Q&A with Bill Gross: Making a case for bonds, even as returns falter

The Pimco chief discusses his outlook on bonds, interest rates and why the so-called great rotation out of bonds isn't likely to happen

By Jason Kephart

Mar 10, 2013 @ 12:01 am (Updated 4:57 pm) EST

Bonds, interest rates, Pimco
Tim Rue

First, the good news: Bill Gross, co-founder of Pacific Investment Management Co. LLC, the world's largest bond shop, doesn't foresee interest rates rising sharply enough to cause the kind of big losses in bond funds that could send investors fleeing.

The bad news is, the scenario that he does see unfolding still is pretty bleak.

Mr. Gross expects the return on bonds to drop to the 2% to 3% range — sharply lower than their 8% historical average — meaning that with normal inflation, the return effectively would be zero.

He sat down recently to discuss his outlook on bonds, interest rates and why the so-called great rotation out of bonds isn't likely to happen.

InvestmentNews: Over the past four years, assets in bond mutual funds have more than doubled to over $2 trillion. How should financial advisers be thinking about their bond portfolios?

Mr. Gross: The future for bonds is a lower-return future than in-vestors have come to assume. Bond investors should be expecting 2% to 3% returns over the future years. What we caution — and not just because we're a bond shop — is that bond returns will be lower than expected, but the important thing is, they're still better than cash and will provide positive returns.

InvestmentNews: It doesn't sound as if you are very concerned about interest rates rising quickly and causing big losses in bond funds. How do you see interest rates moving?

Mr. Gross: I call it a smile. I've got a happy-face button on my desk. It's got the two eyes and a gradual little smile for its mouth. The way we see it, interest rates are like the very gradual smile on the right side of the face, so to speak. Interest rates, on the 10-year [Treasury], for example, will rise 10 to 15 basis points a year.

A big spike in interest rates is certainly a worry for bonds, but it wouldn't be friendly for stocks, either.

InvestmentNews: If interest rates aren't a big concern, what is?

Mr. Gross: As a bond investor, I would be afraid of inflation. Inflation is the enemy of bonds. At the moment, it's very controlled at less than 2% a year. You need to be able to discriminate which bonds will be affected by inflation. Eliminate your long-term bonds and start to look outside the U.S. for countries with a less bearish outlook.

InvestmentNews: The Federal Reserve's quantitative-easing programs have played a big part in the pricing of bonds and interest rates. How long can they keep it up?

Mr. Gross: No one really knows, and perhaps even [Fed Chairman Ben S. Bernanke] doesn't know when QE is going to end. We have a sense that the Fed will continue QE until real growth is stabilized in the 2% to 3% range for at least six to 12 months. The earliest that would be is January 2014.

InvestmentNews: What happens when the Fed stops buying assets?

Mr. Gross: There's a chance interest rates will start to go up, or they lose control of asset prices, which they've delicately been trying to engineer. What we saw [Feb. 20] and a little bit [Feb. 21] is evidence that when the Fed stops writing checks, stocks, high-yield bonds and other risk assets are at risk. The risk is that they produce a 10% to 15% bear market in stocks by ending QE too soon — and therefore a potential new recession.

InvestmentNews: High-yield bonds have been popular for investors looking for yield. How should advisers be thinking about high yield?

Mr. Gross: Our research does suggest there's a higher risk in buying high-yield bonds today than there was 12 or 24 months ago. If you're buying a high-yield bond at 6% today, recognize that there isn't much room for capital appreciation.

InvestmentNews: With the outlook for bonds dim, do you see investors moving more into stocks?

Mr. Gross: The great rotation from bonds to stocks doesn't really have legs. The world is getting older by the day. That plays right up the bond market alley. The world is going to be dominated by bonds. A 68-year-old retiree in Des Moines, Iowa, can't afford to buy Apple [Inc.] at $700 and watch it go to $450. They can't have their 401(k) turn into a 201(k). Bonds are almost a necessary strategy in many cases.

InvestmentNews: If that is the case, what was the reason for ex-panding into active equities at Pimco?

Mr. Gross: It was just a matter of filling out the menu. We don't want to be In-N-Out Burger and only have one or two things on the menu. We want to be the Cheesecake Factory. We call ourselves “your global investment authority,” and we already offered commodities and a few other things. It's the right business strategy. It's not something that said, “Hey, stocks are going to take over the world.”

InvestmentNews: So advisers are going to have to be happy with their 2% to 3% bond returns?

Mr. Gross: The media used to be optimistic and promote the expectations of sugar plums and tooth fairies. When you go on TV, it's a better business strategy to say, “We can get you 5% or 10% returns.” [Pimco has] always thrived on straight talk.

jkephart@investmentnews.com Twitter: @jasonkephart