The financial crisis buried mortgage-backed securities and junk bonds in 2007 and 2008, and Gundlach dodged most of that carnage. But 1994 was a disastrous year for virtually all fixed-income assets, and his portfolio got hit, at least temporarily.
In 1994, interest rates rose rapidly over a very “compressed timeframe,” right after a period of major interest rate declines. The mortgage market was refinancing at the most rapid rate in history prior to 2003.
That created a phenomenon where mortgage-backed securities (MBS) morphed into short-term vehicles. “If half of mortgages refinance in one year, the securities backing those mortgages become definitionally short-term securities with low durations,” he noted.
The yield curve was very steep in those days and when rates rose, the refinancing opportunity disappeared. The MBS market went from being one with an interest rate maturity of two years to one with maturities closer to 10 years.
In Ginnie Maes, investors had the experience of “rolling up” the yield curve so the “losses became extreme.” Many investors got margin calls. Orange County, which didn’t hold mortgage-related securities, went bankrupt and was forced to liquidate, throwing many sectors of the bond market into short-term turmoil.
In his most aggressive strategy, Gundlach had his worst year ever. That fund was down 23% in 1994, while his other more traditional strategies performed better, suffering only small losses.
Amazingly, the market reversed pretty sharply in 1995 as then-Fed Chairman Alan Greenspan managed to engineer a soft landing. By June 30, 1995, Gundlach’s aggressive strategy had recouped all its losses and ended the year up 53%.
But the memories still linger. “Anybody who wasn’t in the market probably wouldn’t believe how cheap bonds [were.] We’re talking about government-guaranteed mortgages,” he said. “Treasury bonds were yielding 7% and there were [mortgage] securities yielding 16% to the worst-possible scenario.”
That experience prepared him for the 2007-2008 meltdown. “Valuation means absolutely zero when you are in a brutal bear market,” he said. Supply-demand problems and margin calls overwhelm intrinsic laws of finance.
Signs of distress started surfacing in the MBS market in 2007 and Gundlach, being one of the world’s leading students of mortgage investing, was well-positioned. He recalled that a very good originator, Santa Fe, N.M.-based Thornburg, had a $300 million tranche of adjustable-rate mortgages that were not sub-prime and had never traded below 100 cents on the dollar thanks to the adjustable rate feature.
Suddenly, there was a price talk at 97 cents on the dollar. Gundlach and a Latvian colleague put in “a throwaway bid” at 93 cents of the dollar. Their bid got hit.
His Latvian colleague called it “the craziest thing I’ve ever seen.” Recalling the experience of 1994, Gundlach told Real Vision Pal he was more circumspect. Hearing his colleague make that remark triggered a sense of doom “all the way down my spine.”
He promptly told the Latvian manager, who now oversees DoubleLine’s agency department, to write down his observation on the ticket and said he suspected their yield would go from 8% to somewhere in the teens.
That prediction turned out to be wrong. Eventually the securities collapsed so far that the yields rose to above 40%.
However, the memories of 1994 prompted Gundlach to also declare a moratorium on future purchases of mortgage securities for the time being, setting his funds up to be among the biggest beneficiaries of the mortgage crisis.