Gross Counters Gundlach Pushing U.S. Bank Bonds DoubleLine Shuns

Pimco's Bill Gross
Pimco's Bill Gross. Photographer: Andrew Harrer/Bloomberg

Pimco’s Bill Gross bet on debt of big U.S. banks last year, his worst against peers. DoubleLine Capital LP’s Jeffrey Gundlach cut bank bonds in May, dodging their second-half slide and beating 99 percent of rivals.

The competing bond managers haven’t changed their minds. Gross, whose $244 billion Pimco Total Return is the world’s largest mutual fund, recommended financial debt in this month’s investment outlook for Newport Beach, California-based Pacific Investment Management Co., saying senior, higher-rated securities “should be considered” as clients await the result of central-bank efforts to reinvigorate the global economy.

“You want to be underweight banks,” Gundlach told clients of Los Angeles-based DoubleLine Capital in a Jan. 5 conference call. “Certainly, we are.”

More than three years after the U.S. rescued major banks, money managers are debating how the industry will cope in a world of stricter regulation, Europe’s debt crisis, lower Wall Street trading volumes and sliding home prices. Gross’s main fund trailed 69 percent of peers in 2011, the worst performance in Bloomberg records going back to 1995, and suffered its first net redemptions, while Gundlach’s Core Fixed Income Fund and Total Return funds won new cash as they whipped rivals.

Gross is taking a risk betting on bank bonds.

The bonds of banks, insurers, real estate firms and financial-services companies had the lowest risk-adjusted returns in the five years ended Dec. 31 among 16 industry groups tracked by Bank of America Merrill Lynch Indexes. In 2011, banks were among the five worst groups ranked by the same measure.

Risk-Adjusted Return

Banks had a risk-adjusted return of 6 percent over the five-year period, compared with 9.5 percent for automotive bonds, the top-performing group. The risk-adjusted return is calculated by dividing total return by volatility, or the degree of daily price-swing variation, giving a measure of income per unit of risk. The number isn’t annualized.

Pimco Total Return Fund had 12 percent of assets in investment-grade financial bonds as of Dec. 31, almost three times their share in the $1.8 billion DoubleLine Core Fixed Income, Gundlach’s competing fund. Gross had more than 1.3 percent of Pimco Total Return in the bonds of Citigroup Inc. as of Sept. 30. The New York bank represented about 0.2 percent of Gundlach’s fund, according to regulatory filings and data compiled by Bloomberg.

Dan Fuss of Loomis Sayles & Co., whose best-known mutual fund beat 92 percent of peers over the past decade, is on Gross’s side. His $20 billion Loomis Sayles Bond Fund increased its holdings of bank bonds from June to November as investors overreacted to bad news for the industry, said Elaine Stokes, another portfolio manager on the fund.

No ‘Disastrous Scenario’

“The U.S. economy is going to continue to get better, interest rates will stay low and Europe will muddle through,” Stokes said in a telephone interview from Boston. “That is not a disastrous scenario for the banks.”

Pimco expected U.S. banks to do well last year. They improved their balance sheets and their debt was poised to rally as the economy picked up, Mark Kiesel, global head of corporate bond portfolios, said in a December 2010 interview on Bloomberg Television’s “Street Smart.”

Citigroup and Bank of America Corp. could be “two of the stars” in the fixed-income market, Kiesel said at the time.

Bank of America’s 5.625 percent notes due in July 2020 lost 5.3 percent in 2011, Bloomberg data show. Citigroup’s 5.375 notes due in August 2020 rose 4.2 percent. Both bonds are among the banks’ most traded, according to Trace, the Financial Industry Regulatory Authority’s price reporting system.

Bet ‘Hurt’

Bank bonds returned 1.7 percent in 2011 and dropped 1.5 percent in the last six months of the year as investors were spooked by Europe’s troubles and signs the global economy was slowing. U.S. corporate bonds gained 7.5 percent and 4.1 percent over the same periods, based on Bank of America Merrill Lynch indexes. Treasuries returned 9.8 percent and 7.3 percent.

“It’s fair to say the bet on financials hurt Gross’s fund,” Eric Jacobson, director of fixed-income research at Chicago-based Morningstar Inc. said in an e-mailed response to questions. Pimco Total Return gained 4.2 percent in 2011 while DoubleLine Core Fixed Income returned 11 percent and the $16.8 billion DoubleLine Total Return, Gundlach’s largest fund, climbed 9.5 percent, both better than 99 percent of peers.

Gross referred questions to Christian Stracke, head of credit research at Pimco.

U.S. banks are “in much better shape than they have been in years,” Stracke said in a telephone interview.

