Bonds, like animals that don’t adapt to their changing environment or armies that don’t change with the times, could go extinct if they fail to keep up with the demands of a changing market, according to Bill Gross, co-CIO of PIMCO.
In his monthly commentary, he compared bonds to the British army in the disastrous Battle of the Somme in 1916. Like the British, who thought their horses and sabers could match the German army’s machine guns, bonds are being overrun by alternative assets, Gross said.
Despite bonds’ 30-year reputation for reliable income, current low yields and a negative 3%–4% two-month return have forced investors to consider alternatives, but Gross — himself a former Navy lieutenant — insisted “there will always be a place for the bond market ‘army.’”
“All investments, bonds included, have a number of modern-day weapons at their disposal which can be used to defend against higher interest rates, weapons that don’t necessarily go down in price as yields rise. These weapons can collectively be categorized as ‘carry,’” he wrote. “When interest rates go up as fast as they did in early May, prices go down for long and intermediate maturity bonds, and the carry associated with maturity extension becomes akin to a horse charging a machine gun.”
However, Gross continued, bonds have other types of carry including credit spreads, which provide a risk-adjusted carry, and volatility premiums. The yield curve and non-dollar currency also provide carry for bonds.
Although maturity risk is investors’ biggest concern in their bond portfolios, Gross reiterated that “there will always be a need for fixed income and therefore maturity extension in investors’ portfolios.” He compared credit, volatility, curve and currency carries to the machine guns of the German army.
More important than simply adopting advanced weapons, though, is the ability to adapt and know when to use them, Gross said: There may be times when duration is a better play than credit. The biggest risk is the total carry of a portfolio, he wrote, and one that is PIMCO’s dominant focus. “In a highly levered economy/financial marketplace, all forms of carry can go up or down at the same time. […] The diversifying aspects of one form of carry versus another may hold form in most future time periods, but when they don’t, almost all investors will regret not focusing on total carry as opposed to discriminating exclusively against maturity extension.”
Ultimately, Gross wrote, when investing prospects look dull, portfolios should be overweight carry, and underweight when prospects start to shine.
“So, fellow generals in this bond war, today’s war college lesson is to be mindful of evolution and the necessity to adapt,” he concluded. “The secret to using [bonds] will be to strategically position their component and combined carry to maintain positive absolute returns.”
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