This is Butler Creek? Bond markets in the first quarter of this new millennium were the most unstable, the most dynamic and the most iconoclastic since the fall of 1981 when Paul Volcker’s monetary straight jacket escalated long Treasuries to 15 1/4%. What a three months we’ve had, and if ever there was a testament to the need for active bond management, this was it. So all you have to do is clip those coupons, do you? Well which ones would you have clipped these past three months? Surely not high yield or even investment grade corporate coupons; not Aaa agencies, nor mortgages except for those GNMAs; Treasuries galore, of course, but mainly those on the long-end of the curve, and yes, lots of convertibles and emerging market bonds. Excluding the equity-like convertibles, the range of returns from the low performing to the highest performing bond market sector exceeded 10% - for the quarter - which when annualized would be 40% and counting. Enough range there, I’d say, to make many a bond market hero and a few goats to boot. The Treasury buyback program seemed to kick-start the affair in mid-January, and the question of government agency creditworthiness shifted it into high gear in late March, but betwixt and between there was a whole lot of shakin’ goin’ on as portfolio managers struggled with historic concepts of valuation that were being radically transformed. There were so many changes taking place, it seemed impossible to cope unless they were placed within the context of a grand design – a secular , not cyclical movement whose violent winds were turning the bond market upside down, shattering historical icons, and leaving it closer to OZ than to Kansas, perhaps never to return again.

This new millennial tornado is actually not hard to locate. It’s been driving the stock market for at least several years now under the guise of the “New Economy” – an economy able to supposedly grow faster and longer due to the extended benefits of globalization and technological innovation. Funny though, that up until now, investors had myopically focused on the stock market as the sole beneficiary of its power. Escalating P/Es, accelerating earnings’ forecasts, and an implicit recognition of a new/old dichotomy within the market itself led to the ascendance of a new equity investment culture as well as the abdication of many a prince-like portfolio/hedge fund manager of yore. While much of this equity transition rests on the fragile foundation of human greed and avarice, and tech stocks are no doubt significantly overvalued, it is clear that fundamental changes have and are taking place in our global economy which justify the escalation of  the NASDAQ to the same or higher place as The Dow on the CBS Nightly News. Dan Rather is finally getting it. It’s a new economy, stupid. While the NASDAQ itself may have seen a top, the New Age Economy will continue, absent a crash. If it should crash, then you can abruptly discard at least some of what you’re about to read.

The logical follow-up question though is “why just stocks?” If these forces are so powerful, then they should affect other markets as well – and as it turns out they have. With bonds, the entire focus prior to the past few months was on the benign effect the “new economy” would have on inflation. PIMCO’s Butler Creek range-bound world was predicated upon moderate interest rate changes and the exploitation of yield as opposed to price in strategic decisions. PIMCO (and later other portfolio managers) promoted the implementation of a method of investing I once described as “the structure is the strategy” – meaning yield enhancement via Brylcreme-like allocations to higher yielding bond sectors. You could almost hear “a little dab’ll do ya” coming out of our pens as we allocated 3-4% positions to high yield, emerging markets, and other riskier yet ultimately profitable sectors during the past 5 years. Structure ruled as the 20th Century came to a close and it seemed as if Butler Creek would run shallow, not deep, for as long as the eye could see or the clock would run. It has not.

During the past few months, astute bond managers have begun to sense the dynamics of the New Age Economy in a myriad of ways, which in my opinion center on two common themes. They are:

(1) The New Economy promotes private sector debt and public surpluses. As described in my February and March Investment Outlook, the buildup of private sector debt and Treasury surpluses have already had dramatic repercussions on bond market valuation. Why, though, are these phenomena necessarily “new age” related? The answer is that both are a direct result of the higher rates of economic and productivity growth fostered by advances in technology and globalization. Look at it this way: Technology and the Net have been substantially responsible for raising U.S. levels of GDP, its stock market, and therefore federal and state taxes. Government surpluses, therefore, are a New Economy phenomena. As long as the New Age persists (and politicians keep their grubby hands out of the cash register) Treasury buybacks and paydowns will continue.

In turn, dramatically higher levels of corporate investment are taking place because of the opportunities made possible by technology and the prosperity it has produced. While most high tech investment has been funded via IPOs in the stock market, the purchase of their products has eaten into the cash flow of the old economy, leading to record levels of corporate bond issuance in order to fund those investments. On top of that, the raging success of tech stocks has convinced old economy CEOs that their own stocks are cheap by comparison, even at 30x earnings. Stock buyback upon stock buyback has followed that specious logic, almost all funded by corporate debt offerings. Similar thinking has promoted dramatic increases in margin debt on the part of the investment public, to say nothing of the “good times” credit card and home equity borrowing that have led to levels of consumption that are based upon more debt as opposed to income growth. In short, our New Age Economy has led to speculative bubbles, which promote burgeoning private sector deficits and conspicuous public sector surpluses.

