Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

Pimco just won more freedom to play the role of distressed investor.

Its $87 billion Total Return Fund, which has shrunk drastically since losing its title as the world's biggest bond fund in the past few years, just doubled the limit of assets it will be allowed to invest in junk debt, to 20 percent. The change will go into effect next month, according to a filing reported by Bloomberg News reporter John Gittelsohn

On the one hand, this can be viewed as a vote of support for risky U.S. credit, which the investment firm has been trumpeting for months. But here's an alternative: Perhaps Pimco is preparing for a broader deterioration in the credit cycle that leads to profound stress. It wants to be able to pounce on opportunities in mass without bumping up against its previous ceiling.

It also has something to prove. The Total Return Fund reported an additional $1 billion of withdrawals last month, even as the Pimco Income Fund experienced $1.5 billion of inflows. Its performance has lagged behind its peers after the firm pushed out larger-than-life fund manager Bill Gross. 

Lagging Returns
Pimco's Total Return Fund has lagged behind broader bond-market benchmarks this year
Source: Barclays index data, Bloomberg

This most likely isn't a short-term move, especially because the Total Return Fund seems satisfied at this point with its 10 percent cap on junk-rated investments. High-yield credit accounted for just 2.5 percent of the fund's assets as of April 30, although that doesn't include mortgage-related, emerging-market and sovereign debt.

But Pimco has already demonstrated an appetite to delve into unloved assets, making bolder bets at challenging times for specific companies and industries. Consider energy, for example. Mark Kiesel, Pimco's chief investment officer for global credit, said on Bloomberg Television on Monday that the firm bought beaten-up bonds of oil and gas companies earlier this year and that it is willing to hang onto distressed assets even through bankruptcy proceedings. 

While Pimco has become "more selective" recently and is reducing exposure to these companies, it seemingly wants to prepare for the next bout of turmoil.

“Now is a good time to increase credit,” Kiesel said on Monday. “We think it’s an income world in a 1 percent to 3 percent real growth environment."

"When short-term traders like hedge funds need to get out of positions, long-term investors like Pimco can step in and capitalize on that," Kiesel said. "When these markets dislocate that's actually a huge advantage for Pimco."

 On the surface it seems like a generally risky time to go all in with some highly leveraged companies. Defaults are picking up, the U.S. faces a questionable economic outlook and borrowing costs have risen substantially for troubled countries.

But Pimco isn't in the mood to play it safe, and that pool is pretty shallow anyway. Yields have plunged around the world to record lows, even as some signs emerge that inflation rates are creeping up in the world's biggest economy. Central bank policies globally are pushing investors into a finite pool of "safe" assets, such as Treasuries, Japanese and German government bonds.

U.S. junk bonds, however, are still paying decent premiums over government rates relative to investment-grade debt.

Wiggle Room
Junk bonds are still paying decent premiums over benchmarks relative to high-grade debt
Source: Bank of America Merrill Lynch's U.S. corporate bond indexes

With the Total Return Fund having lost more than half its assets since 2014, its investors will probably be just fine with the extra emphasis on high-yield debt if returns truly increase. If not, even more could head for the exits.

It's a gamble for Pimco, but it's running out of options if it truly wants to make a splash. High yield is now the deepest end of the pool.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net