Replay: Alternative Strategies Fund Webinar with Jeffrey Gundlach

Interviewee: Jeffrey Gundlach, DoubleLine
Interviewer: Jeremy DeGroot, Jason Steuerwalt
Date: December 1, 2022

Mike: Hi, everyone! I’m Mike Pacitto, with IM Global Partner. Thanks for joining us, today for our webinar with DoubleLine CEO/CIO, Jeffrey Gundlach. And an update on the IMGP Alternative Strategies Fund.

Before we get started, let me just invite you here to enter any questions you may have, via the interface on your Zoom platform that you see in front of your screen. We’ll try to answer any questions that you might have live, during the conversation, today.

Our speakers – alongside Jeffrey – are Jason Steurwalt, head of Alternative Strategies, and co-portfolio manager of the Alternative Strategies Fund. And, Jeremy DeGroot, US CIO, here at IMGP.

The first 10 minutes or so of our webinar will be an update on the fund; performance, positioning and outlook. Then we’ll get to our market’s discussion, that I’m sure you’ll all be waiting for. That’ll be with Jeffrey and Jeremy.

Quickly, on the IMGP Alternative Strategies Fund – this is one of our flagship strategies here at IMGP. You’ll see on the pie chart that the DoubleLine Opportunistic Income Strategy makes up one-fifth of the allocation, alongside five other unique strategies that are exclusive to the fund. The purpose of the fund is to represent either a core-alternative’s position or a fixed-income diversifier to client portfolios, without being excessively complex or over-engineered.

Here are some basics statistics for the fund, since inception. Solid, absolute-returns. Low, relative volatility. Low-beta to stocks. And low-correlation to bonds. Resulting in a top-decile peer-group Sharpe Ratio.

While 2022 has been a challenging year, when you look at the long-term history of the fund, you’ll see that year-by-year, it’s done its job quite well – in terms of delivering low volatility, absolute-return. Particularly, compared to core fixed-income and to the Morningstar multi-strategy category.

Since we’ll be talking mostly today about fixed-income, we put together some slides that show how the fund has done specifically against core fixed-income. It’s acted as an excellent diversifier for bond portfolios, since inception; this year, as well. Beating the Agg by around 500 bps in 2022, with a similar yield and low-correlation to core bonds.

On this next slide – this is going to be my final slide, before I hand it over to Jason – you’ll see some upside/downside capture data. Specifically, against the Agg. It essentially is showing that the fund has captured the upside of the Agg nicely, while mitigating the downside.

Jason, if you’re ready, I’m going to hand it over to you for an update on positioning and outlook for the fund.

I first wanted to go over the position of DBI. DBI is a specialist in hedge fund replication. Meaning to replicate the [pre-P] performance of a targeted group of hedge funds, at a fraction of the cost – within an extremely liquid portfolio.

They’ve been very successful at this. We work with them to define custom strategies, specifically for the fund. We call it enhanced-trend. It’s a combination of 75% trend-following, 25% equity-hedge. We wrote about it extensively, and it’s available on the fund website, so I won’t go into detail, here.

As most people probably know, trend-following provides huge benefits in a year like this – with positive long-term expected returns over cycles. That’s complemented by an equity-hedge strategy, which does better in more normal periods. It should capture a lot of the benefits of hedge funds’ major style rotation.

Had our timing been a bit better, it would have mitigated some of the draw-down, this year. That said, the allocation, we view as a long-term strategic allocation. We expect it to be additive to [funder] trends, overall – regardless of the timing. It should be very beneficial in an extended market dislocation, like we had this year.

A quick update on performance through October. The fund was down 9.4% versus the S&P down around 18%. High-yield down about 12%. The Agg down the most, at 16%.

In October – the first month – DBI was up 2.1%. Year-to-date, through October, Water Island was up almost 1%. Blackstone Credit, DCI, up about 2%. FPA was down around 15% — about in line with their net-long exposure – compared to the MSCI ACWI.

The downside performance, unfortunately, was for the fixed-income-oriented managers – [Lewis] and DoubleLine. Both down around mid-teens. It’s obviously been a tough year for almost all asset classes. But relative to typical ranges of return, it’s been very rough for fixed-income. Especially, considering we’ve barely seen an uptick in distress and defaults.

Inflation – and the Fed response – is obviously a key force, here. Wreaking havoc with even thoughtful portfolio-construction. There’s much more to come on all things macro and fixed-income.

I’ll just end here, by highlighting some of the fund positioning, which we think is extremely attractive. We’re going to be brief, since I know everyone wants to hear Jeffrey. I certainly do, too. But, given our conviction in the potential for returns, going-forward, we think it’s worth a quick run-through.

There are no guarantees, obviously, but when we’ve seen metrics like these in the management sleeves, previously, it’s been a harbinger of very good times ahead.

These are as-of 10/31. DBI had defensive positioning. Short bonds; long dollar. Modestly-short commodities/equities. Long-US; short-EM and international. This hurt in November, of course. But it should be a buffer, in the event that we return to the direction in which things had been heading, previously. Also, we should point out that the strategy is very flexible and can adjust relatively quickly. It could be quite different in a sustained recovery.

Turning to DCI. It’s a good opportunity set. There’s an okay — not amazing, but decent level of absolute credit-spreads. Pretty high differentiation between the modeled credit spreads and market pricing. And significant differences in fundamental corporate performance

The [CDS] sleeve has about doubled the gross exposure, as it did at the beginning of the year – which is reflective of a much-better opportunity set. That’s still market-neutral. The last time we had a setup like this was late-2018 or early-2019 – which preceded the strongest year for that strategy.

FPA – really attractively valued. Very high-quality portfolio of equities. A mix of some of the more new-tech and internet-oriented names that are now arguably pretty cheap. As well as more traditional value exposures, at the higher-end of the quality spectrum. Credit-exposure is kind of in the mid-single-digits, including a basket of busted converts that yield in the mid-teens, with upside-optionality.

