Fri Jul 30, 2010 2:16pm IST
By Natsuko Waki
LONDON (Reuters) - Investors wary of investment grade corporate bonds because of a heavy presence of banks in them may have a rethink thanks to greater clarity surrounding European banks, prompting a switch back from high-yield debt.
High-yield bonds -- typically riskier paper rated below investment grade -- have been a hot credit asset over the past year as it was an "ex-banks" trade for those who were worried about the fallout from Europe's sovereign debt crisis.
This resulted in a rush of funds into the so-called junk space, with fund tracker EPFR estimating nearly $6 billion had flown into a broader high-yield bond universe since January.
However, the tide may be turning in favour of higher-quality investment grade after last week's European bank stress tests were conducted without incident and banking regulators scaled back proposals to beef up global bank capital and liquidity rules.
"High yield has outperformed basically because it was not banks. That was pretty much the best thing you could say about the asset class," said Christian Dinesen, head of international corporate credit research at Bank of America Merrill Lynch.
"But for the rest of the year, senior financials should, particularly after this benign result of the stress test, have a pretty good run. High-yield is okay but ... risk-return wise investment grade is probably better."
A Reuters poll of global asset managers published on Thursday showed exposure to investment grade bonds rose to 22.6 percent in July from 19.7 percent in June. High yield debt was less popular.
Until now, investment grade bonds have struggled this year, especially in Europe, where more than one in two issues come from banks.
European high-grade corporate issues, which have sovereign-like ratings in the investment grade space, returned 0.7 percent less than benchmark governments this year, BofA Merrill estimated.
In contrast, junk debt gave an excess return over government bonds of 0.94 percent in the same period.
Based on prices, global junk debt rose 22.7 percent over the past year while top-rated corporates gained 7.3 percent.
BofA Merrill forecasts spreads of high grade European debt to tighten 27 basis points from current levels to 202 bps towards the year end, giving an excess return over government bonds of 1.5 percent.
Goldman Sachs expects spreads of triple-B issues -- the riskiest segment within the investment grade space -- to hit 175 bps this year, their lowest since late 2007.
The positive performance outlook comes against a backdrop of falling default rates. According to Standard & Poor's, the 12-month rolling default rate for global investment grade paper stands at just 0.21 percent, down from 0.41 percent in 2008.
"We remain confident in investment grade, this is one of our clear risk trades. The risk rewards are clearly tilted towards the positive side. On HY, valuation is a little bit too stressed," said Franz Wenzel, senior strategist at AXA Investment Partners in Paris.
A Fitch survey of 85 asset management houses showed investment grade financials moved to the top slot for most favoured credit investment choice, with 21 percent of investors picking them, versus 14 percent for emerging market firms.
HIGH YIELD RISKS
High-yield debt by definition gives a higher return than investment grade bonds, but it carries a bigger risk of default and loss on principal and interest.
Furthermore, supply risk appears to be higher in the junk universe. Citi expects high yield to be the only key market where issuance is likely to be higher than 2009 and to be one of the highest in the past 10 years, at over $200 billion.
Investment grade bonds can also be appealing when compared with equities, especially for those who are looking to increase exposure in the banking sector. Apart from its intrinsic structure that is safer than equity, valuation is one reason.
Generally speaking, investment grade credit has lagged equities in recovering from a May sell-off.
The credit derivatives swap index for most-liquid investment grade issues in Europe, measured by the iTraxx , fell 26.4 percent since its May risk aversion peak. The VIX that measures equity option volatility more than halved.
"When you're investing in credit, all you care about is to get your money paid back," Dinesen said.
"When it comes to comparing banks in terms of equity and credit, in a scenario like this, you're likely to get the performance first in credit, then in equities."
(Additional reporting by Jeremy Gaunt, editing by Mike Peacock)
(For more business news on Reuters India click in.reuters.com)
From Reuters published on Fri Jul 30, 2010 2:16pm IST
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Bill Gross: Bonds Have Seen Their Best Days And Stocks Are The Better Investment
Vincent Fernando, CFA
As Pimco begins to offer stock investment funds, after establishing itself as the largest bond fund manager in the world, Bill Gross sheds light on the firm's strategic thinking.
Bonds have done well over the last thirty years, and this has earned Pimco a lot of money since many investors now favor bond investments over stocks.
Yet, the next ten years could be much different, and Pimco doesn't want to be stuck in last decade's asset class.
Washington Post:
The three-decade rally in bonds, the securities that made Gross famous, will eventually fizzle out, according to Pimco's outlook. Gross said the rally will come to an end as nations sell record amounts of debt to fund their deficits, spurring a return of inflation and rising interest rates.
"Bonds have seen their best days," said Gross, who anticipates returns of 4 to 5 percent in the new normal.
The king of bonds is now talking up stocks as a better long-term investment. He said that as U.S. Treasury returns fall, investors will have to take more risk with high-yield bonds, equities and, eventually, real estate.
"If you're talking about the next 10, 15, 20 years, there's certainly the recognition that assets will grow faster in those categories," he said. "Over the long term, stocks return more than bonds when appropriately priced at the beginning of an investment period."
