.

We all know what the oldest profession is, but few of us know enough about one of the youngest professions; the art and science of active bond management. Although PIMCO and Bill Gross are the primary focus of this book, its compelling story of active management of fixed-income portfolios reaches far beyond PIMCO’s remarkable track record and Bill Gross’s powerful leadership. Fixed-income management is fascinating, complex, essential to our economic system, and a great way to grow your wealth—if you know what you are doing. Yet many investors in these markets understand much less about fixed-income fundamentals than they should, which puts them in the same class as the millions of innocents who have been fleeced time and again in the stock market.

Indeed, until about thirty years ago, the lender handed the money over to the borrower and then collected interest until the borrower repaid the loan. That was all there was to it. The notion that anyone might routinely trade these instruments by selling them to other investors prior to maturity did not exist. The polite and conservative society of bondholders—primarily insurance companies, savings banks, personal trusts, and retired people of wealth—would have shunned such a drastic step as something not quite acceptable. There was modest activity in government securities, a limited number of big-name credits listed on the New York Stock Exchange, and a quiet over-the-counter market on the side.

The interesting question is why bond trading took so long to develop. Mispriced assets are just as likely to occur in credit markets as anywhere else. There is no good reason why the original pricing of the deal should be immutable through the life of the loan. Neither the particulars of each situation nor the fundamental economic environment is likely to stand still. The quality of a credit will change as the borrower’s financial position shifts over time. Bonds frequently include options, such as call provisions or convertibility into equity securities, and their prices should fluctuate with the value of these options. Volatility patterns are also unstable.

Finally, the biggest and most tenacious enemy of lenders is inflation, the chance that the money repaid will not buy as much as the money originally lent. But until the 1960s, inflation had been only a wartime phenomenon that disappeared the instant the peace treaties were signed. Inflation in the United States from 1800 to 1965 averaged merely 0.8 percent a year; prices rose in only 84 out of those 165 years, which included fourteen years when the country was at war. The relaxed outlook for inflation over that very long time span was the primary factor in persuading lenders that a buy-and-hold strategy was best for their business.

The bond market was such a sleepy place that even the theory of interest rates developed at a remarkably slow pace. The classical economists of the nineteenth century believed that interest, like all prices, was determined by the immutable laws of supply and demand. If interest was the price of capital, then the supply of saving and the demand from business firms for investment would be its primary determinants. This was a simple paradigm suggesting only modest volatility in interest rates.

In 1930, the distinguished Yale economist Irving Fisher introduced the idea that interest rates reflect expectations of inflation as well as the supply and demand for real capital. This was a remarkable insight in view of the absence of any kind of structural inflation in American or English economic history up to that time, but Fisher pressed the point even though empirical support for his hypothesis was lacking.

In the depths of the Great Depression, John Maynard Keynes launched a powerful attack on the classical view of the “real” rate of interest, in which he included Fisher. Keynes emphasized the critically important role of the cost of capital in business decisions to invest in plant and equipment. However, he insisted that the rate of interest was determined not by the supply and demand of capital or even by inflation expectations but as a kind of risk management tool, ruled by the demand for liquidity from risk-averse investors in an uncertain world relative to the supply of liquidity provided by the banking system.

In 1938, Frederick R. Macaulay’s magisterial book on the bond market, commodity prices, and stock prices launched a bitter attack on Fisher (Macaulay, a personal friend of mine, told me Keynes was not worth the trouble), focusing mercilessly on the weak empirical support up to that time for Fisher’s case. There were too many irregularities in the historical statistics to satisfy Macaulay. Yet Fisher ultimately turned out to be right about the impact of inflation expectations on interest rates, as peacetime inflation became an increasingly serious challenge in economies around the world during the late 1960s and the 1970s.

We must be grateful to Macaulay nevertheless: He provided a critically important innovation while shaping his argument against Fisher. Macaulay recognized he had to build his case from the foundation of a meticulous definition of the long-term interest rate. As he worked through that definition, he noted that a bond’s maturity date, while important, did not necessarily identify the moment when lenders would have their principal back. Simple interest at 6 percent would return the original investment in less than seventeen years even though a bond might have a maturity of twenty years; by reinvesting the semiannual coupons of 3 percent, investors would earn enough additional interest to have their money back even sooner. Accordingly, Macaulay proposed the concept of duration, which, in a general sense, measures the length of time required before the cash flows of interest and principal paid by the borrower equal the amount of money originally provided by the lender. As a bonus, duration turned out to be a strategic element in assessing the volatility of bond prices in response to changes in interest rates. Today, Macaulay’s definition of duration is the basic metric of risk in the bond market.

