CRE Finance World magazine is pleased to have the opportunity to interview Jeffrey Gundlach, CEO and chief investment officer of DoubleLine Capital, for its feature cover article. Mr. Gundlach is widely recognized as one of the foremost experts in fixed income investments. He is referred to by many as “The New King of Bonds” — taking the mantle from former PIMCO manager Bill Gross. DoubleLine’s assets under management are over $76 billion. This includes significant allocations to commercial mortgages and CMBS B-pieces. Mr. Gundlach shares with us his analysis
and insight into the reality of the markets, world economies, and monetary and fiscal policy. We are deeply appreciative to Mr. Gundlach
for sharing his thoughts with us. The interview took place on December 7, 2015.
Stephen Renna: Thank you for joining us. I appreciate your taking the time to talk with us about your market outlooks and insights into managing risk and generating return.
Jeffrey Gundlach: Happy to do so.
Stephen Renna: The United States’ economy has been growing
modestly. Europe and Asia are near recession. What is your
outlook generally for these economies and their relationship
to today’s investment environment?
Jeffrey Gundlach: The trend has been solidly in place now for the
last few years. Entering each new year, global economic growth
forecasts have come in higher than actual growth ends up by
year-end. That pattern is so persistent that it’s starting to become
Every year, if you go back to what the guess was for 2013, back when the guess was made in 2012, the global economy was supposed to grow at like a four and three quarter number, and it came in a percent and a half lower than that. And then 2013’s–2014’s guess started out a little bit less optimistic. It was downgraded by the same amount when it was finally realized, and that continues to be the pattern.
What’s different is every year, the guess or the hope for the coming year keeps coming down, and yet as that year unfolds, you get still the same type of downward revisions. So we’ve already started with the guessing for 2016, and the estimates have already been downgraded even before the year has started. So we’re looking at a global economic growth rate which is obviously lower than people wish for or are accustomed to.
This slower growth rate is being driven partially by demographics, which are powerfully negative in parts of Europe such as Spain and Italy, and in Asia. For example, Japan, which has suffered negative for years, now is being joined by China. And Russia has horrific demographics, actually worse than anyone else in the world.
These demographic headwinds overlay an over-stimulated economy
encumbered with tremendous debt growth over the past multiple-year
timeframe. Very stimulative interest rate policies in the developed world have served only to bring investment returns and economic growth forward. Bringing growth forward means borrowing it from future economic possibilities. This is why economic growth keeps suffering downgrades with the passage of time. And, obviously, the area that has been of maximum scrutiny for the last few years as a candidate for underperformance has been China.
Now rather than being a worry, economic underperformance is an observed reality in China. Why? Because the investment-based boom that was used to always stabilize the Chinese growth rate at a very high level like 8% is no longer practical. The magnitude of infrastructure development has been so vast. Today, with the Chinese population no longer growing as the consequence of a generation or two- of one-child policies, China doesn’t need to build more airports or cities or roads.
And so, understandably and appropriately, the Chinese officials have
decided they need to transform the economy from this investment-based
boom into a consumption-based economy. But not surprisingly, this transition is difficult to execute properly, and certainly it cannot be done perfectly. And so, after an enormous boom drove the Shanghai composite 2,000 to 5,000-plus over about an eight-month period, the whole edifice came crashing down.
I think global economic growth is unlikely to get kick-started because so much of this growth was borrowed from the future with aggressive stimulus and indebtedness. The durable result is a global growth rate which is so low that the dispersion of individual countries’ growth around the mean results in significant economies now being negative. Take the example of the largest economy in South America: Brazil has been running for three quarters in a row of substantially negative year-over-year GDP growth, and the forecast is for more of the same. And in countries suffering from shrinking economic output, not surprisingly there are calls from the local populations to do something. Unfortunately, there’s not
enough global economic growth to go around. So “do something” ends up meaning currency devaluations around the world. And the currency that everybody is devaluing against is the dollar — and everything that is pegged to the dollar.
The dollar has appreciated 25% on a trade-weighted type basis since the middle of 2014. We are facing the consequences of that. Specifically, the United States has been importing disinflation while other countries implement currency-debasing policies in an effort to take a greater share of exports from the U.S. This is why interest rates are so low. There is not enough global inflation or economic growth. The U.S. in particular has had a really hard time getting the inflation rate up to what the Fed defines as, ironically, price stability.
