Fundmastery Blog

Kurt Brouwer January 7th, 2009

Forbes Magazine did a recent interview with Pimco Total Return Bond Fund manager, Bill Gross. In it, he explained why he is moving away from Treasuries even though other investors are piling in [emphasis added below]:

What Bill Gross Is Buying (Forbes, January 6, 2009, Bernard Condon)

Forbes: Treasuries hit a record low today. What does this mean?

Bill Gross: Government bonds happen to be the one asset that people want to own during a deleveraging cycle. They weren’t leveraged up by hedge funds and mom and pop investors. We were busy buying homes and stocks and risky assets…

…Now we’re deleveraging, and [almost] all assets are going down in price. This is staggering.

How much deleveraging is left?

[BG] I think we’re 75% of the way through. The question is, “What’s the size of the government checkbook and can it match deleveraging in the financial sector?” We think the checkbook is substantial, and sometime in 2009 assets will stop going down.

What are the long-term effects?

[BG] The damage from this Wild West of capitalism…is irreparable…When you lose half your 401(k) you care more about the return of your money than return on your money. The lack of animal spirits will influence investing for years to come. The government will have to play risk taker of last resort.

You’re guessing at the psychology of 300 million people.

[BG] It’s not a slam dunk. It’s my odds-on bet.

Is this cathartic for the economy?

[BG] Yeah, like divorce. Years later you say it was good because you found a new path in life. But it’s painful now.

What’s the impact of government bailouts?

[BG] I’m a registered Republican, and I want little regulation and low taxes. But the government already owns 20% of the banking industry and guarantees 75% of its liabilities. No government coming to the rescue [like this] would allow us to go back to the prior stasis…The government will overdo it, it will muck it up–but it has no choice.

…It will take 15 to 20 years to escape this [new] regulatory environment and the lack of risk taking…

What should investors do?

[BG] We’re buying bank preferred stocks — JP Morgan Chase, Bank of America and Wells Fargo. The government is in the market [through its Troubled Asset Relief Program] to the tune of $150 billion. Its interest rate is 5%. With its equity warrants, that effectively boosts the yield to 6%. We can buy–the public can buy–[similar] preferred shares for yields of 12% or 13%.

This is a very important point. The government is investing huge dollars and getting a much worse deal than private investors can obtain. That makes no sense to me at all. I think we would have been better off just giving investors a tax break for investing in banks. Let Bill Gross and Warren Buffett negotiate a deal and then have the banks offer it to all comers, plus a nice tax break from the Feds. I suspect the capital would have been there.

How safe are these securities? There’s no government guarantee.

[BG] In for a nickel, in for a dime. Or in this case, in for $150 billion, in for $300 billion… It’s close to a guarantee. [The government] is assuming the survival of these companies…

…The banking industry has been nationalized. People don’t realize that. There are so many programs. It’s hard to keep up.

Another good point. If you are going in alongside the Feds, it is unlikely they will let the bank fail. From the Forbes interview and Pimco’s November commentary (see below), 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). Bill Gross and Pimco are well-positioned to operate in this unique government-private environment in which we find ourselves.

• Economy , Geopolitics , Hedge Funds , Investing , Money , Mutual Funds , Personal Finance , Retirement , inflation
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