After years of study and discussion, the SEC finally issued new rules on money market funds. The new rules process began after 2008. The SEC had allowed money market funds to maintain net asset values of $1 per share, even when there actually were fluctuations in their portfolios and on any give day the fund’s portfolio might be worth more or less than $1. After the Lehman Brothers bankruptcy a number of money fund suffered permanent losses of capital, and their net asset values definitely were less than $1 per share. Many fund sponsors shored up their funds to maintain the $1 NAV. But the Reserve Funds suffered substantial losses and weren’t able or didn’t want to add additional capital. The funds were liquidated at a loss to shareholders.
The SEC initially wanted to do away with the $1 NAV fiction. The industry and investors didn’t like that. For most of us, the rules won’t change. Money funds still will retain the $1 NAV fiction except in a few cases. But what will change for a lot of people is that in times of stress a money market fund will be able to stop redemptions. This takes away the idea that money market funds are just like checking accounts with higher interest.
The rules approved on Wednesday aim to prevent any future runs through a combination of measures. In one important change, certain money market funds will have to report a floating net asset value instead of a fixed value of $1 a share. This change is meant to remind investors that the funds are not without risk and that their value can decline periodically.
But not all funds will be covered by that rule. Only funds whose investors are institutions and that purchase corporate debt or municipal securities are covered. Funds whose investors are individuals are not subject to the change.
In addition, the S.E.C. adopted rules that give funds the ability to stem investor redemptions during times of stress. Money market funds, in these situations, will be able to impose fees and delays that temporarily prevent investors from taking out their cash.
Financial journalists have a need to write about what’s happening inside PIMCO ever since Mohammed El-Erian surprised everyone with his resignation early this year. The latest is this bit from The Wall Street Journal.. (Subscription might be required.) It doesn’t say much, though it does have a few behind-the-scenes stories from anonymous sources. Here’s one of several optimistic passages:
Both Messrs. Gross and Hodge said the transition to a new leadership team is going smoothly. Traders say Mr. Gross has been a calmer presence in recent weeks than at times in the past, helping boost morale. And Pimco’s investment performance has improved, leading some executives to feel the firm is close to weathering the recent storm.
Mr. Gross has begun to allow others to share some responsibility, appointing six executives as deputy chief investment officers. The deputies now take turns running investment-committee meetings, held four times a week. Previously, Mr. Gross and Mr. El-Erian split that duty.
“The table is more evenly balanced” than when Mr. El-Erian was at the firm, Mr. Gross said in the June 30 interview. “We needed some additional chefs and cooks. It’s working really well.”
We’re moving from an era when investors wanted primarily growth and capital gains to one when there is more demand for income, says Bill Gross of PIMCO. These investors want high income but also safe income. In this environment is it important that investment managers get right certain other issues, such as the safety of investments and relative yields. Gross pushes PIMCO “new neutral” theme as the appropriate one to follow. In new neutral, the Fed will hold its federal funds rate near zero longer than many people expect, and this will result in repricing of many assets. In his latest monthly essay, Gross explains what this means primarily for stocks and bonds.
O.K., hopefully I haven’t put you to sleep. My point is that if The New Neutral is closer to 0% real than the Taylor 2% which many expect, then all asset markets, which are priced off of it, are less bubbly than they appear at the moment. P/Es of 16-17x seem reasonable with a 0% real policy rate. 10-year Treasuries at 2.60% do as well once a term premium is added to 2% inflation. Credit spreads themselves, while almost historically narrow, may be using the wrong history book IF Taylor is their guide. At 0% real, high yield spreads of 350-400 basis points make more sense as do other alternative asset yields. Collectively of course, all of these asset prices depend on Janet Yellen’s “not too hot, not too cold” assumption that produces at least 4% nominal GDP growth, but that of course is what Neutral means. Minsky and future Minsky moments have not been outlawed. It’s just that PIMCO believes the New rate is closer to 0% than 2%. If it’s closer to 2%, then bear markets in all asset classes await. We think not.
To PIMCO, this means that asset returns will be low, but less volatile than in prior periods. Perhaps that is why the VIX and Treasury volatility are so low currently. The market may be buying into PIMCO’s view of a slow crawl to a New Neutral. Admittedly, on the other side of the argument, I haven’t even discussed the levered global economy, China, Euroland, or other potential hot spots that might spark another flash crash and mass exodus. There is tail risk in a levered global economy both on the inflationary and the deflationary sides.
The PIMCO top dog issued his latest monthly essay and continues to sound more optimistic than he has the last few years. But he didn’t deliver all good news. The foundation of Gross’s thoughts is that he, and PIMCO, believe that interest rates are going to stay low for some time yet, lower than investors currently anticipate based on market prices. While markets expect short-term interest rates soon will rise to near the historic average of 4%, Gross anticipates they will stay closer to 2%
Given that cash is likely to pay 2% or less through about 2020, then stocks, real estate, and other assets aren’t overvalued at today’s prices. They are fairly priced and not near asset bubbles, as they might be if the short-term yield were around 4%. The bad side of that argument is that a long-term cash return of only 2% means that returns from other assets are going to be less than the historic average as long as short-term rates remain low. That means many investors aren’t going to meet their rate of return goals if they follow traditional strategies.
