I’m Still Standing: Bond King Bill Gross and the PIMCO Express Page 2

  Future TV appearances came quickly – CNN, CNBC, FOX and additional Wall Street Week shows which took three business days of travel to the East Coast to ensure an appearance at 8pm EST Friday night. I was always nervous in the early years and extremely self-critical. After each appearance I would get into my car and scream in anguish at what I thought were mistakes in diction or minor stutters. Only in the last 10 years of my career would I comfortably sit in front of a camera. At first I would have to drive two hours up to NBC’s studio in Burbank and two hours back just for 45 seconds of publicity. Once, during the OJ Simpson police chase down the 405 freeway I was canceled entirely. Couldn’t figure out why!

  At Wall Street Week I was eventually asked to be a rotating panelist which provided even more publicity for a West Coast bond firm called PIMCO that was gaining more and more clients. The panelists were each given a viewer’s question to answer in the middle of the program and one week I was given the task to explain America’s burgeoning budget deficit. For some reason, I talked about the deficit’s “expansion” and illustrated it by pulling a preplanned rubber band out of my pocket and aiming it across the table directly at Rukeyser. In true showboating style I purposefully let the rubber band fly and it flew directly past Lou’s left ear – eliciting a startled but pissed-audible laugh. I thought I was a TV genius but Rukeyser thought otherwise. No one, it seems, made fun of the host of Wall Street Week. After the show, producer Rich Dubroff summarily informed me that I was fired! So long Wall Street Week. Future TV would have to be a little more conservative.

  So while the publicity was differentiating us from the rest of a rather staid bond investor universe, so was our performance. The relative numbers were assisted in no small measure by a roaring bond bull market. Having peaked at nearly 15% in 1981, the 30 year bond was producing double-digit annual returns that reflected not only high yields but significant capital gains as well. While the famous “Total Return Fund” had yet to be created (1987), our investment philosophy that centered around a three to five year “secular outlook” was key in capturing these high returns for AT&T and other large pension fund clients. The term “secular’ outlook was so little understood by clients that a few of them asked what “religion” had to do with it! Not much, but it did feature forecasting interest rates over a three to five year horizon, which was blackjack-like in its time horizon of patiently waiting for opportunities over the long term. In addition, the concept of “total return” for which I was to become well known, sought to think of bonds much like stocks which earned a dividend but were also viewed as capital gains vehicles.

  PIMCO’s Secular Outlook was determined once every year at its “Secular Forum” when we invited outside guests and speakers from Wall Street, and Main Street USA. Several of the names would be familiar to you, such as Alan Greenspan, Ben Bernanke, Paul Volcker, Google’s Eric Schmidt, Robert Reich, and many others. There were actually very few years when we changed our three-to-five-year Secular Outlook on interest rates from bullish to even neutral. As it turns out, despite short term yield increases over 12- to 18-month time periods, PIMCO’s bullish outlook proved to be a money maker for clients even though portfolios hardly ever exceed index durations by more than a year or so. The “Kelly Criterion” betting system I learned in blackjack mandated a conservatively larger bet but never one which could underperform market indices by more than 1%. We never did.

  With high interest rates in the 1980’s, bonds had the potential for both – yield plus capital gains – and so we invested with a keen eye toward price appreciation in a secularly declining interest rate world. Getting that longer term forecast for lower yields was key to our success and was constantly updated by daily investment management meetings which started at 12 and ended sometime around 3!. PIMCO was a bond firm – yes – but one with a belief that we could accurately forecast interest rates over a long term time period – much like I used to forecast winning results at blackjack if I stayed at the table long enough.

  In addition to the interest rate forecasting, though, a critical and constant source of “alpha”, or excess return over the market, was what we called “structural alpha”. This concept was illuminated by perhaps my most academic publication in The Journal of Portfolio Management in 1989. Fischer Black, the co-originator of the Black-Scholes options pricing model, had originally introduced the concept of “noise” in asset prices, meaning fluctuations in price that had little to do with fundamentals. The noise was emblematic of human emotion and was separate and distinct from what portfolios now emphasize as “momentum”. “Selling the noise” the title of my 1989 article, then described several ways to produce “structural – almost always” consistent alpha that was built into the financial system by regulations and otherwise.