By the way, in my world, price stability means zero inflation, no inflation, no disinflation, no deflation, it’s just zero. I mean, price stability is the price of bread is $1, and it stays at $1. The Fed defines price stability in a strange way. They say price stability is 2% inflation per year. So by logical extension, they say price stability is to cut the value of the dollar in half over a 36-year period. Extend that idea over a human lifetime. The Fed defines price stability as an 80% decline in the purchasing power of the
dollar over a lifetime. I call that, inflating away the dollar’s value, but they call it stability.
The Fed is having a really hard time achieving what they call price stability. Plenty of inflation measures are at zero. These include “headline” inflation measures, which include energy. If you strip out
energy and or you look at the Personal Consumption Expenditures index deflator, the core rate the Fed likes to use, these measures show declines in the rate of inflation — in other words, disinflation — on a year-over-year basis. The PCE is lower today than it was in September of 2012 when the Fed began QE3, and it’s lower now than it was in June of 2014 when they started tapering QE3. Whether you’re doing QE or tapering QE, the inflation rate has been lower than — and trending lower. You know, if you look at what might drive the Fed to do things, obviously, there are many
indicators like interest rates, like the unemployment rate, like the stock market being high, all those things. But the inflation rate is not responding like the Fed would want. And with the dollar pretty much near its all-time high, which was set in March, it’s not likely they’re going to get that inflation to come back.
It’s funny; there are various estimates of the potential growth rate of the U.S. economy. The potential of the U.S. economy from the Congressional Budget Office is something like a 2.5% growth rate. The Fed’s estimate is much lower than that. A few years ago, the Fed deemed a 2% growth rate to be below potential. Today the U.S. is still growing at 2%, but the Fed has ratcheted down their forecast for potential to a one handle. So by moving the goal posts, the Fed is able to say: “we’re growing faster than potential.” The actual growth rate hasn’t changed, it’s just the Fed’s definition of potential, which, of course, is extraordinarily arbitrary and squishy.
I’d add that methodologies for estimating the potential growth rates of economies are best taken with a dose of skepticism. Economists stuff a whole bunch of variables into their computer, and out comes some number based upon past coefficients and correlations. But the world is always mutating, so these backward-looking models don’t work very well.
Things haven’t really changed very much, but the way in which people choose to perceive them has changed. No doubt the U.S. economy’s failure to get back to the 3%–4% growth rate we used to think was long-term achievable is behind the seemingly orchestrated perception shift.
Stephen Renna: What are your thoughts on the Fed raising interest rates at this time? I know in the past you’ve been strongly against for all the reasons you just outlined.
Jeffrey Gundlach: Yes. I think absolutely nothing has changed except that employment has stayed stable at a decent level now for a few years. Employment is certainly growing. It’s been about 200,000 per month with volatility, of course But the big red flags against raising interest rates are credit spreads. The prices of junk bonds are at multi-year lows today. They’re vastly lower than they were in September of 2012 when the Fed started QE. The spreads to Treasuries on investment grade corporate bonds are at levels where the Fed has never raised interest rates before. Commodity prices are at a 14-year low. They’re dropping like a stone. You’ve got oil today at 37 handle. That’s pretty low.
If inflation is part of your thought process, it’s fine for the Fed people say: “well, there are lags so, inflation might be about to put in a V bottom, and it could be headed higher, and if we don’t do something, we’ll be behind on the inflation rate.” I understand that argument, but it would be important to identify some evidence that’s underneath that argument. That something has changed and junk bonds are at the low of the year right now and much lower than they were anytime during 2014, commodity prices have crashed over the past year and, of course, that goes hand in glove with the dollar being up an awful lot.
