I begin with the premise that money returns nothing at the moment. There’s an old song that goes “Nothing from nothing…
“…leaves nothing.”
That’s right. The song is about a relationship, not money, but the fund is positioned with that in mind. If you start at zero and aim to deliver a 4% or 5% annual return, you’ve got to lever your assets to some extent. The positions in the fund are primarily volatility-related, because volatility has the lowest amount of risk, relative to return, of the elements I mentioned.
Years of easing by central banks mean that interest rates in most of the developed world will fluctuate narrowly. That offers an opportunity to sell volatility to create return. If you bought a 10-year Treasury bond today and nothing changed, you would get a 1.9% yield. If you bought a seven-year German Bund, you’d get zero. If, however, you sold a three-month call or three-month put on that same Treasury with a 20-basis-point [hundredths of a percentage point] variation—in other words, the yield stayed in the range of 1.7%-2.1% for three months—the trade would produce an annual return of 6%, as opposed to 1.9%.
The risk is that interest rates will go up or down by more than 20 basis points over a three-month period. But my premise is that central bankers will do anything possible to contain interest-rate fluctuations. The sale of volatility is producing the predominant amount of return in my fund.
...Think of the old Monty Python movie, The Meaning of Life. A grotesque, rotund guy keeps eating to demonstrate the negatives of gluttony, and finally is offered one last thing, a“wafer-thin mint.” He swallows it and explodes. It’s pretty funny. Is our financial system, with $58 trillion of credit, to the point of a wafer-thin mint? Probably not. But we’re to the point where every bite is less and less fulfilling. Even though credit isn’t being created as rapidly as in the past, it doesn’t do what it did before.
Central banks believe that the historical model of raising interest rates to dampen inflation and lowering rates to invigorate the economy is still a functional model. The experience of the past five years, and maybe the past 15 or 20 in Japan, has shown this isn’t the case.
So where does that leave our economy?
In the developed financial economies, as a bloc, lowering interest rates to near zero has produced negative consequences. The best examples of this include the business models of insurance companies and pension funds. Insurers have long-term liabilities and base their death benefits, and even health benefits, on earning a certain rate of interest on their premium dollars. When that rate is zero or close to it, their model is destroyed.
To use another example, California bases its current and future pension payments to civil workers on an estimated future return of 8% or so from bonds and stocks. But when bonds return 1% or 2%, or nothing in Germany’s case, what happens? We’ve seen the difficulties that Puerto Rico, Detroit, and Illinois have faced paying their debts....
When interest rates get to zero—and that isn’t the endpoint; they could go negative—savers are destroyed. And savers are the bedrock of capitalism. Savers allow investment, and investment produces growth....
If the Fed raises rates, the euro and yen could weaken. That would mean rates in Europe and Japan don’t have to go negative, or to extreme lows. In a sense, the Fed is driving everything. But it can’t raise rates too much without threatening a country like Brazil, whose corporations have tons of dollar-dominated debt....
The concept, again, is letting corporations borrow for you to produce a return higher than the 1% to 2% return the bond market gives you today.
You’ve had an extraordinary career. Who, among today’s younger bond managers, might become the next Bill Gross?
I don’t think there will be another, and that’s not because I’m some kind of Babe Ruth. My career coincided with a unique period in which credit expanded from $1 trillion to $58 trillion, and returns justified that growth. That isn’t going to happen again. The Earth is fully formed now; it isn’t in a molten stage anymore. In other words, the system itself has matured.
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