Goldman Shuns Bonds Pimco’s Gross Favors in ‘New Neutral’Charles Stein
As Bill Gross vows to restore top performance at the world’s biggest bond fund, he’s taking a path many of his rivals shun.
Gross, who manages the $230 billion Pimco Total Return Fund at Pacific Investment Management Co. in Newport Beach, California, is betting five-year Treasuries, which are more sensitive to changes in the central bank rate than longer-dated bonds, will do well because markets overestimate how much the Federal Reserve will raise interest rates. Bond managers at Goldman Sachs Group Inc., BlackRock Inc. and JPMorgan Chase & Co. say he’s wrong and the intermediate bonds he holds will suffer when the Fed lifts borrowing costs.
“Once they see the whites of the eyes of full employment, they will want to normalize rates at a faster clip,” Jonathan Beinner, co-head of global fixed income at Goldman Sachs Asset Management, said in a telephone interview.
Gross, 70, is betting on an economic view he calls the “new neutral,” which argues that the top speeds of the biggest economies and their equilibrium interest rates have declined and won’t return to levels seen before the financial crisis. While most bond managers agree rates will be lower, with the federal funds target ranging somewhere between 3 percent and 4 percent by 2018, Gross sees it at just 2 percent, making bonds attractive to Pimco that BlackRock and Goldman Sachs won’t touch.
As of April 30, his Pimco Total Return Fund had 94 percent of its money in bonds with maturities of 10 years and less, according to the firm’s website, with the biggest concentration, 38 percent, in bonds with maturities of three to five years. Gross was betting against bonds with maturities of greater than 20 years.
If he’s right, the bond king could emerge triumphant and end his fund’s longest streak of redemptions. If he’s wrong, he could underperform peers for a third year in four.
“Believe me, by the end of 2014, Pimco’s going to be at the top, not close to the middle,” Gross said in a May 14 interview with Erik Schatzker and Olivia Sterns on Bloomberg Television’s “Market Makers.” He said he’s buying bonds maturing in five years to seven years.
Pimco’s new forecast, published in a report May 13, is the product of its annual Secular Forum, which guides the firm’s world view and investment philosophy over the next three to five years. In the aftermath of the 2008 financial crisis, that forum used the term “new normal” to describe an era of subdued returns, heightened government intervention and increasing clout for emerging nations in the global economy.
The heart of Pimco’s “New Neutral” message -- that interest rates will not return to historically normal levels anytime soon -- is broadly accepted. The predictions for the benchmark rate differ. Beinner at Goldman Sachs says it could be 3.5 percent to 4 percent by 2018. His counterparts at BlackRock and JPMorgan say 3 percent is probably a better bet.
“Rates will be lower than they have in the past,” Rick Rieder, chief investment officer for fundamental fixed income at BlackRock, the world’s largest money manager, said in a telephone interview. Rieder, who oversees $700 billion, cited slower global growth, an aging population and subdued consumer spending as reasons to expect relatively low rates for an extended period.
Still, Rieder, 52, expects interest rates to rise as the U.S. economy grows “at a pretty steady 3 percent,” barring problems in the housing market.
Robert Michele, who oversees $370 billion as head of fixed income at JPMorgan Asset Management, is looking for U.S. growth in the 3 percent to 3.5 percent range over the next few years. An expansion of that pace, combined with some pickup in inflation, would allow the Fed to push up rates gradually to about 3 percent.
The distinctions are big enough to drive very different investment choices. Gross argues that intermediate-term bonds reflect market expectations for Fed rates of as much as 4 percent, meaning they will do well once markets realize that the central bank has limited room to increase borrowing costs. Longer-dated bonds offer less value after rallying the most this year, he says.
Treasuries maturing in five years have returned 2.3 percent this year through yesterday, compared with gains of 6.6 percent for 10-year notes and 14 percent for 30-year bonds, Bank of America Merrill Lynch Index data show.
