GENERATING HIGH CASH FLOWS & MANAGING RISK WITH INFLATION/DEFLATION

In May of 2009 I said we were experiencing a “once in a generation opportunity in distressed debt and the corporate bond market in general.”  Since then bond markets have universally experienced tremendous returns.  But as the equity market rally begins to fizzle and signs of recession appear on the horizon the inflation vs. deflation debate is taking center stage as investors wonder if the bond market will remain a safe place to park cash.

Jeff Gundlach, founder of DoubleLine LLC believes he has the all weather solution.  Mr. Gundlach recently authored a superb piece in Pensions & Investments which gave an inside look into the thinking of one of the truly great debt investors.  Within the article, the bond guru cited his macro outlook (deflationary recession) and how to generate high single digit returns in such an environment.

“So my base case is deflation and its attendants: recession, deteriorating credit and, at the long end of the Treasury curve, tame-to-falling Treasury yields.  That said, I distrust portfolios constructed on unidirectional, all-or-nothing macro outlooks, even on my own base case.  Everyone makes mistakes.  A mistake in security selection involves that security.  A mistaken macro bet engulfs the entire portfolio.”

These are brilliant comments on many different levels.  The most important of which is Gundlach’s admission that he could very well be wrong.  This is the role a good risk manager must always play – not one based on hubris and “all-in” bets (we call those guys gamblers in this business), but intelligently devised portfolios that generate alpha, allow for some margin of error while at the same avoiding potential black swans.  Too many supposed gurus have suffered reputation ending defeats at the hands of their own personal (over)confidence.  Gundlach understands that being wrong is part of this business.  But Gundlach sees an opportunity regardless of what happens with the macro environment:

“Here’s the good news: today’s market affords an opportunity to develop a portfolio that generates high cash flow while managing risk under both my base case and an alternative future of inflation, growth, improving credit and rising yields.  The idea is to exploit the juxtaposition of two market conditions: distressed pricing in the mortgage credit segment of the bond market and the historically steep slope of the U.S. Treasury yield curve.”

In this base case, Gundlach likes the typical deflation plays – government backed paper:

“In a context of near-record maturity spreads, deflation lowers yields at the long end, flattening the curve.  So I’m fond of high duration securities backed by the full faith and credit of the U.S. government.  In particular, I like long-dated Treasuries and long-dated tranches of CMOs back by agency MBS.  The trained professional investor can obtain yields of about 7% in this corner of the mortgage sector.  Furthermore, if yields narrow at the long end, prices in these securities should rally, reaping the bonus of capital gains while the investors clips the healthy coupon.”

But as I mentioned above Gundlach isn’t making a unidirectional bet.  He isn’t willing to risk portfolio implosion just because he has conviction in a particular outlook.  So how does he hedge his bet in case the deflation scenario fails to unfold?

“That’s an attractive trade assuming my base case, but watch out. Everyone makes mistakes. Regardless of asset class, income investors should beware portfolios that gamble on unidirectional market forecasts. My base case is further deflation. What if my base case proves wrong and inflation accelerates? The likely result would be a surge in interest rates, the bane of high-duration investments. Another corner of the mortgage sector holds the solution. Portfolio managers can pair allocations to high-yielding high-duration securities with allocations to a different investment that also delivers high cash flows but exhibits negative duration – in other words, an asset whose price rises with Treasury yields. Among the assets with these characteristics are certain distress-priced mortgage bonds whose principal is not guaranteed by the U.S. government, also called legacy non-Agency residential mortgage-backed securities (RMBS). The careful pairing of long-dated Treasuries/Agency CMOs with non-Agency RMBS results in lower portfolio duration than that of the Barclays Aggregate U.S. Bond Index.”

Now imagine a world of rising Treasury yields. That scenario is consistent with a world of economic growth and accelerating inflation, or at least consensus expectation of these phenomena. Growth and inflation are bullish for depression-priced credit. Default rates should fall, and recovery rates on liquidated collateral should improve. In such a context, depression-priced mortgage credit should rally. This relationship is demonstrated in history as well as explained by theory. Since depression discounts became the rule in mortgage credit, prices of certain non-Agency RMBS have rallied during back-ups in Treasury yields and fallen during declines in Treasury yields.”

Asset managers can blend investments with offsetting interest-rate correlations to create portfolios that can realistically generate returns in the high single digits while exhibiting low interest-rate sensitivity. In my view, this integrated trade solves the income problem while steering a safe course between the shoals of credit and duration risk. Investors can feed themselves without banking on dreams.”

Excellent stuff.  I’ve always believed that investors graduate to credit markets when they reach a certain level of market sophistication.  A glimpse into the world of Mr. Gundlach’s process is certainly fascinating.  What’s most interesting in this article, however, is not the trade, but the thought process and psychology behind the trade.  Mr. Gundlach’s track record has proven him to be one of the finer debt investors in the world.  What this article displays is not just superior market knowledge, but a remarkable humility for a guru.  The very best investors know they will be wrong.  But most importantly, they plan on being wrong – just in case.