It's easy to be a bit cynical here and say Mr. Gross is talking up his company's latest product offering, as we've been guilty of in the past. Nevertheless, one has to admit that despite Pimco's new move into offering stock funds, it would still benefit the firm more, from a purely marketing perspective, to continue pushing bonds over stocks given that the majority of Pimco's business remains in bond investment. Thus a cynic's view of Mr. Gross's latest stocks vs. bonds assessment doesn't hold water.
From The Business Insider published on Mon Jul. 26, 2010, 5:19 AM
As Pimco begins to offer stock investment funds, after establishing itself as the largest bond fund manager in the world, Bill Gross sheds light on the firm's strategic thinking.
Bonds have done well over the last thirty years, and this has earned Pimco a lot of money since many investors now favor bond investments over stocks.
Yet, the next ten years could be much different, and Pimco doesn't want to be stuck in last decade's asset class.
Washington Post:
The three-decade rally in bonds, the securities that made Gross famous, will eventually fizzle out, according to Pimco's outlook. Gross said the rally will come to an end as nations sell record amounts of debt to fund their deficits, spurring a return of inflation and rising interest rates.
"Bonds have seen their best days," said Gross, who anticipates returns of 4 to 5 percent in the new normal.
The king of bonds is now talking up stocks as a better long-term investment. He said that as U.S. Treasury returns fall, investors will have to take more risk with high-yield bonds, equities and, eventually, real estate.
"If you're talking about the next 10, 15, 20 years, there's certainly the recognition that assets will grow faster in those categories," he said. "Over the long term, stocks return more than bonds when appropriately priced at the beginning of an investment period."
It's easy to be a bit cynical here and say Mr. Gross is talking up his company's latest product offering, as we've been guilty of in the past. Nevertheless, one has to admit that despite Pimco's new move into offering stock funds, it would still benefit the firm more, from a purely marketing perspective, to continue pushing bonds over stocks given that the majority of Pimco's business remains in bond investment. Thus a cynic's view of Mr. Gross's latest stocks vs. bonds assessment doesn't hold water.
From The Business Insider published on Mon Jul. 26, 2010, 5:19 AM
Bond giant Pimco taking another shot at equities, driven by belief in 'new normal'
By Seth Lubove and Sree Vidya Bhaktavatsalam
Bloomberg News
Sunday, July 25, 2010
Bill Gross, who runs the world's biggest mutual fund, takes a seat in a conference room and makes a confession. Overlooking the ocean at the headquarters of Pacific Investment Management Co., Gross describes missteps that doomed his bond firm's earlier experiment with equities.
At meetings where Pimco set its strategies, Gross's bond traders overwhelmed the firm's handful of equity managers, shooting down their bullish arguments promoting stocks. With limited freedom to pursue their investing ideas, the equity managers quit after about two years.
"Those sessions basically said, 'Hey, we're a bond shop. This is what we're going to do. It's the party line,' " said Gross, 66, "If I've been a problem, then I can be the solution in terms of allowing equity investments to grow and prosper."
Pimco, which has been synonymous with bonds for almost four decades, is taking another run at equities. It might not be the most propitious time to plunge into stocks. Volatility, as measured by the Chicago Board Options Exchange Volatility Index, was at a 14-month high in late May, as the sovereign debt crisis swept through Europe.
Driving Pimco's move into equities is its chief executive, Mohamed El-Erian, who says the global economy is entering a period of fundamental transformation he calls the "new normal."
El-Erian says mounting deficits and tighter financial regulation will dampen growth in the United States and the euro zone for the next three to five years. Emerging-market nations such as Brazil and China, with stable levels of government debt and expanding middle classes, should continue to thrive, he said.
In the new normal, investors will be faced with anemic returns and they'll seek alternatives, said El-Erian, who's embracing several new asset classes. In the past year, he's presided over the creation of an equity mutual fund and a unit to invest in hedge, real estate and buyout funds. Pimco has also started 10 exchange-traded funds, or ETFs.
"We are living through a remarkable time of change," said El-Erian, 51, who shares the title of chief investment officer with Gross. "We want to make sure we navigate the changes for our clients."
Not everyone agrees with this analysis from Newport Beach, Calif.-based Pimco. Some U.S. Cabinet officials and securities analysts said El-Erian's new normal is off the mark.
End to bond rally
More than 2,000 forecasters set price estimates showing the Standard & Poor's 500-stock index will jump 26 percent in the 12 months through May 2011 as corporate profits rise, according to data compiled by Bloomberg.
Some investors say the firm might be better off sticking to what it knows best. Gross's flagship Pimco Total Return Fund, using a complex concoction of bonds, futures and credit-default swaps, has outperformed 97 percent of its fixed-income rivals during the past decade.
"When a fund company expands into new business lines, I get very nervous," said Martin Weil, whose Healdsburg, Calif.-based MW Investment Strategy Group manages $30 million, much of it in Pimco funds. "I have a very high degree of respect for Pimco. Am I going to dive into their equity offerings? No, but I'll take a look."
The three-decade rally in bonds, the securities that made Gross famous, will eventually fizzle out, according to Pimco's outlook. Gross said the rally will come to an end as nations sell record amounts of debt to fund their deficits, spurring a return of inflation and rising interest rates.
