There’s a saying that goes “Those who predict don’t know, and those who know don’t predict”. Even now, we still live in an age where sell-side analysts remain a prominent and influential part of the investment universe.
With all of that said, can we rightly criticize sell-side analysts for misinterpreting past results and steering less sophisticated potential investors into investment choices with inferior risk/return characteristics?
To that bolded question, I unequivocally say “yes”. Like anyone else, it’s much easier to write about and analyze what you know well. As my day job is running a bond portfolio I am an astute follower of well known bond fund managers such as Jeffrey Gundlach, Lacy Hunt, and Bill Gross among others.
An interesting article caught my eye this week as Morningstar released their list of candidates for “Bond Fund of the Year”. As a shareholder of the DoubleLine Total Return Fund since inception, I found comments made very peculiar. Eric Jacobson of Morningstar wrote the following on December 12, 2011:
“There were some standouts (in the intermediate-term bond group), such as Jeffrey Gundlach, the manager of DoubleLine Total Return Bond (DBLTX), which smoked its competitors with a 9% gain through Dec. 6. But while that fund and Gundlach clearly deserve an honorable mention, the fund’s fat returns were fueled by atypically large stakes in nonagency and exotic mortgage-backed securities. Those allocations gave it a much more aggressive risk profile than that of most rivals and could make the fund perform quite differently than most investors would expect from a more conventional core bond offering.”
Regular readers of my blog and anyone within shouting distance of the fixed-income markets knows that this bolded statement is flatly false. In fact, non-agency MBS has been one of the poorest performing sectors within the bond markets as the risk-off trade has hit RMBS hard. The below shows the ABX index thus far in 2011. While this is a synthetic index that’s used to track subprime (DoubleLine mainly owns Alt-A & Prime), it is nonetheless a decent proxy for the average reader to see how far its fallen.
Now that we have that cleared up, where has his outperformance come from? Earlier this year many bond fund managers were bracing for higher rates and holding many defensive short bonds. A review of DoubleLine’s holdings shows many prudent purchases such as Ginnie Mae last cash flow (LCF) CMO’s bought at a deep discount. A number of these bonds which were purchased in the $70’s are now trading well north of par. Even more prescient was purchasing these Agency CMO’s with Jumbo mortgage collateral. This type of collateral pre-payed quickly – a benefit when you are purchasing bonds at a discount to par.
As we are speaking about CMO’s such as this, it brings up another gross misrepresentation by Morningstar. Morningstar employee Karen Dolan, CFA, wrote on November 11, 2011:
“If a fund’s process or risk profile changes, it can affect its rating. For example, DoubleLine Total Return Bond (DBLTX), managed by Jeffrey Gundlach, has really sparkled since it launched in 2010. The fund has posted outstanding returns, paid one of the highest yields in its peer group, and has been resilient when markets turned choppy. Yet, Gundlach is employing his heretofore successful process differently today than when he was at TCW; the portfolio is steeped in esoteric securities that have histories of suffering in market panics regardless of their fundamentals. Stated more simply, though the fund’s positioning has worked in its favor thus far, it carries more risk than before. That is more complexity and risk than one would normally expect from a core, intermediate-term bond portfolio and is the primary driver behind the fund’s Analyst Rating of Neutral.”
Jacobon was quoted in the Wall Street Journal on October 5, 2011 to the same effect:
“The risks, however, are far different from those in a plain-vanilla bond fund, where the primary concerns are the direction of interest rates and credit quality. For starters, the privately backed CMOs are highly illiquid and their prices fall during periods of risk aversion. The government-issued mortgage-backed securities help balance the risk by gaining in value when investors panic. The fund also recently had more than 17% of its assets in cash, up from about 7% in 2010.
“But even that isn’t a guarantee that Mr. Gundlach will navigate the treacherous landscape unscathed. He is holding more risky assets than he did during other treacherous periods — and a double-dip recession, a further slide in housing prices or a default in Europe could harm his privately backed securities, says Eric Jacobson, director of fixed-income research for Morningstar. “He’s tremendously confident that he can move around this,” Mr. Jacobson says. “But it may not matter how nimble he is if we end up with a big selloff too quickly.” ”
Fact or Fiction? Here is a sector breakdown of the holdings of DBLTX as of the end of November: http://www.doublelinefunds.com/funds/total_return/statistics.html
Non-Agency MBS: As you can see from the sector breakdown for DBLTX, non-Agency RMBS accounted for ~35% of the portfolio as of the end of November 2011. While managing TGLMX, after the credit meltdown created the distressed-price opportunity in the non-Agency sector, Gundlach and his team invested ~50% of the portfolio in non-Agency RMBS. This fact was attested to by Morningstar in 2009 (a year for which Gundlach and the fund were nominated Fixed Income Manager of the Year and Fixed Income Manager of the Decade). A Morningstar analyst report on TGLMX (The fund Gundlach & team ran at TCW) by Lawrence Jones, dated January 7, 2009:
“Additionally, beyond the fund’s solid defensive characteristics, Gundlach and Barach sought to take advantage of steep price declines in parts of the mortgage market. Specifically, the team purchased higher-quality (currently AAA rated) nonagency mortgage securities (near 45% of assets) at price levels where management thinks the issues offer strong total return potential even with significantly added stress on the housing and mortgage markets.”
Tell me readers: Is a non-investment grade bond (BB or lower) “risky” no matter what? Little known to many, astute investors such as Seth Klarman, Kyle Bass and Daniel Loeb have been big buyers of non-agency MBS. The reason? A huge margin of safety exists. Draconian default and loss assumptions are built in before purchasing these bonds. Even if things get worse (DoubleLine stated they use a base case of housing declining ~15% further) attractive returns will still be realized. The catalyst of maturity is powerful, each dollar pre-payed is received at par. So if you buy a bond at $0.60 on the dollar and $0.65 is returned to you in addition to your coupon, that’s a pretty attractive return. It’s only “toxic” and “risky” to the person who holds it at par. If you compare these “Loss Adjusted Returns” to HY bonds for instance – one very key point may be missed. That is, HY bonds are being run to historically low default figures. Not an apples to apples comparison. When you build in such extreme scenarios into these bonds, it becomes difficult to lose – and outstanding risk/return profiles are created.
Fact or Fiction #2: DoubleLine holds large amounts of “esoteric” bonds. I obtained the following updated Agency CMO breakdown from DoubleLine Capital:
Inverse Floaters 6%
Principal Only 0.1%
Interest Only 0.1%
Inverse IO 3%
Z tranche CMO 15%
Other CMO 7%
Are these positions unprecedented for