Active bond managers could use more of Bill Gross’s swagger.
No sooner had the hall-of-fame bond manager announced his retirement on Monday than the financial press declared his downfall. The Wall Street Journal headline proclaimed “Bill Gross, Onetime Bond King, Retiring After Messy Last Act,” and another in the Financial Times read “How the ‘bond king’ Bill Gross lost his crown.”
That messy last act refers to Gross’s stint as manager of the Janus Henderson Global Unconstrained Bond Fund since 2014. Gross made some big bets at Janus Henderson that didn’t pay off, most famously a wager last year that rates on U.S. Treasuries and German bunds would converge, resulting in sagging performance for his unconstrained bond fund.
Even though Gross’s calls didn’t turn out the way he and his investors had hoped, Gross was right to bet boldly on his best ideas, and active bond managers would be wise to follow his example.
The pivot to unconstrained investing was a brave departure for Gross, who had spent the previous three decades perfecting the “total return” approach to bond investing with the Pimco Total Return Fund he founded in 1987. The strategy attempts to outpace the broad bond market by taking modestly more risk, often by buying lower-quality bonds than are reflected in broad-market bond indexes while targeting a similar average maturity.
No one did it better than the Bond King. The institutional share class of Gross’s total return fund outpaced the broad bond market, as represented by the Bloomberg Barclays U.S. Aggregate Bond Index, by 1 percentage point annually during his run from June 1987 to September 2014, a huge margin for a bond manager. And he did it with only modestly more risk, as measured by annualized standard deviation (4.3 percent for Gross’s fund compared with 3.9 percent for the index).
Active bond managers have dazzled investors by outpacing the bond market in recent years. But it’s a simple sleight of hand, and the big reveal is coming.
The trick is that bond managers have been quietly loading up on low-quality bonds. They pay a higher yield than top-quality ones to compensate for their greater risk of default — in technical parlance, a credit premium.
When times are good, as they have been in recent years, there are few defaults because borrowers have little trouble paying their debts. Bond managers collect their credit premiums and easily beat the broad bond market indexes, which tend to be dominated by high-quality bonds.
When the economy slows, however, the defaults start to pile up, handing losses to holders of low-quality debt. And suddenly bond managers don’t look so smart.
It’s a worthwhile trade-off for managers. The booms normally last longer than the busts, which means that credit premiums are usually a boost to performance. And nothing attracts investors like a hot hand, or the appearance of one.
But it’s not great for investors. They often don’t realize that their bond manager is taking more risk until the losses show up. And investors who want riskier bonds can almost always buy them more cheaply through index funds. They would be better served by a closer inspection of bond managers’ tricks of the trade.
Alan Greenspan, chairman of the Federal Reserve from 1987 to 2006, sent a shiver through investors last week.
In an interview on “The David Rubenstein Show: Peer-to-Peer Conversations” on Bloomberg TV, Greenspan warned that the U.S. may be poised for a period of stagflation, a rare combination of high inflation and high unemployment.
The U.S. last experienced such an episode in the 1970s and early 1980s, and the memory still haunts those who lived through it. The annual inflation rate jumped to 9.8 percent in 1980 from 2.9 percent in 1972, according to the core PCE price index, a measure of personal consumption expenditures excluding food and energy and the Fed’s preferred inflation gauge. Meanwhile, the unemployment rate swelled to 10.8 percent in 1982 from 3.5 percent in 1969, according to the Bureau of Labor Statistics.
For members of Generation X — which includes me — and subsequent generations, stagflation is ancient history. Annual inflation hasn’t topped 3 percent since 1993 and has averaged just 1.8 percent since then. And the current unemployment rate of 3.7 percent is the lowest since 1969.
Still, the implications for investors of skyrocketing inflation and unemployment come quickly to mind. According to lore, a surge in inflation would lift interest rates, causing bond prices to decline and thereby wrecking bond portfolios. Higher interest rates would also thump stock prices because future corporate earnings would be worth less when discounted at higher rates. And all of that would come when many investors would lean on their savings to offset higher living costs and possible bouts of unemployment.
It’s not clear, however, how much of that received wisdom is reliable. Yes, when inflation creeps up, interest rates tend to follow. The correlation between annual inflation and the yield on 10-year Treasuries has been strongly positive (0.76) since 1959, the first year for which numbers are available for the core CPE price index. (A correlation of 1 implies that two variables move perfectly in the same direction, whereas a correlation of negative 1 implies that two variables move perfectly in the opposite direction.)
One thing is certain: A U.S. recession will eventually come along. The question is what will cause it and when. Among the oft-discussed culprits is corporate debt. Bloomberg Opinion columnists Nir Kaissar and Noah Smith recently met online to debate whether companies have accumulated too much debt and if that poses a risk to the economy.
