An in-depth talk with Jeffrey Gundlach

Aston Asset Management’s Aston Doubleline Core Plus Fixed Income Fund (ADLIX) will mark its three-year track record this week. The fund is managed by Jeffrey Gundlach of Doubleline Capital. Aston chief executive Stu Bilton sat down with Mr. Gundlach recently to discuss a number of issues related to the state of the current market.

Mr. Bilton: Jeffrey, the name DoubleLine is a metaphor for lines you should not cross when investing. What lines are you currently afraid to cross?
Mr. Gundlach: At DoubleLine, we always try to ensure that we understand the risks we are taking and to avoid the risks for which the potential return is likely to be inadequate. For example, there are times when ideas become too popular and investors don’t understand the risks of an asset. Today the biggest area of unrecognized risk is low volatility. Consider the measures of market volatility, the VIX index on the S&P 500 or the MOVE index on bonds: both are at multiyear lows. Yet we see investors betting against a rise in volatility. We believe this is very dangerous because when volatility has been low — which has been the case for the last few years — then the premium for writing options gets lower at a time when the odds of volatility going lower still become virtually nonexistent and the odds of it rising significantly keep increasing. The VIX rarely drops below 10 for any length of time, and it is currently at 11.4. An investor assuming that the VIX is going lower might perhaps make 6%, but when volatility picks up, and it will — it’s just a question of when, not if — then the VIX could reach 20, 30 or 40. Therefore we have a return that’s probably one-fifth of the size of the risk being taken. That is what DoubleLine tries to avoid investment positions that have poor asymmetrical risk/return trade-offs.
In fixed income, we are concerned about the high-yield bond market where, at this point in time, there seems to be an underappreciation of risk. Perhaps this complacency stems from 2013, when high-yield bonds went up a little in price while other segments of the bond market fell. But high-yield bonds do have interest rate as well as default risk, especially in the wake of recent spread compression. I think a lot of investors have been lulled into complacency about high-yield bonds as they chase yield. One of the sectors we have underweighted more this year has been high-yield bonds, where we think too many of them are priced for perfection.
Mr. Bilton: What about emerging markets?
Mr. Gundlach: Emerging markets did poorly last year. In fact, it was a most unusual year: High-yield bonds did quite well while emerging markets were sharply to moderately negative. We entered 2014 looking for stronger returns from emerging-markets debt, and it has been among the top-performing sectors year-to-date. We believe that the risk/return trade-off for emerging-markets debt is going to continue to be favorable partly because of the need for pension plans to find long-maturity assets to populate their portfolios. Pension plans are shifting from stocks into bonds because last year their funding status improved dramatically as their liabilities, which are present-valued by interest rates on A corporate bonds, went down in value (yields rose) and their assets generally went up. Many pension plans had a 20-percentage-point improvement in funding status. It means that corporate pension plans are likely to increase fixed-income assets to immunize their asset/liability mismatch. In fact, we’ve already seen plenty of evidence of this shift in allocation. U.S.-denominated emerging-markets debt is the perfect vehicle to do this. While short-term volatility is always at hand in emerging markets debt, the long-term fundamentals are very favorable. These countries enjoy natural resources, population growth, better debt-to-GDP ratios than exist in developed markets, and improving budget deficits. This provides a long-term asset that matches almost perfectly with a long-term liability with a yield that is a few hundred basis points higher than traditional fixed income. So I think emerging-markets debt will probably do well in the second half of 2014 just as it did in the first half; just be sure it is U.S. dollar-denominated.
Mr. Bilton: Are you still concerned about developed-markets debt, particularly European?
Mr. Gundlach: European debt is remarkably unattractive with a German bund yielding 1% less than equivalent U.S. government bonds. French bonds even yield something like 80 basis points less than the U.S., despite a French banking system that can never resist a poor credit. Then there is the European periphery (Spain, Italy, and Greece) where the economic systems are in a shambles; yet there was a day recently when Spanish 10-year bonds yielded less than the equivalent U.S. bonds. So U.S. government bonds actually have a good relative value compared with other developed-markets bonds. The main argument for eurozone bonds has been one of real interest rates. With Europe in a deflationary trend, it is argued that yields should be low because disinflation means their real interest rates are actually high. The problem with this argument for a U.S. investor is that the CPI in a specific country is relevant only if you live in that country. The fact that Spain has a negative inflation rate makes their real interest rate look attractive, but that’s irrelevant to a U.S. investor living in the U.S. buying goods and services here.
