Earlier this fall, William H. Gross, in one of his last
moves as portfolio manager of Pimco’s $200 billion flagship Total Return fund,
made a quick change to his investor prospectus. He was bullish on the bonds of
emerging markets in Mexico and Brazil but, having bought so many of them, was
fast approaching Pimco’s own 15 percent limit for the fund’s exposure to
emerging markets.
By the time the added wording came into effect in October,
Mr. Gross had left the money management firm he co-founded. But its impact on
the Pimco Total Return fund will be long-lasting. The bond fund, the world’s
largest ($162 billion at last count), could now buy short-term Mexican,
Brazilian, Russian or Chinese local currency government bonds by the bucketload
and not exceed its safety ceiling for emerging markets.
Moreover, Pimco deems these securities equivalent to cash —
a curious description for a class of investment prone to bouts of extreme
volatility and lack of liquidity, not least in recent weeks as bonds and
currencies in Brazil, Mexico and Russia have plunged.
The change also highlights a worrisome trend among the
world’s largest bond funds, a number of which surpass in size the economies of
major European countries. With interest rates in the major markets at record
lows, many of these funds, which are popular with retirees, have loaded up on
high-risk, high-return securities and, in the process, have become ever more
opaque about the risks involved.
Pimco’s outsize wager on emerging markets seems at the
moment to be particularly ill timed. Many of its big positions are in local
currency bonds and derivatives of oil-dependent economies like Mexico, Brazil
and Russia. These securities have tumbled with falling oil prices and a strong
dollar. Pimco is not the only fund giant to make use of abstruse, high-yielding
securities to bolster returns.
Last month, a working group of global watchdogs, headed by
William C. Dudley of the Federal Reserve Bank of New York, warned of the
consequences when large bond funds accumulate concentrated positions in
hard-to-sell securities, especially when investment banks have cut back on
their trading operations.
The paper cautioned that even traditionally liquid
securities like United States Treasury bills — to say nothing of complex
mortgages and real-denominated Brazilian bonds — are becoming harder to sell
when markets tumble. All of which increases the stakes for both Pimco and
DoubleLine, archrivals and major beneficiaries of the bond market investment
boom. They must now show jittery investors that their funds can thrive in an
environment of rising interest rates.
Both Pimco and DoubleLine defend their risk management and
reporting practices. Loren Fleckenstein of DoubleLine said that the fund
disclosed its exposure to these complex securities during quarterly webcasts
and that Mr. Gundlach, through his superior performance record, had shown that
he could responsibly deploy these investments.
Since January of this year, when public accounts of a
divisive leadership struggle at Pimco began to arise, the competition between
the fund giants has intensified, with DoubleLine pushing hard to present its
flagship fund as an alternative.
Financial executives will often disparage their competitors
anonymously, but they rarely do so publicly — more from superstition,
generally, than politesse — and Pimco managers have said privately that Mr.
Gundlach’s public musings were uncalled-for. For Pimco executives, the outflows
from the Total Return fund — $85 billion so far this year — are doubly
frustrating in light of the fund’s recent performance: Over the last two
months, their main fund has outpaced most of its peers, according to
Morningstar.
Some analysts accept that DoubleLine’s fund, with its larger
pile of high-yielding mortgage bonds, may be riskier than its rival, even as
its exposure to these sophisticated structures has come down to 3.5 percent
from 25 percent several years ago. These securities include so-called inverse
floaters, a high-risk mortgage tranche, whose interest rate moves in the
opposite direction of benchmark rates and that can be difficult to sell.
Nevertheless, the drama surrounding Mr. Gross’s departure
has kept the spotlight on Pimco. In particular, many hedge funds have been
betting against Pimco’s emerging market investments. They calculate that as
investors continue to pull out their money, the Total Return fund will have to
sell part of its emerging markets portfolio, a wide range that includes
peso-denominated Mexican Treasury bills and dollar-based bonds issued by the
Brazilian energy giant Petrobras.
Pimco executives say that for the Total Return fund, the
difference is largely made up of Chinese, Mexican, Russian and Brazilian
credit-default swaps, insurancelike instruments that Pimco sells to investors
who believe that these countries will default.
Just as it does with Mexican and Brazilian local currency
bonds that mature in less than a year, Pimco designates these derivatives as
equal to cash. Of course, in today’s buoyant climate, just about any investment
can be described as liquid, be it a Russian credit-default swap or a
high-yielding mortgage tranche. Until it’s not, that is.
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