The Big Picture Isn't Pretty

The nation's leading fixed-income manager is bearish on the economy and bullish on municipal bonds.

When Bill Gross talks about the economy and the bond market, investors listen. Gross, arguably the nation's best-known bond-fund manager, is chief investment officer of Pimco, a Newport Beach, Cal., firm that manages fixed-income assets totaling $747 billion. He and his team are known for their uncannily accurate big-picture calls on the economy and the direction of interest rates.

Their forecasting skills have helped propel Pimco Total Return, the firm's flagship, to one of the best records in the fund business. The institutional share class (symbol PTTRX) returned 9.1% last year, compared with 4.7% for the average intermediate taxable-bond fund, according to Morningstar. Over the past 20 years to February 1, Total Return gained 8.4% annualized, compared with a category average of 7.0%.

You need $5 million to buy the institutional shares. Other classes with sales charges or higher fees are available with lower minimums. But Gross also runs Harbor Bond (HABDX), a low-minimum look-alike that is a member of the Kiplinger 25. Harbor's fees are only slightly higher than those of Pimco's institutional class.

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With the economy weakening and markets in turmoil, it seemed like a perfect time to get Gross's perspective. What follows is an edited version of the interview, conducted on an unusually chilly day at Gross's Southern California office.

KIPLINGER'S: Is the U.S. economy in recession?

GROSS: I think so. The drop in consumption during the Christmas shopping season and the continuing housing debacle combined with a slowing global economy may have produced the beginning of a recession.

How severe a downturn do you expect? That's a hard question. Our economy has never experienced anything like this -- an implosion of the credit markets, a reversal of what we call the shadow banking system (meaning hedge funds, structured investment vehicles, all sorts of financial conduits), a reduction in lending of significant proportions and diminished prospects for a reversal anytime soon.

In previous cycles, the solution was always to lower interest rates, get banks in the spirit of things, and away we go. Now it's not so easy because the banks themselves have problems. And because adjustable-rate mortgages are passé, the housing market is not really linked to short-term interest rates anymore. The 30-year mortgage is the mortgage du jour, and 30-year rates aren't low enough to stimulate a housing recovery -- and probably can't go low enough. It's hard to know how long this will continue.

You've described a bleak scenario. It certainly paints a picture of very slow or even negative growth for much of 2008. And 2009 will not be that prosperous because the tools that we have used in the past to produce relatively strong recoveries are not applicable in this kind of environment.

Meaning one in which the banks are reluctant to lend? Yes. But in the past five years, lending has really been taken over by the shadow banks. To bring back the spirit of lending means that you not only have to get the banks healthy, but you also have to have some rejuvenation of this shadow system, which frankly is not coming back soon.

Did you manage to keep your funds out of the toxic areas? Two years ago, it became obvious with all the funny-money mortgages being created that something was amiss. And so what we did here at Pimco was to take ten of our credit analysts, the people who were following General Motors and IBM, and said, "Hey, that's not where the problem is. The problem is in real estate. So each of you is assigned to a different city in the U.S. Pretend you're a home buyer and come back and report on the trends in the housing market in your particular area." And so we were the first ones to know that subprimes were dangerous, and we stayed away from them entirely. That's one of the reasons we're at the top of the heap, as opposed to the bottom.

Is that how you managed to earn 9% last year at Pimco Total Return? We pulled off a double play. Staying away from the junk was the out at second base, so to speak. But to get the next out at first base, we acted on the expected policy response -- meaning the Federal Reserve lowering interest rates -- and we bought two-year and three-year Treasuries, safe assets but ones that would benefit from the decline in the federal funds rate that we expected. So the throw to second, the throw to first, double play.

What's your assessment of the government's fiscal-stimulus package? I think it's required. It puts money back in the hands of Americans and consumers. But let's not forget that the problems that got us here are problems of consumption and undersaving -- that is, no savings -- and this just represents more of that. It takes money and puts it into the hands of a consumer in Des Moines, who spends it at a Wal-Mart, which ultimately shifts it over to China. That's fine. Let's give the economy a little bit of a jolt. But ultimately, fiscal policy has to be oriented into something that deals with infrastructure, R&D and housing, and encourages saving.

