Gross was – and still is – one of a kind: a bond investor who has never been afraid to express an opinion. He has published them on the web, he has broadcast them on TV, and he is the first port of call for any journalist looking for a heavy-hitting view on the global bond markets. Gross stands out. As do his funds. His total return fund has grown to be almost the largest mutual fund in the world and Gross’s profile must have been a contributory factor in that success.
But investing has always been based on the idea that the more exposure you court, the greater the risk you take. The bond market’s only celebrity was certain to become a target. Soon, the whispers began: Gross talks his own book, his comments are designed to move the markets in the direction that suits his own portfolio.
And so it is little wonder that Gross is often given one of two wildly differing epithets. The first, and the one the press tends to rely on, is “The King of Bonds”. The other, more often heard from bond market rivals, is less complimentary: “The King of the Frontrunners”.
Pimco is an asset management firm that invests more money in bonds than any other, controlling assets comparable to a large American bank, with $349 billion under management. As a snapshot comparison, America’s fifth largest bank, BankOne, has total assets worth $348 billion and Bank of America, the third largest US bank, has a total loan book of $337 billion. So in terms of allocating resources to the US and global economies, Pimco indisputably plays a huge role.
Agreed, there are institutional investors with more assets under management and there are bigger banks. But unlike other asset management firms, Pimco only buys bonds and unlike the banks, Pimco talks to the press. As a result, when Gross pronounces his views on a borrower, the bond market frequently moves.
But how does Gross, Pimco’s chief investment officer and chairman, respond to allegations that he uses Pimco’s weight to influence the market?
For a start, Gross doesn’t seem to mind the question – perhaps it’s not the first time it’s been aimed at him. “What I’ve always tried to do throughout the entire history of being in front of the press, on television and so on is basically speak my mind and let investors know what we’re doing,” he says. “Frankly, when I talk about the Treasury market having seen better days – having seen its salad days – that’s a negative for the bond market and that means Pimco might be losing some assets.”
So Gross doesn’t talk his own book? “In contrast to others, such as analysts and many forecasters that talk their own book, I’m willing to talk the book as I see it, good or bad. And when it goes against Pimco, in the case of a declining bond market, then I’ll still talk it. This interchange creates credibility and trust because people understand we always tell it like it is…the good, the bad, and the ugly of it.”
What about General Electric? In March last year, Gross voiced concerns about GE’s accounting and dependence on short-term commercial paper in his monthly Investment Outlook. Gross wrote: “While GE Capital enjoys the benefit of a Aaa rating, they nonetheless have commercial paper outstanding which totals three times the size of their bank lines which back them up.” At the time, more than 40% of GE Capital’s $245 billion of debts were in commercial paper and only $33.5 billion of that debt was supported by any bank backstop facilities.
Now Gross was raising doubts about not only the world’s largest company in terms of equity but also the most indebted corporate. Gross’s conclusion was that Pimco would not be buying any GE commercial paper “for the foreseeable future”.
The financial markets unsurprisingly reacted badly: spreads on GE bonds widened by almost 7bp to 76bp while spreads on US financial bonds in general were steady. But there was speculation that Pimco stepped in shortly after and bought up GE commercial paper on the cheap.
Gross doesn’t respond to that specific allegation. However, he has since written: “My intent was to focus on the sorry state of corporate disclosure, using Warren Buffet [one of the investors Gross says he respects] as the good guy with the white hat and GE as the high-profile example of the rest of the pack.”
Gross also admits: “Four months later Pimco was buying GE bonds but this time at 40 basis points higher to Treasuries than before. After this example, who could doubt that the pen is mightier than the sword?”
And as Gross says now: “GE was just another example of telling it like it is. As a result GE did change its ways for the betterment of everyone.” And in fairness to Gross, GE has set about reducing its dependence on short-term debt: by the end of the first quarter of this year, GE had $82 billion in outstanding commercial paper.
In any case such aspersions of frontrunning are as likely to be born of envy of Pimco’s size and success as of any real evidence. The market is perpetually being reminded of Pimco’s successes, as USA Today breathlessly told readers in July this year: “The [Pimco Total Return] fund, which Gross has managed since 1987, has gained an average of 9.5% a year [over] the past 15 years… that’s the bond market equivalent of Joe DiMaggio’s 56-game hitting streak for the Yankees in 1941.”
