In Part III of a series of interviews PIMCO’s acclaimed and widely cited fund manager Bill Gross gave for Morningstar, Gross puts forward the argument that with US interest rates so low, investors should broaden their bond-market horizons and look for diversification beyond Treasuries of various duration. Bill Gross spoke to Morningstar’s Director of Fixed Income Research Eric Jacobson shortly before S&P downgraded its rating for US sovereign debt. See Part I: Treasuries’ Risk-Reward Balance Is Off and Part II: Better Sovereign Debt Opportunities Outside US.
Eric Jacobson: I think a lot of people have looked at the weighting or lack thereof of US interest-rate risk in terms of Treasuries and the overall shorter-than-benchmark duration of the portfolio as a comment on eminent fear of rising interest-rate/upper-moving yield curve. I guess my question is can you help frame that for us in terms of, how much of it is a valuation issue and how much of it is an actual expression of a particular thinking? For example, what’s going to happen and how related is it to the second round of quantitative easing, and my question is isn’t it priced in? And the other question is when are federal funds most likely to go up?
Bill Gross: Well its mostly a valuation issue as I just expressed. It's hard to know how much Treasury yields have been suppressed by the Fed's buying up of Treasuries and incented others that we spoke to in terms of the Chinese. But let's say at least 50 to 100 basis points. So it’s a valuation issue, but it's also a recognition that at least in terms of policy-rate terms and money market terms we’ve reached a zero bond. I mean no one would dispute that. We can have legitimate argument and disagreement, but you can’t go lower than zero, as Japan has found out for the last 10 years. For the typical duration play that has typified the past 30 years in the bond market, we’ve had a swell bull bond market ever since 1981, and bond investors have gotten so used to that. That’s what total return is all about--yield plus a little bit of capital gain. And put it together, and we’ve got a nice total return.
So when interest rates per se get so low, when yields get down to the zero bond, it becomes impossible for additional capital gains. You only have the potential for capital loss and so, what PIMCO and the total return fund and other funds at PIMCO have been expressing is that there are probably better what we call safe spreads. I mean duration is a spread because it provides a yield. Let's take the 30-year Treasury. It’s a spread, and it yields 4.5%. It may not be safe, which is our point from the standpoint of duration because the price goes up and down. But it’s a spread. There are other spreads in terms of corporate spreads or in terms of nondollar currencies, all of which express some type of yield or return relative to that zero bond or policy rate which is itself riskless.
So what we are trying to say is, "Hey, duration’s been great for 30 years." We’ve been willing participant, but at this point it’s fair to put it on a level basis in comparison with other spreads. I mean you don’t have to simply buy duration and call your self a bond manager. You should be looking at duration and should be looking at credit spreads whether it’s corporate, high yield, or emerging markets. You should be looking at nondollar currency types of levels, but you should put them on a level plane and within the same menu.
Before bond investors basically opened the menu, the entree page was dominated by duration. If you bought long bonds for the last 30 years, absent one or two years during a cyclical move, then you are a winner. There were a many firms that made their reputation simply by buying 30-year Treasuries. We're saying the menu is more complicated now. Its sort of like a menu over across the street at the Cheesecake Factory. They don’t just offer, like In-N-Out Burger, they don’t offer just one burger. They offer like 10 different pages of choices while the In-N-Out Burger has been the entrée of choice for the past 30 years--duration. Now we've got other choices, and its fair to put them within the same menu.
