Posted by: Aaron Pressman on June 28, 2007
Jeff Gundlach is not a rock star but he could play one on TV with his blonde crew cut, sharp blue suit and pink tie. And visiting Chicago from his hometown environs of southern California, he seems decidedly more hip than anyone else in the room. Unfortunately for hard rockers, the venue is Chicago’s bland McCormick convention center and the show is Morningstar’s annual investment conference. Still, since Gundlach is Morningstar’s reigning bond fund manager of the year, he’s a rock star of sorts to the assembled throng of investment advisers, brokers and other money managers.
You don’t get to be manager of the year unless you can shred your Bloomberg keyboard as fast as Hendrix or Jack White can on guitar. Gundlach, who specializes in mortgage-backed securities — the heavy metal of the bond world — has pounded the competition for the past 10 years at the helm of TCW’s Total Return Bond Fund. He’s beaten 97% of his competitors over the past 10 years with an average annual gain of almost 7% (p.s. - past 10 year return on the S&P 500? 7% annually). That’s far better than PIMCO’s Bill Gross, who still carries the titles of most famous and most quoted bond fund manager.
So as the designated bond rock star of 2007, Gundlach wants to deliver. He’s ready to riff on the two hottest licks stuck in the heads of every bond markets fanboy today. First, did the market meltdown of the past few weeks mark the end of 20 plus years of the bull market for bonds? And second, is the chaos in subprime mortgage going to take down more hedge funds, maybe a few Wall Street firms or even the whole U.S. economy?
Gundlach warms up the crowd with a few lame jokes, imitations of his 16-year-old daughter’s various Valley girlish “Oh my god”-isms. He’s trying a little to hard to impress with the tunes off his new album. Finally, he gets to the hot stuff and he’s ready to go all retro. With charts and graphs he’s pulled off his Bloomberg, Gundlach shows that while interest rates are breaking through a trend line of declines from the past couple of years, when you look back to the Reagan era, the market remains on track, if only just. Since bond prices rise when interest rates fall, the trend has been the fuel for an almost non-stop party for bond funds for 20 years. “We’re still hanging in there,” Gundlach declares.
But he’s got more - what about the subprime mortgage meltdown that’s all over the headlines? Already the riskiest bonds backed by mortgages taken out by people with the lowest credit scores have dropped 40% in value. Better stuff is down only 10% to 30% and the very best, basic AAA-rated stuff isn’t off much at all. But it’s all a house of cards, Gundlach explains. Each tier of risk is built on the one below. As the first borrowers default, holders of the riskiest bonds take the hit. As defaults pile up, the losses flow up the chain. Most of the bonds are in the higher rated categories so the total damage so far is probably a loss of just 5% of the $2 trillion of outstanding subprime mortgage market, Gundlach estimates.
The delinquency rate on subprime mortgages is almost 14% and it’s still climbing, he warns. No one knows where it will peak. Even just a few more points higher will wipe out some. Even 30% is a possibility given the watered-down lending standards and crazy loan structures, Gundlach says. If that happened “nothing is okay.”
So the world is ending, right? Not exactly. Almost no mutual funds own subprime bonds (Gundlach’s got none in his fund). It’s mostly foreign investors and hedge funds. Bottom line - as bad as it may get, “it’s a very big problem for a relatively thin slice of the market,” Gundlach says.
Of course, Gundlach is just a bond fund guy and he’s got his eye on bonds. An equity manager or individual investor might use the same information to assess the value of consumer credit stocks. If it’s going to get a lot worse, worse than most suspect, there may be more than a few overvalued stocks out there in finance land. Maybe Peter Lynch or George Soros should hit the stage to play the equity drums backing Gundlach when he returns for his encore.