Gross Overhauls Dialynas’s Unconstrained Fund

Bill Gross overhauled the Pimco Unconstrained Bond Fund after replacing Chris Dialynas as manager, taking control of Pacific Investment Management Co.’s best-selling alternative to traditional fixed income.

The $25.6 billion fund jettisoned 30-year Treasuries and most of its agency mortgage bonds, increased a wager on corporate debt through credit-default swaps, and ended bets that the U.S. dollar would appreciate against the Chinese yuan, according to data on Pimco’s website. The effective duration, a measure of sensitivity to interest rate changes, more than doubled in December, when Gross assumed control of the unconstrained fund.

“We became more credit friendly in anticipation of an improving economy and a positive stock market,” Gross said in a telephone interview. Gross said he extended the fund’s duration in light of “an undervalued Treasury market which was too high yielding,” adding that “Mr. Dialynas might have done the same thing.”

Dialynas joined Pimco in 1980 and had managed the Unconstrained fund since its inception in June 2008. Pimco announced his plan to take a sabbatical in the beginning of December, a month before the abrupt resignation of Chief Executive Officer Mohamed El-Erian spurred leadership changes at the $1.9 trillion investment firm.

Gross Differences

The management switch raises questions over whether there would be wholesale changes at Pimco Unconstrained, said Eric Jacobson, a research analyst at Chicago-based Morningstar Inc. Gross is a “glass-half-full” kind of investor while Dialynas is more of a “sky-is-falling” type manager.

Gross is taking charge of Pimco Unconstrained as investors flock to flexible go-anywhere strategies while fleeing core fixed income in anticipation of rising interest rates. Pimco Unconstrained attracted $8.7 billion in 2013, according to Morningstar, with some of that money coming from Gross’s flagship Pimco Total Return, which had a record $41 billion of net redemptions last year.

Unconstrained funds can invest across a broad array of fixed-income securities, regardless of maturity, credit quality and geographic origin of the issuer. They can also shield themselves from the impact of rising interest rates by adjusting duration.

One potential advantage is that the funds seek absolute returns rather than to outperform the Barclays U.S. Aggregate Index, the benchmark for core bond funds such as Pimco Total Return.

Government Debt

In a March presentation for the State Universities Retirement System of Illinois, Pimco said the market for U.S. government debt had increased by $6 trillion since the financial crisis, forcing the Barclays Aggregate to load up on interest-rate-sensitive Treasuries.

According to Pimco, U.S. Treasuries comprised some 36 percent of the Barclays Aggregate in 2012, up from 25 percent in 2008. Pimco included a headline in the March 2013 presentation that asked “Do you want the U.S. government deciding your asset allocation?”

Pimco also said in the presentation that future gains from core bonds such as Pimco Total Return are “likely to be challenged” and suggested Illinois move some money to an unconstrained strategy. The university withdrew about $432 million from Pimco Total Return and moved it to Pimco Unconstrained, according to a June 30 report.

Lackluster Returns

The fund has attracted cash despite lackluster returns. Pimco Unconstrained fell 2.6 percent to trail 84 percent of peers in 2013, and has lagged behind 67 percent of rivals over the past five years, according to Morningstar. This year through March 3, the fund returned 1.2 percent, putting it ahead of 71 percent of other nontraditional funds, Morningstar data show.

Sabrina Callin, the product manager for Pimco’s unconstrained bond strategy, said Morningstar includes a variety of funds within its unconstrained category, some of which are highly correlated with high-yield bonds. That makes comparisons difficult, she added.

“It’s a very heterogeneous universe” in which the various funds aren’t necessarily seeking similar returns or risk objectives, Callin said. “One of the objectives we are seeking is to limit downside risk to preserve capital.”

‘Model Dominates’

Pimco in December published a “Strategy Spotlight” interview with Gross in which he said that there would be no changes in the “investment philosophy, process or approach” at the Unconstrained fund. Saying that the Federal Reserve’s plans to keep interest rates low were more important than the central bank’s decision to taper its bond purchases, Gross said that Pimco Unconstrained and other funds run by the firm would bet on the shorter-term debt, while pulling back from 5-, 10- and 30-year exposures.

“There may be Gross versus Dialynas differences at the margin, but they won’t be significant,” Gross said in the published interview. “There is only so much leeway the portfolio managers have here and the model dominates.”

Pimco Unconstrained’s effective duration had been declining during the second half of 2013, falling from 1.83 years as of June 30 to 1.74 years on Sept. 30 and 1.57 years on Nov. 30, according to Pimco data compiled by Morningstar’s Jacobson. During December, the fund’s duration jumped to 4.1 years, suggesting that the fund would benefit if interest rates declined and suffer should they rise.

Pimco Anticipation

Gross may have been increasing Pimco Unconstrained’s duration during December in anticipation of a decline in Treasury yields in January. The yield on 10-year Treasuries rose from 2.83 percent on Dec. 4 to 3.03 percent on Dec. 31, and declined to 2.64 percent by the end of January. Pimco Unconstrained returned 0.58 percent in January, the equivalent of a 7.1 percent annual return.

“You can see how it would be an opportunistic bet,” said Jacobson, who tracks the performance of funds managed by Newport Beach, California-based Pimco. “The fund has been humming along with relatively short number for quite a while,” Jacobson said in a telephone interview, referring to Pimco Unconstrained’s duration.

In a report posted on its website, Pimco said the fund added most of its duration during the fourth quarter through the use of money-market futures and options.

Bullish Bet

Under Dialynas, Pimco Unconstrained had purchased credit-default swaps on corporate bonds as well as indexes that track such debt, positioning the fund to profit should the spread, or difference in yield, between corporate debt and Treasuries widen. Gross had taken the opposite tack at Pimco Total Return, reducing the amount of protection it purchased on corporate bonds while issuing such insurance for other investors, essentially a bullish bet.

During the fourth quarter, Pimco Unconstrained divested almost all of the credit-default swaps it had purchased, including insurance on corporate bonds with a face value of $3.1 billion and another $4.4 billion of protection tied to high yield and investment-grade indexes. The fund increased the amount of credit default protection it issued on corporate and sovereign bonds.

The fund sold $5 billion of Treasury notes that matured in either 2014 or between 2018 and 2022, according to the data on Pimco’s website. The fund more than quadrupled holdings in Treasuries that mature from 2015 to 2017 to around $9.94 billion at Dec. 31.

Agency Debt

The fund also sold much of its debt issued by government-sponsored enterprises such as Fannie Mae and Freddie Mac, as well as all of its Treasury bonds, which matured between 2021 and 2042 and had coupons ranging between 2.75 percent and 8.125 percent. These Treasury bonds had a face value of $833.7 million as of Sept. 30 and a market value of about $1.02 billion.

“That reduction was in anticipation of the Fed continuing to taper,” Gross said in the telephone interview. As a result of the tapering, the central bank is “buying fewer 30-year Treasuries and fewer agency” mortgage-backed bonds.

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