You might think that Pimco’s size is a mixed blessing: trying to move such vast amounts of money in an asset as illiquid as bonds, especially government debt, should be difficult. Not so, according to Gross. “Our size is an advantage for us and, ultimately, for our clients,” he says. Pimco’s size doesn’t mean it invests more in the same bonds; it just spreads its bets more widely.
Credit and fixed-income analysts are usually expected to cover more names than their colleagues in equity – often at least double – but there is still a limit to the number of borrowers they can analyze. And this is Pimco’s edge, says Gross: being able to employ more analysts and more risk management systems to keep a careful eye on its portfolios. “It’s our ability to spread the risk in our portfolios through small bets,” he says. “The result is that we are able to create portfolios that we believe are well positioned to capture pockets of alpha as well as being comprised of multiple securities to ensure that if one security or sector performs poorly it doesn’t derail the whole portfolio,” he adds.
Anyway, Pimco isn’t that big, says Gross. “Contrary to popular belief, we have grown at about the same pace as the global bond market over the years, and therefore we are quite comfortable in our position as a large player.” It is unclear what figures Gross uses to make this modest assertion. Pimco started out with $18 million under management in 1971 and as of the middle of this year had just short of $350 billion. Regardless of any surge in government borrowing in the 1980s and corporate borrowing in the 1990s, the global bond market has certainly not grown by a factor of almost 20,000 in the past 32 years.
Even Pimco’s recent growth has outpaced the growth in the bond markets. According to Lehman Brothers, between 1997 and today the total number of dollar-denominated bonds globally has increased by just over one half, from $7 billion to $11 billion. In comparison, Pimco’s assets under management have gone from $118 billion to $350 billion – a threefold increase. Not even the prolific growth in corporate borrowing in the late 1990s kept pace with this.
Gross admits Pimco is unable to “dart in and out” of illiquid corporate bonds. “But this is not something we would do even if we could,” he says. “Speed is more important to a short-term, trading-oriented manager than to a long-term, value player like Pimco.”
Gross has always advocated a long-term investment horizon, which is commonly referred to at Pimco as the “secular philosophy”. As Gross says: “We believe that secular, or long-term, trends such as demographics, political factors and structural changes in the domestic and international economy are the most powerful and sustained influences on global bond markets and interest rates.”
Even as far back in 1982, Gross was talking about foxes (short-term investors who “know many things”) and hedgehogs (long-term investors who “know one big thing”). The big thing that hedgehog investors know is that “markets tend to move like broad secular waves” – the implication being that Pimco is a hedgehog.
This “secular philosophy” has two advantages: it stops the firm getting the “bouts of euphoria or depression” that often characterize financial markets; and it fits better with Pimco’s ability to earn money over the long term by analyzing the fundamentals of economies and credits than its ability to time short-term market movements.
But the sheer enormity of the firm must surely create other problems. For example, how does a company with 573 staff, including 67 portfolio managers and bond analysts located in seven offices ensure that everyone is singing from the same hymn sheet?
The answer, says Gross, is that Pimco ensures its decision-making process is broadly consultative. Although to outsiders it might appear that Pimco’s strategy is dictated by Gross and one or two others, the reality is quite the reverse. “Our investment themes are a collaboration of ideas from all our portfolio managers and analysts,” says Gross. The firm’s cyclical view – the one-year short-term outlook – is hammered out in three meetings each year involving all 67 portfolio managers and analysts. The secular forums – the long-term, three- to five-year outlook – are conducted in the same way once a year.
“I see this input from all our investment professionals as an integral component of our process and one that clearly differentiates us from our competitors,” says Gross. “If our investment ideas were based on the opinions of just a few people, there is the risk that we could miss out on opportunity of adding value for our clients or run into a hole that a small group of people would fail to spot. And because ours is a collaborative approach, it ensures that we’re all on the same page when we do go public.”
But what about the individual fund managers, what place does their intuition play in this strategy? Apparently none. “We try to remove emotion from the equation,” says Gross. “Intuition involves emotion; we deal in facts.”
Outlook on credit
In the first half of 2003, both high-grade and high-yield corporate bond markets in the US and Europe have rallied considerably. So from an asset allocation perspective, do corporate bonds represent value in a broad bond fund?
