Gloom and doom.

Gross Gets Out of Bonds Just in Time

Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of "“The Up Side of Down: Why Failing Well Is the Key to Success.”
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Bill Gross is out at Pacific Investment Management Co. For those of you who don't follow the bond market, that may not seem all that interesting. So here's some background color: Bill Gross was, until today, the absolute monarch of the world's largest bond fund, which he founded, and has run for decades.

In hindsight, you can see this coming. Pimco had a sterling run over the last 20 years, because inflation has fallen across the globe, and falling inflation means that fixed income securities get more valuable. But interest rates and inflation pretty much can't go any lower, so bond funds have entered a tougher market. And although being the largest bond fund certainly conveys advantages, generating outsized returns becomes progressively harder, because your trades move the markets.

Meanwhile, the complaints have long been a-simmering that Gross -- who is 70 -- is micromanaging to the point of destruction. He has failed to groom an obvious successor (Mohamed A. El-Erian, a fellow Bloomberg View contributor who was the presumptive heir when I interviewed him, announced his departure last January after what were reportedly repeated clashes with Gross over the management of the firm).

More generally, Pimco has been in the news entirely too much over the last year, especially on the negative side; most recently, over complaints by the Securities and Exchange Commission that Pimco misvalued some of its bonds. It has been reported that Allianz, which bought Pimco in 2000, was preparing to fire Gross over his "increasingly erratic behavior." Gross is departing to Janus funds, which presumably means that in order to hasten his departure, he's been let out of whatever non-compete clause he signed.

Still, however unsurprising this might be in hindsight, it gave markets, and reporters, quite a shock. Bill Gross isn't some third-tier manager who can be unseated because the CEO didn't like his tie.

What does this mean for you, the investor? In general, right after these sorts of announcements is the worst time to flee a market, because there's a big risk premium assigned to "not knowing what the heck is going to happen," and if you head for the exits, you're going to be the one paying for the risk premium. But a lot will depend on how many people decide to leave Pimco over this, and how much stuff Pimco has to sell, at what prices, in order to pay them off. Bond spreads widened this this morning as dealers prepared for redemptions, again, because being the biggest bond fund in the world moves markets.

In other words, expect a bit of a bumpy ride as the markets sort through the chaos.

  1. For those who did not take Finance 101, here's what I mean.

    Say you have a bond with a face value of $1,000 and a coupon (interest payment) of 10 percent. That means that if you own that bond, you will get $100 every year, plus $1,000 when the bond matures in 10 years.

    Now say we've all been expecting annual inflation of 10 percent. In ten years, $1,000 will be worth just over a third of what it is now, because it will take almost three times as many dollars to buy something. Your $100 payment in year nine will also be worth a lot less than today's coupon payment. So you're going to want a pretty hefty discount to buy this bond.

    But let's say we get a new Fed chief -- call him Pal Folker -- who has committed to cutting inflation in half, and you believe him. Suddenly you realize that your $1,000 bond will buy you a lot more in year ten than you previously thought it would. So you'll be willing to pay more for it now, because it's worth more in terms of purchasing power.

    As inflation fell from its 1970s highs, over the next two decades bond funds benefited twice from the decline: The coupon payments they were giving investors were worth more than they'd predicted, and as a consequence, the bonds in the funds were also worth more, so they got capital gains, as well as a steady income.

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To contact the author on this story:
Megan McArdle at mmcardle3@bloomberg.net

To contact the editor on this story:
James Gibney at jgibney5@bloomberg.net