Loomis – up almost 8%, yield-to-maturity, as of 10/31 – with a 2.5-year duration.

We showed the credit-quality metrics here. I should not that it’s a little misleading. It’s not that there’s 35% in investment-grade bonds and 40% in high-yield bonds. Just that 35% of the portfolio is investment-grade, and 40% is below-investment-grade. They have a mix of corporates. A lot of securitized — as well as some equity and converts.

Water Island does have the flexibility to do more in softer-catalyst, special-situations. The portfolio’s close to fully-invested in merger-arb positions, given the attractiveness of that space, with an annualized average gross-yield spread in the portfolio that’s in the mid-teens. That’s based on their projected close dates and the deals that extend, obviously. Deals could break. But that’s historically been a really attractive entry point.

DoubleLine – you can see the stats on the page. But I’d just note that the 48% is below-investment-grade. Not 48% high-yield bonds. We’ve got a portfolio-break-down on one of the slides, coming up. You’ll see it’s a mix of quite a few types of credit exposures, in addition to some agency MBS. As of the end-of-October, it had a yield of almost 12% over that 4-year duration.

I guess I’d just leave you with this. Overall, we’re disappointed in the performance, so far, this year. But we’re extremely excited about the fund’s positioning and prospects, going forward. With that, I’ll turn it over to Jeremy.

It’s a great pleasure to welcome Jeffrey Gundlach back, as I think about our annual call or meeting, and I really appreciate your time today, Jeffrey. We have a lot of listeners and participants on the call, and a lot of ground to cover. So, thank you for your time.

Jeremy: Yes! It looks like it’s kind of rainy out where you are. It’s raining, here in Northern California. I don’t know. Maybe it’s just the shade.

There are kind of three broad topics I’d like us to cover. They overlap, obviously. But just for the audience, I’d like to start with a recap of the year.

We all know, broadly, what’s been going with fixed-income – financial markets – the economy. But it’s been an extremely challenging year. Just setting the stage for the current market backdrop.

Then secondly, more importantly, looking forward. Your outlook – near-term, medium-term for macro-markets.

Then finally, and really most-relevantly for shareholders – the positioning of the Opportunistic portfolio. As Jason alluded, and as we see on the screen, it’s kind of an eye-popping yield-to-maturity there, with relatively-low duration. I think there’re a lot of exciting opportunities, now, as a result of a tough year.

I’ll just open it up with a broad-based question. If you could kind of highlight the key drivers of the markets, this year. Really, how it’s been for you as a portfolio manager of fixed-income portfolios, in what’s been probably the worst year for core bonds – at least going back to the ’30s.

By far, it’s the worst year for index-fund bond investing, if you use the Bloomberg Aggregate Index. Through October, it’s down 15%. It had never been negative by more than 2%, in history. So, it’s by-far-by-far the worst year for that type of investing.

It’s kind of hard to believe that 15 months ago, people thought the Fed was going to raise rates maybe 50-bps in 2022. The only way you could get a yield of 5% — 15 months ago, out of US-fixed-income, anyway – was to leverage the junk bond index by 50%. The yield was down at 3.5%. It’s hard to believe.

I do a webcast the first part of January, every year. It’s called, “Just Markets.” All we do is talk about markets; no strategies.

In that presentation in early January of 2022 here, I started out talking about how overvalued stocks were, using the S&P 500 as a proxy. Versus its own valuation history.

Just looking at P/E ratios, the CAPE Ratio, price-to-book, price-to-sales – all these types of things – there are about 30 metrics. You can go back decades and decades. As of January 4^th when I think I did that webcast, most of those valuations for the S&P 500 were in the top-percentile of overvalued. I think every one of them was in the top-3 percentile of overvalued, going back decades.

But, as I set that up for the audience of that webcast, I then pivoted and said – “As overvalued as the S&P 500 is, versus its own valuation history, it’s actually cheap to bonds.” Using the 10-year treasury as a proxy for bonds.

If you looked at the yield on the 10-year and compared it to the yield on the S&P 500 – which is basically the inverse of the P/E ratio – the stock market was actually well-below average valuation versus bonds.

We had a horrible setup for bonds, and obviously when you have a yield of 1% on the index, and a duration of the index interest rate risk of about 6%, you shouldn’t expect great things to be happening. In fact, we’ve done a study. If you read academic handbooks, they’ll poo-poo the idea that yield is a good proxy for future-return. But they’re actually wrong; it’s a very good proxy for future-return. If you match up the duration of the portfolio to the analysis-horizon for the return.

In other words, if you’re just looking at an index fund, say the duration is 6. If you start with a yield of 1, you should expect a return of about 1% per-annum over the ensuing six years. There’s a reason that works out, that the duration matches up. I won’t get into the wonky facts of it.

Entering 2022, you should have expected about a 6% return, cumulatively, out of an aggregate index fund, over six years. Very interestingly, it’s negative-15 through October. Let’s just say it ends the year, there; it probably won’t. It will probably end at more like negative-12. So, let’s say negative-12.

I’ve been running this strategy using this type of risk-profile, using different sectors, over the many years. I’ve been doing it now for 31 years. This is not the worst year that we’ve had.

The worst year was actually 1994. The Fed tightened– kind of the way they did this year – even a little less. But we had a real problem in the mortgage-related securities market, which is where my portfolio was positioned, going into 1994. The return in 1994 was negative-23 for the strategy. Interestingly, the return — the ensuing six months into 1995 – was over 30%. For the year 1995, the return was 48%.

One thing that’s been really crushing the fixed-income market this year is obviously changes in the Fed’s posturing. The surprise that the CPI was not transitory, but instead, went to 9.1 peak on the headline number.