The inflation-based indicators, the undeniable stress in sectors of the corporate economy and pricing in the junk bond market, all of these argue against the raising rates. But the Fed isn’t really making an argument based on data — regardless of what they say about data dependency. They simply want to be off zero. The data haven’t changed since the Fed declined to raise rates in September and again in October. What’s changed is they’ve decided to try to talk investors and markets out of overreacting. “Please don’t freak out, investors. Please don’t have a fit in the financial markets.” They’ve talked a lot about raising rates, without causing a fit in the equity market, so they think that the coast is clear to raise rates. There’s another aspect to the prolonged jawboning about raising rates. They must worry that the Fed risks becoming the boy who cried wolf and lose credibility if they don’t follow through. So they’re going to raise rates unless the markets freak out.
Now, what’s curious is, the markets that I have already referenced — commodities, including oil, and junk bonds — are fully freaking out. Leveraged money loaded up to the gills on a credit overload from a year ago. They’ve been freaking out for a year and a half. New bank loans are issued at around $0.99 on the dollar. An index constructed by Standard & Poor’s of the 100 most liquid names is trading with an 88 handle today. That’s down 11 points from date of issue. That’s a huge decline, one which cannot be attributed to interest rate fears because the index constituents are floating rate loans. People are avoiding bank loans due to fears of a credit overload being followed by sustained low commodity prices, a
development that threatens rising default rates.
Now the default risk is more concentrated in junk bonds than it is in bank loans. The latter are higher up in the capital structure, and the energy sector is less involved in bank debt than in high yield bonds. So if you’re at the Fed, you’ve got to ask yourself a question: with bank loans and junk bonds tanking in the past 18 months, why you don’t think of that as a signal? Well, I guess it’s because equity markets are more visible. So I think the Fed is going to raise rates, and if they do, as I’ve said all year, they will do so for philosophic reasons as opposed to fundamental reasons. They want to prove that they aren’t manipulating the markets and that they have some objectivity. And they want to avoid becoming the boy who cried wolf. They’ve said all year they’re going to raise rates in 2015. They want to do it so they say, “See, we did what we said we were going to do”. The Fed thinks that the markets have calmed down to the point where if they raise rates and if they talk gently enough about the
future, then the markets will continue to cooperate. That’s why they think they have a window.
Stephen Renna: Well, obviously, you’re not particularly sanguine
about the Fed strategy, and I do recall former Fed Chair Bernanke
often saying in news briefings that we can’t do it all with just monetary policy. So the Fed’s basically shot all its bullets from a monetary standpoint. Bernanke also would point to the fiscal side of the equation. The question I’m getting at is what do you look at as the way out of this low growth cycle with very accommodative monetary policy?
Jeffrey Gundlach: I think you’re going to see louder cries for fiscal
stimulus. You’re seeing it in Europe for sure. You had a fellow named
Wolfgang Munchau write an op-ed piece in the Financial Times saying that QE isn’t really that effective anymore because there aren’t enough bonds for investors to buy. I could go on for two hours about how weird that logic is. So they’re saying instead, the ECB should send every single person 5,000 Euros. Just send them money. And he said if that doesn’t work, we should send another check for 5,000 Euros.
This is a legitimate person in a legitimate publication. We’re not talking about the Onion or Mad Magazine. We’re talking about the Financial Times, and they’re printing, giving respect to this idea that the Central Bank should just send people money. And we did that already in the United States. We did it twice. It wasn’t 5,000 Euros, it was $500. That was George W. Bush who gave most citizens $1,000 over like a one year period, and that amount was too small to move the needle very much because conditions were too tough at that time. But now people talking about 10 times that twice in the Eurozone. And today, there’s an article that somebody — and I think it’s Finland — says that they should give every citizen $10,000 a year as a basic income stipend.
Now, the budget deficit in the United States has gone way down from the horrific levels that we saw in the credit crisis where you had 10% of GDP just about in the budget deficit. Now, its way down, GDP is bigger and the deficit is down to a $400 billion handle. And so, you have vastly lower deficits. The deficit represents only two point something percent of GDP. I could imagine there could well be some talk about increasing fiscal stimulus.
In fact, some people advocate raising policy short-term interest rates as a sort of through-the-side-door means of fiscal stimulus. They say the Fed raising rates would help the economy by increasing money going to savers and, therefore, effecting in essence a transfer of money from the Treasury to savers. In the process, the government would increase the budget deficit to pay the additional interest. The problem is, giving money to savers is not going to support the economy. Do you know why? They’re savers. They have savings. If they were inclined to spend their savings, they’d be spending their savings. Giving them a little bit more return on their savings is very unlikely to move the needle very far in terms of consumption. In fact, I would argue that the incremental return would act as a disincentive to spending savings because savers would want to continue enjoying those better returns.
