Exclusive: Jeffrey Gundlach warns advisers on ‘unconstrained’ bond funds

DoubleLine Capital founder warns advisers that unconstrained managers are taking too much risk.

Jeffrey Gundlach is warning investors that they may not get what they expected out of mutual funds engineered for an era of rising interest rates.
The DoubleLine Capital founder said Tuesday that unconstrained bond funds, whose managers are given wide latitude on their investment selections, are delivering a “mixed bag of results” under the spotlight of bond market volatility.
“What’s going to happen is that unconstrained investors are going to find themselves disappointed,” Mr. Gundlach said in an interview with InvestmentNews. “I think they will be surprised that they are actually doing worse in many of these funds — in 2015, as interest rates are rising — they’re doing worse than they would in an index fund.”
The closely-watched fund manager’s remarks come as some of his peers’ performance has slipped amid a market rout that has driven some bond prices lower.
(More: Caution flag raised on unconstrained strategies)
Bill Gross’ Janus Global Unconstrained Bond Fund (JUCAX) and the $22 billion Goldman Sachs Strategic Income Fund (GSZAX) have delivered negative returns so far this year. The funds’ managers did not respond to a request for comment.
EXPENSIVE SHORT
At the heart of Mr. Gundlach’s concerns are the use by managers of a potentially expensive short on Treasuries, the cost of which weighs on returns.
The trade is used to achieve negative duration and benefit from rising rates, and is often coupled with low-credit junk bonds of the same maturity as the shorted Treasuries. (Duration measures the potential sensitivity of a bond’s price to rate increases.)
Mr. Gundlach described that trade as an “unacceptably high commitment to credit risk” that’s “long credit risk and short safety.”
“Investors are probably encouraged to believe that the funds will always go up, and I think that’s poor communication on the part of the sponsors,” said Mr. Gundlach. “I’m quite sure that investors are being told that these are strategies that have a better prospect for rising rates than other, traditional funds.”
Morningstar’s nontraditional bond category, which includes unconstrained funds and other strategies, is up 1.4% overall this year through Tuesday. Twenty-nine such funds have been launched in the U.S. over the last year.
Investors have turned against the category, pulling $2.4 billion from the offerings this year through April 30 after adding $78.7 billion over the two prior years, according to Morningstar.
That trend won’t last, according to Rick Rieder, chief investment officer of fundamental fixed income at BlackRock Inc. and a manager on the firm’s Strategic Income Opportunities Fund (BASIX). The fund gained 5.2% over five years, far ahead of its benchmark and competitors.
“Unconstrained is going to keep growing and growing because there’s a limited supply of fixed income,” said Mr. Rieder. But he said managers in the space often trade one risk — that rising interest rates will erode a bond prices — for credit risk.
“The moniker is wrong because what unconstrained allows you to do is take less risk,” said Mr. Rieder. “We’ll use negative duration. We’ll use it in places where we think it makes sense and particularly when you get a bang for your buck quickly.”
EXCEPTIONAL CIRCUMSTANCES
Matt Cody, chair of the asset allocation committee at Wetherby Asset Management, said his financial advisory firm uses unconstrained funds only in exceptional circumstances. He said his firm would prefer to control its portfolio duration itself and employ specialist managers as needed.
“In the marketing materials they send out it shows it’s low risk because it’s low duration, but what happens if there’s an equity selloff, a flight to quality?” said Mr. Cody. “What they tend to do is sell the equities and high-yield bonds and buy Treasuries.” Such a move would imperil the trade designed to achieve negative duration.
Mr. Gundlach’s own offering in the category — the DoubleLine Flexible Income Fund (DFLEX) — has climbed 2.8% this year through Tuesday, beating the Barclays U.S. Aggregate Bond Index, a widely watched benchmark that has returned 0.3% over the same period.
The fund has taken significant stakes in emerging-market debt, collateralized loan obligations and residential mortgage-backed securities alongside junk bonds. It says many of those securities are largely less sensitive to rates. DoubleLine also correctly read a January rally in Treasuries as a sign of a bear market to come, Mr. Gundlach said.
That’s when the yield on the benchmark 10-year U.S. Treasury note bounced from a low of 1.64%, on Jan. 30, to a high of 2.29% last Wednesday. Yields move inversely to prices.