Also, massive outflows from fixed-income. Just non-stop outflows across the industry. That’s created, here in 2022, the worst sustained-illiquidity I’ve ever seen in the bond market. I’ve seen worse liquidity last a day or two – like March of 2020. Maybe the global financial crisis – March of 2009. December of 2008.

But this is sustained illiquidity that just doesn’t go away. There’ve been periods in June and July, also in October into early November, where there was just no trading in sectors of the bond market. You saw it in the treasury market, too.

We were bouncing along kind of sideways on the 10-year treasury yield. but it was changing a lot day-to-day. Let’s just talk about the 30-year, which has the most volatility.

You’d pull up the screen one morning and it would be down 1.5 points. Then the next day, it’d be up 2 points. It was just bouncing around like that. I don’t think that was really price-discovery that was going on in the market. I think it was just the bid-ask spread. There’s such illiquidity that there could be something like a 5-or-8 bps bid-ask spread, even on a 30-year treasury bond.

When the world wakes up and it’s feeling lousy about bonds, it gets marked to the bid side. When the world wakes up and it’s feeling better about bonds, it gets marked to the offered side. That creates price-swings of about 1.5 points per-day.

There’s an index that measures the liquidity of the treasury market. The higher the index goes, the worse the liquidity is. That index analyzes bid-ask spreads on treasury bonds. It’s been elevated at levels never seen before – all year. That means really bad liquidity.

You’ve gotten to the point where you were yield-starved, 15 months ago. You couldn’t even get 5% without leveraging junk bonds, to yield everywhere. We’ve gone from an environment where bonds – 10-year treasuries – looked overvalued. Versus terribly overvalued stocks, based upon their metrics –

To a point now where bonds are wickedly cheap to stocks. Particularly the type of portfolio that we’re running, here.

Jeremy, you pointed out that the yield is actually 12%, today. I’m looking at data from just a couple of days ago. 12%. Our duration is now 4.9. Basically, the starting point that we’re at today is probably as good a starting point as we’ve had since – I’d say – the taper-tantrum in 2013, near the end of the year. Where it was set up for just huge returns. Of course, we had huge returns in 2014.

Also, yield-spreads – as treasury yields have gone up so much with the two-year treasury up 400-plus bps – spreads on credit products have widened. Across the board. Not so much on investment-grade corporate bonds, which seems to be under the Federal Reserve protection program. But on things like junk bonds that were out. Emerging markets have been just disastrous, this year, with returns.

They’ve gotten better. Everything’s gotten better in the last few weeks. But returns on emerging markets have been like negative-25%. Worse than the Nasdaq.

You’re at a point where to get yield out of the bond market, at the beginning of this year, you were basically buying bonds at-par or at a premium. And a yield that was maybe 4%, if you were lucky.

Now, because prices are down – thanks to yields going up tremendously on treasuries, and spreads widening on all credit sectors – you’re now at a totally different price-point.

Look at our portfolio, here. We have an income-stream. Just taking the income flow from the coupon. Dividing by the price of the portfolio – which is about 81, today. You have a 10.5% income-stream coming off of this portfolio – which is just unheard-of, compared to historical comparisons in recent years.

We believe that we’re going into a recession. We can talk about that. We believe default-rates are going to go up. But when you have a portfolio that’s at 81, and your coupon-flow is 10.5, which is where we are, right now –

When we’re talking about a yield of 12, we’re not expecting or assuming that we’re going back to 100 on all of our bonds. We’re anticipating losses. We’re anticipating losses on defaults, and I think we’re being too conservative. But we’re anticipating losses.

When we talk about a 12% yield-to-maturity, we’re talking about maybe we have 10 points of losses from defaults. I think that’s too high. Parts of the portfolio will not have any defaults. That’s obviously the agency mortgages, which are 18% of the portfolio. But also, the non-agency mortgages. I think we’re going to have zero defaults in the non-agency mortgages.

The non-agency mortgages are not the cheapest part of the portfolio. It’s, “only,” a yield — I say that in air-quotes – of 8.2%. But I think there’s just some no-risk, there. The housing market is up 40%. It’s dropping a little bit now, and it will probably drop further. But these loans that are underneath our RMBS – these originated with LTVs of 70 or 80. And there’s home-price appreciation of 40%.

No one’s going to default, when their house is up. Let’s say they drop. Let’s say they go from up-40 to only up-20. Let’s say we have an almost 20% drop in the housing market. So what? I mean, if someone’s economically distressed, they’re not going to mail in the keys, when they can sell the house at a profit. We don’t think there’s any risk, there.

When you put that together, we have over 50% of the portfolio that has basically no risk.

I’d also add that the cheapest part of the portfolio – which is CLO – we expect nothing in the investment-grade category – which is about half of the CLO position – will default. The triple-B-minus – the double-B CLOs – are just wickedly cheap, with dollar prices of 0.77. A coupon of 9. You’re getting an income flow that’s well-over 10%.

They’re risky, but assuming we have some defaults there, that piece of the portfolio yields 18%.

The starting point – I’ve been at this game for over 40 years. One thing that I try to impress upon, when I’m mentoring younger people – the starting point of where you buy bonds is incredibly important. If you’re buying credit above-par, you’ve got tons of downside – which we experienced this year. And you have almost no upside.

Many bonds in the credit market are callable, or – in the mortgage-market – prepayable.

You start at 100 and what are you hoping for? You’re hoping to get the yield — so you build some yield into the portfolio. But when you’re down to 81, there’s every inclination for bonds to head toward par, over time.

The average life of this portfolio basically tells you the expected time of getting the money back. The average life of the portfolio is – I’m trying to get the total, here. It’s five years. It’s not like you’re waiting forever to get your money back.

We don’t own 100-year Austrian bonds. There, if you’re at a price of 81, it’s like, “So what?” That’s only a percent-a-year, or something.

