Rent Bond Savvy on the Cheap

12/23/2011 10:00 am EST

Focus: FUNDS

Igor Greenwald

Chief Investment Strategist, MLP Profits

Star fund manager Jeffrey Gundlach has assembled a bargain-basement portfolio that offers several ways to win, writes senior editor Igor Greenwald.

The rent is too damn high, and it’s only going to go higher.

This can hardly come as a surprise with millions of former homeowners now renting, residential construction near historic lows, and more than a million homes vacant for lack of creditworthy buyers or enterprising landlords.

US rents have been rising relative to home prices for two years now, to the point where it’s almost more expensive to rent a typical home than to buy it with no money down, if such a thing were still possible.

That’s one reason construction starts for multi-family homes took off in November. An Associated Press story reporting on the surge quoted two relevant stats:

  • The average rent is up 2.4% this year to $1,004 monthly, according to real-estate data tracker Reis.
  • The ranks of renters are expected to swell by 2 million households a year over the next decade.

The dislocations in the housing market are such that, in many areas, a smart landlord with good credit can get the tenants to pay off his mortgage, building equity and getting a tax deduction for his trouble.

Of course, not everyone’s cut out to be a landlord. But any investor can take advantage of the safety net that rising rents place under the housing market, by making default a less attractive option.

That should benefit funds that bought private mortgage securities at big discounts this year on worries of another leg lower in home prices. Fixed income manager and finance blogger David Schawel makes a convincing case that star bond-fund manager Jeffrey Gundlach has been particularly adept at this game, taking advantage of what Schawel calls “draconian default and loss assumptions” that were already priced in.

I wrote last month about the recent uptick in mortgage delinquencies, as reported by HSBC (HBC) as well as the consumer credit agency TransUnion.

But if TransUnion is right about delinquencies peaking at just above 6% early next year, and then declining significantly from there, Gundlach figures to win even bigger on his DoubleLine Total Return Bond Fund’s (DLTNX) 33% allocation to the residential mortgage-backed securities not guaranteed by the US government. (Those are the ones that have been discounted most mercilessly.)

DLTNX is Gundlach’s flagship fund, and it’s roughly doubled the return of comparable funds since he defected from former employer TCW and set up his own shop not quite two years ago. DLTNX is up 9.2% year-to-date, nearly 4 percentage points more than its category, according to Morningstar. The fund yields 8.2% on an annual basis via regular monthly distributions.

How much will you pay to let the hottest bond-fund manager on the planet find the fixer-uppers that are his specialty on your behalf? The expense ratio is a reasonable 0.74%, which beats the 2-and-20 (2% plus 20% of investor gains) king’s ransom some hedge-fund managers charge for similar acumen. The minimum investment in DLTNX is just $2,000.

If a 9% return doesn’t sound so impressive, given the 15% yield of a mortgage REIT like Annaly Capital (NLY), consider that Annaly is leveraged 5:1, while DLTNX is not borrowing to invest. If rates should continue to fall, or if the Federal Reserve should buy more mortgage securities, Annaly’s interest margin will shrink amid prepayments.

In contrast, lower rates and higher prepayments actually benefit Gundlach’s portfolio, because some securities bought cheaply would be redeemed at par, while others bearing long-term risk would rise in value.

The downside is that the fund‘s assets aren’t as liquid as Treasuries or the plain vanilla government-backed agency bonds, so it might not fare so well in a panic. But it should do better than OK across a range of other outcomes, with room for significant upside should the economy improve or mortgages become more accessible.

For those who want to see what Gundlach might be able to do with a little leverage, DoubleLine recently filed papers for the DoubleLine Opportunistic Credit closed-end fund, which will be able to borrow 33% of assets and buy whatever tickles the wunderkind’s fancy, according to Morningstar.

But I’d look first to DLTNX, which should benefit for years to come from what right now looks like some very shrewd recent shopping.

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