DoubleLine Total Return Bond Fund Pairs High Yield with Low Volatility

You might say that Jeffrey Gundlach is a man on a mission. In December 2009, TCW fired the hugely talented bond manager, and each side sued the other. That came at the end of a decade in which TCW Total Return Bond (symbol TGLMX), which Gundlach managed, was the top intermediate-maturity bond fund, even besting the return of the great Bill Gross’s Pimco Total Return (PTTRX).

Not long after falling out with TCW, Gundlach formed his own firm, which he named DoubleLine. Much of his bond team and many investors followed the pied piper out the doors of Los Angeles–based TCW. Ten months later, DoubleLine has more than $5.5 billion of assets under management (Gundlach ran $75 billion at TCW), half of it in its flagship, DoubleLine Total Return Bond Fund I (DBLTX).

With much to prove, Gundlach (who manages Total Return with longtime partner Philip Barach) is continuing where he left off. From Total Return’s inception, on April 6, 2010, through September 28, the fund returned a blazing 14.6%, six percentage points ahead of TCW Total Return and eight points better than Barclays Capital US Aggregate Bond index. Based on recent distributions, the DoubleLine fund yields 9.4% (its so-called SEC yield, a concept that takes into account the likelihood that many of a fund’s holdings selling below or above face value will pay off at face value, is 11.8%). And all of this comes with low volatility, largely a reflection of the portfolio’s low duration (a measure of interest-rate sensitivity).

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Total Return focuses like a laser on the mortgage-backed-securities market. Gundlach says that since he and Barach launched TCW Total Return in 1993, mortgage securities have consistently offered the sweetest combination of high return with low volatility in the fixed-income category. Hence, the pair decided to focus DoubleLine Total Return on mortgages.

Consider how Gundlach is currently arranging his fund to protect against the opposing risks of both deflation and inflation. As of the end of August, Total Return had nearly half of its assets in high-quality Ginnie Maes and other mortgage securities backed by government agencies (these are pools of mortgages that come with an implicit government guarantee and are traded much like bonds). Those interest-rate-sensitive securities will gain in price if deflationary pressures continue and long-term interest rates decline. (See Good Mortgage Bonds for more on Ginnies.)

The other half of the portfolio is in non-agency mortgage-backed securities, which come without the implied backing of the government. These riskier, higher-yielding securities should perform well if inflation and interest rates surge, which would imply a strengthening economy. The securities are much less sensitive to interest-rate swings than agency-backed securities and in many cases actually gain in value when rates rise.

The fund’s high yield is mainly generated from large holdings of non-agency securities, many of them rated below investment grade and purchased at steep discounts to face value, or par. “These were trashed during the financial crisis because it’s hard to analyze credit risk, but we’re experts at it,” says Gundlach. For instance, a security with a 6% coupon acquired at 60 cents on the dollar yields 10% (20% of Total Return’s holdings are priced at less than 80% of par value).

Total Return mitigates risk in a number of ways. For instance, the team of 30 mortgage analysts stress-tests pools of securities for a variety of bad outcomes, including depression-like default rates and deteriorating rates of recovery on the underlying assets of loans in default.

This kind of intensive research pointed Gundlach in the direction of subprime debt and Alt-A securities (those filled with mortgages taken out by people with credit ratings between those of subprime and prime debtors) issued between 2002 and 2004 and selling at wide discounts to face value. Gundlach says that the underlying mortgages, issued before the “garbage underwriting” of 2005–07, are holding up well yet have been “trashed” in the market. One reason is that many investors, such as insurance companies and pension plans, must unload securities if they’re downgraded to junk status. Gundlach believes most of these securities will ultimately pay back 100 cents on the dollar -- and while he waits, he’s collecting a handsome stream of interest payments.

Gundlach, never at a loss for words or opinions, is bearish on the U.S. economy and, in particular, the housing market and the nation’s ability to service its debts. But that’s not a bad mind-set for a fund manager who’s constantly weighing risks and striving to protect shareholders’ capital.

Total Return’s institutional share class requires a $5,000 minimum investment for an IRA and $100,000 for taxable accounts. Its annual expense ratio is 0.49%. The retail share class (DLTNX) requires a $2,000 minimum for regular accounts and a $500 minimum for IRAs. Its expense ratio is 0.74%.