I’m going to one-up Mark Twain in the quantity department and spin two yarns about jumping frogs, one which has been frequently told, the other not so much. Neither of them have anything to do with Samuel Clemens’ heralded short story, but both, metaphorically at least, describe our current investment markets and how to think about the future. My first story is the one you’ve all heard about. Put a frog in a kettle of boiling water and he’ll jump out faster and further than any of those blue ribbon winners at the Calaveras County jumping frog contest. Put him in a pot at room temperature, however, slowly turn up the temperature to boiling, and you’ll have frog legs for dinner. This latter, more unfortunate toad temporarily adapted to his external environment, which seemed like a practical thing to do, until – well, until he reached 212° at which point he was cooked. Today’s bond investors are experiencing a similar fate with nary a “ribbet” of complaint.
All right fellow frogs, so we’re being repressed and shortchanged in order to allow Uncle Sam to balance its books. Whatta we gonna do about it? “Frogs of the world unite,” as Lenin might have said, and so here’s where I harken back to Mark Twain and my second lesser-told frog story. There was this other frog who instead of being tossed into a pot of hot water was left to cool its heels in a pitcher of cold milk. Unable to jump out, he churned and churned those frog legs until eventually the milk turned into butter and the hardened butter allowed him the platform to leap to froggy freedom! Well, let’s get churnin’, fellow frogs. If the U.S. or the U.K. or any other government is going to attempt to boil us alive, let’s make butter! Butter in this instance is what PIMCO characterizes as “cheap bonds.” Potentially confusing, “cheap bonds” is really a simple concept – sort of like the teeter-totter. Any bond, even a Treasury bond, is composed of several pieces – sort of like an atom with its neutrons, electrons, protons, positrons, neutrinos (whoops, don’t wanna go too far here). There’s an interest rate or yield piece, commonly measured by “duration.” There’s a credit piece, typically referred to as a “spread” when you buy a corporate bond. And there’s a volatility piece, a liquidity piece and other little bits and particles that will go unexplained for now. The important point, though, is that if the government is going to artificially repress yield, then an intelligent frog should focus on the parts of a bond that are less repressed! You can, for instance, produce a 1% expected return in today’s market in a number of ways. Buy a repressed 3-year Treasury note at just under 1%, or purchase an A-rated corporate floating rate note (FRN) with little to no durational risk at a 3-month LIBOR +75 basis points spread, currently returning 1%. Which is the better deal? Well, they both appear to lead you to the same place but our cheap bonds argument would maintain that the FRN gets you there with a lot less risk. The credit piece, in other words, is a safer spread than the duration piece.
Journalists, financial advisors, and perhaps even some clients marvel at how PIMCO can be doing so well in 2011 while being underweight the Treasury/durational component of the bond market. Folks – we’re making butter. If you’re being repressed, our strategy is to churn those legs, get out of the pitcher, and above all stay away from boiling pots of water.