Inflation and Bond Investing

Food for Thought

Bill Gross of Pimco the world’s largest fixed income manager issues periodic analysis of the markets and the economies. The newly released newsletter is a particularly good one and is highly recommended.

Gross has been in the high inflation camp for several years and in the current piece he levels a high degree of skepticism about official government inflation numbers. He points to data for a representative group of countries developed and emerging which shows an average inflation rate of 7% for both the last 10 years and the past 12 months. Official US government inflation rate for those 2 periods: 2.6% for the last 10 years, 4% for the last 12 months. Gross (and I would agree) find that gap not credible.
Two graphs from his newsletter are at the top of this post.


Gross’ conclusions for investors make sense. Since we are not traders we have integrated emerging market foreign securities and commodities into our portfolios for quite a long time. While Gross’s caveats with regards to TIPS are valid they still make sense in a portfolio and as he notes are far superior to conventional treasuries.

A readjustment of investor mentality in the valuation of all three of these investment categories – bonds, stocks, and real estate – would mean a downward adjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial real estate…..

What are the investment ramifications? With global headline inflation now at 7% there is a need for new global investment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest: 1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars.


http://www.ft.com/cms/s/0/37f7e034-2878-11dd-8f1e-000077b07658.html
As for his positioning in his bond fund, Gross (see below as reported in the Financial Times) is implementing his view that US treasuries are extremely unattractive given their negative real yield. Instead he has moved into mortgage backed debt based on the yield spread over treasuries and what he perceives as a strengthened implied government guarantee for Fannie Mae and Freddie Mac. Our portfolios have moved into mortgage backed securities in a more cautious manner by investing in a GNMA bond fund. GNMAs are mortgages which carry the full faith and credit of the US treasury (unlike fannie and freddy) yet it seems the mere word “mortgage has scared away investors and pushed up yields. The Vanguard GNMA fund currently yields 4.76 vs 3.20 for their equivalent maturity treasury bond fund

Pimco's Gross makes big mortgage debt bet
By Deborah Brewster in New York
Published: May 23 2008 03:00

Bill Gross, the manager of the world's biggest bond fund, has switched gears to make a big bet on mortgage debt, almost tripling his holding of it to more than 60 per cent of the fund…..
Mr Gross said his decision to raise exposure to mortgage debt in recent months was based on the US government's implicit guarantee of Freddie Mac and Fannie Mae, the government-sponsored mortgage agencies.
"Government policy is moving to sanctify the status of the government-sponsored agencies . . . it became a question of which institutions would be sheltered by the government umbrella," he said…..
Mr Gross said Pimco was buying primarily mortgage agency debt and "not the subprime garbage"…..
Mr Gross was heavily overweight US Treasury bonds in the early 2000s but is now scornful of them and the fund is using derivatives to gain from any downturn in Treasuries.
He called Treasuries "the most overvalued asset".
"If there was a bubble, the -popping has produced a counter-bubble in quality securities. The safe haven has been way overdone. Treasuries are yielding 2 to 3 per cent, there is no real return on that at all," he said.
"This is an asset class that is held by sovereign wealth funds and central banks . . . but that is not any reason to follow them