Bill Gross: beware investors' 'irrational exuberance'

PIMCO bond chief Bill Gross has called on investors to rein in their ‘irrational exuberance’ over the potential for high yield but has stressed it still has a role to play in balanced portfolios.

The colourful market commentator and bond manager made the statement in his latest investor note, entitled ‘Rational Temperance’, in which he addresses the potential overheating of credit markets.

'On a scale of 1-10 measuring asset price “irrationality”, we are probably at a 6 and moving in an upward direction,' said Gross.

'Be bullish if you want, but lower return expectations on all asset classes.'

Gross, who runs the $285 billion PIMCO Total Return Bond fund, centred his investor note on a speech made by member of the Board of Governors of the Federal Reserve Jeremy Stein.Stein, who echoed former Fed chairman Alan Greenspan’s previous concerns over market euphoria, suggested a significant amount of ‘reaching-for-yield’ behaviour among credit investors is bordering on the irrational.  

'In fact, investors bought over $100 billion of high yield and levered loan paper last year, a record level even exceeding the ominous levels in 2006 and 2007,' wrote Gross.

He stressed high yield and corporate credit is currently ‘somewhat exuberantly and irrationally priced’ and said this is at a time when spreads are tight, corporate profit margins are at record peaks with room to fall and the economy is still fragile.

‘Still that doesn’t mean you should vacate your portfolio of them [high yield bonds and corporate credits].’

‘It just implies recent double-digit returns are unlikely to be replicated and that when today’s 5-6% high yield interest rates are adjusted for future defaults and recovery values, that 3-4% realised returns are the likely outcome.’

In terms of pricing, Gross pointed to academic work by Bianco Research which framed high yield bonds and corporate credit as a ‘low beta equivalents of stocks’. This is due to high yield spreads narrowing at the same time equity risk premiums also narrow.

Gross did caveat his acceptance of this idea by the widespread influence of QE on asset prices but added investors should remain cautious as to what prices will do once the QE effect has worn off.

‘We join Governor Stein – and perhaps Alan Greenspan – in encouraging not an exit but a reduced expectation,’ said Gross. ‘Credit spreads nor interest rates cannot be artificially compressed forever, nor can stock prices rise perpetually on their coattails.’