A Sensible Way of Buying Fixed-Income Risk

In a world where the Charles Schwab YieldPlus fund has fallen more than 25% this year alone, statements that bond funds just aren’t risky enough are likely to be met with a hollow laugh from some quarters. But it’s true: bond funds just aren’t risky enough.

I’m not talking about the leveraged funds which helped to bring down Bear Stearns, I’m talking about the products available to retail investors. If you’re an individual, the options available to you in the equity space are very broad indeed, from index funds and 130/30 funds through to high-growth, high-risk technology funds. Then, if your risk profile from equities is too aggressive, the done thing is to buy a few bond funds as well, to add a bit of safety to your portfolio.

But equities are no longer the only place to seek high returns. Hedge funds and university endowments have been making lots of money elsewhere for decades, and in the wake of the credit crunch there’s a strong case to be made that the best returns over the next few years will be made in the fixed-income space, which looks as though it has overshot to the downside in many areas, rather than in the equity space, which mostly hasn’t.

What’s more, emerging-market local debt is a good way to play the foreign exchange market as well, if you’re sophisticated enough to be able to work out what happens when you layer credit risk and the legal risk of not having debt issued under New York or London law on top of foreign-exchange risk.

And most importantly, as the cash bond market pales in liquidity next to the CDS market, it’s increasingly important that managers understand and use effectively the full spectrum of derivatives instruments available to them.

And there’s the rub: a moderately risky, widely diversified bond fund is not the kind of thing which can be started up by a couple of guys with a Bloomberg. Fund managers like John Paulson do well because they do a deep dive into something like housing credit, see a mispricing, and make a big directional bet. That’s fine for a hedge fund, but it’s not something to offer to retail.

If you were to start up a bond fund with a hefty risk appetite, you’d need much more than some diligent credit analysts. You’d need a good grasp of global macroeconomics, an expertise in medium-term foreign-exchange movements, a strong legal team, a large set of derivatives experts, and, crucially, a rock-solid counterparty risk rating. If you had all that, however, you could venture into areas few mutual funds have ever dared enter, and launch a fund which, in the best case, could get equity-like returns even if and as the stock markets were going nowhere.

But who has all that? Well, the first and most obvious name is Pimco. And guess what:

Pimco, a unit of Allianz, plans to launch a fund, Pimco Fixed Income Unconstrained Fund, which can invest in derivative vehicles such as options, futures contracts or swap agreements, or in mortgage-backed or asset-backed securities.

More broadly, the fund can invest in fixed-income investments with durations ranging from three to eight years and in an unlimited number of securities denominated in foreign currencies, according to a filing Pimco has made with the Securities and Exchange Commission.

The fund may also invest as much as 50% of its assets in securities and instruments economically tied to emerging-market countries and may invest as much as 40% of its assets in junk bonds.

This move makes a lot of sense to me. I doubt the Unconstrained fund is ever going to be a true monster in terms of size: fixed-income investors by their very nature tend to be risk-averse animals. But this fund could attract risk capital into the fixed-income space to a degree rarely seen in the past, just as retail investors are looking for areas where someone with a long enough time horizon can try to pick up undervalued debt.

What’s more, the Unconstrained fund would also fit in to a strategy of moving Pimco more broadly into alternative investments and higher-risk activities.

The risk to Pimco, of course, is that the Unconstrained fund blows up and drags the reputation of the entire firm down with it. But the one word I don’t see in its mandate is "leverage" (although it’s trivially easy to simply embed leverage in derviatives if you’re so inclined). Given how nimbly Pimco has managed to navigate the current credit crunch, I’d say the firm has as good a claim as any to being able to say that it’s capable of avoiding disaster.

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