10 Questions With Bond Guru Bill Gross

It's a fine time to talk about bonds. And you can't talk about bonds without talking about Bill Gross.

There's little doubt that bond buyers have been faced with a slew of unusual circumstances as of late, from the company-specific (such as blowups in the telecommunications and energy sectors) to the macroeconomic (the threat of rising inflation, a declining dollar and the expectation that stocks won't return any more than bonds in the near term). Few portfolio managers are better suited to evaluate the landscape than Bill Gross, the chief investment officer of Pacific Investment Management Company (better known as Pimco). Gross manages Pimco's $260 billion portfolio, including the (PTTAX Quote)Total Return Fund , which, at $53 billion, is the largest bond mutual fund in the U.S.

The fund's success is well-known. It boasts an 11.25% return in the past 12 months, beating 97% of its peers, according to Morningstar. The fund's three- and five-year annualized returns -- 8.16% and 7.98%, respectively -- put it in the top 5% of the intermediate bond funds category. Indeed, the fund hasn't been hindered by its size.

Gross primarily relies on interest rate and sector bets, rather than individual bond selection. The fund has a large stake in mortgages, but far more interesting is the sector bet he's making on telecommunications companies such as Sprint(FON Quote), AT&T Wireless (AWE Quote), Deutsche Telekom (DT Quote) and France Telecom (FTE Quote).

Convinced that these corporate bonds are substantially undervalued, Gross has invested heavily in specific companies. Pimco holds about $4 billion in Sprint bonds and some $2 billion in AT&T bonds. Total telecom exposure amounts to $12 billion, about 5% of Pimco's total holdings.

Gross' somewhat aggressive approach -- he also has recently purchased about $4 billion in energy company bonds -- makes the fund slightly more volatile than many of its counterparts. But the fund's strong record (it has been years since the fund has finished below the category's best quartile, according to Morningstar) makes it a one-stop bond shop for most investors' needs.

Talking With: William H. Gross Manager, Pimco Total Return (PTTAX)

Sales charge:4.5%

Expense ratio: 0.90%

Managed Since: January 1997

1-Year Return: 11.25%, beats 97% of its peers

3-Year return: 8.16%, beats 95% of its peers

Top Holdings: Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA)

Assets: $5.1 billion

Source: Morningstar, data current as of 5-30-02

Gross expects modest inflation, sturdy consumer spending, a 10% decline in the dollar and a whole lot more. Read on.

1. It's rumored that your career in finance began as a blackjack counter in Las Vegas. How is managing fixed income like counting cards?

It's more than a rumor; it's a fact. Basically, gambling and money management are pretty much the same. In each, the goal is to spread the risk and avoid becoming emotional while staying focused on the odds.

Vegas taught me that I could beat the system with a combination of hard work, coming up with ideas that no one has yet thought of, and the ability to tolerate a constant routine others would definitely find tedious.

2. In mid-May the Fed decided again not to increase short-term interest rates. So what's keeping long-term rates so high?

Doesn't seem logical does it? You would think that as investors' inflation fears were easing, the long-term rates would have come down. But they didn't. Their inflation fears and realization that yields were so low already meant that there wasn't much reward for that much risk.

3. With inflation so low for so long, it seems it has nowhere to go but up. When do you expect to see that happen, and how will that affect the bond market?

We believe rising inflation will emerge, but only modestly. Increased defense spending, uncertainties over the prospects of war in the Middle East, and support for increased government regulation in the wake of the Enron scandal, telecom busts and related bankruptcies all point to a new era of higher inflation.

However, other anti-inflationary factors should hold the rate at the next cyclical peak to no more than 4%. But long-term bond yields do not currently reflect this. Long-term bond yields may touch 6.5% during this cyclical upswing. Over our full three- to five-year forecast period, bond price erosion should be relatively mild and not reach the level of a bond bear market.

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4. When do you expect the Fed to start raising rates again?

We may see a rate increase late in 2002. The Fed typically waits until an economic recovery is well under way before raising rates. After the last recession it took a year and a half before the Fed began to tighten. Previous recessions in '69-71, '74, and '79-81 produced no significant hikes until an average of 12 months later.

5. Aside from what you expect the Fed to do, what do you think should happen?

Mr. Greenspan should at least threaten to raise rates in order to mollify the long end and stabilize long yields.

6. What other macroeconomic (or political) issues are most central to fixed-income investors?

What we've really started to pay attention to is the declining dollar. Because of the large and growing U.S. account deficit and global disillusionment about U.S. corporate profitability, the dollar could decline by as much as 10% over the next three to five years.

Foreign investors and foreign institutions own lots of dollars and lots of U.S. securities. If these foreign investors see the dollar weakening, they may begin to sell stocks, sell high-yield bonds, sell corporate bonds, sell government bonds. And all of a sudden you have liquidation instead of accumulation.

7. How important is asset allocation in the bond part of an individual investor's portfolio? Is diversification within a bond portfolio important?

An investor needs to stay informed about the markets in order to decide what to buy and when to buy it.

The asset allocation question is very customized -- a personal question with an answer that depends on many variables such as current income, risk tolerance, tax bracket, age that they would like to retire, and so on. And as you might expect the bond guy to say yes, everyone should have some bonds in his portfolio. And speaking like a sales guy, if you invest in a diversified bond mutual fund, you could let someone like me do the driving for you. Let your portfolio manager decide whether you should be in munis, emerging markets, corporates or junk today.

8. Now that investors have dramatically scaled back their performance expectations for the stock part of their portfolios, what's a reasonable expectation for their bond portfolios?

You're correct, stock investors can no longer expect 10% to 15% to 20% types of returns. Given today's investing environment, stock and bond investors alike should reset their expectations to somewhere in the range of 5% to 7%.

9. It seems that when the stock market nears a bottom, more companies will issue convertibles, particularly mandatory convertibles. Do you expect this to happen?

For many companies, convertibles are the only way to get financing while maintaining their credit ratings and issue stock at a premium. For investors, convertibles provide a nice coupon cushion with equity upside when industry conditions improve. Investors are paid to wait.

If a company thought the stock market was bottoming, they would not want to issue equity or equity-linked securities like a mandatory convertible unless they absolutely needed capital, because they wanted greater operating leverage and were not creditworthy. Mandatory convertibles are sometimes issued for tax reasons or to issue "equity at a premium."

10. How should investors view convertibles -- as part of their bond portfolio, stock portfolio or another animal altogether? How do you evaluate a convertible?

A convertible security can look like a stock, bond or something in between, depending on the structure, stock price and credit. As markets change, they become more bond-like or more stock-like. Therein lies the difficulty. Investors need to make these adjustments to their portfolios. For a fixed-income investor, convertibles give an opportunity to either buy new issuers, cheaper bonds of the same issuers, or a way to participate in the equity upside.

Evaluation of a convertible bond is in general more involved than that of a straight bond: It's not just a function of a credit view, but also an opinion on the underlying stock and value of the call option.