Yet the bond market itself remained somnolent until the mid-1960s, more than fifteen years after World War II, when inflation began to creep up from a range of 1 percent to 2 percent a year to annual rates of more than 2 percent and soon to more than 3 percent. By 1968, as inflation surpassed 4 percent, the price level was no longer just creeping upward; by 1970, prices were climbing at an annual rate of 6 percent. Fixed-income investors were finally beginning to get the point. As the yield on long-term Treasury bonds climbed along with the rate of inflation, the prices of outstanding bonds sank ever more deeply. Soon the bitter words “certificates of confiscation” became the popular phrase to describe bonds—once upon a time considered the safest investment anyone could make.

Consider the case of an investor in 1965 who invested $100,000 in a 30-year bond priced at 100 with a promised yield of 4 percent. Fifteen years later, the price of this bond would have fallen to 45, or $450 for each $1,000 invested. As inflation took its terrible toll, that $450 would have been able to buy less than 40 percent of what $450 could have bought in 1954. Buy-and-hold appeared to make less and less sense. The bond market would never be the same.

In 1972, when the most serious damage was still in the future, a slim new volume on bond investing set the tempo for active bond management to become a reality—indeed, a necessity. Written by two Salomon Brothers economists, Sidney Homer and Martin Leibowitz, Inside the Yield Curve finally awakened bond portfolio managers to the complexity of their fixed-income instruments and the trading opportunities that complexity provided. The book was in many ways a primer whose lessons today are taken for granted, but few people at the time were aware of its importance. As the authors point out in their very first paragraph, “Too often the dollars and cents significance of bond yields is taken for granted and sometimes even misunderstood.”

For example, the mathematics underlying the calculation of a bond’s yield to maturity assumes that the semiannual interest payments, or coupons, are reinvested at the same rate as the promised yield on the bond at the time of purchase. Such an outcome would be a rare coincidence. When interest rates averaged 2 percent or even 3 percent, the interest rate at which bondholders reinvested their coupon income made little difference. But reinvesting coupons of 6 percent or more on a bond with a life of over twenty years is something else entirely. Now you are talking about real money, sums that could exceed the original amount of the principal lent. You are also invoking the power of compound interest—“interest-on-interest” as Homer and Leibowitz dubbed it—making this extra source of return a dominant factor in the investor’s ultimate payoff.

The book goes on to explain volatility in bond prices, a phenomenon that nobody had to bother about in the good old days but one that is now a source of opportunity as well as risk. To cap their story, Homer and Leibowitz describe in detail the kinds of trading in the bond market—“bond swaps”—that could turn a profit for the active and analytically inclined investor.

At about the same time as the appearance of the Homer-Leibowitz book, a few intrepid investment professionals decided to try their hand at developing active management strategies, based on widespread mispricing of bonds as most investors hung on to their longstanding policy of buy-and-hold in an increasingly unstable environment. The darkening outlook for inflation and the bond market’s rising volatility offered a wide variety of new opportunities. These pioneers soon built up enviable track records from sophisticated interest rate and yield curve forecasting as well as from the plethora of inefficiencies provided by a notably illiquid marketplace. The profession of active fixed-income management was born.

Among these pioneers was a West Coast insurance company called Pacific Mutual (now Pacific Life), which early on undertook active fixed-income management in its own portfolio. In 1971, it established a subsidiary called PIMCO to carry out the mission of active management for clients. Bill Gross was there right at the start: His first job out of UCLA business school was with PIMCO.

Bill Gross spends a certain amount of time looking at the world upside down, literally—he practices yoga. He refuses to pay attention to the conventional wisdom in life and in business, and over his legendary thirty-year investing career, this perspective has paid off. Gross manages $360 billion in fixed income assets and has consistently delivered returns averaging more than 10 percent annually.

