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Gross' Compares Bondholders To Slowly Boiling Frogs, Explains How PIMCO Is Profitable Despite Treasury Short Position

Tyler Durden's picture




 
Just out in Bill Gross' latest monthly missive in which he compares Treasury longs to frogs in a pot, which are slowly starting to boil. As a result, he issues a clarion call to all: "All right fellow frogs, so we’re being repressed and shortchanged in order to allow Uncle Sam to balance its books. Whatta we gonna do about it? “Frogs of the world unite,” as Lenin might have said" and urges bondholders to be properly compensated for their risk by switching out of "rich" fixed rate into "cheap" floating rate exposure. The reason is that nominal yields, Gross contends, just make no sense: "Prices are already nearing the boiling point and his coupons are subzero, CPI adjusted. Total return…and our frog…are cooked, or if not they are certainly trapped in a future low return kettle of water." Then, Gross once again goes on a detour to explain how contrary to being short Treasury exposure (and we will have more of a breakdown on this shortly), PIMCO is still having a good year: "Journalists, financial advisors, and perhaps even some clients marvel at how PIMCO can be doing so well in 2011 while being underweight the Treasury/durational component of the bond market. Folks – we're making butter....We suggest buying “cheap bonds” focusing on “safe spread,” which means buying more floating and fewer fixed rate notes, adding an additional credit component – be it investment grade, high yield, non-agency mortgage or emerging market related – and shading your portfolio in the direction of non-dollar emerging market currencies. Investors shouldn’t give their money away, and at the moment, the duration component of a bond portfolio comes close to doing just that – not because a bear market is just around the corner come July 1, but because it doesn’t yield enough relative to inflation. Come on frogs, make butter, not someone else’s dinner." As always an engrossing read.
From Pimco:
Buy Cheap Bonds with Safe Spread
  • ?Rather than outright default, many countries attempt rather successfully to keep nominal interest rates lower than would otherwise prevail.
  • Over the long term, this “financial repression” results in a transfer of wealth from savers to borrowers.
  • Investors shouldn’t give their money away, and at the moment, the duration component of a bond portfolio comes close to doing just that – because it doesn’t yield enough relative to inflation.

Because the QEs cover an extraordinary period of monetary policy with a limited time frame, there is not enough data to indicate whether the end of QEII will lead to higher or even lower rates, although higher is our strong preference. “Who will buy them?” remains a critical question to be answered. There is, however, overwhelming evidence – now provided by Carmen Reinhart among others – that existing Treasury yields fail to adequately compensate investors for the risk of holding them, when measured on a historical basis.

