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TCW Total Return's Mortgage Master

Jeffrey Gundlach on managing in today's market. (11/20/08)

Eric Jacobson: Hi, I'm Eric Jacobson. I'm a fixed-income specialist with Morningstar. We are here today with Jeffrey Gundlach. He is the chief investment officer of TCW. He is also the manager of TCW Total Return TGLMX.

With us today also is Larry Jones, the associate director of fund analysis, and also a fixed-income specialist to talk to Jeffrey about the fund. Thanks for joining us, both of you.

Larry Jones: You're welcome.

Jeffrey Gundlach: Thanks Eric.

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Larry Jones: Jeffrey, I'm wondering if you could initially talk about one of the areas of opportunity that you've been finding in the fund for quite a while now. It's the non-agency mortgage-backed sector. The last we spoke, which was about mid-year, I think about 45% of the fund was in non-agency mortgage-backed paper.

A lot of these securities, they tend to be AAA rated, the ones that you're purchasing, but their prices also tend to be quite depressed when you purchase them. We're wondering if you can talk a little bit about that opportunity and where you see it today and going forward.

Jeffrey Gundlach: Yeah. The non-agency mortgage market suffered some real price deterioration late in the first quarter of this year, right around the time that Bear Stearns ultimately was taken over by J.P. Morgan.

At that point, mortgage credit was just so dominant in terms of its evaluation versus treasuries versus agency debt versus even corporate credit and emerging market debt, that it seemed like a very good choice.

We did invest now in the high 40s still of the Total Return Bond Fund in non-agency mortgages. We have most recently been focused on prime pools of fixed-rate mortgages by the better quality underwriters, because during the summer, even the prices of the prime mortgage market suffered some significant decay.

Kind of quietly, the prime mortgage market went from 80s to 90s price market in the first half of this year down to about 70s to high 60s market during the third quarter, and that seemed to be a very good opportunity.

Really dominating the other opportunities in the market, we took advantage of that for its cash-flow characteristics and the senior nature of these securities in the capital structure means that even with very significant depression like loss scenarios, returns would still be, believe it or not, in the double digits, while generating a very high cash flows, as we wait for any kind of price improvement to take place.

Larry Jones: Just following up with that, the price deterioration that you said was seen in the third quarter, would you ascribe that primarily to greater fear over the underlying fundamentals of these securities or more technical factors within the market that we've seen in other market segments too holding.

Jeffrey Gundlach: I think the fundamentals continue weak, but nothing new really happened in the third quarter on the fundamentals. What started to occur was predictable, but often the market doesn't quite fully react until events really transpire.

In this case, those events were downgrades. It became clear that some of these AAA rated prime very senior securities would maybe return a very significant fraction of their principal value in the mid-to-high 90s even.

But at the letter rating, if you don't receive a 100 cents back, would get cut repeatedly. In fact, if a security in bonds is going to return $0.99 on the dollar, the rating should be D for default. We can argue about whether that's the right regime, but that is the regime that we're in.

When investors start to see downgrades coming, and start to say, "Wait a minute, if I buy one of these assets and it gets downgraded, I might be forced to sell it because of whatever guidelines or capital charges that various institutions have to follow, cause investors to pull back from the market."

There was a week in August when most markets were fairly calm, that that fact seemed to materialize in the market, and all of a sudden, the bid vaporized from the market and it dropped from the high 80s to the mid to low 70s.

That I think was largely due to shrinkage due to liquidity based on downgrades that were coming, but still, the fundamentals are very poor, and in a way, twisted in our market today, the technicals kind of are becoming the fundamentals.

We can say that price deteriorations are all technical, but when they drop, it causes actions to take place, that end up filtering into the fundamentals of the market, like the capital base of banks, like the consumer's consciousness.

So, in a sense, the technicals and the fundamentals are almost one and the same these days. But still, the lack of liquidity, great excess of supply caused by all the leverage that was in the system being pulled back has created a tremendous imbalance between the real money and these overhanging supply of securities that were created really to be investment vehicles for borrowed money that's not there anymore.

So, the technical on that basis remains very, very negative underneath some of the decline in the market for sure.

Larry Jones: When we talked here about TCW Total Return Bond, we typically talk about the mortgage markets, since those are the markets that the fund is traditionally applied over the years.

I'm wondering if you could talk to us a little bit about some other markets where there might be opportunities that eventually TCW Total Return Bond may venture into.

Jeffrey Gundlach: In October, the fact had been in place pretty powerfully for most of the year change. The fact had been that if you're going to take credit risk, really mortgage credit risk was grossly under-priced relative to other types of credit risk.

In October, the markets melted down. High-yield bonds dropped 30 points. Investment-grade corporates in some cases 20 points, the stock market down very substantially.

