GLOBAL - Fixed income specialist Pimco has warned that investors must expect government bonds to deliver poorer returns over the coming years than recently seen, as the state of US government borrowing is likely to frighten investors away when the market is being flooded by paper.
The latest investment outlook from Bill Gross, co-CIO and founder at Pimco, suggests investors such as pension funds will in future have to expect "considerably lower rates of return that what they grew accustomed to only a few years ago" and investors will need to be more careful about the investments they hold.

More specifically, he argues bond holders should "confine maturities to the front end of yield curves when continuing low yields and downside price protection is more probable" as the state of US government borrowing, for example, is already encouraging people to sell dollar-denominated bonds ahead of what will eventually have to be substantial Treasury bills issuance against GDP.

"Staying rich in this future world will require strategies that reflect this altered vision of global economic growth and delivered financial markets," said Gross.

His focus on government borrowing suggests whereas the US government debt to GDP ratio is currently 45%, the US government is already generating an annual deficit of 10% of GDP, so "five more years of those 10% of GDP deficits will quickly raise America's debt to over 100%" and a point at which credit ratings agencies may be forced to cut ratings.

Similarly, he argued it is likely to be difficult to clear those deficits in countries such as the US and UK while the marginal tax rates are still below 40%.

"The rather conservative US government debt ratio will likely be anything but in less than a decade's time. The immediate question is who is going to buy all of this debt?" said Gross.

"Estimates suggest gross Treasury issuance of up to $3trn (€2trn) this calendar year and net offerings close to $2trn" he continued, but "added the Chinese and other surplus nations cannot fund the deficit even if they were fully on board - which they are not", he continued.

Investors are now also so nervous of the impact this will have that many are "beginning to look for diversification in other currencies, selling Treasury bonds in the process".

"It is probable that trillion-dollar deficits are here to stay because any recovery is likely to reflect ‘new normal' GDP growth rates of 1-2%, not 3%+ as we used to have," said Gross.

"Staying rich in the ‘new normal' may not require investors to resemble Balzac as much as Will Rogers, who opined in the early 30s that he wasn't as much concerned about the return on his money as the return of his money," he concluded.

For further insight into PIMCO's thinking, see the interview with Bill Gross and Mohamed El-Erian in the June edition of IPE.