A much more effective approach, although a little bit radical, would
be something along the lines of the Munchau or Finland proposals.
Borrow money, thereby increasing the deficit, and give the cash to people who lack savings, to people whose incomes have been falling, people who are having a hard time making ends meet. I’m not advocating that be done, but your question is what can be done, and that’s something that could be done. Furthermore, if you did it at a high enough rate in a high enough magnitude, you would ignite inflation. To illustrate, let me use a facetious, hyperbolic metaphor. What if the Federal Reserve sent everybody $1 billion today? The United States would have enormous inflation. Imagine the lines at the BMW dealers if the prices of the cars were left unchanged. So we know how to get there. Now the problem with
fiscal policy — as with monetary policy — lies in execution — if you believe in central planning, that is. When I was in elementary school, we were lectured about the evils of central planning. Those were the days of the Cold War, and the communists did central planning. But for the sake of argument, let’s say you believe in central planning. The problem is you must get it exactly right. Central planning is a very blunt instrument, and yet you have to buy into the idea that you have scalpel-like precision with it — and, of course, you don’t.
I’m a bit surprised that we haven’t heard more of a call for fiscal stimulus. You have started to hear it. For years, it was watch out for the deficit. The deficit is bad, we’re harming our children, grandchildren. But guess what, this year, I’ve heard loud and clear a candidate with double digit support, even up to 30% support in the Democratic base, calling for a radical increase in the deficit, that’s Bernie Sanders. Rather than being booed out of the room or laughed out of the room, he’s actually managed to capture about a third of the party. So some support exists for fiscal stimulus.
However, the federal government has run deficits for so long that the cumulative debt is pretty big. So much of the electorate is still allergic to the idea of aggressive fiscal stimulus.
Stephen Renna: Shifting gears a little bit to the bond market. We’re hearing, not necessarily in the CMBS sector, but in the bond market more broadly, concerns about illiquidity. What is your view on this? And if you do feel that the market is illiquid, and if so, what might be driving that illiquidity?
Jeffrey Gundlach: Well, regulation is driving illiquidity. It’s the pullback
of participation from broker-dealers because they’re being heavily regulated in terms of capital. They can’t play the same type of role that they did 10 years ago. And when you see news stories day-by-day, you know, such as Morgan Stanley cutting 20% of fixed income trading, this firm exiting certain sectors of the market entirely, it’s because of regulation. This topic has been very much in the news for about 18 months now.
I actually think it’s kind of normal for bonds to be illiquid. What’s
unusual is the amazing amount of bond trading that went on 10 years ago. Bonds used to be a buy-and-hold investment class. They were owned by annuity providers and insurance companies. Fifty years ago, institutional holders didn’t even bother to mark their bonds to market. There wasn’t any market. You just bought bonds, and the beauty of it was that after whatever the maturity is, this comes due and you reinvest it — a sleepy old way of traditional investment. The onset of volatility of interest rates in the late ’70s ushered in an era of tremendous amounts of bond trading all the way up to probably 2009. That three-decade period of hyperactivity, I think, was actually rather abnormal for bonds.
Bonds are about building a portfolio, earning it out, reinvesting at
maturities and, sure, when a credit is about to really turn sour or if it gets really, really highly bid, maybe you want to hit that bid. But a bid being high means you’ve got liquidity at least for that moment. That’s the definition of liquidity; someone wants to buy from you. If someone wants to buy your holdings for a very high price, you may as well sell it to them.
Bond fund managers who fret about liquidity probably use strategies
that depend on high-frequency trading or at least run portfolios with
high turnover. At DoubleLine, we’ve never been very concerned about bond liquidity, or lack thereof, because we run incredibly low turnover bond portfolios. The DoubleLine Total Return Bond Fund, our flagship fund, if you will, has a turnover of about 10% a year. We’re kind of old school in that regard. I think it’s kind of weird that bonds ever had liquidity.
