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Berkshire Hathaway's (NYSE: BRK-B ) Warren Buffett sounded the alarm earlier this month when he predicted a looming crisis in municipal bonds, given the poor fiscal health of many states in America. But that doesn't mean investors should steer clear of investing in all municipal bonds.
Bill Gross, founder and co-chief investment officer of Pacific Investment Management Company (PIMCO), the world's largest bond fund manager with just over $1 trillion under management as of March 31, said in an interview that there is a risk of a crisis in municipal bonds. But Gross is willing to bet the federal government will bail out the states. As such, he says investing in "munis" offers its reward for investors. We also discussed the best investments in bonds now.
Gross is to bonds what Buffett is to stocks. Dubbed the king of bonds, Gross warned about the subprime mortgage meltdown in 2005.
He manages the Total Return Fund (PTTRX) at PIMCO -- the world's largest mutual fund. In the midst of the market crash in 2008, Class A shares for individual investors of Gross' Total Return Fund yielded 4.3% for the year, which was 9% above similar funds, according to Morningstar. The fund has averaged an annualized return of 7.21% for the past 10 years, beating the benchmark by 0.84%.
Here is an edited transcript of our conversation.
Jennifer Schonberger: There are concerns that there could be a looming crisis in municipal bonds. Do you think there is indeed a crisis looming?
Bill Gross: There's fat tail potential [high risk]. That's not a way of ducking the question. It simply means that these days, based upon the foundation of other financial crises and delevering throughout the global financial system, that the states' balance sheets and their necessity to roll and to issue new debt has to be included within that context -- and to a certain extent that there are potential crises in Greece, Euroland, and elsewhere. It's hard to estimate. Ultimately, I think as [Warren] Buffett suggested, the probability of the fat tail really depends upon the willingness of the federal government to step in and to write a check.
Schonberger: Do you think the federal government has somewhat already stepped in with these Build America Bonds (BABs)?
Gross: Yeah, they've done that. The BABs are one way to assist all the technical units. So that's the private market. But the government doesn't do anything there other than a 35% subsidy, which accrues to the benefit of the non-taxable investors, like PIMCO.
The main subsidy has been through stimulus programs, and probably will continue to be -- a check in the form of Medicaid and education benefits. There's one now that's still in Congress that Obama's endorsed, a $50 billion stimulus for the states that may or may not get through. But you have a situation that's so dire that the U.S. government is ultimately the last arbiter, in terms of whether or not there's a crisis or not.
Schonberger: Buffett has said he thinks this crisis could be five to 10 years off. How far off is this potential problem in your view, and what happens that would cause this to snowball into something that really puts it at a crisis level, throws the financial markets for a loop, and perhaps hinders economic growth?
Gross: I think the crisis is more near-term than what Mr. Buffett suggests. Obviously you have states finding it difficult to raise money. For instance, the state of Illinois simply stopped paying its bills. They owe more than $5 billion to just the people that work for them and the people that collect rent, etc.; not their creditors, not their bondholders. So that's a crisis.
I think their situation is mimicked by California, New Jersey, and other large states that simply haven't addressed the need for more balanced budgets. By law, and this has been fiction, 49 of the 50 states have to have a balanced budget. But that's obviously not been the case. Our numbers show that in 2011, the deficits for all of the states in combination, you average 15% of the deficit as a percentage of the state budget. So, if that's not a crisis, I don't know what is.
Schonberger: Do you think states have become complacent about their fiscal situations, given the advent of insurance for municipal bonds, and as a result are taking on more debt than they otherwise would? Has that in a sense sort of created moral hazard?
Gross: Yeah, I think that certainly didn't help. Obviously, the insurance in the past 12 to 18 months has vanished as a support mechanism for the market, so to speak. But yeah, up to that point, investors and certainly individual investors took the word literally that they were insured -- and I guess rating agencies did too, right?
So, these-AAA insured municipalities were able to get away with very narrow spreads, very low yields, and they issued a lot of debt because it was cheap. So yes, I think that exacerbated the problem. Now, of course, that's recognized for what it was. So they're on their own from the standpoint of insurance.
Now as you mentioned, they shifted to the 35% BABs subsidy. So, in some form or fashion your point is a good one. They've been subsidized for the past 10 or 15 years in the form of their debt issuance, which has helped to put them to sleep from the standpoint of recognizing the problems down the road.
Schonberger: What does that mean for the insurers of municipal bonds like? Are we going to be looking at AIGs (NYSE: AIG ) here down the line?
