Bill Gross: Value Is Returning to Parts of the Bond Market

From PIMCO Managing Director Bill Gross's monthly market commentary for March 2008:

It seems obvious that ... a prolonged period of risk aversion and deleveraging of our global shadow banking system lies ahead. Tighter lending standards, reduced risk budgets, and increased regulatory scrutiny all promise to produce a reduction in the growth rate of lending. Mortgage credit, for instance, grew at 10%, then 11%, then 13%+ annualized rates during the shadow’s heyday just a few years past. Now, despite the obvious rescue efforts of the Federal bureaucracy (much of which is aimed at preventing a contraction of mortgage credit), it promises to grow at tiny single-digit rates due to diminished housing starts and a buyer’s strike of significant proportions. Similar trends lie ahead for consumer credit, and importantly, commercial lending which heretofore has held up the investment side of the GDP ledger.

Slow credit growth is a harbinger, however, for slow economic growth (if any) and that in turn leads to the necessity for low short-term interest rates for an extended period of time. I think Ben Bernanke knows that restarting the U.S. growth engine almost by definition requires nominal GDP growth of 5%. He’d prefer that nominal rate be composed of 3% real and 2% inflation, but desperate times sometimes require compromise: 2% real and 3% inflation may be the best he can hope for in 2009 as soaring commodity prices and a declining dollar add to the equation’s complexity. If so, a bond investor should expect a prolonged, several year period of low short-term rates (Fed Funds averaging 2½%) with vulnerability on the intermediate and long-term portions of the U.S. curve due to inflationary fears and the diminishing support of foreign central banks and SWFs. If, as a bond investor, I expected 3% inflation (2% in 2008 – higher in the out years), a 3% 5-year Treasury would not seem very appealing. Nor, I should add, would a 3.80% 10-year or a 4.65% 30-year bond.

... Still, [my CIO partner Mohamed El-Erian and I] would agree that value is returning to many parts of the bond market. If an investor requires 5%+ yields to compensate for future inflation, then they can increasingly be found in authentic AAA assets – not disguised Old Maids. There’s not a hint of plastic surgery in agency-backed FNMA and FHLMC mortgages at 5¾%, although their actual ages (average lives) may be somewhat in doubt. Similarly, SBA government-guaranteed loans at LIBOR+ 125 basis point yields are beginning to entice, as are some of those bank loans when priced in the high 80s as opposed to 95 cents on the dollar. If capitalism is a going enterprise – and we think it is – then investors will eventually return to play similar, perhaps more conservative games – much as they have in the past. And if Washington gets off its high “moral hazard” horse and moves to support housing prices, investors will return in a rush. PIMCO wants to sit at this more attractive return table – to provide an attractive return on your money (no matter what the asset class) as well as a return of your money.

Comments

[ballsschweaty:]

I still remember Bill's "Dow 5,000" call at the bottom of the last bear market.

It pays to fade Bill. He's just another self promoting snake oil salesman.

2008 Feb 26 10:14 AM

[whidbey:]

Mr. Gross is, to a degree that would shock most investors, a very euphoric bond manager. Usually they are more conservative and cautious: He says distains moral hazards as "staw men" and favors of liquidity! Would that affect yields? Would you want such a man managing your money, or national policy? Fade him, he is no ones friend.

2008 Feb 26 09:33 PM

[CHM97:]

Mr. Gross says Washington has to "support housing prices"....That is what they have been doing for the last 75 years! FHA,Fannie Mae, Freddie Mac,deductibility of interest, tax credits,zero down VA loans,first time home buyer programs, affordable housing, special rates for first responders & TEACHERS. All these programs (I am just scratching the surface) and houses are still too expensive relative to incomes.

2008 Feb 27 11:49 AM