|Share Class||Class I||Investor|
|Min. Initial Investment||$100,000||$2,000|
|Availability*||S, A, F||SIO, SO, AN, FN|
|Managers||Jeffrey E. Gundlach and Philip A. Barach|
|*Certain restrictions apply. Please check with your broker/dealer for details.|
In the past few months, we made two site visits to DoubleLine’s Los Angeles office, spending several hours with members of the Total Return investment team. We talked with CEO and lead portfolio manager Jeffrey Gundlach, mortgage group portfolio managers Joseph Galligan and Vitaliy Liberman, deputy chief investment officer Jeffrey Sherman, mortgage-backed securities (MBS) traders Michael Lee and Kunal Patel, and chief risk officer Cris Santa Ana III.
The goal of our recent visits was to refresh our due diligence and confirm our understanding of the team’s investment edge. Our conversations with team members reinforced our understanding of the process, as well as our confidence in the strategy. DoubleLine Total Return Bond remains Recommended in the Intermediate-Term Bond category, reflecting our confidence that the team will outperform its benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index, over a credit cycle.
Security analysis was a primary focus during our meetings. At the heart of DoubleLine’s mortgage securities analysis is convexity. Convexity relates to a bond’s expected price (and yield) changes at various yield levels. DoubleLine’s goal is to find securities with positive convexity, although they will accept neutrally convex securities. Positive convexity occurs when the amount by which a bond’s price rises when yields fall is greater than the amount by which that bond’s price falls when yields rise by an equivalent amount.
To estimate a security’s convexity, the team thinks through top-down and bottom-up dynamics. Specifically, they consider various interest rate scenarios, the economic backdrop that is causing rates to change, and how a change in rates will impact the fundamentals and valuation of a security, which, for this fund, is typically a pool of mortgages. At the security level, changing interest rates can impact prepayment speeds depending on a mortgage pool’s average loan balance, average loan quality, the remaining life of that mortgage pool, geographic concentration, etc. At the market level, the team estimates how investors will value the security (i.e., whether investors will require a different yield premium to a risk-free rate as rates change).
The team evaluates qualitative inputs for three interest-rate scenarios: the 10-year Treasury rate rises by 100 basis points, remains unchanged, or declines by 100 bps. These three rate scenarios are given equal weight in the team’s convexity analysis. Galligan explains that using a smaller increment, such as 50 bps, might not be substantial enough to cause meaningful changes in prepayment rates, for example, whereas larger moves, such as 200 bps, are considered too significant because such a large move would fail to account for intermittent changes in the opportunity set and portfolio shifts along the way.
Given the team’s focus on security-level convexity, interest rate levels have a material influence on portfolio construction. For example, given the poor convexity profiles generally available in a low-yield environment, the team will pass on most securities, and the fund’s cash balance will rise. As Galligan puts it, “If you are a disciplined mortgage investor from a convexity standpoint, as rates go lower, convexity gets worse.” This is because at low absolute rate levels, a fall in yields leads to only a small increase in price, while an equivalent rise in rates leads to a larger potential decrease in price. In higher-rate environments, convexity profiles improve, the portfolio will find more securities that are attractive, and the portfolio’s duration will consequentially extend. So, there is a natural reinforcement of how the portfolio duration ebbs and flows, depending on prevailing yield levels.
The team does employ a duration overlay but only at the margin. Duration indicates the amount of interest rate risk built into the portfolio at any given time. The strategy’s duration is generally lower than that of the index, meaning the fund is relatively less sensitive to interest rate moves. The team’s view on whether rates might change is partially based on an assessment of macroeconomic conditions, with Gundlach potentially believing conditions could merit a change in rates.
