Pimco's Gross: Corporate Bonds Irrationally Priced as Risks Rise

Wednesday, 27 Feb 2013 12:05 PM

 

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Pacific Investment Management Co.’s Bill Gross, manager of the world’s biggest bond fund, said asset-price irrationality is rising after years of record low benchmark interest rates by the Federal Reserve.

The level of asset prices signal investors should be cautious and the degree of irrationality is about six on a scale of one to 10 and rising, Gross wrote in his monthly investment outlook posted on Newport Beach, California-based Pimco’s website.

He noted that Fed Governor Jeremy Stein earlier this month said some credit markets, such as corporate debt, are showing signs of excessive risk-taking, while not posing a threat to financial stability.

“Corporate credit and high yield bonds are somewhat exuberantly and irrationally priced,” Gross wrote. “Spreads are tight, corporate profit margins are at record peaks with room to fall, and the economy is still fragile.”

Banks have underwritten $89.6 billion of high-yield debt this year, up 36 percent from the same period in 2012, according to data compiled by Bloomberg. Last year’s $433 billion of sales was an all-time high for the asset class, the data show. Meanwhile, investors poured $33 billion into mutual funds and exchange-traded funds dedicated to junk bonds last year, 55 percent more than in 2011, according to Morningstar Inc.

Yield Spreads

Falling interest rates have increased demand for higher-yielding debt, boosting prices on dollar-denominated junk bonds to a record 105.9 cents on the dollar last month, according to Bank of America Merrill Lynch data. As yields have collapsed to 6.54 percent from a peak of 22.7 percent in late 2008, junk bonds have become more sensitive to the risk that underlying government bond yields could increase.

The extra yield investors demand to own junk bonds over government debt, known as the spread or risk premium, has contracted by 16.69 percentage points since 2008 to 5.24 percentage points, according to the Bank of America Merrill Lynch Global High-Yield Index.

“Still, that doesn’t mean you should vacate your portfolio of them,” Gross wrote. “When today’s 5 percent to 6 percent high-yield interest rates are adjusted for future defaults and recovery values, that 3 percent to 4 percent realized returns are the likely outcome.”

Gross reduced his holdings of investment-grade credit securities in his flagship $2.86 billion Total Return Fund to 9 percent in January, from 10 percent in December, according to the latest available data on Pimco’s website. Treasurys are his largest holdings at 30 percent.

Inflation Tolerance

Gross has said growing central-bank tolerance of inflation means investors should hedge higher prices by purchases Treasury Inflation Protected Securities, known as TIPS. Gross warned investors against purchasing longer-term Treasurys and advocated notes with about five years to maturity, a sector the Fed has been acquiring through quantitative easing.

The Fed is buying $85 billion in Treasury and mortgage debt a month after purchasing over $2 trillion through prior quantitative easing programs since 2008. The central bank’s benchmark rate has been locked in a range of zero to 0.25 percent since December 2008.

“Returns for both high yield and equity markets have been unduly influenced in the past few years by quantitative easing, the writing of trillions of dollars of Federal Reserve checks and the exuberant migration of institutions and households alike to the grassier plains of risk assets dependent on favorable economic outcomes,” Gross wrote. “If and when the support dissipates or if the economy remains anemic, investors should be cautious and temper their enthusiasm.”

Fed Caution

Several Fed policy makers have publicly debated the risk of financial instability, including Stein, who also said some credit markets, including leveraged loans and junk bonds, show signs of potentially excessive risk-taking. Kansas City Fed President Esther George has warned of risks from farm land prices at “historically high levels.”

“We are seeing a fairly significant pattern of reaching- for-yield behavior emerging in corporate credit,” Stein said on Feb. 7 in a speech in St. Louis.

The Standard & Poor’s 500 Index this month reached the highest since 2007 while measures of equity volatility had slipped to a post-crisis level. The benchmark 10-year Treasury yield, at 1.86 percent, reached a record low of 1.38 percent on July 25, according to Bloomberg Bond Trader prices.

The Total Return Fund gained 7.71 percent over the past year, beating 93 percent of its peers, according to data compiled by Bloomberg.

Pimco, a unit of the Munich-based insurer Allianz SE, managed $1.92 trillion in assets as of Sept. 30.

© Copyright 2014 Bloomberg News. All rights reserved.

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