Gross: I haven't really looked at that. We don't own the insurers. I've sort of written them off already ... It's fair to say that the states themselves have a low probability of default. But then there are localities and projects. I don't know what the projects are and what the localities are in specific, but there are a growing number of defaults at the local level. So it certainly isn't a positive for the insurers.
Schonberger: Would you recommend that investors steer clear of investing in municipal bonds as a whole?
Gross: I think that's the question of risk and reward. We've talked about the risks. I mentioned the fat tail. I don't know what that implies in terms of the probability. It simply means that it's a higher probability than it was a few years ago. But the rewards have increased substantially.
We'll leave the BABs out of it for second, but the tax-free area on the 30-year side basically equal 30-year treasuries, and with the tax advantage, etc., that's not historically high, but it's close to historical highs. So the rewards for a tax-free investor are certainly there. The BABs side, which we've been investing in primarily, produces a yield of 6.5%. So if you can get 6.5% from a state like New York -- or I can see California being out there at about 300, I guess, around 7% -- the reward is decent.
There is an immediate crisis and ultimately, the question becomes whether Uncle Sam is willing to write a check. But I guess my sense is that they will be. Uncle Sam has written a check, will write a check, and much like Europe has blinked with Greece, Spain, and Portugal, the United States would blink with California, Illinois, and New Jersey. But that's a risk, and so the question becomes whether or not you paid for it. I think at 6.5% to 7% that it's a decent risk. Buffett mentioned five billion. Our portfolios have about $8 or $9 billion ... so we're twice as risky as one.
Schonberger: Aside from the municipal bonds, if we look at the bond universe as a whole, what is the top place you'd recommend investors invest now?
Gross: PIMCO's a real big investor in AIG (NYSE: AIG ) bonds. PIMCO has been buying them for 12 to 18 months. They're supported by $65 billion worth of equity and a third of the government. So for that reason alone, it makes a lot of sense; and they yield about eight and a quarter percent ... So, I'd recommend AIG bonds and what they call hybrid preferreds, which yield even more, like 10% or 11%.
Secondly, we like the bonds of GMAC, now called Ally Bank. This is another company that the government basically injected $25 billion worth of support and checks, and basically owns 60% of the company. We like these government-supported enterprises, so to speak. It's a play on the agencies staying employed. In a way they're quite similar because they're owned substantially by Uncle Sam; but they don't have the pure guarantee of the agencies so they yield a lot more. In GMAC's case, you can buy two- to five- year notes and bonds at 7% to 8%. Retail customers can buy theirs through their broker.
[A spinoff on buying GMAC, or Ally Bank] are GMAC Smart Notes. GMAC started selling them three or four years ago to their customers when they were really up the creek ... the retail customer can go through a broker. The advantage of them is that they're so liquid, tiny, and small. They're perfect for a retail customer. They yield about 1.5% more than what we can buy at PIMCO. We're talking 8.5% to 9%. So, I'd recommend Allied Bank, GMAC, Smart Notes for the duration of maturity.
Third and best -- it sounds like a commercial but it's not because these are closed-end funds. The shares are just bought and sold by other investors, so PIMCO doesn't make any more money. But the closed end funds that I manage on a daily basis. These closed end funds yield 9% to 10%. They're BAA composed in terms of what they own. They own a lot of what I just described, AIG and GMAC, and so on. You can buy them on the New York Stock Exchange. Two examples are the PIMCO Income Strategy Fund II (NYSE: PFN ) and PIMCO Corporate Opportunity Fund (NYSE: PTY ) . Those would be two great examples of income funds that are pretty darn secure. I don't guarantee it, but managed quality is about BAA.
Schonberger: I understand that you do own a small amount of BP's (NYSE: BP ) bonds. Would you recommend retail investors dip a toe in, or is that a pretty risky venture?
Gross: No, but I think it's probably hard. I don't know what split size is offered to an individual investor. We chose to go in the 12-month category, because we didn't know where the bottom was, in terms of the 20 billion or whatever it's going to be. We said it was still going to be a long time in the courts, or a long time, before the government could get their hands on it. That's typically how these things go. In the worst case we assumed 12 months from now, they're still alive and paying their debts. I would recommend it, but I think it's a little less liquid ...
Schonberger: Do you think there are any value plays in Europe right now, or is the European situation too uncertain to dip into?
Gross: Yeah, I think it's too uncertain. We don't own Greece, Portugal, or Spain. There's just too much uncertainty and not enough transparency with the banks and the ultimate size of the government's deficit. It's best to stay away.
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