I have a whole soapbox about liquidity. It’s really a false term. It’s
one and the same as volatility. Is Tesla stock liquid? If you say “yes,”
I would point out that that stock changes 10% in price on a daily
basis with some frequency.
Anything that changes 10% in price over the course of a day, by definition, to me is illiquid because you have no ability to predict what price you’re going to get. In the case of bonds trading, okay, let’s say I thought I was going to get 98 but ended up getting a bid of 97. That’s being termed as illiquidity. In the old days if I get 98 and you got 98, so getting 97 is less liquid, but bonds are about the most liquid thing out there just because they’re among least volatile things.
Now, true illiquidity in a bond market prevails in thinly traded categories — for example, small names of second-tier energy companies these days. Nobody knows where these bonds really trade because there isn’t any observed activity. And if something bad happens in the news to one of those credits, the bid is down 20 or 30 points the next day because nobody really knew what the clearing level was; that mark-to-market was an illusion.
You could say the same thing though about any stock that misses big on earnings. Look at Chipotle, the thing dropped like 18 — this is a multibillion dollar company and it drops 18% in five minutes because of one little statement.
People like to pretend that they live in a continuous world and that financial asset prices move in a continuous way, but we live in a highly discontinuous world, and the financial asset prices are discontinuous. In the mid-00s, people were spoiled by an absurd level of liquidity in the bond market, which we’ll probably never see again.
Stephen Renna: Interesting. Thank you. I did want to ask your
view on investing in real estate debt versus other fixed income
opportunities. What you think about that?
Jeffrey Gundlach: If you’re going to invest in credit in the bond market, for sure you should be in real estate credit. Furthermore, you should be invested in real estate credit to a much greater extent than in corporate credit or emerging market credit because the evils that are plaguing the credit markets are commodity price-related and deflation-related and mostly in materials and productive commodities.
Real estate has experienced zero deflation in the past several years. If commodity prices stay where they are — forget about going lower — if they just stay where they are, that would mean a forward calendar of rising corporate defaults. That’s what the junk bond market is telling you, that’s what the loan market is telling you, that’s what emerging markets are telling you. It’s one thing if oil goes from 100 to 40 to 80; it’s another if oil goes from 100 to 40 to 40 to 40 to 40 because 40 is a money-losing level for a lot of companies.
They’re playing beat the clock: “How long can I wait this thing out?” You can’t blame these companies, hedging costs a lot of money. To hedge your book back in 2013 against $40 oil cost a fortune, and understandably nobody hedges out for 10 years. We’re now in year two of oil being really low, and if it stays at these prices into year three, so 12 months from now, the defaults will be inevitable and on the rise — a scenario that’s going to cause distress in the system.
However, in mortgage real estate debt, if it’s residential mortgages, it’s all good. The home prices have gone up, the lower commodity prices put a small amount of money into the homeowner’s pockets, so they’re more likely to make their mortgage payments.
Commercial real estate has benefitted from the growth in rental units, which have been in very high demand. There’s been a lot of pricing power on rents, which is unfortunate for the renter but pretty good for the operators of commercial real estate.
CMBS is really remarkable for the yield spread available by credit quality. BBB rated CMBS, the lowest tier investment grade, yields 7.5% to 8% today. For a 10-year security, that’s unbelievably high versus what you have in a basket of BBB rated corporate bonds in the 10-year category.
Despite the much higher yield, I would argue that the CMBS market entails less the risk. You’re capturing more yield with less risk because the risk variable of low commodity prices is far less of an issue in the CMBS market. The CMBS market is on its lows. It’s nowhere near as weak in recent weeks as the junk bond market, but it’s on its wide spreads simply because of supply. There’s been a lot of supply. Of course, the year is coming to end, so that’s going to dissipate. The beautiful thing about CMBS really is that here we went through a large-volume market issued in ‘06 and ‘07 that suffered through the Great Recession, suffered through a banking crisis, and yet it survived pretty well.
There were white knuckle moments for sure in that market because it was a highly stressful environment. And the market pricing and the market structuring continues, not surprisingly, to have bad memories of the fears that were prevalent six or eight years ago.
