Bill Gross: Treasury investors will 'get cooked'

CHICAGO (CNNMoney) -- Pimco founder Bill Gross reiterated his warning to cash out of Treasuries Wednesday afternoon.

Investors who have been betting on Treasuries are destined "to get cooked like frogs in an increasingly hot pot of water," the well-known bond bear told attendees at a Morningstar Investment conference in Chicago.

Gross, who manages the $235 billion Pimco Total Return Fund (PTTAX), said real interest rates, which remove the effect of inflation to measure the actual yield an investor receives, have fallen into negative territory.

Remember now, gang, Mr. Gross may be incorrect. Nothing may happen to bond prices. Yields are close to making new lows today. That isn’t happening because someone’s NOT buying them. And it’s less than three weeks to the end of QE2.

This could be interesting.

But, let’s be careful out there.

I remember an investment advisor Martin Zweig, who often repeated these words of wisdom. “Don’t fight the interest rate trend, and don’t fight the Fed.”

In the 19802, these were two different sayings. Now that the private Federal Reserve is buying 70% of newly issued federal debt, the interest rate trend (currently downward) is the major result of Fed action.

Imagine a business (say Enron) has a subsidiary buy 70% of their crap debt. Some people would get sucked into buying the bonds, thinking its low interest indicated a quality company. Their stock would also be overpriced.

But it’s worse than that. Imagine that Enron issued bonds where both the dividend and the principal were paid in non-voting shares of Enron. Who would buy it? But that’s exactly what Congress, the U.S. Treasury, and the private Federal Reserve have done. The banks, who are required to capitalize the Fed, only get a 3% dividend on FRN invested. But that is now higher than the interest rate on 10 year bonds. So the Fed is guaranteed to lose money on bonds purchased at less than 3% (which is currently all durations 10 years or less).

We’ll see soon what happens.

But consider this: Everyone in the markets knows that QE2 ends June 30, 2011. Yet the bonds have been flying. And I’m not talking about new issues here, but bonds and notes on the secondary markets.

Thanks for the very nice post!

Bill Gross made a huge bet last year that Treasurys were going to tank, so he got PIMCO’s Total return Fund out of them completely and put the money into corporates and foreign bonds. He has been trying to justify his strategy by talking Treasurys down ever since. He may ultimately be proven correct, but as my mother used to say, “Consider the source.”

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