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Getting ready for the end of the Fed's stimulus--it's not too early
03/15/2011 8:30 am EST
Bill Gross, manager of the world’s largest bond fund, the $237-blllion Pimco Total Return fund, has cut the fund’s holdings of Treasury bonds to zero. The move doesn’t mark the end of the world as we know it—Gross cut his fund’s holdings of U.S.-government debt to zero in early 2008 and we, the United States, and the bond market are still standing.
But I’d never suggest ignoring Gross’s moves, his timing or his logic. His latest move has important lessons for investors, although not perhaps the obvious ones.
Let’s start at the very beginning, a very good place to start. In his March update on the fund’s investment strategy, Gross explained that his move was in anticipation of the June 30 end of QE2, the Federal Reserve’s program of quantitative easing designed to reduce medium-term interest rates and stimulate the U.S. economy by a massive program of bond buying. The Federal Reserve has been buying more than $100 billion of Treasuries a month. Since the No ember start of QE2, the Federal Reserve has bought $412 of U.S. government debt. By the time the program comes to a end in June, the Fed will have about $1.6 trillion in U.S, government debt on its balance sheet.
Gross calculates that at that pace the Federal Reserve has been buying about 70% of all new Treasury debt with overseas investors, banks, and governments buying the rest.
Which leads him to the logical question, “Who will step up to buy the 70% of U.S. debt that the Federal Reserve is now buying as part of QE2? It’s not like the U.S. government is about to suddenly discover fiscal rectitude and stop running a huge annual budget deficit that the U.S. Treasury needs to finance by issuing more and yet more debt.
Gross’s answer is that overseas buyers will have to be enticed to stop up their buying of Treasuries by the offer of higher interest rates on U.S. debt. Higher yields on new U.S. debt means that the price of already issued U.S. debt will have to fall so that the yields on that debt will rise until they match the yields on the new debt. (A 10,000 bond with a yield of 5% when it was issued, so that it pays $500 a year to the holder, will have a yield of 5.6% if the price falls to $9,000. An investor has to pay less money--$9,000 instead of $10,000 to get the same $500 interest payment every year.)
And, Gross notes, overseas buyers haven’t been especially enthusiastic lately about adding to their holdings of U.S. Treasury debt. There are persistent signs that governments have been looking to diversify their holdings by adding euros, gold, Canadian dollars, and whatever else they can think of.
Indeed, if you’re looking for lessons for your own portfolio in Gross’s strategy, this is Lesson 1: Gross isn’t waiting to see how big a bite the end of QE2 will take out of his portfolio in June. He’s moving now in anticipation of the end of the Fed’s buying program. Investors who are concerned about what will happen when QE2 comes to an end in June and the Federal Reserve stops buying can’t wait until June to protect the value of their bond portfolio, If they do, they’re likely to find themselves selling into a market that has already anticipated their fears.
What’s Gross doing with the money he’s taking out of U.S. government debt? Pimco Total Return—and remember this is the best performing bond fund in its class over the last 15 years, according to Morningstar? He’s got the fund positioned in debt backed by U.S. mortgages, corporate bonds, high yield (or junk) bonds, and emerging market debt. And he’s got 23% of the fund in cash of cash equivalents.
Now maybe those don’t strike you as the most attractive alternatives to U.S. government debt. (And maybe the idea of sitting in cash equivalents making 0%isn’t your idea of a good time.) But here’s Lesson 2: What you pay for what you own is as important as what you own.
Right now mortgage-backed debt isn’t exactly overwhelmingly popular. And everybody knows that this isn’t a great time to be buying emerging market debt since the central banks in those countries are still raising interest rate. But because everybody knows that this isn’t a good time to be buying these assets, it’s possible to buy them at reasonable prices—if you believe that they closer to a turnaround than the market in general thinks.
The end of QE2 might indeed be good news for an asset class such as emerging bonds. If interest rates in the United States start to go up—and bond prices to go down—then emerging market bonds don’t look so uniquely risky. If there is no clear safe haven, then the higher yields of emerging market debt starts to look more attractive.
Which brings me to Lesson 3 in Gross’s bond strategy. He’s not trying to thread the needle here, betting on an impossibly narrow favorable outcome if everything goes right. Instead I can see a number of ways, under very different scenarios, where this move pays off.
First, and most obviously, Gross is getting protection in case the Fed’s withdrawal from the U.S. debt market goes badly. He may not actually make money in this scenario but he will lose less than his peers.
Second, he can win if he gets outperformance from emerging market and mortgage debt as emerging market central banks come to the end of their interest rate increases and as the U.S. housing industry finally starts to recover,
Third, by moving so early on quantitative easing, Gross could even make a profit if he’s wrong. There’s a good chance that anxiety will run higher and higher among investors as the June deadline for the end of the program approaches. If some of those investors panic, U.S. government debt could look like quite a bargain to an investor with 23% in cash.
And, fourth, if the U.S. economy grows more strongly than anticipated then Gross’s corporate and junk bond portfolio could outperform plain vanilla U.S. government debt.
Not a bad set of positive outcomes from a “defensive” move.
Equity investors should think about outcome No. 4. Under at least one of Gross’s scenarios, he will make money if the economy grows more than expected. You shouldn’t think the Gross’s move out of U.S. Treasuries is only a vote on a slowing economy after the end of QE2.
Gross’s strategy is hardly ever that simple.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of January see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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