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Jeffrey Gundlach Talks

Total Return Strategy

August 2018

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1. How is the DoubleLine Total Return Strategy similar to the Benchmark? Why does the team prefer mortgage credit?

When I started the total return strategy nearly 30 years ago*, it came as a result of observing that it was potentially possible to have the same or higher income with the same or lower risk than that of a standard index fund or the index, the Bloomberg Barclays U.S. Aggregate Index (“Agg/Aggregate”), which is the most common index used in the intermediate-term fixed income category. We looked at the historical performance and yields of the various major fixed income

sectors and the data was powerfully convincing that the Agency mortgage market had lower volatility than the Aggregate market and index

and about the same return. So it was possible to have higher risk-adjusted returns just by indexing in Agency mortgages rather than indexing in the Agg. The Agg is comprised roughly of three sectors stylistically. One- third today is government bonds/treasuries, one-third corporate bonds, and one-third agency mortgage-backed securities. In the Total Return Strategy, we consider this same mix of treasury or Agency mortgages and credit risk. In the index the credit risk is taken exclusively in corporate bonds while the DoubleLine Total

Return strategy, has never owned any corporate bonds. This happens

to be one of the distinguishing characteristics: no corporate bond exposure. We do from

time to time take credit risk using non-Agency mortgages. There have been time periods however, where we’ve had no credit risk in the total return strategy and there have been times when we've had roughly 50% of the strategy in credit risk. And that flywheel is a way to help improve the return of the strategy and reduce the risk at appropriate times. Since we started the Total Return strategy at DoubleLine, it's been roughly 1/3 in non-Agency credit securities, sometimes a little bit more, but roughly 1/3 credit and 2/3 in government Agency securities. The vast majority of the government securities are Agency mortgage securities so we have typically run about double the weight in mortgage securities over the index. But when you add up mortgages and treasuries, the weighting is very similar to that of the Bloomberg Barclays Aggregate Index. Much of the time the largest holding of our credit position has been in the non-Agency residential mortgage-backed securities which presently represents over 60% of the credit risk that we’re taking in the strategy. One of the reasons that we prefer not to use corporate

credit in the strategy is the yield-to-risk ratio is unfavorable in

corporate securities versus securitized credit. The

corporate index has a very high duration, of seven years, presently especially given the tremendous corporate issuance that has taken place during this economic cycle. One of the ways that we risk mitigate in the strategy is by using structured credit securities that tend to have lower durations than the corporate bonds. The Agency mortgage securities market has quite a low duration because of the nature of the risk as it intermingles with the economic cycle. Some of the other securities that we use include Asset-Backed securities, Collateralized Loan Obligations (CLOs) and Commercial mortgage-backed securities (CMBS) some of which are floating-rate in nature and have very low interest rate risk. So

we’re able to put together a credit portfolio that has lower interest rate risk than the corporate bond sector with a higher yield. So again,

the goal of the strategy is to have a higher income stream with lower observable risk and volatility.

2. How do you risk mitigate in the portfolio?

As I said earlier, when I started almost 30 years ago, thinking about the relative risks and rewards of the fixed income sectors, it was clear that the Agency mortgage market had

* DoubleLine Total Return strategy started April 7, 2010

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much better characteristics to either treasury bonds or corporate securities. Now 30 years later, we have observed that the relationship has held the entire time. When we map out the standard deviation of the various sectors of the intermediate fixed income market, represented by the Aggregate index on a rolling

basis, the standard deviation of the Agency mortgage market is always lower than treasury bonds and corporate bonds, as well as municipal bonds which are not part of the index. The rolling 5-year volatility chart illustrates this point. Interestingly, the volatility of the of the mortgage sector is also more stable. This might take people by surprise because one of the things that people are concerned about, related to the mortgage market is that the average life or maturity of the securities changes with as interest rates change due to the effects of housing turnover, and most importantly potential refinancing. But even with the life of those securities being more unstable than those of fixed maturity treasuries or corporate bonds, interestingly, the volatility of the return stream of the Agency mortgage market is persistently lower than the other fixed income sectors.

The portfolio allocation between the structured credit and the Agency mortgages in the Total

Return strategy changes over time, as does the overall portfolio

duration. One way in which risk is mitigated in the Total Return strategy is to always have a lower duration than that of the Aggregate index. Much of the last few years our duration has been approximately 40%, or even 50% less, than the duration of the Aggregate index. Our risk management process allows us to respond to changing market environments while the strategy’s philosophy and process remains consistent.