I bring up this history to illustrate the problem that not only the Fed but all central banks face in this new epoch of high leverage. High debt levels don’t necessarily change the rules of finance (you gotta pay to play), but the models upon which they are based. Interest rates have to be lower in a levered economy so that debtors can survive, debt can be reduced as a % of GDP, and economies can avoid recessions/depressions! In a levered landscape, what is the magical “neutral” policy rate that can do all of that? Hard to know. No wonder the Fed and other central banks stumble along with QEs and Twists, extended periods of time, magical blue dots, and other potions and elixirs to try and produce a favorable outcome.
Despite the uncertainty and the recent importance of historical models using unemployment as a practical guide, there has been research that might point to a proximate neutral fed funds rate. Thomas Laubach and John Williams working for the Fed Board of governors wrote an early 2003 piece titled “Measuring the Natural Rate of Interest.” Their updated model from the San Francisco Fed website suggests the “neutral nominal fed funds rate” might be as low as 50 basis points currently and 150 basis points assuming 2% PCE inflation in the future. Others, such as Bill Dudley, President of the New York Fed, gave an important speech in May of 2012 suggesting a “neutral real rate” close to 0% which would imply a 200-basis-point nominal rate if the Fed’s inflation target was hit. PIMCO’s Saumil Parikh in a March 2013 “Asset Allocation Focus” concluded that a 100-basis-point or a 1% nominal fed funds rate was long-term neutral – stabilizing inflation at 2% and nominal GDP growth close to 5%.
Mohammed El-Erian, who departed PIMCO as CEO in January, gave his first television interview since his departure. In the interview with Bloomberg, El-Erian said he primarily left to spend more time with his daughter. It seemed clear to me that he was burned out from the intense schedule he was required to keep in his role at PIMCO and didn’t want to run the firm alone once Bill Gross reduced his hours at some point in the future. The tempest over El-Erian’s departure indicates that while PIMCO remains an excellent investment manager it isn’t as good at public relations. Both Gross and El-Erian have said they were surprised at the attention paid to El-Erian’s departure and the reaction of many investors and the media.
“I have had the privilege of watching him in action and he is just a great investor,” El-Erian, chief economic adviser to Allianz SE (ALV), said today in an interview with Betty Liu on Bloomberg Television. There’s a deep talent pool and an “enormous bench at Pimco and that is key for the firm,” he said.
El-Erian, 55, said he left Newport Beach, California-based Pimco after 14 years to do something different. His departure from the world’s biggest bond manager sparked media reports of tension with Gross as the firm struggled to staunch outflows. Gross, who manages the $232 billion Total Return Fund, said April 10 on a Bloomberg Television interview that El-Erian’s resignation was a mystery to him and he may have been premature in anointing him as his sole successor.
I was told a few weeks ago that the folks at PIMCO were finished talking about the departure of Mohammed El-Erian and would focus on managing money and doing business. But this week Bloomberg Businessweek has an extensive interview with Gross, devoting a lot of space to El-Erian’s departure and all the stories around that. The major take away is that those remaining at PIMCO are surprised that El-Erian hasn’t made any public statements about his departure. It’s a puzzle to outsider and apparently a puzzle to many PIMCO insiders. None of it matters as long as it doesn’t distract from the firm’s investment performance, and it will take a while before we have the answer to that. You also might be interested in this video.
When you ask people who know Gross and the company he built to describe its atmosphere, “intense” comes up a lot. Sometimes the words used are much stronger. Virginie Maisonneuve, the firm’s new head of equities, calls it a “refreshingly direct” culture, one where people are busy and generally get straight to the point, skipping over the chitchat and niceties, something she says she appreciates. “Everything seems to suggest that Bill is extremely hard to work with—he’s an emotional guy, he’s very competitive and tough-minded,” says Bill Thompson, who was CEO of Pimco for 15 years and remains Gross’s close friend. “I think that’s all true. But anyone who’s any good as a trader in the markets has got to have some pretty unusual skills. There’s nothing new about that. That’s what it takes, and he’s got it big time.”
In the April issue of Retirement Watch I tell readers that it’s usually a warning sign when a number of quality high-yield bond mutual funds close to new investors, as has happened recently. Here’s another warning, actually several warnings. In it several money managers, including Jeffrey Gundlach of DoubleLine Capital, state why they believe high-yield bonds no longer have a margin of safety. They’re concerned that once investors decide there’s too much risk or there are better yield opportunities, there will be a steep decline in prices.
Buyers demanded 3.78 percentage points more than similar-maturity Treasuries to own U.S. junk bonds on March 5, the least since 2007, the data show. That’s not enough, according to Martin Fridson, chief executive officer of FridsonVision LLC, a New York research firm specializing in high-yield debt.
