Bill Gross: Potential Returns Are Very Attractive

Kurt Brouwer November 25th, 2008

Bill Gross at Pimco discusses the group’s current outlook on bonds in his latest Investment Outlook.  It would appear that Pimco likes government guarantees in all their glorious profusion these days [emphasis in the original]:

So CQish (Pacific Investment Management / Investment Outlook, November 2008, Bill Gross)

…There will come a time, however, perhaps over the next few weeks or months, when deleveraging of the private sector is met by the leveraging up of the government sectors: the TARP, CPFF, and MMIFF will inject over a trillion dollars of liquidity into the system over a short period of time. At that point, our nuclear atom will begin to stabilize and it should be safer to move a little distance back out toward the perimeter where yields and potential returns are very attractive. PIMCO would focus on the following:

  1. A continued above-average allocation to agency mortgage-backed securities – now yielding close to 6%.
  2. An overweight position in bank capital – bonds and preferred stock in companies where the Treasury has an equity stake. With Uncle Sam as your partner, default seems remote.
  3. A focus on the frontend of the yield curve. The Fed will stay low for an extended period of time while the inevitable inflationary pressures of government bailouts lay further out on the yield curve…

The argument for agency (Fannie Mae, Freddie Mac etc.) mortgage-backed securities is that they have far higher yields than Treasury bonds, yet both are backed by the U.S. government.  Presumably, the Pimco brain trust believes the bond market will figure out that a U.S. government guarantee works equally well on agency bonds as it would on Treasuries.

Similarly, Pimco is following the government into bank securities (bonds and preferred stocks) as well.  Again, partnering up with the Feds seems like a winning bet to them.

Essentially, Gross is betting that the bond market retreats from its doomsday scenario (see Bonds Markets Pricing In Armageddon).  Given how solid his predictions have been during this financial panic, I figure it’s a pretty good bet to tag along (see Bill Gross Was Correct — Treasury To Take Over Fannie & Freddie).

This post from the Wall Street Journal’s Real Time Economics blog adds a little substance to Pimco’s argument for agency-backed bonds [emphasis added]:

Fed Announcements on Household Credit, GSEs (Real Time Economics Blog, November 25, 2008)

…The Federal Reserve announced on Tuesday that it will initiate a program to purchase the direct obligations of housing-related government-sponsored enterprises (GSEs)–Fannie Mae, Freddie Mac, and the Federal Home Loan Banks–and mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Spreads of rates on GSE debt and on GSE-guaranteed mortgages have widened appreciably of late. This action is being taken to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.

Purchases of up to $100 billion in GSE direct obligations under the program will be conducted with the Federal Reserve’s primary dealers through a series of competitive auctions and will begin next week. Purchases of up to $500 billion in MBS will be conducted by asset managers selected via a competitive process with a goal of beginning these purchases before year-end. Purchases of both direct obligations and MBS are expected to take place over several quarters. Further information regarding the operational details of this program will be provided after consultation with market participants.

I thought it was intriguing to see that the Feds will be working with ’selected’ asset managers to buy up $500 billion in mortgage-backed securities.  I wonder if Pimco is one of those selected asset managers? In any case, it would appear that Gross’s argument in favor of agency bonds and mortgage-backed securities was right on target.

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