Five-year note yields fell 1 basis point to 1.5 percent at 9:54 a.m. in New York after the Commerce Department said the U.S. economy shrank last quarter for the first time in three years and a separate Labor Department report showed fewer Americans than forecast filed applications for unemployment benefits. Yields on 10-year debt fell almost 2 basis points after earlier reaching the lowest since July. Yields on 30-year bonds dropped to 3.28 percent from 3.97 percent at the end of 2013.
Most of the other bond managers say they like the 20- and 30-year bonds that Gross is avoiding, while steering clear of the intermediate bonds he recommends. They say that as the Fed starts to raise rates, short and intermediate rates will feel the brunt, while long-term rates will rise less.
“We do NOT like the five-year U.S. Treasury,” John Bellows, a money manager at Western Asset Management Co., wrote in an e-mail. Western Asset, a division of Baltimore-based Legg Mason Inc., manages $469 billion in bonds.
“Holders of those maturities have become complacent about the potential for rising rates,” said Robert Michele. Longer-dated bonds in the 20-year to 30-year range are more attractive, he said, because pension funds, looking to avoid risk, are boosting demand for the securities.
BlackRock’s Rieder said he’s avoiding the “belly of the curve,” bonds with maturities of thee to seven years, and agreed that “long Treasuries make some sense,” because of demand from institutional investors. Goldman’s Beinner said he is steering clear of bonds in the three- to five-year range because they will be hurt in the tightening cycle.
Beinner, who oversees $411 billion in fixed-income investments, also is counting on a stronger U.S. economy, driven by improvements in housing and corporate spending. The U.S. expanded 1.9 percent in 2013, according to data compiled by Bloomberg.
“We are not going to have a boom, but we should do better than the anemic 2 percent growth levels we have seen,” he said.
There are bond managers more in sync with the “new neutral.”
“Rates are going to be lower for longer than anyone wants to think about,” Margaret Patel, who manages more than $1 billion in bonds and stocks for Wells Capital Management in Boston, said today in a telephone interview. “People so want rates to be normal again, but there is no sign that is going to be happen.”
Franco Castagliuolo, who helps oversee $34 billion in government and mortgage bonds at Boston-based Fidelity Investments, expects rates to rise very slowly.
“High rates would be too painful for the recovery,” he said in a telephone interview. Castagliuolo prefers 5-year bonds to 30-year bonds, arguing that yields on the longer-dated securities don’t reflect economic fundamentals.
Pimco, in its second-quarter market outlook, predicted that the economy would expand in the 2.5 percent to 3 percent range. In its secular outlook, the firm wrote that prospects for U.S. growth over the next three to five years “encompass a wider range of optimistic outcomes than do prospects for other major economies, though growth at pre-crisis trends is unlikely for years to come.”
With the Fed boosting rates slowly, intermediate bonds will be “anchored” by the central bank, Scott Mather, deputy chief investment officer at Pimco, said in a telephone interview. Because the Fed has less influence over longer-dated bonds, their future yields are more uncertain, said Mather, who is 45.
“For taking on that extra risk, you are not picking up much extra yield,” he said.
Gross’s fund beat 95 percent of rivals over the past decade, according to Chicago-based Morningstar Inc., on the strength of his calls on the economy and interest rates. He outperformed 99 percent of peers in 2007, according to data compiled by Bloomberg, by being early to see the weakness in the housing market. He trailed 66 percent of similar funds in 2013 when the debt he held lost value after the Fed hinted it would begin to scale back its bond buying program.
Investors pulled a record $41.1 billion from Pimco Total Return last year and $11.3 billion in the first four months of 2014, according to Morningstar.
Gross, in the May 14 interview with Bloomberg, said his fund’s performance this year has improved as the bonds it favors gain ground. Pimco Total Return has beaten 96 percent of peers in the past month.
“Pimco will do well,” he said. “We have a thesis. We are sticking to our guns.”