Janus bond manager Bill Gross devotes his latest monthly investment outlook to the opportunity that an “unconstrained” fund like his can exploit, but his argument also reflects the potential peril of this lack of constraint.
That is because while he painstakingly explains an investment thesis involving risky short selling, he also acknowledges his initial foray didn’t quite work out.
The veteran bond fund manager drew significant investor attention from a tweet last month calling 10-year German bunds: “the short of a lifetime. Better than the pound in 1993. Only question is timing / ECB QE,” he tweeted.
Well, apparently timing wasn’t the only question. Execution is also a question.
That became clear when the bund fell — as Gross had predicted — but fell hard while he expected it to remain in a narrower trading range. His unconstrained bond fund actually lost 2.5%, Bloomberg reports, even though he correctly called the bund’s overvaluation.
“My famous (infamous?) ‘Short of a lifetime’ trade on the German Bund market was well timed but not necessarily well executed,” writes Gross.
In older-but-wiser vein, Gross explicates the investing insight that led him to the German bund short and explains the inherent implementation difficulties while offering some forward-looking guidelines for exploiting such trades in the future.
Today’s central-bank dominated financial world offers unique arbitrage opportunities to investors alert to disparate polices and “staggered implementation,” Gross explains.
So, for example, the European Central Bank (ECB) is committed to buying over 700 billion euros worth of bonds, to lower rates, even while the Fed declares its intent to raise rates later this year. To Gross, this spells opportunity:
“Ten-year Treasuries, for instance still trade at a 175 basis point premium to 10-year bunds versus a long-term historical average of 25 basis or so. A purchase of Treasuries and a sale of Bunds allows for not only a potential capital gain if the spread narrows, but a yield pickup while the Rip Van Winkle investor potentially waits for a probable outcome,” he writes.
The difficulty lies in the endless assumptions an investor has to make to execute a pair trade of this kind.
At the most basic level, one might question whether it is reasonable to expect asset values to return to their historical averages.
No less a personage than Bill Gross himself (as he points out in his outlook) famously declared in 2009 that the market has entered a “New Normal” era, and again in 2014 he declared the “New Natural Policy Rate” — both explicit declarations that “it’s different this time,” in other words that one should not assume a return to historical averages.
Lower growth (“new normal”), lower policy rates (“new natural policy rate”), contrasting policies in different countries create a complex matrix from which to base an investment strategy. As Gross asks:
“What’s the new neutral policy rate, what’s the nominal GDP growth rate, what’s the yield of a 10 [year] Treasury, Bund, Gilt or JGB based upon any or all of the above?
And his answer is that an investor needn’t fill in these blanks with correct absolute values so long as he gets the correct relative values:
“The ‘relative’ narrows the universe significantly under the assumption that ‘relative’ growth rates in the developed world and ‘relative’ new neutrals should be more amenable to mean reversion then absolute values.”
Interestingly, Gross argues that key to pulling off this arbitrage is relative nominal GDP growth rates, which determine yield and risk spreads. This is certainly the consensus view, though recently GMO’s James Montier has argued it is a false assumption.
In any event, Gross also cautions that timing nominal GDP reversion is another “critical variable.”
The bond manager allows three years (2018) for growth rate normalization, and uses IMFO GDP forecasts to plug in his matrix. He also offers his current valuation estimates of major international 10-year bonds. For example, the U.S. 10-year bond he calls “+50 basis points too high,” its UK pair “-50 basis points too low;” and his infamous German bund he calls “-100 basis points too low.”
Looking ahead, Gross says the ECB’s plans to accelerate bond buying in August “is just one example that can make an unattractive sovereigh (Germany) even more unattractive in the short run.”
The key for investors is “to choose the least overvalued asset to hold, and the most overvalued asset to sell.”
An unconstrained Gross, calling the current opportunity “a rare one,” thinks he can pull it off this time.
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