(2) The New Economy leads to deteriorating corporate bond quality. Higher levels of corporate bond issuance are one thing – the ability to service them is another. Doesn’t it seem strange to you that the rolling 12 month average of high yield bond defaults has reached 6% (a level last breached during 1990’s recession) in the face of 5% + GDP growth? Some blame it on the poor quality of the last few years’ junk bond underwritings, and that may be partially true. But try this one on for size: the common accepted wisdom in the stock market is that high tech/net stocks will produce a few big winners and lots of losers – call it the “Amazon.com theory.” If that plays out, then bond investors can only suffer. It’s fine, I suppose, for stock investors to hold a diversified portfolio of net stocks with the anticipation that half will go bankrupt, while the AMAZONs go up 1000%. That same logic doesn’t apply on the bond side, however. Amazon’s non-convertible debt pays only 100 cents on the dollar at maturity while the losers’ debt will pay next to nothing. Admittedly, most Net companies have been financed via venture capital and equity IPOs, but this “winner take all” process may infect the old economy as well. Take a look at J.C. Penney and other struggling retailers to see the havoc wreaked by Amazon.com and its clones. The view of corporate financial health through the use of averages is therefore becoming more and more dangerous as the distribution of profits across the corporate sector becomes more and more one-sided.

Secondly, there’s the possibility, perhaps the probability, that corporate profits in total may one day erode as opposed to grow. Up until now, investors have been treating the struggle between Old and New Economy companies as a zero sum game. Amazon takes revenues from J.C. Penney, but retail sales remain the same. Funny thing is though, that the reduction in Old Economy profits doesn’t imply anything about New Economy profits. There aren’t many, and that may continue to be the case for a long time. If the consumer, as opposed to business, becomes the ultimate beneficiary of technology-based efficiencies, then corporate bond quality will suffer. That same logic applies to the banks that are in the business of lending money to medium and lower grade companies negatively affected by the New Economy.

Even if high tech Armageddon never arrives, many Old Economy stocks have fallen to levels which may prompt LBOs and a further degeneration of credit quality. In sum, the increasing defaults; “winner take all” sales domination; the future of corporate profitability itself; and threats from potential LBOs – all scream “danger” to corporate bondholders. The fact is that rapid change and dramatic growth are not a bondholder’s friend, especially on the corporate side. Smooth and steady is the better of the two alternatives.

Because of these dynamic changes in the New Economy, is it any wonder that:

(a) Treasuries have encountered panic buying at wider and wider spreads to swaps and other corporate holdings? (See chart below.)

(b) The Treasury yield curve has inverted due to the Treasury buyback program?

(c) High yield bonds are having difficulty finding bids in illiquid markets?

(d) Agency credit quality is being questioned for the first time in 13 years?

(e) U.S. Treasuries are outperforming their Euro and Japanese counterparts due to stronger U.S. growth?

(f) Emerging market debt is close to the top of the performance derby?

Some Creek

Figure 1
Source: The Economist, August 1999

No wonder at all to my way of thinking. The explanation, dear Brutus, lies not in our stars, but in a New Age Economy whose outsized growth has in turn led to disproportionate changes in bond market supply and perceived creditworthiness. That’s because the New Age Economy is ultimately a global economy that favors government more than business due to the Treasury’s higher cash flows and diverging credit quality. Granted, tax revenues cannot increase if the Old Economy hollows out and the New one never makes money, but should that occur, there’s still a time lag involved due to receipts and capital gains taxes that may favor governmental as opposed to corporate coffers.

So say a fond farewell to Butler Creek. Those Treasury yield ranges of 4 1/2 - 6 1/2% will still be there, but that’s the only part of the Creek you’ll be able to recognize in the future. Every other part of the bond market – yield curve, sector, international/emerging, and quality spreads – are suddenly in play as perhaps never before shifting violently back and forth as the stock market moves up and down. I wish I had a cutsie name for this new market, a name that would stick in your minds that would signify what lies ahead – just like Butler Creek did for so many years. I don’t, but no matter. It’s a river now and rivers aren’t always peaceful and placid and allow you to sleep peacefully at night dreaming about Butler Creek……Butler Creek. It’ll be enough, I suppose, to navigate this river as opposed to naming it. For now, we at PIMCO are content to be afloat instead of underwater. We’ll leave the naming of this tributary to posterity. 

William H. Gross
Managing Director