"Bonds have seen their best days," said Gross, who anticipates returns of 4 to 5 percent in the new normal.
The king of bonds is now talking up stocks as a better long-term investment. He said that as U.S. Treasury returns fall, investors will have to take more risk with high-yield bonds, equities and, eventually, real estate.
"If you're talking about the next 10, 15, 20 years, there's certainly the recognition that assets will grow faster in those categories," he said. "Over the long term, stocks return more than bonds when appropriately priced at the beginning of an investment period."
Gross's prophecy on bonds might not come true anytime soon. Since May, when he warned that European nations such as Greece cannot rely on growth to finance their soaring deficits and would likely default, investors have poured money into U.S. Treasurys.
Although Pimco estimates that U.S. debt has the potential to soar to 90 percent of gross domestic product, the country remains a haven for investors. Even Gross increased his Total Return Fund's holdings of government-related debt, which includes Treasurys, in May to the highest level since November. The yield on the 10-year Treasury note fell to 2.99 percent.
Push into equities
Spearheading Pimco's push into equities is EqS Pathfinder, a global fund the firm launched in April that buys undervalued securities, mainly in Europe. Its only U.S.-based holding in the top 10 positions is SPDR Gold Trust, an ETF that buys gold. Most of Pathfinder's major positions -- British American Tobacco, French foodmaker Groupe Danone and Hong Kong-based Link Real Estate Investment Trust -- derive at least part of their earnings from emerging markets. Pathfinder, which had attracted more than $500 million, declined 1.7 percent in the month ended June 7, beating 96 percent of similarly managed funds.
Some analysts say Pimco's exceptional performance with bonds gives it an advantage with all investments. In Europe, widening bond spreads last year were a warning sign for equity investors of the looming debt crisis, which sent European stocks to an eight-month low May 25, said Cynthia Steer, chief research strategist at Darien, Conn.-based Rogerscasey.
"It's a needed look at equities through the bond view," said Steer, whose firm oversees $265 billion in assets for institutional investors, many of whom have money with Pimco.
"Their research on sovereign debt is excellent, bar none."
With $1.1 trillion in assets, Pimco is expanding into stocks in an effort to lure more individuals to its funds. They're the fastest-growing group of investors, accounting for 84 percent of all U.S. mutual fund assets at the end of last year, according to data from the Investment Company Institute in Washington.
Individuals also pay more than institutions. The Total Return Fund charges retail customers annual expenses starting at more than 1 percent of assets, compared with less than half that for institutional and 401k investors.
Worrier by nature
The two men responsible for plotting Pimco's strategy share adjoining desks. Their personalities couldn't be more different.
El-Erian deliberates over almost every decision, and Gross often acts out of instinct. At a round wooden table in a 10-by-10-foot conference room that served as Pimco's first bond-trading floor, El-Erian, the son of an Egyptian diplomat, said he's a worrier by nature. When he was 10 years old, his mother, who's French and Egyptian, urged him not to take life so seriously.
"She said to me, 'If you don't have something to worry about, you create something to worry about,' " said El-Erian, who runs day-to-day operations at the firm of 1,300 employees. He worked over the details of starting stock funds for about two years.
Gross, who directly manages 24 mutual funds, relies on his gut, as well as endless reams of data.
"He is much bolder," El-Erian said. "He has this amazing instinct. I've never seen anything like it."
Both men get to work at 5 a.m. -- before the start of trading on Wall Street -- and take their seats in the middle of a tightly packed trading floor that overlooks a parking lot.
Gross is surrounded by seven computer screens with two stuffed animals -- a bull and bear -- sitting on top of them; El-Erian uses four monitors.
The two leaders rarely speak to each other on the floor.
Gross enforces a policy of near silence, sometimes by glaring at offenders who talk too loudly.
"I think Mohamed is respectful of my, sort of, isolation," said Gross, sitting in the conference room with his blue-and-red printed tie unknotted. "You wouldn't find me walking around giving high-fives."
El-Erian, on the other hand, enjoys creating camaraderie around the office. In January, he planned a surprise celebration on the trading floor for Gross. Morningstar had named him the fixed-income fund manager of the decade after earning a 10-year annualized return of 7.7 percent in the Total Return Fund.
The chief executive even found a bakery to deliver a cake at 4:45 a.m. As Gross arrived to work, traders erupted in a standing ovation.
Too much sugar
"Which is about the last thing he wanted, because then he had to say something," El-Erian said. Gross spoke briefly, thanking everyone.
Gross, who keeps fit doing yoga and riding a stationary bike for 90 minutes a day, also said he didn't like to eat that amount of sugar so early in the morning. "It only happens once a decade, so don't worry about it," El-Erian said.
The two executives constantly communicate, often debating investment ideas, mostly through e-mail. The exchanges go on and on through weekends. "He's unrelenting and indefatigable," Gross said.
One thing El-Erian and Gross share is a penchant for publicizing their investment views, which can sometimes move markets. On Nov. 19, Gross wrote in his Investment Outlook on Pimco's Web site that utility stocks were attractive with dividend yields of 5 to 6 percent. On that day, the Dow Jones Utilities Average of 15 stocks took off and hit a one-year high in less than a month.
