Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Pimco is gearing up for a junk bond binge -- or at least opening the door to that possibility. The Pimco Total Return Fund, Pimco’s flagship bond fund, will be permitted to invest up to 20 percent of the Fund in junk bonds beginning on June 13, up from 10 percent currently.

The Fund’s current allocation to junk bonds is only 2.5 percent, so the new 20 percent ceiling would be a monster eightfold increase in the Fund’s allocation to junk bonds if fully utilized.  

Why now? Mark Kiesel, Pimco’s chief investment officer for global credit and one of the Fund’s managers, told Bloomberg News that the junk bond market “is as attractive as it’s been in four or five years.”

My Gadfly colleague, Lisa Abramowicz, noted yesterday that the Total Return Fund has shrunk significantly over the last two years in the wake of Bill Gross's departure from Pimco and is hungry to show that it can generate better returns.

But is now really a compelling time to buy junk bonds?

Junk bonds, you could say, are risk assets masquerading as bonds, and the Total Return Fund is no stranger to risk taking.

During Gross’s towering reign as manager of the Fund, investors were more than compensated for his willingness to take risk. The Fund returned 7.9 percent annually to investors from June 1987 until Gross’s departure in September 2014, with a standard deviation of 4.3 percent (based on the total return for institutional share class), while the Barclays U.S. Aggregate Bond Index returned 6.8 percent annually over the same period, with a standard deviation of 3.9 percent. (Standard deviation is a common proxy for risk; a higher standard deviation implies higher risk.)

Gross Returns
Bill Gross was not afraid to take risk during his tenure at Pimco and his investors were more than adequately rewarded for his efforts.
SOURCES: Bloomberg, Morningstar

The Fund’s willingness to take risk survived Gross, but so far the returns have not. Since Gross’s departure, the Fund has returned 2.7 percent annually to investors from October 2014 to April 2016, with a standard deviation of 3.3 percent, while the Barclays Index returned 3.7 percent annually over the same period, with a standard deviation of 2.7 percent.

Post Gross
Pimco's appetite for risk survives Gross, but so far the returns have not.
SOURCES: Bloomberg, Morningstar

It would be silly to judge the post-Gross era based on only 19 months of performance, but fickle investors are doing just that and dumping the Fund in droves. The Fund managed $293 billion as recently as April 2013, and assets have since shrunk by more than two-thirds to $87 billion.

Clearly, a renaissance for the Total Return Fund has to start with better performance, and one way to juice returns is to pile on more risk. Loading up on junk bonds would have paid handsomely for much of the post-financial crisis period, as yield-thirsty investors provided a steady stream of investment to support ever-higher junk bond prices. The yield on the Bank of America Merrill Lynch US High Yield Master II Index peaked at 20.9 percent in March 2009 (a 4+ standard deviation event!), and by 2014 that yield had plummeted to just over 5 percent.

Granted, a 5 percent yield might do wonders for a bond fund in this low interest rate environment, but richly-priced junk bonds might also come back and bite investors.

When fears of a global downturn surfaced in the fall of 2015, spooked investors dumped junk bonds and the yield spiked to 8 percent. And when those same fears reached a fever pitch in February of this year, yields spiked again to 10 percent. Those selloffs would have done no favors for the Total Return Fund’s ailing fortunes.

And look at the historical data. The High Yield Index’s average yield has been 9.3 percent since 1996 (the longest period for which data is available), and its current yield has reliably danced around its long-term average yield over the last two decades.

Wider View
Junk bonds may seem enticing with interest rates on the floor, but yields are stingy in historical terms.
SOURCE: BofA Merrill Lynch

By that barometer, February would have been a fine time to pick up some additional junk bonds, as the then 10 percent yield implied that yields would likely go lower.

That’s exactly what happened. In just three short months, investors regained their risk appetites and yields shrunk. The High Yield Index now yields 7.7 percent -- well below its long-term average yield of 9.3 percent -- which implies better than even odds that yields will go higher.

So, using yields as a barometer, this doesn’t seem like a great time to go shopping for junk. Yes, a 7+ percent yield on junk bonds may provide a brief boost to Pimco’s starved-for-yield Total Return Fund -- but a spike in junk bond yields would further dent the Fund’s performance, and that's a gamble that Pimco can ill afford to take.

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

To contact the author of this story:
Nir Kaissar in New York at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net