Bond prices and yields move inversely, so as interest rates go down prices go up. I've always wanted to write that. Also it serves as nearly sufficient background for this morning's big Reuters story about giant bond fund manager Pimco, which bought bonds; then the Federal Reserve embarked on a massive program of lowering interest rates, so the prices of Pimco's bonds went up, and its funds made a lot of money. Turns out that the best time to buy bonds is just before the Fed embarks on a massive program of lowering interest rates. Pimco did that. Smart!
The accompanying graph may also offer some helpful background.
That's Pimco's Total Return Fund versus its benchmark index, the Barclays U.S. Aggregate Bond index.* You'll note that Pimco had times of serious smartness, relative to the bond market, and also times of less smartness. Overall, from the time the Fed announced it was buying lots of mortgage-backed securities in November 2008 through today, the Pimco fund is up about 4.7 percent, and the index is up about 8.3 percent. So.**
The story has a lot of interesting detail, though, about how various flavors of quantitative easing worked and helped Pimco. The most raising of eyebrows occurs at the part of the story in which the Fed actually hired Pimco to do a lot of the bond buying, starting in January 2009 and going until the Fed hired its own traders in early 2010. The eyebrows are reacting to the possibility that maybe Pimco had inside information into exactly what bonds the Fed would buy when, so it could make more money than everyone else. There's no evidence that it did have any inside information though. For one thing, the Pimco traders buying for the Fed were walled off from the Pimco traders investing for the firm, and no one at Pimco or the Fed or elsewhere seems to have any reason to think those walls were porous.
For another thing, Pimco's Bill Gross spent a lot of time in that period (also other periods) publicly talking and writing about his strategy, which consisted of trying to anticipate the Fed. That was everyone's strategy, or should have been, but I guess if your strategy was to anticipate the Fed by getting leaked inside information you maybe wouldn't talk about it.
The most suggestive evidence of badness is that Pimco was pretty good at its anticipating the Fed during the year of its partnership. For instance, in March 2009, while buying for the Fed, Pimco had 91 percent of its Total Return Fund in agency mortgage-backed securities, which is what the Fed was targeting. And it had a good year that year.***
On the other hand: The Fed had specifically and publicly announced, in November 2008, well before hiring Pimco, that it was planning to buy $500 billion of agency MBS. And Pimco said publicly that it planned to anticipate that buying and make money off it. So it did. By December 2008 -- before it started working for the Fed -- Pimco's portfolio was 84 percent agency MBS (up from 61 percent in June 2008). The Fed said it was going to buy agency MBS soon, and Pimco went out and bought them first. The question is not why Pimco did that but why everyone else didn't.
Later on Pimco got less lucky; the article suggests Pimco had two pretty good calls on the Fed -- in 2009 and in mid-2011 through mid-2012 -- and two big wrong calls, in early 2011 and in 2013. That's more or less what the chart shows too. That 50/50 record of anticipating what the Fed would do is ... I dunno, meh, it doesn't really sound like insider trading?
While there doesn't seem to be any indication that Pimco misused secret information, there's really no question that it used public information to front-run the Fed. I mean, Bill Gross said he was doing exactly that, though without using the f-r word: "Make them your partner by acknowledging that their checkbook represents the largest and most potent source of buying power in 2009 and beyond. Anticipate, then buy what they buy, only do it first." Or as this guy puts it to Reuters:
"Pimco knew the policy that the Fed was attempting to achieve, and it could readily stock up on those types of securities," says Anthony Sanders, professor of real-estate finance at George Mason University. "Buying for the Fed in the volumes that the Fed was buying would almost certainly result in price increases in the specific MBS. So why wouldn't Pimco build a quick portfolio of these securities and take advantage of valuation increases or cash returns?"
But everyone knew that policy! That policy was public! Not only was the Fed policy public, Pimco's policy of front-running the Fed was public! You could go anticipate what the Fed would buy and then you'd know what Pimco would buy and you could front-run them both. Again, why didn't everyone.
The moral of the story might be just that the Fed is a great client. Most customers, if they came to a broker and said "I want to buy a ton of Bond X next month," would be less than thrilled if the broker then
- went out and bought a ton of Bond X for its own account, and
- told everyone it was doing that and that they should too.
Because then when the customer did get around to buying Bond X, it would be paying much higher prices. And the broker would be making money off it. Sort of a customer-service no-no.
But the Fed isn't a typical customer, because its goal is not to get the best price but to move prices. The Fed wasn't buying bonds as a long-term investment; it was buying the bonds so the price of those bonds would go up, and rates would go down, because prices and rates move inversely don't you know. And rates going down makes the economy better etc., etc.
If the goal is to move prices, your desires are sort of the opposite of what normal traders want in their trade execution. The more front-running there was, the more effective the Fed's easing program would be. That's why Bill Gross could talk about making the Fed his partner by buying what they wanted to buy before they could and then selling it to them at a markup. Normally that's not how you treat your partner. Here, though, they let it slide.
* Technically the iShares ETF on that index, AGG.
** All of the index's outperformance is from late 2008; if you start the clock running in January 2009, when Pimco actually started working for the Fed, it's 6.7 percent for Pimco Total Return versus 3.5 percent for the index.
At one point in March 2009, for example, 91 percent of the Total Return Fund's assets were in agency MBS, according to data from investment research firm Morningstar Inc. That level was unusual for the fund and far exceeds that of any comparable fund at the time. By contrast, agency MBS accounted for 38.7 percent of assets in the Barclays U.S. Aggregate Bond Index, the industry benchmark.
In his January 2009 web posting, Gross said Pimco's aim was to "shake hands with the government." And in an interview with Reuters in February this year, he said: "It is a good strategy to anticipate what the Fed is going to do, and when they do it, to cooperate with them. ... So that is what we've been doing." ...
For all of 2009, Pimco's Total Return Fund posted a return of 13.83 percent. It was the fund's best showing in a decade, beating the Barclays U.S. Aggregate Bond Index by nearly eight percentage points - its widest spread over the benchmark, according to Morningstar, since 1988, the fund's first full year of operation. By far the biggest contributor - at 4.15 percentage points - was the fund's bet on mortgage bonds of all types, according to a confidential breakdown of the fund's returns obtained by Reuters.
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Matthew S Levine at firstname.lastname@example.org