Pimco is gearing up for a junk bond binge -- or at least opening the door to that possibility. The Pimco Total Return Fund, Pimco’s flagship bond fund, will be permitted to invest up to 20 percent of the Fund in junk bonds beginning on June 13, up from 10 percent currently.
The Fund’s current allocation to junk bonds is only 2.5 percent, so the new 20 percent ceiling would be a monster eightfold increase in the Fund’s allocation to junk bonds if fully utilized.
Why now? Mark Kiesel, Pimco’s chief investment officer for global credit and one of the Fund’s managers, told Bloomberg News that the junk bond market “is as attractive as it’s been in four or five years.”
My Gadfly colleague, Lisa Abramowicz, noted yesterday that the Total Return Fund has shrunk significantly over the last two years in the wake of Bill Gross's departure from Pimco and is hungry to show that it can generate better returns.
But is now really a compelling time to buy junk bonds?
Junk bonds, you could say, are risk assets masquerading as bonds, and the Total Return Fund is no stranger to risk taking.
During Gross’s towering reign as manager of the Fund, investors were more than compensated for his willingness to take risk. The Fund returned 7.9 percent annually to investors from June 1987 until Gross’s departure in September 2014, with a standard deviation of 4.3 percent (based on the total return for institutional share class), while the Barclays U.S. Aggregate Bond Index returned 6.8 percent annually over the same period, with a standard deviation of 3.9 percent. (Standard deviation is a common proxy for risk; a higher standard deviation implies higher risk.)
The Fund’s willingness to take risk survived Gross, but so far the returns have not. Since Gross’s departure, the Fund has returned 2.7 percent annually to investors from October 2014 to April 2016, with a standard deviation of 3.3 percent, while the Barclays Index returned 3.7 percent annually over the same period, with a standard deviation of 2.7 percent.
It would be silly to judge the post-Gross era based on only 19 months of performance, but fickle investors are doing just that and dumping the Fund in droves. The Fund managed $293 billion as recently as April 2013, and assets have since shrunk by more than two-thirds to $87 billion.
Clearly, a renaissance for the Total Return Fund has to start with better performance, and one way to juice returns is to pile on more risk. Loading up on junk bonds would have paid handsomely for much of the post-financial crisis period, as yield-thirsty investors provided a steady stream of investment to support ever-higher junk bond prices. The yield on the Bank of America Merrill Lynch US High Yield Master II Index peaked at 20.9 percent in March 2009 (a 4+ standard deviation event!), and by 2014 that yield had plummeted to just over 5 percent.