What The SEC Will Find At PIMCO’s BOND

The SEC is peeling back the covers on common practice.

The SEC is peeling back the covers on common practice.

The Wall St. Journal headline this morning certainly wakes you up: PIMCO ETF Draws Probe by SEC.

So what’s really going on here, and has PIMCO done anything wrong? And should anyone be surprised?

When the PIMCO Total Return ETF (BOND | B) launched in 2012, I fully expected it to outperform. On the day of its launch, I told the Journal the following:

“The advantage of managing the smaller ETF is that it offers Mr. Gross and his team much more flexibility in investment decisions, says Dave Nadig, director of research at [ETF.com]. Because the ETF can buy and sell bonds quickly, it is able to move more nimbly with market fluctuations. It also is able to buy into single bonds, which it isn’t able to do in the Total Return Fund.”

Here at ETF.com, we’ve been calling the ETF the “PIMCO Best Ideas Fund” for years. And having a good idea in the bond market is generally about two things:

1. Getting the macro call right.
2. Finding value.

When it comes to getting the macro call right, there’s not much advantage to actively managing an ETF or a mutual fund or a separate account. It just means being prescient (or lucky) about what’s going to happen with credit spreads and the yield curve. If you pull all of your duration way in right before the 10-year Treasury yield collapses, well, you’re a hero. If you bet hard on corporate debt right before a rash of unpredictable defaults? You’re a goat.

How To Find Value

The “finding value” part of the equation is where the SEC is getting interested. PIMCO is the largest fund manager in the world. It’s the largest bond trader in the world. That gives it enormous buying power.

Because of this enormous power, Pimco has the opportunity to do things smaller investors simply can’t. While that may sound unfair, or against the principles of the market, it’s how all markets actually work.

I, as a small investor, can’t physically go open a gold mine. I don’t have the capital. I don’t know how to dig that well. Someone like Rio Tinto is really good at it. I can participate in Rio Tinto’s success by buying its stock.

Rio Tinto has a competitive advantage, because it has tons of capital and knows how to run gold mines. It’s pretty much exactly what Michael Porter has been writing about at the Harvard Business School for almost 40 years.

PIMCO’s advantages are its size and its knowledge of how the bond market works.

And the bond market, if we’re being honest, is a disaster.

The Indiana Jones Problem

With very few boring exceptions (Treasurys), most of the bond market works like a bazaar in Marrakesh. You know, the kind you see in Indiana Jones movies. If Indy wants to buy a bottle of wine, he starts walking around trying to find one he likes, and when he does, he starts haggling with the guy who has what he wants. There’s nothing wrong with the Indiana Jones model, as long as there are a ton of folks in the market, and a ton of folks staffing the stalls.

The problem is that the stalls have been closing for years. Once upon a time (pre-9/11) there were lots of big bond dealers whose whole job it was to staff the stalls and maintain an inventory. Those days are gone. According to Bloomberg, the inventory held by bond dealers has dropped more than 75 percent since 2007.

The streets of Marrakesh are a ghost town. So now, when Indy wants his bottle, he’s got all the power. He’s the only whale of a buyer in town. The stalls can’t really survive selling wine to each other. He gets to dictate the terms of the sale.

And that’s what the SEC is suggesting PIMCO’s been doing. They’ve been, as I suggested they would two years ago, going out and buying stuff nobody else wants: weird stuff, bonds that are the wrong size to be liquid, bonds people don’t understand. They’re walking up to the stall and saying, “Hey, I know this thing is worth $100, but who are you going to sell it to? I’ll do you a favor and take it off your hands for $90.”

If you’re a PIMCO investor, this is exactly what you want PIMCO to do. You want them out there negotiating hard, flashing the whip and the revolver, and scaring the locals into a good deal. It’s actually its fiduciary responsibility to try and get the best possible price, and its prospectus-bound duty to find hidden value.

Reporting ‘Fair’ Value

The hairy part comes when, in a month, you need to now report how much the bottle of wine or municipal bond is worth. There’s not much of a market for odd-lot bonds and small issuances. The streets of Marrakesh are empty. So how do you value the obscure?

Take it to the extreme: If the town of Bonne Terre, Missouri, issues a $2.5 million bond, and Pimco buys all of it, how do you know how much it’s worth in a year? If Indy buys the last bottle of 1947 Cheval Blanc in the world, how much should he insure it for?

In the hard-assets world—not gold, but wine, art and real estate—there’s an entire industry around appraising fair value, and in general, the markets have learned to live with it. The bond market has its own system that the market has learned to live with too: pricing services. Bond pricing services look for comparable sales and market conditions and make a “best guess” about what you could sell a given bond for.

What the SEC is suggesting is that somehow PIMCO is playing fast and loose here. It’s buying the wine for $90, knowing that the appraisal service will turn around and say, “Yep, that’s a $100 bottle of wine.” There are two enormous problems with this line of inquiry:

1. Of course PIMCO is negotiating the best possible prices on weird stuff nobody wants. That’s PIMCO’s job. That’s the pact it makes with itsinvestors. If it were doing the opposite—knowingly overpaying for things—we’d have a villain. Instead what we have is Indiana Jones.
2. Bond pricing services generally sandbag their appraised values. Think about it: They’re estimating what you could fire-sale every bond in the market for. Every other financial market values things based on last sale, not on the fire-sale offer. Bond prices in net asset values are consistently undervaluing the portfolios. That’s why bond ETFs consistently trade at a premium: The market knows the pricing services are off, but contrary to what the SEC is suggesting, they’re too low.

To say that the SEC is barking up the wrong tree here would be an insult to dogs. Are there real issues in the structure of the bond market and the pricing-service model of establishing fair value? Of course there are. Is this PIMCO’s fault? Hardly. If anything, PIMCO investors should be thankful they’ve got Indy on the case for them.

At the time this article was written, the author held no positions in the security mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.