Pimco’s Mexico Derivatives Wagers Grew Before Gross Exit

Pacific Investment Management Co. Chief Investment Officer Daniel Ivascyn has made no secret about his bullishness toward Mexico, a view that predecessor Bill Gross also backed. Less widely discussed is the firm’s flagship Total Return Fund’s $4.4 billion of Mexican credit derivatives.

The fund, which Gross ran before he abruptly left Pimco less than two weeks ago, issued contracts for $1.42 billion of credit-default swaps on Mexico in the second quarter, boosting its exposure by 48 percent. Pimco has now sold more swaps on Mexico than any other nation except China. While the contracts provide Pimco with regular cash flows as long as Mexico pays its debt, the fund would be on the hook if Latin America’s second-biggest economy ever defaulted on its bonds.

Ivascyn pointed out last week the potential of Mexico, which has changed its oil-drilling laws over the past year to spur investment-driven growth. By using derivatives, bullish investors such as Pimco can get Mexico-linked returns without the added risk of bond losses tied to any jump in yields on U.S. Treasuries, according to SW Asset Management LLC.

The swaps give sellers “a way to strip out the Treasury risk and gain a larger size of Mexican exposure,” Ray Zucaro, a money manager at Newport Beach, California-based SW Asset, which oversees $440 million, said by telephone from London.

Mark Porterfield, a spokesman for Newport Beach, California-based Pimco, didn’t return e-mails seeking comment on the fund’s derivatives holdings.

Record Withdrawals

While the Total Return Fund lost a record $23.5 billion from withdrawals after Gross announced his departure from the firm he co-founded 43 years ago, it’s still the world’s largest bond fund with $202 billion in assets. Funds that large can typically gain exposure to a country more quickly by selling credit-default swaps than by buying bonds, Zucaro said.

The Total Return fund held $9.4 billion of peso-denominated bonds as of June 30, as well as Mexican treasury notes, interest-rate swaps and forward peso contracts. Mexico has about $430 billion of benchmark domestic and overseas bonds in all currencies.

Gross has mentioned Mexico as an investment opportunity as far back as 2001, when he recommended buying the nation’s 10-year bonds. About a month after lawmakers approved constitutional changes to end the state’s 76-year oil monopoly in December, Gross said Mexico was “still the best of the emerging markets.”

Janus Capital

Even following his departure from Pimco, Gross remains bullish. He told Barron’s in an interview published Oct. 4 that he saw “significant” opportunity in Mexico, and that he planned to incorporate the idea in his new job as a money manager at Janus Capital Group Inc.

Pimco’s use of credit-default swaps comes as more investors look to derivatives as an alternative to corporate bonds. Trading in contracts tied to investment-grade companies almost doubled to about $900 billion in the second quarter, while trading in their debt securities decreased, according to data compiled by Barclays Plc and the Financial Industry Regulatory Authority.

Mexico’s peso climbed 0.5 percent to 13.4193 per U.S. dollar at 2:10 p.m. in New York.

Pimco risks losses if Mexico’s creditworthiness declines, according to Edwin Gutierrez, who manages $13.5 billion in emerging-market debt at Aberdeen Asset Management.

‘Good Luck’

Since June, the cost to protect against a Mexican default has climbed to 0.9 percentage point from 0.68 percentage point, indicating a drop in perceived credit quality, according to data compiled by Bloomberg. It could get expensive to exit the derivatives if the market soured quickly, Gutierrez said.

“If they can’t get out of their position, that huge CDS position they built up, good luck in unwinding it,” Gutierrez said by telephone from London.

Trading in Mexico’s sovereign bonds has fallen by almost half in the second quarter, while the use of credit derivatives rose about 10 percent, according to David Spegel, BNP’s head of emerging markets strategy, wrote in a September report.

Default-swap trading for Mexico represented about three times notional bond volume in the period, almost double the previous quarter, Spegel wrote. The jump was the biggest among developing nations.

Trading in Mexican bonds has declined partly because much of it is held by pension funds and insurers, which typically buy and hold, said Jim Craige, a money manager at Stone Harbor Investment Partners LP, which oversees about $65 billion.

Mexico “is owned by longer-term dedicated accounts who do not trade it often,” Craige said in an e-mail. “There is just not a lot of bond flow.”

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