Pimco, Fearing Specter
Of Higher Rates,
Gets Defensive
By AARON LUCCHETTI
Staff Reporter of THE WALL STREET JOURNAL
NEWPORT BEACH, Calif. -- Bond-market guru Bill Gross huddles with his lieutenants over lunch in a conference room they call Everest, his tie draped around his neck like a scarf. "Let's talk about the fabled handoff," he says.
His lieutenants nod, knowing the "handoff" refers to a decision by the Federal Reserve to raise interest rates. That would cause bond prices -- which move in the opposite direction of interest rates -- to fall, perhaps sharply.
No one is sure exactly when that will happen. But Mr. Gross, one of the world's most influential money managers, is spending a lot of time these days discussing how best to prepare. "We're inching toward that point," says Mr. Gross, who oversees $350 billion in bonds and similar assets at Pacific Investment Management Co., better known as Pimco.
What is clear is that interest rates are likely to go up soon. While a weak jobs report recently pushed the yield on the 10-year Treasury note down to about 4%, many people believe a strong economy will push rates up by the end of the year. When rates start rising, it won't be pretty for millions of investors who poured their savings into bonds after the stock-market bubble burst. Mr. Gross, chief investment officer at Pimco, says bonds could face tough times for years, due to big deficits and rising inflation.
Investors, of course, can dump bonds and move back into stocks, as many started doing last year. But the 59-year-old Mr. Gross doesn't have that choice. He is paid more than $40 million a year to focus on bonds and to manage Pimco's flagship Pimco Total Return Fund, the world's largest bond mutual fund. That puts him in the odd position of telling investors to be prepared for losses, but to stick with his fund, which has beaten 95% of its peers since opening in 1987.
Mr. Gross insists there are still ways to make money in bonds. But to find them, the man considered the Warren Buffett of bond investing has altered his strategy. He is betting big on inflation-indexed Treasury securities that should do well if higher inflation returns, while venturing into riskier territory outside the U.S. with emerging-market bonds. In recent months, he has shifted a chunk of his own retirement money into a Pimco commodity-related fund because prices of hard assets rise when economic growth is strong and the dollar is weakening.
The story of how Mr. Gross soured on bonds highlights growing concern that the bond market won't be the haven it has been for nearly a generation. His strategy shifts also offer insights to investors worried about where to put their own money. If Mr. Gross is right, the handoff, as he calls it, could be a watershed event that alters the investment landscape for years.
Rising interest rates could hurt stocks, too. Higher rates make it more expensive for companies to borrow money, cutting into profits. Mr. Gross likes stocks even less than he likes bonds, arguing they are too expensive.
In the upside-down world of bonds, slow economic growth is a good thing. If growth is too strong, the Fed, fearing a resurgence of inflation, steps in and raises rates to cool off the economy. That hurts bond prices. Over the past two years, the Fed, fearing deflation, or falling prices, has instead cut rates to a 45-year low in an effort to spur growth.
Bonds could still do well under such scenarios as another recession or a terrorist attack. If rates go up enough, investors would also have an incentive to shift money to new bonds that pay higher yields.
When the Fed last cut rates, in late June, Mr. Gross viewed the move as a sign that bond-friendly rate cuts were ending. It was the 13th time the Fed had lowered its target short-term rate since 2001, but the size of the cut was smaller than expected. "This was as close to ringing a bell as it gets," Mr. Gross says. He immediately sold "several billions" of dollars in bonds.
The next day, Mr. Gross took about 200 Pimco employees on a long-planned cruise to celebrate the firm's growth. He donned sunglasses and a cowboy hat for a poker tournament.
He also visited a makeshift trading room on board, where Pimco bond managers chattered on satellite phones and tapped away on desktop computers. Across the country, bond investors were frantically digestingwhat they saw as a groundbreaking Fed shift. The yield on the 10-year Treasury note started to surge, to 4.6% in early August from a June low of 3.1%. Mr. Gross realized the move could wipe out billions of dollars of assets. He removed himself from his cruising colleagues, took three sheets of the ship's stationery and started jotting down Pimco's strategy.
Rates were likely to head higher as the U.S. government encouraged inflation and a falling dollar, so Pimco would have to look abroad for "global market alternatives," he wrote. He brought the sheets back to his California office, had them scanned into a computer and then published as part of his widely followed monthly newsletter.
Mr. Gross actually had been growing uneasy for some time. Back in 2002, when the bond market was humming and he was vacationing in Maui, he flipped through a thick book of world financial history with charts that painted an ominous picture. One showed that interest rates tend to go up for years after prolonged periods of gentle declines.
