Q&A: BONDMEISTER WILLIAM GROSS ON TREASURIES, MUNIS, DEFLATION...
With $140 billion in fixed-income assets to manage, William Gross is the nation's leading bond investor. And while Gross has posted a long record of outperformance stretching back a quarter-century, he's still driving to outrun the pack. For example, the Fremont Bond Fund that he runs on behalf of individual investors was up more than 9.3% this year through Sept. 30, besting the broad bond market index by more than a percentage point. Gross, managing director with Pacific Investment Management Co., spoke recently with Business Week's Robert Barker by phone from his Newport Beach (Calif.) office:
Q: What's your view of the bond market right now?
A: Well, just a quick preface. There are actually about four bond markets these days. There's the government market, which draws the headlines. And the mortgage market, the corporate market, and the international market, all sort of disparate, I guess, and each of them go their own way.
But in terms of the government market, which as I mentioned carries the headlines, my sense is that we've come a long way. A 5% long bond, which is where we are now, and 4% two-year note, which is where we are, well, we've come a long way. While they may fall a little bit more, certainly most of the move in yields and most of the move in prices have already been made.
Q: I see.
A: My sense is that the U.S. economy is moving into a recession and that the Fed will be forced to continue to cut Fed funds down to perhaps 4% or maybe even as low as 3.5%. But even if they do, the existing level of Treasuries anticipate much of that reduction.... I'm not disenchanted with this bull market, I guess, but my sense is that it has limits, and we're probably approaching those limits.
Q: Many people think there's a lot of value residing now in the muni market? Do you share that view?
A: I do. The way that most of us usually look at this is as a percentage of, or a ratio to, Treasuries. The fact is that long-term munis now are trading right on top of long-term Treasuries, or at 100% of the stated yield, which is almost historically unheard of. It's historically high. And the last time this happened, years ago, it was in anticipation of a substantial reduction in tax rates, which we don't have at the current time. The current situation is more of a supply-demand situation in which Treasuries have been in demand and municipals have not, and have suffered under a fairly significant [new issue] calendar. So if you can buy a single-A muni at the same yield tax-free as a triple-A Treasury, there's no doubt which one I'd buy if I were in the proper tax bracket.
Q: There's obviously a lot to worry about in the world today -- deflation and liquidity crunches, to name two. Should individual investors worry about that stuff?
A: I think those conditions in the global economic environment and the obvious contractions in Asia, and perhaps in South America and ultimately the U.S., affect all of our financial markets.... I think this global contagion is the most important phenomenon, and the most dangerous phenomenon to financial stability, that we've seen in the past 60 years. So investors have to be concerned about and aware of it, and gear their investment strategies based upon it.
In the bond market, it suggests investing in high-quality bonds, either Treasuries or high-quality municipals or, third, a high-quality mortgage fund, primarily government-backed Ginnie Maes and Freddie Macs and the like. So take the high-quality, triple-A paper because this economic environment is going to get worse based upon the global contagion that we've seen these past 12 months.
That's the first recommendation -- stick to high-quality. The second one would be, to the extent possible, focus on intermediate maturities because they will be the ones that will benefit most from a decline in the Fed funds rate, which I think is going to occur over the next six months or so. When the Fed drops short-term rates, intermediate-term rates tend to fall more than any others, and therefore intermediate notes increase the most in price. So I'd focus on quality, and I'd focus on maturities in the 5- to 10-year intermediate category.
Q: Is actual deflation in the U.S. a realistic prospect?
A: It's becoming more and more possible. I wouldn't necessarily make it the odds-on favorite possibility. My sense is that the U.S. economy is still strong enough to avoid deflation and, based on what we've seen with the weaker dollar in the past few weeks, the most likely forecast is that inflation as officially calculated stops in the zero-to-1% range in the next six months or so.
But the probability of deflation, or of negative inflation, has certainly been moving higher and higher, and I would continue to watch not only the U.S. economy but the global economies for a tip-off to whether we tilt over into a deflationary environment. We know about Asia. If South America, and Brazil in particular, is forced to devalue and those economies tip over into significant recessions, the U.S. can't be far behind, and that would tip zero-to-1% inflation over to actual deflation. But at the moment I still give it a 25% shot as opposed to a 50% shot.
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