“We’re at an extreme over-valuation,” he said in a telephone interview. “When you’re not compensated adequately for the risk, you do tend to get punished for it. If the Fed is still sufficiently energetic about it, they could keep it at an over-valuation through all of 2014.”
One of my longstanding investment rules is that investors who want to buy individual bonds (instead of bond funds) should buy only treasury bonds and only newly-issued bonds. You also can consider buying tax-exempt bonds if they are new issues. The reason for this recommendation is that the market for individual bonds isn’t nearly as efficient as it is for stocks. You’re likely to pay both markups and commissions on the bond purchases. It likely is cheaper to pay a mutual fund its fees and let them negotiate bond purchases.
Here’s the latest evidence, a survey by The Wall Street Journal. (Subscription might be required.) It found that individual buyers of tax-exempt bonds pay far more to brokers than they do for purchases of corporate bonds, and those are considerably more than brokers receive for corporate stock. Yet, individuals are the biggest buyers of tax-exempt bonds. If you buy individual bonds, hold them to maturity. You’ll lose quite a bit if you sell them to a broker.
Individual investors trading $100,000 in bonds of a municipality, such as Washington state, in December paid brokers an average “spread” of 1.73%, or $1,730. That compares with 0.87%, or $870, paid on a comparable corporate bond, such as one issued by General Electric Capital Corp., the data show.
Brokers of stocks and corporate bonds must disclose market pricing and give individuals “best execution” on trades, ensuring they receive the best prices possible. In the municipal-bond industry, those protections are absent, allowing brokers to pocket higher spreads by buying the bonds low and selling them high.
Individual investors, especially retirees, have long been attracted to municipal debt as a relatively safe investment whose interest payments aren’t taxed. They own 45% of all municipal bonds directly and another 28% through mutual funds, amounting to a combined $2.7 trillion, according to data from the Federal Reserve.
Economists think everyone should convert most of their retirement nest eggs into annuities and receive a stream of income that’s guaranteed for life. Very few people actually do that. They want to keep control and have the hope of achieving a higher return, even when they don’t invest aggressively or have a good investment track record. Justin Fox of Harvard Business Review takes a look at annuities and why people don’t buy them for retirement. He doesn’t break any new ground, but it’s a good review of all the angles and has some good quotes and links.
The sustainability of Social Security is a topic for another day. When it comes to annuity puzzles, though, there’s one more factor worth mentioning. In the Palliser novels of Anthony Trollope, which have constituted most of my bedtime reading for the past month, there’s endless discussion of how much money people have. These 19th century fortunes, however, are almost always described in terms of the annual income they produce, not the lump sum.
Hardly anybody talks about investments that way now. Part of it is just that most of us expect to live from our jobs, not the inherited wealth still so crucial in Trollope’s world (and even more so in Jane Austen’s half a century earlier) — so whatever fortune we may have built or inherited isn’t expected to produce income just yet. But I also wonder if asset values have come to play such a big role in modern economic life that we’ve forgotten what those assets are for. In countless ways, financial discourse in the Western world in general and the U.S. in particular has shifted from a focus on income to a focus on assets or net worth.
The Wall Street Journal caused a lot of turmoil this week with its behind-the-scenes report of the big change at PIMCO, when Mohammed El-Erian resigned and the firm promptly promoted six new deputy chief investment officers to assist Bill Gross. El-Erian had been heir apparent at the firm. A subscription might be required to view the WSJ report. If you can’t access it, consider this summary at Bloomberg.com. There’s also this rejoinder from Gross.
I don’t know how accurate the report in the WSJ is, especially since it apparently has no input from El-Erian or Gross. It’s easy to string together a few anecdotes to support a point of view, especially when there no conflicting evidence is reported. I’m also not sure how much it matters if the entire story is true. El-Erian was a very good spokesman but didn’t distinguish himself as a money manager with the funds he was running at PIMCO or in his brief stint as the head of the Harvard Endowment. We also can’t tell from the outside if he was good at being CEO of the firm. What matters to investors is the investment returns. Many of the funds at PIMCO are fairly autonomous, and I’m sure Gross always has made his own decisions at the funds he manages. What the recent changes really mean are that after Gross leaves, PIMCO no longer will be identified with one person. The plan was to have a transition from Gross to El-Erian as the public face of the firm. Now, it will be like the other large mutual fund firms in that he would be clearly identified with only one person.
Some at Pimco have been told to leave the firm but stuck around instead, waiting for Mr. Gross’s anger to ebb and for him to change his mind, according to these people.
Bill Powers, a former Pimco senior executive who left in 2010, says Mr. Gross “routinely grew tired and wary of those closest to him who had assumed significant responsibility, power, and compensation. After a four to five-year honeymoon period, the chosen one’s halo would turn into a crown of thorns where interactions with Bill would turn adversarial, short, and unpleasant.”
When Mr. Gross establishes an investment thesis, he usually doesn’t appreciate dissenting views, employees and former Pimco traders say. Once, when a senior investment manager said a bond in Mr. Gross’s fund appeared to be expensive, Mr. Gross responded: “OK, buy me more of it,” according to a Pimco executive. The purchase was made.