We’ve gone from despair, as fixed-income managers, I’d say in 2020 to 2021 into 2022 – because basically, the opportunity was poor, and the economy was totally haywire. We can talk about how it still is haywire.

We’ve gone now, into a world, where it’s actually exciting to be a bond manager, again. I was wondering if that would ever happen, with rates where they are.

We can drill down to anything you want, Jeremy. But let’s talk a little bit about what’s driving everything. That’s the inflation-rate and the Fed.

I’m going to have a webcast next week on Tuesday — just a few days from now – regarding my Total Return Bond Fund. We’ll go into great detail with my usual 50-or-60 charts, of these ideas.

My favorite chart is actually tracking the Fed Funds rate versus the two-year treasury yield. Historically, they’re exactly the same. With the one qualifier, that the 2-year treasury leads the Fed.

When the two-year treasury yield goes up by 200 bps and the Fed doesn’t even raise rates but 25-bps, they’re wickedly behind-the-curve. I did a TV spot back in March – actually, yes, I think it was March. I was talking about how the Fed just needs to get its act together.

I used the phrase, “Paint or get off the ladder.” I mean stop talking about raising rates, and start doing what you always do, which is to follow the two-year.

I mean just look at the upper-left-hand graph. The two-year treasury, entering year-end, was down about 25-bps. Then you blinked, and it was at 2.50[%], and the Fed was doing nothing.

The Fed should’ve raised rates much faster, and they should’ve somehow figured out that inflation was not going to be transitory at 4% or 5%; it was going to go higher.

Now, they’re kind of rear-view mirroring things, I think. They’re not respecting the fact that the yield curve globally is inverting. There’s an index of global sovereign bonds – 2s and 10s are now inverted. That’s never happened in the past 20 years.

Obviously, the US yield curve is tremendously inverted. Just a few days ago, the 10-year treasury yield had 79-bps more than the 2-year treasury. Right now, the highest yield in the treasury bond market is the one-year T-bill.

The Fed’s getting in-gear with the two-year, but – as the yield curve is flat in the United States, I tweeted out – I’ve got a Twitter account of “Truth Gundlach” – and I tweeted out a few months ago that I think the treasury yield is going to peak in the fourth quarter. I said at the time – and it was probably in September or October – but I said, “Between now and year-end.”

I am pretty sure that treasury yields have peaked. I’m pretty sure that the Fed thinks they’re supposed to go to 5%. I mean that’s sort of the market pricing.

The market pricing is coming down pretty much every day, now, in the past few weeks. I don’t think the Fed’s going to make it to 5%. I think the Fed’s going to probably raise 50[bps]. I talked about this in public five minutes after the press conference. I think I was one of the first people to say that the takeaway from the press conference in November is that the Fed is not raising 75[bps] in December. When the glued these seemingly contradictory ideas together, that the terminal rate is higher – but, “We’re going to get there slower,” – that’s basically saying, “We’re not going 75[bps].”

At this point, I think 50[bps] might even be in jeopardy. It might even be 25[bps]. The market is sending very strong recessionary signals, as it should. I can’t find any sector of the economy that can be relied upon now to be an accelerant to economic growth.

We’ve had tremendous pull-forward of durable-goods purchases with all the government money. They’re way above-trend. Durables should be expected to be negative, in terms of personal-consumption expenditures. Non-durables are still above-trend. Services have made it back to trend. It’s not going to come from that.

How about housing? Well, housing is doomed on a price-basis. You see the collapse in existing-home sales. You see the collapse in new-purchase indices. And of course, it should be. The mortgage rate has gone from 3%, roughly, to high-6s or even 7%, roughly. While home prices have gone up 40%.

This means that the median payment – monthly payment on the median-priced home in America, using a 30-year conventional financing — which is really all there is, anymore – the payment has more-than-doubled. The percentage of disposable income that’s represented by that median home-payment, now, has gone from about 17% to like 34%. It’s almost doubled. That makes sense, because the payment has doubled.

You’ve got leading indicators that are significantly negative. That’s a recessionary indicator. M2 has grown by only 1% over the past year, and was negative over the past six months. The Fed is doing quantitative tightening, stealthily, by letting bonds mature – which, of course, that takes liquidity out of the system.

The liquidity in the system is being heavily constrained. The Fed wants to. The Fed admits that they want a recession. They want it to be soft-“ish,” they say. But there’s really nothing out there other than the inflation rate that is bond-negative, right now, for the treasury bond market.

The oddest thing, and then I’ll just stop and you can direct where you want the conversation to go, Jeremy –

The oddest thing is that the Fed wanted inflation to go up above 2%, back a couple of years ago. That was obvious. They were worried about deflation.

I think they wanted the CPI headline or – they like to use the PCE, which is a little less volatile – but I think they wanted these inflation measures to go up to about 4%, or so. I don’t have any hard data on that – it’s just a hunch. They secretly wanted to make up for past – what they call a “mistake” – of not having inflation too low. I don’t even think it’s the thing. What’s wrong with having inflation at 1% for a few years, even if your target’s 2? What’s wrong with prices not going up very much? Right?

Instead, we had the PCE go up on the headline, close to about 7. We had the CPI go up to 6. Massive overshoot.

The Fed’s now on the case, and they’ve said that they’re resolute and they’re not going to stop until the job is done. The market believes this! The CPI-fixings in the market suggest that the CPI’s going down to a 2-handle in 2023. Most economists, including the Fed, think the CPI is going down into the 2s.

But the odd thing about this – which is the takeaway from the consensus of economists – CPI-fixings and the shape of the yield curve – all these economists and everybody seem to think that the inflation rate going from about 7 on the PCE down to about 2.5 or so – and then something very magical is going to happen. They think or they predict.

It’s then just going to stop there and sit at 2.5% for the next three years. That is absurd! There’s absolutely no chance that that can happen. CPI moves around. These inflation measures move around. There’s no way it’s just going to sit there.