I’m going to one-up Mark Twain in the quantity department and spin two
yarns about jumping frogs, one which has been frequently told, the
other not so much. Neither of them have anything to do with Samuel
Clemens’ heralded short story, but both, metaphorically at least,
describe our current investment markets and how to think about the
future. My first story is the one you’ve all heard about. Put a frog in a
kettle of boiling water and he’ll jump out faster and further than any
of those blue ribbon winners at the Calaveras County jumping frog
contest. Put him in a pot at room temperature, however, slowly turn up
the temperature to boiling, and you’ll have frog legs for dinner. This
latter, more unfortunate toad temporarily adapted to his external
environment, which seemed like a practical thing to do, until – well,
until he reached 212° at which point he was cooked.
Today’s bond investors are experiencing a similar fate with
nary a “ribbet” of complaint. “Total returns” for the first five months
for almost all bond categories show positive price performance, which
when combined with coupon interest income, produce portfolios 3% or so
higher in value than at year-end 2010. That number may not match stocks
or some of the high-flying commodities, but its annualized total return
of 6½ –7% beats inflation however you want to measure it – core,
headline or median CPI. Well – as I frustratingly tried to explain to my
mother for years – this total return concept of price and yield appeals
primarily when yields come down and bond prices go up.
Think of bonds, Mom, as you would a teeter-totter, I would say.
Interest rates go down – bond prices up. Vice versa too, except that
beginning in 1981, the totter rarely teetered in the negative price
direction. Bull markets in bonds, stocks and real estate rode an asset
appreciation escalator that induced an artificial euphoria on the part
of many investors expecting the ride to never end. Even conservative
old-fashioned bonds – more famous for “coupon clipping” than capital
gains – were bolstered by this secularly positive, total return concept.
Well, much like the Tower of Babel, Treasury bond prices cannot
be heaven bound but have more earthly limitations. While stock values
are often complicated by growth rate assumptions and P/E ratios making
their ultimate destination uncertain, bond yields at least have a
mathematical zero bound below which they cannot journey for more than a
few nanoseconds. Investors don’t give up their money for the promise of less
money in return and so negative nominal yields are a mathematical
impossibility aside from fears of government confiscation and temporary
liquidity considerations. But here is where it gets tricky and where our
soon-to-be-boiled frog comes into play. Much like gradually turning up
the temperature on poor froggy’s kettle of water, monetary policy in
developed countries has been lowering the temperature and absolute level
of yields for the past 2½ years post Lehman Brothers. Teeter-totter
yields down, teeter-totter prices up, and froggy’s total return euphoria
at present seems to know no bounds. But once the potential for even
lower interest rates is minimized by the zero floor, our future
frog-legged entrée is left with a rather uncomfortable feeling. He’s
resting inertly in this caldron as prices near the boiling point with
the Fed, the Chinese and the banks all buying up whatever Treasury bonds
are offered. Everything appears well. But bond investors with a
survival instinct (being one and the same as our cooking frog) should
reflect on that old teeter-totter metaphor and realize that prices near
the boiling point automatically imply yields near subzero. Granted,
5-year Treasury rates near 1.70% are not zero and 10s and 30s are even
better, but much of the Treasury yield curve now rests in negative
territory when compared with expected future inflation, and that should
send our bond investor into a hoppin’ funk. Prices are already nearing
the boiling point and his coupons are subzero, CPI adjusted. Total
return…and our frog…are cooked, or if not they are certainly trapped in a
future low return kettle of water.
Carmen Reinhart and coauthors writing for the National Bureau
of Economic Research have exposed this dilemma in more sophisticated
prose. In her second research paper, entitled “The Return of Financial
Repression,” she affirms PIMCO’s thesis of skunking, pocket-picking and
frog cooking by describing a century-old policy maneuver used by
governments facing a debt crisis. Rather than outright default, many
countries attempt rather successfully to keep nominal interest rates
lower than would otherwise prevail. Reinhart characterizes this as
“financial repression” because over the long term it results in a
transfer of wealth from savers to borrowers. Governments, having taken
on too much debt, rather stealthily lower interest rates via
central-bank-enforced policy rates or maneuvers such as “quantitative
easing.” The artificial yields, in effect, act as a tax on savings,
undercompensating asset holders and transferring the haircut benefits to
the debtor nation. Coincidentally (and certainly serendipitously),
corporate and some household balance sheets are re-equitized as the
negative or historically low real interest rates allow economic growth,
profits and some wage earners to build up a margin of safety for future expansion.
 
Chart 1 shown below is graphic evidence of Reinhart’s
financial repression over the past century, comparing two repressive
periods (1945–1980 and 2008–2011) to a more normal interest rate
environment without artificial government yield dampeners (1981–2007).
Both periods of repression show bell-shaped curves shifted markedly to
the left, with today’s current cycle offering 2½% less yield for the
average G-7 nation than what bond investor frogs have gotten used to
since 1981. Actually, in the U.S., May’s month-end estimate for real
Treasury bill yields shown in Chart 1 would be 5% less than what Reinhart shows as the average compensation for the last 30 years! 
 
 
 
