Pimco's Gross Shifts to Defensive Investment Model

Wednesday, 29 Feb 2012 11:28 AM

 

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It's time for defense, says Bill Gross, manager of the world's largest bond fund.

Gross, manager of Pimco's $250 billion Total Return bond fund, used American football as a metaphor for his investment model in his March newsletter.

He wrote that he has turned defensive as he watches out for potential downside risks and warns about the government's increased demand on available capital in the economy.

"Over the past 30 years, an offensively minded Federal Reserve and their global counterparts," or other central banks, "were printing money, lowering yields and bringing forward a false sense of monetary wealth," Gross wrote.

"Successful investing in a deleveraging, low interest rate environment will require defensive in addition to offensive skills," he added.

He pointed out that "low yields, instead of fostering capital gains for investors via the magic of present value discounting and lower credit spreads, begin to reduce household incomes, lower corporate profit margins and wreak havoc on historical business models connected to banking, money market funds and the pension industry.

"The offensively oriented investment world that we have grown so used to over the past three decades is being stonewalled by a zero bound goal line stand," Gross said. "Investment defense is coming of age."

For example, these have been hard times for retirees who depend on interest income from their fixed-income investments to pay their bills.

"It is Main Street that has failed to keep up with Wall Street and corporate America in the race to see who can benefit more from lower yields," Gross wrote. "As the interest component of personal income gradually weakens, the ability of the consumer to keep up its frenetic spending is reduced."

Gross has positioned his Pimco Total Return Fund in defensive mode by scaling back on riskier assets like non-U.S. developed countries' securities and emerging market bonds. Instead, the fund in January held half its assets in mortgage-backed securities and 38 percent in Treasurys and Treasury-related securities.

This is a reversal from Gross's call last year that the rally in Treasurys was over, when he eliminated U.S. Treasurys from his portfolio.

Pimco's "offensive" strategy up until last year was to recognize the downward trend in interest rates and scale duration accordingly: Emphasize income and capital gains; utilize prudent derivative structures that benefit from systemic leveraging like financial futures or swaps, and follow careful bottom-up security selection to seek consistent alpha.

The bond fund's "defensive" strategy in 2012 is to recognize zero-bound limits and systemic debt risk in global financial markets, and accept financial repression, which involves measures by which governments channel funds to themselves as a form of debt reduction, but avoid its impact when and where possible. His last guideline is put simply: Emphasize income that is relatively reliable or safe; seek consistent alpha.

In addition, he wrote about the need to "de-emphasize derivative structures that are fully valued and potentially volatile, and seek consistent alpha with admittedly lower nominal returns than historical industry examples," Gross said.

Gross mentioned Warren Buffett's business model as "Omaha/West Coast" offense being duplicated around the world, thanks to central bank monetary policies, placing an increasing emphasis on stock and investment selection as opposed to business model liability funding.

"Buffett will succeed, based upon his continued strong offensive play calling, but the rules of the game are changing," Gross wrote. "The emphasis these days should be on the defensive coach."

© 2014 Thomson/Reuters. All rights reserved.

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