“Yes and no,” says Gross. “Corporate credits taken in comparison with equities look attractive, since the US equity market continues to look overpriced.” Despite most stock markets falling consistently from early 2001 to the start of this year, they have not yet shaken off the excess exuberance of the “the biggest equity bull market in history.”
“To think that stocks have bottomed out on the higher end of fair would be wrong. On a risk-adjusted basis, I would be more comfortable purchasing corporate credits in a company rather than its stock.”
But that doesn’t mean Gross is bullish on corporate credit. “I would consider them to be a neutral play at best with respect to other sectors of the bond market. Late last year, when credits were in their dark period and spreads widened to 230 basis points, there were plenty of opportunities to pick up alpha on individual names that had been unfairly beaten down. However, at the moment they probably don’t offer great value as spreads have tightened.”
According to Mark Kiesel, head of Pimco’s investment-grade corporate desk and a senior member of the firm’s strategy group, Pimco is generally cautious about credit over the next 12 to 24 months. The reason is that while companies have been reducing their leveraging, the pace of balance sheet repair has continued to be slow. And global competition and excess capacity are still “significant headwinds” for many industries.
In effect spreads have tightened on the expectation of an improving credit situation, which has yet to materialize. “We feel spreads are ahead of themselves and the market is overly optimistic,” says Kiesel.
In a nutshell, Kiesel believes there is value in selected pipeline, media & cable, utility, and telecom companies; unfortunately he doesn’t specify which. Also, Pimco is avoiding most retailers and rails, and remains underweight some cyclical sectors such as paper and chemicals.
In the high-yield market and emerging market bonds, Pimco is also picking its investments selectively. Unprecedented net inflows into high yield and emerging market mutual funds in the first half of 2003 have left spread levels looking very tight. Nevertheless Gross says there is no reason the huge rally needs “to end in tears. The key is selecting the right high-quality bonds.” For high-yield corporates, this means “selecting quality corporates that don’t deserve junk status – fallen angels.”
As for emerging markets debt, Gross expects a “consolidation or continuation of the rally, albeit at a more moderate pace, rather than a deep correction.”
“I believe,” he adds, “that emerging markets will continue to be an attractive sector for the long run as the current trend to global convergences continues and a number of these emerging markets assume their place alongside the developed economies.”
In September last year, Pimco recommended mortgage-backed deals as a good way for fixed-income investors to find low-risk yield. In addition, Pimco have been long-term bulls on mortgage bonds. The argument is that because US homeowners are allowed to refinance their mortgage at any time, they are in effect buying a put option – the right to repay the money before maturity – on their loan. But because America’s homeowners do not appreciate the true value of this option and therefore pay too much for it, whoever sells the early repayment option – the holder of the mortgage-backed security – is being overpaid.
There have however been recent rumours that Pimco has turned bearish on mortgage deals. Homeowners only refinance their mortgage when rates are falling, but the Fed’s short-term rate is now at 1% – the lowest for 45 years – and most market commentators expect any future move to be upward. This means the maturities of mortgage-backed deals may start to become longer as new, full-length mortgages are extended to homebuyers; at the same time the rising government interest rate may push down the value of existing bonds. So does Pimco still stand by that September recommendation or do the low interest rates make them riskier assets?
Gross’s response is short and a little vague. Of last year’s recommendation he only says that it was made “nearly a year ago.” As to whether mortgage bonds now represent riskier assets, he says only: “I would agree with your current assessment.”
In 2000, the German insurance company Allianz bought 70% of Pimco for $3.3 billion. That deal included a five-year lock-in for Gross which expires the year after next. Maybe in anticipation of retirement, Gross has already started taking the odd cruise: in July, Gross, along with his wife Sue, invited any Pimco employees who wished join them and 100 ‘Orange County Teachers of the Year’ on a cruise to Alaska. So does this presage plans for retirement and how would Pimco survive if Gross did retire?
“Retirement? What else would I do?” he asks. “I have a neurotic need for continual success and perpetual need to keep winning…and the bond market fills that need because it is a new game every day,” he adds. But he does admit that with Pimco’s “succession plan firmly in place, I am confident the company would go on without a hitch.”
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