Operation Twist Claims a Victim

Morningstar reported through the Wall Street Journal that PIMCO’s $244BN Total Return Fund (PTRRX) suffered the first outflow on its history last year. $5BN left the fund in 2011 including $1.4BN in December as investors soured on PIMCO’s mis-timed trades in U.S. government bonds. Bill Gross hasn’t achieved what he has by accident, and no doubt many more good years lie ahead. But the Federal Reserve’s distortion of interest rates, through Quantitative Easing (QE) Versions 1 and 2 and more recently Operation Twist illustrate the problem. Bond yields today do not reflect the private market’s appetite to lend money; they are being held down by the Fed’s buying. Consequently, ten year treasuries offering a yield of less than 2% are guaranteed to slowly erode the real value of the money invested in them even in a tax-deferred or tax-exempt account. For a taxable investor the erosion takes place more quickly.

Last Summer PIMCO publicly spurned U.S. debt as offering an insufficient return, and after lagging the indices badly while a Fed-induced rally took hold they reversed course. PIMCO no longer hates government bonds and a look a the holdings of PTRRX on Morningstar reveals several positions in long term government bonds. 2.3% is invested in the 3.5/8 of 2/2021; 1.5% in the 2.1/8% of 8/2021, and so on. 27% is in government debt – and yet, since the hold to maturity real return will most assuredly be negative, the justification for these holdings is that they will zig when other things zag. In a flight to quality, “risk off” trade (in which the market engages fairly often) holdings of treasuries can be relied on to retain their value or even appreciate. The negative return is in exchange for reduced volatility, and extracting real value from such holdings therefore requires that they be sold by a nimble PM at precisely the time of crisis. This is increasingly what active bond managers are faced with – they need to be good at market timing to justify some of their holdings.

PIMCO may well be good at that too, last year notwithstanding. As the government stealthily imposes loss of purchasing power on savers, successful bond managers will be those who are nimble enough to keep time to the music.