A recession is probably under way, says the Pimco bond guru, so the best deal today may be in municipal bonds. By Manuel Schiffres, Executive Editor January 31, 2008 Bonds don't get much respect, except when the stock market is tanking. That makes this a perfect time to check in with Bill Gross, arguably the nation's most respected bond fund manager. Gross is chief investment officer of Pimco, a Newport Beach, Cal., firm that specializes in bonds. Under Gross's leadership, Pimco manages fixed-income assets totaling $747 billion. Gross and his team are known for their big-picture calls on the economy and the direction of interest rates. It is the uncanny accuracy of those forecasts that has propelled Pimco Total Return, the firm's flagship, to one of the top records in the fund business. The fund's institutional share class (symbol PTTRX) returned 9.1% last year, compared with 4.7% for the average intermediate-taxable-bond fund, according to Morningstar. Over the past 20 years, Total Return gained 8.5% annualized, beating the category average by an average of 1.3 percentage points per year. And in no one year has the fund ever been in the bottom half of its category. Advertisement You'll need a cool $5 million to invest in Total Return's institutional shares. Other classes with sales charges or higher fees are available with lower minimums. Fortunately, Gross and colleagues also run Harbor Bond (HABDX), a no-load clone of Total Return that charges only slightly higher fees. Harbor Bond is a member of the Kiplinger 25. We visited Gross on a chilly southern California day in late January for his take on the direction of the economy and the markets. Here are edited excerpts of our conversation. KIPLINGER'S: Is the U.S. economy in recession? GROSS: I think so. The drop in consumption during the Christmas shopping season and the continuation of the housing debacle in combination with a slowing global economy may have produced the beginning of a recession. Advertisement Your recent commentaries don't lead us to believe you're expecting a mild, short recession. You talk about the loss of trillions of dollars of lending power. What are you expecting? That's the hard question. Our economy hasn't experienced something like this, an implosion of the credit markets, a reversal of what we call the shadow banking system, a reduction in lending of significant proportions and the diminished prospect for a reversal anytime soon. In prior cycles, the solution was always to lower interest rates, get banks in the spirit of things and away we go. Now it's not so easy because the banks have problems, and the housing market is not really linked to the short-term interest rate any more. The adjustable-rate mortgages are passé and dangerous, and the 30-year mortgage is the mortgage du jour. And those rates aren't low enough and probably can't be lowered enough. So it's hard to know. It's helpful that some of the world, Asia obviously, is growing at a decent pace and sort of saves us. But it's hard to know how long this will continue. Advertisement You've painted a dire picture. It certainly paints a picture of very slow or even negative growth in 2008 for a long period of time. It means that 2009 will not be that prosperous of a year because the tools that we have used in the past to produce relatively strong recoveries are not applicable in this kind of environment. Meaning one in which the banks are reluctant to lend? Yes, but in the past five years, the lending has really been taken over by the shadow banks, meaning hedge funds, structured investment vehicles, meaning all sorts of financial conduits. To bring back the spirit of lending means that you not only have to get the banks healthy, but you have to have some rejuvenation of this shadow system, which frankly is not coming back. Advertisement Did you see this coming and manage to keep your own funds out of the toxic areas? Two years ago, it became obvious with the subprime loans and all the funny-money mortgages that were being created that something was amiss. And so what we did here at Pimco was to take ten of our credit analysts, the people who were following General Motors and IBM and American Express, and said, "Hey, that's not where the problem is; the problem is in real estate. So each of you is assigned to a different city in the U.S. One of you goes to Miami, one goes to Vegas, to Detroit, to Boston, to ten different cities, and pretend -- it was sort of a ruse but not illegal -- to be a buyer of a home. And you come back and report on the trends of the housing market in your particular area." So we didn't have to look at monthly government numbers, which are suspicious to begin with. And so we were the first ones to know that subprimes were a very dangerous kind of proposition, and we stayed away from them entirely, and that's one of the reasons we're at the top of the heap, as opposed to the bottom. Your flagship fund, Pimco Total Return, was up 9% last year and some funds were down in double digits. Yes. We stayed away from junk housing, but then we also did something like a double play. Staying away from the junk was the out at second base, so to speak. But to get the next out at first base, we then took the policy response, meaning the Federal Reserve lowering interest rates. Instead of investing in the subprimes, we invested in the Federal Reserve, basically by buying two-year Treasuries, three-year Treasuries, safe assets but ones that would participate from the decline in the Federal Funds rate that we expected. So the throw to second, the throw to first, double play. It sounds so simple in retrospect. You were talking about the decline in mortgage rates. But 30-year mortgages are now at about 5.5%, and I see prices going down. Isn't that an ideal combination: low rates and lower prices? Is that not enough to revive housing? Because of the decline in prices, about 5% on a national basis, and the decline in mortgage rates, to about 5.5%, homes are certainly much more affordable now than they were six to nine months ago. As a matter of fact, affordability is now about average relative to the past ten years. I suspect, though, that much like you need a much lower interest rate to get things going, you need a higher than average affordability index. You need