Bond Fund Chief’s Dour Outlook

There’s no mistaking Jeffrey Gundlach for an economic optimist. The TCW Group investment chief puts the odds of a U.S. recession in 2007 at about 75%.

He thinks Americans are spent-out, and that the weakening housing market will only make them feel worse.

“I think we easily could be looking at a relatively rare consumer-led downturn” in the economy, Gundlach says.

Stock investors, he says, ought to be very cautious and consider lightening up.

But this should be a good time for owners of high-quality corporate, government and mortgage bonds, he says: If the economy weakens, interest rates ought to decline, which would boost the value of older bonds paying higher fixed yields.

Gundlach notes that long-term Treasury bond yields have been sliding since late June. The 10-year T-note yield ended Friday at 4.78%, the lowest since March 28 and down from a four-year high of 5.24% on June 28.

As TCW’s leading authority on mortgage-backed bonds, Gundlach could be accused of “talking his book,” which is Wall Street parlance for pitching a forecast that would benefit his own portfolio.

But even investors who have Gundlach’s same dour outlook for the economy may have misgivings about mortgage bonds in that environment. One fear is that falling interest rates could spur another mortgage refinancing wave that could retire many of the highest-yielding bonds earlier than investors had hoped, cutting into their returns.

But Gundlach says he doubts that long-term rates would get low enough to fuel a repeat of the major refinancing wave of 2002-03. So he’s more confident about the outlook for sustaining the interest income of his TCW Total Return Bond fund, which now generates an annualized yield of about 4.5% on its I-class shares that are sold directly to investors. The fund’s total return (interest plus principal change) year to date is 2.4%.

Another concern is that some investors in mortgage bonds might bail out in a panic if they feared that home loan default rates could soar. In 1994, the mortgage securities market suffered a sharp sell-off when the Federal Reserve doubled short-term interest rates. That temporarily pounded the share values of some TCW bond portfolios.

Although the market’s vagaries are always a risk, Gundlach notes that all of the bonds in his mutual fund have the highest possible credit rating. The securities either are issued and guaranteed by finance giants Fannie Mae and Freddie Mac, or are secured by collateral guaranteed by those firms or by U.S. agencies such as the Government National Mortgage Assn., known as Ginnie Mae.

In other words, Gundlach says, even if more people default on their home loans, that isn’t a concern for investors who own mortgage bonds backed by credit guarantees -- as long as they can stick with them.

Investors interested in more on Gundlach’s views can visit www.tcw.com.