Bill Gross warns investors to steer clear of bond funds

This past Friday, bond-fund manager Bill Gross published a commentary titled They Just Wanna Sell You a Bond Fund.

Color me envious. My headlines aren’t that good. (The proof lies above.) What’s more, his short but pungent missive covers much ground. In just eight paragraphs, Gross disputes claims that bonds are enticingly priced; offers his macroeconomic outlook; and questions his peers’ motivations. From bond king to sound bite king!

Point number 1: Ulterior motives

Let’s address those items in reverse order, beginning with Gross’s accusation that bond-fund managers are bullish on bonds because they profit from the belief. Funny how that goes. I made that very same argument about Mr. Gross himself last month, in The Dangerous Myth of ‘The New Normal’, which addressed his influential 2009 forecast that stock prices would languish. They certainly did not.

We were each right. Without question, bond-fund managers wish to sell bond funds, just as those who invest otherwise hope to market their offerings. My take, however, is more charitable than Gross’: People see what they wish to see. As I wrote, “Growth-stock managers perceive opportunities everywhere; any day now, value investors expect that their holdings will turn around; and bond-fund managers anticipate economic gloom. Such is human nature.”

Of course, self-belief is not always wrong. That bond-fund managers favor their own investments does not necessarily invalidate their predictions. It just means that their words should be treated cautiously. An endorsement from a neutral party, such as an equity manager, carries greater weight. This is common sense. But I state the obvious because the obvious tends to be overlooked when the portfolio manager is esteemed. In 2009, few observers questioned Gross’ independence.

Point number 2: Macroeconomic outlook

Gross’ second assertion is that long-term circumstances require higher bond yields. To expand at an acceptable rate, the United States economy will require steep credit growth, most of which must come from the Treasury Department, because business/consumer debt levels are largely stagnant. Thus, we should expect “net increases in Treasury debt of $1 trillion to $2 trillion or more annually,” which will lead to an “inexorable upward climb in Treasury supply and the likely Sisyphean decline in bond prices.” (Now he’s outdoing me in classic allusions.)

That theory sounds fine, but I’m not buying it. Not that I can disprove Gross’ belief. My skepticism arises instead from experience. Over the decades, I have heard scores of apparently irrefutable macroeconomic arguments by people who know far more about such topics than I do (not a difficult feat), most of which proved erroneous. Fooled once, shame on you. Fooled 100 times, shame on me.

To cite one of many, many examples, in 2010, the economics editor for The Guardian newspaper warned that the Federal Reserve’s policy of quantitative easing raised the real danger of creating a “bubble to end all bubbles.” The ensuing crisis, he posited, might well doom President Obama’s reelection campaign. As with Gross’ “New Normal” outlook, The Guardian’s article made claims that I could not rebut. That did not, however, make those views correct.

So … shrug. Believe what you will about the future. I will remain agnostic.

Point number 3: Bond prices

Now for something more tangible: Gross’ investment math. He points out that when Treasury yields peaked in the early 1980s, it was difficult to lose money on even the longest bonds, because they paid so much yield, so quickly. Even if interest rates rose sharply, the security’s income would cushion its capital losses.

Let’s test that thesis. (The following is my work, not Gross’.) On Sept. 30, 1981, a 10-year Treasury note paid 15.84%. Conversely, its yield was 0.52% on Aug. 4, 2020. Currently, the figure stands at 4.50%. The following chart depicts the total return for each investment over a 24-month horizon, assuming the market yield were to finish the period 2 percentage points higher or lower.

(For these computations, I used Omni Calculator’s bond-pricing tool and kept things simple by setting aside the bonds’ payments, rather than reinvesting them. Also, note that when the starting yield is 0.52%, the falling-rate scenario establishes an ending yield of negative 1.48%, meaning that investors would pay the government to hold their debt. That sounds silly. However, such pricing is not only theoretically possible but has recently occurred with Japanese debt.)

Although this illustration supports Gross’ assertion, it is incomplete. It displays nominal returns when real performance is what matters. Consequently, I revised estimates by computing the inflation-adjusted value of each note, by discounting their future values by the inflation rate that existed on the dates of their starting yields. (In chronological order, those rates were 9.92%, 1.15%, and 3.04%.)

That cements the case. Using real returns removes the chaff from the 1981 note’s projections because much of that performance would be consumed by inflation. Nevertheless, the odds remain firmly in the favor of the higher-yielding securities. After inflation, the three investments perform similarly in a bond bull market, but their extra income will pay major dividends (both literally and metaphorically) should a bear market arrive.

Another way of viewing the issue is to consider the payout on Treasury Inflation-Protected Securities. A 10-year TIPS note currently pays 2.14% in real yield, which means that if held to maturity, it will outgain a conventional 10-year Treasury if inflation averages more than 2.36% over the next decade. To put the matter another way, do you think it likelier that inflation will average 3.36% through the next 10 years, or 1.36%? Unless you believe the latter, TIPS are the better option.

Wrapping up

Mr. Gross is more convinced the bond market will struggle than I am. He writes, “Look for 5%-plus 10-year yields over the next 12 months—not 4.0%.” His confidence makes sense; as Daniel Kahneman liked to point out, leaders are paid to project resolution. In contrast, researchers are permitted to dither. In this instance, however, I will not seek that refuge. I agree with Bill Gross: I don’t care for nominal bonds at today’s prices. Unless their yields rise by another percentage point, to 5.5%, I prefer cash and/or Treasury Inflation-Protected Securities.