Related topics: Treasurys, bonds, Federal Reserve, investing strategy, Jim Jubak
Bill Gross, the manager of the world's largest bond fund, $237 billion Pimco Total Return (PTTAX), has cut the fund's holdings of Treasury bonds to zero. The move doesn't mark the end of the world as we know it -- Gross cut his fund's holdings of U.S. government debt to zero in early 2008, and the United States and the bond market are still standing.
But I'd never suggest ignoring Gross' actions, his timing or his logic. His latest move has important lessons for investors, although perhaps not the obvious ones.
Let's start at the beginning, always a good place to start. In his March update on the fund's investment strategy, Gross explained that he was dumping Treasurys in anticipation of the June 30 end of QE2, the Federal Reserve's quantitative easing program designed to reduce medium-term interest rates and stimulate the U.S. economy via massive bond-buying. The Fed has been buying more than $100 billion of Treasurys a month. Since the November start of QE2, the Fed has bought $412 billion of U.S. government debt. By the time the Fed is done in June, it will have added about $1.6 trillion in U.S. government debt to its balance sheet.
Jim Jubak
Gross calculates that the Federal Reserve has been buying about 70% of all new Treasury debt, with overseas investors, banks and governments snapping up the rest. That has led him to a logical follow-up question: Who will step in to buy that 70% of U.S. debt when QE2 stops? It's not like the U.S. government is suddenly going to discover fiscal rectitude and stop running a huge annual budget deficit. The U.S. Treasury will still need to finance its debt by issuing more and more Treasury securities.
Gross' answer is that overseas buyers will have to be enticed to step up buying Treasurys through higher interest rates on U.S. debt. And higher yields on new U.S. debt mean that the price of already issued U.S. debt will have to fall. The yields on that debt will thus rise until they match the yields on the new debt. (A $10,000 bond with a yield of 5% when it was issued, so that it pays $500 a year to the holder, will have a yield of 5.6% if the price falls to $9,000. An investor has to pay less money -- $9,000 instead of $10,000 -- to get the same $500 interest payment every year.)
And, Gross notes, overseas buyers haven't been especially enthusiastic lately about adding to their holdings of U.S. Treasury debt. There are persistent signs that governments have been looking to diversify their holdings by adding euros, gold, Canadian dollars and whatever else they can think of.
3 lessons for investors
If you're looking for lessons for your own portfolio in Gross' strategy, this is the first one: Gross isn't waiting until June to see how big a bite the end of QE2 will take out of his portfolio. He's moving now in anticipation of the end of the Fed's bond-buying spree. Investors who are concerned about what will happen when QE2 comes to an end can't wait until June to protect the value of their bond portfolio. If they do, they're likely to find themselves selling into a market that has already anticipated their fears.
So what's Gross doing with the money he's taking out of U.S. government debt? Pimco Total Return -- and remember that it's the best-performing bond fund in its class over the last 15 years, according to Morningstar -- is now positioned in debt backed by U.S. mortgages, corporate bonds, high-yield (aka junk) bonds and emerging market debt. And he has 23% of the fund in cash or cash equivalents.
Maybe those don't strike you as the most attractive alternatives to U.S. government debt. Maybe the idea of sitting in cash equivalents making a 0% return isn't your idea of a good time. But here's the second lesson: What you pay for what you own is as important as what you own.
