Bill Gross: How to play the yield curve

Bill Gross is realizing outsized gains by benefitting from the near record difference in yields between short- and longer-maturity bonds while preaching that investors should prepare for lower-than-average returns. “What we think is most attractive is the positioning in terms of the curve,” said Gross, the manager of the world’s biggest bond fund at Pacific Investment Management Co. “As long as short rates stay at zero or close to zero, and that’s the key caveat, then an investor can make money simply by buying 5-year Treasuries, watching them roll down the curve to four years and then popping back up to five years again.” Gross’s $234 billion Total Return Fund has returned 13 percent in the past 12 months, beating 65 percent of its peers, Bloomberg data show. Returns of 10 percent or higher are unlikely to be duplicated in what Pimco has termed the new normal, a period in which deleveraging, re-regulation and de- globalization will lead to slower growth, Gross said. He said investors should be prepared for returns of around 4 percent to 5 percent from bonds and stocks over the next several years. What makes Pimco’s strategy effective is that five-year notes sit on one of the steeper parts of the yield curve, with the securities above 145 basis points more than the Federal Reserve’s target rate of zero to 0.25 percent. Two-year Treasuries yield about 35 basis points more the funds rate, while four-year notes yield about 1.25 percent. ‘Reach for Yield’ “The five-year is identified as the point on the curve that has the best roll-down and carry,” said James Caron, head of U.S. interest-rate strategy at Morgan Stanley in New York, one of 18 primary dealers that trade with the Fed. “Investors who are looking to reach for yield are doing it.” At the government’s $37 billion auction of the securities yesterday investors and bond dealers submitted bids of $3.06 per dollar of debt offered, the most since August 2006, as the securities sold at a yield of 1.796 percent, the second lowest on record. The gap between 4- and 5-year yields is about 40 basis points, compared with a 30 basis point difference between 2- and 3-year debt, and the 80-basis point gap between 3- and 5-year interest rates is more than the entire 2-year yield of 60 basis points, Caron said. “Most money is managed five years and in,” Caron said. “The five-year note is a lot of people’s long bond,” a term used by traders for the 30-year Treasury bond, the longest-dated security sold by the U.S. government. Five-Year Notes Treasury sold $39 billion of 2.625 percent notes at a yield of 2.689 percent maturing July 2014 at $997 per security with a $1,000 face value in July 2009. An investor buying $100 million of the debt then would have collected $2.63 million in interest, while the securities have risen in price to $105.19, for a total return of $8.11 million. The notes traded at a yield of 1.26 percent today. The yield on the new five-year fell 4 basis points to 1.70 percent at 2:32 p.m. in New York, according to BGCantor Market Data, The 1.75 percent securities due in July 2015 rose 6/32 or $1.88 per $1,000 face amount, to 100 7/32. Last month, Fed Chairman Ben S. Bernanke and his colleagues on the Fed’s Open Market Committee reiterated their commitment to keep the central bank’s benchmark overnight rate close to zero for an “extended period” to help the economy recover from the worst financial crisis and downturn since the 1930s. “To the extent that this ‘extended period’ of time stays with us for two to three years then this roll-down curve strategy for Treasuries or for corporates can add a lot of money to the bottom line,” Newport Beach, California-based Gross said yesterday in a Bloomberg Radio’s “On The Economy” interview with Tom Keene. “The risk is simply that Ben Bernanke gives up on 25 basis points and starts to move upward like some of his fellow governors have suggested.”