Pimco fixed income veteran Bill Gross has argued that bond managers need to adapt to the new “battlefield” as the 30-year bond bull market shows signs of petering out.
In his latest investment note – titled Bond Wars – Gross compares the current state of the markets to the aftermath of the Somme conflict in the World War One, when the British realised their traditional ‘horse and saber’ approach could not match the machine guns and flamethrowers used by the German army.
“Now that bonds have suffered a near Somme-like defeat in the past few months, fixed income investors are concerned about their prior conceptions of bonds as an asset class – an asset that has historically provided reliable income and stable to higher prices,” he says
“With yields so low, and with a negative 3–4 per cent two-month return for bond indices – investors wonder if the bond ‘horse and saber’ has given way to the alternative asset ‘machine gun’ of a new era.”
However, Gross argues that “there will always be a place for the bond market ‘army’” in an investors’ portfolio and highlights the tools other than coupons that can be used to generate returns. He notes other forms of carry, such as volatility premiums, currency plays and yield curve strategies, that can be used to achieve yield.
“It is an open question whether we are still marching three feet apace with 65-pound backpacks into the face of 1,000 machine guns, or safely burrowed in fox holes with revised strategies adaptive to a new era. Trust me, no investment firm has given this transition more thought,” he says.
“While our strategic execution in May/June of 2013 can and has been publically faulted, we are confident that we know how to win this evolving bond war. We have spent months – indeed years – preparing for this new dawn. We intend for you – our clients – to be surviving veterans of this battle, not casualties. Pimco will not go down at the Somme.”
The manager’s Pimco Total Return fund suffered a record $9.9bn in redemptions during June as investors pulled money from bonds after Federal Reserve chairman Ben Bernanke’s tapering comments. The portfolio’s heavy long position in government bonds also meant the fund’s performance suffered more than most of its peer group.
Gross notes that bond managers will be expected to seek less carry from duration and more from credit, volatility, curve and currency as conditions in the bond market change over coming years. However, he notes that duration extension has a place “under certain circumstances”, while the other strategies come with their own risks.
“Know that bonds – while containing a certain amount of maturity risk by very definition – will never be antiquated. The secret to using them will be to strategically position their component and combined carry to maintain positive absolute returns,” he says.
“Unconstrained strategies, alternative assets and stocks will be flexible choices in a dynamic future environment. We want to continue managing them for you. But don’t give up on bonds. Flexible bond managers can adapt as well.”