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Pimco Said to Wager $10 Billion in Default Swaps: Credit Markets

Citibank Branch in New York
Citigroup Inc. raised $1.3 billion with fixed- and floating-rate three-year bonds. Photographer: Craig Warga/Bloomberg

Pacific Investment Management Co. is wagering at least $10 billion in the credit-default swaps market that U.S. corporate bonds will gain as the Federal Reserve extends unprecedented stimulus into 2014, according to traders and investors.

The manager of the world’s biggest bond fund amassed the positions by creating swaps tied to the Markit CDX North American Investment Grade Index, which contains 125 companies from Ford Motor Co. to Staples Inc., according to five people at hedge funds and banks who asked not to be identified because they aren’t authorized to discuss the trades. Investment firms and other non-dealers held a total of $39 billion in net wagers in the index as of last week, industry data show.

Pimco is using derivatives that are quicker, easier and cheaper to trade than the bonds they’re tied to after redemptions and losses shrunk its $248 billion Total Return Fund by 15 percent in six months, ending its five-year reign as the world’s biggest mutual fund. Swaps allow investors to wager on the health of U.S. companies even as dealer debt inventories shrink and a potential Fed bond-buying pullback prompts investors to withdraw cash from bonds paying record-low yields.

‘Perfect Way’

“That’s a perfect way to play it,” Jeffrey Sherman, a money manager who helps oversee $53 billion at DoubleLine Capital LP in Los Angeles, said in a telephone interview. “There’s much more liquidity in the synthetic market. It’s also a levered play, so you don’t have to put up as much capital to do the trade.”

In the credit-default swaps trades, Pimco receives annual premiums in return for agreeing to pay the buyer of protection an amount covering losses should one of the companies in the index fail to meet its debt obligations.

“It’s just an investment in corporate bonds,” Bill Gross, who runs the Total Return Fund as Pimco’s co-chief investment officer, said today in an interview on Bloomberg Radio.

The position accounts for about half a percentage point of Pimco’s $2 trillion of assets, he said. “It’s very liquid, and it’s more liquid than the corporate-bond market, which was the point of entering the CDX complex in the first place,” he said.

Growing Share

Non-dealers had a net outstanding bet on the health of U.S. investment-grade corporate credit of $39 billion through Nov. 1, the most this year and up from $31.4 billion four weeks earlier, according to data from the Depository Trust & Clearing Corp.

While the swaps trades give Pimco a growing share of all outstanding wagers in the Markit CDX index, it hasn’t amassed positions rivaling those taken in an older version of the benchmark two years ago by JPMorgan Chase & Co. that saddled the biggest U.S. bank with a $6.2 billion loss.

Those bets by trader Bruno Iksil, who became known as the London Whale, accounted for 50 percent of all outstanding trades in the less-active index series, making it easier for counterparts and rivals to push prices against the bank when losses started to mount and it sought to exit.

Pimco’s bet, which three of the people said may be as much as $30 billion, is in the current index, which has a gross $311.3 billion notional outstanding, DTCC data show, giving Pimco room for a relatively smoother departure.

Rental Bonds

“It’s a way for them to collect premium quickly and efficiently,” said David Schawel, a money manager at Square 1 Bank in Durham, North Carolina, which specializes in financial services to entrepreneurs and venture capitalists. “They’re so big they need to make bets synthetically, and longer-than-expected easy Fed policy is where spreads would grind tighter and they’d collect that premium.”

Elsewhere in credit markets, American Homes 4 Rent plans to sell bonds backed by U.S. rental homes after Blackstone Group LP’s Invitation Homes completed the first deal of the type this week. A gauge of the health of U.S. financial conditions climbed to a record high.

The Bloomberg U.S. Financial Conditions Index, which combines everything from money-market rates to yields on government and corporate bonds to volatility in equities, increased 0.13 to 1.75, the highest level in data stretching back to January 1994.

Credit Benchmarks

The cost of protecting corporate debt from default in the U.S. fell. The Markit CDX index, which investors use to hedge against losses or to speculate on creditworthiness, declined 0.7 basis point to a mid-price of 73.2 basis points as of 10:56 a.m. in New York, according to prices compiled by Bloomberg.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings rose 1.1 to 83.4.

The indexes typically fall as investor confidence improves and rise as it deteriorates. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Bonds of New York-based Citigroup Inc. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 3.7 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

American Homes 4 Rent intends to market the rental-home securities within the next 90 days, it said in a statement today. The deal would follow Blackstone’s offering, in which monthly rent checks from 3,207 properties will be used to service the $479.1 million of debt.

