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Bonds: Time to Cut Risk

Fund manager Jeffery Gundlach told the Morningstar Investment Conference that the subprime mess is far from over.

If you think the subprime loan debacle can't get any worse, think again. Jeffrey Gundlach, chief investment officer of TCW and the keynote speaker at the Morningstar Investment Conference, which concluded June 29, thinks we're in the early innings of a "totally unmitigated disaster" that could stretch into 2009.

Home buyers who couldn't afford to service loans received loans. Then there are the "predatory borrowers," people who never intended to repay loans. Gundlach says that bankers have been unable even to contact -- get this -- 50% of owners of foreclosed properties. Meanwhile, each month brings rate resets -- higher rates -- on 2% to 3% of subprime loans. Gundlach observes "decaying underwriting standards" on loans from 2003 through 2006. Therefore, swelling loan delinquencies are a safe bet.

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So how does Gundlach, who oversees $60 billion of investment in fixed-income assets, suggest playing the bond market? First, he thinks the fallout from subprime will affect many credit markets. Spreads on high-yield and emerging markets bonds will widen (that is, the yield gap between those risky bonds and safe Treasury bonds will increase); private-equity borrowers will have much more trouble raising cheap money for their buyouts of listed companies. Consumer spending and the economy will slow over the next year, largely because even relatively well-off borrowers will struggle to meet much-higher monthly mortgage payments with the looming bulge in rate resets of adjustable mortgages over the next couple of years.

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Gundlach is acting by lowering the credit-risk profile of TCW's bond portfolio to the most conservative it has been during his 14 years at the helm. High-yield bonds, normally 15% of the portfolio, are now 3%; he's reduced emerging-market bond exposure from a normal 10% to 0%. He finds it "impossible to imagine that you'll be better off over the next two years in high-yield than in high-quality bonds." Gundlach says his Treasury position is the highest ever; he also likes the government-guaranteed AAA mortgage market and municipal bonds.

You can hire Gundlach's bond-investing prowess by purchasing TCW Total Return Bond (symbol TGLMX), which he co-manages with Philip Barach. This fund invests exclusively in AAA paper, most of it government-guaranteed mortgage-backed securities. Over the past five years through June 28, the fund returned 4.6 annualized, putting it in the top quarter of intermediate-term taxable bond funds, according to Morningstar. The fund yields 5.1%.

Neither the return nor the yield figure is especially impressive, but neither are they surprising given the low-interest environment of the past few years. At any rate, this is a bond fund that lets you sleep at night.

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