Bond investing heavyweight Bill Gross does not think highly of the investing world right now.
Gross said that investing is one-third maths, one-third economics and one-third horse trading. Investors, he said, are failing on the first part.
“But back to the 1/3 maths thing,” he wrote Wednesday.
“It’s there that I find the average lay and even many professional investors still thinking and managing assets at the grade school level. The childlike ‘teeter totter’ principle, for instance which couldn’t be simpler in its visualisation of bond prices going up when interest rates go down, produces foggy-eyed reactions from a majority of non-professionals, and from a few supposed experts as well.”
Simply put, Gross believes that many bond investors don’t understand the mathematical concepts that undergird the market. The biggest example of this, in his opinion, is people investing in bonds with negative interest rates.
In explaining his outlook, Gross invoked a concept known as Zeno’s paradox. Here’s Gross:
Zeno was an ancient Greek who posed the following conundrum: Imagine a walker heading towards a finish line 10 yards away but every step he took was half of the length of the step he took before. If so, even if he walked an infinite amount of steps he could never reach his destination. Mathematically correct but the real world resolution was that Zeno’s walker and everything else that we experience moves forward in full step integers as opposed to fractions. It was a mathematical twist only.
By his assessment, negative rates have reached the real world side of this paradox rather than the maths-only. Negative bond rates in countries like Japan and Germany lose investors money, yet people are still buying them. This baffles Gross (emphasis added):
Anyway, for those private investors that continue to hold 5 year OBL’s and lock in a guaranteed loss 5 years from now, many of them are using a bit of Zeno’s paradox to convince themselves that they will never reach the loss-certain finish line at maturity. They think that because 4 year OBL’s yield even less (-40 basis points), the 5 year OBL’s will actually go up in price (remember the teeter totter?) if 4 year rates stay the same over the next 12 months, and the ECB has sort of — sort of — promised that. Whatever it takes, you know. If so, the private investor will actually make a little money over the next year (10 basis points) and she can give herself a slap on the back for having eluded the ECB’s negative interest rate trap!
Put another way, no investor expects to hold the bond until the end. So eventually they believe the price will rise as the yield falls on shorter bonds, the price of their bonds will go up as the asset looks more attractive relatively. Then the investor can sell it before maturity and net a gain.
The problem, Gross said, is that eventually someone will have to hold the bond until maturity, meaning the market will reap the losses of negative rates. And while some people brush this off as just a little money lost by a few bond investors, he points out that 30-40% of current developed market bonds are in negative yields.
In the end, if these unconventional monetary polices do not inspire growth, there will be dire consequences when these bonds come to bear.
“The reality is this. Central bank polices consisting of QE’s and negative/artificially low interest rates must successfully reflate global economies or else,” he concluded. “They are running out of time.”
So not only are investors operating on a “grade-school level”, they’re also putting the world economy in a precarious situation.