Editor's note: Originally published on July 14, 2014
Pimco is putting all their chips on the table, betting that low interest rates, along with lower and more stable global growth, will last for the next 3 to 5 years; an economic condition it is referring to as the "new neutral."
In fact, the company is so convinced of this "sure thing," it's placing a straight bet -- selling insurance against price fluctuations on their $230bn flagship bond fund Pimco Total Return (NYSEARCA:BOND). That means it is offering investors price stability in the bond portfolio, in return for a premium.
Instead of just simply investing clients' money in a normal bond strategy, it is upping the ante by applying a derivatives trading scheme. To this fact, Mr. Gross asserts that Pimco is one of the biggest sellers of insurance against market volatility.
Selling volatility typically involves selling options, which would pay out if a particular market moved by more than a pre-agreed amount. For example, the Volatility index, also known as the VIX, is based on the price of a combination of options on the S&P 500. The more investors are willing to pay to protect themselves, the higher the index goes. The index is said to measure fear in the market place.
Sellers of these types of security derivatives have profited lately from the lack of volatility in the market. This has allowed Pimco to sit back and collect premiums, without having to pay out on market volatility.
Sound familiar? That's because back in the early 2000's, insurer AIG placed a similar seemingly riskless bet. They offered banks a way to get around the Basel rules, via insurance contracts, known as credit default swaps. They insured sub-prime securities for a premium. At the time, I'm sure it seemed like easy money -- after all, the historical loss rates on American mortgages was close to nothing. They employed extremely bright people who created incredibly sophisticated computer models and assured them that this bet was a sure thing. They wagered big on what appeared to be a lock. And for a period of time, they too sat back and collected premiums without having to pay out.
Needless to say, AIG's bad bet ended with an enormous bail out from the Federal Reserve.
But, Pimco is wagering on more than lack of market volatility. Doubling down on its new neutral bet, Pimco is borrowing on the short end to invest in longer end bonds. If rates were to take a sudden spike up, it would be paying more on the short end loans than received in interest payments from their bonds -- and would be forced to unwind that trade.
And further pressing its bet, making this a potential trifecta of financial disasters, you have to remember that Pimco is a huge player in the bond fund space, with over $1.9 trillion in assets under management. Pimco's Bill Gross has decided to go large -- betting that it will win, place and show. If his horse fails to come in and interest rates go up, the price of Pimco's bond funds will fall. Investors, who have already been walking away for a consecutive 14 months straight, will then run to the exit doors, forcing Pimco to sell bonds to meet redemptions, driving interest rates up further. This rise in rates will increase volatility, obliging Pimco to pay out on its VOL insurance and place the company under further duress.
This could be a disaster for both Pimco and the financial markets as a whole, and is reminiscent of the Long-Term Capital Management debacle. LTCM used a combination of leverage and complex mathematical models to take advantage of fixed income arbitrage deals. In 1998, when the market was in turmoil, investors panicked and fled the riskier markets for ones with a higher degree of certainty. LTCM, which also bet on the belief that fat tail events were illusory, found that despite their "supposedly" diversified portfolio, they had basically placed the same bet on low volatility. Like AIG, they too required a bail out.
Pimco is pressing its bet on the belief of a new neutral that low interest rates and low volatility will prevail for the next 3-5 years. If correct, the company will produce a modest return for their clients; but if it is wrong and we get a sudden shock in rates, Pimco's clients will feel compelled to unwind the multi-trillion dollar bond portfolio creating havoc in financial markets, which will put the entire financial system and country in grave danger.
This is just one example of the consequences resulting from addicting the economy to ZIRP for six years. The fact is that a record amount of debt, inflation-driven central bankers and interest rates that have been artificially suppressed at historically-low levels cannot coexist. It is an incendiary cocktail that will soon explode in the faces of our government central planners.
Therefore, we face the daunting collapse of all types of fixed income and high-yielding debt. As a result of this inevitability, the real estate market will tumble as flippers are once again forced to dump their investment properties. The equity bubble will burst when the record amount of margin debt is forced to be liquidated. All forms of adjustable rate consumer and business loans will come under duress. Banks' capital will be greatly eroded as their assets go underwater, just as the rates on deposits are increasing. The Fed will become insolvent as its meager capital quickly vanishes. Interest payments on the national debt will soar, causing annual deficits to skyrocket as a percentage of the economy. And, the over $100 trillion market for interest rate derivatives -- which Pimco now plays a big part in -- will go bust.
But you don't have to get caught on the wrong side of Pimco's bad bet. A savvy investor can turn this into their market opportunity by betting that Wall Street and Washington's fantasy of a normal economic recovery is about to collapse into a nightmare.
Disclosure: No positions.