The Bond King's New World

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 [email protected].