Everything You’ve Heard About Investing Is Wrong!

Book by William H. Gross

Review & Article by GlobalMacroForex

Bill Gross is considered the “Bond King,” and in this 1997 book he lays out some of his original thinking prior to the financial crisis about the coming bear markets.

Some of his main points are:

·      There’s an upcoming bear market in stocks and bonds

·      Despite the upcoming bear market, going long credit spread volatility is overrated

·      Too much diversification is bad

·      Don’t sacrifice yield for liquidity

Modest Diversification

Bill Gross does advocate diversification for risk reduction, but he thinks many people tend to overdo it.

“Good ideas should not be diversified away into oblivion”

He instead thinks investors should focus only on their best ideas so they have more of an impact on the portfolio.  He gives a hypothetical example of 10% of the portfolio in a single idea as a balance.  In addition, he thinks an investor should opportunistically allow for a larger position size when he (or she) has greater confidence in the idea or situation.  He likens it to gambling in Las Vegas,

“When the odds favor the player, it’s incumbent to make a bigger bet.  If you don’t’ do it during the few times the cards favor you, the house will inevitably win.”

Going Long Credit Spread Volatility is Overrated

Because they are considered riskier, corporate bonds and local government debt have higher yields than Treasuries.  When there are times of uncertainty, the yield difference between Corporates and Treasuries (i.e., the “credit spread”) widens.  This is because corporate bonds go up in yield to compensate for the higher risk.  On the other hand, Treasuries yields go down as investors “flock to safety”.  This chart from the Wall Street Journal shows an index that measures this spread, which spiked during the 2008 financial crisis.

This graphic from Investopedia captures the yield curve differences,

Bill Gross argues why going long volatility in bonds is overrated.  Keep in mind this book was written in 1997, prior to the Fed easing in 2008, so his perspective was more accurate then.  But to show his conviction in his idea, Gross suggested it when he was a bear on the overall market – a bear market being a period in which credit spreads widen.

Gross’ idea applies more to bonds than stocks.  Gross argues if long-term Treasury rates go from 9% to 11%, the increase in rates would likely slow the economy and that slowdown would bring rates back down.  On top of that, it’s political unlikely that the Fed would allow rates to rise much.  So he concludes:

“The 11% scenario, then, while just as probable as 9 percent under strict option theory, becomes fundamentally and indeed politically less likely than its downside counterpart.  Option volatility, therefore, becomes overpriced because it’s extreme upside and downside “legs” or “trees” are likely to be truncated.”

Basically, he’s saying that high long-term rates bring a recession.  Recession causes the yield curve to flatten, thus bringing long-term rates back down.  So paying for an option (long volatility) is a waste since the situation corrects itself.  Instead, Gross recommends going short volatility by either selling options or through more risky bonds to pick up extra yield.

Gross discusses a 1986 article in the Journal of Finance from Fischer Black (the creator of the main options pricing theory in which options are valued).  In the article, Black discusses “noise,” which is random movements disconnected from the fundamentals or new information.  Since there are limits to the movement based on fundamentals, therefore the volatility premium is overrated and an investor should sell the noise.

My opinion of Bill Gross’s idea of shorting rate volatility

First, this book is dated; the Fed now has rock-bottom rates which are slowly rising.  So there is a strong likelihood that rates might go up from current levels.  Second, under a 60% equities/40% bond portfolio, the purpose of the bonds is to protect the investor from downside equity risk as the bonds appreciate as rates go down.  So in this type of portfolio, Gross’ idea is much more risky because he’s allocating the “safer” part of the portfolio to riskier assets.  The bonds should be appreciating during volatile “risk-on” events, but under Bill Gross’ scenario, they go down with equities also.  Metaphorically the financial crisis was caused by everyone being short credit spreads for yield.

However in a portfolio where bonds are the primary source of yield instead of equities, then what Gross is saying makes much more sense.  It would be logical then to reach for yield and short the credit spread.  Also if the bonds are being held to maturity, then it makes even more sense, since the spreads widening then would allow a higher reinvestment when it matures.  In addition, if the spread widens only temporarily, the probability of a bond expiring during that period is lower than if someone had an option on the bond like a callable.

Don’t sacrifice yield for liquidity

Bill Gross gives the example of how most fund managers keep a portion of their portfolios in US Treasury Bills so they can easily liquidate them when a great equity stock position opportunity arises.  Gross believes these managers usually don’t find the right position and end up sacrificing yield in the meantime to get the potential liquidity that they don’t even end up using.  He compares it to a baseball player not getting to first base because he insists on a home run.

In my opinion, investors should want the best of both worlds.  If you can manage your liquidity such that either you can sell out of one high-risk position to take an opportunity in a similar asset class (e.g., sell equity to buy equity), then it makes more sense to have the short-term credit be at the highest yield possible, even if it means sacrificing liquidity.  If these short-term bills are being held to maturity, then it makes even more sense.