below-investment-grade bonds, no bank loans, no structured finance to speak of like ABS or CMBS,
all of which are viable asset classes. But the index doesn’t include them.
Active bond managers can buy these things and increasingly over the last couple
of decades have done so.
Active funds are being
measured against an investment-grade U.S.-only index. The active funds can own
tons of emerging markets, junk bonds, bank loans — some of them even
own 10 or 15% equities. Obviously, if a manager is allowed to own equities
against the bond index in a world where bond returns over the last two years
are nearly zero on a total return basis, you can see there’s a lot of ways that
bond managers can game an index more than a stock manager.
Is a stock manager really
going to measure themselves against the S&P 500 and own 50% bonds? I doubt
it. The industry’s evolved in a way that has given us an advantage.
That’s probably going to
turn into the opposite soon, where these activities outside of the boundaries
of U.S.-only, intermediate-grade only bonds will start hurting. Junk bonds are
getting crushed. Investment-grade corporate bonds are doing horribly over
the last year. Typically, these are systematically overweighted by the majority
of active bond managers. Not us, not Doubleline.
You could categorize the
industry fairly accurately with a broad stroke by saying most firms are
perpetually overweight corporate credit, underweight treasuries and they even
have some stocks with below-investment-grade ratings. When you get to a world
where the lower quality material like junk bonds or emerging markets are
starting to come under stress due to falling equity prices, and
perhaps a slowing global economy, well, suddenly, these games that are
often played don’t help.
If you look at 2012,
which was a credit debacle, 95% of active bond managers
underperformed the benchmark in 2012. 95 percent! That didn’t get a lot of
attention at the time because it was an island in an ocean of years that were
broadly outperformance years from 2010 to 2018.
September 7th, 2017 is
not a date most people will use for a performance evaluation start date, but
it’s an important one because that’s when corporate bonds stopped outperforming
and rates started rising. You started to see the dark underbelly of this gaming
of the index.
What is interesting about
the premise of your inquiry is that a lot of active managers are not telling
you the truth. They label themselves active managers, but all they mean is
they’re different from the index. It doesn’t mean that they’re active —
that could be a misapplication of that term.
If I was always 100% in
investment-grade corporate funds, I am not a Barclays Aggregate Index Fund. I
might secretly be a corporate bond index fund and not really tell people but
I’m actually not an active manager. I’m a stopped clock that is doing the same
thing all the time.
I’m not going to name
names, but there are very significant examples of managers that say they’re
active, but they’re not. When they’re really bullish on junk bonds, they have
10 and a half percent waiting in the portfolio and when they’re concerned about
them, they have nine and a half percent waiting in the portfolio. That’s the
extent that some of these firms are active. Active management that isn’t really
active is endemic in the industry.
After a number of years
of closet indexation, the clients finally wake up and say, “why am I
paying an active fee when I can get the same result from a passive fund, with a
lower fee and a higher net return?”
Kaufman: As
an active manager, how do you add value for your clients? Can you walk me
through your process and tell me some strategies that you use?
Gundlach: First,
we make a decision as to how much credit risk we want in the portfolio, how
many treasury bonds and government guaranteed stuff we want in the portfolio.
That mix will often be different than the mix in an index fund. Sometimes we’ll
have much more credit than the index, sometimes we’ll have much less.
Deciding whether it’s an
opportune time to take credit risk is an important lever in moving a
portfolio in an active way. What’s the best way to take the quantum credit risk
that you want?
Do we want bank loans?
Yes is the answer right now. Do we want junk bonds? No is the answer right now.
Do we want investment-grade corporate bonds? No is the answer right now. We are
underweight in those categories versus what we would normally be on average
over a cycle.
Another question is how
much interest rate risk do we want? Do we want to be more exposed to declining
rates than the index or do we want to be less exposed to declining or rising
rates than the index? So we change the duration of the portfolio. Sometimes you have a shorter
maturity and interest rate risk, sometimes we have a longer one. Those are two
big levers in adding value.
There’s a third, which
is: let’s own company A’s debt instead of company B’s debt because we think
it’s mispriced A versus B, or let’s be on this part of the yield curve versus
that part of the yield curve.
All of these things go
together. These decisions, though I present them to you individually, are not
disassociated decisions. They all integrate, and we have to do an analysis
integrating what our best judgment is about how all of these risks will
interplay: rising rates will affect various sectors in slightly different ways,
but rising interest rates might benefit one sector over another sector.
We have a risk
integration approach that helps capture the positives of the intersection of
all our views while hopefully having some risk mitigation if the world
develops in a way that we’re not expecting.
Kaufman: What’s
the best financial advice you can impart?
Gundlach: Patience
is the most important thing in investing. Things take longer to develop and
longer to tip over. Weird situations can be held together much longer than
people think.
I would strongly advise
that people develop their own opinions as best they can and not look for corroboration
of their opinion with everyone else. It’s worthwhile not to say, “I’ll be
comfortable because I have tons of company in this idea.” It’s okay to develop
an independent opinion and probably more profitable if you can apply it with a
fair amount of objectivity.
Anytime everyone’s doing
the same thing, they will all sell together. It leads to a very dangerous setup
that the momentum on the upside turns into the momentum on the downside. It’s
really important to not get sucked into this herding kind of behavior because
you all get slaughtered together, the entire herd.
Kaufman: Do
you have a favorite book on investing that you could recommend?
Gundlach: For
bonds, the best book, though it’s very technical, is Inside the Yield Book by Marty Liebowitz.
By far, the best
investing book is Reminiscences Of A Stock Operator, written years ago.
Everything in that book is absolutely true in terms of how markets work, how
human nature works, the mistakes people make, the greed that they have, the
ways they get themselves in trouble. It’s all exactly the same. We can have the
internet, we can have algorithms. We have robo-advisors, we have drones — you
know what, it’s all just human nature and it hasn’t changed. It’s not going to.
I’m the founder and CEO of American Dream Investing
(www.americandreaminvesting.com), a financial membership service sharing
independent and unconventional thoughts on…MORE
Karl
Kaufman is the founder of American Dream Investing, a financial membership service. If
you want to get text alerts each time we make a trade, sign up for a trial membership.
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