Bill Gross Is the Bond King, But Diversification Is Emperor

“No other fund manager made more money for people than Bill Gross,” wrote Karen Dolan of Morningstar Inc. when naming the bond king the fixed-income manager of the decade in 2010, and she could have extended that to a 35-year title. Now Gross tells us that if we hear people bullish on bonds, “they just wanna sell you a bond fund,” and that the “total return” philosophy he originated at Pacific Investment Management Co. in the depths of 1980s’ bear market is dead.

Total return is based on Bond Math 101. If a 10-year bond is selling at a 0% yield it has a duration of 10, meaning a 1% increase in interest rates will cause it to lose about 10 x 1% or 10% in price (the exact loss is 9.47%). Back in the early 1980s, the 10-year Treasury note was available at a yield of 15.84%. That gave it a duration of five years, which meant rates could go up to 19.50% and the interest on your bond would cover the loss in price. Absent a massive increase in rates to unprecedented levels, you had to make money.

The higher the yield at which you purchase the bond, the lower the duration so the less sensitive you are to interest rate increases, and the more income you have to offset them. Moreover, the 10-year Treasury is just a benchmark for bond investing, Gross was famous for squeezing out extra yield using corporate bonds, mortgages, derivatives and other instruments.

But Gross points out that’s not the whole story. When yields are high it likely means expected inflation is high, or yields are expected to increase, or both. The chart above shows the actual 10-year annualized inflation-adjusted return that investors in 10-year Treasuries earned versus the yield at the time of bond purchase. Gross’ 38 years at Pimco are shown in yellow, all other years are in blue.

The yellow dots illustrate the total return argument. After inflation, investors in 10-year Treasuries earned on average about 75% of the yield at the time of their purchase minus 1%, usually within a percent of the predicted amount. The exception was some negative returns near the end of Gross’ Pimco tenure. They occurred at very low interest rates and began in the Spring of 2012. By the Fall of 2014, Gross and Pimco parted ways. Of course, investors in Gross’ Total Return Fund did considerably better than investors who bought 10-year Treasuries, but no bond manager can buck the market, only add a moderate premium to whatever the Treasury gives.