Investors should take advantage of cracks in fixed income markets through unconstrained bond funds, according to Janus Capital’s Bill Gross, who having made the ‘the trade of his life’ recently in a falling market is increasingly upbeat.
After a shock outperformance of equities in 2014 thanks to lower inflation and mixed economic data from the US as well as several geo-political worries, bonds in the UK, US, Europe and Japan have had an awful 2015.
The European fixed income market has been hit worse hit following yields on 10-year German bunds rocketing up from 0.05 per cent earlier this year to 0.7 per cent, before falling back to their current level of 0.55 per cent.
Gross, the former head of Pimco – the company he co-founded in 1971 – moved to Janus Capital last year prompting tens of billions of dollars of outflows. Since his departure he has been very vocal in his characteristically colourful notes to investors.
He has been predicting an imminent ultra-bearish scenario whereby the end of a 30-year bond bull market comes crashing down and even warning that “capitalism is breaking down at the margins” with no apparent hope for investors.
However, in latest dispatch he strikes a more hopeful tone, believing that the monetary and fiscal policies he had previously decried are throwing up good trades as economies start revving up at differing levels.
Gross says these disparities in monetary and fiscal policies, as well as their slower implementation in the case of Europe, is mispricing government bonds, making US treasuries cheap while UK, Spanish and German government bonds too expensive.
“Similar rich/cheap comparisons can be drawn in risk asset space where corporate and high yield bonds as well as some equity market valuations seem to be two or more standard deviations from historical averages,” he adds.
Gross started shorting bunds – effectively betting that the price of the bonds would go down and their yields would go up – at the beginning of April due to a divergence in monetary policy in the US, Europe and the UK.
“It was a prime example of opportunities hatched by the excess of global monetary policy – zero based policy rates and tag team match quantitative easing programmes which continue to encourage mal-investment in financial assets as opposed to the real economy,” Gross said.
“Interestingly though, central banks and their respective economies seem to be on different time cycles. The ECB, for instance, is still committed for over a year’s worth of €700bn asset purchases, while the US Fed is chomping at the bit to raise policy rates in late 2015. Partially because of these differences, there remain significant disparities in global asset prices that potentially can be successfully arbitraged.”
“10-year treasuries for instance still trade at a 175 basis point premium to 10-year bunds versus a long-term historical average of 25 basis or so. A purchase of treasuries and a sale of bunds allows for not only a potential capital gain if the spread narrows, but a yield pickup while the Rip Van Winkle investor potentially waits for a probable outcome.”
He also seems to have scored a victory against Pimco with ‘the trade of lifetime’ while a host of Pimco funds are taking a hit due to being on the other side of Gross’ April shorting of the German bund market, while he also seeing opportunities open up in markets.
Most fixed income funds have seen a rocky few months since volatility in government bonds, particularly in Europe, has ramped up and markets have sold off.
Almost half of the IA Global Bonds sector’s bottom-decile performers since the beginning of April are Pimco funds focused on Europe with Pimco GIS Euro Ultra Long Duration being the worst affected having lost more than 15 per cent over this period. No funds in the sector have made money over this period.
Performance of funds and sector over 3 months
Source: FE Analytics
Gross believes that only bond funds with an unconstrained or absolute return mandate can make money in this type of environment.
“Even in this modern era of mal-investment in financial assets, investors should want to choose the least overvalued asset to hold and the most overvalued asset to sell. For an unconstrained fund that can both buy and sell, the current opportunity is a rare one.”
JP Morgan’s Bill Eigen, another infamous bond bear, believes that traditional fixed income funds will struggle while those with a ‘go anywhere’ strategy can make cash.
“In some respects, investors have always thought of fixed income as an ‘absolute return’ asset class. For decades they have relied on it to deliver capital preservation, income, and diversification from risk assets. A 30-year bond bull market fostered an environment where investors were lulled into complacency, used to outsized returns and low volatility,” he recently told FE Trustnet.
“However, a major source of those stable returns have been duration or interest rate risk, which has been a powerful stabilising force in fixed income and the only real source of diversification versus riskier assets. Now with global yields at all-time lows, duration turns from a stabilising force for portfolios into a potential source of losses should rates normalise.”
