Emerging-market debt and Pimco risk

December 16, 2011
Jenn Ablan and Matthew Goldstein's article about the slow implosion of Pimco's Total Return Fund is of interest to more than just Bill Gross watchers.

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Jenn Ablan and Matthew Goldstein’s article about the slow implosion of Pimco’s Total Return Fund is of interest to more than just Bill Gross watchers. Specifically, anybody in the large and growing universe of emerging-market debt has good reason to be very worried about this development.

The Total Return Fund has seen $17 billion of outflows over the past 12 months — a period during which the DoubleLine Total Return Bond Fund has trebled in value from $7 billion to $21 billion, and bond funds more generally have seen inflows of more than $100 billion.

Now $17 billion is entirely manageable for the Total Return Fund, which is still a monster $241 billion in size, and which I’m comfortable in saying has extremely good liquidity management. But this kind of performance is very hard to recover from:

The Total Return portfolio is up 3.48 percent so far this year, lagging his peer category which is up an average of 5.87 percent. Put another way, his fund ranks in the 90th percentile, or 163rd out of 181 funds in his category, said Jeff Tjornehoj, head of Lipper Americas Research.

Bill Gross, here, is in a very tough position — his underperformance over the past 12 months has cost his clients some $6 billion, give or take, even as they’ve been paying him hefty management fees. He’s also human, which means he’s going to be sorely tempted to make big bets in an attempt to get his clients their money back. But Gross’s clients don’t pay him to gamble. And big bets have a habit of going wrong:

Gross’s latest move is another bold one.

In September, he ramped up buying of mortgage-backed securities, albeit by using leverage…

Last week, PIMCO said mortgage-backed securities now account for about 43 percent of the holdings of the PIMCO Total Return Fund, as of the end of November.

By loading up on mortgage bonds, Gross is making a bet on higher-yielding securities. But in doing so, he is effectively extending the average duration of his fund’s investments, making them potentially more exposed to a rise in interest rates.

For now, the performance of housing debt is still trailing Treasuries. Since June 30, the total return of mortgage-backed securities is roughly 3.15 percent — more than 200 basis points less than U.S. government bonds.

Gross is a living legend, and you’d have to be a complete idiot to write him off. But it’s pretty clear which way the wind is blowing here. And the base case scenario has to be one in which Total Return — which was getting pretty unwieldy in any case — continues to shrink rather than grow.

And that, in turn, is going to have an important effect on the world of emerging-market debt.

As Pimco in general and the Total Return Fund in general have grown over the past 20 years or so, one of their defining characteristics has been a remarkably consistent long-term bullishness with respect to emerging-market debt. Gross’s co-CIO, Mohamed El-Erian, started at Pimco running the emerging-market portfolio, and made his name with a huge bet on Brazil ten years ago which paid off spectacularly well.

As Pimco has grown into a trillion-dollar behemoth, it has been responsible for a steady multi-billion-dollar flow of funds into the emerging-market debt asset class. That flow has helped to ratify emerging market debt as a smart place to invest, and has also helped to support prices.

Now, however, that mechanism risks being thrust into reverse, with Pimco shedding its EM assets as clients withdraw money from the Total Return Fund in particular and even from Pimco in general. It’s a unique and idiosyncratic risk, which other EM fund managers are highly aware of — and can’t really do anything about.

The world of emerging markets is much bigger than any one fund manager, of course. But today’s twitchy markets have sold off sharply for much less reason than this. Long-only funds tend not to pose much in the way of systemic risk. But when they get this big, risks do emerge. And this is one of them.


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