All right fellow frogs, so we’re being repressed and shortchanged
in order to allow Uncle Sam to balance its books. Whatta we gonna do
about it? “Frogs of the world unite,” as Lenin might have said, and so
here’s where I harken back to Mark Twain and my second lesser-told frog
story. There was this other frog who instead of being tossed into a pot
of hot water was left to cool its heels in a pitcher of cold milk.
Unable to jump out, he churned and churned those frog legs until
eventually the milk turned into butter and the hardened butter allowed
him the platform to leap to froggy freedom! Well, let’s get churnin’,
fellow frogs. If the U.S. or the U.K. or any other government is going
to attempt to boil us alive, let’s make butter! Butter in this instance is what PIMCO characterizes as “cheap bonds.
Potentially confusing, “cheap bonds” is really a simple concept – sort
of like the teeter-totter. Any bond, even a Treasury bond, is composed
of several pieces – sort of like an atom with its neutrons, electrons,
protons, positrons, neutrinos (whoops, don’t wanna go too far here).
There’s an interest rate or yield piece, commonly measured by
“duration.” There’s a credit piece, typically referred to as a “spread”
when you buy a corporate bond. And there’s a volatility piece, a
liquidity piece and other little bits and particles that will go
unexplained for now. The important point, though, is that if the
government is going to artificially repress yield, then an intelligent
frog should focus on the parts of a bond that are less repressed! You
can, for instance, produce a 1% expected return in today’s market in a
number of ways. Buy a repressed 3-year Treasury note at just under 1%,
or purchase an A-rated corporate floating rate note (FRN) with little to
no durational risk at a 3-month LIBOR +75 basis points spread,
currently returning 1%. Which is the better deal? Well, they both appear
to lead you to the same place but our cheap bonds argument would
maintain that the FRN gets you there with a lot less risk. The credit
piece, in other words, is a safer spread than the duration piece.
Journalists, financial advisors, and perhaps even some clients
marvel at how PIMCO can be doing so well in 2011 while being underweight
the Treasury/durational component of the bond market. Folks – we're
making butter. If you’re being repressed, our strategy is to churn those
legs, get out of the pitcher, and above all stay away from boiling pots
of water. Recent press coverage has focused on the end of QEII and what
it may or may not do to Treasury prices. Let me reaffirm what we’ve
said for many months now. Because the QEs cover an extraordinary period
of monetary policy with a limited time frame, there is not enough data
to indicate whether the end of QEII will lead to higher or even lower
rates, although higher is our strong preference. “Who will buy them?” remains a critical question to be answered.
There is, however, overwhelming evidence – now provided by Carmen
Reinhart among others – that existing Treasury yields fail to adequately
compensate investors for the risk of holding them when measured on an
historical basis.
We suggest buying “cheap bonds” focusing on “safe spread,”
which means buying more floating and fewer fixed rate notes, adding an
additional credit component – be it investment grade, high yield,
non-agency mortgage or emerging market related – and shading your
portfolio in the direction of non-dollar emerging market currencies.
Investors shouldn’t give their money away, and at the moment, the
duration component of a bond portfolio comes close to doing just that –
not because a bear market is just around the corner come July 1, but
because it doesn’t yield enough relative to inflation. Come on frogs,
make butter, not someone else’s dinner. Buy cheap bonds!
 

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Wed, 06/01/2011 - 08:35 | 1328006 francis_sawyer
francis_sawyer's picture

FROGS OF THE WORLD UNITE!

http://www.youtube.com/watch?v=LuyS9M8T03A

 

Wed, 06/01/2011 - 08:53 | 1328065 BlackholeDivestment
Wed, 06/01/2011 - 10:46 | 1328560 Mountainview
Mountainview's picture

I feel some heat at an unusual place...

Wed, 06/01/2011 - 08:35 | 1328010 oogs66
oogs66's picture

If Bill keeps this up he may be kicked off Ben's inside information speed dial.

Wed, 06/01/2011 - 08:36 | 1328015 oh_bama
oh_bama's picture

Well it seems bill's relationship with the fed is not getting anywhere..

he used to be a friend of most of the fed people

 

Wed, 06/01/2011 - 08:38 | 1328020 Tense INDIAN
Wed, 06/01/2011 - 08:37 | 1328025 Long-John-Silver
Long-John-Silver's picture

I've put Fried Frog Legs on tonight's menu. Side Salad and Hush Puppies along with gallons of Sweat Tea will round it out. A 1oz Silver round will take care of the meal and gratuity. Dress casually as always.

Wed, 06/01/2011 - 08:46 | 1328041 DavidC
DavidC's picture

Do you actually MEAN Sweat Tea? Yuck!!!

DavidC

Wed, 06/01/2011 - 08:48 | 1328060 Long-John-Silver
Long-John-Silver's picture

If you've ever been to a Southern Fish or Frog fry after Memorial Day you would understand why we call it Sweat Tea. You drink the Tea and it shows up on your forehead immediately. 

Wed, 06/01/2011 - 18:47 | 1330660 DavidC
DavidC's picture

Ah! Thanks for the clarification Long-John.

:-)

DavidC

Wed, 06/01/2011 - 08:40 | 1328027 trav7777
trav7777's picture

why doesn't his bitch ass actually go and do something PRODUCTIVE with the funds instead of sitting around whining for free yield through paper shenanigans.

Gross should really try to go EARN that yield.

Wed, 06/01/2011 - 08:49 | 1328052 Bob
Bob's picture

He's a victim of all that repression, it sounds like. 

Wed, 06/01/2011 - 10:16 | 1328377 4shzl
4shzl's picture

Gross "earns" his keep by LYING: he trash-talks Treasuries while PimPco's traders accumulate zero-coupon 30yrs.  LYING pays very, very well.

Wed, 06/01/2011 - 08:43 | 1328032 TooBearish
TooBearish's picture

Gross is trading with out a stop which is hubris of the first degree- his short in the 5yr note futures is more than 2points against him - its gunna be awesome when he flips position at 1.50 calling for 1.25 5yr yield.....

