Gross: Long-term bondholders beware

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Bill Gross, co-founder and co-CIO of PIMCO, is to my mind one of the shrewdest money men around. His monthly newsletter, this month entitled “Rocking-horse winner”, therefore always makes for thought-provoking reading.

Here are a few excerpts from the report:

“As a November IMF staff position note aptly pointed out, high fiscal deficits and higher outstanding debt lead to higher real interest rates and ultimately higher inflation, both trends which are bond market unfriendly. In the US in addition to the 10% of GDP deficits and a growing stock of outstanding debt, an investor must be concerned with future unfunded entitlement commitments which portfolio managers almost always neglect, viewing them as so far off in the future that they don’t matter.

“Yet should it concern an investor in 30-year Treasuries that the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt? Of course it should, and that may be a primary reason why 30-year bonds yield 4.6% whereas 2-year debt with the same guarantee yields less than 1%.

“The trend promises to get worse, not better. The imminent passage of health care reform represents a continuing litany of entitlement legislation that will add, not subtract, to future deficits and unfunded liabilities. No investment vigilante worth their salt or outrageous annual bonus would dare argue that current legislation is a deficit reducer as asserted by Democrats and in fact the Congressional Budget Office. Common sense alone would suggest that extending health care benefits to 30 million people will cost a lot of money and that it is being ‘paid for’ in the current bill with standard smoke, and all too familiar mirrors that have characterized such entitlement legislation for decades.

“An article by an ex-CBO director in The New York Times this past Sunday affirms these suspicions. ‘Fantasy in, fantasy out,’ writes Douglas Holtz-Eakin who held the CBO Chair from 2003-2005. Front-end loaded revenues and back-end loaded expenses promote the fiction that a program that will cost $950 billion over the next 10 years actually reduces the deficit by $138 billion. After all the details are analyzed, Mr. Holtz-Eakin’s numbers affirm a vigilante’s suspicion – it will add $562 billion to the deficit over the next decade. Long-term bondholders beware.”

Click here for the full article.

Source: Bill Gross, PIMCO – Investment Outlook, April 2010.

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2 comments to Gross: Long-term bondholders beware

  • Paul Sandison

    Oh dear. The great Bill Gross writes:

    “Common sense alone would suggest that extending health care benefits to 30 million people will cost a lot of money and that it is being ‘paid for’ in the current bill with standard smoke, and all too familiar mirrors that have characterized such entitlement legislation for decades.”

    I am afraid Gross could not be more wrong on this. Common sense and smoke and mirrors is exactly not what one should fall back on here, but microeconomics.

    If health insurance is universal the average cost actually comes down for everyone because 30 million more are paying.

    Yes, the poor/incomeless 30 million will have their premiums paid for by the state. But the extra cost in funding the premiums for the poor and incomeless is entirely compensated by the savings in the average cost over the entire population.

    There is also the added macroeconomic advantage of having a healthy population so that the initial costs of raising, educating and training people for two decades or more is not negated by unnecessary sickness, debilitation or death.

    Therefore the common sense idea that 30 million more people insured means a greater cost is just what it is – incorrect.

    A word of warning, however. Much greater and upwards spiralling cost will come if universality is not secured properly and robustly. Therefore it is absolutely crucial is that universality is assured.

    The difficulty in the US is in achieving that universality. It all depends what mind-set a particular nation has. By way of example: Australia requires all citizens to vote by law. That principle would offend the American ‘free spirit’ and the American Dream of each individual living life ‘My Way’.

    So in a country like the United States where a certain segment of the population is not just efficiently watchful but very paranoid about government controlling their lives, universality is difficult to achieve.

    Most US rich are notorious for caring nothing for the 30 million poor and believe they should be left to their fate because they have failed to make the grade according to their social darwinistic version of the American Dream.

    Therefore they don’t want to see the introduction of universal health insurance at all. In this highly individualistic, selfish age the days of passing universal insurance like Social Security with any kind of ease have gone.

    In fact the Senate is not finished with the Health Bill. There are a number of additional clauses still to be thrashed out. One is about the very question of universality. There is an opt-out clause to accommodate those that believe there is no such thing as society and don’t want to be part of the universal insurance but the penalty fee for opting out has been set far too low for the system to remain viable.

    The problem is this. If there is to be an opt-out clause the opt-out penalty must be a very high percentage of the insurance premium if not even equal to it. This is not only to ensure that the universal system remains stable with lower average costs.

    It is also in order to dissuade those for whom the reform has been passed to opt out against their own interests. Again, such a tendency would also destroy universality which would in turn lead to an ever-greater spiral of higher premiums, exactly that which has been the problem with Medicare. The Medicare problem of spiralling costs is typical of insurance systems which only insure certain categories in the population.

    The US as a nation now has to creep to the cross and learn what European countries have learned through bitter experiences over the centuries. Either one lives in a future Wild West dog-eat-dog world or one uses the superb power of capitalism to offer universal insurance.

    Since the US does not have universal health care at the moment there is a lot of ignorance about what universal health care means. Some believe universal health care means communism. However there is no contradiction between universal health insurance and capitalism.

    The best system of health insurance is a universal one under which there is intense competition between private health care providers so that people can exercise maximum choice.

    Since the US can no longer fund its largesse by borrowing from the world’s poor and emerging nations, it is facing a decision of whether to convert under the guillotine to accept universal health insurance at a very late stage.

    Whether the Health Bill just passed is successful and does not unwind like Medicare very much depends on the additional clauses.

  • “Common sense alone would suggest that extending health care benefits to 30 million people will cost a lot of money…”

    Are you sure? What if the health care product was cost-beneficial and added value? What if those who are currently uninsured were already using the system for free anyway? What if the Medicaid being considered reduced costs by requiring non-urgent care to be managed outside the Emergency Room?

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