Investors in Big Bond Funds Should Know About These Three Things

Get to know cross-selling, matrix pricing and payment-in-kind

PIMCO's Bill Gross

Bill Gross crushes fire sales with his fingers

Photographer: Andrew Harrer/Bloomberg

Bloomberg's Miles Weiss reports on Thursday that Pimco's Total Return Fund (TRF) had a pretty nifty way of mitigating the impact of Bill Gross's departure late last year.

As a reminder, when Gross stepped down from the helm of what was once the biggest bond fund in the world, Wall Street expected the TRF would have to sell big swathes of its bond holdings as it sought to raise cash and meet a wave of investor redemptions from the fund. That didn't quite happen. According to a Bloomberg dive into SEC filings, it seems part of the reason that "fire sale" risk never materialized is because the TRF raised cash partly by selling its bonds to other Pimco funds. To be exact, it seems Pimco sold about $18 billion of the TRF's assets to other Pimco funds and accounts between October and March, helping it meet more than $100 billion of redemptions that followed Gross’s exit. 

The move seemed to help avert a fire sale in the bonds, which is a good thing because everyone has been worried about just such an event.

But it highlights some of the more esoteric things investors in bond funds should know, especially when faced with the prospect of a big sell-off in bonds.

1. Cross-selling is totally allowed

Of course, the idea of a bond fund raising money by selling bonds to its other funds, raises some eyebrows. On the plus side, so-called cross-selling can help funds cut their transaction costs, including the mark-ups charged by big dealer-banks, and can also give them a way to keep hard-to-find bonds within the firm. But cross-selling is also tightly regulated by the U.S. Securities and Exchange Commission given the potential for conflicts of interest. For instance, the SEC requires that any such transactions occur at market prices and that they be advantageous to both parties, "to avoid that one fund dumps unwanted assets on another, or sells them at inflated prices to artificially boost its own returns." But what does that mean exactly?

Dear reader, you are about to enter the matrix.

2. Funds use something called matrix pricing 

We don't know exactly what bonds Pimco cross-sold. It seems a bunch of them were inflation-linked U.S. Treasuries, which are relatively liquid things. But what if they weren't? The SEC allows cross-selling because of the requirement to sell at market prices. If bonds are sold at their true market value, so the thinking goes, then it's unlikely that investors are getting ripped off. However, there's one big problem with this. Sometimes it's difficult to know the prices of certain types of bonds -- especially if you're trying to gauge their value during a big market sell-off when things are happening very rapidly. So when it comes to pricing less liquid securities such as junk-rated corporate debt, big funds often turn to the services of third-party companies.

These companies employ something called matrix pricing to come up with a value for such debt. The process interpolating the prices of such bonds by looking at a whole bunch of other factors (hence the "matrix"). There are algorithms and formulae involved and these are based on assumptions about the way finance and markets work. The issue should be obvious; all those assumptions about how markets should work and how they should value bonds could be left in the dust in a big market-sell-off when things are moving rapidly and risk models are being upended.  If a big bond pricing service provider were to suddenly change its assumptions on bonds, that could also even help trigger a wave of securities selling.

Which brings us to redemptions.

3. There's this other thing called payment-in-kind

One other thing investors should be aware of include the ability of funds to redeem "in kind." In English, that means if things get really, really bad mutual funds have the right to return actual bonds to investors instead of cash.

Here's Michael Lipper, mutual fund analyst and  President of Lipper Advisory Services, talking about this last year during the height of the TRF redemptions: “[Payment-in-kind] is mathematically possible, and people should be alerted to the possibility ... But given the size of the fund, the size of Pimco and the size of its parent company, I think the odds are something like 1 in 150.” And here is a regulatory disclosure from Pimco's Total Return Fund that lays it out pretty clearly.

Faced with the possibility of getting thousands of dollars worth of actual securities during a very bad bond market sell-off, a little bit of cross-selling perhaps doesn't seem so bad. 

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