Bill Gross’s recent monthly commentary for PIMCO paints a disturbing picture for investors; his vision ends with stocks being “singed” and bonds being “burnt to a crisp.”

The premise of his article is that the United States needs to get its fiscal house in order or else the Fed will be stuck printing money to pay the debt deficiencies. Strangely, Gross asserts that the United States will resemble Greece if deficits are not conquered.

That is nonsense because the United States is a currency issuer and can never run out of dollars. Greece, in contrast, is a currency user and cannot issue euros at will. But in any case, investors are coming to the conclusion that economic problems cannot be solved by monetary policy alone. In this, Gross is correct; the United States’ and other countries’ decisions on fiscal policy will be the key determinants of future economic performance.

I am thoroughly convinced that, in the interim, fixed-income asset prices will be largely driven by central bank policy. My earlier post on QE went through the mechanics of QE3 and how it has affected various fixed-income classes. Understanding the capital flows caused by the Fed’s balance sheet expansion is important but not essential to understanding the full fixed-income universe.

In fact, the lion’s share of the fixed-income universe is not in the segments I discussed in that article but, instead, in U.S. Treasuries and agency mortgage-backed securities (MBS). The common fixed-income benchmark used is the Barclays Capital Aggregate Bond Index, which novice investors can think of as the bond market’s version of the S&P 500 Index because it is frequently used to measure bond performance.

What’s My Upside?

As with any investment, it’s important to understand the inherent risk–reward characteristics on a potential bond. For the purposes of this bond/math example, we will use the Treasury bond maturing 15 August 2022 (10-year proxy) with a coupon of 1 5/8 trading at par, thus a yield of 1.625%. Let’s pretend investors wake up to another round of fears in the eurozone. Treasury yields plummet, and the 10-year yield falls all the way to 1.25%, which would be a record low.

The price at that point would rise to about 103.50, or a gain of about 3.5%. Conversely, if 10-year yields were to rise to 2.50%, the bond would drop to a price of 92.3, or a loss of nearly 8%. The objective of this simple exercise is not to say whether a 10-year U.S. Treasury bond is an attractive investment but, instead, to quantify the upside of a fairly significant drop in yields. Needless to say, the upside of further gains in U.S. Treasuries is limited because of low absolute yield levels.

What’s Inside the Barclays Index?

The index is currently made up of 42% government bonds (mainly U.S. Treasuries), 31% MBS (primarily Fannie Mae and Freddie Mac), and 24% investment-grade corporate bonds. Geographically, about 92% is U.S. securities, with small amounts in Canadian, German, and Mexican bonds, among others. Because the Barclays index is an intermediate-term bond index, chances are that many “core” bond funds will look fairly similar in composition.

The top 10 specific holdings are all U.S. Treasury bonds and make up more than 18% of the total holdings. Through the end of the third quarter, the index had a total return of 3.77%, which is an annual equivalent of 5.08%. As a proxy, 10-year U.S. Treasuries ended 2011 at 1.87% and finished the third quarter of 2012 at 1.64%, so rates have fallen modestly. Other return components for the Barclay’s index came from tightening spreads in both corporate debt and agency mortgages.

The second largest component of the Barclays index, agency MBS, is trading at record high prices because the Fed is purchasing nearly 70% of new issuance. New 30-year 3% pools are trading near $106, which equates to a yield of about 2% at current prepayment rates. Spreads on these mortgage bonds versus Treasury or swap yields have almost been cut in half since the Fed announced QE3. In short, the compensation for bondholders taking on prepayment risk is at extremely low levels. Mortgage bonds are negatively convex, meaning that when rates fall, homeowners prepay, and when rates rise, the bond extends in length as prepayments fall.

Investors need to understand the types of bonds commonly found in bond funds and exchange-traded funds (U.S. Treasuries and agency MBS) and realize the dramatic impact that the Fed has had on these securities through its QE programs. Personally, I don’t see an imminent rise in interest rates as a major concern. Although the Fed has dramatically increased the base money supply, this money is not finding its way into the economy. Unemployment is stubbornly high and well above desired levels, while inflation is muted and below levels acceptable to many Federal Open Market Committee members. There’s no shortage of uncertainty today between the fiscal issues that Gross mentioned and the unprecedented monetary intervention by the Fed.

In my opinion, the majority of the asset classes found in the Barclays index are now very unattractive because they have been distorted by the Fed’s large-scale asset purchases. Such a large intervention by the Fed can misprice both credit and duration risk as institutions are forced to chase yield from a smaller pool of remaining bonds. Understanding the risk–reward characteristics of the underlying bonds found in many bond funds can help investors decide whether they are worthwhile investment candidates.

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