What sets Gross apart from his peers is vision. Before almost anyone else, he realized that bond investing held untapped opportunity. Perhaps Gross’s greatest contribution to the investment industry is the insight that a fixed-income portfolio can be traded, rather than just held, and that this kind of active management increases total returns. Gross introduced this concept of total returns to bond investing, and today, he manages the world’s largest actively managed mutual fund, and its name says it all: PIMCO Total Return Fund.

This is the story of a remarkable investor who himself once thought of bonds as being boring. Gross did not set out to become the Bond King, but he has undoubtedly become the master of this investment universe. The attribution “Bond King” quickly categorizes Gross, but the details of his investment philosophy and approach depict a complex individual who is nothing short of fascinating.

In 1982, Gross wrote an article in PIMCO’s “Investment Outlook” newsletter, a publication sent to the firm’s clients, that I found particularly telling. In the piece, entitled “Hedgehog Time,” a reference to Sir Isaiah Berlin’s essay “The Hedgehog and the Fox,” Gross explains his secular, or long-range, vision of investing by analogy to the hedgehog. “The fox knows many things, but the hedgehog knows one big thing,” Berlin had written, quoting the aphorism of the ancient Greek poet Archilochus. Gross cast the market as a fox, constantly chasing after the latest thing to catch its eye, and himself as the hedgehog, focused on the big, long-range picture. In 1982 the market had not yet seized on Paul Volcker’s new anti-inflation reality. It was looking back at the prior decade’s bear market in bonds. Gross was looking ahead to what he predicted would be a new bull market in the 1980s. He was correct in his prediction because he was correct in his vision, which itself derived from the focused, dedicated effort that he puts into understanding the world around him.

Berlin’s essay aptly defines the characteristics I find so compelling about Gross. “There exists,” Berlin wrote, “a great chasm between those, on one side, who relate everything to a single central vision, one system less or more coherent or articulate, in terms of which they understand, think and feel—a single, universal, organizing principle in terms of which alone all that they are and say has significance—and, on the other side, those who pursue many ends, often unrelated and even contradictory, connected, if at all, only in some de facto way, for some psychological or physiological cause, related by no moral or aesthetic principle.” Gross is a hedgehog, and not a bad philosopher.

This book, then, is about Bill Gross’s professional life and what we can learn from his experiences and investment strategies. As such, there is little mention of his life as a husband and father. However, these are the roles of which he is proudest. His first marriage ended in the early, time-crushing years of his career, and when he remarried 19 years ago he made a commitment to devote more of himself to his family. These days those who read his newsletter regularly have come to know his wife, Sue, and his teenage son, Nick—so much so that visitors to PIMCO regularly ask how they are doing.

The private Gross is not different from the man you will meet in this book; his focus is just different. On the job, he scrounges for extra returns; on the street walking with Sue, the two scramble to retrieve an errant penny on the pavement because it brings good luck. Someone once calculated that it is not worth Bill Gates’s time to bend over and pick up a hundred-dollar bill—he makes more per second at his day job. Gross will happily scramble for one red cent for purely non-economic reasons. He is not ashamed to say that he is superstitious.

Gross is candid, and is willing to surrender secrets about himself even when they reveal his failures and foibles. In both his personal and professional life, he confesses error reluctantly but in full. I once asked him how he had met his wife, and with a rueful grin he shared the story. It seems Bill and Sue each had registered with a dating service, but she took a pass on him the first time. Six months later, when he asked again, she had a change of heart and agreed to meet him for a drink. “Persistence pays off,” he told me. When he arrived for their date, he realized that he had left his wallet at the office. He tried to hock his watch in the lobby but there were no takers, so he was forced to ask Sue to pick up the tab. She did, proving herself to be a pretty shrewd investor.

The private Gross is currently white-knuckling Nick through driving lessons; the boy is 15 and in California that means he can get a license on his next birthday. Bill says he has laid down the law: “It will be nice when he can drive himself, I guess,” he told me, “as long as he drives himself safely, which is problematic. I’m giving him severe admonitions; if he ever gets a ticket, it’s lights out as far as driving is concerned.”

But mostly the private Gross putters about his 10,000-square-foot oceanfront home near PIMCO’s headquarters, amid his books of history and philosophy and geopolitics, and his stamp collection, and more than a dozen paintings Sue began to produce after she decided modern art is something you can do at home. She is so prolific, her husband says, “We’re going to have to buy a bigger house.”