Subordination levels have increased and underwriting is a little bit better than it was, and yet the default rate through that crisis wasn’t that bad. So we’ve been viewing CMBS as one of the best opportunities in the fixed income market. Where you’re able to pick up credit spread but it in a way that sidesteps the major issues facing the credit market.
We kind of call securitized bond investing, “hard assets for hard times.” It’s hard times in the manufacturing sector, it’s in a recession. It’s hard times for the commodity producers, but we have hard assets underneath residential and commercial mortgage-backed securities, and yet the hard times don’t really affect them so much.
The residential real estate category has seen little new issuance, but there’s still $700 billion of legacy securities. That highly seasoned market is utterly immune, I think, to the problems in the world today because the fundamentals have been improving for the underlying credits as opposed to deteriorating.
Stephen Renna: I want to stay on the theme of CMBS because Double Line has bought I think in 2015 six B-pieces.
Jeffrey Gundlach: Probably more than that but, yes, but we’ve been buying B-pieces, yes.
Stephen Renna: What’s your view of investing in B-pieces and particularly in the end of 2016 when risk retention gets implemented,
and a lot of the burden of having to fulfill the risk retention
requirement will be on the B-piece buyer?
Jeffrey Gundlach: Yes. It probably will. And I think that on the horizon
is already affecting investor behavior. B-pieces require a lot of work. There’s different ways of investing in fixed income. You can find ways to do it where credit research and credit experience are less necessary or helpful. And then you go to B-pieces where they are essential. It’s critical to have people who are experienced and dedicated to understanding and following the loans and modeling out the cash flows. But this is a category where you get paid for that, and we think that, by far, the highest risk-adjusted returns in the fixed income market are in B-pieces and CMBS if they are priced properly.
We’re not just going to buy B-piece assets indiscriminately. If you buy them at the right moment when there is a little bit of fear in the market or a lot of supply, I think loss-adjusted returns in the teens are pretty easy to obtain — and with a higher probability in the CMBS market than, say, in energy bonds where you could get 15% returns if everything works out — but it’s a very binary outcome.
I think you’re right, that risk retention creates a scarcity of capital for the lower end of capital structures. That means that those things should incrementally stay cheap, if not get cheaper. That’s one of the reasons why CMBS broadly is being dragged lower. If you have a scarcity of capital, you’re going to have to increase the potential return to attract that capital. That means that the whole underlying asset has to be a little bit lower in price.
Risk retention without any doubt is going to put further stress on the credit market and — which is another reason why it’s curious that the Fed wants to raise interest rates. Maybe they’re scared to death that if they have to raise them in 2016, they’ll have a real perfect storm on their hands with the onset of risk retention perhaps coinciding with a perception of Fed policy being behind the curve and who knows what else. So I do think that risk retention will create further concerns and, therefore, opportunities in the lower parts of the capital structure of securitized assets. It probably will be more interesting to be a larger buyer, but this opportunity is already quite good. It’s just a question of how good it ultimately becomes.
This reminds me of some things that were happening in ‘07 into ‘08 where the prices were perfectly low enough on RMBS assets in the middle of ‘08, but they got a lot lower because there was a scarcity of capital, then because of ratings downgrades. But we were buyers all the way through once it reached a good-enough level because we’re more than happy to add substantially more to the position if the value becomes even more compelling.
The good thing is we manage a lot of money, about $85 billion. If we wanted to put a really big trade on in CMBS B-pieces, we would be talking about billions of dollars. We can’t wait until we think it’s the optimal minute of the optimal day because there’s no way we’d be able to accumulate anything close to the aggregated position needed to make a meaningful contribution to our portfolio positioning.
We bought RMBS pretty much constantly from March of ‘08 until June of ‘09, and there were a lot of different processes along the way. But all of those trades turned out to be homeruns, and I would say that if you started that program in CMBS B-pieces, with the right approach, the right resources, the right staff, you would have the same type of opportunity to average into pretty high returns.
Stephen Renna: This has been extraordinarily interesting. I know our members and others in the CRE finance industry are going to be very excited to read your thoughts and reflections. Thank you very, very much.
Jeffrey Gundlach: I enjoyed it. Good luck to your readers.