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Bill Gross’ monthly Investments Outlooks follow a four-part format. He begins with a personal anecdote, swings into some substantive observations, inserts a plug for PIMCO, and then summarizes his thoughts. If you skip the chit-chat and the infomercial, what he says should be considered if only because he’s betting real money on his thesis. His Jan ’11 op-ed ends like this:

Investment Implications

1. An astute mantis-like investor must defer immediate gratification, make a 180° turn from that sexy looking female with those long green legs (long term bonds) and mend his ways fast! It is still possible to earn an attractive return from bond strategies (such as PIMCO’s Total Return strategy in 2010), and the way to do it is to focus on “safe spread” that emphasizes credit, as opposed to durational risk.
2. These “safe spreads” include: emerging market corporates and sovereigns with higher initial real interest rates and wider credit spreads; floating as opposed to fixed interest obligations; and importantly currency exposure other than the dollar.
3. For those inclined to lunch on stocks, remember to go where the growth is – developing as opposed to developed markets. If the U.S. must pay an eventual price for mindless deficit spending, then find countries and currencies that appear to have their act under control: Canada, Brazil, and yes even Mexico with its drug related violence. Mexico has a net national savings rate that exceeds our own by 20% of GDP.
4. Above all, remember that all investors should fear the consequences of mindless U.S. deficit spending as far as the mantis eye can see. Higher inflation, a weaker dollar and the eventual loss of America’s AAA sovereign credit rating are the primary consequences. Fear your head – fear your head.

Again, forget the packaging. Cut to the chase. For a lot of reasons (detailed in his other letters), the yields on Treasuries are depressed and are likely to remain so for a long time. But other areas of other markets, mainly those involving credit-risk or investment-risk, seem more attractive to him on what he calls a “safe spread” basis (a term you can look up, but needn’t, because, as other observers note, spread-analysis isn’t a useful way to think about yields.)

This is my take on the matter. Fixed-income investing is such a flexible term that it can mean anything any one wants it to mean. But Bond-investing is a nice, tight domain wherein money is made either by betting on the level/direction of interest-rates, or the level/direction of credit-worthiness. Obviously, combo bets are possible, but the bet can be broken down into just those two factors. For several years now, and, likely, for several years longer, it has been tough to make a real-rate of return (after taxes and inflation) from interest-rate bets. In fact, I’d argue that it is NEVER possible to make a real-rate of return from interest-rate bets, on average and over the long haul. But credit-worthiness bets have been paying off handsomely for a lot of years, and Gross is suggesting that situation will continue.

OK, let’s step back and do some thinking. Interest-rate bets don’t offer a real-rate of return. So why make them? Because the purpose in making those bets isn’t to achieve a real-rate of return but to park cash at predictable and tolerate rates of loss. E.g., if you’re buying the 10-year note at a price that offers you a 4% YTM, but your tax-rate is 25% and if your personally-experience inflation-rate is 5%, then you don’t have an investment gain. But you do have a knowable and predictable downside. Your losses, at worst, aren’t likely to exceed a couple of percentage points. If you take on a bit of credit-risk, your YTM bumps up to the 10%-15% range. You begin to make money, but you also increase your downside-risks. Now you’ve putting yourself into a situation where losses --across a basket of credit-risk bets-- could easily tag -20%. So the question becomes this.

"Am I investing in bonds to park money, or am I investing in bonds to make money?"

Accepting credit-risk, Gross argues and I agree, can be a good way to off-set inflation-risk.
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