Bill Gross speaking at Morningstar conference in June. (Photo: Jim Tweedie)

Bill Gross is relying on derivatives rather than Janet Yellen to raise his returns on government bonds.

The co-founder of Pacific Investment Management Co. sold most of the $48 billion of U.S. Treasuries held by his $221.6 billion PIMCO Total Return Fund in the second quarter, replacing them with about $45 billion of futures, according to an August filing. The contracts require small up-front payments, freeing up money for Gross to invest in higher-yielding securities including Brazilian, Spanish and Italian debt.

“They are taking the cash and buying all these peripheral bonds that have a lot of spread on them relative to Treasuries,” said Erik Schiller, a Newark, New Jersey-based senior money manager at Prudential Fixed Income, referring to bonds issued by European countries other than France and Germany. “It is levering their fund.”

PIMCO in May said that interest rates in the U.S. will remain lower than they had been before the financial crisis, as the economy enters a “new neutral” characterized by global growth converging toward lower, more stable speeds. The Newport Beach, California-based firm is recommending that clients consider strategies implemented with futures, options and swaps to lift subpar returns.

Agnes Crane, a spokeswoman for Newport Beach, California-based PIMCO, had no immediate comment on the fund changes.

PIMCO Total Return trailed 57% of peers this year through Sept. 15, with a return of 3.3%, according to data compiled by Bloomberg. Gross’s main vehicle ranked as the world’s largest mutual fund, with $293 billion in assets, before clients started defecting in May 2013 after the U.S. Federal Reserve signaled it would phase out its bond-buying program, sparking 16 straight months of net redemptions through August.

Performance Promise

Gross, the 70-year-old billionaire who co-founded PIMCO in 1971 and became its sole chief investment officer after the resignation of Mohamed El-Erian in January, has been taking steps to improve returns. In May, he said in a Bloomberg Television interview that PIMCO would again rank among the leading firms by the end of 2014.

PIMCO disclosed in a Sept. 12 regulatory filing that it was changing the investment restrictions for 38 mutual funds, including Total Return, in a way that enhances their ability to carry out the derivative strategy employed by Gross on a broader scale.

Asked about the fund’s Treasuries strategy during a Bloomberg Television interview last week, Gross said the firm has been using futures in lieu of cash bonds for decades, in part because they’re easier to trade in large quantities without moving markets.

Higher Yields

He said the proceeds from the sale of the government bonds can be reinvested in short-term corporate debt that yields 30 to 40 basis points more than lending out cash Treasury bonds through “repos,” or repurchase agreements. A basis point is one-hundredth of a percentage point.

“What it basically means is that PIMCO can turn a Treasury yield into a corporate yield with a Treasury quality and Treasury liquidity,” Gross said in the TV interview. “We like financial futures and it’s been one of the reasons why PIMCO has done so well for 20 or 30 years.”

PIMCO Total Return disclosed selling most of its nominal government bonds in an Aug. 29 filing with the U.S. Securities and Exchange Commission, while reporting that its holdings of Treasury Inflation Protected Securities rose to $31.4 billion on June 30 from $29.5 billion on March 31. The face value of futures on 5-, 10- and 30-year Treasuries more than tripled to $63 billion.

Treasury Allocation

PIMCO Total Return’s allocation to Treasuries, including futures, options and swaps as well as nominal and inflation- linked debt, climbed to 49% from 43% in the second quarter. By adding futures, Total Return maintained much of the duration that would otherwise be lost through the sale of the Treasury notes, said Claude Erb, a former money manager at Los Angeles-based TCW Group Inc.

The portion of PIMCO Total Return’s duration, a measure of how sensitive a fund’s assets are to changes in interest rates, provided by government futures increased to 35% as of June 30 from 8% at the end of March. Its effective duration rose to 5.7 years from 5 years, indicating Gross is taking on more interest-rate risk as the firm sees low rates persisting longer under Fed Chair Yellen than many of its peers do.

Because of SEC restrictions on their use of leverage, mutual funds must set aside cash or highly-liquid securities to cover the potential liability they incur when entering into a derivative contract.

Emerging Markets

Dozens of the firm’s stock and bond funds have limits on the amount of emerging-market securities they can hold, ranging from 15% of assets at PIMCO Total Return to 50% at the PIMCO Unconstrained Bond Fund. As of Oct. 14, the caps will no longer apply to “investment grade sovereign debt denominated in the local currency with less than 1 year remaining to maturity,” according to the Sept. 12 filing.

Total Return increased its stake in European sovereign debt by more than 50% in the second quarter, adding $4.9 billion of Spanish bonds, $6.1 billion from Italy and $121 million from Greece. The fund added $5.7 billion of Brazilian sovereigns, raising its holdings to $7 billion.

Gross invested $23.7 billion in an internal cash-management fund and added $8.5 billion in short-term instruments, including $606 million of treasury bills issued by Greece, $6.5 billion of T-bills from Mexico and almost $3 billion of certificates of deposit. The increases were offset in part by a $2 billion reduction in repurchase agreements.

Wider Discount

Treasury futures usually trade at a small discount to the value of cash bonds to compensate for the lack of interest payments on the derivative contracts. The discount can widen at times, providing what PIMCO quarterly reports call “the opportunity to outperform government securities due to cheapness of futures contracts.”

Such a scenario arose in the second quarter, said Terry Pigott, a principal at Gladstone, New Jersey-based Glacier Peak Capital Management LLC who previously headed U.S. government trading at Daiwa Securities America. As conflicts in Ukraine and the Middle East intensified, investors flocked to the cash market for Treasuries, making them relatively expensive, Pigott said.

“Cash outperformed the futures,” Pigott said in a telephone interview. PIMCO is “just looking on a relative value basis, what is the cheapest thing to buy.”

–With assistance from Mary Childs in New York.

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