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Economic and Market Commentary

*@?#»! Bond Trading and the Tyranny of Indexation

"If an investor is being paid little to await his eventual demise, then it seems he should rethink the proposition."

ike oil and water, politicians and the financial markets don’t always mix, and there have been some memorable historical examples. 1896 presidential candidate William Jennings Bryan, for instance, railed against Wall Street’s “cross of gold” and decades later FDR threatened “to drive the money changers out of the temple.” More recently and perhaps indicative of the changing times, Bill Clinton shifted his venom from a Biblical reference to one closer to the linguistic gutter when he promised that his budget wasn’t going to be “held hostage to some *@?#»! bond traders.” I think I know what he means since my budget has been hostage to *@?#»! bond trading for over 30 years now, although I suppose I would have to replace the *@?#»! with xxoooxxoo’s to be honest about it. While my respect for George W. Bush knows many bounds, I must admit that he and the bond market appear to be much closer than Bill C. and bonds ever were. That’s because W is and has been a tireless promoter of the globalization of democracy, and while he may not know the difference between a Bund and a bond, his two-barreled philosophy emphasizing democracy and the globe has prevailed in the financial markets for at least the past six years now. Actually, trade has quickened its pace ever since the fall of the Berlin Wall and the follow-up ascendancy of the BRICs with finance following in lockstep, such that the global bond and stock markets now exceed a guesstimated total of $60 trillion as compared to $25 trillion only a decade ago. And while “democracy” hasn’t totally permeated the global financial markets (much like the resistance Bush has run into in selected geographical hotspots) it has made unimaginable inroads in the United States. CDOs, CDSs, CDXs, CLOs, tranchettes of any of these, as well as countless funny money derivatives in our unique and wondrous mortgage market are but examples of what has assisted the common U.S. citizen to now command an interest rate close to that paid by the titans of corporate America. Andy Jackson, champion of the commoner, would approve I suppose, even if his administration had been held hostage to those *@?#»! bond traders!

My point in politicizing my profession, which I have no outward self interest in doing, is to lay the groundwork for an analysis of today’s new and perhaps improved bond market and to describe PIMCO’s changing role within it. As clients, you no doubt are wondering whether we can keep on keeping on in the face of the growing competition and lowered returns that globalization and in turn the democratization of credit have engendered. Both of these trends, for instance, bring the dreaded dragon image of hedge funds to mind with perhaps the logical query – how are WE to compete with THEM? They charge fees, which supposedly allow them to skim prize talent off the top, and they utilize leverage while scrambling amongst a multitude of markets that old-line bond managers don’t imitate. But if hedge funds are the most ferocious dragon in the financial world of globalization they are by no means the only new predator. Foreign central banks made famous and in fact prosperous by the miracles of globalization are the symbolic elephants of our new financial marketplace, and while they may stampede or charge only infrequently, they have stripped the bond market jungle of its formerly “alpha rich” vegetation and trampled the high grass such that today’s global yields are but a wisp of their former selves. To further complicate the analysis, their investment decisions are in many cases “non-economic” – stressing development at home as compared to yields abroad as the basis for bond investment. In addition, profit-incented/yield-starved foreign individual investors have joined hedge funds and the PIMCOs of the marketplace in what has been called the Yen carry trade, substituting 0% yields in Japan for double-digit rates in emerging market bonds and currencies, high single-digits in spread product, and in turn “settling” for a mere 400-500 basis point pickup in good old fashioned U.S. Treasuries. The universe of bond managers subject to Bill Clinton’s invective it seems, has changed over the past five years. He’d now be swearing in almost every embassy and at millions of foreign citizens turned bond traders no matter which way he looked. The big “players” of bond trading past, such as banks, insurance companies, pension/mutual funds, and investment management companies which serve as their proxies, have been replaced or at least asked to take a seat on the bench in deference to the new first string. But whether first or second string, my point is that there are a multitude of players now where once in our relative innocence there were but a few. Competition is fierce to not only get a hand on the ball but to prove that a player can continue to score alpha-points.

As a consequence, the final game/total return scores these days are much lower than they used to be, not just because of the aggressive and competitive offenses but because as a consequence a lot of the air, yield and alpha has been let out of the ball as rates have declined worldwide – conundrum or no conundrum. Bond and asset managers alike (and PIMCO fits both descriptions) are faced with global real interest rate valuations capped at 2% in major markets, and yield spreads almost everywhere that suggest maximum future bond returns of 5-6%. Equity prospects are not much better except in high growth export dominated economies. Commodities and real estate of course are legitimate growth and inflation sensitive asset classes, and due to higher risk and in the case of commodities, growth of the BRICs, these assets will logically provide higher returns over the long term. My point, however, is to emphasize that the democratization and globalization of trade and therefore credit has now presented investors with a rather diminished array of future returns upon which to feast. That there are scores of growing and still ravenous diners at the table makes the outcome even more troublesome.

