PIMCO Total Return, Risk Reduction and the Treasury Bond Tsunami

 |  Includes: IEF, SHY, TLT
by: Kurt Brouwer

For some time now, Bill Gross has been taking steps to reduce risk at Pimco’s flagship bond fund, Pimco Total Return (PTTRX). There are several ways to reduce risk in a bond portfolio, with perhaps the most common being to shorten the duration of the portfolio.

What the heck is duration?

Duration attempts to marry two separate aspects of a bond fund: first, the average maturity of all the bonds in the portfolio and, second, the flow of interest income coming in to the portfolio. Duration is generally used as a rule of thumb to estimate portfolio volatility in the event of a quick spike in interest rates. For example, a bond fund with a duration of 5 years would have lower interest rate risk than a fund with a duration of 10 years.

Gross has been shortening the duration of the portfolio and thereby reducing risk for several months.

Pimco Total Return Duration

  • December 2010 – 5 years
  • January 2011 — 4.5 years
  • March 2011 — 3.89 years

It is quite possible the fund may reduce duration further, but, as I understand it, 3 years is about as low as it normally would go. This table shows the latest statistics I have for Pimco Total Return:

Click to enlarge

Source: Pimco

Here are some terms from the table above as defined by Pimco.

1 MV = Market Value Exposure (based on percentage of net asset value), DWE = Duration Weighted Exposure, and Dur in Yrs = Duration in Years 2 Other may include convertibles, preferreds, and yankee bonds 3 Cash Equivalents are defined as any security with a duration under 1 year…* Government-Related may include nominal and inflation-protected Treasuries, agencies, interest rate swaps, Treasury futures and options, FDIC-guaranteed and government-guaranteed corporate securities.

Interest rates on the way up

Gross seems to believe and I agree that interest rates are likely to go up as the Federal Reserve’s intervention into the bond market comes to an end. However, there is another factor that Gross discussed in his last monthly commentary and that is the vast supply of Treasury bonds that have to be issued to cover our yawning Federal deficits.

The Treasury Bond Tsunami

The Monthly Investment Outlook from Pimco’s Bill Gross is always worth a read. In the March column, Gross included three pie charts that communicate his concern about demand for Treasuries [emphasis added]:

…To visualize the gaping hole that the Fed’s void might have, PIMCO has produced a set of three pie charts that attempt to point out (1) who owns what percentage of the existing stock of Treasuries, (2) who has been buying the annual supply (which closely parallels the Federal deficit) and (3) who might step up to the plate if and when the Fed and its QE bat are retired…

Click to enlarge

Source: Pimco

In this graphic (click to enlarge), we have three pie charts. The left hand chart shows traditional Treasury buyers. The middle one shows who is buying now. As you can see, the Fed is buying the bulk of new Treasury securities. The pie chart on the right illustrates the doubt facing us when the Fed stops buying. The big question mark is who will buy when the Fed stops?

I think it is pretty clear from the recent portfolio changes that Bill Gross and Pimco Total Return have decided that Treasuries — at these yields — are not attractive, so they are sellers, not buyers.

If I were Treasury Secretary Geithner or Fed Chairman Bernanke, I think I’d be on the phone to Pimco right now. What do you think?

See also:

Bill Gross: Yields may have to go higher

Bernanke, Interest rates & QE

Hat tip: Kevin Winters

For a slightly different take on this topic, see this post from the folks at the Zero Hedge blog.

Disclosure: Kurt Brouwer owns shares in Pimco Total Return Fund (PTTRX)