When Mr. Gross got back, Pimco Fed watcher Paul McCulley told him that the Fed's steps to prevent deflation -- mainly interest rate cuts -- would help bonds at first, but would sow the seeds for bond losses. Essentially, bonds were getting too much of a good thing. The predicament made Mr. Gross think of a TV commercial that he used to see. As he recalled, it touted oil filters with the slogan "pay me now or pay me later."
The manager took an indirect path into the bond business. The son of a steel-company executive, Mr. Gross graduated with a psychology degree from Duke University in 1966 and went to Las Vegas with a book about winning at blackjack. Playing 16 hours a day, he turned $200 to $10,000 in four months and used the money to pay for business school.
He hoped to get into stocks, but the best job he found was one his mother spotted in the newspaper -- researching bonds at what was then called Pacific Mutual Life Insurance Co. After becoming a manager, Mr. Gross built a reputation for making timely interest-rate calls and using innovative products such as financial futures to boost returns. Along the way, his fund suffered only two years of losses -- 1994 and 1999 -- and easily beat both stocks and bonds since 2000. Its annual return since opening is 9.2%.
About four years ago, Mr. Gross signed a $200 million retention deal with Allianz AG after the German insurance company bought a majority stake in Pimco. His contract keeps him at the firm until at least early 2007.
Sometimes, Mr. Gross is surprisingly outspoken. In 2002, he criticized General Electric Co. for its dependence on short-term borrowing. A former Navy officer who served on a gunboat during Vietnam, he argued against the war in Iraq on both financial and moral grounds. "I fear for my country's proud heritage and even more for its future," he wrote from the study of his Laguna Beach home in an investment letter published in March.
A recent visit to Pimco's offices in Orange County shows how Mr. Gross is grappling with the difficult bond market. He arrives at 5:30 a.m., checks an outsized red binder that outlines Pimco's positions and works a handful of trades. He slips in a break around 9 a.m. -- lunchtime on New York bond trading desks -- to ride an exercise bike, the backup workout when his yoga instructor is out of town.
Back at the office, the day's bond trading winding down, the main event unfolds. Seven senior Pimco managers gather for sandwiches in a conference room off the trading floor. Over the next two hours, they discuss how best to prepare for the "fabled handoff." There are few obvious choices. In U.S. Treasurys, longer-term bonds suffer from the twin threats of deficits and inflation, but safer shorter-term notes have low yields. Mortgages have their own problems.
Some suggest Pimco should hold more cash or very short-term investments now paying about 1%. "We want to have our powder dry," says William Powers, a longtime Pimco manager, after finishing a lunch of two hard-boiled eggs.
Indeed, Total Return Fund recently held nearly 20% of its assets in cash. But Mr. Gross says cash isn't "sufficient" as a long-term strategy. "Keeping powder dry is expensive" when it entails passing up 4% yields in 10-year Treasury notes for 1% yields in cash, he explains.
So Mr. Gross has sought alternatives. He has invested about $32 billion of Pimco clients' money in Treasury Inflation Protected Securities, known as TIPS, that would beat regular Treasurys if inflation heats up. TIPS now account for about 10% of Total Return's assets, up from 1% a year ago.
Mr. Gross has scooped up municipal bonds that he thinks won't suffer as much as U.S. Treasurys if foreign bondholders slow their buying of U.S. government bonds, as Mr. Gross fears. In Treasurys, he is sticking to intermediate-term notes, believing they will hold up, even during the second half of the year when he expects the Fed to start raising interest rates.
Pimco also is investing overseas, mainly because Mr. Gross is concerned about the debt owed by U.S. companies, consumers and the government.
Pimco has put about $12 billion into emerging-market bonds on the theory that rising oil, metal and agricultural prices will help the economies of commodity producers like Brazil and Russia. Last year, emerging-market bonds surged about 30%.
One bet that didn't work out well was Pimco's sale of corporate debt, including junk bonds, last year. Feeling that many corporate bonds had bounced too fast, Mr. Gross sold some bonds for a profit, but he missed out on further gains when the rally continued.
Still, the biggest concern for Pimco is U.S. monetary policy. The Fed, traditionally most sensitive to inflation, has lately been too preoccupied with the possibility of deflation to fight inflation aggressively, Mr. McCulley tells the group over lunch in November.
Fed officials "are fixated" on preventing the kind of deflation that hobbled Japan's economy over the last 10 years, Mr. Gross says. "They're 'reflationists.' "
"Bingo," responds Mr. McCulley.
Mr. Gross asks if anyone disagrees. The room is silent. |
