Gross Departure Signals End of 20-Year Bull Market in Bonds
09/30/2014 10:09 am EST
Bill Gross’s exit from Pimco marks the end of an era for bond investors and reveals two important trends during the transition to a “new normal,” and MoneyShow’s Jim Jubak outlines how long he feels these trends—which are still unfolding—will continue.
Bill Gross’s departure from Pimco, the investment management company he co-founded in 1971 and the Pimco Total Return bond fund that opened its doors in 1987 marks the end of an era.
No, not for Gross. He’s worth $2 billion or so; he’s going to continue to run a bond fund, although initially smaller than the $220 billion fund he’s left behind; and I’m sure that his new employer, Janus, a money manager known for its stock vehicles, will pay him more than adequately for his ability to bring them fixed income assets.
But for bond investors and the bond market, his move does mark the end of an era.
When Gross started the Total Return fund in May 1987, the yield on a 10-year Treasury was 8.5%. Last Friday, September 26, the 10-year yield was 2.5%. Gross has been a gifted bond fund manager for much of his career, the Total Return fund has outperformed its benchmark by almost three-quarters of a full percentage point a year over the last 15 years. But he did manage a bond fund in an era of falling interest rates and rising bond prices. It’s clear that we’re not going to see a six-percentage point drop in 10-year yields from here over the next 15 years. Investors who expect to find a bond fund that will show a total return of 6.2% a year over the next 15 years—as Gross did for the last 15 years—are going to be very, very disappointed.
That observation is rather old news by this point, of course.
But the months before Gross’s departure from Pimco and the Total Return fund do illustrate two important trends during this transition to this new era, a period that Gross himself called the “new normal,” that are by no means old news. I think those trends are still unfolding and that the way they unfold will make up the very unsettling weather in the bond market for the next five years or more.
The first trend that Gross’s departure illustrates is how tricky it’s going to be to get the timing right during this transitional period. The underperformance of the Total Return fund in recent quarters that saw the fund drop from the 12th rank in its category of intermediate-term bond funds over the last 15 years to the 83rd rank in the last year wasn’t a result of Gross missing the end of an era of falling interest rates. In fact, Gross called that end early and loudly. Gross’s problem wasn’t missing the long-term change in trend but getting the short-term timing of that change wrong. Interest rates refused to bottom when Gross predicted and—from already low levels—they proceeded to retreat even further on the strength of a stronger dollar fueled by anticipation of the higher interest rates that Gross was predicting. Gross wasn't alone in being too early, which is exactly my point.
It has proven to be very difficult to call the bottom in interest rates and to predict the turn in the long-term bond market trend from bullish to bearish.
The second trend is related to the first. Because it has turned out to be so difficult to time the turn in the trend, bond traders and investors haven’t had much encouragement to switch to plain vanilla bearish strategies. Combine the difficulty of getting the timing right with the propensity of money managers (like most people) to stick with what they know until it demonstrably isn’t working, and the result has been a creep toward strategies that add risk in an effort to prolong the returns of the bull market period in bonds.
Gross’s own fund is an example. In the second quarter of 2014, Gross sold most of the $48 billion in Treasuries held by Total Return fund and replaced them with Treasury futures. The derivative contracts require relatively little cash up front so Gross could leverage his bet on Treasuries and a temporary increase in Treasury prices if interest rates fell. Some of the money that didn’t go into Treasuries because of the use of futures went into Brazilian, Spanish, Italian, and Mexican bonds, which were all recently paying out higher yields than Treasuries.
I’m not criticizing Gross’s investment choices, for what it’s worth, since I’m not a bond guy. I like Mexican bonds too, for instance.
But the portfolio changes at Total Return certainly qualify as adding risk to the fund—from derivatives and leverage, and from more volatile sovereign bonds—in an effort to deliver something like the returns expected by bond investors whose experience of the last 20 years has colored expectations.
Unfortunately, I think we’re going to see a lot more of this before expectations get reset. It’s one thing to believe—intellectually—that returns are going to be lower in the future than they have been. It’s another thing to accept those lower returns. The solution that many money mangers and investors are going to pursue is to add risk in an effort to match expected returns based on a history with only the slightest relevancy to the future.