I believe that just as the easing of the Fed, and the money-printing and the deficit-spending got the CPI not to 4, but to 9 – and the PCE up to about 7 – I think that when the tightening comes in, with the lags that are long and variable – and the Fed acknowledges this – you’re going to have the inflation rate at –

Maybe it does go down into the 2s. But if it does, and this is one of my highest-conviction ideas – if it does, it’s not going to stop, there. It’s going to keep going lower. In fact, it’ll probably go into a deflationary year-over-year type of print, at some point. That will take away all of this angst about the Fed.

The Fed, I think, isn’t even going to make it to 5%. I think the inverted curve is telling you something.

Let’s say the Fed actually does – and I don’t believe they will – but let’s say they do make it to 5%. Well, how inverted would the curve be, at that point in time? We’re at about 75-bps – 2s and 10s, now. But where would it be?

Let’s assume that it got inverted by 100-bps. Well, that would be the 10-year treasury at 4. I don’t even think they’re getting to 5. And I doubt we get 100, inverted. I don’t know. I sort of think that we’re now in a bullish position, regarding bonds.

Our favorite security, actually, to try to hedge out credit-risk – and we’re having a hard time accumulating these – because the market is so thinly-traded. But one of our favorite things is in the agency mortgage-backed market. We own very little of this now, because we’re having a hard time sourcing it. But we’re working hard at it –

It’s zero-coupon agency mortgages, where they strip down the coupon. There, you’re getting a dollar-price that’s very low. Like 50-cents on the dollar. And, we’re assuming, zero prepayments. Because there is no refinancing activity. But if rates fall, which we think could happen – particularly if there’s a recession – that will change. And that will help hedge some of the credit that we have in the portfolio. We have a lot of credit.

We try to expose the portfolio to the most-attractive reward opportunities. Acknowledging that that comes with intendent risk. But that’s really CMBS, CLOs, and ABS securities. They’ve really not garnered a lot of enthusiasm, so far. Whereas high-yield has tightened somewhat. Emerging markets have gone up decently. These are less-liquid sectors. They’ll probably start playing catchup. We’re noticing, actually, that prices are starting to exceed markets, in terms of trading activity. Somewhat significantly, and increasing every day.

What if the world goes bad, again, and the recession is bad and stocks are challenged? What’s going to happen here? Well, at least we’ve got 10.5% income flow, and we don’t have a huge duration.

I think the risk-reward profile of this type of bond portfolio is about as extremely-compelling – versus stocks. Not so much, bonds. This has some risk to it that’s equity-like. Maybe not quite as big as equities, but –

I think what we’re doing here is taking risk, but getting tremendously paid for it.

I really am extremely bullish on this trade. In fact, I have a very large amount of my own money in this strategy. I’m well into the 8-digits in the strategy. I’m excited about it! I’ll just stop there, and you can figure out –

Yes, let me backtrack to a couple of different points. I do want to just hit on the portfolio management aspect in this very difficult year. Obviously, hindsight is 20/20, and we don’t invest that way. We know the wide uncertainty.

I guess my question is, this strategy and your approach has had this strong risk-integration, as you’ve termed it. Balancing credit and duration effectively. Credit-risk and interest rate risk. Often, the opportunities – because those markets are kind of separated – investors are myopic and just focusing on one or the other. Sometimes putting them together creates this great yield versus duration.

But, given the beginning of the year – starting from these rock-bottom yields — I guess the question is, not trying to be hindsight-completely, but –

What might you have done? Could you have done some things to mitigate some of the short-term losses that we’ve seen? I guess the obvious point would be just to go short-duration and have no credit risk.

Jeff: The problem with that idea – I’ve been asked that question from time-to-time over the years. The problem with that idea is, frankly, I think we wouldn’t have any purpose. What would happen –

The only thing that you could’ve done this year is own cash. That’s it. You could say you’re going to short credit, but I don’t know. Shorting credit, to me, is a tough beat-the-clock game. You end up bleeding whatever carry. I know it wasn’t very high. But you’re still bleeding carry.

What am I going to tell investors? “Hey! I’ve got this strategy, and it’s kind of creative. I’m trying to have high returns, over time. Returns of 500-bps, at least, above traditional bond portfolios.” We’ve done that, here.

You say then, “Guess what? We have a yield of negative-3, and a duration of zero.” Like, “What’s exciting about that?” That’s the ultimate short-term investment.

If you’re wrong on that, you’ve just delivered a nothing-burger to everybody. We’re trying to find the best combination of risk-and-reward.

Jeremy, you talked about the risk-integration thing. The risk-off sets with treasuries versus credit. That’s of no value, this year. The 30-year treasury bond had a draw-down of 50%.

So that’s not going to help you. The 2-year treasury isn’t going to help you.

You basically were dealt – like I said in my opening comments – just about, for financial markets broadly – the worst-possible setup of all time. The Fed behind-the-curve. The inflation rate surprise on the upside. No yield-cushion.

We’re never looking at a six-month time-horizon. We tend to look out a couple or three years; at least, 18 months. We’re trying to figure out how to best navigate, so we end up with the strong absolute-risk-adjusted returns, over time.

Gradually, and as the market would allow, we’d strategically upgrade and comb through portfolios – to try to minimize exposure. Primarily, to defaults. That’s what we’re really worried about.

When we have a setup here with a 10.5% income-flow and an $81 price, as long as we minimize defaults, we can’t be so bold as to expect no defaults. Particularly, in a recession.

We expect some defaults in the emerging market area. We expect some defaults in perhaps some of the triple-B CLOs. We expect some defaults, perhaps, in the riskiest parts of the ABS market.

But I don’t think we’re going to have 10 points of net losses. That’s what we’re assuming, when we talk about a 12% yield.