But this book delves into Bill Gross’s Bond King persona. In reading it, we have the benefit of Gross’s own hard-earned experience. Yet, more importantly, within these pages Gross’s hedgehog view of the investment marketplace unfolds, revealing a perspective and outlook that will help readers prepare for the future.

Business has this in common with sports: There is a score and you know who the winners are. Bill Gross is the Babe Ruth of bonds, and I am grateful he agreed to cooperate when I proposed this book to him. He also asked his partners and employees to fill me in on PIMCO’s way of managing money; the point man who coordinated these contacts was Mark Porterfield, PIMCO’s director of public relations. The amount of work these two men and their associates did to help me is considerable, and I am thankful. If there are inaccuracies in these pages, they are despite PIMCO’s best educational efforts.

My literary agent, Esmond Harmsworth, and my editor at John Wiley & Sons, Jeanne Glasser, became my collaborators on this book, patiently helping me transform my first draft into this much more complete and readable version. A first book—and this is mine—is far more punishing on the publisher than the author, and I am grateful to Esmond and Jeanne for leading me up the learning curve.

In writing about financial markets, and especially their history, I am indebted to Richard Smitten, Jesse Livermore’s biographer, and to the biographers of Bernard Baruch and J. Pierpont Morgan. I have also exploited information from The Economist newspaper as well as the Morningstar Inc., Bloomberg, and ETFConnect.com databases.

I received an enormous amount of support from my editors at MSN Money, notably Mark Palowsky, Richard Jenkins, Erle Norton, and Jon Markman, the best team of bosses I have been fortunate enough to work for. At CNBC I have been aided by colleagues Matt Greco and Mark Haines. More indirectly but no less importantly, I have been fortunate to benefit from a circle of fellow financial journalists without whose help I would not even have wound up in this wing of financial writing: Andy Gluck, Dan Akst, Dan Wiener, Jim Lowell, Rick Green, Mike McDermott, and Randy Myers.

My principal career guidance counselor has been my wife, Joyce Rhea Middleton, who happens to be a school principal. I have been a lucky man, and the best luck I ever had was finding and marrying her. She wrung this book out of me. Our three children, Brendan, Michael, and Margaret, who all are writing books themselves, indulged my absence from more than one important family affair because I was working on this one.

You would never know from looking at him that William Hunt Gross is one of the richest and most powerful men in the United States. At his trading turret, he sits ramrod straight, his sandy brown hair brushed from front to side, his loose tie wrapped around his shirt collar, gazing at his computer screens in seeming immobility. His workplace is one cubicle among many—albeit the most spacious one—on the crowded, 4,200-square-foot trading floor of Pacific Investment Management Company, or PIMCO. It is on the third floor of a small office building three thousand miles from Wall Street, tucked among palm trees between the Newport Beach Country Club and a mall called Fashion Island, an hour south of Los Angeles—a modest setting, indeed, for the tenth most powerful person in the business world, according to Fortune magazine’s 2003 poll.

Gross’s silence and modesty are part of his legend. He is the object of study and fascination, even of divination: like the water diviners of old who would “read” fields and hills to locate aquifers, bond experts parse his every remark and interpret his gestures to predict future movements in the credit markets. They are so intrigued with Gross and his colleagues that they do not even bother to refer to them by name; instead, they call Gross’s bond trading office “The Beach,” in honor of the sunny California sands near the PIMCO office.

In the same way that investors analyze legendary investor Warren Buffett’s stock trades in excruciating detail, so that if he even takes the slightest interest in a company, the stock spikes, wild guesses and rumors about “what The Beach is doing” run rampant through the relatively tame world of the credit markets. Given Gross’s uncanny ability to predict future trends in the economy and his power to move markets for stocks as well as bonds, it is no wonder “The Street” spends so much time trying to outguess “The Beach.” Forget the experts who divine decisions made in cryptic meetings of the Federal Reserve, forget the Buffett-ologists who hazard a guess on his latest acquisitions: the real action is in trying to anticipate, interpret, and explain the stream of thoughts coursing through Bill Gross’s brain.