Where do you see long-term and short-term interest rates a year from now? I see the Fed ultimately going to 2.5% and the ten-year Treasury, which is now around 3.6%, probably remaining at around that level.

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How will people make money in bonds this year? Not with the approach that we've made so much money in -- namely, short-term, two-year Treasuries. The two-year Treasury yields only 2.15%. We are moving away from that.

Is there a bubble in Treasury prices? Even if there is one, if the Fed goes low and stays low, which I think it has to, then the bubble doesn't pop. But 2.15% is certainly an absurd return other than for the safety of the asset. Ultimately, the way to make money in 2008 will be to gradually extend into the high-quality corporate bond area and then into the low-quality areas late in the year. Risk-averse investors are shunning both areas now.

For instance, today we bought $500 million of Wachovia's ten-year senior holding-company notes -- double-A-rated paper issued by one of those too-big-to-fail types of banks. They sold at a spread of 200 basis points over Treasuries, or 5.5% [one basis point is one-hundredth of a percent]. So our strategy is to move gradually from Treasuries to double A's to single A's to Baa [the lowest investment grade] and yes, at some point, God help us, back to junk bonds.

You would presumably want to see some improvement in the economy before wading into junk bonds. Yes, we wouldn't want to invest in a Baa bond or a junk bond unless we saw a recovery.

With the Fed opening the money spigot, are you worried about inflation? Yes. The global economy has changed. We're resource-short and commodity-short, and demand from developing countries is unlikely to decline anytime soon. And so if you have perpetual demand for oil and for commodity-like products -- whether it's food, bauxite or iron ore -- then it's not the same situation as you have with a typical U.S. decline, during which demand tapers off. You also have to be aware that the Chinese currency, the RMB, is appreciating at a 10%-per-year clip against the dollar. All things being equal, that means Chinese exports to us, such as toys and all those other good things, should be going up at a 10% rate, too. So that's another problem.

How should individuals be positioning their bond portfolios? The most attractive area is municipal bonds. Muni bonds have been tossed away for several reasons. First, they're not bought by the Chinese or the Saudis. The Saudis have no use for a municipal bond and its tax advantages. That's one of the reasons they haven't gone up in price and down in yield.

Second, insurers such as AMBAC and MBIA have guaranteed some of these conduit structures that have been affected by the subprime problems. These insurers are now teetering on the edge and may lose their triple-A ratings. If that happens, insured municipal bonds, which are naturally single-A and double-A pieces of paper, will lose their triple-A ratings, and many investors will be forced to liquidate their positions in those bonds. But the inherent quality of single-A and double-A bonds -- a school district in Fresno, for example -- is strong. It's hard to find municipal defaults. So at yields that are more than government yields -- and actually more in many cases than double-A and single-A corporate yields -- munis are really attractive.

What's the best way to buy munis? I own a lot of closed-end municipal bond funds. Many trade at 5% to 10% discounts to their net asset values and at yields of 5%, plus or minus. Pimco has some, Van Kampen has some, Nuveen has some, BlackRock has some. A lot of closed-end funds carry the word insured in their names. Investors have run from those funds as fast as you can imagine and therefore sold them down to unrealistic levels.

Aren't most closed-end muni funds leveraged? That's right. But that's even better because the cost of that leverage is going down, down, down as the Fed lowers rates, and so it's a double play.

How do you analyze these closed-ends to avoid buying one that cuts its dividend? It's difficult. The best thing to know is that during periods of rising interest rates, which is what we'd seen up until last September, the probability of a dividend cut increases dramatically because the cost of the funds' borrowing goes up. When the Fed lowers interest rates from 5.25% to 3%, and maybe lower, then profit margins improve and the possibility of a dividend cut is dramatically lower. The next step is to find a fund family that has a good history of maintaining dividends. The ones I mentioned earlier are good places to look.

If the rating agencies downgrade the bond insurers, won't muni-bond prices decline even more? In most cases, the difference in yield between an insured municipal bond and a double-A bond is 10 to 15 basis points. On a typical maturity, that's a price decline of maybe 1% at most.

To a buy-and-hold investor, a price decline of that size shouldn't matter. Right.

Manuel Schiffres
Executive Editor, Kiplinger's Personal Finance