When you’re facing a potential default cycle, you’re trying to balance the fact that you own credit, but try to do it in the most-sensible way. Those sectors seem really excessively cheap because the risk is identifiable.

You used to be able to talk about airlines. They’re no longer that much at-risk. You used to talk about commercial office-space. You’ve got to watch out for that. You’ve got to watch out for parts of the emerging markets. Thank God we didn’t own Russia or Ukraine.

We don’t have a lot of emerging markets in the portfolio. But we want to, once the dollar definitively turns. I’m getting close to being ready to announce that that’s happening.

Jeremy: How [much below / close to] the 200-day moving average? [I just checked].

Jeffrey: The 200-day moving average – very close. But I’m also using 1.08 on the euro. I think if the euro can get to 1.08 and hold there, I’m going to say the dollar has topped.

What will happen there is, you’ll have outrageous returns – with some default risk — from emerging markets.

Our emerging markets – we’re assuming some defaults. It’s only 5% of the portfolio. We want to go higher, when the dollar definitively turns. With the defaults we expect, the yield on the emerging markets we own is 15%. There’s just a lot of 15s and 16s in this portfolio.

I’ve been telling the team the past couple of weeks that, “You know, earlier this year, I was getting increasingly less bearish on rates.” Because they were going up and going up and up.

I talked about how, when the 10-year treasury got up above 4, it was starting to become an opportunity. Weirdly. Even though it’s a negative-interest rate versus inflation.

That’s what’s keeping people away. They see an inflation rate that’s up to a level, and they look at the bond yield and say, “Why do I want this 4% bond thing?”

Well, this isn’t a 4% bond thing. This is a 12% bond thing. It’s a totally different thing.

It’s really an interesting environment, because I explain this to people and I’ve explained this idea to pension plans and I get the same answer from institutional money. This explains why this is available.

They all say, “I don’t have any money.” They’re all committed to lock up private equity funds, and they’re getting capital calls.

I’ve talked to some of the biggest state pension plans in the country, over the past couple of months. They say, “We have no money.” We understand that –

They’ve got the classic trap. Because you’re trying to squeeze out a certain yield of earning for your pension liabilities, and yields are collapsing and collapsing – they just start going to this pie-in-the-sky stuff. “Oh, who cares?” It’s locked up. They say, “I’m going to get a –” “That’s what I need, and so I’m going to do it.”

Then suddenly, 18 becomes available. Or certainly a not-so-risky 12. And they’re like, “Gosh. I wish I’d waited.” But, here it is.

I think that yes — with the range of returns here — it’s going to be hard to be significantly negative at all in 2023, given the yield-profile and the risk-profile of the fund.

We’re starting to see that sort of demand. It’s a weird situation. The investment looks as-attractive as any time since maybe nine years ago. Yet people don’t have the money to buy it. Those two things are exactly the same things.

Jeremy: Just on the liquidity – we’ve got one question from someone that’s been listening in. The question was, “[Is] there evidence of – when illiquidity is high, that it’s a great time to buy?” But it would seem – seems

My question also is, “What will be the catalyst, in your mind, for that liquidity to improve?” Returns come in and then people start shoveling money? Is it the Fed [stopping] pivoting?

Jeffrey: It’s sentiment. Sentiment flips. You go from doom-and-gloom, and, “These things are going to zero,” mentality – to – suddenly they start going up.

Once they start going up, you get a gap higher. Suddenly, there are no sellers. There are only buyers.

You start to see, “Okay. it doesn’t yield 12%, anymore.” Let’s just say it’s two months from now. It now yields 10.5%. Right? It’s still attractive, but that’s already a big return. People start to chase return, and chase the fact that the yield is still there.

When you’re buying bonds – particularly, when you’re off-the-run, like we are here – and there’s some illiquidity involved –

You can’t wait for the turn to buy. You won’t be able to buy. You’ll go from a yield of 12% to a yield of 9%. It’ll happen really fast. There’ll be a month that’s 8%. Then it’ll be, “Whoa – I missed it.”

One thing I’ve been telling the team about the treasury market for our core funds, where we always own some treasuries. I say, “Look…”

I think the treasury market is pretty cheap, at around 4% or certainly 4.25% on the 10-year. I think it’s very attractive, there. I don’t want to be bearish on rates. But at this point now, I’m starting to feel bullish on rates. Meaning they’re going to fall.

I’ve told the team, when it comes to more index-fund investing, we’d better not be so defensive anymore on interest rates.

When you think, “Okay. Maybe I should buy them at 4.25%. Then they go to 3.85%. Then they go, “Well, I think I missed it. I’m going to wait% for 4, again.”

I told the team – what if it goes to 3.50%? Then what are you going to do? You’re going to be kicking yourself. You’re going to say, “Well, I knew it was cheap, but I was being cute. I didn’t want to buy the rally; I was waiting for the selloff.”

Then, what do you do when it’s 3.50%? I don’t know. That’s the position you don’t want to be in.

I view this type of thing like that. It’s like, “Okay. You’re worried about risk and illiquidity. Maybe a recession’s coming. We’re going to have some defaults.” We factored that into our analysis.

But you want to hold off. Maybe I don’t want to buy it, now. Maybe when somehow J Powell says the right thing. When J Powell says the right thing, it’s not going to be 12%, anymore. It’s going to be 9% – it’s going to be 8%. Then you’re going to say, “Oh, now what do I do?”

I view this as a long-term strategy. I’ve owned this for 31 years. The return – I’ve never sold anything. None of my stake. I’ve only gone higher. I just view it as, “forever.” I guess 31 years is starting to sound like forever. But that’s where I am on it. And it’s by-far the best investment I’ve had, when it comes to fixed-income investing.

