Thursday, March 10, 2011

Seven Reasons Bill Gross Is Not As Bearish As You Think

Yesterday Pimco announced that its $237 billion Total Return fund was cutting its position in U.S. Treasurys to zero.

Since fund manager Bill Gross is widely respected in the bond and investment community, this move received considerable press attention.

Gross's decision has been mostly reported as a move by a savvy fund manager anticipating higher interest rates as well as a reputation of the Fed's QE2 program.

I might be wrong, but I don't really think that Gross is as bearish as reported.

I'll go into more bond details below, but I think this is more a move on the of Mr. Gross to use his "bully pulpit" to get Congress to act on the budget deficit than a serious warning of significantly higher interest rates.

In fact, I would suggest that his portfolio moves - if correctly reported by the press - are actually positioning for a better economy in a fairly benign interest rate environment.

First, some background. Here's the excerpt from this morning's Financial Times on Pimco's move:

The world's largest bond fund {Pimco's Total Return fund} has cut its holdings of US government-related debt to zero for the first time since early 2008 in the latest sign of increasing investor expectations of rising interest rates...

..."Yields may have to go higher, maybe even much higher, to attract buying interest." {Mr. Gross} said.

But here's the part I want to focus on. The FT reports that Pimco:

"After slashing its government-related holdings to zero, Pimco Total Return assets are primarily in US mortgage, corporate bonds, high yield and emerging market debt.

The fund holds 23 per cent of its assets in net cash equivalents, defined as any instrument that has a low sensitivity to movements in interest rates."

However, there is a basic inconsistency between what Pimco is saying and how they are positioned.

Let me give you a few reasons:
  • The large cash position is almost certainly part of a barbell trade - that is, combining cash and longer maturity bonds instead of just buying intermediate securities. The yield curve today is as steep as it has been since the late 1970's, so this trade makes sense;
  • If you think interest rates are going to rise sharply, you really don't want to own mortgage-backed securities (MBS). When rates in general rise, prepayments of mortgages slow. This means that the average life of an MBS extends when interest rates rise, which is of course exactly what you don't want in an rising interest rate environment;
  • If Gross truly believes that Treasury rates are poised to move sharply higher, it would be hard to believe that corporate bonds will offer any protection either. Why? Well, most corporate bonds are traded relative to a Treasury benchmark, e.g., a 10 year corporate bond will be priced relative to a 10 year Treasury note. If Treasury yields are set to soar, corporate bond rates will as well, and the prices of both sectors will tumble together;
  • Corporate bond spreads (i.e. the yield advantage of corporates vs. Treasurys) has narrowed dramatically over the last couple of years. Indeed, spreads have gotten so skinny in recent months that in many cases it is hardly worth the candle to buy corporates instead of highest quality Treasurys. Gross seems to betting that economic conditions will continue to show modest improvement, which would keep spreads tight;
  • Higher interest rates would kill the lower quality corporate area. By definition high yield borrowers are companies that have high debt burdens and uncertain business outlooks. If rates on Treasurys soar, high yield borrowers would be smacked, and defaults would rise as well;
  • Higher US interest rates would also hurt the emerging markets. Countries like Brazil have been raising domestic interest rates dramatically to offset commodity price pressures. What would be the impact on their economy if US interest rates were to suddenly spike?
  • Finally - and Bill Gross knows this better than I do - the capital markets are awash with liquidity. Banks already have more funds than they know what to do with, and there is no evidence that the Fed will be pulling liquidity out of the system any time soon. If the Fed stops buying Treasurys, it will certainly remove a marginal buyer, but there's lots more buyers to step in.
Don't get me wrong - I have enormous respect for Bill Gross and Pimco. It's just in this case I think they have a different agenda than what you're reading today.