But First He Recommends Some Bonds
In his April 2010 letter PIMCO’s Bill Gross advised how to select among the bonds of sovereign issuers. Then he turned around and said in a radio interview that bonds have seen their best days. Not only did he advise both for and against bonds, but his bond allocation consisted of nothing more than a set of binary choices dependent on so many unknowns as to make the advice useless. If you’re still interested, here is a summary of what Gross had to say.
Sovereign Debt Classification
Because of the rising risk of default (and related debt problems), Gross says that the main objective in fixed income investing should be capital preservation. Sovereign debt of developed nations is usually a good place to be for preservation, but the problem today is that the governments of developed nations still need to substitute for their private sectors. This means that they will all need to continue creating debt, but not all can do this without falling into a debt crisis. Gross used a series of two sieves to classify countries into tiers according to their capability to take on more debt:
Sieve #1
The first sieve assesses whether a country has the ability to escape a debt crisis by creating even more debt. Gross condensed this issue into three questions:
1. Can a country issue its own currency and is it acceptable in global commerce?
2. Are a country’s initial conditions (outstanding debt, structural deficit, growth rate, demographic balance) moderate and can it issue future public debt as a substitute for private credit?
3. Can a country’s central bank be allowed to reflate via low or negative real interest rates without creating a currency crisis?
Not surprisingly, Gross answered all of these questions in the negative for Greece, and he suggested that the answers are mostly negative for the other Southern European debtors. More surprisingly, he answered in the positive for the United Kingdom, which he expects to avoid a debt crisis, despite the nation being on PIMCO’s “don’t invest” list.
Sieve #2
Even if a nation seems likely to avoid a near-term debt crisis and passes the first sieve, it may not necessarily be a good investment candidate, because it may yet issue so much debt as to produce inflation and a depreciating currency. This would obviously reduce the return on the nation’s bonds and could in a severe case cause it to fall into a debt trap. Gross classifies the UK in this group.
In contrast, Gross passed the US on both sieves, albeit only conditionally on the second. He suggested that the US debt load may be manageable because of its favorable demographics and growth potential, but that the situation merits close monitoring. His concern is that Treasury issuance may in the future grow to the point that it overwhelms demand, given that “the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt.”
Where Gross Advises Investing
As his allocation strategy, Gross would restrict investments to the sovereign debt of countries that pass these tests – escape a debt trap, reflate their economies, and suffer no severe consequences like runaway inflation or currency devaluation. He included investments in both the front end and back end of the yield curve (short or long maturity) depending on whether the nation seems likely to experience reflation or debt deflation.
Specifically, he advised front end investments in countries like the US and Brazil that are likely to experience successful reflation, and back end investments in countries like Germany and “core Europe” that can withstand potential debt deflation. Elsewhere, Gross has been recommending the debt of countries such as Germany and Canada that have low deficits.
Another consideration is the risk of rising interest rates as quantitative easing is eventually reversed and the world economy reflates. Whenever this happens (no telling when), Gross believes that the prudent way of boosting yield will be by sacrificing credit quality rather than by extending duration.
So Long and Thanks for All the Fish
Gross added one caveat: The validity of his recommended strategy depends on the continuing stability of the world economic and financial system. “Spreads in appropriate sovereign and corporate credits are a better bet as long as global contagion is contained. If not, a rush to the safety of Treasury Bills lies ahead.” (Italics mine.)
In other words, if you buy the recommended foreign securities and the world recovers (save for a few smaller countries, I suppose), you have a chance of surviving with your scalp still attached. If you buy the recommended foreign securities and the world falls apart, that’s just too bad because you should have kept your portfolio exclusively in long Treasuries. How nice of Gross to provide us with a strategy whose execution depends on the binary outcome of an uncertain future event, “global contagion is contained”. Thanks for all the deep insights, Bill.
No wonder the performance of the Total Return Fund was only at the 54-th percentile last year.
Bonds Have Seen Their Best Days
Given that Gross has just written a letter advising a fixed income investing strategy, you might think that he is bullish on bonds. You might also be mistaken, because Gross said in a March 26 Bloomberg radio interview that “bonds have seen their best days.” A rising interest rate environment is an “argument to not own as many” bonds.
He added that the U.S., Japan, and other nations will have to sell record amounts of bonds, which will eventually lead to inflation. Although Gross did not specify the timing, it looks like the three decade long bond bull really is ending -- sometime.
No wonder PIMCO has been moving into equity investing.
PIMCO’s Advice to “De-Risk”
In the April edition of his US Credit Perspectives PIMCO Managing Director Mark Kiesel provided a perspective that somewhat unifies these seemingly disparate viewpoints into a more coherent, near-term strategy: De-risk fixed income portfolios by upgrading credit quality.
The rationale for this advice was a combination of both short-term and long term risks. In the short term, the current support of the world economy through accommodative fiscal and monetary policies seems likely to end, as the developed nations unwind their stimulus programs and face the prospect of fiscal tightening. In the case of the US, for example, policy support of the economy “will likely fade” in the second half of 2010. The long-term risk is the growing government debt loads of the developed nations.
Because spreads are currently tight between high and low credit quality bonds, this provides an opportunity to upgrade: “As a result, investors should take advantage of the tighter credit spreads and focus on de-risking their portfolios in order to prepare for the increasing long-term secular headwinds stemming from the growing deterioration in public sector balance sheets in many developed economies.”
At least Kiesel's message lies somewhere in a reasonably risk-sensitive middle ground somewhere between the rhetorical extremes in Gross's various messages.
