On the bubble

Bill Gross, head of Pimco, has shown his pessimism about the corporate bond market by removing his own money from a Pimco-managed fund. Is this a timely move or has he jumped too soon? Linda Corman reports

Bill Gross, who sits at the helm of Pimco, the largest bond mutual fund in the world, is the 800-pound gorilla of the bond world. In the January issue of Outlooks, Gross’s monthly newsletter, he made it known that he believes the corporate bond market is overblown and that anyone who thinks there is still value to be eked out is headed for a rude fall. And, as if to counter suggestions that he should put his money where his mouth is, Gross has withdrawn his own money from his $73.8 billion Pimco Total Return fund – which invests largely in investment-grade debt – and invested it elsewhere.

“I think what we have now is a mini-bubble in the corporate bond market,” Gross told the New York Times in mid-January. “Investors have chased yields so low that the future risk is not worth what you are being paid.”

Gross believes that growing federal budget deficits, the falling dollar and lower tax rates will inevitably ignite inflation and compel the Federal Reserve to raise interest rates. Bonds are overvalued because although many companies have strengthened their balance sheets in the past year, many are still highly leveraged, says Mark Kiesel, executive vice president and portfolio manager at Pimco, who collaborates with Gross on market analyses. Debt-to-cashflow ratios are still fairly high and now that profits are increasing, companies are levering up again, Kiesel says.

Despite the Sarbanes-Oxley Act, which introduced major changes to the regulation of corporate governance and financial practices in 2002, corporate executives still have their eyes on stock prices because that is the measure by which they are judged and compensated, says Kiesel. As a result, it is natural for them to resume capital spending and to begin looking for merger and acquisition opportunities, he says. “They only care about bondholders when they have no flexibility, as they did in 2002,” he says. “It’s human nature.”

Accordingly, Gross favors – and has placed his own money in – closed-end municipal bond funds, Tips (Treasury inflation-protected securities), funds that play on rising commodity prices in inflationary environments and global bonds denominated in non-dollar currencies. Gross reportedly is also betting on emerging markets bonds because he thinks that the rising prices of oil, metal and agricultural products will boost the economies of Brazil, Russia and other producers of these products.

Closed-end municipal bond funds are attractive because they can borrow and, taking advantage of prevailing low rates, buy additional municipal bonds, and so augment the funds’ returns. It is much better to borrow at 1% than earn 1%, Gross says. So, for example, a 50% levered fund borrowing at 1% can turn 4–5% long-term municipal bond yields into a 6.5–7% yielding portfolio, writes Gross in the January issue of Outlooks. Gross is also reportedly investing in municipal bond funds because when interest rates rise, municipalities tend to slow down their issuance of bonds, cutting supply and providing support for their bond prices. Further, municipal bonds are attractive because foreign investors do not buy them. Thus when foreign investors, who are now supporting the US’s gargantuan current-accounts deficit, decide to take their money elsewhere as the dollar continues to decline, the municipal bond market will not be as hard hit, says Kiesel.

Global bonds in non-dollar currencies are attractive because the dollar is expected to continue its slide and as it does, non-dollar investments gain in value. Also, non-US bond markets – primarily Europe, Canada and Australia – provide investors with higher interest rates and therefore the possibility of earning more than inflation in the long run, Gross said in his newsletter. European government bonds are a good bet because some European economies are struggling with 10% unemployment and currencies that have appreciated 20% in relation to the dollar, says Kiesel. Those economies characteristically lag the US’s by nine to 12 months and so the Fed is likely to raise interest rates well ahead of the European Central Bank, he said.

Mitchell Stapley, a portfolio manager at Fifth Third Bank Investment Advisors, believes that if we are not in a bubble right now, “we’re very close to one”.

“There’s not a lot of compelling value in the market,” he says. As long as the Fed stays on hold, there may be some value to gain in corporates, he believes. “But you have to have your heart in you throat” the moment the Fed begins to hint that it is beginning to be concerned about inflation, he adds.

Stapley thinks now is the time to be taking some profits, taking off some duration, underweighting expensive securities, holding some cash and waiting for an opportune time to reenter the market. “Patience is going to be your friend,” he says. In the coming year, Stapley expects the best returns to be found in support tranches in asset-backed securities, higher-coupon mortgage-backed securities and Tips.

More upside

Gross’s stature notwithstanding, there are many in the bond market who believe spreads can narrow further and that there is value to be gained in corporates. Eric Misenheimer, director of taxable high yield and co-manager of the Core Plus fund at Northern Trust Global Investments, says that an investor’s view on inflation depends on their time frame. He and others do not expect inflation to accelerate any time soon. Misenheimer says that significant productivity gains, low industrial capacity utilization and a slack job market mean there is considerable room in the economy before inflation will take off. “What’s his time frame?” Misenheimer asks of Gross’s inflation predictions.

