Important news has a way of being released at the exact moment when everyone is looking the other direction – such was the case with the Wall Street Journal story that PIMCO was being investigated by the SEC. While investors were focused on Alibaba and Jack Ma’s obsession with Forrest Gump, the SEC was taking action against PIMCO. The probe into how PIMCO determined prices on illiquid bonds held in the Total Return Fund transported me back to April 2007.
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In the spring of 2007 an obscure hedge fund within the behemoth that was Bear Stearns began to get redemption requests. These redemptions were complicated by the fact that the hedge fund had potentially mispriced assets. Kate Kelly, now of CNBC was then with the Wall Street Journal and wrote eloquently about the Bear Stearns hedge fund debacle.
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Kate explained how these funds would come up with valuations on illiquid securities:
Unlike stocks and Treasury bonds, whose prices are continually quoted and easily obtained, many of these derivative instruments trade infrequently and don’t have clear market prices. To come up with market values for these investments — a process known as “marking” their positions to market — investment funds often rely on their own valuation models.They might also ask the dealers who sell them the bonds to update them on changes in the bonds’ underlying value. When there are no sales to base prices on, dealers come up with prices based on their own statistical models and an array of assumptions about what’s happening in the market or the assets that back the securities.
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As we would find out later, virtually every mortgage trader and fund on Wall Street was using a pricing model that was flawed. They used these models because the bonds rarely traded and thus market prices were not observable – the problem, of course, is that this practice lends itself to error at best and fraud at worst.
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In the post-crisis financial markets, models are still being used to price illiquid securities. More accurately, bond market participants use what is called Matrix pricing. For those wishing to learn more about Matrix pricing I suggest reading this FT story by Tracy Alloway “Investors in Junk Bond Funds Face Matrix Moment.” As Tracy explains:
Often performed by third-party service providers, Matrix pricing involves interpolating the current price of a bond by looking at similar debt issues and then applying algorithms and formulas to tease out a reasonable value.
The similarity in the pricing mechanism from then to now should make it clear that Matrix pricing could pose a threat. To be clear, I am not suggesting that PIMCO has done anything wrong – I have absolutely no way of knowing how it priced its securities – good or bad. What I do know is that PIMCO is not the only fund manager using Matrix pricing which means that this is not an isolated event.
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Disorderly Cascade
Why do I even care about this? Because if investors feel they have been misled then they will sell first and ask questions later. In this environment a large wave of selling in the corporate bond market could cause a disorderly cascade. Since the financial crisis, brokers have reduced risk dramatically resulting in very low levels of liquidity for corporate bonds, especially junk bonds. Additionally, investors reaching for yield have piled into High Yield ETFs creating bubble-like conditions. The following chart depicts the amount of corporate debt outstanding vs. assets on broker balance sheets.
Since the financial crisis broker-dealers have reduced assets by -45%, while corporations have increased outstanding debt by 71%! This mismatch should worry every investor because if a wave of selling commences there will be nothing to stop it.
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Stock Market Implications
Much of the bull market has been fueled by financial engineering – corporations have used cheap debt to buy back stock and boost earnings in a low growth environment. As investors begin to exit the corporate bond market, either for fear or fundamentals, this fuel source will be cut-off. So while everyone else in enamored with the latest tech trend, savvy investors will be watching the corporate bond market.
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Disclosure: Brian is short HYG through put options
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You can follow Brian Kelly @BrianKellyBK and his website www.BrianKellyCapital.com