a lower mortgage rate and lower housing prices to really get someone back into the market. When people get scared in housing, they simply lay back and say, "I'll wait three to six months." There's been a lot of commentary about the Fed's three-quarter-point drop in interest rates between meetings. Some say the Fed is focusing too much on stock prices. Others say the Fed is worried that the economy is in worse condition than people think. What's your take? I think it's a little bit of both. The coincidence in the timing was too remarkable to think that anything other than stocks was part of it. I think the stock market is on the list, but the stability of the financial market is a priority. But to the extent that they felt they needed to go to 3% anyway, they might as well get it done quickly [the Fed lowered its key Federal funds rate to 3% on January 30]. And there was a stock market debacle occurring the day of the big cut, so I guess it made sense. Can you have a recession without a bear market for stocks? You could have the bear market occur before the recession. And then stocks normally start to improve in the middle of a recession. There are three critical pieces to the stock market's valuation: one, the level of profits, and the problem there is that they're historically high and there's going to be some giveback, not just because of the recession but because of the potential for a Democratic president seeking to reverse some of the tax breaks that have resulted in higher after-tax profits over the past seven years. You have the stock market depending on the volatility of those future profits. And we've been very volatile here, and that's not good. And third is the level of real interest rates, and they've come down pretty dramatically. So you've got a saving grace with real interest rates. The hard part is just trying to figure out what corporate profits are going to be and how volatile the damn things are going to be over the next 12 months. The period of the great moderation is over. Where do you see long-term and short-term interest rates a year from now? I see the Fed ultimately going to 2½% and the ten year, which is now around 3.60% or so, at probably around the same level. Where will people make money in bonds this year? Not with the approach that we've made so much money in, namely, short-term two-year Treasuries. The two year Treasury yields only 2.15%. What does that tell you? We are now moving away from that. Is there a bubble in Treasury prices? Even if there is one, if the Fed goes low and stays low, which I think it has to, then the bubble doesn't pop. But 2.15% is certainly an absurd return other than for the safety of the asset. Ultimately, the way to make money in 2008 will be to gradually extend into the high-quality corporate bond area and then into the low-quality areas late in the year. Both areas are now being shunned by risk-averse investors. For instance, we're buying bank bonds. This afternoon we bought $500 million of Wachovia ten-year senior holding company notes, double-A paper issued by, yes, one of those too-big-to-fail types of banks. They sold at a spread of 200 basis points over treasuries, or 5½% (one basis point is one one-hundredth of a percent). So our strategy is to move gradually from Treasuries to double A's to single A's to B-double-A's and yes, at some point, God forbid, back to junk bonds. And that presumably would be at a time when the market's starting to anticipate an economic recovery? Yes, we would want to see that. We wouldn't want to invest in a B-double A bond (the lowest investment-grade rating) or a junk bond unless we saw a recovery. What advice would you give individual investors with respect to their fixed income portfolios? The most attractive area, the one that's been tossed away for a number of reasons, is the municipal-bond area. There are hundreds of closed-end municipal-bond funds that trade on the New York Stock Exchange. Many trade at 5% to 10% discounts to their net asset values and at yields of 5%, plus or minus. Municipal bonds have been tossed away for several reasons. One: they're not bought by the Chinese or by the Saudis. The Saudis have no use for a municipal bond and its tax advantages. That's one of the reasons they haven't gone up in price and down in yield. Second, they have been put into some of these conduit structures and guaranteed by companies like AMBAC and MBIA. These insurers are now teetering on the edge. Because of that, insured, triple-A municipal bonds, which are naturally single-A and double-A pieces of paper, are in danger of being liquidated. But the inherent quality of single-A and double-A bonds -- a school district in Fresno, for example -- is strong. The history of defaults among those kinds of bonds is minimal. It's hard to find municipal defaults. So at yields that are more than government yields and actually more in many cases than double-A and single-A corporate yields, municipal bonds are really attractive. I own a lot of muni closed-end funds. Pimco has some, Van Kampen has some, Nuveen has some, Blackrock has some. A lot of closed-end funds carry the word "insured" in their names. Investors have run from those funds as fast as you can imagine and therefore sold those funds down to unrealistic levels. How do you analyze these closed-ends to avoid buying one that cuts its dividend? It's difficult. The best thing to know is that during periods of rising interest rates, which is what we'd seen up until last September, the probability of a dividend cut increases dramatically because the cost of the funds' borrowing goes up. When the Fed lowers interest rates from 5¼% to 3% and maybe lower, then profit margins improve and the possibility of a dividend cut is dramatically lower. The next step is to find a fund family that has a good history of maintaining dividends. If the rating agencies downgrade the bond insurers, won't even more people bail out of insured bonds and cause further price declines? In most cases, the difference in yield between an insured municipal bond and a double-A bond is ten to 15 basis points. On a typical maturity, that's at most maybe 1% in terms of price. Even so, munis are still attractive. To the buy and hold investor, a price decline of this size shouldn't matter. Right.