Fixed Income's Barometer Changes With the Climate

The staid fixed-income arena doesn't breed stars in the fashion of

Peter Lynch

, but if the market has any voice, it's

Bill Gross'

. His $25.8 billion

(PTTRX) - Get Report

Pimco Total Return fund, the largest bond fund in the country, ranks in the top 10 among intermediate investment-grade bond funds for the past five years.

He'd been pounding the table on Treasuries for several months, even as bonds moved off their 4.7% low yield back toward 5.5%. It wasn't hard to see this point of view: For the past couple of years, if you weren't long, you were wrong.

But that long-term view means he's been kicked around a bit lately. According to

Lipper

, the Total Return fund lost 0.23% for the three months ended March 18, placing his fund 92nd of 266 funds. For one month, he's up 0.34%, ranking 62nd of 266, still in the top quarter.

So after five years of unabashedly being one of the loudest bulls in the fixed-income arena, Gross finally pulled back a few months ago, saying the bull market in bonds was over.

Like Gross, other investors had clung to a view that a price-driven Treasury rally would continue, based on forecasts for lower inflation and strong productivity. After some astounding economic data, investors stuck with their bias and came out looking bull-headed. Treasury bonds put in their worst one-month performance in almost 20 years, and yet surveys still showed that investors maintained long positions.

"The buy-side guys were looking for the market to do better, and the thing is, they're already long and that's part of the market's problem," says Ken Logan, managing analyst at

Thomson Global Markets

. "Traders don't have the firepower to press the market down and don't see the upside right now. We're just waiting for something to untie this Gordian knot."

Yield, Don't Run

Gross made his new view public in February, saying long Treasuries were now in a 5% to 6% range. This call sounded a bit late, as the price-movement rally in Treasuries ended in December. But Gross said it was hard to get rid of his old take after so many years, especially because he sees greater risks in grabbing for yield, which he's now more or less resigned to doing.

"It's a little depressing because now we've reached that point and backed off and are in an evaluation zone or range," Gross said in an interview Monday. "I talk about

yield with some caution because yield strategies were all the rage in 1998 and you saw what happened there, with the

Long Term Capitals

of the world blowing up. At some point, if the economy slows down, I think then reaching for yield has some negative repercussions."

Since he's still looking for an economic slowdown, Gross is uncomfortable with a strategy that bets on lower-rated corporate debt, and currently he's overweighted in mortgages. About 45% of the fund is invested in mortgages, compared with the high 20s for the

Lehman Aggregate Index

. His decision to overweight mortgages and underweight Treasuries earlier this year limited the downside in his fund in the past few months.

Investors like Gross attempt to locate trends to drive their decisions over a longer period, so they often have to deal with short-term pain. Traders don't have to play that way. And from a historical perspective, it's difficult to argue with Gross. Cumulative 12-month total returns for his fund, which invests across the fixed-income spectrum, are 7.79%, ranking him fifth of 245 funds.

"In 1994, the Bill Gross style was challenged decisively when the market sold off sharply, but if you were steadfast, you benefited a good deal," says Tony Crescenzi, chief market strategist at

Miller Tabak Hirsch

. "It takes a long period of underperformance for people to feel misguided."

War of Resistance

What contributed to the limited trading volume during the past several months was that traders and investors were fighting their own resistance war by looking at different factors. The idea that global contagion could still affect the Treasury market didn't really register among traders. But investors pondered that notion and expected it would materialize in some kind of fear-driven rally, even if that was based on hope rather than true concern. Gross represents the investors' side of the equation.

He wrote in December that it was "highly probable that there will be another flight to short-term/intermediate Treasuries." He now believes the global outlook is improving, but he's cautious. "There's reason to be slightly optimistic on a global front, but only slightly, because no doubt deflationary forces are still at work, and those take years to work off," he said.

Meanwhile, traders remain more concerned about monetary policy, citing reasons why the

Federal Reserve

may change its policy bias to tightening, such as rising oil prices and outsized

GDP

gains. Investors tend to use the Fed's approach to monetary policy to affirm their forecasts of low inflation.

But neither approach translates to a significant rally in prices, something that's only recently caused investors to modify their approach. Barbara Kenworthy, portfolio manager and head of taxable fixed income at

Prudential Investments

, says she can see how Gross' view has become maddeningly conflicted. She's still watching out for a surprise to send yields down again, but short of some cataclysmic outside event, she's not sure what will move the market, either.

"I find myself looking for what makes the market break out on the up or downside. Where is that factor?" asks Kenworthy, who manages $4 billion in bonds and has lightened her exposure to Treasuries.

Last week,

MCM Moneywatch's

weekly investor survey showed investors finally carrying a shorter duration in their portfolios than the average index, which means they're accepting that price appreciation isn't going to be the winning strategy it's been for the past several years.

"I think the fundamentally successful strategy going forward is to wipe the slate clean of the duration, to relegate it to a backseat and focus on sector concentration," Gross said.

Now, about 40% of the Total Return fund is in Treasury securities, underweighting the Lehman Aggregate's approximate 50%.

"There's a certain psychological fixation or association with being a bull or being a bear or even an agnostic, especially when the bull market has run for so long," Gross said. "I do remember being bearish -- it's hard to recognize that image in the mirror."