Pimco Trades

Pimco has amassed similar trades in the credit-swaps index in recent years. The money manager sold $10.7 billion of credit protection on the Markit CDX in the second quarter of 2011, increasing its total positions in the index contracts to $11.8 billion, according to an August 2011 regulatory filing.

The face value of swaps the fund sold on indexes for high-yield, emerging-market and investment-grade debt rose to $21.6 billion at mid-2011 from $5.6 billion in June 2010.

Pimco had bought $11.9 billion of protection through U.S. high-grade and high-yield swap indexes and 2.9 billion euros ($3.9 billion) in indexes in Europe at the end of last year, fund disclosures show.

Iksil’s Bet

Pimco had also sold $2.5 billion of protection on emerging market credit-swaps indexes as of Sept. 30, and $578.8 million on the ninth series of the investment-grade swap index created in 2007, the same one in which JPMorgan’s Iksil had built a position so large that it distorted price relationships in the market.

Iksil sold contracts guaranteeing more than $80 billion of debt tied to that index, or about 50 percent of the total outstanding contracts in the series, making it difficult to find buyers, according to a 301-page report by the Senate Permanent Subcommittee on Investigations released in March.

Investors started pulling cash from U.S. bond funds in May after Fed Chairman Ben S. Bernanke said that sustainable labor-market progress could prompt the central bank to reduce $85 billion of monthly bond purchases that have bolstered credit markets, prompting concerns that a three-decade rally in bonds was poised to end.

The stimulus measures helped push the average yield on investment-grade corporate bonds in the U.S. to a record-low 2.65 percent in May, according to the Bank of America Merrill Lynch U.S. Corporate Index. They’ve since climbed to 3.27 percent.

Net Redemptions

U.S. bond mutual funds saw net redemptions of $117 billion in the four months through September, while stock funds received $35 billion, according to the Investment Company Institute in Washington.

Pimco’s Total Return Fund is on track for its worst redemptions ever in 2013, losing $4.4 billion in October and $33.2 billion for the year, according to Morningstar Inc. It has shrunk by $45 billion since May.

At the same time, corporate-bond trading has thinned and dealer inventories have plunged as market makers pull back on risk-taking. After cutting a broad measure of corporate and some asset-backed debt from a peak of $235 billion in October 2007, the 21 primary dealers that trade with the central bank pared investment-grade holdings to a net $11.7 billion as of Oct. 23, Fed data show. That’s down from $13.5 billion at the end of May.

Jobs Revival

An average of $12.4 billion of dollar-denominated investment-grade bonds of all coupons, ratings and maturities traded every day over the past year, according to Finra’s Trace system. That compares with $15.7 billion of default protection that was bought and sold on the Markit CDX swaps index last week, DTCC data show.

Concern that job-market conditions weren’t improving stayed the Fed’s hand in September, pushing out changes to the policy to March, according to a Bloomberg survey of economists conducted Oct. 17-18.

The benchmark swaps index rallied, reaching as low as 70 basis points on Oct. 22, adjusted for shifts to new series, Bloomberg prices show. That means a contract covering $1 billion of corporate debt sold the day before the Fed’s Sept. 18 announcement would have rallied 13 basis points through that day, translating to a profit of $1.3 million.

Pimco Total Return lost 1.02 percent this year through Nov. 6 with dividends, Bloomberg data show. The fund is beating 51 percent of its peers.

Treasuries Recommendation

Gross has recommended investors purchase shorter-term Treasuries as the Fed weighs tapering quantitative easing and the market underestimates how long it will then take the central bank to begin raising interest rates.

“As the Fed tapers, as they perhaps leave quantitative easing, the liquidity will shrink,” Gross said in the Bloomberg Radio interview today. “So we want to be in the most liquid paper possible; and those, believe it or not, are those CDX derivatives.”

The swaps index has a five-year maturity, compared with an effective maturity of 5.15 years in the Total Return Fund as of Sept. 30, according to Pimco’s website. More than a third of the fund’s holdings mature between 5 and 20 years.

U.S. credit accounted for 9 percent of the Total Return Fund holdings as of Sept. 30, data on Pimco’s website show. The fund had $1.8 billion of call options tied to the prior series of the swaps index.

“It’s not unusual for the fund to use swaps like this,” Eric Jacobson, a senior fund analyst at Morningstar, said in a telephone interview. “They use it in both directions, on the way up to get exposure when you’ve got so much cash to put to work you can’t put it to work right away, and at same time as a defensive posture when you’re concerned you could have more redemptions, to be able to act quickly.”

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