Gundlach’s DoubleLine: Worst Time Ever to be a Passive Bond Investor
This article was edited on September 9, 2020, to add a link to the slides from the webcast.
Passive bond funds – particular those that track the popular Barclay’s AGG index – offer the worst risk-return profile ever, according to Jeffrey Gundlach’s DoubleLine Capital.
Gundlach spoke to investors via a webcast, which he titled, “Hey Kid, Want Some Candy?” The candy theme was to suggest that what tastes good in the short term is not necessarily good for you in the long term. The focus was on his flagship total-return fund (DBLTX). Slides from the webcast are available here. Gundlach is the founder and chairman of Los Angeles-based DoubleLine Capital.
Gundlach’s co-presenter was Andrew Hsu, a portfolio manager for the total-return fund.
DoubleLine tracks the historical ratio of yield-to-duration on the AGG. This ratio shows the expected return (yield) per unit of risk (duration). Given historically low yields and an increase in the duration of the AGG over the past decade, Hsu said, “this may be the least attractive time ever to be invested in a passive fixed-income fund.”
Gundlach also said that high-yield bonds are the most overvalued in their history.
High-yield spreads are “crazy,” he said, when viewed in the context of the last two recessions. Those spreads typically rise prior to a recession and then continue upward. But in 2020, the front end of the recession saw the peak in spreads, and they subsequently contracted about 50%, due to Fed-injected liquidity.
Many junk bonds are priced in excess of their recovery rate if they were to default, according to Gundlach.
With the high-yield default rate at about 7%, Gundlach said there a solvency problem. “I am quite certain this rate will go higher,” he said.
Loan standards are tightening, he said, which has led to higher default rates in prior recessions. The high-yield default rate could be 10% to 11% a year from now, he said.
But tightening loan standards have not been matched by a rise in high-yield spreads as in prior recessions.
Gundlach provided data illustrating that large bankruptcies are accelerating. Companies with $1 billion of debt are going bankrupt at a faster pace than in prior recessions.
Despite this, flows to the JNK ETF, which tracks the high-yield market, have been strong over the last few months.
Yields on junk bonds are approximately 2.35% and are near historical lows.
The economic outlook
Gundlach’s overall view of the global economy was that the worst may be just behind us.
Global trade volume has been very volatile, he said. It declined in the same way as it did during the global financial crisis. He follows the South Korean stock market because it is extremely sensitive to exports, and because it is a “good read” on trade prospects. It is up nearly 10% this year, he said, indicating global trade has bottomed out.
U.S. GDP looks like it will be -5% and global GDP will be -3.9%. That forecast is supported by data from the New York Fed, he said. He called the forecast “strange,” because the U.S. fiscal and monetary response has been one of the strongest in the world. The U.S. stock market has done a lot better than global markets over the last 10 years, even though its economy is growing slower than the rest of the world.
That dissonance should inform investors’ asset allocations, according to Gundlach.
Based on the leading economic indicators (LEIs), there has been a huge economic collapse, mirroring the global financial crisis. The LEIs went very sharply into recession mode earlier this year, after deteriorating slowly for a couple of years.
The non-manufacturing Purchasing Managers’ Index (PMI) is 58.1, which he said is “really high,” indicating it is expanding from a “big hole that was dug at the start of the pandemic.” The manufacturing PMI is 56.
Data for weekly hours worked showed weakness prior to the pandemic, and then it had its lowest reading ever once the pandemic unfolded. “It has not rebounded strongly,” Gundlach said.
Consumer confidence “fell off a cliff,” he said, as it did when the dot-com bubble burst. It is not at a record low level, but it reflects the view that government subsidies will be going away.
He compared real-time to expected consumer confidence, and it shows that the view of the future is substantially worse than that of the present. “But it can flip very quickly,” Gundlach said.
“There will be headwinds for the economic recovery,” he said. He believes the equity market rally from the March lows doesn’t reflect the economic outlook. “Straight-line market movements were out of sync, and that was reflected in the recent equity market downturns.”
“This should be expected as we restart the economy,” he said. “There will be surprises.”
Are we coming back from the lockdown?
Gundlach surveyed a number of metrics indicative of how the U.S. economy is emerging from its lockdown.
Office occupancy rates have not improved from their pre-pandemic levels, he said. They dropped in March and have been stable ever since.
Remote jobs are heavily concentrated in large-population areas. Overall, 37% of all jobs are now being done remotely, but that rate is higher in big cities, including Chicago, Los Angeles, New York, Boston and especially San Francisco.
The TSA data for airline traveling is down about 60% from its level a year ago. There had been some increase in that rate, but it has ceased.