  If there are one or two specific portfolio ideas that I slap my own back for, it’s articles I wrote for The Journal of Portfolio Management and Financial Analysts Journal. Forgive me for saying this, but upon review of these two articles for inclusion in this book, I emailed my editor Seth Lubove, “Man, I’ve forgotten how smart I was 20 years ago!” “Consistent Alpha Generation Through Structure” for the September 2005 Financial Analysts Journal and “Selling the Noise” for the Spring 1989 issue of The Journal of Portfolio Management were fundamental, near perpetual observations of “game playing” that allowed PIMCO to outperform competitors despite numerous mistakes in interest rate forecasting. If you read nothing else, read those two articles – they have relevance even now.

  One structural alpha money maker was high-yield, one-year short term bonds that were rated BB and just below investment grade – thus preventing them from ownership by most banks, insurance companies and pension funds. The yield spread was (and remains today) excessively wide between similar maturity Baa rated issues because of regulatory mandate.

  PIMCO would use these short-term “money market” equivalents to back our purchases of interest rate futures (we called these bonds “Lambda cash”), thus combining the cheapness of these “futures” contracts in the 80’s and 90’s with 1% to 2% higher yielding 12-month or shorter Ba rated bonds to in effect produce a synthetic Treasury bond yielding 2% to 3% more than those available for cash purchase. Since bond market indices contained 60% or so U.S. Treasuries, simply matching the index Treasury component would produce structural alpha in the vicinity of 1% or more per year.

  Another strategy engineered by Managing Director Changhong Zhu was to use Eurodollar futures and roll down the yield curve from the 5th forward quarterly contract (1.25 years) to the 4th (one year). Industry reporting standards mandated the same duration number for the 5th as well as the 4th contract since they were both three-month forward maturities. The 5th contract, however, yielded 20-25 basis points more than the 4th and added price appreciation to boot as it approached the value of the 4th in three months’ time.

  While this may be a little technical to the reader, this and the short-term, high yield strategy were typical of PIMCO’s portfolio construction over many time periods no matter where interest rates headed. The Eurodollar strategy doesn’t exist today due to Jerome Powell’s 0% interest rate policy and it may never return again. Nevertheless, we exploited these and other strategies to produce low volatility, high return annual results that led to me (and PIMCO) to be known as the “King of Bonds, ” first mentioned by Fortune magazine in the late 1990’s.

  PIMCO in the millennium’s last decade was doing very well. Assets were $10 billion, $20 billion, $100 billion and growing. One of our long standing traditions was to ring a large bell every time we got a new client and it seemed like it was ringing every day. Portfolio management, though a focus, was not the singular reason for our success. As mentioned a few pages later, PIMCO was built from the beginning on a three-legged stool which in addition to the investment side, depended on marketing and client servicing, as well as business management. PIMCO would not have been PIMCO without Jim Muzzy and Bill Podlich – both brilliant in their respective areas of marketing
(Muzzy) and planning (Podlich). Muzzy – five years older than yours truly would help PIMCO thrive until 2009 and Podlich – one year younger than I – would choose an early exit in the mid 90’s to enjoy family and railroad trains, of all things.

  Jim Muzzy and I spent hours/weeks/years traveling together on the road in search of new clients and our success ratio was well over 50%. The “Muzz” would warm up the audience and I would close with strategy and forecasts. But we had some interesting times together before and after the meetings. Jim was the heart and soul of keeping expenses low although Dean Meiling – our fifth partner — took first place with his edict that all employees should save and recycle paper clips. Jim though took pride in staying at the cheapest motels/hotels. One time in New York City when three of us were presenting, we all shared the same $125 room and had to flip a coin for who would sleep on the floor. I wasn’t the loser, but then toe to toe with Jim was not my idea of even frugal business travel. Another motel in Connecticut came at $55 and was furnished with a “gel” bed, overhead mirrors and rather exciting wallpaper. We could hear the trucks roll in and out of the parking lot all night.