Without an immediate inflationary threat, Misenheimer is expecting interest rates to remain flat. Any rise will not take place until year-end and will be 25 basis points at the most. Misenheimer also says that high-yield bonds are trading at fair valuations considering the strong fundamentals in the economy. Profits are rising, revenues are growing and default rates are declining. Defaults in high-yield bonds stood at 5.5% in 2003, according to Moody’s, and are expected to decline further to 3.5% this year, says Misenheimer. “A bubble happens if fundamentals are deteriorating, but they are not.” Misenheimer expects further tightening in spreads and that high-yield bonds will return as much as 10% this year while investment-grade debt will return between 3% and 4%.

Andy Palmer, a portfolio manager at ASB Capital Management, also thinks that fundamentals support the argument that there is room for further tightening. There is liquidity in the market, he says, because issuance has been down and there are a fair number of bonds coming due.

Spreads are not at their all-time tightest levels and valuations are warranted given the widespread improvement in balance sheets and the current stage of the economic cycle, says Sid Bakst, a portfolio manager at Weiss Peck & Greer. Bakst also takes issue with the notion that there is a danger that companies will begin levering up again. Ratings are lower on average than they were when spreads were last at their tightest, in 1996, so companies do not have the ability to pile on debt again as they did then, he says.

“While balance sheets have improved in the past 12 to 18 months, they haven’t improved to the point that [companies] can enter into any deal they want and lever up with impunity,” Bakst says.

Mark Vaselkiv, manager of the T. Rowe Price High Yield fund, wrote recently in an analysis issued by the company that improving productivity, repaired cost structures and balance sheets among high-yield credits argue for these companies’ valuations. And, he says that lower-quality bonds are more dependent on underlying fundamentals and are not as interest rate sensitive as higher-quality issues.

Improving credit quality will outstrip deteriorating credit quality, says William Reynolds, director of T. Rowe Price’s fixed-income division. Nevertheless, he does not anticipate that spreads will tighten any further than they already have.

According to Andy Harding, portfolio manager at National City, we are not in the midst of a bubble in corporate bonds, but there are “pockets” of froth. “We’re about 14 to 15 months into a positive credit environment,” he says, and he thinks there is still another year to go.

Kamalesh Rao, an economist with Moody’s, also thinks there is value still to be gained in the high-yield market and that if the equity market continues to pick up, investors’ appetite for risk will grow, making high yield even more attractive.

Cherry-picking

Bubble or no, no one is claiming it is going to be easy to get substantial returns this year. “I couldn’t say we’re not ahead of ourselves in spread levels,” says Bakst of Weiss Peck & Greer. “Maybe the market is building in all the good news and higher yields are not prepared for a major setback. I could buy into that analysis, but not to the extent that I’d call it a bubble. It will be a cherry-picking kind of environment. There will be more singles to be hit, not home runs. You’ll need to scratch and claw.”

“You’ll need to identify those securities that are fundamentally improving versus those that have tightened because everyone else did,” adds Misenheimer.

Bakst says he will look to junk bonds, telecommunications, automobiles and “yieldier” insurance companies, and some more exotic strategies like structured and roll-down plays to produce the best returns this year.

Harding of National City agrees. “We feel that many credits have appreciated indiscriminately as a result of the ‘rising tide that lifts all boats’ phenomenon,” he says. Security selection will be key. It will also be important to stay away from securities like those of Duke Energy, which recently decided not to cut its dividend, and Fedex, which recently announced it was acquiring Kinko’s, he says. Harding, like Gross and Kiesel, says that investors have to watch out for companies that veer toward becoming shareholder rather than bondholder friendly. If companies start to re-leverage, “we’ll say, ‘see you later’,” he says. But, overall, he expects companies to remain bondholder friendly.

Having said that spreads are tighter than the average for the past 20 years, Kiesel concedes there is always the risk that spreads will tighten if the economy does better than he and Gross are anticipating. He doubts this will happen though because consumers are “pretty much tapped out”. Spending for a while has been supported by Bush’s tax cuts but this has provided only a temporary boost, he says. And Gross says that inflation may not take off right away, but eventually it will, and the markets will anticipate that.

Stapley, too, says that inflation could remain at bay for some time, aided in part by what he calls “the engines of deflationary growth” – India, China and Russia. It is possible that there is now a unique combination of factors at work that are conspiring to keep inflation quiescent despite the enormous pressures in the opposite direction. “But ‘this time is different’ can be very expensive words,” he says.