Why Bill Gross says Treasury investors are like frogs in a pot of hot water

Pacific Investment Management Co.'s Bill Gross said investors in U.S. Treasuries are being lulled into a false sense of security by positive returns this year because yields aren't high enough relative to inflation. Gross, who oversees the world's biggest bond fund, said bond investors face a similar fate as a frog that remains in a pot of water while the temperature is gradually increased until the amphibian is cooked. Inflation erodes the value of the fixed payments of bonds over time. “Much of the Treasury yield curve now rests in negative territory when compared with expected future inflation, and that should send our bond investors into a hopping funk,” Gross wrote in his monthly investment commentary today on Newport Beach, California-based Pimco's website. “Prices are already nearing the boiling point.” Treasuries have returned 2.6 percent this year as Gross reduced government and related debt in his $243 billion Total Return Fund to minus 4 percent of assets as of April 30. Gross said governments such as the U.S. are intentionally keeping interest rates lower than they should be to help reduce record debt levels. The fund has returned 0.56 percent in the past month, lagging behind the performance of 77 percent of its competitors, according to data compiled by Bloomberg. “Bond yields at least have a mathematical zero bound below which they cannot journey for more than a few nanoseconds,” Gross wrote. “Monetary policy in developed countries has been lowering the temperature and absolute level of yields for the past 2 1/2 years post Lehman Brothers.” Real Yield The Federal Reserve has kept its target rate at a record low range of zero to 0.25 percent since December 2008 to help stimulate growth after the worst recession since the Great Depression. Yields on 10-year notes fell below 3 percent today for the first time since December after ADP Employer Services reported that U.S. companies added fewer jobs in May than economists forecast. With the consumer price index rising 3.2 percent on an annual basis in April, the benchmark note offers investors a so- called real yield of negative 0.20 percentage point. Gross recommends that investors buy “cheap bonds” and focus on “safe spread,” or buying more floating and fewer fixed-rate notes. Investors should also add credit components that may include investment grade, high yield, non-agency mortgage, or emerging market related sectors, and increase the non-dollar emerging market currencies portion of their portfolios, he wrote. Total Return Fund The Total Return Fund has returned 8.13 percent in the past year, beating 78 percent of its peers, according to data compiled by Bloomberg. Gross, the founder and co-chief investment officer at Pimco, has averaged returns of 8.93 percent on average over the past five years, topping 98 percent of his competition. The fund can have a negative position by using derivatives or futures or by shorting. Shorting is borrowing and selling an asset in anticipation of making a profit by buying it back after its price has fallen. The firm's U.S. government-related debt category can include conventional and inflation-linked Treasuries, agency debt, interest-rate derivatives, Treasury futures and options and bank debt backed by the Federal Deposit Insurance Corp., according to the company's website. Pimco, a unit of the Munich- based insurer Allianz SE, managed $1.28 trillion of assets as of March 31. --Bloomberg News--