used to explain to reporters when asked to describe the ideal bond manager, that he should be 1/3 economist, 1/3 mathematician, and 1/3 horse trader. It was a catchy answer, but at the time, almost 3/3 true. Bonds have a mathematical bent to them that stocks somehow manage to partially circumvent, and interest rates are no doubt highly correlated to movements in the real economy and the inflation or deflation that it produces. The horse trading aspect is a little bit harder to explain, especially for a long-term oriented bond manager such as PIMCO, but there are day trades like we see in stocks, and lifetime trades like some have in good marriages and invariably lots of trades in between. A good horse can last for quite a few years, as any good cowboy knows, so the trading or perhaps the strategizing is definitely a part of a great bond manager’s psychological resume.
Over the past few years, however, I’ve come to believe that a bond superman should be divided into four, not three pieces. The advent of what PIMCO called Butler Creek in 1994, as well as, the demise of Long Term Capital Management in 1998, have taught me that structural, as well as strategic, economic, and quantitative inputs are critical to the successful management of bond portfolios. The final quarter then, that depends upon skills that can properly diversify a bond portfolio within the three-dimensional context of risk, reward and just as importantly – time – demands the skills of not just a mathematician, economist, and a long-term horse trader, but that of an architect as well.
I’d like to talk about that aspect of bond management but first I know you’d like to hear a little bit about the market itself and what I think lies ahead. For that, I’ll put on my economist hat with a touch of bond math and strategizing to boot, but I’ll return to puzzle making and blueprint reading because, as I’ve just suggested, there’s value to be found in the architecture as well.
At PIMCO, as you know, the economics start at the very top but, as in mountain climbing there are legitimate questions as to how high is high. Too much elevation or too long of a time period can suffocate the bond manager in a perhaps futile quest for certainty – if only given enough time. Keynes recognized the flaw in relying on the long run – we are all dead – as is any firm that begs for just one or two more years to prove the validity of its portfolio’s pudding. The request is seldom granted nor does the pudding usually age well within the hoped for timeframe. Still a manager in this day and age must expand his timeframe at a minimum to the next several years and at least be aware that the globe at this moment is encased within a capitalistic cocoon and an American cocoon at that. Free markets, open information, democratic politics and the pursuit of happiness via wealth creation have become the adopted economic ethos of almost the entire world. Cuba, North Korea, numerous African dictatorships, and a few important Middle Eastern holdouts are all that’s left of the bipolar world that we knew as recently as 1988. The walls of Berlin however, and perhaps biblical Jericho itself came tumbling down shortly thereafter and our world has transformed itself within the space of a half generation.
Interesting, you might say, but what on Earth could that possibly mean for the management of bonds? Enough to have accelerated an already existing secular trend of disinflation, I would answer, and to catapult bond prices to heights reached in the fall of 1998 that were in some cases multiples of what they were just 20 years before. The ongoing and then accelerating process of globalization led to more competition and innovation, not just between companies, but amongst countries as well. In addition, our current New Age Economy with its emphasis on investment, technology and access to information has brought inflation down and kept it down. This has been no Jack Dempsey/Gene Tunney 12-second long count. It’s been an inflationary knockout and pricing power has been on the deck for years now because of the global adoption of America’s capitalistic way of doing things in contrast to the models of Communism, Japan, or even France’s “third” way.
Not only companies, but countries as well have joined the globalization frenzy in a desperate effort to attract capital and compete. Since investors have signaled that they hold strong currencies, high growth, and low inflation most dear, governments have moved from large fiscal deficits to in some cases, startlingly large fiscal surpluses, and central banks have adopted what is known as “inflation targeting” to insure that foreign and even domestic capital has a place to prosper in a low inflationary environment. Net result: global prosperity and low interest rates with admittedly some pretty rough bumps along the way.
It’s those bumps that I’d like to address now, because for all the benefits of the American capitalistic ethos, there are negatives as well. The French would claim that American capitalism is no cocoon to be emulated, in fact is no cocoon at all. But aside from the unsolvable philosophical differences of stressing equalité and fraternité before economic liberté, they have a point about the process itself. American capitalism is in relative terms, reminiscent of our wild wild west as opposed to the refined culture of Paris. It allows for risk and risk taking – backstopped of course in many ways by government and central bank policies but flexible enough to promote the modern entrepreneur in his quest for a profit. That promotion, however, provides for, even encourages, risk and innovation and in most cases allows for not just success, but outright failure and bankruptcy.
It is this lesson, I believe, that a bond investor must recognize and learn above all as we wind our way up the long-term mountain of portfolio management in this New Age Economy. The adoption of a system that can offer all the advantages of disinflation and technology-based prosperity carries within it perhaps not the seeds of its eventual destruction as Marx proclaimed, but certainly the seeds of “creative” destruction as Schumpeter more accurately recognized. And when capitalism – especially American capitalism – is at its most vital, then creation and destruction should move to relative extremes as well. That, in a word is my simple economic message to you today. Expect “destruction.” Note that this admonition goes beyond the simplistic and almost always accurate forecast of predicting that markets will be volatile. Of course they will be and especially so when capitalism is on the move. I suggest instead that you should expect destruction, which in bond manager terms means default, bankruptcy, and loss of principal.
New Age Economy advocates know this already, but they explain it under the optimistic guise of a diversified portfolio of technology/internet oriented stocks from which there will be a few large winners and numerous small losers. Destruction is no big deal for stock managers if there are a few CISCOs at 2,000% appreciation to balance out the forgotten “no names” which returned them nothing. But in the bond market there are no CISCOs, no Microsofts, and no future standouts that will ever pay them more than par at maturity. Because of this mathematical limitation and the certainty of 10 or 20 cents on the dollar at best for the losers, corporate bond investing in a New Age Economy is a dangerous proposition. It flies smack into the headwind of Schumpeter’s “destruction,” while a diversified portfolio of equities seemingly moves in the other direction, soaring and then jet streaming along at the benefit of Schumpeter’s “creative” tailwind.