That change in corporate credit made for the time being, the competitiveness of corporate credit versus mortgage credit to be pretty much equal.

In our diversified bond fund, our core fixed income fund, we did move, for the first time in three or four years incrementally into corporate credit, because really the dynamics were pretty on par with the mortgage market.

Subsequent though, in the last week or so, the mortgage market once again with the TARP program being mutated has gone down a lot, particularly CNBS and the subprime market. Those markets put us back to the condition that now it seems again that mortgage has kind of dominated corporate credit.

Unfortunately, what that probably means is in the short term, we'll probably see another leg down in corporate credit to kind of get it back in sync with where mortgages are.

I think corporate credit is a good market to average into. I think corporate credit is a terrific market instead of the equity market, where you're in a senior capital position; you have tremendously increased cash flow.

Corporate credit looks something like a no-brainer to me versus equities, but I think with the most recent ratchet down, corporates will unfortunately be a better opportunity as we move into year-end, than they are today.

Larry Jones: Another thing you've written about recently in your CIO letter is the question of counter party risk. I'm wondering if you can talk a little bit about that risk, obviously it's an involved issue, but a little bit about that risk and where you see that going forward, including there has been a talk about creating a clearing house for CDS, credit default swaps, and if you think that that will eventually be successful and help mitigate this problem?

Jeffrey Gundlach: I think it will ultimately be a clearing house for all manner of derivatives, but if we step back, I think the biggest issue is to observe is that the derivatives markets exploded in size.

The notional value of derivatives according to one bureau is $600 trillion. According to another bureau, it's $200 trillion. I'm getting nervous already, because if we don't know the number within $400 trillion, that means there's a lot of opacity here, which could come back to bite us.

Well, I really think the best way to analyze the situation is to focus in on CDS. The CDS market is $32 trillion based on one bureau, and $58 trillion based on another.

Again, I'm getting nervous already, but let's just take the mid point and say it's $45 trillion. Here is where I think the problematic issue lies. If the corporate bond market is priced at all rationally, and I think we all understand that some of it is technical, and some of it is rising defaults, but the high-yield bond market today has a 20% yield if there are no defaults.

One way to think about that is, if there is even 10% default rate per year for three years, and an 80% loss, because we're in a bad economy and the recovery rates will be poor, that would still mean a 12% loss adjusted yield in high yield, which sounds OK.

It's not as good as mortgage credit, but sounding pretty attractive. But that also means, a 30% accumulative default rate with an 80% severity, which means about a 25% loss in the high-yield market. By extension, probably something in the 20% area in the total corporate-bond market.

Well, if there's $45 trillion of CDS, and 20% of it is going to be a loss, that means that there is a $9 trillion transfer payment that needs to take place.

Now, the people who operate in these markets always tell me how well managed their risks are and don't worry, be happy, because for every long there is a short, but that still means $9 trillion has to be transferred.

If you haven't checked lately, capital isn't all that available in the banking system, and there is probably no way that there is $9 trillion around to be transferred. Which means that the base case, I'm sorry to say, is that there will be a default in the CDS market.

This is why I think the government has put a $158 billion into AIG, is to try to keep the genie in the bottle on derivative default risk. I'm afraid that when you think about what the markets tell you in high yield bond prices, those defaults, what it means is that you will have potentially a default event.

Which means that all manner of counter party risk and all manner of strategies that are involved in derivatives, if you can get out of them today with essentially no penalty, you should get out immediately, because that risk is overhanging in the market and there is very little payoff for taking a lot of derivative exposures.

There is a lot of risk if what's embedded in the CDS default. So, this is what I meant when I say avoid counter-party risk. The payoff, one could argue, is very small. The risk could be very large.

Investors and funds that are synthetically oriented or derivatives oriented, might be gated while CDS needs to be sorted out. They may have outsized losses depending upon how that type of crisis--I'm not saying it must happen, but I am observing that the market forces powerfully indicate the potential.

If it does happen, you're going to be very glad if you moved to a cash-only type of investment strategy, and not surprisingly, Total Return Bond and all of my bonds that just have always been sensitive to these issues and stayed in kind of good old-fashioned cash types of activities.

I think that already we've seen problems in the bond fund industry from, what I would call the synthetic trade, where you do a dollar roll or a forward contract and put the money in a short-term asset pool.

Well, those pools have deteriorated in value. So, that strategy has failed, but another side of it could be the counter-party risk failure, and it will be a good idea for investors to think carefully whether they really want to be exposed to that area, when there are perfectly good alternatives with competitive returns that don't have that risk. It's important I think for investors to understand that. So, thanks for asking.

Larry Jones: Thanks very much coming and speaking to us today Jeffrey.

Jeffrey Gundlach: My pleasure.

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Eric Jacobson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.