Bill Gross, former star manager of PIMCO and now of JANUS, is the voice of experience in the debt markets. It is true that his published views have not always been right, but perhaps his unpublished reflections have been mostly right. In fact, for us, Gross has been a great communicator of self-interested views. That is to say that at any given moment it has suited him that the markets/investors/clients have reacted to his published opinions in a certain way. Let us not forget that Gross is a veteran and influential voice like few others.
He has recently published this article entitled ‘Bon Appétit!’ in which he uses a culinary metaphor to illustrate the insatiable appetite for returns that most investors constantly display. The problem is that diners find only meagre fare on the table, most of which is in a very poor state – in other words, posing a serious health risk. He is essentially saying that excessive debt and the abuses of central banks’ unorthodox policies prevent the growth and returns of the past from being repeated. in any type of asset. Negative or near-zero interest rates make fixed-income investments a suicide mission for the income investor, who must throw themselves into the arms of risk in exchange for just a few tenths of a percentage point in yield. And at the slightest hint of a shift in the yield curve, the fall in bond prices will wipe out past and future returns. In his own words: «My main argument in this Outlook will be that all forms of “carry” in financial markets are compressed, resulting in artificially high asset prices and a distortion of the future risk relative to potential return that an investor must face.«
Until interest rates return to normal – and there’s still a very long way to go before that happens (just ask the Japanese) – it’s absolutely impossible to replicate the growth and returns achieved over the past 40 years, both in fixed income (which have been around 7%) as in equities (almost double-digit). Let’s see how Gross sums it up:
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Duration is undoubtedly at risk in markets with negative yields. A yield of minus 25 basis points on a 5-year German Bund will yield nothing but losses five years from now. A yield of 45 basis points on a 30-year JGB offers a current “carry” of only 40 basis points per year for a duration risk of nearly 30 years. That’s a Sharpe ratio of 0.015 at best, and if interest rates rise by just 2 basis points, an investor loses her entire annual income. Even 10-year US Treasuries with a 125-basis-point “carry” relative to current money market rates present similar duration-related headwinds. Extending maturity in order to capture “carry” is hardly worth the risk.
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Similarly, credit risk or credit “carry” offers little reward relative to potential losses. Without going into too much detail, the return on holding a 5-year investment-grade corporate bond over the next 12 months is a mere 25 basis points. The IG CDX credit curve offers a spread of 75 basis points for a 5-year commitment, but its expected return over the next 12 months is only 25 basis points. An investor can only earn more if the forward credit curve – much like the yield curve – does not materialise.
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Volatility. Carry can be earned by selling volatility in many areas. Any investment with a longer maturity or lower credit quality than a 90-day Treasury Bill sells volatility, whether a portfolio manager realises it or not. Much like the ”VIX®”, the Treasury “Move Index” is at a near-historic low, meaning there is little to be gained from selling outright volatility or other forms of it in the duration and credit sectors.
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Liquidity. Spreads on illiquid investments have narrowed to historic lows. Liquidity in the Treasury market can be measured by the spreads between “off-the-run” and “on-the-run” issues – a spread that is virtually non-existent, meaning there is no “carry” associated with less liquid Treasury bonds. Similar evidence can be found in corporate CDS compared with their less liquid cash equivalents. This can also be observed in the “discounts” to NAV (Net Asset Value) in closed-end funds. These are at historically tight levels, indicating very little “carry” for taking a relatively illiquid position.
Gross is not the only one to point this out; think-tanks such as McKinsey have done the same. Perhaps it was not possible to save the financial system without saving the debtors, and in turn this was not possible without harming the creditors. We shall see whether that harm gets out of hand and ends up wiping out those who are debt-free and need a return on their investments, which would also bring down the financial system itself. In short, it seems that the remedy is beginning to prove – for the time being – just as bad as the disease, and on the silence of the Conservatives lurks.
The final and indisputable conclusion is that the «carry» on any asset whose value is expected to generate future returns (bonds, shares or even rental property) is so extremely overvalued that the risk-return ratio is suicidal for any investor, and even more so, if anything, for private and institutional investors (pension funds). And in this scenario, particularly during the phase when central banks are tapering and a real rise in interest rates begins, not losing money will be the primary objective. And to make a consistent profit without relying on lucky casino-style gambles will deserve the highest praise. Read the original article, because the foresight of a veteran like Gross needs to be absorbed fully in order to face the times that are already upon us.
Source: Bon Appétit!
By Bill Gross