UPDATE 2-Pimco's Gross bets on short-dated debt as inflation in focus

Thu Jan 9, 2014 11:04am EST

By Sam Forgione

NEW YORK Jan 9 (Reuters) - Investors should focus on shorter-maturity debt as key interest rates are set to remain low for longer than expected given tepid U.S. inflation, said Pimco's Bill Gross, manager of the world's largest bond fund.

Gross, who oversees the flagship Pimco Total Return Fund, said investors should also put greater emphasis on inflation rather than the unemployment rate when it comes to strategizing their portfolios.

In his monthly letter to investors, Gross said the personal consumption expenditure (PCE) annualized inflation rate was "the critical monthly statistic for analyzing Fed policy in 2014. Why? (Ben) Bernanke, (Janet) Yellen and their merry band of Fed governors and regional presidents have told us so".

In the note entitled "Seesaw Rider", Gross said he believes there will be no rate hike until 2016, at the earliest, because "at the moment, the Fed's fork or target for PCE inflation is 2.0 percent or higher while December's annualized rate was only 1.2 percent".

The U.S. Commerce Department releases the PCE price index monthly together with its personal income and spending data. The PCE price index is the Federal Reserve's preferred gauge of price pressures facing consumers.

HEAVYWEIGHT

The Pimco Total Return Fund had a 37 percent exposure to U.S. government-related securities, which include inflation-protected securities, at the end of November, according to the latest data available on the firm's website.

That constituted the largest holding for Gross's flagship fund which has $237 billion in assets.

His monthly commentary is significant because Pacific Investment Management Co. (Pimco), a unit of European financial services company Allianz SE, is one of the world's largest bond managers.

It had $1.97 trillion in assets as of Sept. 30, 2013, according to the firm's website.

Gross, Pimco's co-founder and co-chief investment officer, said total return bond portfolios like his "should float above water in 2014". He added investors can expect 3-4 percent returns in bond portfolios this year, but offered "no guarantees".

His comments came after his fund fell 1.9 percent last year, marking its worst performance since 1994 and its first annual loss since 1999, according to data from Morningstar.

Its performance beat that of just 40 percent of its peers, and led investors to pull a record $41.1 billion from the fund throughout the year, according to Morningstar data [ID: nL2N0KD156].

The outflows stripped Gross's fund of its status as the world's largest mutual fund, a title which switched to the Vanguard Total Stock Market Index Fund.

In the letter, Gross likened 2013 to a nearly decade-long period after founding Pimco in 1971 when he was "dog-paddling like crazy just to stay afloat", but was ultimately rewarded when a 30-year bond bull market sent prices higher.

Gross said clients disappointed by a negative return may be "shortsighted," and the current low-interest-rate environment creates greater potential for interest rates to rise rather than fall.

"When your annual return shows a minus sign, clients wonder why they should pay you a fee to lose money. They have a point, although it may be somewhat shortsighted," Gross said.

IN THE RED

His fund took a hit last year when interest rates shot higher after Fed Chairman Ben Bernanke told Congress on May 22 the central bank could cut its $85 billion in monthly bond-buying stimulus later in the year.

Investors feared that would cause a spike higher in interest rates and price losses on bonds. The Fed surprised investors on December 18 when it announced a $10 billion cut to its monthly bond-buying, starting in January.

The yield on the benchmark 10-year U.S. Treasury spiked about 140 basis points from 1.62 percent on May 2 through the end of the year. Bond yields move inversely to their prices.

Gross's fund was not the only one to suffer losses last year.

The Barclays U.S. Aggregate bond index, the benchmark by which many U.S. funds gauge performance, fell over 2 percent in 2013 after the bond market selloff to mark its first annual loss since 1999 and its worst performance since 1994.

In addition, U.S.-listed bond funds posted record outflows of $86 billion last year, data from TrimTabs Investment Research showed.

Unemployment hit a five-year low of 7 percent in November. The Fed has said since December 2012 it would hold rates near zero at least until unemployment falls to 6.5 percent, as long as inflation stays in check.

The central bank has kept the key federal funds rate near zero since late 2008 to help the economy recover from recession and has promised to keep it there for a while longer, probably until 2015.