Bond rock star says subprime won't kill the party

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.

Reader Comments

Michael Panzner

June 28, 2007 12:49 PM

The Wall Street Journal's MarketBeat blog, in a post entitled "That's Why They Call it Subprime" [http://blogs.wsj.com/marketbeat/2007/06/28/thats-why-they-call-it-subprime/], seems to be saying that Mr. Gundlach's comments were somewhat less sanguine than you are suggesting:

Ian McDonald has this report from Chicago on the latest in the subprime meltdown:

Another dire prediction for the subprime market surfaced at the Morningstar Investment Conference in Chicago last night.

Jeffrey E. Gundlach, chief investment officer of TCW Investment Management, had this to say: “The subprime area is an unmitigated disaster and it’s going to get worse,” he said in the annual conference’s opening speech. And he should know what he’s talking about. Mr. Gundlach oversees TCW’s fixed income department and helped start its Mortgage Backed Securities Group in 1989. Today that group has some $60 billion under management.

His thesis on why the subprime bomb’s blast zone will grow is pretty simple. By his count, about 20% of sub-prime mortgages will have their rates reset between now and year-end. Because rates are higher today than when the mortgages were taken out, that means borrowers’ monthly payments will bump up. That will likely trigger even more defaults and more volatility for mortgage-backed bonds.

That, in turn, will whipsaw hedge funds and other investors holding bundles of mortgage-backed bonds. Many hedge funds and rating agencies will continue to be embarrassed by the sector’s collapse — with investment-grade-rated, mortgage-backed bonds yielding north of 30% due to their risks and declines in value — because their sophisticated financial models didn’t include a scenario with so many defaults.

As for the fund he runs, Mr. Gundlach says it has no “subprime garbage in it.”

Aaron Pressman

June 28, 2007 2:12 PM

Michael, don't miss the forest for the trees. As I mentioned, Gundlach said the subprime area could get much worse, even wiping out all of the triple-A rated subprime backed securities. But he also said the damage would limited and most bond investors wouldn't be hurt. When asked if the situation was similar to the S&L mess, he disagreed because the damage back then was so much more widespread. That's the real news, not yet another alarmist quote about subprime. The real money quote remains: "It's a very big problem for a relatively thin slice of the market."

Jake Kaldenbaugh

July 3, 2007 5:58 PM

Aaron,
Don't get drawn in by Michael. He runs a website called "Financial Armageddon". Interesting that a site predicting the next great crash is actually a dot-com. Regardless, you've highlighted the important point that most journalists are either missing or ignoring in pursuit of more salacious headlines. Subprime is going to hurt a few people badly; the people who bought the riskiest tranches of collateralized mortgage debt. I know a lot of people in finance and I don't know anyone who owns that stuff. Someone will get hurt, but it might be the ultrawealthy.

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Bloomberg Businessweek’s Ben Steverman focuses on the latest moves in financial markets and emerging trends in stocks, bonds, and funds, always with an eye toward giving readers a better understanding of the sometimes confusing and often chaotic world of money. Standard & Poor’s senior index analyst Howard Silverblatt will also provide his take on companies’ finances and the markets. Voted one of the “Top 100 Finance Blogs” in 2007.

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