One week ago, in an interview with Bloomberg, Bill Gross made a surprising announcement when he said that he was starting to short credit. As he said at the time, "It’s really hard to change your psychological makeup and to be a hedge manager that is comfortable with being short,” he said during his interview. “I’m working on it, because I’m an investor that ultimately does believe in the system, but believes that the system itself is at risk."
In his just released monthly letter, "Bon Appetit!", he provided some additional insight on why he has become so bearish on credit instruments. In short, as he says that since the inception of the Barclays Capital U.S. Aggregate or Lehman Bond index in 1976, investment grade bond markets have provided conservative investors with a 7.47% compound return with remarkably little volatility.
He then says that his take from these observations is that this 40-year period of time has been quite remarkable – "a grey if not black swan event that cannot be repeated."
He attributes this tremendous performance to the "carry" trade, facilitated by ever higher debt, and ever lower interest rates over the past 30 years, a condition he thinks will not repeated again.
What does this mean in practical terms? Gross summarizes his thesis in more compact form, noting that anyone seeking such historical returns, will not find them on earths: perhaps on Mars.
"For over 40 years, asset returns and alpha generation from penthouse investment managers have been materially aided by declines in interest rates, trade globalization, and an enormous expansion of credit – that is debt. Those trends are coming to an end if only because in some cases they can go no further. Those historic returns have been a function of leverage and the capture of “carry”, producing attractive income and capital gains. A repeat performance is not only unlikely, it is impossible unless you are a friend of Elon Musk and you’ve got the gumption to blast off for Mars. Planet Earth does not offer such opportunities. "
He then goes on to explain why the "carry" trade will no longer provide the kind of returns investors are used to.
- Duration is unquestionably at risk in negative yielding markets. A minus 25 basis point yield on a 5-year German Bund produces nothing but losses five years from now. A 45 basis point yield on a 30-year JGB offers a current “carry” of only 40 basis points per year for a near 30-year durational risk. That’s a Sharpe ratio of .015 at best, and if interest rates move up by just 2 basis points, an investor loses her entire annual income. Even 10-year U.S. Treasuries with a 125 basis point “carry” relative to current money market rates represent similar durational headwinds. Maturity extension in order to capture “carry” is hardly worth the risk.
- Similarly, credit risk or credit “carry” offers little reward relative to potential losses. Without getting too detailed, the advantage offered by holding a 5-year investment grade corporate bond over the next 12 months is a mere 25 basis points. The IG CDX credit curve offers a spread of 75 basis points for a 5-year commitment but its expected return over the next 12 months is only 25 basis points. An investor can only earn more if the forward credit curve – much like the yield curve – is not realized.
- Volatility. Carry can be earned by selling volatility in many areas. Any investment longer or less creditworthy than a 90-day Treasury Bill sells volatility whether a portfolio manager realizes it or not. Much like the ”VIX", the Treasury “Move Index” is at a near historic low, meaning there is little to be gained by selling outright volatility or other forms in duration and credit space.
- Liquidity. Spreads for illiquid investments have tightened to historical lows. Liquidity can be measured in the Treasury market by spreads between “off the run” and “on the run” issues – a spread that is nearly nonexistent, meaning there is no “carry” associated with less liquid Treasury bonds. Similar evidence exists with corporate CDS compared to their less liquid cash counterparts. You can observe it as well in the “discounts” to NAV or Net Asset Value in closed-end funds. They are historically tight, indicating very little “carry” for assuming a relatively illiquid position.
The “fact of the matter” – to use a politician’s phrase – is that “carry” in any form appears to be very low relative to risk. The same thing goes with stocks and real estate or any asset that has a P/E, cap rate, or is tied to present value by the discounting of future cash flows. To occupy the investment market’s future “penthouse”, today’s portfolio managers – as well as their clients, must begin to look in another direction. Returns will be low, risk will be high and at some point the “Intelligent Investor” must decide that we are in a new era with conditions that demand a different approach. Negative durations? Voiding or shorting corporate credit? Buying instead of selling volatility? Staying liquid with large amounts of cash? These are all potential “negative” carry positions that at some point may capture capital gains or at a minimum preserve principal.
But because an investor must eat something as the appropriate reversal approaches, the current penthouse room service menu of positive carry alternatives must still be carefully scrutinized to avoid starvation. That means accepting some positive carry assets with the least amount of risk. Sometime soon though, as inappropriate monetary policies and structural headwinds take their toll, those delicious “carry rich and greasy” French fries will turn cold and rather quickly get tossed into the garbage can. Bon Appetit!
A fair warning, but one which will be ignored for the simple reason that at least for now, the music is still playing, and as Sandy Weill said it so well not too long ago, the dance must go on.