Gross: ‘No Regrets’ Over Missing Short-Term Treasury Rally

Thursday, 09 Jun 2011 08:40 AM

 

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Bill Gross, manager of the world’s biggest bond fund, is proving once again that he’s willing to suffer short-term pain for long-term gain.

The billionaire investor and co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co. has seen his flagship Total Return Fund gain 2.52 percent since eliminating U.S. government debt from his holdings in February, and betting against the securities, foregoing an additional 3.1 percent in Treasury returns in the last three months, according to data compiled by Bloomberg. The fund beat just 55 percent of its peers in the past month, the data show.

While that may seem disappointing for a manager who has outperformed 99 percent of his rivals the past five years, history shows that Gross’s calls often seem wrong before proving accurate and generating above-average returns for investors. In 2007, his fund lost about 0.8 percent through June, trailing the performance of 80 percent of comparable funds before rebounding to beat 99 percent of them for the year as the Federal Reserve began to lower interest rates, as he predicted.

“I certainly don’t have any regrets.” Gross said of his current strategy in an interview yesterday in Chicago. “We’re beating the market by 50 basis points. We’re not completely satisfied but it’s not the negative headline that one sees.”

Reiterates Call

Gross, 67, has helped catapult Pimco into a firm overseeing $1.2 trillion over the past 40 years, reiterated his call that the 30-year bull-run in bonds is over.

The fund, which has attracted retail investors, public and private pension and retirement funds, exited Treasurys before the securities outperformed all other debt classes in May. Gross didn’t anticipate that investors would largely ignore warnings on the rising budget deficit and the stalemate in Congress on increasing the $14.3 trillion debt ceiling.

“He missed the rally,” said Edward Lashinski, senior strategist in Chicago at ABN Amro Clearing LLC. “Ultimately he may be correct. Even the smartest investment business doesn’t get it right all the time. Gross has substantially underestimated the prospect for lower Treasury yields in the near-term.”

The yield on the benchmark 3.125 percent Treasury note due in May 2021 has fallen to 2.96 percent from this year’s high of 3.77 percent on Feb. 9, Bloomberg Bond Trader prices show.

Below Potential

Yields have fallen as reports on jobs, manufacturing, housing and consumer confidence suggest that the economy isn’t recovery as fast as forecast, keeping inflation from accelerating.

“The economy is still producing at levels well below its potential; consequently, accommodative monetary policies are still needed,” Fed Chairman Ben S. Bernanke, 57, said June 7 during a speech to a conference in Atlanta. “Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established.”

Gross isn’t the only manager wary of Treasurys after Standard & Poor’s and Moody’s Investors Service both warned that the U.S.’s AAA credit rating is in jeopardy if lawmakers aren’t able to reduce the deficit.

At the same time, the Fed’s efforts at injecting cash into the has caused the Labor Department’s consumer price index to rise 3.2 percent in April from a year earlier, the biggest increase since 2008. That’s higher than the yields on bonds due in 10 years or less.

‘Fiscally Irresponsible’

“We would not lend money long-term to a fiscally irresponsible entity with unattractive real yields,” said Thomas Atteberry, who manages $3.7 billion in fixed-income assets at First Pacific in Los Angeles. “I don’t know if Congress will have any kind of credible debt ceiling spending reduction proposal in place by August. The level of rates today is because people believe that it’s all going to work out with the U.S. credit.”

While First Pacific has 25 percent of its holdings in Treasurys, its longest-maturity bond is one maturing in October 2012, Atteberry said.

“We share Bill Gross’s view towards Treasurys and their values,” he said. “It would have been speculative to have invested in Treasurys because even at 50 or 60 basis points ago, they still didn’t offer value.”

Gross has had his share of misses. Pimco held bonds of Lehman Brothers Holdings Inc., in at least 12 of its funds, including the Total Return Fund, before the investment bank filed bankruptcy in September 2008. Gross was buying the debt as recently as June 2008, data compiled by Bloomberg show.

‘Mistake’

In May 2005 he said a Fed rate of 3.25 percent to 3.5 percent “is all the economy can stand.” At the time, the Fed had lifted its benchmark eight straight times to 3 percent, and didn’t stop increasing it until June 2006, when the target reached 5.25 percent.

