Bill Gross and Thin and Trendy Credit

Bill Gross is no idiot. I would deeply appreciate if he published a book of his collected investor letters/investment outlooks since 1971. I can’t easily imagine the breadth and depth of knowledge. This dude has navigated vicious bear markets in bonds. Gross was one of the first to see how revolutionary the arbitrage pricing revolution really was for finance. Yet he retained the core recognition that despite the probabilistic advances this paradigm offered, there is a part of fixed income that is about taking what is available. There is always something inescapably mathematical about credit, but there is always something inescapably centered on cutting a deal.

That is to say: I value his intelligence and track record. So I read his latest investment outlook published at his new digs at Janus. The jist: investment in the future is going to be boring. Be satisfied with yield to maturity and return of capital. Take income producing assets and apply some modest leverage.

Let me expand on what I believe to be the underlying phenomena: the lack of liquidity. It seems clear that with central banks buying up a large chunk of the available supply of government paper and increasingly regulations that raise the cost of financing risk on market-makers’ balance sheets, all markets are thin and trendy. Thin and trendy markets in turn mean there are few shorts to support the market in a sell-off and all the trades are crowded.

Honestly, this is less of a problem in credit than elsewhere. Credit trading has and always been and always will be more thin than trading common. And credit has always been one-way—meaning buy and hold. Only until recently have we seen long-short positions with synthetic optionality.

The thinking is that this optionality (credit derivatives) adds volatility to credit. I disagree. Credit has never sold off in a staid way. I would argue that these implicit short positions do not contribute to extreme sell-offs. Credit risk triggers extreme sell-off, straight down to expected recovery value. Arguably, a short just creates support levels, even in credit. What makes fireworks in credit is leverage. And in a boring world of mediocre to crappy yields, leverage is necessary to survive.

So I’m looking for places with decent yield, and something outside of the prevailing trend. I’m looking at the carry trade, and I’m looking for sustainable yields. I’m looking at linkers in emerging markets. This means Latin American bonds.

Think about it this way: if commodity prices do not recover and these economies become dependent on central bank stimulus of magnitudes like the Fed, ECB, BoJ, and BoC has conducted, then the effect will be currency depreciation and corresponding inflation. Linkers will not be immune from capital light, but they will be protected from inflationary effects. If these economies pick up, the inflation expectations will keep them bid. If nothing appreciably changes, you have decent yield. Have a look at the total return on Latin American linkers.

latam linker TR.jpg

On a yield basis, they are over a hundred basis points cheap to model, shown below.

latam linker model.jpg

The risk-return distribution is decent too. The red line is normal and the green line is a kernel density estimate. The kernel density shows a much higher probability of lower yields than continued selling. The implication is that this paper is amenable to the modest leverage Mr. Gross recommends.

Latam linker distribution.jpg

At least at an aggregate level, it also provides emerging market returns uncorrelated with commodity prices.

Latam linker commodity correlations.jpg


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