From the May 2004 issue of Investment Advisor • Subscribe!

The Bond King's New World

Bill Gross and PIMCO face two big challenges:stormy markets and tough regulators

In the world of bonds, there is PIMCO, and there is everyone else. Once a boutique fixed-income shop, opened 33 years ago in the placid Los Angeles suburb of Newport Beach by Bill Gross, an often acerbic Vietnam vet who financed his MBA with his Las Vegas blackjack winnings, PIMCO has grown in tandem with the incredible 23-year-long bull market in bonds. Purchased for $3.3 billion in 2000 by Germany's largest life insurer, Allianz, PIMCO--short for Pacific Investment Management Company--manages nearly $400 billion, including PIMCO Total Return, whose $75 billion in assets make it the largest bond mutual fund on earth. "PIMCO is," says Joachim Faber, CEO of Allianz Dresdner Asset Management, "the authority in bonds."

PIMCO's luxurious headquarters, offering expansive views of the Pacific Ocean and the occasional glimpse of Gross peering across the trading floor from his glass-enclosed office, reinforce this feeling of self-assurance. But while PIMCO's success has its rewards, it would be a mistake to conclude that the firm is resting on its laurels. Indeed, it is now trying to get its arms around a series of challenges that could shake the firm's very foundations.

The challenges are twofold. One comes from securities regulators. The second comes from the bond market itself. Either would be sufficient to give most bond traders more than a few sleepless nights.

The immediate regulatory challenge comes from state and federal

regulators. PIMCO acknowledges that the Securities & Exchange Commission is

considering taking action against two affiliated companies, PIMCO Advisors

Fund Management and PEA Capital (Allianz Dresdner's New York-based equity

fund management unit), as part of its broad investigation of market timing

practices in the mutual fund industry. In addition, New Jersey Attorney

General Peter C. Harvey in February filed state fraud charges against

Allianz Dresdner Asset Management of America LP, PEA Capital, Pacific

Investment Management (Gross' Newport Beach bond arm), and PIMCO Advisors

Distributors.

The New Jersey case stems from investigations into the market-timing efforts of hedge fund manager Edward Stern and his firm, Canary Capital Partners. Harvey's charges largely center on alleged actions by equity fund managers at PEA. These actions, Harvey says, permitted Canary to make hundreds of short-term trades in several PEA stock funds while also using PIMCO bond and money market funds to park their assets between the equity transactions. Harvey contends that these trades were not disclosed to other investors and came even as the funds' distributor was working to keep smaller market timers off its customer rolls.

Gross declined repeated requests for an interview. But he has posted his reaction to the charges in a letter written with PIMCO Chief Executive Officer William S. Thompson. In the letter, which is posted at www.pimco.com, they write that, "to the best of our knowledge, PIMCO has never had any arrangements pertaining to 'sticky funds,' late trading/stale pricing arbitrage, or improper dissemination of fund holdings." While conceding that Canary had invested in PIMCO funds, Gross and Thompson added that any efforts to attract its funds "did not violate the shareholder protection of our prospectuses...which had monitoring provisions to prevent excessive trading." In mid-April, Kenneth Corba, PEA's chief executive officer, resigned from the firm. While Harvey's complaint discusses alleged activities by Corba to attract Canary's assets, he has not been charged with wrongdoing. Corba did not respond to requests for comment.

Transcontinental Tension

The New Jersey case has brought to the surface longstanding tensions between the California fixed-income team and the far smaller New York-based equity group, which one senior Newport Beach official says had been kept "separate and distinct" from the equity side despite sharing the same PIMCO brand name. Ronald Rog?, a fee-only advisor in Bohemia, New York, and major investor in PIMCO funds, observes that "the problem is that when the Germans bought the company, they put the PIMCO name on their [existing] equity business." That decision, says the Newport Beach veteran, "was a huge mistake for us."

The Californians' frustration over their perceived lack of influence over the New Yorkers has already led Allianz to drop the original PIMCO Equity Advisors name for the East Coast group and replace it with the more neutral-sounding PEA. Allianz Dresdner officials are tight-lipped on specifics of any other changes. But Faber, who at Allianz Dresdner oversees some $900 billion worldwide, says that he is committed to "the highest fiduciary standards, as trustees for our clients. As CEO of this company I would exercise the utmost [effort] to bring people back into line."

