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PIMCO’s Latest Woes: The Good, the Bad & the Ugly

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On Monday, bond shop PIMCO said the Securities and Exchage Commission had sent it a Wells notice. It was looking into potential mispricing of non-agency mortgage-backed securities bought by PIMCO’s Total Return Active ETF (BOND) in early 2012, after the fund first started trading.

The SEC did not say it was looking into PIMCO’s related flagship Total Return Fund (PTTRX). However, regulators also are looking at the fund’s performance disclosures, as well as PIMCO’s related compliance policies and procedures.

According to Michael Herbst, director of manager research for fixed income strategies in North America for Morningstar, a Wells notice indicates that the SEC “is considering charges against a firm based on a specific set of events.”

“Our understanding is that the SEC is looking at how PIMCO may have assigned prices to ‘odd lots’ of those securities,” Herbst explained in an online report early Thursday.

Odd lots are smaller lots of bonds than those typically traded by large institutions, which often trade bonds in increments of $1 million, he notes. “In our opinion, it’s likely PIMCO was able to purchase odd lots at prices below what third-party pricing services would assign to round lots of identical or very similar securities.”

PIMCO, which declined to comment on Morningstar’s latest analysis, saw its co-founder Bill Gross, who ran the Total Return Active ETF, depart in late September; its assets under management dropped 15% from $1.9 trillion in September 2014 to $1.6 trillion as of March 2015.

The SEC seems to be reviewing whether or not PIMCO improperly priced odd lots of non-agency MBS so that BOND could have had an unfair performance advantage. “If the SEC finds fault with how PIMCO priced those securities, it could also take issue with how PIMCO reported the performance of BOND or with the policies and procedures PIMCO used to price less liquid securities,” Herbst explained.

Moreover, the SEC is likely looking into any possible harm to BOND shareholders. “Theoretically, early shareholders in BOND may have benefited from those securities’ price appreciation,” the Morningstar researcher said. “But if those securities’ prices were artificially inflated, then subsequent buyers of BOND may have been negatively impacted if BOND’s share price was affected by an artificially high net asset value.”

BOND, which was not structured as a share class of the Total Return Fund, beat its sister fund by 1.60% in March 2012, 0.53% in April 2012, 0.91% in May 2012, and 0.28% in June 2012, according to the Chicago-based research group.

“Between BOND’s Feb. 29, 2012, inception through June 30, 2012, its 6.26% gain far exceeded PIMCO Total Return’s 2.84%, driven in part by the strong performance of its non-agency mortgage-backed stake,” noted Herbst.

However, from March 2012 to July 2015, the annualized percentage difference has been 2.09%.

Morningstar is not changing its views of the bond shop in light of the Wells notice: “PIMCO’s Stewardship Grade remains a C, and its Parent Pillar score remains Neutral. We may revisit that stance as more information comes to light,” explained Herbst. (Morningstar Analyst Ratings of funds are based on five pillars: Process, performance, people, parent and price.)

“Some Wells notices lead to disciplinary actions, others do not,” he stated.

If the SEC does find PIMCO at fault, it is likely to bring administrative proceedings, a process that could entail a settlement in which the bond family might agree to pay restitution to BOND shareholders and/or fines.

Broader Issues

While Herbst says that it’s – of course – hard to say what the SEC will do next, the broader fixed-income pricing issues at hand “are neither unique to PIMCO nor intrinsic to ETFs.” Smaller funds that operate in less liquid parts of the fixed-income markets – especially those that are growing quickly – “may have grappled with similar issues and likely benefited from purchasing less liquid securities at bargain prices.”

This is because bonds do not trade on an exchange; they trade over the counter. In this marketplace, buyers like PIMCO can turn to many sellers and get different prices for the same security. In addition, Herbst says, traditional fixed income players, such as large banks, have been whittling down inventories since the financial crisis of 2008.

In such an environment, a smaller fund can benefit more from a smaller position in a discounted security than a bigger funds.

“If a third-party pricing service doesn’t make distinctions between how it prices odd lots and round lots of those same securities, there could very well have been material differences between the prices BOND paid for various odd lots and the prices that third-party pricing services would assign to those same securities,” he explained. “We don’t know for sure that’s what happened, but trading and pricing in the fixed income markets are such that it could have.”

Villain or Hero?

There is another way to look at the issues involved with PIMCO’s Wells notice, according to Morningstar columnist John Rekenthaler, which has to do with the SEC’s recent proposal to ensure consistent pricing and its quarterly electronic-filing requirement.

“If two funds hold the same security on the same day at different values, it’s possible that one fund is overstating its net asset value — and thus its fund performance. Thus, the SEC hopes to see one price for every discrete CUSIP,” Rekenthaler stated in a column on Friday.

This is indeed ironic, he says, “because it appears that PIMCO’s infraction, from the SEC’s perspective, may be that it used a single price for one CUSIP without adjusting for the odd lot.”

Could the goal of having a single price for one CUSIP be changed in the case of odd lots? That “quickly gets tricky,” Rekenthaler explains. “Which securities would have volume adjustments and which would not? At what level would the trigger go off? Would it be a two-step function, or would there be multiple pricing levels? How large would the discount(s) be?”

Though the facts seem too slim to reach any firm conclusion, the issues are “murkier than if PIMCO were served for carrying incorrect stock prices,” the analyst says. “It’s the bond market. It’s complicated.”

—Check out PIMCO Releases Asset Allocation Strategies for ‘New Neutral’ on ThinkAdvisor.