Pimco's bad bets on emerging markets add to firm's troubles


Betting on emerging markets has led to losses for many over the past year—but among big investors few got the timing of their wagers as wrong as Pacific Investment Management Co., the giant bond firm that has recently been roiled by a rupture at the top.

While a lot of attention has been paid to a dramatic falling out between co-founder Bill Gross and former CEO Mohamed El-Erian, and the underperformance of and outflows from its flagship Total Return Fund, few have taken notice of the firm's failed investments in emerging markets debt.

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In particular, it has made made some ill-timed bets in the Brazilian, Mexican and Russian debt markets. It made substantial investments in some companies that have gone belly-up, such as Brazilian oil company OGX Petróleo e Gás Participações SA, which was controlled by Eike Batista, who only two years ago was estimated to be the world's seventh-richest man but whose business empire has now largely crumbled.

Brent Lewin | Bloomberg| Getty Images

Gross, El-Erian, and a Pimco spokesman declined to comment for this article.

Already, investors have pulled almost $2 billion from Pimco's emerging markets debt funds during the first four months of this year, according to Morningstar data, with $639 million of that departing in April alone. By comparison, the funds bled $2 billion of net outflows for all of 2013.

The missteps suggest that Pimco, which is owned by Germany's Allianz, may have been tempted given the low returns available from safer bond investments to make outsized bets in riskier markets, fund consultants said. Pimco's $1.94 trillion asset base, which gives it the ability to play a dominant role in the U.S. Treasury and other major debt markets, may not provide it with such an advantage in illiquid emerging debt markets where large investments can be difficult to exit and losses can mount when prices are plummeting.

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Pimco probably got caught in "a vicious circle" as wrong calls led to fund redemptions by investors that forced it to sell bonds into a volatile market, driving the prices of remaining holdings down even further, said Todd Rosenbluth, director of mutual fund research at S&P Capital IQ. The problem is worse because Pimco's size means it has "to make bigger bets" to move the dial, he added.

Mongolian mining

Pimco's troubled debt investments in the past two years have included a Mongolian mining company, Mexican home builders and a Brazilian sugar and ethanol producer.

The firm also had large holdings in Russia as President Vladimir Putin ordered the invasion of Crimea and unrest in eastern Ukraine grew, triggering Western sanctions against Moscow. Pimco has said bond prices in Russia have dropped to appealing levels, while it also sees risks. "Though de-escalation of the crisis is our base case, potential miscalculations cannot be ruled out," Pimco said in first quarter investment report published on March 31

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Russia was the firm's top country holding in its emerging market corporate bond portfolio at nearly 25 percent at the end of March, according to Pimco's website. Russian debt has dropped 12 percent and the rouble is down more than 8 percent so far this year.

The performance stats reflect the reversals.

The $10.86 billion Pimco Emerging Local Bond Fund, which invests primarily in local currency government bonds in emerging markets, declined almost 11 percent in 2013, trailing 88 percent of its peer category. This year, things have improved but it is still lagging behind 52 percent of its peers, according to Morningstar.

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The $1.37 billion Pimco Emerging Markets Corporate Bond Fund, which invests in fixed income securities issued by corporations in emerging markets, has also sufferedwith a negative 1.89 percent return for the 12 months to April 30, versus a 0.002 percent gain in the benchmark JPMorgan Corporate Emerging Markets Bond Index Diversified, or CEMBI. Since its inception in 2009, the fund has trailed the benchmark on an annualized return basis by an average 1.55 percentage points.

And the blame for at least some of the underperformance of the Total Return Fund, with its $232 billion in assets, can be traced to the impact of its 6 percent to 8 percent holding in emerging market investments over the past 12 months. The fund, which is mainly in U.S. Treasurys and mortgage-backed securities, has seen a massive $55 billion outflow of money since last May.

Short-term fundamentals improving: El-Erian

To be sure, the plunge in emerging markets has taken a bite out of the performance of funds managed by some of its biggest rivals, including top names on Wall Street, including BlackRock, Morgan Stanley, and Goldman Sachs.

And while Pimco has gone through tougher times in the past couple of years, its longer-term investment track record for a firm of its size is unmatched.

Pimco's emerging markets bond funds are also some way away from being the worst performing this year - in the first four months, its four funds in the sector were ranked 43rd, 53rd, 68th, and 81st out of 100, according to Morningstar.

