Be Prepared for the Worst With DoubleLine Total Return Bond Fund

The stock market's plunge has stunned a lot of investors. Not Jeffrey Gundlach. A well-regarded bond fund manager, Gundlach thinks that after the government revises various data, economists will conclude that that the U.S. sank into a new recession in the first quarter. "We're going through a period of crisis and economic weakness that stems from decreased government spending," he says. "There is no recovery. There are no jobs."

And this is not the time to invest in stock, says Gundlach, who runs DoubleLine Total Return Bond Fund (symbol DBLTX). “It seems suicidal to buy a broad-based basket of stocks or economically sensitive commodities or emerging markets stocks -- all of which are very leveraged to economic growth,” he says.

Gundlach believes it will take several years before the economy begins to feel normal. Why? “We were living in a debt-based economy for the past 30 years. Recessions were kept short and shallow by piling on debt.” Now the bill has come due. Standard & Poor’s’ downgrade of America’s debt rating on August 5 is a manifestation of the bill collector’s arrival. (See PRACTICAL ECONOMICS: U.S. Voters, Politicians to Blame for National Debt Woes.)

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Gundlach is even more worried about Europe. He sees the mainly European banks that own euro-zone government debt facing enormous risks. “We have a financial system that has a global banking panic looming over its head at any minute,” he says. “To overestimate the problem is almost impossible. You have to start thinking very seriously about the European banking system’s solvency.”

When it comes to big-picture views from smart fund managers, I listen carefully to what they say, but I pay far more attention to how they invest. Because of his gloomy forecast, Gundlach has tweaked his portfolio so that about 55% of its assets are in government-guaranteed mortgage-backed securities. But, just in case he’s wrong, he has 44% of the fund invested in high-yielding private mortgage securities, which will do well in an economic recovery or even if inflation picks up.

Hedging his bets is a hallmark of Gundlach’s investing style. The name of his firm, DoubleLine, comes from the double yellow stripes in the middle of roads where no passing is allowed. Gundlach always deploys his assets on both sides of the street.

His approach to mortgages has worked -- in spades. Since its inception in April 2010, DoubleLine Total Return has produced eye-popping numbers. Over the past 12 months through August 5, the fund gained 13.2% -- a whopping 8.1 percentage points better than Barclay’s U.S. Aggregate Bond index. The fund yields 8.7%.

The above figures are for the fund’s institutional share class, which charges annual expenses of 0.49%, a modest price. If you use a broker, this is the best share class to buy, even if you have to pay a transaction fee. The institutional share class’s minimum investment is $100,000 for a regular account but only $5,000 for an IRA. The fund’s N class shares, with the symbol DLTNX, are frequently sold without a transaction fee and require only $2,000 to start but charge annual expenses of 0.74%. Minimum investments are generally much lower for both share classes when you invest through a broker.

Gundlach’s career -- and his success -- didn’t begin last year. He has produced a brilliant record since 1993, when he took the reins at TCW Total Return Bond (TGMNX). From the time he launched the TCW fund through December 2009, it returned an annualized 6.9%, compared with 6.0% for the Barclay’s index.

TCW fired Gundlach at the end of 2009 in a bitter dispute over who owns the rights to the investing methods he employs. That battle is being waged now in a California courtroom. Fortunately, it doesn’t seem to be a major distraction for Gundlach, 51, who took many of his best analysts with him when he left TCW.

Gundlach’s methods are unusual in bond land. In Total Return, he specializes in mortgage-backed securities, a complex sector of the market. Even government-backed mortgages are confusing. They pay higher yields than most other bonds, but, because mortgage holders refinance when rates drop, bond investors get their money back at the worst possible time to reinvest.

One of the best ways to invest, in my opinion, is to find a difficult-to-navigate sector -- and then identify a savvy manager in that sector who brings a lot of resources to bear. With some 30 analysts, Gundlach probably has more professionals analyzing mortgage-backed securities than any other firm.

It’s best to think of his portfolio as having two sides -- a risky side and a safe side. The risky side will do well if the economy firms or inflation heats up; the safer side will do well in a rotten economy because the mortgages are government-guaranteed.

In the risky part of Gundlach’s portfolio -- the private mortgage-backed securities that precipitated the 2008 financial meltdown -- intensive research is crucial. His analysts examine the underlying loans of each security, determining what percentage of borrowers are making payments, what their credit ratings are, whether documentation was submitted when they took out the loans and whether they’ve ever missed a payment. Analysts also look at where homes are located, how good the loan servicer is at recovering money in defaults and how careful the lender was in making loans.

Total Return owns a mix of private mortgages. Some are prime loans, which are extremely likely to pay off. Others are Alt-A loans, which are riskier than prime loans but safer than subprime loans. And a handful are subprime mortgages, loans made to borrowers with shaky credit.

Gundlach and his team choose among dicey private mortgage securities with extreme care. Given how good his record is, the only mystery to me is why the fund has assets of only $8.7 billion.

Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C. area.