  Podlich was replaced by Bill Thompson, who was managing the Salomon Brothers office in San Francisco in 1994. Thompson, our second CEO after Podlich, presided over PIMCO’s quickest growth period from 1995 until 2012. Assets increased from $100 billion to nearly $1 trillion before the financial crises of 2009. He was a people’s man extraordinaire, serving up hot dogs for all on his July birthday and helping to keep my testosterone in check when needed. He thought I was funny in our private moments and during my more serious public moments he was a moderating influence. We became good friends at the office and on the golf course, even traveling to the AT&T Pebble Beach Pro-Am together.

  Our first trip to the AT&T in 2003 was perhaps the most remarkable. The amateur prize had been and still remains to make the top 10% of amateur/pro team scores after three days of play come Saturday afternoon. Veteran amateur players had told Thompson and I that 18 under par for the team score usually made the cut, but my pro partner Kevin Sutherland and I had finished 16 under. Bill (14 under) met me at the 18th green and said: “Let’s go home we aren’t in the top 10%.” I reluctantly agreed and we headed for the airport. While in line for check-in, Ron Maggard – a friend from our local club in Newport Beach – came up to me and told me that my 16 under indeed might qualify – that my team was tied for the one remaining spot which would be determined later that night. I was forced to say goodbye to Bill and checked back into the hotel.

  At 9 pm that night my caddy – a rather scruffy veteran named “The Rock” – called my room and said, “Mr. Gross we made the cut”. “Great, ” I replied whence he continued, “And guess who we’re partnered with at 8:30 tomorrow morning on the 1st tee?” “Who’s that” “TIGER” he shouted and I almost fell over. Playing with Tiger Woods on Sunday, as was playing with Phil Mickelson five years later in the last group on Sunday, was an amateur’s dream come true. I am indeed the luckiest (not the best) pro-am golf player ever. But to think that unless I had not accidentally met Ron Maggard at the Monterey Airport and returned back to my hotel is the golf story of my career; I would have been waking up on Sunday morning in Newport Beach while Tiger was being stood up by a rank amateur at 8:30. Unbelievable!

  PIMCO’s People

  But besides Thompson and Muzzy, there were now hundreds of professionals in offices other than Newport Beach. Bill Thompson had truly taken PIMCO global with New York, London, Tokyo, and Munich forming the family. And we were managing global bonds – ”Bunds” we joked – as well as domestic paper. One of the keys to PIMCO’s success was our ability to investigate and endorse (in some cases) new products as the investment markets developed.

  Chris Dialynas, who joined in 1980, was a key supporter of financial futures in the mid-1980’s and served as my co-pilot until my 2014 dismissal. Chris was a professional baseball player wannabe who saw more dollar signs at PIMCO than with the Anaheim Angels. He joined the trading desk, such as it was, in the early 80’s and was more “badass” than yours truly when it came to dealing with brokers. When confronted with an impasse on price, Chris would frequently say, “You’re between a rock and a hard place buddy and I’m the hard place. I’m not movin’!” Chris would inevitably win the argument! We would share a large bag of M&M’s every morning and the sugar high that came out of it would rocket us to the moon much more than the cocaine featured in movies such as “The Wolf of Wall Street” and other stereotypical flicks about the industry in those days.

  Chris was also instrumental in generating one of the key PIMCO trades in the early 80’s. After traveling to Chicago to visit the CME and its initial attempt to market interest rate futures, Chris learned about an early contract called the GNMA CDR which professed to allow traders to hedge their mortgage portfolios. The CDR, however, was flawed and after investigation, we determined that it was structured to allow an investor (PIMCO) the option of owning high coupon/short duration GNMA mortgages or a perpetual 8% annuity. One option made the CDR a short maturity bond, the other allowed it to be an 8% government-backed long bond. If interest rates went up, we could own the short maturity option. If they went down and below 8%, we could choose the annuity. The incredible part of the trade however, that it was only being priced as a short maturity bond. Chris and I, after consulting with legal and CEO Bill Podlich, decided to go for it.