All right Gross, to the point please – how is PIMCO going to compete against all these new *@?#»! bond traders? Well, in part, I’ll take sort of a nonchalant Warren Buffett late 90’s approach to all this. Dot Coms? “Let ‘em come and mostly go,” he suggested because in part he didn’t have the inclination to identify the few Amazons or Googles in a high-risk/high-priced market. We all know the result. But the current low level of government yields is not a dot com bubble as long as globalization and democratization of credit persist. These trends are likely to be with us as long as the U.S. trade deficit/Asian mercantilistic growth push continues, and if the substitution of labor for capital continues to dominate global growth. So a total boycott of bonds like Buffett boycotted dot coms is not to my mind a profitable response. Buffett after all, still owned lots of stocks in the late 90s. But Buffett’s assessment of high prices in dot coms has its parallels in bondland even if one accepts the new reality of globalization and the redistribution of wealth and reserves – which PIMCO most assuredly does. When one can buy a U.S. agency guaranteed FNMA mortgage at a higher yield than almost all emerging market debt, then there exists an irrational pricing of credit. In general, almost all risk and associated “premia” are now trading at illogically low levels and as Alan Greenspan warned just months ago, history has not dealt kindly with the aftermath of protracted periods of low risk premiums. “Periods of relative stability” in fact, “often engender unrealistic expectations of permanence and at times lead to financial excess and economic stress,” he said.

Observers and even *@?#»! bond traders, including yours truly, often have to be reminded that risk premiums include not only the more observable ones associated with credit but liquidity, curve, and option premia as well. Alpha harvesting is an occupation dependent on selecting when and which premia to over or underweight. Outperforming riskless government bills and/or producing alpha compared to bogies often comes from accepting the risk associated with assets with attached risk premiums. Now, however, as Greenspan warns and Buffett observed with the dot coms, with almost all premia at compressed levels, strategic alpha in 2006 and perhaps beyond likely will come via the voiding of most premium or carry trades from portfolio composition. Dreaded dragon hedge funds of course cannot only void, but short these overvalued levels and their associated securities. Allow me to let you in on a little secret though. PIMCO can too! Option, credit, curve, and liquidity premia can be bought, voided, or sold and it is only your guidelines and our assessment of and proclivity to take risk that prevent us from breathing fire and assuming dragon-like status as well. Let me however, assure you of one thing: PIMCO is not becoming a hedge fund. I will also acknowledge though, that the well advertised flexibility of hedge funds has been a PIMCO characteristic for decades. First in mortgages, first in futures, first in derivative equity index products, first in global, first in TIPS, first in commodities, first in the asset allocation of the combined group. If not indisputable, these claims are certainly not far from the mark. Today, while leverage is not our trademark, there should be no reason, absent your guidelines, why innovation should not continue in sector and risk allocation as well as the mindset that accompanies their use. Standard bond investors adhere closely to index levels, and become nervous if they drift too far away from home. It’s that nervousness and those bogies however that in today’s low return investment jungle may work to their detriment.

This is a delicate topic but common sense would dictate to me that there is less risk in not buying index-related holdings trading at high prices and low risk premiums, than in buying an average level of them in an attempt to blend in with the pack. Successful money management has always depended on riding the wave of the crowd until it crests and crashes to the ocean floor. The crash of risk assets and their return to normalcy may be hard to time, but as Greenspan pointed out, these periods never end well. If an investor is being paid little to await his eventual demise then it seems he should rethink the proposition. If you’re going to hell in other words, you might as well get paid for it and bond investors for the most part are not being paid today. Whether or not we’re headed for purgatory will depend I suppose on whether God mimics the attitude of Bill Clinton, FDR, and William Jennings Bryan. But for an astute bond manager, moving farther from index levels or even voiding a portfolio of overvalued low carry securities would seem to be rational responses to today’s jungle environment with trampled “alpha less” grass.

My previous sentence describing asset portfolios as containing low carry applies globally but primarily in the U.S. because it is our markets since mid-2004 that have been the main recipients of the Yen carry trade, a phenomena made possible by the widening spread of U.S. and Japanese short rates and the relative assurance by the BOJ that the Yen would not be allowed to appreciate significantly against the dollar. This one-sided bet has fostered the borrowing/exodus of money from Japan and the reinvestment of those funds in anything with a yield here in the U.S. The democratization of credit mentioned previously has provided a major assist. But with the U.S. Fed now almost done and the BOJ removing quantitative easing and threatening a tightening cycle of their own, the carry trade and importantly the existing level of the U.S. dollar vs. the Yen and almost all currencies is at risk. As global real interest rates converge, the export potential of comparative economies should begin to dominate exchange values and it is there, of course, where the U.S. is so critically deficient. Japan as we all know is an export powerhouse. Less well known is the ongoing ability of Germany as the center of Euroland to command global market share. The ascendancy of China’s production for export is of course unquestionable. That leaves the U.S. with its increasingly hollowed out manufacturing core as the near certain loser in currency valuations going forward. To be blunt, the dollar must go down as it loses its carry.