El-Erian frequently touts the new normal on financial news shows and his firm's Web site. An economist with a PhD from Oxford University, El-Erian argues that the United States faces structural and long-lasting economic burdens, such as massive public debt. He says the U.S. jobless rate -- 9.5 percent in June -- will remain elevated for the foreseeable future. In May 2009, he said that the U.S. economy would expand at an annual rate of 2 percent or less in the next several years -- a forecast he hasn't revised.
After El-Erian presented his outlook last year, the U.S. economy grew 3 percent in the first quarter, suggesting that the new normal was too pessimistic. El-Erian said the expansion will slow as federal stimulus spending dries up.
'The old cyclical'
In an April speech at Princeton University, Christina Romer, head of the White House Council of Economic Advisers, said she found the fatalism of the new normal distressing. Romer said that shorter-term cyclical events such as the drop in demand were the real drag on job creation.
"Unemployment is high fundamentally because the economy is producing dramatically below its capacity," Romer said. "That is, far from being the new normal, it is the old cyclical."
El-Erian's biggest challenge might be internal. As the chief executive builds a stable of new funds, he'll have to overcome the embedded bias for bonds that took root in 1971 with the founding of the company. When Gross and his two bond-trading partners left Pacific Mutual Life Insurance Co. to set up their own firm across the street, they decided against taking an equities manager with them.
"It would have been better to bring the equity person," Gross said. "We would have been balanced from the beginning."
Decades later, the then-parent company of Pimco took a stab at stocks that ended in a legal scandal. In 1999, Pimco Advisors Holdings started Pimco Equity Advisors. The stock unit was separate from Gross's bond shop and didn't provide any financial benefits. Yet the equity group hoped to get a boost from the success of Gross's business by taking the Pimco name.
The equity managers got off to a fast start, almost doubling assets to $9.6 billion by 2000 before running into legal trouble. In civil complaints, the SEC and New Jersey's attorney general accused the equity unit in 2004 of allowing a hedge fund to engage in market timing, a practice of making short-term trades to exploit market inefficiencies.
Following the lawsuits, Gross said that he regretted allowing the group to use the Pimco brand. The equity unit, which didn't admit or deny wrongdoing, paid a combined $68 million in fines and repayments to investors to settle the lawsuits. Allianz dissolved the stock group after the settlements. Allianz spokesman Eduard Stipic declined to comment on the lawsuits beyond previous statements.
Pimco learned a lesson from the fiasco. "We don't do well when we rent our brand," El-Erian said.
This time, Pimco will control the equity funds and integrate them into the firm. And, true to form, in 2008 he rolled out an elaborate method to involve every part of Pimco in choosing new assets to manage.
He gave executives a spreadsheet matrix and asked them to use the color green to indicate markets the firm should enter because it has the experience to do so. Yellow meant areas the company should pursue but doesn't have the know-how. Red signaled businesses to avoid. Portfolio managers used the matrixes to rank ideas for specific funds, and sales reps indicated their clients' preferences using the colors too.
"We got all these matrices back, we put them on top of each other and we had this overlapping matrix approach that resulted in a road map for Pimco," El-Erian said. Asset-allocation funds, which invest in a variety of securities, earned a green; equities, a yellow; and direct private-equity investments, a red.
A global view
From April 1999, when El-Erian joined Pimco, to the middle of 2004, his flagship Emerging Markets Bond Fund posted an annualized return of 21.3 percent.
The Harvard Management Co. board hired El-Erian in October 2005 to be chief executive and revamp the university's endowment, which was in turmoil. Before El-Erian's arrival, about 30 managers, including the entire fixed-income team, and chief executive Jack Meyer had left amid criticism from alumni who said they were overpaid.
Some managers had pocketed as much as $35 million a year.
Under El-Erian, the payroll went down as he hired managers who were compensated using an existing formula that paid new employees less. El-Erian was the top earner at the endowment in fiscal 2007, making $6.5 million.
In overseeing teams at Harvard that focused on U.S. and emerging-market equities as well as real estate and commodities, El-Erian gained experience that would help him lead Pimco's expansion. At Harvard, in addition to creating a foreign-exchange group, he developed tail-risk hedging, which involved using portfolio insurance to try to protect investors from unexpected events that would hammer markets. In fiscal 2007, the then-$34.9 billion endowment posted a 23 percent return.
El-Erian says he didn't realize a financial tsunami would devastate markets a year later when he announced his departure in September 2007. At the time, mortgage delinquencies were rising and credit markets were just beginning to tighten.
The endowment performed well for months after El-Erian left for Pimco in December 2007. It rose 8.6 percent while the S&P lost almost 15 percent in the fiscal year ended June 30, 2008.
Six months later, Harvard began to go into a financial tailspin and would pay banks almost $1 billion to terminate wrong-way bets on interest-rate swaps made prior to El-Erian's arrival. The endowment, down to $26 billion, fell 27.3 percent in fiscal 2009.
Gross, then 64, brought back El-Erian to be co-chief executive with William Thompson, who retired at the end of 2008. "Your most important job, certainly in your 60s, is to plan for succession," Gross said. "We knew that Mohamed could fill an important part of the puzzle."
