February 28, 2012

PIMCO’s Gross Makes Big Break With Past Strategy

‘Defense, defense, defense’ is now mantra for the foreseeable future, bond king says

Bill Gross (left) and Liz Ann Sonders at Schwab Impact in November. Bill Gross (left) and Liz Ann Sonders at Schwab Impact in November.

PIMCO’s Total Return strategy of emphasizing income and capital gains, the strategy that made Bill Gross rich and famous, no longer works, according to the bond king’s March commentary.

Gross employs a football metaphor, advising investors to take a defensive position for the foreseeable future.

“The old, now politically incorrect show tune laments that ‘you gotta be a football hero, to fall in love with a beautiful girl,’ but football and any of life’s heroes can play on either side of the line, it seems,” Gross writes in his now-famous folksy style.

“The secret to getting rich since the early 1980s had been to borrow someone else’s money, throw some Hail Mary passes and spike the ball in the end zone as if you had some particular genius that deserved monetary rewards 210 times more than a doctor, lawyer or an Indian chief,” he adds. “Nah, I take that back about the Indian chief. The chiefs, at least, have done pretty well with casinos these past few decades.”

Over the past 30 years, an offensively minded Federal Reserve and their global counterparts were printing money, lowering yields and bringing forward a false sense of monetary wealth. Successful investing in today’s deleveraging, low interest rate environment will require defensive in addition to offensive skills, he argues.

“It is Main Street that has failed to keep up with Wall Street and corporate America in the race to see who can benefit more from lower yields,” Gross writes. “As the interest component of personal income gradually weakens, the ability of the consumer to keep up its frenetic spending is reduced. Metaphorically, it’s akin to a fourth quarter two minute Super Bowl drill, but one where the receivers haven’t been properly hydrated. They’re a half step slow, their legs are cramping, and it shows. Lower interest rates are having a negative impact on households because their water bottles are filled with 50 basis point CDs instead of Gatorade.”

PIMCO’s offensive strategy, deployed from 1981 to 2011, was to recognize downward trends in interest rates and scale duration accordingly. As a result, the firm emphasized income and capital gains, apparent in its PIMCO Total Return strategy. It also utilized prudent derivative structures that benefit from systemic leveraging–financial futures, swaps (but not subprime). It then combined those two points with careful bottom-up security selection to seek consistent alpha.

PIMCO’s defensive strategy for 2012 and beyond is to recognize zero bound limits and systemic debt risk in global financial markets, and accept financial repression but avoid its impact when and where possible. It will then emphasize income we believe to be relatively reliable and safe and de-emphasize derivative structures that are “fully valued and potentially volatile.” It will combine these two points with security selection to “seek consistent alpha with admittedly lower nominal returns than historical industry examples.”

“I suppose if I had any common sense I would hold up that clipboard to the front of my mouth like sideline coaches during big games,” Gross says. “Don’t want to chance any of the competition reading our lips to get a heads up on PIMCO’s next offensive play call. But then that’s never been my or Mohamed’s [El-Erian] style, given the importance of informing you, our clients, of what we are thinking when it comes to investing your hard-earned capital.”

“Go ahead competitors and read our lips, we’ll just pound that pigskin down the field anyway,” he taunts in his conclusion. “Besides, as I’ve pointed out, the emphasis these days should be on the defensive coach. Leveraging has turned into deleveraging. 15% yields have turned into 0% money. The Super Bowls of the future will have their Mannings and Bradys, but the defensive line may record more sacks and make more headlines than ever before.”

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