Chances are good that Gross' team, at least, will be able to survive the tangle with regulators with minimal damage. Morningstar Inc. analyst Eric Jacobson, for example, has advised his firm's clients to sell PEA equity fund holdings while taking no action on fixed income and other funds managed by Gross' own PIMCO team. PIMCO executives themselves note that inflows into their funds have remained at high levels. "I don't think this is something that's systemic throughout the whole organization," says Rog?. "We feel confident," says a Gross associate, "that this situation will not be a bad one."

PIMCO probably will be able to cope with the rising level of bond-market stress as well. Gross, who received a $200 million retention bonus as part of the Allianz takeover, has posted only two down years in the last 10 at Total Return and has handily trumped his competition. Given his record of agility and PIMCO's extensive network of bond experts in North America, Asia, and Europe, it is likely that he will do much better than just muddle through if the Federal Reserve, as widely anticipated, starts to nudge up interest rates later this year or in 2005.

That expectation is certainly spreading around PIMCO. The big fear is that a recovering global economy and surging commodities prices are both signals that the lengthy bull market in bonds is finally running out of steam. This realization has driven Gross not only to shift strategy in PIMCO's bond mutual funds and other fixed-income accounts, but also to step up the pace of applying the firm's total return-oriented asset management discipline to funds that are designed for an environment of inflation rather than one in which prices are stable or on the decline.

This strategy, which actually began long before the current spate of bond-market jitters with PIMCO's move into funds investing in equity indexes (see table, page 68) and inflation-protected U.S. Treasury debt has now expanded to include commodities, real estate, and tactical asset allocation. One result: This onetime bonds-only house now offers mutual funds representing nearly the full breadth of the asset allocation spectrum. This is of special interest to advisors, who generate nearly all of PIMCO's mutual fund assets (see chart, page 63) and may be looking for easy solutions for their clients' asset allocation needs.

Staying ahead of the curve is a hallmark of PIMCO's management style, however. As a bond guru, for example, Gross has been garnering headlines since his prescient January, 1978, warning of rising interest rates. That warning, he has written, "helped to build our franchise in the 1970s bear bond market." Today, while Gross and his colleagues are not exactly out-and-out bears, they do think that investors who aren't preparing themselves for stormy weather are making a mistake. Gross, whose pithy monthly market newsletter can be found at pimco.com, has grown increasingly concerned over the bond outlook since 2002. In 2003 he moved 40% of Total Return's assets into short-term bonds. He argued recently that the U.S. economy is "laden with debt and [suffers from] the inability of policymakers to retreat in any meaningful way from reflationary policies, whether they be budget deficits, currency depreciation, or negative real short-term interest rates." The result: Higher inflation, especially past 2004.

One major PIMCO client who attended a recent two-day conference the firm staged at its headquarters for about 40 advisors recalls Gross telling the group he thinks inflation will remain in the 2% to 3% range for now, and that he doesn't expect the Federal Reserve to push interest rates higher before 2005. In his Web postings, meanwhile, Gross indicates that he has not made up his mind on whether the current economic upswing will end in "financial destruction or a potential deflationary economy." But PIMCO analysts maintain that one thing is for sure. "We are at the end of the secular bull market in bonds," says Managing Director Paul A. McCulley. He believes that "the only path for nominal interest rates is up--unequivocally up," and that the Federal Reserve will push the benchmark short-term Federal Funds rate as high as 3%, triple its current level. As a result, he says, "We are as defensive as we have been in a long, long time."

Lower Duration

In general terms, this means PIMCO is continuing to reduce its duration--the sensitivity of a portfolio to changes in interest rates--in the U.S. and Japan. Morningstar estimates that as of February 29, some 40% of Total Return was in cash. Gross himself not long ago unloaded some personal holdings in PIMCO Total Return in favor of closed-end municipal bond funds, commodities, and inflation-indexed U.S. Treasury debt. According to the client present at the Newport Beach conference, Gross talked up these alternatives as well as global bonds.

Gross is a particular fan of emerging market sovereign debt. While they may appear risky at first glance, emerging markets have brought PIMCO's investors a tidy reward. Over the past five years, PIMCO's Emerging Markets Bond fund has racked up an average annual total return of 22.3%, more than three times that of the Merrill Lynch global bond index. To the fund's manager, Mohamed A. El-Erian, the current global economic upturn, while worrisome to the U.S. fixed-income crowd, will only "act as a tailwind" for emerging market investors.

El-Erian, who manages $13 billion in mutual fund and institutional emerging market assets and finds himself on a plane to some far-flung locale at least once a month, believes that developing countries' fiscal policies are improving, debt is declining, and hard currency reserves are on the rise. One big reason is the influence of China, whose surging economy is serving as a "locomotive" that is benefiting countries that supply its growing needs for imported raw materials.

