• Embed Doc
  • Copy Link
  • Readcast
  • Collections
  • CommentGo Back
Download
 
InvestmentOutlook 
BillGross
August 2003
Hot Tips
Last month’s
Outlook
entitled“Happiness Running” seems a little bit prescient and perhaps just a touchironic at this very moment. With July having witnessed one of thesharpest bear markets in modernnancial history, it may seem like a bond manager’s happiness is not onlyrunning, but is galloping at ank speedstraight out of Dodge City. With thexed income bull market over, it’sgood to see the bond geeks back onthe second page where they belong,I suppose. But wait! Some bond marketgood tidings have left the planet, butthere’s a booby prize of not insignicantproportions still to be won.You see bond managers are the onlycapitalists who root for the priceof their product to go down. I daresay you wouldn’t catch the Boardof General Motors clinking wineglasses to toast a newly announced$500 discount for a Chevy Suburban.I betcha you wouldn’t nd JeffreyImmelt with a huge grin on his face just after GE cut the price of a powerturbine by $200,000 a crack. But bondmanagers are different. Ask themabout the Fed reducing the price of money by 50/100/500 basis points andyou’d think their team had just wonthe Super Bowl on a last second HailMary pass. They do this of course with just a smidgeon of logic and a completevoid of long-term common sense. Thelogical part is that lowering interestrates raises bond prices – the longerthe maturity the better. Hurray! Butsince the total market of bonds has anaverage maturity of around 5 years,their exuberance is short lived. A half adecade down the road, if yields remainlow, then the earning power of theirassets will be anemic as well. My pointin all of this, of course, is that highinterest rates, not low interest ratesshould be a bond managers’ friend. Weshould root for the price of our productto go up not down, just like any otherrational capitalist. Because while anincrease temporarily depresses “totalreturns,” in the long run the apparent booby prize is really a diamond in therough, a silk purse not a sow’s ear. Socome on, take that frown and turn itupside down bondholders! Your future
 
Investment Outlook 
August 2003
earnings power has just increased by150 basis points annually.Do I really believe this? Of course Ido, although the pain in getting to thepromised land can be signicant andit helps to shoot some low durationNovocain into your portfolio beforeprices plummet and clients howl inrevulsion. But this Alice in Wonderlandphenomenon is really a game between buyer and bond issuers when it comesto long-term and intermediate maturity bonds. If the buyer demands higheryields at the expense of repricing hisexisting portfolio then at least thesellers – corporations, governments,homeowners – will have to pick upa larger tab down the road. Moneymarket securities, however, withmaturities inside of 1 year are adifferent story. There’s nothing the buyer can do with 30-day commercialpaper because the price of this moneyis xed – by the Federal Reserve. It isnot a free market. And should the Fedchoose to x an interest rate so low thatit is less than ination, then holders of money market funds and overnightdeposits will suffer mightily. Such isthe case right now with Fed Funds at1% and ination at 2% - short-termyields are a negative 1% on a real, orination adjusted basis.In last month’s
Outlook
 , on the rst of my little “Crystal Harmony” notes tomyself, I mentioned that in a nanced based economy with reation as astated goal, “the Fed must use allmeans, including ‘ceilings’ to keepthe cost of nancing low”…and that“the Fed’s (goal) is to cap the returnsof bondholders.” They do this not by spooking the market ala this Julyand driving yields higher but bysweet-talking it and most importantlymaintaining a negative or extremelylow real short-term interest rate.It seems as of now that they havefailed at the sweet talk but succeededfamously at reducing and maintaininglow short-term interest rates. They canand probably will keep Fed Fundsextraordinarily low for a long time – itis their primary reationary weapon.My point, however is that thisenvironment is not a bondholder’sfriend. Not only do short-term moneymarket and bondholders receive closeto nothing in after-ination or realterms, but the extended period of low real yields ultimately creates areationary environment which furthererodes the prices of intermediate andlong-term bonds. The Fed, in effectis double-teaming the bond market– rst by keeping short rates low andsecond by forcing bond prices downvia ination. This assertion is aptlydisplayed in the two charts below, therst which displays a 75-year historyof real short-term rates and the second
 
which shows the same time periodfor real total returns for intermediategovernment bonds.As Chart 1 statistically depicts, realshort rates were extremely low or evennegative for a period of some 45 yearsfrom 1935 to 1980. Obviously moneymarket or Treasury Bill holders wereearning next to nothing (or less) onan ination adjusted basis but Chart 2tells a more frightening tale. Over thesame time period – a stretch of nearlyhalf a century – holders of intermediatematurity government bonds woundup with less money after inationthan they began with. Suckers! Those50 years as you’ll recall included twomajor wars with enormous decitspending and interest rate caps from1939–1951 in order to help nanceWWII. It was an extended periodduring which the Fed and governmentspending drained wealth on anination adjusted basis from banks,insurance companies, and individualsavers, and reliqueed/reinvigoratedindustrial corporations. While theparallels are not perfect, today’senvironment is strikingly similar. War,decits, low real interest rates, andBernanke-style threats to lower long-term bond yields would/will help tomend corporate America, reduce theironerous pension liabilities, and reateaway much of the accumulated debt burden of the past several decades, butit will do little for bond holders on anination adjusted basis. We thrive onhigher rates – yes – but higher real
  
�
���������
of 00

Leave a Comment

You must be to leave a comment.
Submit
Characters: ...
You must be to leave a comment.
Submit
Characters: ...