On April 19, three weeks before he called the end of the 30-year bull market in bonds, Bill Gross said he was buying inflation-linked Treasuries, a bet that money printing by the world’s central banks would push up consumer prices.
While Treasuries subsequently fell as he had predicted, so did inflation expectations, amplifying rather than limiting losses for Gross’s Pimco Total Return Fund (PTRAX), which had 12 percent of its $289 billion in Treasury Inflation-Protected Securities at the end of the first quarter. The world’s largest mutual fund fell 4.7 percent in May and June, prompting $9.9 billion in withdrawals last month, the most on record.
The losses highlight the difficulties Gross faces as he steers Pacific Investment Management Co. through what’s arguably the biggest market challenge for the $2 trillion bond-fund manager since its inception in 1971. A premature bet against Treasuries caused his flagship to trail peers in 2011, prompting Gross to apologize to clients. With about 10 percent of the TIPS market owned by Pimco, according to Morningstar Inc., his success is tied in part to an asset class fellow bond manager Jeffrey Gundlach has avoided.
“Unless inflation goes higher, then all you have with TIPS is interest rate risk, just like every other Treasury,” said Gundlach, the portfolio manager for the $39 billion DoubleLine (DBLTX) Total Return Bond Fund. “It’s an asset class that is exposed to investor surprise and disappointment.”
Gundlach, who called TIPS a “disaster” and a “trap” during a webcast last week, lost 2.6 percent in the two months through June and is down 0.3 percent so far this year in his main fund, beating 83 percent of peers. None of Gundlach’s funds reported holding any TIPS as of March 31.
Gross has had between 9 percent to 12 percent of Pimco Total Return’s net assets invested in TIPS since at least the end of 2011, convinced that efforts by U.S. Federal Reserve Chairman Ben S. Bernanke and other central bankers to stimulate their economies will ultimately fuel inflation. The government bonds provide protection against inflation by increasing in par value with the U.S. Consumer Price Index.
At the end of the first quarter, Pimco Total Return had about 33 percent of its net assets invested in Treasuries, including $52.9 billion of traditional or “nominal” bonds and $34.3 billion of TIPS. The latter proved costly during the second quarter, when TIPS swooned under muted inflation expectations and sales by funds that lost money under a leveraged investment strategy employed by money managers such as Ray Dalio, known as risk-parity funds.
The TIPS held by the fund as of March 31 declined in value by $3.9 billion during the second quarter, according to data through June 28 compiled by Bloomberg. In contrast, the value of the fund’s holdings in nominal Treasuries fell by about $1.9 billion, assuming the holdings were unchanged.
Gross made another bad bet on Treasuries almost 2 1/2 years ago. In February 2011, he eliminated his allocation to Treasuries, only to miss out on a rally in government bonds that left Pimco Total Return trailing 70 percent of peers. Gross, in a letter to clients at the time titled “Mea Culpa,” called 2011 a “stinker.” His fund lost an estimated $5 billion to withdrawals that year, according to Morningstar.
Pimco Total Return rebounded in 2012 to beat 95 percent of peers and has outperformed 93 percent of rivals over the past five years, according to data compiled by Bloomberg.
The fund’s allocation to Treasuries, a category that also includes futures, rose to 39 percent in April and then dipped to 37 percent in May, when Bernanke told Congress that the central bank’s policy-setting board could begin to curtail quantitative easing in “its next few meetings” if the Fed is confident gains in the economy can be sustained. Bernanke expanded on his comments last month, telling reporters on June 19 that the central bank will probably taper its $85 billion bond buying program later this year, as long as the economy performs in line with Fed projections.
While the yield on 10-year Treasuries soared as high as 2.66 percent on June 24, from a low of 1.61 percent on May 1, yields on inflation-indexed debt climbed even faster and further. As a result, the narrowing in the difference between yields of nominal Treasuries and TIPS, known as the break-even rate, showed that investors viewed inflation as less of a threat in the short term and thus were cutting the price they would pay for insurance against it, said Daniel Shackelford, a fixed-income portfolio manager at T. Rowe Price Group Inc. in Baltimore.
“Inflation expectations haven’t budged after three or four years of hyper-easing and now we are looking at an expectation for a Fed that will become less accommodative,” said Shackelford, who runs the $496 million T. Rowe Price Inflation Protected Bond Fund. “It was sort of the worst news that the TIPS market could receive.”
Shackelford’s fund lost 6.8 percent this year, trailing 76 percent of similarly managed funds. It beat 86 percent over three years and 56 percent over five years, according to data compiled by Bloomberg.