Some people are simply smarter than other people, and Gross belongs to the former tribe. In March 2002, Gross’s Investment Outlook newsletter was devoted to what he considered glaring inconsistencies in the financial statements of General Electric Company. This most-admired of American corporations—its sterling success usually credited to its razor-sharp management and its relentless ability to boost earnings—was, Gross argued, a flawed version of Warren Buffett’s Berkshire Hathaway. Gross described GE not as it is usually known—as an industrial conglomerate—but instead as a ragtag bunch of investments owned by a pool of capital desperately and heedlessly searching for profit opportunities. Unlike Berkshire, which is insulated from outside investors and controlled by a genius, GE’s cash-producing arm, GE Capital, is a part of a public corporation that raises money through the sale of commercial paper to institutions like PIMCO. And, despite GE Capital’s Triple-A credit rating, Gross wrote, “They nonetheless have commercial paper outstanding which totals three times the size of their bank lines (of credit) which back them up.”

Gross was pointing out that GE’s structure looked like a tottering tower that was about to fall from the pressure of its enormous debt. GE’s cash was as leveraged as a hedge fund, and it was using that cash to buy numerous business, but it lacked someone to select those acquisitions with the skill and care of a Buffett. To top it off, the stock was marketed as if it were one of the safest, gilt-edged blue chips. PIMCO, Gross said, would own no GE commercial paper for “the foreseeable future.”

GE and a tide of brokerage firm analysts attacked Gross’s analysis vehemently; Gross had not anticipated such an uproar. But GE’s paper, including its bonds, sold off immediately. In reaction, GE announced a substantial deleveraging of its borrowings. Experts across the world saw the truth of Gross’s analysis: the blue chip to end all blue chips was partly a risky venture fund, with no Warren Buffett or John Doerr at the helm. The prophet of the credit markets had struck with pinpoint accuracy.

Gross’s fearless eye has done more than affect single—if dominant—companies; he has been known to move markets, too. On the last day of February, 2000, news of a series of bond purchases, supposedly coming from “The Beach,” rocketed through the trading floors of firms like Merrill Lynch, Goldman Sachs, Bear Stearns, and Lehman Brothers. The story was: Gross is out there in the credit markets, and he’s buying! Like wildfire, PIMCO’s competitors began snapping up Treasuries, good quality corporates, and mortgage bonds. Within hours the price of these bond issues hit the roof and the nation’s long-term interest rates tumbled (bond yields are the reciprocal of their price, so when prices rise, rates fall). The fall in rates rattled the nerves of those who believed stocks were dangerously overpriced. A few days later, in March, the stock market hit a high that it has never reached again and began its sickening tumble to who-knows-where.

It was as if everyone began simultaneously wondering whether Bill Gross knew something about the equity markets they did not. Anxious investors, spooked by the clairvoyance of “The Beach,” questioned whether the wild returns of the 1990s were a bubble after all and, selling their internet stocks en masse, stampeded like a herd of sheep into the haven of bonds. That day, and in the weeks and months that followed, Gross had more influence over the stock and bond markets than Warren Buffett, President Clinton, or even Alan Greenspan. Is it any wonder that people spend their days and nights interpreting, second-guessing, and analyzing the actions of The Beach?

Gross begins his days with an early 10-minute commute in a Mercedes that could qualify for the Monaco Grand Prix. Fast, hot cars are an obsession with him (although he is a careful, sensible driver). Depending on his mood, he either listens to classical music or to rock (his love for Mozart is matched by a yen for classics of the 1970s like the Doobie Brothers and contemporary artists like the Dave Matthews Band). He follows East Coast business hours, and for a man working in Newport Beach, that means a 5:30 A.M. start at the office. This may seem onerous to some, but to Gross, the California lifestyle is something that can never be compromised.

Once he arrives at The Beach, Gross goes straight to his office. His shirt is starched but the collar is open, the tie draped like vestments, his jacket on a hanger. He flips on his computer screens in the same order and adjusts the pair of fluffy dice in front of him precisely; they display the numbers five and six, the roll at craps when nearly everybody wins. Like a dedicated gambler, he sticks to this routine superstitiously; even the smallest change could cause his luck to turn.

Gross keeps his crowded, busy office funereally quiet, because he hates distractions. (Sometimes he drives his colleagues nuts: “He doesn’t say anything for hours!” one of them confided to me.) He sits rigidly like a beanpole praying mantis, his thin form directed in intense thought at his computer screens. Occasionally, when the numbers on the Bloombergs change and he thinks something interesting is happening, his head pivots between the screens as if on ball bearings, like a gun on a battleship. He sits like that behind his trading turret, staring at one screen like a marble statue and then, suddenly, swiveling to face the next.

