Lessons From A Bond King’s Fall From Grace

Posted on February 22, 2019 by Gemmer Asset

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This isn’t so much beating a guy while he is down, but more a cautionary tale for us all. There but for the grace type of thing.


Bill Gross was close to a god in this business for decades. He helped co-found PIMCO over 40 years ago and built it into a $2 trillion firm at the peak. He was the first Bond King. There was even a book about him when he had a snazzy mustache.


I remember seeing him talk at a PIMCO conference maybe 10 years ago, tie draped around his shoulders, Paul McCulley at his side. They looked and sounded invincible, and for a time they were. But then Paul left. And then Mohamed El-Erian departed for no clear reason, and it steadily grew apparent that large egos were probably clashing.


And so it came to pass. In what turned out to be a pretty staggering coup, Bill was forced out of PIMCO by his top people and he joined Janus in 2014 to run an unconstrained bond fund. The move garnered a lot of attention, and even George Soros was rumored to have put money into the new fund. But returns were lackluster, and the death blow came in 2018 when the fund lost -3.9%. Redemptions pulled the fund’s assets below $1 billion, and much of the money was Bill’s own.



While the underperformance wasn’t massive (the bond index was flat last year), investors were expecting more from the ‘Bond King.’ What happened? What trade did Bill in?


Take a look at the chart below.



This shows the spread between the yield on the U.S. 10-year Treasury and the equivalent German bond. For example, today the 10-year Treasury yields 2.70% while the 10-year German Bund pays 0.13%.


Bill bet this line would fall. He was short German bonds and long U.S. Treasuries. However, the line went up. Year after year. After year. His comments to Tom Keene earlier this month sum things up:


“…for the past three or four years, the negative trade… has been Germany versus the United States. In terms of the spread, 10-years German bunds started out in my portfolio at 190 basis points over [US Treasuries] and they are now 250 basis points over. It’s been the big decider and probably one that I shouldn’t have put as many chips on the table. The old Ed Thorpe term – the gambler’s ruin concept said that you only bet 2% of your total capital and certainly I had positions… that were significantly more than that, especially the German-US Treasury note trade and that was probably too much. It was an unconstrained portfolio and investors were expecting hedge-fund-like returns…”


So, where’s the lesson here? It’s not so much getting a trade wrong. Everyone does that. It’s part of the game. But Bill bet too big. In retrospect he was swinging for the fences rather than going for singles or doubles. He had an investor base that wanted absolute returns, after all, that is what an unconstrained fund is for. They weren’t in it for losses.


Bigger picture, reversion to the mean trades are tough. Long-Term Capital went belly up making bets that old relationships would revert back to normal. In their case they did, but only after they went bust. Could the German 10-year go negative again and the spread get wider before it contracts? Looking at the chart below you have to think why not? A recession in Europe this year would almost surely push this negative.



Now longer-term will German inflation remain materially below U.S. inflation? This is a tough question. Certainly, Europe looks more like Japan ten or fifteen years ago than it does the U.S. Secular stagnation could be the name of the game on the continent. But regardless of your view, Bill’s lesson is to keep your bet small if you want to make the trade.





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