The Pimco Total Return Fund, the world's largest bond fund run by Bill Gross, decreased its mortgage holdings to its lowest level since mid-2011, ahead of the prospect of higher interest rates and emerging inflationary pressures.
The $285.6 billion fund also in January increased its exposure to U.S. government and Treasury-related securities, which include U.S. Treasury notes, bonds, futures, and inflation-protected securities, data from the firm's website showed on Monday. Pimco increased its Treasury holdings to 30 percent from 26 percent, the most since July.
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The Pimco Total Return Fund decreased its exposure to mortgages, its largest holding, to 37 percent in January — the lowest since August 2011 — from 42 percent in December, after hugely profitable bets last year. The Pimco fund was up 10.36 percent in 2012, surpassing 88 percent of peers.
Pimco reaped huge profits from its mortgage holdings after the U.S. Federal Reserve began monthly purchases of $40 billion in government-backed mortgage-backed securities in an effort to stimulate the U.S. housing market and economy, a move the central bank announced last September.
Gross, who is also the co-chief investment officer at Pimco, had repeatedly noted that with U.S. Treasury yields at extraordinary low levels, Pimco had migrated toward mortgage-backed securities, or MBS, as those securities not only sported higher yields, but they performed well when interest rates were stable.
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When rates rise sharply, as they have begun to since the start of the year, there's less incentive for homeowners to refinance; thus prepayments of principal in mortgage-backed securities slow and prices fall more quickly than for other bonds and duration increases. (Duration is a measure of a bond's price sensitivity to yield changes.)
To maintain their portfolios' duration relative to the benchmark, MBS investors must buy non-callable Treasury bonds when rates fall, and sell them when rates rise. This forced buying and selling exacerbates volatility of the overall market.
The Pimco Total Return Fund is the flagship of Pacific Investment Management, based in Newport Beach, Calif., which is a unit of European financial services company Allianz and had $2 trillion in assets as of Dec. 31.
The fund slightly decreased its holdings of investment-grade credit to 9 percent from 10 percent in December, but kept its exposure to riskier high-yield "junk" credit unchanged at 2 percent.
The Pimco Total Return Fund is down 0.21 percent so far this year, as it is feeling the bite of slowly rising interest rates, but is still besting 67 percent of other U.S. intermediate-term bond funds, according to Eric Jacobson, director of fixed-income fund research at Morningstar. The fund attracted $1.08 billion in new cash in January, Morningstar added.
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The fund left its exposure to emerging market debt, non-U.S. developed markets, municipal bonds, U.S. government agency debt, and "other" forms of credit unchanged in January.
Its holdings of emerging market securities stayed at seven percent, its holdings of non-U.S. developed market securities at 12 percent, its holdings of municipal bonds at five percent, its holdings of U.S. government agency debt at 4 percent, and its holdings of "other" forms of credit at one percent.
In his February letter to investors, entitled "Credit Supernova!," Gross said heavy reliance on credit in the U.S. will lead to inflation and, eventually, a breakdown in credit markets.
Gross said inflation-protected Treasurys and bonds of Mexico, Brazil, Italy, and Spain could produce returns of 3 percent to 4 percent, while the stock market could earn 5 percent to 6 percent.