At 9 A.M.—lunchtime in Manhattan—he walks across the street to the Marriott for his daily exercise, supervised by a tough personal trainer who is a former Marine. Gross habitually works out for an hour and a half each day. His regimen combines an element of cardiovascular exercise with intense yoga and stretching. He cannot still fit into his college chinos, but middle age has taken his waist only to about 35 inches from 32.

At noon he strolls into the daily investment committee meeting, one attraction of which, he admits with a miser’s glee, is a free lunch. He leaves the office a little after 4 P.M.—this is the West Coast, remember, and the bond market has been dark for hours—and hits a bucket of balls at his country club. Then he drives back to his home on the ocean in Laguna Beach.

A night out with his wife Sue might include a 5:30 P.M. table at a Mexican restaurant with a total tab of $20; he is back home by 6:30. He collects stamps and reads voraciously—Virginia Woolf got more ink than Alan Greenspan in his “Dow 5,000” column—and is early to bed because, as his work requires, he has to be early to rise, flipping on the Bloombergs in his home office before 5 A.M. He eats the same fruit in his cereal at the same time each morning, because Sue says the antioxidants in the fruit are good for his heart; they are about the only richness in his yogic diet. On the weekend he plays a round of golf; he plays with his wife when they manage to get to their place at Indian Wells, a golf community outside Palm Springs. “From November to May it is one gorgeous spot, not only the high desert but the temperatures and the golf course and all of that,” he says. “It’s very peaceful living.”

It is peaceful in a Grossian way. When Gross plays golf, he is on a mission. He took the game up late in life and considers himself to be early on the learning curve. His handicap is 13 but, says Mark Kiesel, PIMCO’s investment-grade corporate bond specialist, a scratch golfer himself, “in a tournament he becomes an 8 real quick.” In fact, Gross plays in several tournaments a year. In 2002 at the AT&T National Pro-Am at Pebble Beach, his foursome included Tiger Woods. “I pursue the game with an obsession,” he told me, “much like that six-day marathon that I ran 20-plus years ago. I have to say, though, my obsession is making limited progress in terms of improving my game.” He never stops trying; shortly after one of my interviews with him he was headed with Bill Thompson, PIMCO’s chief executive, to Oregon’s Bandon Dunes, a pair of courses 100 feet above the Pacific ranked by Golf Magazine as among the top 100 in the world.

Bill Gross is not your ordinary number cruncher with a math Ph.D., heading up the fixed income department in a bank. His mystique gives him a bully pulpit that can sway the markets with incredible force. He prizes clarity of thinking and concentration and he lives a rich life outside his work. He explores his inner self and makes decisions with a clarity gained through his yoga practice and his obsessive reading. Whenever he makes a mistake, he feels it keenly: after a particularly off day, he has been known to take the stairs rather than the elevator the next morning so that he does not have to see or speak to anyone. Although voraciously competitive and obsessive, he is a very spiritual, questioning person.

In the rest of this book, I discuss in detail the techniques Gross uses in each area of the bond market. But even more important than his strategies is his intense, Grossian philosophy of investing. Unlike most legendary money managers, Gross sees investing as akin to legalized gambling. He believes he has a “system” that can work as well as advanced blackjack card counting works in Las Vegas. And the advantage for Gross is that, in the bond markets, there is no “house” to play against, and no security guards to toss you out of the casino when they realize you are playing a system.

The second lesson Gross gives us is best encapsulated by the old saying: “Know thyself.” Make sure you know what you are doing before you get serious about managing your investments. Know what risks you are exposing yourself to and control them. Play the game for the long term. Above all, know what the odds are. The investing game is not filled with innocent widows and orphans; if you are a rube you are going to lose. Therefore, you need to study up.

Today, Gross remains at the helm of PIMCO, which remains at the top of its game. Whatever his thoughts about the future, he remains for the present glued to his discipline with a fixity that is spectral. Indeed, Gross reminds me of what the cosmologist Martin Rees said of his colleagues in his Scribner Lectures at Princeton University, which were published under the title Our Cosmic Habitat (Princeton University Press, 2001). Speculating about the origin and fate of the universe does not faze them, although much of their subject is unknown and may ultimately be unknowable. They are, Rees says, “often in error but never in doubt.”