Not all emerging economies are on the rise, of course, so El-Erian looks at his world in terms of "risk buckets" to help guide his investment picks. His "anchor bucket" contains Mexico, Chile, Russia, and South Africa, whose economies feature relatively stable credit ratings and where the biggest risk remains rising interest rates. He augments his anchor investments with high-yielding "return engine" plays in promising countries such as Ecuador, Peru, and Brazil, whose debt, he believes, "is going to be investment grade within two years." President Luis Inacio (Lula) da Silva, he notes, has turned out to be "a fiscally principled populist" who has become "the toast of the market."

El-Erian also has an "intensive care bucket" of countries he shuns because their high yields aren't enough compensation for the attendant risks. In this pail go Argentina, Venezuela, Turkey, and the Philippines. But he cautions that countries can rapidly lose favor. Several years ago, for example, PIMCO bailed out of Argentina before the peso, once pegged to the U.S. dollar, collapsed. "Their fiscal situation was out of control," El-Erian recalls. "We didn't think we were smart enough to be the last one out of the door. So we were the first one out."

Mind the Index

If emerging market debt is PIMCO's more venturesome high-yield offering, its Real Return Bond and Commodity Real Return funds are its bulwarks against inflation in a resurgent economy. Both are run by John B. Brynjolfsson, who sees commodities as "a supercharged asset. If inflation goes from 2% to 4%, commodities might double." Rather than try to pick commodities, Brynjolfsson invests partly in instruments pegged to the broadly based Dow Jones-AIG commodity index, and partly in U.S. Treasury Inflation Indexed Securities, commonly known as TIPS. The strategy, which pushed Commodity Real Return up nearly 16% in the first three months of 2004 after a 13.7% advance in '03, is based on having part of the fund in government debt with "a substantial, locked-in real yield," says Brynjolfsson. His Real Return Bond fund is built around Brynjolfsson's notion that "the 20-year cycle of deflation we have been enjoying will be coming to an end." So popular has that notion become that PIMCO now manages some $20 billion in real return-oriented strategies.

For those who have a hard time choosing among PIMCO's various options, the firm has turned to Robert D. Arnott, a well-known tactical asset allocator and former chairman of First Quadrant L.P., to run All Asset, a fund that can trade in and out of any mutual fund that Gross' team offers. There is some irony in a firm that is currently tangling with authorities over market timing offering a fund that seeks to time various asset classes. But Arnott notes that rather than making the huge trades that got some investors and funds in trouble with the law, his activities tend toward smaller daily transactions aimed at "adjusting the mix" of assets in his fund.

The only outside manager that PIMCO employs, Arnott runs All Asset with a goal of delivering "a real return of the consumer price index plus five percentage points or better, and I'd like to beat that two years out of three." For the past several quarters, at least, this strategy has been going gangbusters. All Asset turned in a total return of nearly 20% in 2003 and nearly 6% for this year's first three months, and with a volatility that Arnott notes is half that of a typical balanced portfolio composed of 60% stocks and 40% bonds. The fund's correlation to such a model portfolio, Arnott contends, is zero. To be sure, Arnott admits that he has benefited from "a multiple-asset-class bull market" that is unlikely to persist. The attitude has prompted him to take some profits on TIPS, via the Real Return fund, and move 25% of the fund into PIMCO's commodity and emerging market offerings, about what he has in stocks. But PIMCO's enthusiasm for his eclectic style of investing prompted the firm to start up recently another version of All Asset. Dubbed All Asset All Authority, the new mutual fund has some characteristics of a hedge fund in that it is permitted to use leverage and sell the S&P 500 short.

You would be surprised to see such a fund emerge from many bond houses. But somehow, it's not surprising to see PIMCO take this challenge on. Gross and his colleagues have worked long, hard, and successfully to remain a step ahead of the market. In a handwritten note clipped to a self-published compilation of his market newsletters entitled PIMCO: 30 Years and Counting," Gross provides one simple bit of advice. "Buy bonds!" he counsels. "The right ones, that is." For more than three decades, Gross' nose for the right strategies has served PIMCO well. But as the market and regulatory environment both grow more and more complex, the team in Newport Beach will have to work harder to maintain their edge.

Editorial Director William Glasgall can be reached at bglasgall@ia-mag.com.

Reprints Discuss this story
This is where the comments go.