World's biggest fund
The $227.9 billion Total Return Fund became the world's biggest mutual fund in 2009, as Gross lured in investors with his handling of the financial crisis. Gross saw the mortgage debacle coming and was able to dodge most of the damage -- thanks partly to yoga.
In 2005, he suspected a housing bubble had formed. During a yoga session, it occurred to him to send analysts posing as home buyers into the field to test his theory. The research helped him decide as early as 2005 to avoid subprime-mortgage-backed securities.
While Gross shunned subprime debt, he hasn't shied away from other complex investments in his Total Return Fund.
Morningstar analyst Eric Jacobson said the manager boosts returns partly by using derivatives -- contracts whose value is derived from stocks, bonds, loans and currencies.
Gross increased his holdings of credit default swaps in 2009 as the sovereign-debt crisis began to shake Europe. The fund sold insurance on credit from countries such as Italy and Britain and almost doubled its CDSs on sovereign debt in three months, to about $1.4 billion on Dec. 31, according to Pimco's February filing with the SEC. The manager boosted his bet in the first quarter, selling default protection covering almost $5 billion in sovereign debt on countries such as Brazil, France, Panama and Britain.
Charges of manipulation
Some traders accuse Pimco of crossing the line from market influence to market manipulation. In a lawsuit filed in 2005, two individual investors and a derivatives-trading firm claim that Pimco artificially drove up prices of Treasury futures on the Chicago Board of Trade.
The suit claims that Pimco bought $16 billion worth of 10-year Treasury futures and then hoarded a majority of the most desirable notes underlying those contracts to drive up the value of securities traders needed to fulfill their futures agreements. The plaintiffs, who are seeking $600 million, had sold the contracts short and claim they had to pay higher prices to replace them.
The U.S. Supreme Court in February let stand a federal appeals court ruling that the traders who filed the lawsuit in Chicago could pursue the litigation as a class action. Pimco denies the allegations.
"The plaintiffs include hedge funds and other sophisticated investors who made speculative investments and are now trying to profit from what turned out to be their bad bets," a Pimco spokesman says.
'Drip, drip approach'
Pimco won't become a powerhouse in equities anytime soon.
The company has hired only about 12 executives, managers and analysts to work in stocks, ETFs and funds of funds, with plans to add several more.
"In terms of the drip, drip approach of doing this slow, I can't say it's going to be successful," Jacobson said. "But they want to make sure everybody they bring in is not only Pimco caliber, but also Pimco style in their thinking."
El-Erian says he's expanding cautiously to avoid damaging the main bond business upon which Pimco is built. "We are very careful not to dilute what has served our clients well," he says. "And that comes from being very realistic about what you can deliver."
Anne Gudefin and Charles Lahr, the value-oriented managers who run Pimco Pathfinder, aren't in a hurry to buy stocks.
In December, El-Erian hired the duo, who had managed Franklin Templeton Investment's Mutual Global Discovery Fund. Their Pathfinder fund held about 22 percent of its assets in cash as of the end of April.
'We've grown up'
Following the 10 percent plunge in the MSCI World Index in April and May, the managers might deploy more money. "We're happy to say that the current sell-off is highlighting some interesting opportunities," the managers said in an e-mail.
Thirty-nine years after he founded Pimco, Gross says the firm's new funds are a sign of his own evolution.
"It simply means, perhaps, we've grown up, and I have," he says. "I'm 66 now and recognize there are lots of different pieces to a puzzle and they each have a right to a place in the capital markets."
Gross says he has no plans to retire. But as he prepares for succession, this may be one of the last chances for the king of bonds to help his equity managers thrive and share the Pimco limelight.
A version of this story first appeared in Bloomberg Markets Magazine.
From The Washington Post published on Sunday, July 25, 2010
Bloomberg News
Sunday, July 25, 2010
Bill Gross, who runs the world's biggest mutual fund, takes a seat in a conference room and makes a confession. Overlooking the ocean at the headquarters of Pacific Investment Management Co., Gross describes missteps that doomed his bond firm's earlier experiment with equities.
At meetings where Pimco set its strategies, Gross's bond traders overwhelmed the firm's handful of equity managers, shooting down their bullish arguments promoting stocks. With limited freedom to pursue their investing ideas, the equity managers quit after about two years.
"Those sessions basically said, 'Hey, we're a bond shop. This is what we're going to do. It's the party line,' " said Gross, 66, "If I've been a problem, then I can be the solution in terms of allowing equity investments to grow and prosper."
Pimco, which has been synonymous with bonds for almost four decades, is taking another run at equities. It might not be the most propitious time to plunge into stocks. Volatility, as measured by the Chicago Board Options Exchange Volatility Index, was at a 14-month high in late May, as the sovereign debt crisis swept through Europe.
Driving Pimco's move into equities is its chief executive, Mohamed El-Erian, who says the global economy is entering a period of fundamental transformation he calls the "new normal."
El-Erian says mounting deficits and tighter financial regulation will dampen growth in the United States and the euro zone for the next three to five years. Emerging-market nations such as Brazil and China, with stable levels of government debt and expanding middle classes, should continue to thrive, he said.
