Why Bill Gross’s mistake is excusable

By Felix Salmon
August 31, 2011
Stevensaysyes asks if I could reassess my take on Pimco's Total Return Fund, given its underwhelming performance year-to-date.

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Commenter Stevensaysyes asks if I could reassess my take on Pimco’s Total Return Fund, given its underwhelming performance year-to-date. Always happy to take requests!

So, first, and most obviously, you’d have to be an idiot to exit the Total Return Fund on the basis of its performance over the past nine months. This is a long-term investment vehicle, and has still comfortably outperformed nearly all of its peers over any reasonably long-term time horizon. Everybody is human, even Bill Gross, and Gross is more than happy to fess up to his mistakes and learn from them.

But of course it’s also important to look at exactly what Gross’s mistake was, and whether it was stupid or reasonable. And the answer is that it probably falls in the “reasonable” category.

The big picture here is that the Total Return Fund does what it says on the tin: it’s a fixed-income fund which tries to maximize the total return to investors. Fixed-income instruments come with a certain yield; all else being equal, the higher the yield, the higher the return to investors. And as a rule, Treasury bonds have the lowest yield of any fixed-income instruments. As a result, then, you’d expect the Total Return Fund, in normal times, to own no Treasury bonds at all.

When bond investors turn bearish, they do a couple of things. One is to reduce duration: sell bonds with long maturities and buy bonds with shorter maturities, which are safer. And the other is to reduce credit risk: to sell riskier bonds which are more likely to default, and buy safer bonds which are less likely to default. The safest bonds of all, in this respect, are Treasuries, which is why Treasuries tend to rally when the rest of the market is falling or bearish.

Buying Treasuries, then, is not something you should do every time you think they’re going to rise in value. If there’s a broad-based environment of falling interest rates, with yields on corporate bonds falling at the same rate as yields on Treasuries, then you’re still better off in the higher-yielding corporate bonds than you are in Treasuries.

So the only time that you’re wrong to sell out of Treasuries is in advance of a time when rates fall even as spreads rise. Holding corporate bonds makes sense over the long term, but in the short term, if credit spreads are rising, that’s likely to mean that prices are going down and you would have been better off waiting to buy. And, according to a handy S&P research note from earlier this month, credit spreads have been rising for most of this year.

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This chart, in a nutshell, is why Gross’s decision was a bad one — he didn’t expect spreads to rise nearly as far or as fast as they did. And they did so in exactly the worst way possible for Gross — as Treasury yields were falling. Here’s what’s happened since the beginning of July:

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That’s the kind of environment you very much want to be long rates and short credit — the one environment where owning lots of Treasury bonds makes you look smart.

Over the long term, though, I’d rather my bond-fund manager erred on the side of credit rather than on the side of caution. Pimco is one of the few fixed-income investors which does a huge amount of credit research; it should take advantage of that, and buy bonds which are trading cheap compared to their probability of default. Yes, it should play the rates game too. But as a general rule, if I want to maximize my total return, I don’t want to be holding vast quantities of low-yielding Treasury bonds. Gross is guilty of bad timing here. But I don’t for a minute think that this is the beginning of the end of the legend of Bill Gross, bond-market guru. Especially since he’s managed to do the one thing asked of all fixed-income managers, which is preserve value. His fund might be up less than those of some of his peers. But it’s still up for the year. Which counts for something.

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