Let’s talk a little bit more about the Fed. Your base-case, I guess, is as you said – they probably will not get to 5%. The market is going to adjust to that. However, that’s because you view the – well – I don’t want to put words in your mouth, but –

Jeffrey: Right. But it is with almost metaphysical certitude that we’re going to come down in the next 5 months. What got the Fed so frightened, and what got yields on the march to the upside was starting in late 2021, and the first few months of 2022. Every single CPI print was above expectations. There were a bunch of 0.9s in there. 0.7s – 0.9s. If you annualize them, they’re big numbers.

We have a classic base-effect thing, which must happen, basically. [Decline] prices are down. Home prices are falling. I know owners-equivalent rent will probably stay on a lag basis. But energy-inflation is coming down.

We think we’re going to get more like 0.2 or 0.3 types of numbers. What’s rolling off is something like 0.7. We’re talking about year-over-year inflation dropping by easily 2 or perhaps even 3 percentage points in the next six months.

Suddenly, it’s not going to be, “Oh, my God! Inflation, inflation, inflation.” It’s going to be, “Wow! It’s actually starting to look like 4%.” That’s not going to take a year. It’s going to happen.

We actually predict that the number printing in June – which is the May CPI type of number – is going to be about 4.25%. Based upon our model, which is pretty simplistic, but it’s been pretty helpful.

Suddenly, you start to talk about, “Well, J Powell wants positive real interest rates.” He said so in plain English. He wants them across-the-curve. Well, at 4.25% on the CPI, you’re sort of already there.

Besides that, if you look at the implied yields from TIPS versus nominals and stuff, there are real interest rates. Real interest rates have gone up.

Jeffrey: They’ve gone from negative-1% to plus-1.5%. Maybe even negative-2% [at mid-year] to plus-1.5%. Inflation expectations are pretty relaxed. I mean the 5-year never seems to change. It’s always at 2% or 2.5%.

The Fed is going to get its wish, I think. The economy is not booming. In fact, it’s almost zero-growth. We have quantitative tightening. We have the Fed already very aggressive.

There’s an NFL ad that was for Crown Royal Whiskey. I don’t know if they still run it. But there’s a bar full of people, and this guy dressed up like a referee in full uniform, comes in. He blows a whistle and says, “Everybody – your next drink is a water.” The tagline is, “Stay in the game.”

Every time the Fed raises rates 25-bps, it’s like the guys in the bar doing a shot. They did one shot, then they did two shots. Now they’ve done three shots, four times. It’s like, “Have a water!” I mean, come on! Make it to the third quarter. Stay in the game!

The Fed is already, I think, over-tightening. That’s the message of the 10-year. It’s now – I mean, it looks to me like it’s — pushing to 3.50%, here. That’s a pretty strong message.

I just want to reiterate that we have a litany of recession-indicators that predict how long will it be to recession. A year ago, there was maybe one you had to look at. I said, “There’ll be no recession in 2022, but I expect one in 2023.” At this point, I think we’ll be acknowledging that we’re in something of a recession in the first half of next year. It’s only about six months away, at the most.

Quickly, on real yield. Getting a bit more esoteric, here. But that’s been a key driver for equities.

As you mentioned it, when you look at the 10-year TIPS, it’s a 1.5% real yield. We haven’t seen that since pre-GFC. Right?

Jeremy: I guess what I’m asking is, where’s the new-normal? Nothing’s in equilibrium, forever. But —

I guess there are TIPS and then there are just the 10-year versus inflation. But do you think the world can sustain 1% or 2% real-yields? Or is the new normal around a zero-percent real-yield? If you think that way, at all. If it’s relevant to how you think.

Jeffrey: I sort of think that the real-yield – the “normal,” now – it probably is very near zero. Maybe 50-bps. Something like that.

When we talk about real-yields, one thing that’s interesting is, the copper/gold ratio – which is one of my favorite starting points for, “Where should the 10-year yield be, on a fair-value basis?”

People ask, “Why copper/gold?” I say, “Why not soybeans/orange-juice?”

It’s because copper is economically-sensitive. Obviously, it reflects strong housing, manufacturing, and inflation. If it’s a strong economy or inflation, copper goes up. Those are things that are bad for the 10-year; so yields should go up.

Gold is kind of a flight-to-safety thing. When things are bad, maybe gold can be a storehouse of value. It makes sense that the numerator should go up with yields, and the denominator should go down with yield.

Eighteen months ago, we had one of the biggest divergences in the copper/gold ratio in history. The copper/gold ratio said the 10-year treasury yield is way too low. It should actually be about 3%.

Now, it’s the opposite. The 10-year treasury yield was up at around 4%, just a few days ago. The copper/gold ratio says it should be at 2%.

I always respect the copper/gold ratio. It can get distorted because of economic manipulation, which we have in spades in the past three years. But it tends to win out.

I think that suggests that the 10-year treasury may go to 2% next year. If it does, we’re probably going to have a recession. We’re probably going to have some defaults in credit. But at least you’re going to have a base effect that cushions the decline.

If spreads have widened out by 200-bps just on treasuries going down, it’s like, “So what if they go out a total of 300? It’s not going to be the end of the world.” I think that’s what we’re looking at.

What that suggests is that if the 10-year goes to 2%, and the inflation rate kind of overshoots on the downside there, which i think it would, you’re probably hovering down at zero to [50]% real yields at that point.

Someone asked for a couple of examples that you have not rated, in your portfolio. A good chunk is in the, “not-rated,” category.

Jeffrey: Yes. A lot of that is in securities that simply haven’t paid for a rating. They tend to be in the residential mortgage market. In fact, when we say, “Not rated,” most people – understandably – assume that they’re mega-junk bonds. Like, below-triple-C. That’s not the case here, at all.

Rating agencies are way different than they used to be. A lot of securities just don’t bother to get a rating. A lot of that exists in that securitized, non-agency MBS portfolio. That’s where the majority of it is. We actually think they have no –

We’d actually put them as – I don’t know if I’d call them, “triple-A,” exactly – but maybe they’re double-A.

