Most Popular ArticlesJune 9, 2009
Although the yield curve is already at one of its steepest levels in history, Gundlach expects more to come. The steepness of the curve will reach “significantly new highs – out of context with historical patterns,” he said. The Fed will engineer and keep short rates at zero while the market will rebel against debt and fundamentals, forcing longer rates higher.
Gundlach favors the high yield market over the investment grade market, but he recommends investors avoid both as “a lot of juice” is out of the corporate markets, where he expects spreads to remain stable.
In the mortgage markets, Gundlach said government buying of mortgage securities is no longer able to keep rates low. The key 10-year Treasury rate has bottomed. “This is not good news for supporting the housing markets,” he said, and signals an increase in default rates.
The Case-Shiller housing index is down 30% since its peak, and loan-to-value ratios on many mortgages are now at 100%, since most mortgages were made with 30% equity. “The main driver of default rates is loan-to-value ratios reaching 100% or more,” Gundlach said. “We are at the cusp of a resurgence in default.”
Investors should not embrace reports that the rate of acceleration in the decline in housing prices has abated. As long as housing prices continue to decline at their current rate of 18%, trouble will persist.
Subprime defaults are leveling off, but this too is not as good a sign as a naïve interpretation would suggest, Gundlach said. “This only means there is equilibrium between new defaulters and existing defaulted properties being liquidated through foreclosure sales,” he said. Foreclose sales are 17% of subprime loans, which means defaults are also at 17%.
Uncertainties in the housing market continue to offer opportunities in the mortgage-backed securities markets, where performance depends not just on interest rates, but on prepayment, default, and loss-severity rates – and the timing of each rate. In this regard, Gundlach described an inefficient market, where investors can earn double-digit yields under very conservative assumptions. Overall, the market is overestimating the risk of future defaults.
In addition, Gundlach said mortgages historically perform well in inflation, because they have a lower effective duration than traditional bonds. “Long term interest rates will rise,” he said, but mortgages “will not get whacked.”
In the fourth quarter of 2006, the Case-Shiller index had fallen by one-half of one percent, and Alan Greenspan said the housing market had hit a bottom. At that time, Gundlach said that Greenspan “had lost his mind” and predicted that the housing market would bottom in 2010. “Now we are very much on track toward that bottom,” he said, adding that “the housing market will not come rocketing off the bottom.”
“We are only in the sixth or seventh inning of this crisis,” he said.
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