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Gundlach: Shaky Mortgages to Solid Returns

Investors gave this unorthodox fund manager $1.7 billion -- and so far have not been disappointed.

NEW YORK (TheStreet) -- As manager of TCW Total Return Bond (TGLMX) - Get TCW Total Return Bond I Report, Jeffrey Gundlach compiled an eye-popping record. During the 15 years ending in 2009, the fund returned 8% annually, topping 99% of its intermediate-term competitors, according to Morningstar. Gundlach slightly outpaced PIMCO Total Return (PTTRX) - Get PIMCO Total Return Inst Report, the giant fund run by star manager Bill Gross.

What made TCW's record particularly noteworthy was that Gundlach focused solely on mortgage-backed securities. Most competitors owned a wider range of holdings, including corporate and government bonds, as well as mortgage securities. Gundlach seemed to play with one hand tied behind his back. The handicap became especially important as the credit crisis unfolded and many mortgage securities collapsed. But Gundlach sailed through the turmoil, delivering solid returns.

The strong performance came to an end in December, when Gundlach quarreled with his bosses. Charges and countercharges flew, and the portfolio manager was forced to look for new work.

In April, he opened

DoubleLine Total Return Bond

(DBLTX) - Get DoubleLine Total Return Bond I Report

. Loyal investors have poured $1.7 billion into the fund -- and so far have not been disappointed. During the past three months, Gundlach has returned 6.6%, outdoing 99% of competitors.

The fund's showing is due to an unusual strategy. To take advantage of peculiar conditions in fixed-income markets, Gundlach has divided his portfolio in two. About half the assets are in shakier mortgage securities that are not backed by government agencies. Most of the rest of the portfolio is in long-term securities backed by ironclad government guarantees. Both positions have been racking up gains.

Gundlach bought the long-term securities because of his belief that the economy would remain sickly. The government stimulus program simply adds to the country's debt problems without creating productive jobs, he says. "If you borrow money to hire makework government employees, you just create the illusion of recovery -- not real growth," he says.

In the spring, Gundlach figured investors would become worried about the bleak economic outlook and seek shelter in Treasuries. That would push up Treasury prices. When bond prices rise, yields decline. He thought yields on 10-year Treasuries would drop about a percentage point in coming months. To capitalize on the move, Gundlach bought long securities because prices of those enjoy a big bump when rates fall. His call was on target, though the market moved faster than he expected.

Can rates continue declining? Yes, Gundlach says, but the biggest moves are in the past. He notes that the yield on two-year Treasuries is now 0.49%, below the figure that occurred during the worst days of 2008. The skimpy yield suggests Treasury prices are peaking, Gundlach says. "We are 80% through with the Treasury rally that began in the spring," he says.

Gundlach bought the shakier mortgages because the yields were in double digits. Investors demanded the high yields because homeowners with lower-quality mortgages were defaulting at an annual rate of around 15%. Gundlach felt that the yields on the mortgages more than compensated for the risks.

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His bet paid off in recent months as officials in Washington began talking about providing support for homeowners facing default. Such a program would lower the default rate. That helped prop up Gundlach's mortgages.

The move into shakier mortgages is a departure from the approach Gundlach used during most of the past decade. Over the years, he typically put most assets in high-quality securities from

Ginnie Mae

and other agencies and held limited positions in mortgages that came with no guarantees. Early to spot problems in the subprime mortgage markets, Gundlach jettisoned his riskier holdings and moved entirely to government-backed issues in 2007. That enabled him to stay in the black in 2008 when many nongovernment issues sank.

By the second half of 2008, the bargains became irresistible, and he began gradually buying issues that came with credit risk. By early last year, the fund had half of its assets in deeply discounted securities. Those rose sharply as markets stabilized. Gundlach says that the prices are still too low, and the securities will continue climbing. "There is still a little more gas left in the tank," he says.

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Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.