Advice On How To Trade Gross' Treasury Dump From A Former PIMCO Employee

From Brian Rogers at Fator Securities

The PIMCO call

The commentary today is about the bond fund manager PIMCO and the US Treasury holdings in their flagship $236bn Total Return Fund, the largest bond fund on the planet.  An article today on Zero Hedge discussed how as of 2/28/11, the Total Return Fund had reduced its holdings of US Treasuries down to 0%!  (link here)  This is a very big deal and the only time to my knowledge the fund has ever moved total US Treasury holdings to 0%. 

To give this call some perspective, the PIMCO Total Return Fund is managed vs. the BarCap Aggregrate Total Return Index (this is the former LBAGG or Lehman Brothers Aggregrate).  The BarCap Agg index has a total allocation to US Government securities of around 40% (link here).  This means that PIMCO is underweight its bogey in US Treasuries by about 40 % which in the bond market is a MASSIVE underweight.  PIMCO has also reduced duration in the fund to 3.89 years which is the lowest since December 2008 at the height of the liquidity crisis.

Why is this significant?

Having worked at PIMCO for 4.5 years, I can tell you that this kind of a major allocation decision was not reached overnight nor was it reached without considerable debate by every senior member of the firm.  In other words, the decision to lower total US Treasuries to 0% was discussed by senior portfolio managers, senior account managers and many prominent outside consultants for days and perhaps even weeks before it was finally implemented.  They never do anything over there without vigorous debate and discussion.  For example, Alan Greenspan is a paid consultant to the firm and often participates in their quarterly Secular Outlook meetings.  I don’t know if Mr. Greenspan participated in the debate about this decision but I wouldn’t be surprised if he or others of his stature did.

By this move PIMCO is clearly indicating, almost by putting their reputation on the line because imagine the underperformance they face if they are wrong, that bond yields in the US will be rising soon, US Treasury prices falling and liquidity drying up to some degree.

Does this move make sense?

While it’s impossible to know the future, in my opinion this is something that should NOT be ignored.  The S&P has rallied about 25% on pure QE2 since late-August 2010 which is not organic or sustainable.  Commodity prices have surged and it is becoming well-documented that many companies are having a hard time passing along price increases without facing demand destruction: this leads to margin compression.  If rates do rise as PIMCO suggests, add into the mix a cost of capital that could go up by at least the move in Treasuries which Gross argues should be at least 150bps to compensate Treasury investors for their risk.  Which means that cost of capital could go up by at least 150bps while input costs are rising, margins are compressing and liquidity drying up.  This is a sure recipe for a sell-off so yes, I think this move by PIMCO makes sense.

Another thing to consider is that because of their sheer size in the fixed income market, PIMCO is a market mover no matter what they do.  So simply not being in the US Treasury market means a huge buyer is missing and rates will rise simply due to this supply/demand imbalance so to some extent, PIMCO can make interest rates go up all by themselves by simply not buying.  Very few organizations on the planet can exert this kind of pressure on rates outside of central banks.

How should equity investors play this?

If this call is correct, and of course there is no way to know if the people at PIMCO will ultimately be right, BUT, if this call is correct, I think the way to play this news is as follows:

1.    Sell positions that have done well since Aug 2010 when Bernanke first announced QE2 at Jacksonhole.
2.    Move into an overweight position in large, liquid names.
3.    Buy defensives like utilities and telecoms as dividend plays should outperform growth plays.
4.    Raise cash with the idea of being a liquidity provider at some point in the future after the market has moved lower.
a.    To this end, create a “wish list” of stocks that you like but think are too expensive.  They are likely to get cheaper soon.
5.    Liquid Brazilian names to consider include Petrobras, Itau, AmBev, Copel, and Vivo.



* Fator Securities LLC, Member FINRA/SIPC, is a U.S. entity and a member of the Fator group of companies in Brazil. The comments below are from Brian Rogers, who is employed by Fator Securities (Brian’s opinions are his own and do not constitute the opinions of Fator Securities or the Fator group of companies).

Fator Securities LLC is not affiliated with Zero Hedge or any third party mentioned in this communication; nor is Fator Securities LLC responsible for content on third party websites referred to in this communication.

This material was not prepared by Fator Securities LLC. U.S. Persons seeking further information must contact Fator Securities LLC in New York at (646) 205-1160. This material shall not constitute an offer to sell or the solicitation of any offer to buy (may only be made at the time qualified participants are in receipt of the requisite documentation, e.g., confidential private offering memorandum describing the offering, related subscription agreement, etc.). Securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful or until all applicable regulatory or legal requirements of such jurisdictions have been satisfied. This material is not intended for general public use or distribution and is intended for distribution only to appropriate investors. The opinions contained herein are based on personal judgments and estimates and are, therefore, subject to revision. Past performances are not indicative of future results.