direction, then we are in sync even for classic bond strategies such as the PIMCO Total Return Strategy. Less carry from duration, more carry from credit, volatility, curve and currency in the future years ahead.
But can it be that simple? No, because adaptation is required not just philosophically at war colleges in anticipation of evolving weaponry, but on the battlefield itself during the heat of the battle. There will be times when duration is advantaged at the expense of credit, a time when volatility and curve perform less well than a 30-year Bund denominated in euros. What is commonsensical and relevant to disclose in an Investment Outlook meant primarily for clients, is that we are aware of the choices, that we know maturity/duration extension is becoming a tired horse, but that it may still have a place on the battlefield under certain conditions. Will PIMCO charge the machine-gun-laden front lines with consistently overweighted durational bond strategies? No, but we might try to outflank them if yields rise too much like today. Will we be aware that credit, curve, volatility and currency have their risks as well and could be outdated just as easily? Yes. In fact, the total carry of a portfolio is perhaps the risk most critical in today’s bond/unconstrained/alternative asset or even equity wars. Thetotal carry or the total “yield” of a portfolio is PIMCO’s dominant focus, not duration reduction. In a highly levered economy/financial marketplace, all forms of carry can go up or down at the same time. They did for successive weeks in May and June. They may do so again. The diversifying aspects of one form of carry vs. another may hold form in most future time periods, but when they don’t, almost all investors will regret not focusing on total carry as opposed to discriminating exclusively against maturity extension.
How much carry should a portfolio manager/PIMCO hold for its clients today relative to their desired indices? Here’s a helpful guide: Capitalism depends on the successful offering and capture of carry in its multiple forms. If capitalism is faltering (recession) in developed/developing economies and yields are close to the zero bound, then portfolios should have less carry than before. If prospects are mediocre, portfolios should be overweight carry. If prospects are very bright, they should again be underweight bond carry. If we can be mindful of this, and accurately forecast it, we will be successful. This may be the most important conceptual change I have ever written about in an Investment Outlook. Readers who have stuck with this Outlook at least to this point have a scoop, if not a magic feather.
For the first quarter of 2022, the Voss Value Fund returned -5.5% net of fees and expenses compared to a -7.5% total return for the Russell 2000 and a -4.6% total return for the S&P 500. According to a copy of the firm’s first-quarter letter to investors, a copy of which ValueWalk has been able Read More
So, fellow generals in this bond war, today’s war college lesson is to be mindful of evolution and the necessity to adapt. Know that maturity extension worked well for 30 years and will work less well with yields close to zero. Know that there are other weapons at your disposal, but they too contain risk and their combined carry is itself probably the most critical variable in future asset return wars. And know that bonds – while containing a certain amount of maturity risk by very definition – will never be antiquated. The secret to using them will be to strategically position their component and combined carry to maintain positive absolute returns. Unconstrained strategies, alternative assets and stocks will be flexible choices in a dynamic future environment. We want to continue managing them for you. But don’t give up on bonds. Flexible bond managers can adapt as well. PIMCO will not go down at the Somme.
Bond Wars Speed Read
1) Bond managers must adapt to a new world of near zero bound interest rates and the likelihood of lower total returns.
2) Reducing maturity is not the only potential strategy to win this new war; in fact because of near 0% money market yields, at times it may be counterproductive.
3) By focusing on “carry” and its diversifying characteristic components, a bond manager can help protect downside risks.
4) Carry consists of maturity extension, credit spreads, yield curve differences, volatility, and currency components.
5) Stick with PIMCO, we’re going to win this new war!
William H. Gross
*Included as an attachment is an earlier 1986 version of my first “Bond Wars” which in retrospect seems pretty insightful.