Wed, 06/01/2011 - 08:50 | 1328053 Boston
Boston's picture

That's exactly what I was thinking he might do!  As I was loading up at 2.0%, I was thinking of the catalysts that could ultimately drive it down to even 1.0% (near last fall's lows).

And a Bill Gross flip flop is on my list of possibilities.

He really blew it on this one!

 

Wed, 06/01/2011 - 08:46 | 1328054 HpDeskjet
HpDeskjet's picture

Yep, without QE3 (at least for a month or 5-6), the government will be forced to cut spending => both inflation and growth will drop fast. Holding bonds for the next few months is not stupid... Longer term (if the printing presses are started again) Gross can be right

Wed, 06/01/2011 - 08:42 | 1328039 Boston
Boston's picture

Thanks Bill.

As soon as the 10 year crashes through 2.5% (3.0% now), I'll take up your advice and exit (or fully hedge) my long position (which is 50%+ of the portfolio).

In the meantime, I'm enjoying the ride.....which began at 3.6%.

Wed, 06/01/2011 - 09:00 | 1328040 Mercury
Mercury's picture

Whatta we gonna do about it? “Frogs of the world unite,” as Lenin might have said" and urges bondholders to be properly compensated for their risk by switching out of "rich" fixed rate into "cheap" floating rate exposure.

Yes but a "risk off" trade triggered by the end of QE2 (and articulated yesterday on ZH)http://www.zerohedge.com/article/qe3-has-already-started could drive even more funds into (fixed rate) Treasuries which would push yields even lower (and prices higher).

A few different ways this could break in the near/medium term even though there is probably only one end game...

Wed, 06/01/2011 - 08:50 | 1328055 bigwavedave
bigwavedave's picture

i've commented before here on ZH about how PIMCO moves their exposure. They are a like a big tanker negotiating a storm. BG himself is fond of sailing analogies. They are making good money in all their funds. They are not short much of anything. Remember that all boats need to sail into the wind. That is where the traction is. I'm of the opionion that BG is bang on. They are a smart consensus group of thinkers and dont change tack often. They have to be early as I have said before because they are BIG. Short? They are short the USA not net short anything.

Wed, 06/01/2011 - 09:16 | 1328111 topcallingtroll
topcallingtroll's picture

You should spend more time in a sailboat.

Running with the wind is the fastest. Sailing tight sheets close hauled into the wind is slow torturous, and gives you a headache and a pounding, not the good kind.

But Bill is definitely sailing into the wind. Maybe the hard slow way will be the right way in the end.

Wed, 06/01/2011 - 09:45 | 1328251 disabledvet
disabledvet's picture

"tacking."

Wed, 06/01/2011 - 09:19 | 1328133 TooBearish
TooBearish's picture

Really - so how do you explain the -650k institutional short in FV note futures?

Wed, 06/01/2011 - 08:49 | 1328062 monopoly
monopoly's picture

I think he will win. Just taking some time. Nice ADP report.

Wed, 06/01/2011 - 08:55 | 1328075 Downtoolong
Downtoolong's picture

God I hate it when I find out I’ve been thinking like Bill Gross, especially since most of my moves come from my gut and not the infinite dissection of bond value and rate minutia he gets into. I’ve been shifting out of my total bond fund (mostly treasuries) into short-term corporate bonds for six months now, anticipating the price collapse in treasuries that he is talking about. But, thanks for the heads up Bill, better late than never.

Wed, 06/01/2011 - 08:58 | 1328077 Caviar Emptor
Caviar Emptor's picture

Frog went a courtin' and he did ride, uh-huh
Frog went a courtin' and he did ride, uh-huh
Frog went a courtin' and he did ride
With a sword and a pistol by his side, uh-huh uh-huh uh-hu

Wed, 06/01/2011 - 08:59 | 1328082 topcallingtroll
topcallingtroll's picture

You populists and anti-rich ought to agree with this.

Somebody is going to lose during this rebalancing.

Do you prefer to risk bondholder returns not keeping up with inflation, or do you prefer increasing unemployment and general suffering of poor people in a depression.

People in debt and the bottom 50 percent in general fare worse under depression than mild inflation. Inflating out of ones problems makes bondholders and savers ( the rich) pay.

Wed, 06/01/2011 - 09:16 | 1328123 HpDeskjet
HpDeskjet's picture

You are right, but the "inflation-route" has been tried the last 2 years and it failed miserably... It only accomplished oil prices at $100+ that kill "the recovery" while U6-unemployment did not improve at all.

US has just to bite the bullet of reducing government spending, cutting entitlements, cutting medicare etc. and face the accompanying depression that has been kicked down the road 2 more years

Wed, 06/01/2011 - 09:18 | 1328132 topcallingtroll
topcallingtroll's picture

You are probably in the top half of the income scale and dont have significant debt.

