Bill Gross: Avoid bank stocks in negative interest-rate world

NEW YORK (Reuters) - Bill Gross, the widely followed investor who runs the Janus Global Unconstrained Bond Fund, said Thursday investors should not be tempted into buying beaten-down bank stocks against a backdrop of interest rates potentially turning negative.

Bill Gross speaks at the Morningstar Investment Conference in Chicago, Illinois, June 19, 2014. REUTERS/Jim Young

In his latest Investment Outlook report, Gross said negative yields threaten bank profit margins as yield curves flatten worldwide and banks’ net interest rate margins narrow.

“The recent collapse in worldwide bank stock prices can be explained not so much by potential defaults in the energy/commodity complex, as by investor recognition that banks are now not only being more tightly regulated, but that future Return On Equity’s will be much akin to a utility stock.”

Gross noted the collapse in bank stock prices after the collapse of Lehman Brothers in 2008: Citi was at $500 in 2007, currently trades around $38; Bank of America at $50 but now trades around $12; Credit Suisse was at $70 and now trades around $13; Deutsche Bank at $130, now around $16, and Goldman Sachs was at $250, and is now at about $146.

Gross warned investors: “Banking/finance seems to be either a screaming sector ready to be bought or a permanently damaged victim of write-offs, tighter regulation and significantly lower future margins. I’ll vote for the latter.”

Gross said investors should not reach for the “tantalizing apple of high yield or the low price/book ratio of bank stocks.” Those prices are where they are because of low or negative interest rates, Gross said.

Additionally, investors should not reach for the seemingly momentum-driven higher prices of German bunds and U.S. Treasuries that negative yields have produced, he said.

“A 30-year Treasury at 2.5 percent can wipe out your annual income in one day with a 10 basis point increase,” Gross said.

He said the secret, in a negative interest-rate world that poses extraordinary duration risk for AAA sovereign bonds, is to keep bond maturities short and borrow at those attractive yields in a mildly levered form that provides a yield and expected return of 5-6 percent.

Gross said investors should focus on sectors that are less volatile and less affected by the evolving changes of the monetary system, such as closed-end funds at deep discounts, or highly certain acquisition arbitrage stocks.

All told, Gross said: “Central bankers seem ever intent on going lower, ignorant, in my view, of the harm being done to a classical economic model that has driven prosperity, until it reached a negative interest rate dead end and could drive no more.”

Editing by Chizu Nomiyama and Bernadette Baum