In the new normal, investors will be faced with anemic returns and they'll seek alternatives, said El-Erian, who's embracing several new asset classes. In the past year, he's presided over the creation of an equity mutual fund and a unit to invest in hedge, real estate and buyout funds. Pimco has also started 10 exchange-traded funds, or ETFs.
"We are living through a remarkable time of change," said El-Erian, 51, who shares the title of chief investment officer with Gross. "We want to make sure we navigate the changes for our clients."
Not everyone agrees with this analysis from Newport Beach, Calif.-based Pimco. Some U.S. Cabinet officials and securities analysts said El-Erian's new normal is off the mark.
End to bond rally
More than 2,000 forecasters set price estimates showing the Standard & Poor's 500-stock index will jump 26 percent in the 12 months through May 2011 as corporate profits rise, according to data compiled by Bloomberg.
Some investors say the firm might be better off sticking to what it knows best. Gross's flagship Pimco Total Return Fund, using a complex concoction of bonds, futures and credit-default swaps, has outperformed 97 percent of its fixed-income rivals during the past decade.
"When a fund company expands into new business lines, I get very nervous," said Martin Weil, whose Healdsburg, Calif.-based MW Investment Strategy Group manages $30 million, much of it in Pimco funds. "I have a very high degree of respect for Pimco. Am I going to dive into their equity offerings? No, but I'll take a look."
The three-decade rally in bonds, the securities that made Gross famous, will eventually fizzle out, according to Pimco's outlook. Gross said the rally will come to an end as nations sell record amounts of debt to fund their deficits, spurring a return of inflation and rising interest rates.
"Bonds have seen their best days," said Gross, who anticipates returns of 4 to 5 percent in the new normal.
The king of bonds is now talking up stocks as a better long-term investment. He said that as U.S. Treasury returns fall, investors will have to take more risk with high-yield bonds, equities and, eventually, real estate.
"If you're talking about the next 10, 15, 20 years, there's certainly the recognition that assets will grow faster in those categories," he said. "Over the long term, stocks return more than bonds when appropriately priced at the beginning of an investment period."
Gross's prophecy on bonds might not come true anytime soon. Since May, when he warned that European nations such as Greece cannot rely on growth to finance their soaring deficits and would likely default, investors have poured money into U.S. Treasurys.
Although Pimco estimates that U.S. debt has the potential to soar to 90 percent of gross domestic product, the country remains a haven for investors. Even Gross increased his Total Return Fund's holdings of government-related debt, which includes Treasurys, in May to the highest level since November. The yield on the 10-year Treasury note fell to 2.99 percent.
Push into equities
Spearheading Pimco's push into equities is EqS Pathfinder, a global fund the firm launched in April that buys undervalued securities, mainly in Europe. Its only U.S.-based holding in the top 10 positions is SPDR Gold Trust, an ETF that buys gold. Most of Pathfinder's major positions -- British American Tobacco, French foodmaker Groupe Danone and Hong Kong-based Link Real Estate Investment Trust -- derive at least part of their earnings from emerging markets. Pathfinder, which had attracted more than $500 million, declined 1.7 percent in the month ended June 7, beating 96 percent of similarly managed funds.
Some analysts say Pimco's exceptional performance with bonds gives it an advantage with all investments. In Europe, widening bond spreads last year were a warning sign for equity investors of the looming debt crisis, which sent European stocks to an eight-month low May 25, said Cynthia Steer, chief research strategist at Darien, Conn.-based Rogerscasey.
"It's a needed look at equities through the bond view," said Steer, whose firm oversees $265 billion in assets for institutional investors, many of whom have money with Pimco.
"Their research on sovereign debt is excellent, bar none."
With $1.1 trillion in assets, Pimco is expanding into stocks in an effort to lure more individuals to its funds. They're the fastest-growing group of investors, accounting for 84 percent of all U.S. mutual fund assets at the end of last year, according to data from the Investment Company Institute in Washington.
Individuals also pay more than institutions. The Total Return Fund charges retail customers annual expenses starting at more than 1 percent of assets, compared with less than half that for institutional and 401k investors.
Worrier by nature
The two men responsible for plotting Pimco's strategy share adjoining desks. Their personalities couldn't be more different.
El-Erian deliberates over almost every decision, and Gross often acts out of instinct. At a round wooden table in a 10-by-10-foot conference room that served as Pimco's first bond-trading floor, El-Erian, the son of an Egyptian diplomat, said he's a worrier by nature. When he was 10 years old, his mother, who's French and Egyptian, urged him not to take life so seriously.
"She said to me, 'If you don't have something to worry about, you create something to worry about,' " said El-Erian, who runs day-to-day operations at the firm of 1,300 employees. He worked over the details of starting stock funds for about two years.
Gross, who directly manages 24 mutual funds, relies on his gut, as well as endless reams of data.
"He is much bolder," El-Erian said. "He has this amazing instinct. I've never seen anything like it."
Both men get to work at 5 a.m. -- before the start of trading on Wall Street -- and take their seats in the middle of a tightly packed trading floor that overlooks a parking lot.
Gross is surrounded by seven computer screens with two stuffed animals -- a bull and bear -- sitting on top of them; El-Erian uses four monitors.
The two leaders rarely speak to each other on the floor.
