PIMCO’s $20M Fine Highlights Bond Pricing Fiction

PIMCO’s $20M Fine Highlights Bond Pricing Fiction

Exploiting market inefficiencies led SEC to fine the ETF issuer.

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Reviewed by: Dave Nadig
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Edited by: Dave Nadig

The headline last night seems like a big deal: PIMCO is paying a $20 million fine to the SEC because it engaged in some less-than-obvious bond pricing strategies, which had the effect of boosting the headline performance of their flagship PIMCO Total Return Active ETF (BOND), particularly in 2012.

But as usual, when it comes to both ETFs and bond pricing, it’s far less simple than it seems.

No Big Deal?

When news originally broke earlier this year that PIMCO was being looked at for these pricing discrepancies, I brushed it off. The allegation was pretty simple: PIMCO, the best bond trading desk in the world for the past 20 years or so, was buying odd lots (less than $1 million) of nonagency mortgage-backed securities, and then using full-lot prices to calculate net asset value.

On the surface, this should make any bond guy shrug. Bond pricing is notoriously awful. Unless a bond trades RIGHT before you decide to strike your net asset value, every bond in any mutual fund or ETF is at best being valued on a guess.

These guesses have gotten more educated over time, and there are a handful of companies that have healthy businesses doing not much else except providing good guesses as to how much a bond is worth every day, just for this reason.

This particular case highlights another quirk of the bond market—nobody wants stub ends of bonds. You want to move $10 million of a Citibank bond? You’ll find a good bid. You want to move $250,000? Fuhgeddaboudit.

So the fact that a new, small PIMCO ETF was buying up odd lots and using round-lot pricing seems like not the biggest deal. It overstated performance a little bit, because PIMCO was taking cash for creations, and using that cash to buy bonds that were then magically “worth more” than they paid, but as an actual investor, it really doesn’t matter.

If PIMCO’s NAV was, for instance, consistently 1% higher than it should have been, for a year, any investor who bought and sold in that year was just fine–they paid 1% too much, but they got 1% too much when they sold.

In fact, the only place investors got hurt was over the past year, when we can assume PIMCO has revised its practices, and thus lowered the value of odd lots on its books, creating an equally artificial loss to offset the initial artificial gain.

 

Except For The Smoking Gun

The actual order from the SEC, however, points to a smoking gun none of us saw when the story broke: This was actually a deliberate plan to boost initial performance, not a matter of policy or industry practice. Just before BOND launched, PIMCO’s own desk sent around a note to the BOND portfolio managers about how to use odd lots to goose returns:

“We can find you several odd lot positions in the coming days that trade well below round lot levels and therefore pricing marks which will help with performance out of the gate.”

And that’s just what it did. The final cease-and-desist from the SEC notes a handwritten note from BOND’s portfolio manager to its trading desk in March 2012 ordering them to:

“Today – ASAP – within the next 2 hours – find 1-2 million bonds in your area that are 2 points or more cheap to how they would be marked by pricing services at close tonight.”

Which, in fact it did, and which, in fact, it was rewarded for with special $1,000 bonuses.

Silver Linings?

I’m ultimately an optimist, so I try and find the good in pretty much any bad story. Clearly, there was some dirty pool being played here. But consider that the reason PIMCO could even do this is because it’s very, very good at what it does.

It is in fact the reason investors give PIMCO lots of money. With the demise of the dealer market, large asset managers like PIMCO are in fact, the bond market, cognizant of all the weird ins and outs of the marketplace. As an investor, you actually want PIMCO to be out there looking for inefficiencies.

In this case, its knowledge of an inefficiency was used for fairly sketchy performance juicing purposes, taking cash and turning it into cash-plus with the stroke of a pen, and of course that crosses a line.

But it also highlights just how utterly broken the bond market is, and how crazy the bond pricing system is. The good news here is, perhaps, that the SEC was paying attention, that the boards of bond funds have been put on notice, and will clean up their acts industrywide, and that maybe, just maybe, a few more people will understand that end-of-day bond pricing is nothing more than a convenient fiction.

At the time of the writing, the author did not hold the security mentioned. You can reach Dave Nadig at [email protected].

 

Prior to becoming chief investment officer and director of research at ETF Trends, Dave Nadig was managing director of etf.com. Previously, he was director of ETFs at FactSet Research Systems. Before that, as managing director at BGI, Nadig helped design some of the first ETFs. As co-founder of Cerulli Associates, he conducted some of the earliest research on fee-only financial advisors and the rise of indexing.