Is DoubleLine Total Return Bond Fund Too Risky?

Going against the conventional wisdom is often the key to successful investing. Consider mortgage-backed securities. Investors flocked to them because of their juicy yields until the bonds blew up during the real estate collapse. Since then, most investors have been unwilling to touch these securities. Who, after all, is crazy enough to invest in subprime mortgages?

Enter DoubleLine Total Return (symbol (DBLTX), an aggressive investor in private mortgages -- that is, those not backed by the government. From its inception in April 2010 through July 27, the fund, a member of the Kiplinger 25, has returned an annualized 13.9%, compared with 7.1% for the Barclays U.S. Aggregate Bond index. Over that period DoubleLine ranks in the top 1% among intermediate-term taxable bond funds, according to Morningstar.

That’s not all. The fund hasn’t lost money in any quarter since its launch. Its 30-day yield is a healthy 5.6%, and its 12-month yield is 7.4%. (The figures are for the fund’s institutional share class, which can be bought through most online brokers and charges 0.49% in annual fees; the retail shares, with the symbol DLTNX, charge 0.74% a year.)

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How do managers Jeffrey Gundlach and Philip Barach churn out such good results with such potentially toxic securities? In a word, carefully. To start with, they currently have two-thirds of the fund’s assets in government-guaranteed mortgages, such as those issued by the Federal National Mortgage Association. The rest is in private mortgages. Gundlach varies the mix, but the fund has never had more than 40% or less than 28% in private mortgages.

Of the private mortgages, almost half are considered prime -- meaning the risk of default is minimal. Another 10% are commercial real estate mortgages, most of which are high quality. Only 6% are subprime (2% of the entire fund), and a little more than one-third are Alt-A. Alt-A mortgages were given to borrowers whose credit was better than that of subprime borrowers but not pristine enough to qualify for prime mortgages.

Gundlach and Barach don’t stop there. They have about 30 analysts and traders who examine the individual mortgages inside of a security. They look at each borrower’s credit score at the time the loan was made. They also look at the value of the loan compared with the appraised value of the property at the time the loan was made, and they adjust their assessment based on subsequent changes in the metropolitan area’s property values. They favor bigger loans because, Gundlach says, the borrowers are more likely to refinance or pay off their mortgage.

All that work has boosted returns, Gundlach says. But sector-allocation moves have mattered more. These include changes in the proportion of private mortgages to government-backed mortgages. They also include changes in the mix of private mortgages among prime, subprime and Alt-A loans. Gundlach says he invested more in Alt-A mortgages earlier on than he does now. Today, he’s buying more prime mortgages.

He also closely watches and adjusts the interest-rate sensitivity of the fund’s government-guaranteed mortgages. Rising rates today wouldn’t hurt the fund nearly as much as they would have in the past. The government mortgages in DoubleLine’s portfolio would lose about 4% in price if interest rates on similar securities rose by one percentage point (bond prices generally move in the opposite direction of interest rates).

Gundlach says that the interest-rate sensitivity of government and private mortgages offset each other to some degree. If rates rise, inflation will likely climb, too, and that should increase the value of the private mortgages. Conversely, if the economy weakens, pushing down the value of the private mortgages, the prices of the government-guaranteed issues are almost sure to rise.

Finally, just like cheese and wine, mortgages get better with age, Gundlach argues. People who’ve been paying on their mortgages for five years or more are likely to continue paying. No private mortgages -- that is, mortgages without government backing -- have been issued since 2007.

More big investors have discovered the attractiveness of subprime and Alt-A mortgages in the past couple of years. The “junk” credit rating of these securities means they should continue to produce good returns if the economy strengthens -- unlike higher-quality bonds, which may be close to peaking. (See VALUE ADDED: The Dangers Lurking in Bonds.)

Gundlach has been investing in mortgages successfully since 1985 -- most of that time at TCW Total Return Bond (TGMNX). (A bitter legal battle ensued after TCW fired Gundlach in 2009.) Without question, many of the private mortgages he’s been investing in over the past few years are riskier than the lion’s share of the securities he owned during most of his years at TCW.

Morningstar, the fund rater, worries that DoubleLine Total Return is too risky. Its oversized yield alone raises warning flags, says analyst Sarah Bush. “Swim at your own risk,” reads the title of her latest analysis of the fund. She’s concerned about the fund’s holdings in mortgage-backed derivatives, including inverse floaters, whose yields move inversely to those of ordinary mortgage securities. More to the point, the floaters can be volatile and hard to trade.

I worry about the fund, too. No bond fund that boasts returns and yields as high as this one can do it without taking risks. The fund’s girth -- $29.4 billion in assets -- also concerns me. At the end of the day, making a judgment about DoubleLine comes down to one’s faith in the ability of Gundlach and Barach to navigate mine-infested waters. Their consistently superb returns are impossible to dismiss, and that’s why I recommend DoubleLine Total Return. But it’s a fund that I -- and you -- should watch carefully.

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

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