Pimco overhauls unconstrained fund as Gross takes control

The Pimco Unconstrained Bond Fund (PUBAX), one of the firm’s most important offerings as clients turn away from traditional fixed-income products, overhauled its investments in the fourth quarter, when Bill Gross replaced Chris Dialynas as manager of the $25.6 billion fund.

The 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 Pacific Investment Management Co.’s website. The effective duration, a measure of sensitivity to interest rate changes, more than doubled in December, when Mr. Gross assumed control of the unconstrained fund.

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

Mr. Gross has taken charge of Pimco Unconstrained as investors are flocking to flexible go-anywhere strategies while fleeing core fixed income in anticipation of rising interest rates. Pimco Unconstrained attracted $8.7 billion in 2013, despite lackluster returns, as clients pulled a record $41 billion from Mr. Gross’s more famous and far larger Total Return Fund (PTTAX), according to data from Morningstar Inc.

UNCONSTRAINED TRAILS

Mr. Dialynas joined the Pacific Investment Management Co. 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 Mohamed El-Erian spurred leadership changes at the $1.9 trillion investment firm.

Pimco Unconstrained fell 2.6% to trail 84% of peers in 2013, and has lagged behind 67% of rivals over the past five-year period, according to Morningstar. This year through March 3, the fund has returned 1.2%, putting it ahead of 71% of other nontraditional funds, Morningstar data show.
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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, Ms. Callin said. “One of the objectives we are seeking is to limit downside risk to preserve capital.”

Pimco in December published a “Strategy Spotlight” interview with Mr. 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, Mr. Gross said that Pimco Unconstrained and other funds run by the firm would bet on the shorter-term debt, while pulling back from five-, 10- and 30-year exposures.

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

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.

DURATION LEVELS

Pimco Unconstrained’s effective duration declined 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 Eric Jacobson, a Morningstar analyst who tracks the performance of funds at Pimco. 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.

Mr. 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% on Dec. 4 to 3.03% on Dec. 31, and declined to 2.64% by the end of January. Pimco Unconstrained returned 0.58% in January, the equivalent of a 7.1% annual return.

“You can see how it would be an opportunistic bet,” Mr. Jacobson said. Mr. Gross is a “glass-half-full” kind of investor, Mr. Jacobson said, describing Mr. Dialynas as more of a “sky-is-falling” type manager.

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.

Under Mr. 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. Mr. 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.

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% and 8.125%. 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,” Mr. 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.
(Bloomberg News)