01 Apr 2011 ‘Grossly Wrong?’

Indications are that the US economy maintains sufficient momentum to avoid a double dip recession. Non-farm payrolls rose by 216,000 jobs last month and the unemployment rate inched down from 8.9% to 8.8%. Domestic stocks, as measured by the MSCI US Broad Market Index, were up 5.8% for the first quarter of the year. The Dow Jones Industrial Average gained 6.4% for its best first-quarter since 1999. The Fed, eyeing economic strength might be thinking about increasing rates sooner rather than later as well. Minneapolis Fed President Narayana Kocherlakota said it was “certainly possible” for interest rates to be raised by more than half a percentage point this year. 

The Fed’s quantitative easing program of buying $600 billion in US Treasuries appears to be helping in the area of job creation according to Bill Gross. He says “their objective obviously is to improve the economy and to create jobs, but also to put a floor under the stock market, and we know that’s working,” Gross said. “The question remains, when the Fed stops buying Treasuries, does the private sector take the baton and run the last leg of the relay race?” The Fed has a dual mandate to control inflation (first) and to maintain full employment. The Fed can’t keep rates artificially low forever due to the threat of inflation, so how much longer will they maintain low rates and what happens when they start raising them? And some insist they better start raising them soon.

Gross, an expert in fixed income investing has a very large following and his opinions and predictions carry significant weight. In his monthly investment commentary released this week he said that US Treasuries “have little value” because of the growing US debt burden. The US has unrecorded debt of $75 trillion, or close to 500% of gross domestic product, counting what it owes on its bonds plus obligations for Social Security, Medicare and Medicaid. Unless entitlement programs are reformed The US will experience inflation, currency devaluation and low-to-negative interest rates after accounting for consumer inflation.

Mr. Gross’ insights are not new in either significance or hyperbole. When someone of influence bad-mouths an asset class (Treasuries) and touts another (Corporate bonds) he gets a desired and immediate effect after placing his bets. HE influences downward the prices of the assets suggests selling (and in fact has already sold himself, maybe even shorted them), while influencing higher the prices of his new preferred holdings. His gravitas also attracts buyers to his managed bond fund. Many may feel they do not have the expertise to follow the twists and turns of the stock or bond markets.

Mr. Gross has made a huge bet for his investors by ignoring almost half of the US bond market. The danger for outsiders who follow his portfolio tactics, are two-fold. One, he may be wrong altogether. Two, they may likely miss the next move Gross makes, staying with the tactic too long. Consider Gross’ latest move. What you heard Gross say was Treasuries “have no value.” With that information you abandon Treasuries and buy high grade corporates. Back in 2007 the Bond Fund of America was operating with the similar idea that corporate bonds offered ‘superior’ return potential. During the financial crisis of 2008 the Bond Fund experienced a 12.3% decline, while 7-10 year Treasuries were up 18%: That’s a 30% differential. Mr. Gross’ Total Bond Fund was up 4.8%. Point is, portfolio managers like Mr. Gross speak from their self-interested strategies. These should not influence your own plan if you take a passive portfolio approach.

As you know, we are passive portfolio managers. We use bonds to reduce the volatility in our portfolios caused by stock price fluctuations. Mr. Gross and others are now concentrated much more highly in corporate bonds. However, corporate bond prices act much more like stocks than Treasury prices do. In portfolio management parlance, Treasuries have a much lower correlation (very often negative correlation) to stock price movements than corporate bonds. For that reason, Treasuries provide a considerably better hedge against stock price declines than do corporate bonds.

Bond funds are not good portfolio allocation choices for a number of reasons. Two significant ones are tax efficiency and transparency. If you own a bond fund in your taxable account a significant portion of your return goes to taxes due to high turnover (such as selling all one’s Treasury position). The 10-year average return for PIMCO of 7.33% is reduced to 4.97% according to Morningstar for someone in the highest federal income tax bracket (state income tax not included). For the Bond Fund of America the 10-year return is reduced from 4.61% to 2.61%.

Secondly, with a fund, one never really knows what he owns. Mr. Gross, for instance no longer owns Treasuries. We didn’t know for as much as three months that Mr. Gross’ fund didn’t own Treasuries. When the next crisis hits, how badly will corporate bonds perform? If we get another 2008, investors who use corporate-heavy bond funds as their hedge against portfolio volatility will have in fact amplified their portfolio’s volatility. Investors who used the Bond Fund of America or PIMCO during 2008 were hurt worse than those who used Treasuries. For example take a portfolio invested 60% in stocks and 40% in bonds. During 2008 portfolios using Bond Fund of America experienced declines of 28%. Those using PIMCO experienced a 21% decline. Those losses compare to a 15.6% decline for the investor using 7-1 year Treasuries. On a million dollar portfolio that’s a range of $53,000 to $121,000.

One might reasonably argue that things are different today. He or she might say that because of 2008 and since the New Deal, the US government has been heading toward bankruptcy. Because entitlements are so engrained into the fabric of our society, political remedy is unlikely or impossible. Then I would have to ask:

With such a view is it not all the more important to seek ongoing professional oversight of a plan that ensures proper funding relative to your important goals? 

Truth is no one knows what tomorrow will bring, from earthquakes, to tsunamis, to wars to terrorist attacks. The future and markets are uncertain. Managing the allocation segments of a portfolio in an isolated fashion, without regard to the impact the changes will have on the total over the long run can have significant and unintended lifestyle implications. By reducing uncertainty through an efficient and passive approach, lifestyle and funded status can be more confidently protected.

We control what we can; costs taxes, and under-market performance, while planning for what we cannot – uncertainty. Isn’t that a better way to enjoy your weekend?