TIPS funds fell an average of 7.2 percent from the end of April through June 28, more than double the 3.3 percent decline in the Barclays US Aggregate Index, a fixed-income benchmark, according to Michelle Canavan, a mutual-fund analyst at Chicago-based Morningstar Inc. who follows inflation-protected bond funds.
At Pimco Total Return, TIPS were the largest detractor from the performance during May, said Eric Jacobson, another Morningstar analyst, even though the fund’s holdings in nominal Treasuries were about 50 percent larger.
Pimco Total Return’s holdings in nominal Treasuries may have helped limit the fund’s underperformance, because the debt fell less than corporate, municipal and agency mortgage-backed bonds. U.S. municipal securities have declined 1.36 percentage points more than similar-duration Treasuries since April 30, and corporate investment-grade bonds have lost 88 basis points more, based on Bank of America Merrill Lynch indexes. A basis point equals a hundredth of a percentage point.
According to Jacobson, Pimco funds and accounts own about $100 billion of inflation-linked bonds, most of that in TIPS. The total market value of TIPS outstanding is $869 billion, not including $111 billion that is held by the Fed, according to Paul Wynn, the portfolio manager for the $837 million Western Asset/Claymore Inflation-Linked Opportunities & Income Fund.
With such a large market share, it’s difficult for Gross and other Pimco managers to meaningfully change their positions without moving prices, said a former bond manager at the firm who requested anonymity. As a result, Gross must accept short-term volatility in the fund as the price of making long-term bets in the TIPS market, he said.
After TIPS tumbled following lower-than-average demand at the Treasury’s five-year auction in April, Gross wrote in an April 19 Twitter message that he was buying more inflation-protected debt. And in a June 6 interview on Bloomberg Television’s “Market Makers,” Gross said he continued to expect that “trillions of dollars of check writing” by central banks would spur enough inflation during the next three to five years to give some “traction” for insurance against rising prices “on the TIPS side.”
Jeremie Banet, a Pimco portfolio manager who specializes in inflation-linked investments, said in an interview that the contraction of the break-even rate shows that the market doesn’t see the economic improvement that the Fed is citing as a basis for tapering. If the market did see that the economy was expanding, inflation expectations would rise, leading to a higher break-even rate, Banet said.
“We think the reason interest rates are rising is because people expect the Fed to be less accommodative,” not because the economy is improving, Banet said in a telephone interview. “If inflation is really as low as what is priced into the TIPS market,” Banet said, the Fed “should be concerned about premature tightening.”
The change to the Fed’s asset purchases that Bernanke signaled by itself was too small to drive the decline in financial markets that followed, said Wynn at Western Asset. His closed-end fund has declined 7.5 percent this year through July 2, trailing 81 percent of peers.
The market declines began with money-losing bets that leveraged hedge funds made on the outcome of Japanese government stimulus efforts and have snowballed because banks, faced with higher capital requirements, are providing less liquidity when volatility increases, according to Wynn.
“Fundamental to the price action in the last month-and-a-half is the leveraged investors unwinding,” Wynn said in a telephone interview. “The TIPS market has been a casualty of this environment.”
Within the TIPS market, much of the recent selling came from risk-parity funds that follow an asset-allocation strategy pioneered by Dalio, the founder of Bridgewater Associates LP in Westport, Connecticut, according to Wynn and four other managers and dealers who trade inflation-linked debt.
These funds, which seek to diversify by the types of risk they face under different economic environments, typically devote 25 to 60 percent of the notional value of their assets to inflation-linked bonds, including TIPS, said Tim McCusker, the head of traditional research at NEPC LLC, a Cambridge, Massachusetts, investment consultant to pension plans, foundations and endowments.
While risk-parity strategies are designed to provide higher returns in a variety of economic environments, they fare poorly when there is a tightening of monetary policy or an expected tightening, McCusker said. The $1.2 billion AQR Risk Parity (AQRIX) Fund, run by Cliff Asness’ AQR Capital Management LLC, has fallen 11 percent since the end of April, according to data compiled by Bloomberg.
Michael Mendelson, a portfolio manager for AQR’s risk-parity strategies, said in a telephone interview that some risk-parity managers sold TIPS last month to bring their portfolios back into balance or to reduce their holdings. He also said that the aggregate holdings of such traders in all types of global inflation-linked bonds, not just TIPS, was only in the “mid-tens of billions” and therefore too small to drive the market’s recent decline.
“Risk-parity investors are important TIPS investors, but we are not that important,” Mendelson said.
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