This week, I’m going to tackle a natural follow-up question to last week: What’s behind ...
Bond King Dumps T-Bills—Is it a Signal?
03/15/2011 9:00 am EST
Pimco's Bill Gross just made what looks like a very smart move to get out of Treasury bonds. Here are three lessons from his move and four ways it could play out in his favor.
Bill Gross, manager of the world's largest bond fund—the $237 billion Pimco Total Return (PTTAX)—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 US government debt to zero in early 2008, and the United States and the bond market are still standing.
But I'd never suggest ignoring Gross' actions, his timing, or his logic. His latest move has important lessons for investors, although perhaps not the obvious ones.
Following the Numbers
Let's start at the beginning, always a good place to start: In his March update on the fund's investment strategy, Gross explained that he was dumping Treasuries in anticipation of the June 30 end of QE2, the Federal Reserve's quantitative easing program designed to reduce medium-term interest rates, and stimulate the US economy, via massive bond-buying.
The Fed has been buying more than $100 billion of Treasuries a month. Since the November start of QE2, the Fed has bought $412 billion of US government debt. By the time the Fed is done in June, it will have added about $1.6 trillion in US government debt to its balance sheet.
Gross calculates that the Federal Reserve has been buying about 70% of all new Treasury debt, with overseas investors, banks, and governments snapping up the rest. That has led him to a logical follow-up question: Who will step in to buy that 70% of US debt when QE2 stops?
It's not like the US government is suddenly going to discover fiscal rectitude and stop running a huge annual budget deficit. The US Treasury will still need to finance its debt by issuing more and more Treasury securities.
Gross' answer is that overseas buyers will have to be enticed to step up buying Treasuries through higher interest rates on US debt. And higher yields on new US debt mean that the price of already issued US debt will have to fall.
The yields on that debt will thus 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 US 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.
NEXT: How to Follow the Signs|pagebreak|
3 Lessons for Investors
If you're looking for lessons for your own portfolio in Gross' strategy, this is the first one: Gross isn't waiting until June to see how big a bite the end of QE2 will take out of his portfolio. He's moving now in anticipation of the end of the Fed's bond-buying spree.
Investors who are concerned about what will happen when QE2 comes to an end 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.
So what's Gross doing with the money he's taking out of US government debt? Pimco Total Return—and remember that it's the best-performing bond fund in its class over the last 15 years, according to Morningstar—is now positioned in debt backed by US mortgages, corporate bonds, high-yield (aka junk) bonds and emerging-market debt.
And he has 23% of the fund in cash or cash equivalents.
Maybe those don't strike you as the most attractive alternatives to US government debt. Maybe the idea of sitting in cash equivalents making a 0% return isn't your idea of a good time. But here's the second lesson: What you pay for what you own is as important as what you own.
Right now, mortgage-backed debt isn't exactly popular. And everybody knows that this isn't a great time to buy emerging-market debt, because central banks in those countries are still raising interest rates.
But because everybody knows that this isn't a good time to buy these assets, it's possible to purchase them at reasonable prices. That's not a bad strategy—if you believe those markets are closer to a turnaround than investors in general believe.
Indeed, I think the end of QE2 might 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 go down—emerging-market bonds don't look so uniquely risky. If there is no clear safe haven, the higher yields of emerging-market debt start to look more attractive.
This brings me to the third lesson of Gross's bond strategy. He's not trying to thread the needle here, betting on a vanishingly narrow favorable outcome if everything goes right.
Instead, there are a number of ways, under very different scenarios, in which this move could work out quite well for his investors.
4 Ways His Bet Could Pay Off
First and most obviously, Gross is getting protection in case the Fed's withdrawal from the US debt market goes poorly. 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. At some point, central banks in emerging markets will come to the end of their interest-rate increases, and the US housing industry will finally start to recover.
Third, by moving so early on quantitative easing, Gross could make a profit even if he's wrong. There's a good chance that anxiety will run higher and higher among investors as the June deadline approaches. If some of those investors panic, US government debt could look like quite a bargain to an investor with 23% in cash.
And fourth, if the US economy grows faster than anticipated, Gross' corporate and junk-bond portfolio could outperform plain, vanilla US government debt.
That's not a bad set of positive outcomes from a "defensive" move.
Equity investors should think long about the fourth outcome. Under at least one of Gross' scenarios, he will make money if the economy grows more than expected. You shouldn't worry that his move out of Treasuries is only a vote on a slowing economy after the end of QE2.
Gross' 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 (JUBAX), 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 here.
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