“We have made a mistake over the past 12 months expecting the Fed, first of all, to stop before 5.25 percent and, second of all, to maybe start to ease a little before where the market expects it to ease,” Gross said May 17, 2007. “If there’s been a mistake, that’s it.”

Perhaps is his biggest correct call was on housing. During a yoga session in 2005, he thought of sending analysts posing as homebuyers into the field to test his theory that the bubble was about to burst.

The research helped him decide to avoid subprime mortgage- backed securities as well as riskier credits. His emphasis on what he at the time called “quality” lower-risk debt and government-backed debt helped his fund return 9.1 percent in 2007, better than 99 percent of its peers.

Good Call

Gross said in 2007 that falling home prices would be the main driver of U.S. monetary policy for “several years.” Bear Stearns Cos. and Lehman rode the U.S. housing boom from 2000 to 2005 as the top two underwriters of new mortgage securities, just before the values of homes plunged.

Bear Stearns collapsed and was sold to JPMorgan Chase & Co. in March 2008 and Lehman declared the world’s biggest bankruptcy on Sept. 15 of that year, both suffering from losses in mortgage securities and spearheading a systemic crisis that prompted the Fed to drop its target rate for overnight loans between banks to a range of zero to 0.25 percent as of December 2008.

In May 2005, Gross said 10-year Treasury yields might fall as low as 3 percent this decade because there was little threat of accelerating inflation. The yield on the 10-year note touched a record low 2.035 percent in December 2008 and the consumer price index fell 2.1 percent in July 2009, the biggest year- over-year drop in about six decades.

Fund Assets

Pimco’s Total Return Fund has advanced 3.4 percent this year, ranking sixth out the 10 biggest actively-managed bond funds that invest mainly in U.S. debt as of May 31, according to data compiled by Morningstar.

Treasurys are considered the safest and most liquid, investments in the world. The U.S. is the world’s biggest debt issuer. It has $14.2 trillion of debt outstanding, while marketable Treasurys total $9.7 trillion. Central banks and other overseas investors own $4.48 trillion, or 46 percent of marketable debt.

The fund had minus 4 percent of its assets in government and related debt in April, compared with negative 3 percent in March, according to figures from the firm’s website. The negative position reflected trades that would profit from a decline in Treasurys. Cash and equivalents, the largest component, rose to 37 percent from 31 percent.

Treasury Alternatives

“The Treasury market up to seven or eight years is negative in terms of real interest rates, and that’s not a positive for savers,” Gross said in an interview on June 3 with Tom Keene on Bloomberg Radio. “To the extent they can risk a little bit of their capital, then there are alternatives.”

Investors should increase holdings of corporates, mortgages and other country bonds with better balance sheets than the U.S., such as Germany, Canada and Brazil that have “half the debt,” Gross said June 3, adding that those bonds are “better opportunities” because they have higher yields and are safer credits.

Gross has been betting against U.S. debt through short sales, in which the Total Return Fund would borrow and then sell government bonds, hoping to profit by repurchasing the securities at a lower price in the future. The fund’s annual report showed that, as of March 31, it had sold short about $2.2 billion of Treasurys that mature in about 10 years and $5.8 billion of agency debt that comes due in 2041.

Rate Swaps

In addition, the fund also entered into 10- and 30-year interest-rate swaps with a face value of about $15.2 billion during the fourth quarter of 2010 and first quarter of 2011, according to filings. In order to obtain the contracts, which are the equivalent of betting against Treasurys, the Total Return Fund paid upfront premiums totaling about $331 million to 12 Wall Street banks, the filing shows.

While the swaps are costly for the fund, given that it must pay out more than it takes in under the contracts, Gross would reap big profits from the trades should long-term rates rise, causing Treasurys to tumble. Conversely, a decline in long-term rates would punish the fund’s returns.

“Over the long-term Treasurys and all U.S. bonds are overvalued and he’s correct,” said Mark MacQueen, a partner at Austin, Texas-based Sage Advisory Services Ltd., which oversees $9.5 billion, and holds 25 percent to 30 percent of its portfolio in Treasurys.

© Copyright 2014 Bloomberg News. All rights reserved.

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