What do bond investors and boiling frogs have in common? Bill Gross thankfully answers the question.
“Put a frog in a kettle of boiling water and he’ll jump out faster and further than any of those blue ribbon winners at the Calaveras County jumping frog contest,” PIMCO founder Gross writes in his latest monthly commentary. “Put him in a pot at room temperature, however, slowly turn up the temperature to boiling, and you’ll have frog legs for dinner. This latter, more unfortunate toad temporarily adapted to his external environment, which seemed like a practical thing to do, until – well, until he reached 212 degrees at which point he was cooked.”
Today’s bond investors are experiencing a similar fate with nary a “ribbet” of complaint, according to Gross. Much like gradually turning up the temperature on poor froggy’s kettle of water, he writes, monetary policy in developed countries has been lowering the temperature and absolute level of yields for the past 2½ years post Lehman Brothers.
“Teeter-totter yields down, teeter-totter prices up, and froggy’s total return euphoria at present seems to know no bounds. But once the potential for even lower interest rates is minimized by the zero floor, our future frog-legged entrée is left with a rather uncomfortable feeling. He’s resting inertly in this caldron as prices near the boiling point with the Fed, the Chinese and the banks all buying up whatever Treasury bonds are offered.”
He notes Carmen Reinhart, writing for the National Bureau of Economic Research, exposed this dilemma in more sophisticated prose. In her second research paper, entitled “The Return of Financial Repression,” she affirms PIMCO’s thesis of skunking, pocket picking and frog cooking by describing a century-old policy maneuver used by governments facing a debt crisis. Rather than outright default, many countries attempt rather successfully to keep nominal interest rates lower than would otherwise prevail.
Reinhart characterizes this as “financial repression” because over the long term it results in a transfer of wealth from savers to borrowers. Governments, having taken on too much debt, rather stealthily lower interest rates via central-bank-enforced policy rates or maneuvers such as “quantitative easing.” The artificial yields, in effect, act as a tax on savings, undercompensating asset holders and transferring the haircut benefits to the debtor nation.
So we’re being repressed and shortchanged in order to allow Uncle Sam to balance the books. What are we gonna do about it, he asks?
“We suggest buying ‘cheap bonds’ focusing on ‘safe spread,’ ” which means buying more floating and fewer fixed-rate notes, adding an additional credit component – be it investment grade, high-yield, non-agency mortgage or emerging market related – and shading your portfolio in the direction of non-dollar emerging market currencies,” he writes. “Investors shouldn’t give their money away, and at the moment, the duration component of a bond portfolio comes close to doing just that – not because a bear market is just around the corner come July 1, but because it doesn’t yield enough relative to inflation. Come on frogs, make butter, not someone else’s dinner. Buy cheap bonds!”