The question was, “What are the chances the Fed causes the recession without fanning inflation?” You’ve laid out a case where you see more likely that –

If they get inflation down, we’re maybe heading into disinflation or deflation.

Jeffrey: Here’s the statement, and it’s a qualified statement. It’s very important that the audience understands this.

If the Fed succeeds at getting the inflation rate below 3% in 2023 – which is what the predictions are – I think we get a negative year-over-year CPI on the headline. It’s not going to stop there.

I want to point out that I haven’t even touched on this. People are using credit a lot, right now. People got used to a certain lifestyle on government money. They spent a lot of it – sure – if you’re in the top-40% of income, you probably still have a lot of cash.

You see the statistics, “Oh, there’s still a lot of cash around.” Not for bottom-60%, there isn’t.

What they’re doing is using their credit cards and applications for non-secured loans are going way up. Credit card use is going way up. Delinquencies are going up.

Anecdotally, Walmart is reporting a tremendous influx of first-time customers. They used to shop for their food at Whole Foods. But once you start having problems with your budget, thanks to gasoline and food prices at Whole Foods, you find a really easy way to save money on food. You shift to Walmart. The prices are like 25% lower.

Walmart has this huge influx of new customers. The other thing that suggests economic stress at the consumer level. The other thing is what Walmart is reporting.

These new customers and existing customers have shifted mightily from using debit cards – which means checking accounts – to credit cards. That means they’re in a tractor-pull lifestyle. Every month, you borrow more money to buy food. So you have more interest payments next month. You borrow even more, and you’re in a compounding cycle the wrong way.

The 11^th Wonder of the World – said Ben Franklin – is compound interest. The 8^th Deadly Sin is the opposite. Where you’re paying compounding interest. That’s where the US consumer is, right now.

I don’t know if I have ever seen an environment where you can’t really identify any sector that is going to be an accelerant to the economy. Just look at the shifts in relative-performance. How growth had been such a world-beater. It’s getting crushed. All the leaders on the upside – the FANG stocks and the like – they’re now of course the leaders on the downside.

I think what that tells you, broadly, and this is a off-topic, but I’ll bring it back onto topic in a moment. What it tells you broadly is that these trends of the past decade with the US outperforming everything and stocks blowing everything away – the Nasdaq crushing the S&P. The S&P crushing emerging markets. Those are all in the process of changing.

I talked about this two years ago. Many of them have already convincingly shifted, and it’s going to keep going.

I think we’re going to start to see stocks show up screening at the bottom of returns. I think you’re going to start to see fixed-income and emerging markets versus the United States — all of these trends are going to be very powerful in the years ahead.

I think investors should by emerging market equities, once we get that 200-day moving average. I would go very heavily in there.

When we feel that the time is right, we could easily quadruple our exposure to emerging market debt, and maybe sell out some of these other sectors that have held in better.

We did get a question about equities. Since you mentioned it, I think it probably goes without saying, but I don’t want to put words in your mouth. If the recession scenario does play out, and all the indicators are there – the market went down about 24% or 25% this year. It’s rebounded.

Is your view that, if your scenario plays out, equities are going to break through those lows? Call it the S&P we saw earlier?

Everybody in the world – when the S&P was at 3550 – said it was going to 3400. Frankly, that was my inclination, too.

I started to become suspicious of that when it started losing momentum. Then every time I turned on the TV, somebody said, “It’s going to 3400.” I thought, that doesn’t sound right, to me.

I started to toy with the idea that we could get up towards 4000 on the S&P, but that’s kind of where we are. I don’t know. I think earnings are going to be revised lower. I think wage-pressures are going to be a problem. I think you’re going to have real problems with advertising.

Obviously, these high-flying meme-stocks rely on advertising. They’re doomed.

You’ve got FTX. You’ve got a classic fraud-scam, which characterizes an unhealthy market. All of these things are going on.

I’ve got a feeling that the moves down – particularly in the high-flyers – and that includes, of course, the crypto space –

I think those types of concerns, where we all collectively went crazy and bought GameStop and Peloton. Peloton! The stock is down like 99%! There are going to be a lot more of these mineshaft-equities. It might not be broadly, in quality names, where you suffer those problems. But around the fringes, where people are in rank-speculation mode, there are going to be more problems. I think in aggregate, that leads to more of a feeling of caution and reluctance. That will make the stock market meet a P/E probably several points lower than where it is, right now.

I know your Superbowl pick is the Bills. I don’t know if you have a World Cup pick.

Jeffrey: I don’t have a World Cup pick. I’m not much of a soccer afficionado. I don’t know much about it. But I’m going to pick some team that wins all the time.

Jeffrey: Yes. Okay. Let’s go with Brazil. The Bills, I don’t know. Everybody in the NFL – their injuries are just piling up. That’s the thing about football.

Von Miller says he’s going to try to play through. He’s got a torn lateral meniscus. I don’t even know what that is. But he’s going to try to play. I’m not even sure that’s good. If you’re not really full-power.

But yes, we’re optimistic. And I guess the Bills are still favored to win the Super Bowl. I’ll stay hopeful. Let me put it that way.

Jeremy: All right, Jeffrey. Thank you so much for the time and extra overtime play, here. We look forward to talking again. Just to reiterate – we are long-term investors. This setup now – we completely agree with your approach. You have to take some short-term pain to generate the superior long-term returns. That’s what we think history shows for the vast majority of great investors.

Jeffrey: Thank you! Thanks for your support, and talk to you later. Bye, now.

Corrina Steinberg – behind the scenes – our producer – thanks for your great work on this, as well.

Until next time, we wish you all very happy holidays. If we can be helpful in any way, reach out to us. Otherwise, until next time. Take care.

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