The Bond King Signals a Shift: Why Total Return Strategies May No Longer Work

According to Gross, ‘total returns’ in bonds are dead and buried.

For investors and many analysts, the idea of getting capital appreciation and yield in fixed income investments has been a rallying cry in recent months. Gross says not so fast. That doesn’t mean that bonds are dead, but investors need to think about them differently going forward.

Back in the 1980s, Bill Gross did something radical with bonds and based his whole career and his asset management firm, Pacific Investment Management Co. (PIMCO), on this idea.

When you buy a bond, you are essentially lending someone money for a period of time. In exchange for that, investors are provided a series of coupon/interest payments. And on the maturity date of the bond, investors will receive their money back. Before Gross, that was all investors thought about. Bonds were bought and held to maturity. It’s one of the reasons why there isn’t an exchange for bonds like stocks and their trading is done in the OTCBB exchanges.

But as we know, over the two, 10 or 30 years of a bond’s life, its price changes radically.

Gross focused on the price changes. Here, he used variables, credit research, and other fundamentals to determine a bond’s value. He often bought and sold bonds based on these variables. The end result was that Gross was able to provide a high total return—both yield and capital gains—to his investors. Eventually, his signature fund, the PIMCO Total Return Fund—one of the largest mutual funds on the planet—and numerous copy-cats were launched.

Today, a total return approach to bonds is now the standard way most managers run their portfolios.

But lately, the Bond King has been very vocal on the idea that total return investing in bonds is now dead. This flies in the face of many bond managers who suggest that the current environment is now once again a great period for this style of investing.

In his last missive, titled “They Just Wanna Sell You a Bond Fund”, Gross throws cold water on the idea of total return. And his logic seems sound. ¹

For starters, Gross points out that when he popularized total returns, long-term Treasury yields were 15%+. Meanwhile, durations for such bonds were low. As such, even if interest rates rose sharply, the bond’s high income would help cushion any capital losses. It was simply a good bet and gamble.

The key is what happens next. The Fed broke inflation in the 1980s and drove interest rates down. Then during the pandemic, Treasury yields hit a low of 0.52%.

The issue is that low starting point yield. As the Fed has raised rates, bonds have provided a negative return. Gross points out that Vanguard Total Bond Market Index Fund has provided a negative 0.1% total return over the last five years. This includes income plus price changes. With yields at 4.5%, the math doesn’t add up. This chart from Morningstar highlights what Gross was saying in terms of the risk-reward scenario for bondholders across the peak/valley and where we are today.

Source: Morningstar

But if yields fall and the Fed cuts, should we get a good total return? Gross says not so fast. That’s because other factors are now at work to keep rates high.

We finally may have hit the point that the United States’ debt load—which increased by 10% last year—is causing many investors to think twice. The U.S. requires about $1 to $2 trillion in new debt each year to keep the economy humming. That means there will be a lot of new debt issued and that could suppress their prices. Moreover, so-called bond vigilantes are starting to demand more in terms of yield to compensate for the growing risks.

With that, the Fed may never be able to cut rates in a manner that many bond managers are looking for to justify strong total returns. According to Gross, you’ll see 5% plus Treasury yields going forward and not the 4% or lower as some analysts are hoping for.

That means bonds will continue to show losses on a total return basis.

With Gross making a strong case for losses on price and that the concept of total return is now dead and gone, investors in bonds are facing an interesting quandary. However, Gross’ viewpoint doesn’t mean that bonds or other fixed income assets don’t belong in your portfolio. We just have to think about them differently.

And that’s going back to the coupon clipping mentality.

That means focusing on yield and holding bonds to maturity. Investors will be made whole when a bond matures, so price changes over its life don’t necessarily matter. Accomplishing this is a matter of buying bonds directly. Another choice could be crafting a CD ladder to lock bond-like income.

Another choice could exist in so-called target date bond ETFs. These funds show hundreds of bonds and have a maturity date. As bonds in the ETF are repaid, the fund holds these assets in cash. And then when the ETF hits its end-date, the fund pays one last distribution at NAV to shareholders. Both iShares and Invesco have wide product line-ups featuring a variety of bond types, including munis and even junk bonds.

These ETFs were selected based on their low-cost exposure to bonds with a set maturity timeline and represent a small swath of the available target-date bond ETFs on the market. They are sorted by YTD total return, which ranges from -0.2% to 2.5%. They have expense ratios between 0.07% to 0.42% and have assets under management between $54M to $3.5B. They are currently yielding between 2.2% and 7.1%.

In the end, the Bond King’s words hold some serious weight. Those hoping for total returns from their fixed income assets may be in for a world of trouble. Perhaps, it’s best to think about bonds as once again a source of income and stability, rather than trying to juice a few more percentage points of returns out of them.

Investors looking for total returns from their bonds may be sadly mistaken. That’s according to the concept founder, Bill Gross’ latest missive. The Bond King says that rising debts and low starting yields mean that total return is dead and gone. Investors looking toward bonds need to think about them differently.

¹ Bill Gross (May 2024). They Just Wanna Sell You a Bond Fund