Pimco Total Return Fund reduces cash & repo in favor of futures exposure. Are they feeling the lack of liquidity in repo?

A September 17th article in Bloomberg “Bill Gross Used $45 Billion Derivatives to Lift Fund Gain” by Miles Weiss and Susanne Walker left us wondering if Pimco is having second thoughts about the repo market. Lets take a look.

The basic story is that PIMCO sold most of their $48 billion of US Treasuries held in the Pimco Total Return Fund (PTTRX) replacing them with futures contracts. Why?

“…The contracts require small up-front payments, freeing up money for Gross to invest in higher-yielding securities including Brazilian, Spanish and Italian debt…”

It looks like the Total Return Fund is leveraging up their returns and playing a reinvest game.

The article said,

“He said the proceeds from the sale of the government bonds can be reinvested in short-term corporate debt that yields 30 to 40 basis points more than lending out cash Treasury bonds through “repos,” or repurchase agreements.”

and

“…’What it basically means is that Pimco can turn a Treasury yield into a corporate yield with a Treasury quality and Treasury liquidity,’ Gross said in the TV interview…”

If they sold their Treasuries, replaced the exposure with futures, and now bought EM and peripheral Euro debt with the cash generated, that is an aggressive strategy not seen since the Wild West of the securities lending reinvest days. But it begs the questions, why couldn’t they have simply repo’ed out the Treasuries to generate the cash?

As for turning a Treasury yield into a corporate yield, we suspect an incomplete explanation there. The strategy will bump up yield, but by creating additional credit and liquidity exposure. Leverage on top of the additional credit risk from EM and peripheral Euro debt is not a free lunch. Some of those peripheral Euro yields are so low as to suggest very low risk. We question if those 30 to 40 basis points are coming from that paper?

We wonder if Pimco is seeing capacity issues or higher costs baked into repo and are using futures to substitute? Pimco is not a client we imagine that most dealers would impose tough credit constraints on. But as a big player, Pimco relies on large amounts of liquidity being there, in both the cash and financing markets, day in and day out. Futures create synthetic cash positions on the cheapest to deliver + financing. As Gross noted, the derivatives are often more liquid than the underlying. While futures can be cheap to Treasuries or visa-versa, this sounds like it is a strategy that goes well beyond.

With the recently announced departure of Gross from Pimco, it will be interesting to see if their strategy shifts. Some speculate that cash will flee Pimco as a result of the management change. If that happens, they may have to unwind some of their positions and we will see how liquid the reinvest paper is.

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