Like Warren Buffett, who also still goes to work every day, Gross has achieved his power and success by exploiting rather elementary notions of value, which an ordinary investor can readily learn. Gross also makes heavy use of institutional investing’s big guns—Ph.D.’s in mathematics and the computers they control, as well as crack traders. He also has a mastery of the bond universe’s exotic financial derivatives. All these weapons enable him to squeeze extra dollars out of virtually every successful investment—and limit losses on the unsuccessful ones. Buffett is somewhat similar, using a strategy unavailable to individual investors: while he acquires some companies outright, Buffett has taken stakes in others in the form of interest-paying convertible preferred stock that is issued only to him. Because of these advantages, it is almost impossible for average investors to beat Gross or Buffett at their own game. However, you can at the very least come close, and that means making tremendous returns on your bond portfolio. You can confidently expect to improve your investment returns if you heed the wisdom he has acquired in a career spanning more than 30 years.

In Part One of the book, I discuss Gross’s life and his career success; in Part Two I analyze the Total Return method Gross employs in detail across all sectors of the bond markets. In Part Three of the book, I show you how to use the Gross method to devise a bond investing strategy and significantly increase your returns.

William Hunt Gross was born on April 13, 1944, in Middletown, Ohio, a midsize town in the state’s southwest corner, near the Indiana and Kentucky borders. Located in Butler County, Middletown is a small industrial town halfway between the bright lights of Cincinnati and Dayton. Years later, Gross would fondly recall his Middletown summer afternoons swimming in placid little Butler Creek. It seemed so safe and welcoming in contrast with the swirling torrent of the Mississippi River or the bottomless depth of the Pacific Ocean.

The 1940s were a risky time for children; their growing-up didn’t seem as assured as it does today. Polio was a serious threat until April, 1954—when Dr. Jonas Salk’s pioneering vaccine went into mass testing—and epidemics of scarlet fever were not uncommon. Gross himself nearly died of scarlet fever when he was two years old, landing in the hospital for the first of what became too many times for his liking.

His middle name, Hunt, came from his mother’s side of the family. According to family lore, the Hunts were farmers in Manitoba, Canada, migrating south in the 19th century. One branch of the family moved south to Texas. “That was the H.L. Hunt half that struck it rich,” Gross says. “Unfortunately, my half went to Minnesota to farm, and, in the case of my mother, later to Ohio.” The oil Hunts are perhaps best known for H.L.’s failed attempt to corner the silver market in the late 1970s. It created a national mania in which families sold silver coins and table service—for as much as $25 an ounce—that was later quashed by federal intervention. Though his own connection with that branch of the family is more than a century distant, Gross muses, “Maybe the markets were in my genes as far back as the 19th century.”

His father was a sales executive with Armco Steel, the economic backbone of Middletown. The company, now weakened, still has a mill there under its new name, AK Steel. In the good old days, Armco produced diversified metals for various industrial consumers; in the 1940s and 1950s its principal customers were the leaders of the auto industry, located almost due north in Detroit.

When Gross was 10, his father was transferred to San Francisco to open a sales office for Armco designed to serve customers on the West Coast and in Japan. Complete with their German shepherd, the Grosses boarded the California Zephyr in Chicago and, three days later, arrived in the Golden State. Gross discovered his ability to adjust to new circumstances: it was an exciting time. He was dazzled by the freeways, the endless traffic lights, and the varied activities available in the metropolis; San Francisco was as different from a soot-stained Midwestern steel town as a place could get. Aside from his college years and military service in Vietnam, Gross has not left California since.

Tall and lanky, he now stands 6 feet tall and weighs 175 pounds. “Well, 176 today; I just weighed myself a few minutes ago,” he said during an interview in August 2003. He was much thinner in high school and played on the varsity basketball team; he had a good set shot. His high school hero was Jerry Lucas, a top college basketball player from Ohio State who eventually turned pro; Gross kept a scrapbook he still thinks he has narrating Jerry Lucas’s career. When it came time for college, his parents pressured him to attend Stanford or some other nearby school but, he says: “I had to get away. That was paramount to me. I needed to assert my independence, so the East Coast was all I considered.”