The team believes the U.S. economy is range bound. In their view, there is too much leverage in the system to allow the economy to take off, but the Federal Reserve does not want a deflationary spiral so it will work to ensure the economy does not collapse. Galligan says this environment could be characterized by the economy bouncing between optimistic (“risk-on”) and pessimistic (“risk-off”) periods. Risk-on periods will see a stronger economy, rising interest rates, and a generally good credit environment where non-government-related bonds perform better. During such a scenario, the team expects to take advantage of higher credit prices by selling them on the margin to fund the purchase of out-of-favor government-related bonds at relatively attractive yields. Similarly, during risk-off periods when the economy is weaker, rates are lower, and government bonds are priced higher, the team expects to purchase out-of-favor credit securities. Since credit and government-related securities perform differently across changing economic periods and interest rate levels, the team aims for lower portfolio volatility through simultaneous exposure to both.
The portfolio is predominantly built based on where the team finds the best overall fundamental characteristics (such as convexity). But there are other considerations. Among the bigger-picture factors considered for portfolio construction purposes are fundamental economic variables, such as expected inflation and GDP growth; market technicals, such as the potential effects of bond fund redemptions following specific events (for example during the Taper Tantrum in 2013, or following the election of President Donald Trump); and secular issues like the total amount of societal debt. The high and rising level of debt in the United States is one reason the team believes the yield on the 10-year Treasury note could reach 6% in a few years. Galligan says the most likely solution to this debt burden is massive inflation, which could be a precursor to eventual higher interest rates.
What will this significantly higher interest rate level mean for the portfolio? As discussed above, higher absolute rate levels can improve the convexity profiles of individual securities. This is especially true for agency MBS, whose convexity profile would be expected to be far superior to that of Treasurys (and would therefore allow for meaningful outperformance relative to the benchmark, which has a high Treasury allocation). As the convexity of agency MBS improves, the Total Return portfolio will likely consist mainly of agency MBS in a higher-rate scenario. Galligan says the pathway to higher rates will provide opportunities to use the portfolio’s regular cash flow distributions from existing holdings to purchase securities offering higher yields and better convexity profiles, which will ultimately benefit performance.
Legacy non-agency residential MBS has been an important contributor to the strategy’s success following the financial crisis. But this opportunity set has been steadily declining given there has been no new supply since the financial crisis. DoubleLine’s mortgage team—divided into subsectors that include asset-backed securities, commercial MBS, collateralized loan obligations, and residential MBS—remains on the lookout for new attractive opportunities. The residential MBS team has been evaluating an opportunity related to the legacy non-agency market. While many individual home loans were securitized by non-agency financial institutions prior to 2008, many similar loans were not securitized and remained on the banks’ balance sheets. As the market has become more normalized over the past couple of years, banks have started to securitize these loans. Galligan says issuance has been robust—around $15 billion in each of the past two years. The team thinks the securities are cheap from a cash flow perspective but believes they potentially face relatively high liquidity risk given the newness of the market. The team continues to evaluate this space.
One area of interest to mortgage investors is the Fed’s anticipated balance sheet reduction program, whereby it will likely reduce the number of agency MBS it holds as a legacy of quantitative easing. The team notes that the market’s anticipation has already affected the mortgage market, which has been one of the worst-performing fixed-income sectors over recent periods. While no one knows exactly how the Fed will proceed, the team believes the process will be smooth and will have only a modest effect. As the Fed reduces its holdings, the team expects the spread between agency MBS and comparable-maturity Treasurys to widen in the range of five to 15 bps. Agency valuations have already come down over the past year to what the team considers roughly fair value, so further spread widening can potentially result in attractive investment opportunities.
DoubleLine Total Return Bond remains Recommended, reflecting our confidence that the fund will outperform the Bloomberg Barclays U.S. Aggregate Bond Index over the market cycle. A cornerstone of our confidence is DoubleLine’s mortgage expertise. The firm has deep mortgage-related fixed-income roots, dating back to when Gundlach and other senior personnel were employed by TCW prior to 2009. The DoubleLine Total Return Bond team continues to execute the strategy in what we believe to be a highly disciplined and effective manner.