Noah Smith: More people are worrying about U.S. nonfinancial corporate debt, which is at an all-time high as a share of the economy. Bloomberg News looked into a bunch of big acquisitions and found that a lot of companies are so leveraged that they would have a junk label if credit raters weren’t being lenient (sound familiar?). The Federal Reserve is starting to watch the leveraged loan market carefully as these loans proliferate. Bank of America is on “recession watch,” modeling losses from a junk-bond crash. Bloomberg Opinion’s own Danielle DiMartino Booth believes that large amounts of so-called investment grade debt isn’t actually very safe, consisting of leveraged loans, junk bonds and BBB-rated bonds. Meanwhile, credit spreads have shrunk to levels that often presage a recession. And the Fed intends to continue raising interest rates.
Why shouldn’t we be worried about corporate debt?
Nir Kaissar: I don’t see much in companies’ financial statements to be alarmed about. For one thing, they don’t seem excessively levered. The Standard & Poor’s 500 Index represents roughly 80 percent of U.S. public companies by market value. Its debt-to-equity ratio is 113 percent. That’s lower than the average of 163 percent since 1990, and half as much as during the past two market peaks in 1999 and 2007.
Of course, some of that is related to deleveraging by banks since the 2008 financial crisis. The D/E ratio of the S&P 500 Financials Index is 158 percent, down from 563 percent in 2007 and 585 percent in 1999. But the numbers are no more concerning after excluding the banks. The D/E ratio of the S&P 500 Ex-Financials Index has climbed to a relatively modest 93 percent from 75 percent in 2007 and a post-crisis low of 68 percent in 2010.
Those numbers don’t suggest excessive demands on companies’ ability to pay their debts. The S&P 500’s EBIT margin — or earnings before interest and taxes as a percentage of sales — is 13.3 percent, which leaves lots of room for companies to absorb higher interest rates at current leverage levels. Yes, EBIT margins will contract during the next downturn, but interest rates would most likely decline, too.
There are things to worry about, but excessive corporate debt doesn’t appear to be one of them.
Watch volatility spike, and then watch investors scatter for safety. Only this time, they don’t seem to know where to hide.
After years of calm, market turbulence has returned. The annualized daily standard deviation of the S&P 500 Index — a common measure of volatility — has been 18.6 percent from 1928 through March. But the market was much quieter from 2012 through January, with a standard deviation of 12 percent.
That quiet ended abruptly in February. The S&P 500 tumbled 8.5 percent in just five trading days from Feb. 2 to Feb. 8, and its standard deviation has spiked to 23.4 percent since February.
There are reasons to be skeptical about high-yield bonds, but not for the ones investors have been worried about lately.
For starters, there’s little indication that investors are fleeing risky bonds for good. Yes, two of the biggest U.S. junk-bond ETFs have experienced outflows this month. Investors pulled $1 billion from the SPDR Bloomberg Barclays High Yield Bond ETF through Friday and $600 million from the iShares iBoxx High Yield Corporate Bond ETF.
But there’s nothing unusual about those outflows. The SPDR ETF experienced outflows in 30 of the 71 months since 2012, and the iShares ETF experienced outflows in 33 of those months. Both funds have also had bigger monthly outflows since 2012 than they’ve had so far in November. None of those occasions appear to have dimmed investors’ fondness for junk bonds. In fact, there are indications that money is already flowing back in.
Pimco is gearing up for a junk bond binge — or at least opening the door to that possibility. The Pimco Total Return Fund, Pimco’s flagship bond fund, will be permitted to invest up to 20 percent of the Fund in junk bonds beginning on June 13, up from 10 percent currently.
The Fund’s current allocation to junk bonds is only 2.5 percent, so the new 20 percent ceiling would be a monster eightfold increase in the Fund’s allocation to junk bonds if fully utilized.
Why now? Mark Kiesel, Pimco’s chief investment officer for global credit and one of the Fund’s managers, told Bloomberg News that the junk bond market “is as attractive as it’s been in four or five years.”
A lot of people are worried about corporate leverage. Years of cheap credit have encouraged corporate borrowing, and credit spreads have widened recently on fears of a global slowdown — all of which makes for a potentially explosive cocktail. By one measure — the debt-to-earnings ratio — corporate leverage is at a 12-year high.
But other measures of corporate leverage suggest that fears of a corporate debt binge are overdone. According to Bloomberg data, the debt-to-Ebitda, debt-to-equity, and debt-to-assets ratios for the S&P 500 Index are all well below their historical averages since 1990. The U.S. is not alone. All three ratios for the MSCI ACWI ex-USA Index are also well below their historical averages since 1995 (for both the S&P 500 and ACWI ex-USA, the first year for which data is available).