Mr. Bilton: Last year when we spoke, you were one of the few people who were not anticipating a major bear market in bonds in the U.S. The analyst community seems to be coming around to that perspective. Do you still hold that point of view?
Mr. Gundlach: Yes. When interest rates started to move higher last year and once they got above 2.35% on the U.S. 10-year bond, it was quite clear they would get up into the high twos. Then the question was whether the 10-year was going to stop in the high twos or very low threes or go higher. I didn’t believe that we were looking at a secularly higher interest rate trend, but rather a repricing that was caused by some special circumstances in the summertime. As it turned out, the 10-year hit its high exactly on Dec. 31, 2013. It reached 3.03% and then dropped all the way down to 2.4%, which is about where it started from in May 2013. So year-over-year, there’s been virtually no change in the U.S. 10-year bond. With the conditions that we have in the market for the rest of the year, we are looking at a range that is probably a bit lower than the range of last year, so perhaps 2.2% to 2.8% on the 10-year. The market seems to love the 2.6% area — right in the middle of the range. So that’s what we’re expecting.
The argument for higher interest rates has a lot to do with the decline in bond purchases driven by the Federal Reserve’s taper of its quantitative-easing program. We are now experiencing the third reduction in that program or other forms of stimulus, and each time the bond market has rallied. So I find the taper argument for higher rates unpersuasive. The Federal Reserve has already reduced monthly purchases from $85 billion to $35 billion with little or no impact on bond markets; I don’t believe that the taper is the main driver in bond prices. Instead the key variable seems to be relative value. We can expect higher interest rates only when we get improved economic growth, which is unlikely in the near-term. I don’t think bond yields are going to rise much this year.
Assuming quantitative easing drops toward zero, there has understandably been a lot of talk that the stage is being set for short-term interest rates to rise to 2% on the federal funds rate. The market has begun to anticipate that the first 100 of the 200-basis-point expected increase will begin next year, with the second 100 basis points increase occurring in 2016; and then the funds rate will stay at 2% for a very long time. I doubt that this will happen; I don’t believe that the Federal Reserve is going to raise interest rates until there’s some real reason to raise rates. If the reason is a strong economy, interest rates could rise faster than people think. It is interesting that the market’s perspective on when rates will hit 1% and 2% has not changed in the last few years. What has changed in recent months is the market’s interpretation of when the fed funds rate will get to 4%; it used to be 2017 and now the yield curve suggests that the consensus viewpoint is we won’t reach 4% until 2021. I don’t agree. I think the fed funds rate will be either 4% in two years or zero in two years, one or the other. I’m not sure which, but I don’t think the rate will be 2%. If there’s enough logic to raise them to 2% then there will be enough logic for the Fed to raise it to 4%.
Mr. Bilton: What would you say to an investor who is afraid of bonds because he or she expects interest rates to rise?
Mr. Gundlach: If that is really your fear, then you should think about what rising interest rates could mean for all of your investments and then make changes depending on your level of conviction. I certainly think we could see a very different interest rate world six or seven years from now. It could be very different, but that doesn’t mean it will happen tomorrow. That said, if you believe a cycle of rising interest rates is imminent, then you should move into lower interest rate risk funds. The trick is to do that while recognizing that you are taking a different kind of risk, not the least of which is lower current income. We’ve started some funds for the rising interest rate crowd. I don’t endorse them much because I don’t share that point of view, but I’m not going to argue. We have diversified our offerings to include products, including low duration and floating rate strategies that work in that environment.
Jeffrey Gundlach the founder of Doubleline Capital, an investment firm that specializes in fixed income. It subadvises the Aston Doubleline Core Plus Fixed Income Fund (ADLIX).
Stuart Bilton is chief executive of Aston Asset Management. He is chairman of the firm’s Investment Committee which is responsible for the selection and monitoring of all subadviser relationships.