Pimco's Gross: Leave U.S., Buy Abroad

Pimco's Bill Gross and FPA's Bob Rodriguez are warning investors of a longer-than-expected recession and deeper credit problems.
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Bill Gross of

Pimco Total Return

(PTTAX) - Get Report

and Bob Rodriguez of

FPA New Income

(FPNIX) - Get Report

say investors should prepare for a prolonged recession and more turmoil in bond markets. For protection, the bond managers recommend owning government-backed securities and avoiding riskier corporate debt. Their views carry weight because they have long records for making accurate forecasts.

Gross's pessimism is especially noteworthy. As manager of the $150 billion Pimco Total Return, the largest bond fund, he has long been an influential figure whose moves are closely watched by other managers.

During the past decade, Gross has finished in the top half of the intermediate-term bond category during nine years. By avoiding subprime mortgages, he outperformed 98% of his competitors in 2007, according to Morningstar. Last year the Pimco fund finished in the top quarter of the field with bets on AAA-rated securities.

Gross has most of the fund's assets in safe mortgage securities of

Fannie Mae

(FNM)

and other agencies, now backed by the U.S. Treasury. He is steering away from corporate bonds rated below investment grade.

Speaking at the Morningstar Investment Conference in Chicago last week, Gross said caution is necessary because rising federal debt will crimp economic growth for years. He noted that government debt now equals 60% of the gross domestic product. Within four years, the figure will climb to 100%. When that happens, ratings agencies will lower the U.S. credit rating from AAA to AA. Eventually the dollar will lose its status as the world's reserve currency. All that will undermine confidence in stocks and bonds, Gross warned. "We simply have too much debt," he said.

With regulation increasing, corporate profit margins will be smaller in the future than they were in the past decade. That will hold down economic growth and stock market returns in the U.S., Gross said. Growth will be faster in emerging markets where millions of consumers are joining the middle class for the first time.

With that backdrop, he urged investors to keep less of their assets in stocks and more in high-quality bonds. U.S. investors should consider shifting money to the developing world. "Go with Brazil, India and China -- and all the surrogates -- because that's where the growth is," he said.

While Rodriguez shares some of Gross's bleak views, the two managers take different approaches. Gross typically holds broad collections of bonds, making a series of small bets. Rodriguez acts on his strong opinions, often taking sizable positions in a single asset class. When he sees trouble, the FPA manager is willing to back away from bonds and hold cash.

Rodriguez currently has 34% of his assets in cash. Most of the rest of his portfolio is in short-term AAA-rated securities from issuers such as Fannie Mae. Big positions in cash and high-quality securities enabled the fund to return 4.3% in 2008, outdoing the average intermediate-term bond fund by 9 percentage points.

Criticizing government policy during a speech at the Morningstar Investment Conference, Rodriguez won cheers and a standing ovation from an audience of financial advisers. The portfolio manager said the credit crisis was caused by excessive debt in the economy. The government should be working to promote saving, he said. Instead, Washington is engaged in a misguided effort, helping consumers borrow to buy houses and cars. "Encouraging the consumer to take on more debt is like trying to help a recovering heroin addict lessen his pain by providing him with heroin," Rodriguez said.

By maintaining a cautious stance, Rodriguez has delivered positive returns for 25 consecutive years, a rare achievement. Seeing that record, some investors may be inclined to buy FPA New Income. But before you write a check, keep in mind that Rodriguez is a diehard contrarian. He sometimes takes positions that can seem outlandish for years.

Beginning in 2003, Rodriguez became convinced that Federal Reserve Chairman Alan Greenspan was keeping interest rates too low. To avoid trouble, the fund manager began holding cash. The first year, the cautious stance dragged down returns, and FPA New Income lagged 93% of its competitors. Results improved in 2004, but in 2005 and 2006, the fund again finished in the bottom half of the standings. Investors fled, as assets in the fund dropped from $2.1 billion to $1.6 billion.

Then in 2007, the credit crisis appeared, and Rodriguez seemed smart again. He outpaced competitors by a wide margin. During the 10 years through May, the fund returned 5.5% annually, beating 83% of competitors.

While some analysts predict the economy will recover in the next year or two, Rodriguez said markets won't resume functioning normally until consumers recover the wealth that has been lost in the downturn. That will take 10 years, Rodriguez said. Until then, the economy will struggle, and bond investors should remain wary.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.