Gross enforces a policy of near silence, sometimes by glaring at offenders who talk too loudly.
"I think Mohamed is respectful of my, sort of, isolation," said Gross, sitting in the conference room with his blue-and-red printed tie unknotted. "You wouldn't find me walking around giving high-fives."
El-Erian, on the other hand, enjoys creating camaraderie around the office. In January, he planned a surprise celebration on the trading floor for Gross. Morningstar had named him the fixed-income fund manager of the decade after earning a 10-year annualized return of 7.7 percent in the Total Return Fund.
The chief executive even found a bakery to deliver a cake at 4:45 a.m. As Gross arrived to work, traders erupted in a standing ovation.
Too much sugar
"Which is about the last thing he wanted, because then he had to say something," El-Erian said. Gross spoke briefly, thanking everyone.
Gross, who keeps fit doing yoga and riding a stationary bike for 90 minutes a day, also said he didn't like to eat that amount of sugar so early in the morning. "It only happens once a decade, so don't worry about it," El-Erian said.
The two executives constantly communicate, often debating investment ideas, mostly through e-mail. The exchanges go on and on through weekends. "He's unrelenting and indefatigable," Gross said.
One thing El-Erian and Gross share is a penchant for publicizing their investment views, which can sometimes move markets. On Nov. 19, Gross wrote in his Investment Outlook on Pimco's Web site that utility stocks were attractive with dividend yields of 5 to 6 percent. On that day, the Dow Jones Utilities Average of 15 stocks took off and hit a one-year high in less than a month.
El-Erian frequently touts the new normal on financial news shows and his firm's Web site. An economist with a PhD from Oxford University, El-Erian argues that the United States faces structural and long-lasting economic burdens, such as massive public debt. He says the U.S. jobless rate -- 9.5 percent in June -- will remain elevated for the foreseeable future. In May 2009, he said that the U.S. economy would expand at an annual rate of 2 percent or less in the next several years -- a forecast he hasn't revised.
After El-Erian presented his outlook last year, the U.S. economy grew 3 percent in the first quarter, suggesting that the new normal was too pessimistic. El-Erian said the expansion will slow as federal stimulus spending dries up.
'The old cyclical'
In an April speech at Princeton University, Christina Romer, head of the White House Council of Economic Advisers, said she found the fatalism of the new normal distressing. Romer said that shorter-term cyclical events such as the drop in demand were the real drag on job creation.
"Unemployment is high fundamentally because the economy is producing dramatically below its capacity," Romer said. "That is, far from being the new normal, it is the old cyclical."
El-Erian's biggest challenge might be internal. As the chief executive builds a stable of new funds, he'll have to overcome the embedded bias for bonds that took root in 1971 with the founding of the company. When Gross and his two bond-trading partners left Pacific Mutual Life Insurance Co. to set up their own firm across the street, they decided against taking an equities manager with them.
"It would have been better to bring the equity person," Gross said. "We would have been balanced from the beginning."
Decades later, the then-parent company of Pimco took a stab at stocks that ended in a legal scandal. In 1999, Pimco Advisors Holdings started Pimco Equity Advisors. The stock unit was separate from Gross's bond shop and didn't provide any financial benefits. Yet the equity group hoped to get a boost from the success of Gross's business by taking the Pimco name.
The equity managers got off to a fast start, almost doubling assets to $9.6 billion by 2000 before running into legal trouble. In civil complaints, the SEC and New Jersey's attorney general accused the equity unit in 2004 of allowing a hedge fund to engage in market timing, a practice of making short-term trades to exploit market inefficiencies.
Following the lawsuits, Gross said that he regretted allowing the group to use the Pimco brand. The equity unit, which didn't admit or deny wrongdoing, paid a combined $68 million in fines and repayments to investors to settle the lawsuits. Allianz dissolved the stock group after the settlements. Allianz spokesman Eduard Stipic declined to comment on the lawsuits beyond previous statements.
Pimco learned a lesson from the fiasco. "We don't do well when we rent our brand," El-Erian said.
This time, Pimco will control the equity funds and integrate them into the firm. And, true to form, in 2008 he rolled out an elaborate method to involve every part of Pimco in choosing new assets to manage.
He gave executives a spreadsheet matrix and asked them to use the color green to indicate markets the firm should enter because it has the experience to do so. Yellow meant areas the company should pursue but doesn't have the know-how. Red signaled businesses to avoid. Portfolio managers used the matrixes to rank ideas for specific funds, and sales reps indicated their clients' preferences using the colors too.
"We got all these matrices back, we put them on top of each other and we had this overlapping matrix approach that resulted in a road map for Pimco," El-Erian said. Asset-allocation funds, which invest in a variety of securities, earned a green; equities, a yellow; and direct private-equity investments, a red.
A global view
From April 1999, when El-Erian joined Pimco, to the middle of 2004, his flagship Emerging Markets Bond Fund posted an annualized return of 21.3 percent.
The Harvard Management Co. board hired El-Erian in October 2005 to be chief executive and revamp the university's endowment, which was in turmoil. Before El-Erian's arrival, about 30 managers, including the entire fixed-income team, and chief executive Jack Meyer had left amid criticism from alumni who said they were overpaid.
Some managers had pocketed as much as $35 million a year.
