Are bonds expensive or cheap after the sharp rise in their yields recently?For Bill Gross, the man who was once considered, justifiably, “the bond king”, the answer is expensive. In a recent article in the FT he recommended that investors exit bonds, with the exception of U.S. Treasury bills up to 1 year.
Bill Gross was unquestionably the best bond manager in the world from 1987 to 2009. However, in 2011 he made the big mistake of assuming that the end of quantitative easing (QE) by the Fed would send bond yields soaring. So he sold down to zero the bonds held by the PIMCO Total Return Fund, resulting in large losses as yields fell while investors rushed to buy them, seeking a safe haven.
It was the beginning of the internal conflicts that led to his exit from PIMCO. Afterwards, Gross took over a Janus Henederson fund but continued making mistakes. This time, in 2017-2018, he wrongly bet on the convergence of U.S. and German interest rates.
On the opposite side stands James Bianco, a veteran Wall Street manager, who has correctly predicted what would happen in bonds from 2020 onward. In the era of de-globalization, tariffs, supply chain problems, and the two wars in Ukraine and Iran.
Bianco therefore announced that he is increasing the average duration in his bond portfolio above the benchmark, effectively strengthening his position in medium- to long-term bonds. The reason?
Bianco does not believe that bonds are now expensive, but neither are they cheap. They are not expensive because most of the U.S. yield curve is within the 5%-6% that is the expected GDP growth rate. If bond yields were above the 5%-6% growth rate, then they would be cheap.
He does not link the rise in bond yields to the increase in public debt as most in the market do. As he says: The bond market may stop panicking if the Fed starts panicking. With this reasoning, the biggest mistake would be to compress interest rates below the nominal GDP growth rate.
As for inflation, Bianco estimates that the problem is not that it is rising. The non-steady deceleration in goods prices that would lead it below the 2% target of the Fed or other banks is the real problem.
Nor does he believe that a long period of economic growth should lead to higher interest rates out of fear that inflation might rise. Here fits the well-known observation of economist Rudiger Dornbusch that economic expansions do not die of old age but are “murdered,” e.g. by large interest rate hikes.
Bond yields may well rise further in the coming months. However, bond mathematics show that the impact of a one percentage point increase in yield, for example on the 10-year, results in losses close to 1.5% but also gains of 12%+ if the increase turns into a decline in yields.
Two veteran fund managers with different views on the course of the bond market. Bill Gross versus Jim Bianco. In 6 months to 1 year we will know which of the two was wrong and which was right.