My point in bringing up the dollar and currencies is to circle back to my main theme of our new bond/asset market participants and their trampling of the high alpha grass in recent years. In the face of overvaluation, a strategy which seeks to void certain elements of bond indices and benchmarks concludes in today’s market that cash or “near cash” substitutes are attractive replacements since their yields match longer dated assets. The near cash I refer to consists primarily of tranches of eurodollar futures contracts maturing in 2007 and 2008 which will benefit from an eventual Fed easing. Short-term eurodollar futures should not necessarily be confused with a reduction of portfolio duration but their inclusion in portfolios does recognize that they should have more than competitive yields/future returns in today’s marketplace. The asset manager that fails to recognize this by suggesting that cash is not a part of his or her index is making a serious mistake. But whether invested in eurodollar futures or long bonds, dollars or yen, my main theme in this presentation is not to describe our current portfolio strategy for 2006. It is to emphasize that in a global bond market devoid of historic risk premia, that a different approach should be considered. To paraphrase Barry Goldwater, an extreme position in relatively safe out-of-index securities is no vice, while a safe position in extremely overvalued index securities is no virtue. The tyranny of indexation as I alluded to previously is the culprit here, and those of us, those of you, that adhere to benchmarks and a horse race based upon relative performance to those benchmarks are probably making a mistake.

This introduces the whole developing theme of course of “absolute” returns and brings back the topic of the meteoric rise of hedge funds and the reason for that ascendancy. In a sense the phenomena of hedge funds and the focus on absolute returns is an attempt to manufacture alpha in an alpha deficient world. It says that ultimately “absolute” returns will provide a higher alpha or spread to the composite index of all investments. Whether the achievement of that absolute alpha is possible given the high fees they demand is a serious question which I, Buffett, and others have written about in recent years. Nonetheless, the psychological old line money management mentality, and ultimately the restrictiveness of plan sponsor index guidelines should perhaps give way to a more flexible focus on divergent strategies that break the tyranny of adhering to the index mean. If most of an index is egregiously overvalued and “alpha-less,” what does that say for your and our future unless we decide as intelligent elephants to move across the African plain in search of the higher grass. That migration as I’ve importantly pointed out, need not involve an increase in absolute risk. “Near cash” is not an absolute risk to your plan, it’s only a relative risk compared to your benchmarks – the yields and returns of which have been driven down to unjustifiable levels. What I’m suggesting is essentially this: to be successful in the future a money manager/plan sponsor must in today’s market be willing to embrace more risk outside of index space by accepting (remarkably) less risk in absolute space. Ultimately your absolute returns should benefit and the volatility of those returns may in fact be significantly lowered.

A similar comparison can be justified when viewing dollar and non-dollar denominated assets no matter whether your index is U.S. centric or global in nature. With the U.S. dollar significantly overvalued, the blanket acceptance of an index amount of dollar denominated assets in order to mimic risk in index space would seem to be accepting an excessive amount of risk in absolute global purchasing power space. The fact that foreign currencies are high beta assets in index space and in fact are not part of most indices at all, limits the amount of non-dollar exposure a portfolio manager or a plan sponsor is willing to assume. But the real long-term risk in my opinion, is in holding dollars, and if so, absolute returns in global purchasing power will suffer if they are held.

Today’s *@?#»! bond traders are faced with a dilemma. Increased levered competition and a plethora of new moneyed non-economic buyers have changed yield, total return and alpha generating expectations in future years. How to cope and combat is the question to be posed and answered. PIMCO suggests in the near term that a total boycott of the bond market is impractical since non-economic central bank buyers should continue to dominate. We do suggest, however, a strategic boycott of most risk assets based on the reality that an investor is not being paid adequately to hold them, as well as the Greenspan assumption that today’s low risk premiums ultimately lead to future periods that end badly. In turn, we currently suggest a substitution of near cash assets and non-dollar currencies for standard index assets. These out-of-index bets ultimately should produce higher returns with less than expected risk if done in moderate quantities. As with people, bad things can happen to historically good assets if driven to overvaluation. Blindly adhering to an index in order to insure a positive but diminishing relative alpha return is probably not an intelligent response to today’s dilemma. Recognizing and ultimately avoiding the tyranny of an index can in effect produce a higher return with less risk. We hope with your guidance to be able to move in that direction in order to remain the future “Authority on Bonds.”

William H. Gross
Managing Director


Past performance is no guarantee of future results. This article contains the current opinions of the author but not necessarily those of Pacific Investment Management Company LLC. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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