Wed, 06/01/2011 - 10:59 | 1328631 MachoMan
MachoMan's picture

Even in your inflationary "less worse death" scenario, wages are stagnant...  so that debt isn't getting repaid anyway. 

Wed, 06/01/2011 - 09:53 | 1328270 BobPaulson
BobPaulson's picture

I sortof thought the can kicking has been more like 30 years.

Wed, 06/01/2011 - 11:03 | 1328659 MachoMan
MachoMan's picture

Probably more than that (since our last collapse), but less obvious...  Hopefully all the pressure built up in the meantime doesn't cause an exponential increase in the devestation of collapse...   

Wed, 06/01/2011 - 09:01 | 1328083 Life of Illusion
Life of Illusion's picture

 

Now he wants to calm nerves and say it’s a process not an event.

Too bad politically he could not purchase gold when it was below 1k or other hard assets.

In 5 years he will act like his call was spot on. Gold will be over 3k oz.

 

Wed, 06/01/2011 - 09:20 | 1328135 buzzsaw99
buzzsaw99's picture

He finished with the pimpco rendition of It Ain't Easy Being Green.

http://www.youtube.com/watch?v=hpiIWMWWVco

Wed, 06/01/2011 - 09:30 | 1328179 BobPaulson
BobPaulson's picture

Thanks for these kinds of posts. This is where I learn stuff on ZH.

Wed, 06/01/2011 - 09:38 | 1328195 casey13
casey13's picture

It seems like many want to milk the last few percentage points of this move before exiting. Bill Gross has a huge fund and can not be nimble so he has exited a little early. He is not wrong and playing this move for a little more can be a dangerous game when you are dependant on governments especially foreign ones for support. A currency crisis is almost inevitable at some point when it starts it will be fast and the bond exit funnel will be very small.

Wed, 06/01/2011 - 10:15 | 1328392 blindman
blindman's picture


London Banker
http://londonbanker.blogspot.com/search?q=Concentration%2C+Manipulation+...
...
"In October 2008 the global financial markets crashed. The story in the media is
that it was a panic caused by the insolvency of Lehman Brothers. This is not the truth -
or at least not all of it. The crash actually followed a $2 trillion margin call by these
four global banks on their prime brokerage clients and OTC counterparties - effectively a
30 per cent increase in required margin. It was the margin call that forced liquidation
of global portfolios of all asset classes - and particularly the high quality, most
liquid asset classes."
..
comment and links.....
leverage margin call doomsday opaque
derivatives.. - paper scam. ongoing
dr. strangelove written all over it.
.
Max Keiser NAPK???= PEY?O TPA?Z? (drugs, banks
and the Crisis, Greek subs)
http://maxkeiser.com/2011/05/31/max-keiser-napk%cf%89%cf%84%ce%b9%ce%ba%...
.

http://www.thepeakeffect.com/2011/04/top-25-holders-of-derivatives-total...
.
According to the 2rd qtr. OCC Derivative Report, the 5 largest holders of derivatives
(commercial banks) hold 97% of all derivatives.
http://investmentwatchblog.com/according-to-the-2rd-qtr-occ-derivative-r...
.
There is still over $1000 TRILLION in bad paper sitting out there according to the Bank
of International settlements!
November 8th, 2009
http://investmentwatchblog.com/there-is-still-over-1000-trillion-in-bad-...
.
http://www.democraticunderground.com/discuss/duboard.php?az=view_all&add...
.
The Doomsday Machine in Dr. Strangelove
http://www.youtube.com/watch?v=cmCKJi3CKGE
.
all right, this is too much information.
i couldn't easily find the european exposure/participation in the derivative deal.
or london but it is probably substantially likewise fictitious?
.
"the whole point of a doomsday machine is lost if you keep it a secret
why didn't you tell the world, ey.?" dr. strangelove.

Wed, 06/01/2011 - 18:24 | 1330584 Anonymouse
Anonymouse's picture

There was this other frog who instead of being tossed into a pot of hot water was left to cool its heels in a pitcher of cold milk. Unable to jump out, he churned and churned

A Chritopher Walken classic:  http://www.youtube.com/watch?v=51lFmdChOA0

 

 

 

Wed, 06/01/2011 - 19:26 | 1330768 unum mountaineer
unum mountaineer's picture

Long bond over dxy...thats easy to see. Debasement of the dollar is so visible

Wed, 06/01/2011 - 19:26 | 1330769 unum mountaineer
unum mountaineer's picture

Long bond over dxy...thats easy to see. Debasement of the dollar is so visible

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