He visited Cornell, Princeton, and Duke. His mother considered Princeton a suitable substitute for Stanford, but Duke was already gaining what has become a premiere reputation in college basketball, and it was Duke he chose. “I broke my mother’s heart,” he confesses, but Duke also offered a scholarship (academic, not athletic), which Princeton did not, and she assented to his desire to settle into central North Carolina.

He majored in psychology and minored in Greek—as in Fraternity Row. At the beginning of his senior year, he was dispatched to fetch doughnuts for Phi Kappa Psi’s pledge candidates. It was rainy and he was driving too fast; he lost control of his Nash Rambler and smashed into oncoming traffic. He went through the windshield on the passenger’s side and the glass sliced off three-quarters of his scalp. In shock and unaware of this, he was stunned when a doctor soon loomed over him and said, “Son, there’s nothing I can do for you.” Moments later a state trooper walked into the emergency room with Gross’s scalp, however, and the doctor was able to help him after all. Gross has been sensitive, and even a bit vain, about his carefully coifed locks ever since.

His injuries were serious, and Gross spent so much of his senior year in the hospital that he resolved never to return if he could help it. Always athletic, he began a workout regimen with what was becoming his characteristic, obsessive rigor. The most obvious instance of this is when, on a dare, he ran from San Francisco to Carmel, California—a distance of 125 miles—in six days. He ran the last five miles with a ruptured kidney which, of course, sent him to the hospital. He also managed to tear up his knees pounding the Southern California pavement, and today his workout consists of a combination of yoga and work on an exercise bike to limit wear on his joints.

While his scalp and his body mended in a North Carolina hospital, Gross picked up a book entitled Beat the Dealer, written by a man named Ed Thorpe. It taught a system for counting cards at blackjack. Not unlike the way Goren taught students of bridge to tally the power of their hands, it simplified a seemingly impossible task. Instead of keeping track of individual cards, the system keeps track of three groups. Twos through sixes count as minus one. Sevens through nines are ignored; they count nil. Tens, face cards and aces are plus one. You do not actually count cards; you just know moment by moment whether the count is negative, meaning a lot of low cards have been dealt, or positive, meaning high cards have fallen. Blackjack is also called 21. Aces count as either one or 11, face cards 10, and all others their own number. Players can draw as many cards as they want, although if they go over 21 they are busted. Dealers (who automatically win ties) cannot draw if their cards total 17 points or more. But they can go bust themselves if, for example, they were to have, say, 12 points showing and draw a face card.

It takes a certain mathematical bent as well as concentration and memory to keep track of the odds at blackjack, but Gross had this knack—he has always been good with numbers and can compute quickly in his head, although he has never considered himself a math genius. He spent his hospital time, and plenty of the rest, studying Thorpe’s book and testing his abilities with his fraternity mates. Counting cards with a single deck is elementary; sometimes most of the face cards will fall before the game is half done, so the player can draw without going bust more frequently toward the end. Sometimes the opposite is true, but with only 52 cards, 16 of which are face cards and tens, keeping track is not difficult. For this reason, blackjack tables deal cards from a “shoe” containing as many as six decks. Such a shoe holds 96 cards that count as ten points, plus 24 aces, plus 212 others—and not all the cards are played before they are shuffled again. But the Thorpe system works regardless, Gross insists, though it is painfully rigorous—all those unpleasant and usually untidy drunks around the table, day after day—and inevitably gets you thrown out when security or pit bosses figure out how you are winning so consistently.

The youthful gambler became absorbed in this endeavor and hatched a plan to try his luck as a professional gambler when he graduated. He had enlisted in the Navy—the alternative was to be drafted, most likely into the Army, and Vietnam was already creeping towards the front page—but he did not have to report until October, 1966. In June, he set off for Las Vegas with a kitty of $200 and a head full of numbers, his psychology major already retreating toward a minor, but not unimportant, interest (Gross is interested in human behavior as it affects markets, not individuals). Gross does not deny what his senior partners say of him, which is that he is not a “people person,” detests managing staff or the business and is far more comfortable staring raptly and silently at computer screens of numbers, for hours on end.

Gross moved into the Indian Motel for $6 a day (with a few free nickels kicked back for the slots at a local casino), walked the Strip—he had no car anymore—and began to gamble. “My parents told me I would be back in a day and a half,” he once told The New York Times