Under El-Erian, the payroll went down as he hired managers who were compensated using an existing formula that paid new employees less. El-Erian was the top earner at the endowment in fiscal 2007, making $6.5 million.
In overseeing teams at Harvard that focused on U.S. and emerging-market equities as well as real estate and commodities, El-Erian gained experience that would help him lead Pimco's expansion. At Harvard, in addition to creating a foreign-exchange group, he developed tail-risk hedging, which involved using portfolio insurance to try to protect investors from unexpected events that would hammer markets. In fiscal 2007, the then-$34.9 billion endowment posted a 23 percent return.
El-Erian says he didn't realize a financial tsunami would devastate markets a year later when he announced his departure in September 2007. At the time, mortgage delinquencies were rising and credit markets were just beginning to tighten.
The endowment performed well for months after El-Erian left for Pimco in December 2007. It rose 8.6 percent while the S&P lost almost 15 percent in the fiscal year ended June 30, 2008.
Six months later, Harvard began to go into a financial tailspin and would pay banks almost $1 billion to terminate wrong-way bets on interest-rate swaps made prior to El-Erian's arrival. The endowment, down to $26 billion, fell 27.3 percent in fiscal 2009.
Gross, then 64, brought back El-Erian to be co-chief executive with William Thompson, who retired at the end of 2008. "Your most important job, certainly in your 60s, is to plan for succession," Gross said. "We knew that Mohamed could fill an important part of the puzzle."
World's biggest fund
The $227.9 billion Total Return Fund became the world's biggest mutual fund in 2009, as Gross lured in investors with his handling of the financial crisis. Gross saw the mortgage debacle coming and was able to dodge most of the damage -- thanks partly to yoga.
In 2005, he suspected a housing bubble had formed. During a yoga session, it occurred to him to send analysts posing as home buyers into the field to test his theory. The research helped him decide as early as 2005 to avoid subprime-mortgage-backed securities.
While Gross shunned subprime debt, he hasn't shied away from other complex investments in his Total Return Fund.
Morningstar analyst Eric Jacobson said the manager boosts returns partly by using derivatives -- contracts whose value is derived from stocks, bonds, loans and currencies.
Gross increased his holdings of credit default swaps in 2009 as the sovereign-debt crisis began to shake Europe. The fund sold insurance on credit from countries such as Italy and Britain and almost doubled its CDSs on sovereign debt in three months, to about $1.4 billion on Dec. 31, according to Pimco's February filing with the SEC. The manager boosted his bet in the first quarter, selling default protection covering almost $5 billion in sovereign debt on countries such as Brazil, France, Panama and Britain.
Charges of manipulation
Some traders accuse Pimco of crossing the line from market influence to market manipulation. In a lawsuit filed in 2005, two individual investors and a derivatives-trading firm claim that Pimco artificially drove up prices of Treasury futures on the Chicago Board of Trade.
The suit claims that Pimco bought $16 billion worth of 10-year Treasury futures and then hoarded a majority of the most desirable notes underlying those contracts to drive up the value of securities traders needed to fulfill their futures agreements. The plaintiffs, who are seeking $600 million, had sold the contracts short and claim they had to pay higher prices to replace them.
The U.S. Supreme Court in February let stand a federal appeals court ruling that the traders who filed the lawsuit in Chicago could pursue the litigation as a class action. Pimco denies the allegations.
"The plaintiffs include hedge funds and other sophisticated investors who made speculative investments and are now trying to profit from what turned out to be their bad bets," a Pimco spokesman says.
'Drip, drip approach'
Pimco won't become a powerhouse in equities anytime soon.
The company has hired only about 12 executives, managers and analysts to work in stocks, ETFs and funds of funds, with plans to add several more.
"In terms of the drip, drip approach of doing this slow, I can't say it's going to be successful," Jacobson said. "But they want to make sure everybody they bring in is not only Pimco caliber, but also Pimco style in their thinking."
El-Erian says he's expanding cautiously to avoid damaging the main bond business upon which Pimco is built. "We are very careful not to dilute what has served our clients well," he says. "And that comes from being very realistic about what you can deliver."
Anne Gudefin and Charles Lahr, the value-oriented managers who run Pimco Pathfinder, aren't in a hurry to buy stocks.
In December, El-Erian hired the duo, who had managed Franklin Templeton Investment's Mutual Global Discovery Fund. Their Pathfinder fund held about 22 percent of its assets in cash as of the end of April.
'We've grown up'
Following the 10 percent plunge in the MSCI World Index in April and May, the managers might deploy more money. "We're happy to say that the current sell-off is highlighting some interesting opportunities," the managers said in an e-mail.
Thirty-nine years after he founded Pimco, Gross says the firm's new funds are a sign of his own evolution.
"It simply means, perhaps, we've grown up, and I have," he says. "I'm 66 now and recognize there are lots of different pieces to a puzzle and they each have a right to a place in the capital markets."
Gross says he has no plans to retire. But as he prepares for succession, this may be one of the last chances for the king of bonds to help his equity managers thrive and share the Pimco limelight.
A version of this story first appeared in Bloomberg Markets Magazine.
From The Washington Post published on Sunday, July 25, 2010
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