3. Why do you favor structured credit over corporate credit?

In recent years corporate bond issuance has more than doubled from the 2007 levels with

corporate CFOs taking advantage of lower interest rates and leveraging their balance sheets to very high levels. Overall corporate credit as a percentage of GDP in the United States is now at the highest level in history. By issuing more and more long dated debt, investors have piled into investment grade corporate bonds for the last few years now. Unfortunately, buyers of corporate bond issuance may not

know that they will find themselves with unintended interest-rate risk consequences on top of the inherent credit risk so late in the economic cycle. In fact as

we look at the lower tiers of the investment-grade market and into

Lower Volatility: Rolling 5-Year Volatilities of Investment Grade Bond Sectors January 1, 2001 through March 31, 2018

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the junk bond market, we have seen tremendous erosion in the credit quality and covenants of the securities that are being issued. There has been research widely reported about a large number of companies in the corporate bond index, in particular the triple B category, that have very thin interest-rate coverage ratios relative to their EBITA. In the junk bond market, there are many securities where the revenue streams of the company do not even cover their interest rate exposure. So, the question is will they default during the next

downturn? We are starting at very tight spread levels so it’s our view that corporate bonds could have significant risk. Therefore, we are very

comfortably not owning corporate bonds in the Total Return strategy presently. Again, we believe that structured credit in the non-agency mortgage market, the CMBS market, the ABS market and the CLO market are all much less susceptible to the next economic downturn than corporate bonds both investment-grade and below investment grade. The duration of the Bloomberg Barclays U.S. Corporate index was above 6.02 years as of July 31, 2018 vs. the Total Return strategy representative portfolio of 4.20 years. In a rising rate environment an investor needs a significant yield to makeup for the principal loss inherent on a 6.02 year

duration portfolio. This is a major reason why we prefer mortgages

and structured credit. They have shorter durations which is an advantage in a rising interest rate environment. We often get

asked are non-Agency mortgages going away because they were issued prior to the credit crisis, have pay downs and refinancing. And that point is well taken. However, in recent years issuance continues in the non-Agency mortgage market with extraordinarily high underwriting quality. This is because in the aftermath of the mortgage meltdown over 10 years ago, the standards for underwriting were completely shifted from a reckless type underwriting regime into one that as a backlash became one of the safest underwriting regimes in decades. So as non-Agency MBS vintages prior to 2007 are winding down, other opportunities have arisen in structured credit and the newly issued non-Agency residential mortgage market. Away from the residential mortgages, other structured credit areas with opportunities include Asset-Backed securities, Commercial Mortgage-Backed securities (CMBS) and Collateralized Loan Obligations or (CLOs). While MBS fundamentals improve, technical considerations between supply and demand create additional opportunities so we expect to see growth in the sector over the next few years especially as

prerecession loans come due. The Total Return strategy and the Aggregate index presently have very similar credit exposure. However, the Total Return strategy credit mix is actively managed. The credit component of the portfolio has gone from nearly all of it being non-Agency residential mortgage securities of a legacy type, to now about 60% of those assets being non-Agency residential mortgages, some of which have been issued in recent

years. Historically, we take only what the market offers, avoiding asymmetric risk/reward profiles and don't chase momentum. The key is

always striving to generate the best risk-adjusted returns while maintaining lower volatility than the traditional Barclays Aggregate type of investment.

4. Why don’t all bond fund managers use a similar approach?

We get asked why don't all bond fund managers learn from this and adopt potentially a similar approach. The answer is quite simple. We don't think they know how. DoubleLine has a large experienced and robust structured products team. Many firms have traders focusing only on one subsector or the entire firm focusing on just a subset of the opportunity set available in structured credit. Some competitors have a focus on

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commercial or non-Agency MBS but don't know how to intermingle their risk profiles. Even if you can find a capable manager who can trade all of the subsectors successfully, that's only one part of the equation. The second part involves intermingling, the risks.

Knowing through experience, how to integrate these risks appropriately, which involves a deep understanding of the underlying collateral and sectors and asset types, knowing when to shift allocations on top of changing markets is the key. We think this second part of the puzzle gives us a competitive advantage.

5. What Opportunities do you see going forward and how will rising rates effect the strategy?

I've been widely quoted saying that “the 10-year Treasury could make it up to 6% or so sometime between now and the next presidential election”. In fact, I made that statement nearly two years ago in July 2016 when the consensus viewpoint was strongly of the opinion the 10-year Treasury was headed to 1%. So my prediction of perhaps a 6% 10 year, five years down the road was a stark contrast to the 1% consensus idea. I was basically of the mindset that interest rates could rise 100 basis points per year on average over the coming five years. Certainly, I never believed it

would happen in a linear fashion, but interest rates have risen exactly on pace for that 6% rising from 1% consensus viewpoint in the past two years. It's fascinating that the 5-year treasury is up almost exactly 200 basis points over those two years. So were exactly on track for a 5% rise in interest rates over a five-year period. The 10-year Treasury yield has risen a little less than that. But that's up 150 basis points as well.