If indeed we are in the process of a New Age transformation, then high quality bonds – primarily government bonds – will benefit by “default” or perhaps more accurately by the lack of it. This forecast must seem especially galling to European investors, especially those of you here at Allianz that have focused for so long almost exclusively on sovereign securities. You and others must be chomping at the bit to charge into high yield telecoms and technology-related issues but while total abstinence is unnecessary, caution certainly is. There will be a better time – perhaps years in the future but there will be a better time. For now, the lure of sovereign quality issues is particularly appealing, especially when governments are creating so few of them.
But I must move on now or better yet move back to my opening tease on the newfound importance of structure in managing bond portfolios. It was always important of course, but the same New Age, Schumpeterian surge that has stressed economic and strategic changes for corporate bond holdings, warns that New Age bond architecture will be critical as well. The formal recognition of this by others and me at PIMCO occurred in late 1993 upon implementation of a strategy we labeled “Butler Creek.” Because our long-term secular forecast suggested a range-bound interest rate world, the incorporation of a yield vs. price strategy was called for, which in turn led to the need for structuring a portfolio with just enough yield and just enough risk in order to provide PIMCO’s expected 100 basis points per year excess returns. Our record over the ensuing years would indicate that we must have mastered our architecture lessons quite well, but others were not so fortunate. As the bond and hedge fund world moved decisively into the realm of financial architecture with their VAR models and presumptions of portfolio diversification, it seemed that returns were almost limitless if given enough time and leverage. 1998 and Long Term Capital Management changed all that, not because their strategic ideas were wrong, but because of too much leverage and too little time.
This combination of leverage and time is a critical one to recognize in any portfolio blueprint. Leverage can be dangerous, but is less dangerous given enough time for fundamentally sound investment ideas to work out. Just ask Warren Buffett. His belief in superior equity returns over the long term has been wrapped in a womb of insurance company balance sheet leverage. That leverage, however, has been more or less impervious to being “called in” at inopportune times. Unearned insurance premiums and even policy loans and long-term debt have semi-permanence to them that overnight lending and subscriber capital does not. And so Buffett has prospered while John Merriwether temporarily stumbled. Buffett, for all his equity brilliance, should be equally applauded for his skills as a financial architect, skills he developed and lessons he recognized long before Markowitz, Myron Scholes, or Fisher Black developed their own brilliant theories. He has shown, as did the blow-up of LTCM, that time is a vital third dimension in financial architecture, and that portfolios must reflect the time tolerance, be they regulatory or customer oriented, of the assets’ actual clientele.
The commonly accepted time tolerance in the pension asset management business is generally between 2 to 3 years. That time frame, of course, does not speak to investment strategies whose assets themselves are subject to specific liquidity requirements of a much shorter nature, but knowing that a client will allow you on average two to three years to cook your own goose, or the sauce for someone else’s, is helpful in determining overall time parameters for strategies themselves.
In addition to time, there are a host of other structural considerations that demand appropriate architecture. Harry Markowitz’s theory of portfolio diversification is perhaps the most critical, although it didn’t work for LTCM primarily because of leverage and systematic deluge. Given enough time, however, there is no more important talent to master than the construction of a core portfolio in combination with its diversified and hopefully profitable “wings.” I refer not of course to the West Wing or The Lincoln Bedroom, but to minor amounts of high yield, emerging market, and option oriented strategies that can add value when properly timed and which may – with Markowitz’s miraculous discovery – actually reduce volatility if not actual risk.
To these architectural considerations should be added the exploitation of other investment manager’s blueprint limitations, which may afford opportunities for your own benefit. Insurance company cost accounting and mortgage banking hedging of inventory prepayment risk are just two obvious examples of architectural handcuffs that can offer performance bonuses for those managers with fewer constraints, and the ability to move more quickly and freely.
I’ve learned that whenever a speech delves into the land of the accountants that eyeballs glaze over or eyelids inexorably come together. I should stop to allow yours to come unglued. One last point though about that ideal bond manager. Although conceptually his skills must be divided into quarters, I have little doubt that Mr. Perfect must wear the cloak of a “statesman” as well. To my mind, a statesman is distinct from that of a politician. A statesman has the maturity, wisdom, and courage to choose a path that is beneficial for society over the long term, not just for himself and his constituents in the short term. Now a bond statesman can never forget his constituency, but he must also recognize the vital importance of his profession to the overall well being of economic society. Institutional investors, especially bond mangers I believe, are guardians of that society. The decisions we make in terms of allocating capital can have near life or death consequences for companies, countries, and continents alike. And if “death” be an exaggeration, then paralysis is certainly an apt substitute. Recent crises involving U.S. savings & loans in the 1980s, Southeast Asian short-term debt in the mid-to-late 90s, and of course hedge fund over-leveraging in the past few years, point out the potential ramifications of lenders going too far down the wrong road. Time magazine’s cover heralding the “Committee to Save the World” just two years ago may seem like hyperbole now, but it resonated differently then. And for those of you who agree with Shakespeare’s idea in “King Henry VI” that come the revolution, they kill the lawyers first, let me speculate with near certainty that shortly thereafter they’ll take the money managers second. I intend to be retired come the revolution, but there could be others who may not share a similar fate. It’s best to put on the statesman’s cloak then, if only to protect the mathematician, the economist, the horse trader, and the fresh young architect as he travels his tortuous path in search of an extra 100 basis points.
William H. Gross
The above speech was presented on July 25, 2000.