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Fed should be ‘more cautious’ amid investor bond binge: Bill Gross

The Federal Reserve headquarters in Washington.

Kevin Lamarque/REUTERS

Influential bond investor Bill Gross of Janus Henderson Investors warned Thursday the Federal Reserve should be "more cautious and easier" in its interest-rate hiking campaign, given the enormous exposure investors have to pricey risk assets including corporate bonds and high-yield junk debt.

"Should a crisis arise because of policy mistakes, geopolitical crises, or other currently unforeseen risks, the ability to protect principal will be impaired relative to history," said Gross, manager of the $2.2-billion Janus Henderson Global Unconstrained Bond Fund.

Prior market tops – including in 1987, 2000 and 2007 – allowed asset managers to partially insure their risk assets by purchasing Treasuries that could appreciate in price as the Fed lowered policy rates, Gross noted in his last Investment Outlook for the year. "Today, that 'insurance' is limited with interest rates so low. Risk assets, therefore, have a less 'insurable' left tail that should be priced into higher risk premiums."

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So far this year, U.S.-based corporate bond funds have attracted more than $205-billion of inflows while U.S.-based equity funds have pulled in just $153-billion, according to Lipper data. For their part, U.S.-based Treasury government funds have netted inflows of roughly $30.56-billion this year.

Gross also raised warnings flags about the credit-based U.S. economy. "Our entire financed-based system – anchored and captained by banks – is based upon carry and the ability to earn it," he said. "When credit is priced such that carry can no longer be profitable at an acceptable amount of leverage/risk, then the system will stall or perhaps even tip."

Until that point, however, investors should stress an acceptable level of carry over and above their index benchmarks, Gross said. "The carry may not necessarily be credit based – it could be duration, curve, volatility, equity, or even currency related," he said. "But it must out-carry its bogey until the system itself breaks down. Timing that exit is obviously difficult and perilous, but critical for surviving in a new epoch. We may be approaching such a turning point, so invest more cautiously."

There are risks for the economy when everyone is in cash, Gross said. "When the possibility of default increases and/or the real return on credit or liquidity decreases and persuades creditors to hold classical 'money' (cash, gold, bitcoin), then the financial system as we know it can be at risk as credit shrinks and money increases, creating liquidity concerns," Gross said.

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