Raising Capital

The biggest banks have raised capital over the past two years, and cut risk by keeping more cash on hand and relying on stable sources of funding such as customer deposits, Stracke said. Pimco favors senior bank bonds that offer more protection in the event the economy weakens, because their principal is paid back before subordinated debt in a bankruptcy, he said.

Pimco doesn’t break out statistics on bank holdings as a share of its portfolios. In the Barclays Capital U.S. Credit Index, a common benchmark for bond managers, banks account for about two-thirds of financial bonds.

Loomis Sayles Bond Fund’s assets in bank bonds grew to 7.8 percent as of Nov. 30 from 6.6 percent in June, according to the firm. Loomis Sayles likes “too-big-to-fail” banks best because the U.S. government won’t allow a repeat of the 2008 failure of Lehman Brothers Holdings Inc.

In the fourth quarter, the firm bought Bank of America’s 7.625 percent notes due in 2019. The yield on the bonds, rated A- by Standard & Poor’s, reached 8.2 percent in November.

Attractive Yield

“Where else can you get a yield like that in a solid investment-grade credit?” Stokes said.

A rally in bank debt has since cut the yield to 5.8 percent, according to data compiled by Bloomberg. In December and January through the 23rd, global bank bonds enjoyed their best back-to-back performance since August and September 2009, according to Bank of America Merrill Lynch index data.

While U.S. bank bonds remain an attractive long-term holding, they aren’t enticing enough at current prices for Loomis Sayles to buy more, Stokes said.

Pimco’s Stracke agreed, saying the firm will wait for “better entry points” to add to its bank securities.

DoubleLine referred questions to Bonnie Baha, head of global developed credit. The firm started 2011 with fewer financial bonds than most of its peers and began paring them back in May when Europe’s debt crisis escalated, Baha said in a telephone interview.

DoubleLine Core Fixed Income Fund had about 4.5 percent of its assets in investment-grade financial bonds and less than 3 percent in bank debt at year-end, Baha said. Financial bonds represent 6.5 percent of the Barclays Capital U.S. Aggregate Bond Index, and bank debt 4.3 percent.

‘Not Enough’

U.S. banks have made progress by increasing deposits, adding capital and shrinking their holdings of nonperforming assets, Baha said.

“It’s not enough to have stronger balance sheets,” she said in a telephone interview. “Going forward how are they going to make any money? What’s the business model?”

U.S. banks are in the midst of the industry’s worst two years of revenue growth since the Great Depression, according to Mike Mayo, an analyst with research firm CLSA in New York.

JPMorgan Chase & Co., the largest U.S. bank by assets, said Jan. 13 its fourth-quarter profit fell 23 percent as trading revenue and investment-banking fees declined. Citigroup, the third-biggest bank, said Jan. 17 that fourth-quarter profit dropped 11 percent, missing analysts’ estimates for a gain, as securities trading revenue declined.

BofA Profit

Bank of America, the second-largest U.S. lender, swung to a fourth-quarter profit as the company sold assets and built capital faster than expected, the Charlotte, North Carolina-based company said Jan. 19.

The bank abandoned plans to charge $5 a month for debit cards in November after a backlash from consumers and lawmakers.

“Is that how desperate they have gotten to find new revenue?” Baha said.

Gundlach’s DoubleLine Core Fixed Income Fund benefited in 2011 from its stakes in Treasuries and mortgage-backed securities and by holding less in high-yield debt and bank bonds than peers, Baha said. Investors deposited $1.4 billion into the fund last year, Morningstar data show.

Gundlach’s larger fund, which buys mortgage-backed securities, owns no corporate debt, according to the firm. Gundlach, 52, founded DoubleLine, which manages $23 billion, in December 2009.

Gross, 67, shunned Treasuries in the first half of the year, missing a rally as investors rushed to the safety of government-backed debt. The 9.8 percent return for Treasuries in 2011 was their best showing since 2008, according to Bank of America Merrill Lynch indexes.

Sentiment Brightens

Gross later reversed course on Treasuries, which accounted for 21 percent of his fund as of Dec. 31, according to Pimco’s website. The fund lost $5 billion to redemptions in 2011, according to Morningstar, the first net withdrawals in records going back to 1993.

“This year is a stinker,” Gross wrote in an October letter to clients titled “Mea Culpa.” Total Return “had too little risk off and too much risk on,” Gross wrote.

Investor sentiment toward U.S. banks has brightened in 2012. Bank bonds gained 1.9 percent this year through Jan. 23. The KBW Bank Index of 24 stocks rose 10 percent through yesterday.

DoubleLine isn’t joining the bandwagon.

“We are not sure you are being compensated enough for risks that no one can clearly understand,” Baha said.

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