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Online Extra: "The Bond Market Is at Risk"


Even if you don't know a darn thing about bond market, you probably know about Bill Gross. A 30-year veteran of fixed-income money management, he has made more money on average every year for his investors -- in both bull and bear markets -- than some of the best stock pickers around. He founded Newport Beach (Calif.)-based Pacific Investment Management Co. in the 1970s and now manages more than $320 billion in assets, including the world's largest bond fund, the $73 billion PIMCO Total Return Fund (PTTAX), which has earned up to 9.56% annually since its 1987 launch.

Standard & Poor's, in partnership with BusinessWeek magazine (sister companies under the McGraw-Hill corporate umbrella), recently picked Gross as 1 of 10 mutual-fund managers to receive the first annual Excellence in Fund Management awards. Markets and investments editor Mara Der Hovanesian spoke with the 58-year-old, known affectionately among his followers as "the Guru," to quiz him on investing, the prospects for a continued bull market in bonds, and his views on a potential war with Iraq. Following are edited excerpts of their conversation:

Q: You got a lot of guff in the media for using your March investment newsletter to clients to air your opposition to the potential war with Iraq and other opinions on more esoteric topics. When did you decide to move your commentary away from the market and into foreign policy and the meaning of life?

A: The investment outlook has been a 30-year project. Ever since the early 1980s, it has had this flavor -- it has been a very personal thing. I realized early on that if it was just a pure investment outlook -- well, at least I think people now read it for the investment views -- that unless it had a little spice, pepper, and oregano, they'd throw it in the trash. It has always been a statement on life and living.

So that brings up the question: How far should I go? I don't want to impose my views on anyone, but it's not like I'm co-opting the public airwaves: It's my investment outlook, and I do put it on our Web site. It's not like I'm demanding attention. It's just what I do.

Of course, with a delicate subject like war, obviously there are opposing views, and it brings out the juices in terms of people who read it. I recognize that there's a point beyond which it's not practical to incite the readership. I don't know what you would expect, but people who support me have written...and I don't claim this as a justification, but it has been 10 to 1 in favor of what I wrote, and that's nice.

My musings on Virginia Wolfe have nothing to do with the bond market, but you may argue that Iraq has something to do with it, and I may agree. It may lead to a wider deficit and affect interest rates. But whether or not I support war shouldn't have any impact on my positioning in the Harbor fund or any other fund I manage. So, I throw it out there and hope for the best.

Q: Interest rates are at the lowest they've been in your long career. How does this affect your management style, and what should it mean in terms of investor expectations?

A: They're at the lowest in my career, which means the prices are the highest, and that suggests a potential for reversal. It suggests at least that if rates can't go much lower, then at some point -- and the critical question is when -- they have to go higher. So that's not so good for bonds. Practical common sense would suggest with interest rates as they are and with Treasuries in the 2% to 3% yield rate, there isn't much [more] juice you can squeeze out of the orange.

Q: So are you saying we're headed for a bear market in bonds?

A: Without suggesting we're headed into a bear market, the years of double-digit returns are probably over. The problem that bond investors have is they tend to expect a continuation of the same trend. That's what got us into trouble in the stock market, and for the bond fund it's the same thing.

It's obviously fanciful. In bond-market terms, it's almost not a debatable type of question: If, for instance, Treasuries as your benchmark offer 2% to 4%, then it's almost impossible to provide a 10% return, absent a Japanese-type of deflation.

We've exhausted the bulk of the capital gains that have been at the back of the bond market for the past 20 years. We're basically down to coupon, if that. In other words, you may start to get some negative returns. The bond market has seen its salad days. My firm rejoinder would be to simply be content with lower returns. We're in a low-return world for bonds and stocks.

Then you add the underlying potential for increasing a guns-and-butter policy, too, and at some point reflation of the U.S. economy.... I don't express that as a probability, but I do suggest with rates this low and the U.S. involved in lots of guns and lots of potential butter in the form of tax cuts and the like, both of which lead to $300 billion deficits, there's a potential for reflation and the potential down the road -- not in 2003 -- for inflation to move higher as opposed to lower. And that's the dreaded enemy of the bond market. So yes, based upon low yields and this guns-and-butter policy, I think the bond market is at risk.

Q: But not in 2003?

A: That's where I get a little cute and say: Not quite yet. The U.S. economy and the global economy have to sort of move back into a self-sustaining path of growth. It needs to gain what economists call self-sustaining traction. We need for the business sector to jump on board and for individuals to be rehired and spend and all of those good things.

Under the fog of war and simply the very slow growth of the global environment, 2003 is not that traction year. Ultimately, they can reflate the economy, and, therefore, bonds may pay the price of that reflation. I just don't think it's going to happen in 2003. Maybe that's a hedge. Maybe that's begging your investors not to cash in Harbor and buy Magellan. But our first 10 years were in an extreme bear market, and we survived. That's where PIMCO got its roots.

But at some point, unless you can get dour and think Japan and the 1930s, I think that there are a lot of efforts on the part of the Fed and the Administration to avoid that. And while I don't necessarily support all of those efforts, I recognize they may happen. I believe that there's a possibility that [Federal Reserve Governor Ben S.] Bernanke [who suggested participating in open markets with other bond vehicles, such as corporates and mortgages] might pull that trigger, but at the same time, I don't support his right to do it. I believe that it's a perversion of capitalism. But I believe that there's potential for Bernanke to do these types of things if pressed.

Q: What do you mean by a "perversion of capitalism"?

A: There's a perversion of the process to the extent that the Fed does go in and buy stocks or mortgages or corporates without a reflection of their effect on the price and the signal that those prices send -- we distort the capitalistic system. It doesn't mean in the short run they won't make things hunky dory, but when you start buying securities -- without attention to the price and simply buy -- you ultimately pervert the process. It distorts the pricing system. It's not because it's wrong to want the economy to go up. It's just not the proper way to do it.

Q: So what's a bond manager to do?

A: You shorten your maturities. You move out a little bit on the risk spectrum. You don't take those 2% and 3% from Treasuries. You look to corporates and buy some higher-yielding mortgages and dabble a bit, as Harbor does, in emerging-market situations and maybe even a smaller percentage in less-than-investment-grade junk bonds.

You take a little bit more risk at the margin. You have to recognize that people who invest in bond funds do so because they know it's relatively safe compared to stocks. They want their money back. So we take that to heart, and we just add a little spice.

That process has already begun: We've got some positions in Mexico and a smattering of Brazil. Mexico yields 8%, and Brazil yields 13% to 14%. It's not enough to sink the performance, but it's enough to beat the market, if we're right. It's the same thing if we invest 2% to 3% in high-yield -- it will come back if the economy gains traction where investors have confidence. It depends on that confidence and lessens the probability of default.

There are situations where investors throw the stuff away under the assumption that [it'll] never come back. There are bargains to be had, but it's dangerous swimming. There are a lot of sharks.


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