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Today, almost all investors are tied into Bonds because Bonds have performed for thirty years. Yet at no other time has so much been invested to earn so little yield (and at such a high price) than today’s bond market.

Too Big To Sell

March 4th, 2015 by Kurt L. Smith
  • As a long-time reader you know that I believe the bear market in Bonds began in June 2012. This is a “considerable” length of time ago, to use the parlance of the Federal Reserve, but when you are describing the end of an almost thirty year bull market run for Bonds, well, the longer they are, the harder they fall.

    For those of you watching (and waiting) for mile markers to come (and go) along the way of this budding bear market, we have another one this past week. Paul McCulley, long-time lieutenant to PIMCO’s captain, Bill Gross, left the firm this past week. Mohamed El-Erian, another Gross lieutenant, was the first to leave in January 2014, even ahead of the captain himself when Big Bill left last September.

    With well over a trillion dollars in Bonds under management, no firm epitomizes for me, the Bond market itself, quite like PIMCO. With Big Bill Gross as its founder and captain, together with the thirty year Bond bull market, he made PIMCO THE bond firm. Bonds, Gross and PIMCO were one and the same.

    But as the market giveth, the market taketh away. Sailing with the winds of a bull market at your back and traversing a more than challenging bear market are two completely different animals, particularly with a trillion dollars under management. With the shift occurring in June 2012, the PIMCO titanic hit a monumental iceberg in the now unfolding Bond bear market.

    In my PIMCO analogy, Mohamed was the first to recognize the new reality. USS PIMCO was beginning to take on water and Mohamed made the decision to jump ship. Perhaps this was only a flesh wound, but when the captain abandoned ship in October those not paying attention should. After thirty years at the helm, Gross met his match with the nascent Bond market bear. And now another lieutenant, McCulley, jumps as well.

    With the initial damage from the iceberg showing itself in 2013 performance, we witnessed the Bond market taking its first dive in years. But just as many economists and pundits jumped on the higher rate bandwagon (and lower bond prices), we first had to experience the hope that perhaps all is not lost. We witnessed a nice bounce back in bond prices in 2014 and now that move appears to be over and the ravages of a bear market are about to show themselves in 2015. In a matter of just a few weeks in February, ten year treasury note prices have fallen 4% while long-term treasury bonds are down 11%, according to my Bloomberg. I believe the bear is on; with McCulley’s recent exit, I believe it more.

    Whether an asset manager could possibly sell a trillion dollars in bond assets is at best a rhetorical question. It also misses my point. I don’t know why Bill and his gang left PIMCO, but this is my narrative. One does not jump a smooth sailing ship into one’s own retirement; one does jump from a sinking one and a turn from bull market to bear market is an iceberg of epic proportions.

    You may be old enough to have owned bonds before the bull market began thirty years ago. If you did I would bet (heavily) that you did so in the name of diversification and also that you didn’t have that much money back then. In other words, not many (any?) investors have experienced a bear market in bonds. You may remember 1992 or 1998 (tiny swoons) and certainly you remember 2008 as more than a swoon. But all of these occurred with a backdrop of occurring within a larger bull market. A bear market is different, hugely different, and worthy of abandoning ship over.

    Whereas the financial crisis that began in 2007 can be seen as a banking crisis, I believe the Bond bear market will lead to an asset management crisis. Gross and company chose to abandon a trillion dollars in assets under management; Gross is essentially starting over. In banking we have too big to fail; in asset management it appears we have too big to sell. Gross was the skipper of his ship for most of his smooth sailing, later selling to Allianz, an asset management conglomerate that might not like what it takes to prepare for a punishing bear market.

    Let’s face it, nobody likes bear markets, and who can really fathom what a bear market for Bonds can even mean? The last time we had one…well no body can remember and nobody had any money tied up in it anyway. Today, almost all investors are tied into Bonds because Bonds have performed for thirty years. Yet at no other time has so much been invested to earn so little yield (and at such a high price) than today’s bond market. The amounts are almost unfathomable.

    With so much at stake one would think asset managers would prepare, especially after watching the leaders in their industry, Gross and company, abandon ship. But as we see with PIMCO, perhaps the entire industry is too big to sell. Easier to jump ship and start anew than to try and restructure a trillion dollar bond portfolio. If that is the case then again I say this bond bear market will be unfathomable.

    We, as investors in the multitudinous municipal bond market, have been preparing for the Bond bear market for many years now. We have even been well served over the past several years when it looked like the bond market bull may run forever. We believe that not to be the case and we have marked Thanksgiving 2012 as the turning point and the beginning of the municipal bond bear market. Since then we have seen Detroit and Puerto Rico, and I am in agreement with the most fervent of bulls that these are merely flesh wounds. I however believe they are flesh wounds because the real damage lies ahead.

    Almost no one can envision how interest rates can go higher. This is exactly how markets work, as we discussed last month. My PIMCO narrative above is as good a reason as any (again, it is my narrative), but it is based on the trends of the Bond market. Prices are trending lower, this we know, and we also know that prices can go lower, and a lot lower faster, as we have seen in Gold, Oil and even foreign currencies. This is why preparation is key.

    I am not assuming a swoon; I am assuming a relentless downward trending market that will have enormous implications for financial markets and the asset managers that must navigate waters that I believe will become ever more treacherous. I believe El-Erian, Gross and now McCulley are very smart people who also saw the significance of a new Bond bear market. I, however, am not abandoning ship (nor do I have a trillion dollars to try and manage). Instead we are preparing and prepared to keep improving your portfolio as the journey is in its early, yet quickly developing, stages.

    Eagle Mountain & Saginaw Independent School District, TX Refunding

    S&P AAA (AA- Underlying) Fitch: AAA (A+ Underlying)

    Permanent School Fund Guaranteed

    Due 8/15 Dated 2/15/15 Maturity: 8/15/2032

    Sale Amount: $69,479,751

    YEAR MATURITY COUPON YTM*
    0 2015 2.00% 0.15%
    1 2016 2.00% 0.39%
    2 2017 2.00% 0.69%
    5 2020 2.00% 1.50%
    5 2020 5.00% 1.50%
    6 2021 2.50% 1.69%
    7 2022 2.125% 1.92%
    8 2023 2.50% 2.09%
    9 2024 5.00% 2.24%
    10 2025** 5.00% 2.35%
    11 2026** 4.50% 2.50%
    12 2027** 4.00% 2.73%
    12 2027** 5.00% 2.57%
    13 2028** 5.00% 2.68%
    14 2029** 3.00% 3.18%
    15 2030** 5.00% 2.79%
    16 2031** 5.00% 2.84%
    17 2032** 5.00% 2.89%

      *Yield to Worst (Call or Maturity) **Par Call: 8/15/2024

    Source: Bloomberg

    This is an example of a new issue priced the week of 3/2/15

    Prices, yields and availability subject to change

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