It's constructive to take a look at the performance of the Total Return strategy over that two-year rate rise period versus the treasury part of the Aggregate index. July 2016, the bottom in rates, the 10-year treasury yielded 1% and the Agg yielded about 1.8%. At that time, rates had risen 200 basis points so we can take a snapshot of what has been the empirical experience of the Total Return strategy during what is now accumulated to a significant rate rise experience. On a net of all fees and expense basis, the Total Return strategy is up 1.3% annualized. That's fascinating because it's a 200 basis point increase in rates, and yet, it's a higher return than if rates hadn’t moved at all and investors had just owned treasuries during that period. It’s one of those things that people don't understand with the mortgage related aspect of

strategy. Rising interest rates do not lead to systemic underperformance. In fact, the opposite has been the case over

the fullness of nearly 30 years. When interest rates rise, generally, mortgages do extend and do get longer in duration during rising interest rates. They still have a lower duration than Treasuries and corporate bonds. Typically, for that reason, you see a lower standard deviation, lower drawdown and actually a higher return net of fees from the Total Return strategy that you would've had from a treasury portfolio if rates just stayed where they were over that two-year period. Of course, other bond sectors have been much worse. Corporate bonds have been negative over that time period corroborating the fact that they suffered during rising rates due to their duration. Even the Aggregate index has been negative over that time period. So

we have experienced strong outperformance during this rising rate environment. Looking forward towards perhaps 6% tenure over the next few years, we will most likely see tradable rallies and volatility. We would expect the Total Return strategy to have a higher return than the Agg, if the tenure goes to 6% in a nonlinear fashion. If it stays absolutely unchanged it is true that we might lose 2-3% in principle per year. However, we’re throwing off approximately 3 1/2%, nearly 4% cash flow now, so if rates rise to 6% that cash flow would rise along with the rising yields and we’ll end up with the cash flow yield somewhere around 7-7 1/2%, leaving us in a very good

Past performance is no guarantee of future results.

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position moving forward. One of t the things we understand about the mortgage market is that they are often mispriced. It takes an experienced team to identify these opportunities early by combining government securities with a structured credit component. There will usually be a part of the portfolio that is in demand and can serve to potentially offset losses or provide liquidity for the rest of the portfolio for any given market environment. That of course does not preclude a negative return or periods of underperformance versus the benchmark. It simply

means we try to manage our risk by actively moving the duration of the portfolio versus the Barclays Aggregate. The duration is always less than the Agg. Sometimes it’s close in duration and other times it can be quite a bit lower than the Agg. The duration decision depends upon our viewpoint on interest rate risk and the economic cycle.

6. What would be negative for the performance of the strategy and most fixed income markets?

A rapidly rising rate experience over a concentrated time frame. Perhaps do some sort of fiscal stimulus or budget deficit problem. A few years from now we like will be facing some large headwinds with quantitative easing deficits rolling off and having to actually be floated. There would be lots of corporate

bonds rolling over at higher interest rates with the great volume of maturities that are facing the corporate bond market over the next few years. Of course with all of these bonds coming due, we also have the President’s tax package which is scooping an estimated $280 billion out of the treasuries revenue stream, along with massive infrastructure and military spending being proposed adding to the deficit over the next couple of years. The good news is we don't see it happening over compressed timeframe

7. Do you think you will close your Total Return Strategy at some point?

We don't want to grow much above the $60 billion mark in this strategy. If we feel that there's a capacity constrain in any of our strategies that might possibly compromise performance, we would close the strategy or at least cease marketing it further. We did cease actively marketing another mortgage based strategy after the Taper Tantrum in 2013 for about six months for this very reason. So, we strive to ensure the client has the best experience possible and if that means closing strategies to maintain performance, that’s what we do. Remember, DoubleLine believes in offering quality products that will not compromise the quality of return for the clients. Fortunately, the mortgage market is quite large and we don’t believe there are any capacity

constraints for the Total Return strategy at this time.

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Definitions Agency MBS - Mortgage securities that are issued by U.S. government agencies, GNMA, FNMA and FHLMC, with an implied government guarantee. Bloomberg Barclays Capital Aggregate Bond Index - An index that represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Fannie Mae (FNMA) - The Federal National Mortgage Association (FNMA), usually known as Fannie Mae, is a government-sponsored enterprise that buys loans from mortgage lenders, packages them together, and sells them as a mortgage-backed security to investors on the open market. Freddie Mac (FHLMC) - Freddie Mac (FHLMC) is a stockholder-owned, government-sponsored enterprise (GSE) chartered by Congress in 1970 to keep money flowing to mortgage lenders in support of homeownership and rental housing for middle income Americans. Non-Agency MBS- Non-Agency mortgages are mortgage securities issued by private entities that have no guarantee. Quantitative Easing - An unconventional monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective. A central bank implements quantitative easing by buying specified amounts of financial assets from commercial banks and other private institutions, thus raising the prices of those financial assets and lowering their yield, while simultaneously increasing the monetary base. Important Information Regarding This Report This report was prepared as a private communication and was not intended for public circulation. Issue selection processes and tools illustrated throughout this presentation are samples and may be modified periodically. Such charts are not the only tools used by the investment teams, are extremely sophisticated, may not always produce the intended results and are not intended for use by non-professionals. DoubleLine has no obligation to provide revised assessments in the event of changed circumstances. While we have gathered this information from sources believed to be reliable, DoubleLine cannot guarantee the accuracy of the information provided. Securities discussed are not recommendations and are presented as examples of issue selection or portfolio management processes. They have been picked for comparison or illustration purposes only. No security presented within is either offered for sale or purchase. DoubleLine reserves the right to change its investment perspective and outlook without notice as market conditions dictate or as additional information becomes available. 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