to Sell Treasury Bonds
September 27, 2011
Discussion
There are two distinct considerations that bear on a fixed income portfolio’s allocation to Treasury bonds. The first of these is that the yield on Treasury bonds has been very low relative to their associated risk. In an article in October 2010, I showed that Treasury bonds were delivering lower yield relative to their risk than corporate bonds, which was precisely the basis of Gross’ argument that credit risk looked more attractive than interest rate risk in February.
The other piece of the argument, however, is that even if an asset class looks unattractive on a standalone basis, it may still be desirable for its portfolio diversification effects. As I noted in my article on this topic in May of 2011,“The fact that long-term government bonds looked unattractive on a standalone basis back in October 2010 did not suggest that there was no place for an investment in this asset class.”
Because of the value of diversification, the optimal income portfolios in October 2010 included allocations to Treasury bonds even though they were overvalued when viewed in isolation.
With my analysis of PTTRX using data through February, the picture was more nuanced. When I created optimized portfolios that combined PTTRX with allocations to Treasury ETFs, I did not identify portfolios with meaningfully higher yields at the risk level of PTTRX. In fact, while the optimal portfolios had substantial allocations to Treasury bonds, their yields were essentially identical to that PTTRX. My view, therefore, there was no clear strategic imperative for Gross to have held Treasury bonds.
The optimal portfolios, though they had almost identical yield and risk projections as compared to PTTRX, had some notable differences. First, the optimal portfolios were more highly correlated to AGG. Second, the optimal portfolios had higher interest rate risk, because of their exposure to Treasury bonds.
The result of Gross’ decision in February to reduce interest rate risk and increase credit risk was that PTTRX had higher exposure to equity risk (as expressed in its beta). While Treasury bonds typically have zero or slightly negative betas, corporate bonds have modest positive correlations to equities. The tradeoff between rate risk and credit risk was quite substantial, and it did not pay off.
So what is our take-away? First and foremost, Gross performed a nuanced reduction of interest rate risk and increase in credit risk, resulting in a portfolio with the maximum available yield for the risk level. But over a very short period this tactical bet went bad. Gross was not secretive about his position that he preferred credit risk to interest rate risk, which flows naturally from the ‘New Normal’ paradigm that he and PIMCO have developed. Substantial inflation is one of its core precepts, and it follows that managers should reduce interest rate exposure.
Gross did exactly what his outlook suggested he should do. He took a tactical position without giving up any yield or taking on any additional risk. In doing so, however, he increased his tracking error relative to his benchmark (recall the lower correlation between PTTRX and AGG). The tactical reduction in Treasury exposure resulted in an increase in exposure to equity market volatility. Over the next six months, Treasury bonds rallied and equities declined, with the unsurprising result that PTTRX exhibited poor relative performance.
Over a longer horizon, however, Gross’ positioning of PTTRX should have produced positive results relative to his benchmark. Credit risk provides more yield at a given risk level than Treasury bonds. The problem for Gross is that mutual fund investors are not a patient lot and, as the person at the helm of the world’s largest mutual fund, his short-term performance gets considerable scrutiny.
Geoff Considine is founder of Quantext and the developer of Quantext Portfolio Planner, a portfolio management tool. More information is available at www.quantext.com.
Geoff’s firm, Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com), an innovative brokerage firm specializing in offering and trading portfolios for advisors and individual investors.
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