Jeffrey Gundlach turned defensive on the U.S. bond market at the end of January, almost precisely when yields were at their lowest point. Whether his outlook changes hinges on the direction of the 30-year bond and if it retests its low yield of 2.45%.
Gundlach is the founder and chief investment officer of Los Angeles-based DoubleLine Capital. He spoke to investors via a conference call on April 7. Slides from that presentation are available here. The 30-year bond closed at 2.52% on the day he spoke and closed at 2.58% on Friday.
“We are at a pivotal point in the market,” Gundlach said. “If the 30-year Treasury can find its way below 245 again we will see the other part of the bond market rally as well.”
He added, however, that if it fails to go below 2.45%, then investors should expect “choppiness” rather than a trend. He reiterated his base-case forecast for the bond market, which is that will close the year roughly where it began.
“I’m not really looking for higher interest rates,” Gundlach said. “I don’t really see any fundamental reason why they should be higher.”
“I wouldn’t be surprised if interest rates on Treasuries ended the year similarly to where they started,” he said. “Short-term interest rates will probably have a hard time going down from here. They have dropped so far this year, and I really don’t see them going lower.”
Gundlach devoted most of his talk to an assessment valuation in various sub-classes within the fixed-income market. Let’s look at which sectors he said were over- and undervalued. I’ll conclude with his forecast for actions by the Fed.
Bond market valuations
To measure relative valuations within the bond market, Gundlach and his team at DoubleLine have been using a methodology they originally developed about 20 years ago. He did not discuss the underlying specifics, but the result is a graph that shows the fair value for each type of bond over time, on a total-return basis, along with bands that depict one- and two-standard deviations of over- and undervaluation.
For example, here is the view of the investment-grade bond market, showing that it is approximately two standard deviations above fair value:
“This is truly one of the most overvalued periods using this analysis for investment-grade corporate bonds,” he said. One reason, according to Gundlach, is that these bonds have a high duration, which drove their prices higher during the last bond-market rally.
The methodology incorporates an assumption about the default rate, which is just below its long-term average. But investors should not take much comfort in that, he said, because default rates have historically been bipolar – either very high or very low.
Most defaults occur in the high-yield market, about 20% of which Gundlach said is now “distressed,” mostly because of the effect of low oil prices on energy bonds. Historically, he said, there has been a high correlation between those bonds that are classified as distressed and subsequent defaults.
Gundlach is not worried about imminent defaults or downgrades in the high-yield market, but “one of the things we are going to be thinking about as we move forward managing money for the next three- to four-year horizon is the timing of the next credit cycle.”
High-yield bonds, which were at their most overvalued point in history at the end of 2013, are now fairly valued, according to Gundlach. He said that investors should not expect to make money in high-yield bonds over the long term; one has to be mindful of valuations to determine entry and exit points. Now is a good time to invest, he said, because very few bonds will mature over the next two to four years. The bulk of maturities begin in 2019, which is when Gundlach predicted a problem, particularly if rates rise and companies cannot refinance their debt.
“The real question will be if rising interest rates come our way and they come because of inflation or because of improved economic prospects,” he said. If it’s the latter, companies could have sufficient cash flow to meet their debt-servicing needs.
He cautioned that the high-yield market has never faced a rising-rate environment, and investors have little historical data on which to base forecasts.
According to Gundlach, leveraged loans are “kind of overvalued” and less attractive than high-yield bonds. That sector, he said, also faces a surge in maturities in 2019 and 2020, which could exacerbate refinancing problems in the high-yield market.
Government-guaranteed mortgages (GNMAs, FNMAs and FHLMCs) are fairly valued, Gundlach said.
Convertible bonds look “really scary,” Gundlach said, in part because equity valuations play a big role in their assessment. The last time convertibles where this overvalued, he said, was in 1999; but then they proceeded to become more overvalued.
At their current valuations, convertibles – and hence the equity market – would experience a “pretty substantial correction” if valuations “break down” from their current level. That, he said, is true “broadly in risk assets. With margin debt at a historically high level, he said that a 10% drop in equity prices could trigger a bigger, downward move.
“When you do get the drop I think it is not going to be a small drop,” he said.
Emerging-market debt is fairly valued, according to Gundlach.
Likewise, Gundlach said TIPS are undervalued. Inflation is not an issue, he said, even though the “downward pressure” from commodities has abated.
Viewed on a pre-tax basis, some munis are undervalued, said Gundlach. He expects those to outperform comparable Treasury bonds. He said Puerto Rican bonds are “pretty cheap” and yield over 10%.
Gold, he said, is going to $1,400 this year for three reasons: “the charts,” “the sentiment positioning,” and “enormous” buying by central banks.
Gundlach expects the dollar to go higher over the long term, on top of the 25% increase it has experienced in less than a year.
“I do think the dollar ultimately goes higher, and if it does the Fed won’t be able to raise interest rates,” he said.
Will the Fed raise rates?
As he said in his conference call last month, Gundlach believes the Fed is “philosophically” inclined to raise rates in June. Even though the April employment report was weak, as was data on retail sales and existing home sales, Gundlach said that other “real-time data” was improving.
The consensus is that the Fed will raise rates in September, he said, but it’s still possible that the increase will come in June. Part of the reason, he believes, is that the Fed wants to have some room to lower rates if the economy should weaken or go into a recession.
If the Fed raises rates in three or more incremental steps, as some predict, Gundlach said it would be forced to retract and lower rates again.
“One way or the other the Fed wants to get off of zero,” he said.
Read more articles by Robert Huebscher