  After a few months we owned nearly $2 billion notional of this futures contract. By then interest rates were falling and the 8% perpetual coupon was dominating the contract but the CDR price hadn’t changed. We decided to take delivery of the CDR with the intention of converting it to an 8% perpetual bond. Word, however, spread amongst traders and dealers who belatedly realized our option was working against them. We were told that at the end of our month’s long buying spree, floor traders on the Chicago Board of Trade were waving white handkerchiefs in surrender. I met executives of Salomon Brothers at the LA airport a week later and negotiated an exit of all parties. Profits of $70 million went straight to client portfolios. Thanks Chris.

  This propelled us on our way to investigate and endorse new financial products if cheaply priced and principal safe. In the years following our endorsement of financial futures, foreign bonds, and TIPS (inflation protected securities in the late 90’s) led to wide outperformance and promoted the image of PIMCO as a conservative yet innovative bond manager. That’s a hard combination I suppose but that was what PIMCO was all about. Interest rate forecasting? Sure. But innovation was key as well. There was more than one Bond King in our new offices in Newport Beach, just across from our old home at Pacific Life.

  We were later joined by other trader/portfolio managers who were strange but incredibly successful in their own right. Ben Trosky – Mr. High Yield – who we nicknamed “Doobie” based on observations of his enjoying some “weed” on his way home – was one of the best. His fund received top honors and his purchases filtered their way into my portfolios that would later earn me three Morningstar “Bond Manager of the Year” awards and Manager of the Decade. He shares pieces of those trophies. So too does Dave Edington, known forevermore at PIMCO for nailing his shoe on the door of the Partners Lounge one drunken evening to protest something that I’ve long forgotten. His ideas and performance with his own portfolios were exceptional.

  And then there was Frank Rabinovitch, the mathematical genius who chewed and digested small pieces of paper during the trading day. We hired Frank on the basis of his multiplying 133, 768 times 643, 215 in his head (our number) before we could even check the result on a hand calculator. Frank later left PIMCO rather prematurely to put the Bible on the Internet in in its early days. And then there was John Brynjolfsson, who developed PIMCO’s first of its kind TIPS portfolio into a raging success. Mark Kiesel, master of corporate bonds, was crucial to PIMCO’s success and still is in 2021. Strange, brilliant minds, but an important piece of PIMCO’s success along the way.

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bsp; The mortgage desk, headed over the years by John Hague, Bill Powers and Scott Simon, was perhaps the most consistent “alpha” generators of any of PIMCO’s specialty areas. Their funds were always in the top 90th percentile and of course my total return funds made extensive use of FNMA and FHLMC mortgages throughout their years.

  Perhaps one of the least well known but most accomplished strategists on the PIMCO trading floor was Changhong Zhu, a mid-30-ish portfolio manager at Bank of America when he came to our attention. Over his 10 or so years at PIMCO he was responsible as a partner and member of the Investment Committee for many yield curve strategies involving futures and for emphasizing the structural alpha features of Eurodollar futures. For most of his tenure, the U.S. yield curve was attractively positive, meaning that 5 year Treasuries yielding 4%, for example, could, like a caterpillar becoming a butterfly, turn into 4 year Treasuries yielding 3.8% one year later, even if interest rates themselves were unchanged. In essence, they would “roll down” the yield curve, providing not only 4% interest income but another 1% in price appreciation. This concept when applied to 15 month Eurodollar futures rolling down the curve over three months to a 12 month maturity, provided an incredible “alpha” or outperformance boost to portfolios. He suggested many more ideas, and was undoubtedly the smartest strategist PIMCO ever had. We lost an honest and loyal partner when he and his family moved back to his native China at the end of 2009 to accept a position with the country’s State Administration of Foreign Exchange.

  Almost all of these people departed long before my departure in 2014. Some of them like Tad Rivelle left to start their own firms like MetWest, that was to become the industry’s second largest mutual fund manager, much larger than the supposed new “Bond King” Jeffrey Gundlach, with his firm DoubleLine Capital. Gundlach’s performance in these last five years has been anything but deserving of the title. If anyone is deserving, as I once mentioned in an interview, it would be Scott Minerd, the chief investment officer at Guggenheim Partners, in part because of his great long-term perspective, as well as his performance.