Consistent discipline is evident throughout the process. Traders and portfolio managers emphasize fundamental security analysis in finding and evaluating investment opportunities. As discussed above, the convexity assessment is a critical part of DoubleLine’s process and serves to identify securities with appealing risk/reward across interest rate scenarios. Each security is selected on its own merits, and the team’s focus on mortgages allows them, we believe, to recognize attractive relative-value opportunities within and across mortgage sectors. This was brought to life during our security-selection discussions with the traders. We came away confident that the bottom-up work done by the team drives the fund’s performance.
The importance of Gundlach to the success of this strategy is a question we have evaluated. This is not a solo performance by Gundlach. At the security level, there is a team of experienced mortgage investors, all of whom have a clear sense of the sought-after fundamental characteristics. Day-to-day trades are not made by Gundlach, although he does keep a close eye on all trades. At the broader portfolio level, Gundlach relies heavily on members of DoubleLine’s fixed-income asset allocation committee for input into the relative-value opportunities that exist within and across sectors of the mortgage market. Together with the committee, Gundlach could direct the team to focus on increasing exposure to certain types of securities. Gundlach will have views on interest rates that could lead the team to steer the portfolio’s duration in a certain direction. But as mentioned above, we believe this is at the margin, as the team’s focus on convexity is the primary driver of the portfolio’s duration. It is our view that the strategy could remain successful if Gundlach were not contributing to this strategy, though our opinion would vary by strategy. Our impression is that Gundlach’s relative-value views across sectors play a much bigger role in more flexible, multi-asset strategies.
Asset size is an important factor we have written about in the past and frequently address with Gundlach. Assets in the strategy stand at around $61 billion currently, down from a peak around $70 billion in 2016. As we consider assets in the fund, there are potentially some marginal advantages to being a larger player in the mortgage market. Discussions with DoubleLine and other mortgage investors we respect suggest size might allow DoubleLine to be a bit more aggressive in seeking the best trade execution, and outside brokers might contact DoubleLine with opportunities first. But there could also be disadvantages to running the current asset base in a low-rate environment. The reality is we are not mortgage experts or traders, so we cannot be certain about the ideal level of assets. Looking ahead, should rates rise, we believe the fund could effectively run a larger asset base. As explained above, higher rates enhance the convexity profile of MBS and provide additional positive-convexity opportunities. Importantly, these securities are very liquid, so as the convexity of agency securities improves, we think the team could put lots of money to work. Still, the risk remains that should Gundlach and the team overestimate their ability to manage too large an asset base, this could impact their ability to reposition the portfolio in response to changing market conditions. For example, if the team were running a larger asset base, and interest rates suddenly fell sharply, we think the team’s flexibility would be inhibited. We will continue to monitor and discuss the asset base with the team.
We have known this team since mid-2008, and our confidence remains strong. For the reasons discussed above, DoubleLine Total Return Bond remains Recommended, and we use the fund in our balanced portfolio models as part of our core bond exposure. However, investors should recognize that this fund is a mortgage portfolio and performance will reflect the opportunities presented within this space. We have high confidence in the team’s approach and ability to assess relative value across the mortgage market, while maintaining a strong risk focus. This gives us the high conviction that the fund will outperform the benchmark over a full market cycle.
–Alistair Savides, CFA, and Jack Chee
|Calendar Year Returns||Trailing Returns*|
|YTD||2016||2015||2014||2013||2012||One-Year||Three-Year||Five-Year||Since Start of Rec.|
|DoubleLine Total Return Bond||2.46%||2.17%||2.32%||6.73%||0.02%||9.16%||1.41%||3.04%||3.59%||6.17%|
|Vanguard Total Bond Market Index||2.35%||2.50%||0.30%||5.76%||-2.26%||4.05%||-0.54%||2.33%||2.02%||3.28%|
|*Start of record May-2010.|
|Non-Agency Residential MBS||23.7%|
|Collateralized Loan Obligations||4.3%|
|Number of Issues||2,168|
|Weighted Average Life||5.36|
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