Hotel occupancy has dropped off like it did in 2009, Gundlach said. It has come back because of seasonal factors, but not all the way back to pre-pandemic levels.
OpenTable data for restaurants has improved slowly to about 60% of pre-crisis levels.
RealClearPolitics data shows that confirmed coronavirus cases have tracked Trump’s approval rating, Gundlach said. He still believes Trump will prevail in the election, provided there is not a spike in virus cases.
The race for control of the Senate looks like it is a “dead heat,” he said.
The impact of federal giveaways
Gundlach looked at the size and impact of the fiscal stimulus programs enacted this year.
Real disposable income has been “pumped up” by $3 trillion, he said. “Those government programs make 2008 look like child’s play.” Government spending has gone mostly to large and small businesses.
He said that even a $300 unemployment payment would replace half the income for many of its recipients. The $600 program was generous and the $300 plan may continue to dis-incentivize people from looking for jobs.
But consumer spending increases have not translated to revenue for small businesses. Many small businesses have gone under, he said, citing anecdotal data from his local coffee shop and dry cleaners. “There are legions of small business about to go under if the lockdown continues,” Gundlach said.
All this has resulted in a spike upward in the money supply, but monetary velocity has gone in the opposite direction.
The consequences of the giveaway programs show up in the deficit, he said. The deficit is now 15% of GDP. “This is one for the record books,” he said, “and it is very hard to see how we will get out of this situation.”
The debt-to-GDP ratio is 126%, higher than the last recession and during World War II.
Gundlach noted that the Fed is buying TIPS, and now owns about 18% of the TIPS outstanding. The TIPS market is small and the Fed is driving real yields down. “This is at odds with economic fundamentals,” he said. “The Fed’s activity has manipulated the TIPS market and made nominal bonds more attractive.”
He also noted that the Fed has not used many of its programs, including ones to allow it to purchase commercial paper and mortgages.
In addition to his uninviting outlook for passive and high-yield bond funds, Gundlach discussed valuations in other sectors of the fixed-income market.
The leverage ratio among U.S. bond issuers has gone from 2.0 to 3.5, with junk bonds going from 3.5 to 5.2. That 50% increase should mean higher compensation for corporate bond investors, but that is not the case, Gundlach said.
Flows into the investment-grade ETF LQD have risen non-stop since March, when the Fed started buying those ETFs. As a result, a “disease” of low yields is crippling investors, according to Gundlach.
Investment-grade spreads spiked at the start of the pandemic, as they do in most recessions. But once the Fed started “jawboning,” he said (in reference to its program to support the bond markets and buy ETFs), the spread decreased and is now near its historical average.
The investment-grade bond market is rated by the agencies “way lower” than it has been historically. The share of the market that is BBB relative to junk bonds has gone from 100% to 200% to about 250%. The risk is that the junk bond market could be overwhelmed by downgrades and “capsize,” he said.
We are on a pace to set a record for investment-grade bond offerings. “Why wouldn’t companies offer debt at 2% for risk?” he asked rhetorically.
Downgrades have already started to happen. The percentage of fallen angels (investment-grade bonds downgrade to junk) has gone from near 0% to about 12%.
Bank-stock funds have had outflows, he said, reflecting the low-rate environment. But prices have recovered a lot – an enigma – explained by the fact that those loans yield about 4%.
In the CLO market, the top-rated deals have recovered to pre-pandemic levels, but lower-rated tranches have not. The market is saying that AAA and AA CLO tranches have no risk, but Gundlach said there are better opportunities.
Since February, there has been an “incredible correlation” between high-yield credit-default swaps and the Russell 2000. This is a risk-on concept, he said, showing the distortion in the high-yield market. The high-yield market is driving the Russell 2000 higher, indicating that it is also overvalued.
The party’s over
The party that was the strong U.S. equity market may have ended a week ago, Gundlach said.
The S&P 500 is the most overvalued relative to GDP in history. Since early July, the FAANGS plus Microsoft have been underperforming the S&P 500.
“The generals have abandoned the battlefield ... maybe,” Gundlach said.
“When that move no longer shows leadership,” he said, “it is something to pay attention to.”
The S&P 500 P/E ratio in “nosebleed territory,” he said, near its 1999 levels. The forward P/E has matched the level preceding the dot-com bubble.
The Shiller CAPE ratio looks like it did in 1929, and is only surpassed by the dot-com level.
The issuance of special-purpose acquisition companies (SPACs) has exploded, he said, which is a warning sign of “imprudent behavior at the party.”
The last six months have seen the greatest expansion of P/E multiples ever.
Retail investor activity is “downright terrifying,” he said and, when viewed by investors like him who have experienced multiple cycles, is a “terrible sign.”