Pimco’s BOND Can Now Use Derivatives

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The Pimco Total Return ETF (BOND | B) will soon be able to invest in derivatives such as options, futures and swaps contracts, Bloomberg reports, allowing it to be more like its mutual fund counterpart, Pimco’s $225 billion Total Return Bond Fund (PTTRX).

The latest Securities and Exchange Commission ruling, which Pimco tells us will take effect about 60 days from its latest filing July 31, might seem like a mere technicality to ETF investors. But the decision matters to the extent that the use of derivatives has been a key element in Pimco’s mutual fund success, according to the firm’s co-founder Bill Gross himself. That mutual fund is the world’s largest bond fund today.

Gross said recently in a conference in Chicago that the secret to his mutual fund strategy includes three key structural elements, the first of which is the use of derivatives in a way that allows Treasurys in the portfolio to behave more like corporate bonds in disguise. That, in turn, he says, generates additional income from otherwise-low-yielding Treasurys, and offers protection on the downside.

Now, BOND can do that too. Up until now, the actively managed ETF couldn’t use options, futures and swaps contracts—the very tools Gross uses in the mutual fund. BOND, which is designed to offer the same type of exposure its mutual fund counterpart does, came to market when the SEC still had in place a ban on derivatives use in any proposed new strategies.

That ban, which lasted for about two years, was lifted, and ETF industry insiders have been expecting Pimco to change BOND’s strategy.

“This certainly gives Pimco more freedom than they had in the past,” ETF.com’s Matt Hougan said of BOND’s new status. “Derivatives are often used to protect against massive dislocations. Now BOND has a cushion for extreme negative movements.”

Good Timing For A Cushion

That cushion comes at a time when there’s a lot of concern about the performance of the bond market going forward. The ongoing tapering of quantitative easing has many bracing for higher rates from historically low levels as the Federal Reserve takes its foot off the pedal and looks to spur inflationary pressures, and higher rates, ahead.

In the past year, the actively managed BOND—which strives to keep duration within two years of the Barclays Aggregate Bond Index, has delivered 5.1 percent in total returns.

That performance was actually slightly higher than the mutual fund’s 4.1 percent return seen in the same period, and it slightly outpaced the broad market, as measured by the passively managed iShares Core U.S. Aggregate Bond ETF (AGG | A-97).

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BOND_Vs_AGG_1_YR_Perf

Chart courtesy of StockCharts.com

Pimco’s recipe involves three key structural elements that have allowed its mutual fund template to deliver a strong performance, according to Gross.

  1. “Bonds Plus”— a strategy where Pimco turns Treasurys into corporate bonds through futures and options contracts. That allows the Treasurys to behave like corporate bonds. It adds income.
  2. Emphasis on intermediate maturities and rolling down the yield curve . Historical studies have shown that over a long period of time, a five-year Treasury basically has equaled the performance of a 30-year Treasury as it rolls down the yield curve, getting capital gains with every passing year. As Gross puts it, “The secret is patience. The five-year Treasury is a great structural bet in a structural template with less volatility.”
  3. Use of 30-year mortgages to sell volatility, and collect premiums in times when there are many tail winds in the market. It’s essentially a form of portfolio insurance. “Volatility has to be underwritten and priced appropriately,” Gross says. “It’s good business. Over time, it’s a very respectable alpha generator.”

        This template, Gross says, generates about 75 basis points in additional “structural alpha” every year. The latest SEC ruling allows BOND to benefit from it more fully.

         

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