For most of the last 30 years, bond investors have been spoiled. While some of those relying on collateralized mortgage obligations and other bad real estate loans originating in the 2000s certainly got clobbered, for the most part, bond investors have benefited from a massive, long-term decline in interest rates since 1980.
The mirror image of falling rates, of course, is an increase in bond prices. Throw in a marked decline in inflation – a cancer to long-term lenders of all stripes – and real returns to bondholders have been strong for a generation.
Well, all good things must come to an end, and it looks like that’s the case now for bondholders. Interest rates have been picking up across the board, pushing bond prices down. The Barclays U.S. Aggregate Bond Index (AGG) is down 2.68 percent year-to-date, as of the market close on August 15, 2013. The Global Aggregate index is down 3.67 percent. Bond investors are quickly getting reacquainted with the concept of risk.
What Does This Mean for Income Investors?
If you need income from a portfolio, you have got to get it from somewhere. So what should the income-oriented investor keep in mind as we enter a potentially long headwind of rising interest rates?
Well, the short answer would be to choke up on the bat. Pull in your average maturities or durations in your portfolio to shorter periods. This way, small interest rate increases should produce more modest losses.
But Bill Gross, the manager of the PIMCO Total Return Fund (PTTRX) the largest bond mutual fund in the world, thinks that’s not the optimal strategy. Indeed, he compares it to the British using outdated tactics at the Battle of the Somme, and getting mowed down by modern German machine gun fire.
“I write to alert you to evolving thinking that might win this new war without causing you – the investor – to desert an historical and futurely valid asset class that we believe can still provide reliable income and hopefully steady returns even in the face of higher interest rates,” Gross writes.
Bill Gross’ Strategy
What’s Gross’ thinking?
In a nutshell, Gross is trying to make the case for bond investing by thinking beyond pure semi-annual interest payments, and into other factors that can fuel total return, over and above periodic interest payments. To unlock these factors, Gross tips his hand: Rather than rely entirely on a rush to safety and the short end of the yield curve, Gross hints at forays into assets denominated in other currencies, for example. As the dollar loses value against other currencies, much of the risk of a risking interest rate in the U.S. can by diversified away.
We see this already in Europe and Asia: Despite the fall in both the U.S. and Global aggregate bond indexes since the beginning of the year, both the Barclays Asian Pacific Aggregate Index and the Barclays Euro Aggregate index are up year to date, by 1.62 percent and 0.86 percent, respectively.
Gross also writes that the skilled bond investor can also generate alpha, or excess risk-adjusted return, by exploiting things like the volatility premium, mispriced credit risk, and taking advantage of underprice points in the yield curve – emphasizing a “bullet” strategy of focused investment on an underpriced duration point rather than a barbell or diversified strategy.
Gross is, of course, advocating a ‘risk on’ strategy to navigate the rising rate environment – he’s just adding risk from different directions to make up for pulling in on the yield curve, much like a boat captain might navigate a strong head current by revving up his engines or adding more sail and tacking back and forth as he sails into the wind.