June 25, 2010

Weekend Interview: Bond Fund Guru Jeffrey Gundlach

Question: Are we in a depression? Answer: Definitely.

Jeffrey Gundlach, founder of DoubleLine Capital and former CIO of Trust Company of the West (TCW) gave the keynote address at the Morningstar Investor Conference on June 23. He sat down with Wealth Manager Editor in Chief Kate McBride in Chicago that day to talk about his outlook.

Wealth Manager: When we spoke earlier for a podcast, you'd mentioned the giant bond funds using derivatives with or instead of holding the underlying bond securities. Would you talk about that?

Jeffrey Gundlach: The bond fund industry is dominated by a few big firms, PIMCO, BlackRock, Western, Vanguard, American, Dodge & Cox, and Loomis Sayles. The mega funds use synthetic strategies--anyone with more than $200 billion.

They can't really buy real bonds anymore--there aren't enough in the marketplace, and [the issue is] counterparty risk. The investor gets no payoff for the counterparty risk--so why take the risk for no payoff? Firms get the scale, and monstrous fee income and investors take the risk.

Nobody has been able to explain this to me in a way that makes me comfortable. In bonds there's a $600 trillion shadow market in a world that only has one-tenth of that in actual [underlying bond] assets. The total value of the bond mutual fund market is bigger than the total bond market; it's leveraged 10 to 1. The [counterparty] risk that showed up in September '08--Lehman--investors should get some payoff for that.

In September '08 if you had marked counterparty risk to market--what it would actually trade at--there would have been a run on the industry. No one will talk about it.

WM: So was it that mark-to-market wasn't done?

JG: It's possible mark-to-market was suspended on a special case basis--too big to fail.

And reference notes, derivatives that refer to real securities, create leverage beyond what is in the economy: there is close to a quadrillion dollars, that's $1,000 trillion in derivatives, floating around in the world. The total M3 money supply is [only] $13 trillion.

You can't have debt go to 700% of GDP. It's not possible. The house falls down. We have to stop spending. Government policies have to change.

We have 22% unemployment, not 10%, if you count short-term discouraged workers and long-term discouraged workers. That becomes very low growth. There's deflationary pressure, because of the debt burden, that may make an inflationary outcome seem like a good idea.

WM: You announced that DoubleLine has just hit $1 billion in assets in just a few months of operation. What else is happening at the firm?

JG: There's a broader global investment strategy that invests in stocks, bonds, currencies, and commodities--that seeks to preserve capital/preserve wealth.

WM: Where do you stand on financial services reforms?

JG: The unintended consequences are much bigger than the intended consequences. The problem is it could harm banks--reduce credit and lending, counter-stimulate and weaken the economy.

Banks stopped lending to businesses 30 years ago; lent to consumers instead, leading to consumption and (sometimes) non-payment. Student loans are a good idea; you have something better after that, someone who can earn more. Consumer loans, auto loans--my parents never borrowed money for a car--not a good idea The U.S. standard of living has to drop in relation to other developed countries.

WM: Are we in a depression?

JG: Definitely. Some don't say that in polite company, like we didn't want to talk about sovereign debt and defaults. It's obvious that housing is in a depression. The social contract has hit its limits.

WM: What's the rosiest part of your outlook?

JG: Still possible--through austerity--to ease back from the trends over a three- to four-year window.

We've already had the inflation. Issuing debt over the last 30 years created inflation, and paying it back creates deflation. Pay back the debt, money becomes scarce, prices go down. We're seeing it, though gold, Toronto real estate, and vintage wine are up; oil and real estate are down.

Socrates says you have to understand that you don't know everything.

WM: So what's the end game?

JG: It would be foolhardy to say you know what will be. Pay attention. Bet half on inflation and half on deflation.

Read about Jeffrey Gundlach's keynote address from the archives of InvestmentAdvisor.com.

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