But such positions in the table are a far cry from the days when El-Erian's daring yet highly profitable bet on Brazilian bonds in 2002, when others had unfounded concerns about the election of a left-wing government, helped to make his and Pimco's reputation as a strong player in the sector.

Wooed by Batista

Perhaps Pimco's biggest single misfire in emerging markets debt was the firm's investment in the bonds of Batista's OGX. Batista's fortune dropped from an estimated $30 billion in March 2012 to less than $300 million two years later, according to Forbes, mainly due to the ugly combination of a large debt burden and investments in assets that failed to produce returns.

Batista's empire was already beginning to collapse even as Pimco amassed a big position in OGX bonds maturing in 2018 and 2022. Sources familiar with the situation have told Reuters that they estimate the bet got as high as $800 million at one point in May last year.

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Pimco declined to answer questions about the position.

OGX, which in October made Latin America's largest bankruptcy filing with more than $5 billion in liabilities, has since changed its name and is now known as Óleo e Gás Participações.

The company's bonds maturing in 2022 fell 93.7 percent in 2013, and, according to one of the sources, Pimco's losses from its OGX investment are now estimated to be more than $300 million.

The timing of the OGX debt purchases by the firm was particularly perplexing, the sources said.

Su Fei Koo, an emerging markets portfolio manager at DoubleLine Capital, one of Pimco's main competitors, said: "Everyone was excited about OGX around May 2011—right before they issued bonds—and I thought to myself: 'Here's a company with no EBITDA (earnings before interest, tax, depreciation and amortization) and no discovery of oil," adding that she saw "no improving credit path" and therefore didn't buy the bonds.

It is unclear who at Pimco made the decision to invest in OGX debt.

According to Morningstar analyst Eric Jacobson, Mark Kiesel, global head of corporate bond portfolio management, and his credit team have led the way on Pimco's OGX coverage. Kiesel has recently been elevated to become one of six deputy chief investment officers under Gross in the wake of El-Erian's departure.

Kiesel met with Batista one-on-one in late 2012, months before OGX debt came under severe selling pressure, and at a time when Pimco was building its investment in the bonds, a person familiar with the situation told Reuters.

The results of that meeting could not be ascertained.

Brigitte Posch, who was head of emerging market corporate debt investing at Pimco until last fall, would not comment for this article. She is now leading a new emerging markets debt investment team at Babson Capital Management in London.

Neither would her last boss at Pimco, Michael Gomez, who is co-head of the firm's emerging markets portfolio management team.

Pimco declined to make Kiesel available for comment.

'Big gains' are behind us: Pro

OGX declined to comment for this story. Efforts to reach Batista for this story were unsuccessful. The law and investment firms advising Batista, Pimco and some of the investment management companies involved in the OGX restructuring plan declined to comment.

Among some of the holdings that Pimco's Emerging Markets Corporate Bond Fund had over the past year were bonds issued by coal producer Mongolian Mining Corp that have fallen 30 percent over the past year as prices of coal fell to a record low.

Another reversal was in the bonds of ailing Mexican homebuilders Corporación GEO SAB (which filed for bankruptcy in March), Urbi Desarrollos Urbanos SAB and Desarrolladora Homex SAB, which have all grappled with curbs in government subsidies for commuter-town projects and a tumble in the value of their landholdings. Their bond prices all dropped by at least 50 percent in 2013.

As of the end of last year, Pimco also owned bonds from Brazilian sugar and ethanol producer Aralco SA Indústria e Comércio, which this March filed for bankruptcy after sugar prices fell to a three-year low and Brazil would not ease caps on fuel prices, hurting its ethanol business.

'Leery of horsemeat'

It is unclear how much of a role Gross and El-Erian have had in the misfires.

Early last year, Gross was encouraging investors into Brazil and Mexico just before their currencies plunged. On January 16, 2013, Gross wrote in a Twitter message that the Brazilian real and Mexican peso were a better use of cash than high-yield junk bonds. Gross then followed a month-and-a-half later with another tweet: "Be leery of horsemeat & currency mispricings. Yen, Pound & Euro reflect weak economies. Underweight them. Buy Mex peso, Brazil real."

The following month he made similar noises about Brazil and Mexico, and had a similar tale in June.

Gross had changed his views by January of this year. He said at the 2014 ETF Virtual Summit in January that Brazil was no longer a major preferred emerging market for Pimco.

By late April this year, though, Kiesel said in a report for clients that he was "more bullish" on Brazil after a recent trip and he sees opportunities in sovereign notes and debt from Brazilian companies, including oil producer Petrobras.

By Reuters