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He has long been the guru of the bond market, the Oracle of Orange County, and the most widely quoted and closely watched bond expert in the country. But William H. Gross, chief investment officer of the world's largest bond-fund manager, is not above making a bad call.
For the past year, Gross and his colleagues at Pimco in Newport Beach, Calif., have been somewhat bearish on bonds. Their rationale: Interest rates were approaching historic lows, and the Bush Administration was intent on jump-starting the economy through tax cuts and deficit spending. Bond prices, meanwhile, had been on a multiyear tear. By December, Gross was ready to declare that, at least in terms of U.S. Treasury bonds, the market's "salad days were over."
The salad, however, has stayed fresh. The Lehman Brothers Aggregate Bond Market Index, a sort of Standard & Poor's 500-stock index of the bond world, is up 11.3% in the past 12 months. Some sectors, like junk bonds and the debt of emerging-market nations, have delivered double-digit returns so far in 2003.
"COCOONING" MODE. And the Federal Reserve continues to signal that the era of low rates isn't over. On June 3, Fed chief Alan Greenspan said it may be necessary to lower rates again as "insurance" against deflation. The yields on two-year Treasury securities, which move opposite to prices, fell to record lows that day. Gross admits that he's somewhat flummoxed. "We're in a very delicate period that's hard to analyze," he says. "We've rarely, if ever, witnessed a central bank so intent on reflating the economy. Typically they're inflation fighters as opposed to igniters."
Gross says Pimco has now entered a "cocooning" mode. He has taken the average maturity of his portfolio back up to and slightly above the market average of 3.8 years, a position that would benefit his investors if interest rates continue to decline. Gross is keeping a third of his money in mortgage-backed bonds, right at the market average. He's underweighted in corporate bonds and Treasuries, which have both appreciated rapidly in recent months.
Nearly 30% of Pimco's flagship Total Return fund is in cash, but Gross says that's the result of a hedging strategy Pimco employs rather than an attempt to keep money handy for purchases if the market declines. "Our portfolios are pretty close to home," Gross says. "That reflects the uncertainty. I'd much prefer to have a take on where we go from here."
"A ROAD MAP." In this unpredictable market, Gross sees few screaming buys. Pimco has a 10% position in foreign-denominated bonds, mainly those of European nations like Germany where Gross says the economy is weaker, and central banks are likely to lower rates further. He's postitively pounding the table for municipal bonds, many of which now trade at similar yields to Treasuries despite the fact that munis are free from state taxes. In particular, he likes closed-end muni-bond funds that trade like stocks and have the added attraction that they sell at discounts to the value of the bonds in their portfolios.
While Gross often has specific ideas of where fixed-income investors should put their money, he's equally well-known for making big-picture market calls. To a large degree, he attributes his extraordinary record -- an average annual return of better than 10% over 30 years -- to a three-day investment summit held every May at Pimco headquarters. During this Secular Forum, the firm's 100 or so top employees and a few invited speakers ponder the future of the world's economies. "We try to take the day-to-day depression and euphoria out of the market," Gross says. "It provides a road map."
Those maps have led to consistent profitability for his clients. Gross's bear-market call in the stagflated 1970s helped Pimco's funds outperform the pack. A bullish stance in the following two decades boosted the firm's assets from $5 million, when Gross joined the firm in 1973, to over $345 billion today. "I think they do a very good job in describing their thoughts and on macro analysis," says Eugene Flood, chief executive of Smith Breeden, a bond-fund management firm in Chapel Hill, N.C.
"WET LOG." Yet Gross is capable of the occasional misstep. At the 2002 summit, he and his fellow strategists began to sense another big-picture turn. As Pimco managing director and chief Fed watcher Paul A. McCulley explains: "The post-bubble world has fundamentally weakened the spirits of capitalists. They're in retreat. We're starting a new bull market in government." For bond investors, that would mean higher deficits, greater issuance of government bonds, and higher interest rates as the Treasury offers higher yields to entice investors to buy the new debt.
In May, however, Pimco began to revise its view a bit. Longer term, say, over three years, the firm believes that interest rates will rise, but in the short run, perhaps the next year or so, Gross likens the economy to a "wet log" that won't burn despite being doused with higher government spending and lower interest rates. That means flat to declining rates.
Gross's cautious outlook is by no means a consensus. Widely watched economic analyst Edward Hyman of the International Strategy & Investment Group sees the gross domestic product growth rate doubling to between 4% and 5% in the second half of 2003. "Equity markets are up, operating profits have been rising fairly steadily, and fiscal policy has been kicked into high gear," says Tad Rivelle, chief investment officer at bond manager Metropolitan West Asset Management in Los Angeles and a former Pimco employee. "The likelihood is that rates are going higher."
INDEX-BEATER. Perhaps, but fear not for investors in Pimco's funds. Despite Gross's being off-target the past year, his Total Return fund, the nation's largest mutual fund with $75 billion in assets, was up 10.27% in 2002 and 5% so far in 2003, beating the Lehman index in both periods. Gross attributes that to savvy bets in emerging markets and telecom bonds. Bonds of Sprint (FON
), for example, of which Pimco holds some $5 billion worth, have doubled in price since the firm began buying them a year ago.
That's why he remains the master of figuring out where bonds might be headed -- even if the macro look is unusually murky at this stage of the game.
Copyright 2003, by The McGraw-Hill Companies Inc. All rights reserved.
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