PIMCO Goes Short The Entire Developed World

[muldoon]

speaking of "the next credit crisis", the largest bond fund on the planet PIMCO just shorted the entire developed world.
This is a seriously huge move.  seems to be alot of eyebrow raising things in the news lately.   

PIMCO Goes Short The Entire Developed World

http://www.businessinsider.com/pimco-gets-ahead-of-the-next-credit-crisis-2010-2

If you're concerned about potential storm clouds on the global debt horizon, then PIMCO Global Advantage Strategy Bond (PSAIX) may be worth a look. This world-bond fund takes a novel, and in some ways defensive, approach to the global market. But it also takes on potential risks in trying to separate from the crowd.

Rather than using a capitalization-weighted bond index as a starting point for its country exposure, this global bond fund focuses on GDP weightings. PIMCO has created the Global Advantage Bond Index, or GLADI, and uses it as the benchmark for this portfolio. The fund's managers, Mohamed El-Erian and Ramin Toloui, then make incremental, active calls versus the GLADI in terms of duration (a measure of interest-rate sensitivity), credit, and currency exposures.

Why a New Index?
Focusing on GDP rather than capitalization weightings helps avoid the trap of investing increasing amounts in a country's bonds as its indebtedness--and thus its benchmark weighting--grows. In the GLADI, a country's weighting rises as its income (that is, GDP) grows. This should lead the fund to buy more bonds in countries that have a growing capacity to repay their debts.

By contrast, debt-laden countries and currency zones make up the majority of the standard, cap-weighted Barclays Capital Global Aggregate Index. What's notable is that these tend to be in so-called developed markets. Historically, debt crises have usually hit emerging markets, as those countries often suffered from poor governance and excessive borrowing. Now, though, lenders are more worried about developed markets. For example, the eurozone, which accounts for nearly 30% of the BarCap Global Aggregate Index, is feeling the heat from Greece's debt crisis, with Portugal, Italy, Ireland, and Spain also staring into the abyss.

Things don't look a whole lot better for the United Kingdom or Japan, which, combined, represent another 23% of the Global Aggregate. U.K. consumers are struggling through their own housing crisis, and the International Monetary Fund expects public debt in the U.K. to climb to nearly 82% of GDP this year, from about 69% in 2009. Bill Gross, who shares PIMCO's CIO role with El-Erian, recently described U.K. government gilts, which are British government bonds, as lying dangerously on a "bed of nitroglycerin." With two failed decades behind it, Japan looks even worse. Its debt/GDP ratio is projected to cross 200% in 2010.

Such numbers have made manager El-Erian and Toloui quite bearish on developed markets and more defensive overall. The fund's U.K. weighting is just 3% of duration, and management has reduced the fund's Japanese exposure from 8.9% of duration in September 2009 to less than 3% by year-end. PIMCO believes that a buyers' strike is possible in Japan, after its citizens have faithfully bought low-yielding government bonds for years.

Theory Meets Reality
Ignoring debt-market capitalizations helps the fund limit its exposure to such vulnerable countries, but focusing on GDP may not necessarily be an elixir either. For one thing, there can be significant disconnects between a country's GDP weighting and the development of its bond market. This can create challenges in constructing a GLADI-based portfolio. China, for instance, has the world's third-largest economy by GDP, but the fund has only about 4% of its assets there because of the relative dearth of bonds.

Furthermore, many such countries happen to be emerging markets. That helps explain why the fund's 16% position in emerging markets, while sizable, is lower than the GLADI benchmark's weighting. Still, it's important to note that the fund's 16% position is one of the bigger emerging-markets stakes in the world-bond category, and that weighting is also significantly larger than that of the BarCap Global Aggregate Index, which stands at less than 3%.

PIMCO believes that bond markets are on the cusp of a turning point. In a break with historical precedent, PIMCO now considers emerging markets generally safer than many developed markets. That's because many of these countries have relatively low debt/GDP ratios. Asian governments, in particular, learned their lessons about overborrowing after the Asian crisis in 1997 and the Russian debt crisis in 1998. Indonesia and Korea, for example, now have relatively reasonable debt/GDP ratios that are below 40%. In addition, El-Erian and Toloui point to trends in economic growth and demographics that strongly favor emerging markets.

It's worth recalling, however, that emerging-market bond funds still got walloped in 2008 during the height of the credit crisis, losing more than 17% on average. Alternatively, the typical world-bond fund lost just 1.6%. When push came to shove, investors still fled to the perceived safety of U.S. Treasuries.

So, even though the fundamentals may now favor emerging markets, it is not clear that investors would stick with emerging markets during the next crisis. As economist John Maynard Keynes said, markets can remain irrational longer than you can remain solvent.

Conclusion
Without question, this is an intriguing fund worth monitoring. However, anyone interested in investing in it would need to share PIMCO's conviction that capital flows will follow fundamentals next time around. For even if the fund's managers continue underweighting emerging markets versus their own benchmark, the fund will still have a large emerging-markets allocation compared with most rival funds. While it's possible that we have reached an inflection point, the exact timing of such a shift is unknown. True, the fund's defensive stance in other parts of the portfolio should help mitigate this emerging-markets stake. But this should not be considered a conservative offering.

I cannot say if its worth even considering such a fund.  The fact it exists should scare the hell out of you.  You have the richest bond purchasers in the world creating a structure to profit from the collapse of the developed world.  And marketing it.  These are the same bond markets that *set* the rates these sovereigns borrow at by simply refusing to fund them. 

[muldoon]

Along equally appalling lines,


Citi plans crisis derivatives

http://www.risk.net/risk-magazine/news/1590861/citi-plans-crisis-derivatives

Credit specialists at Citi are considering launching the first derivatives intended to pay out in the event of a financial crisis. The firm has drawn up plans for a tradable liquidity index, known as the CLX, on which products could be structured that allow buyers to hedge a spike in funding costs.

I believe it will reduce the systemic risk in the industry, akin to how the advent of swaps means that people don't worry about interest rate exposures anymore

Like the untraded US rates liquidity index (USRLI), the CLX is constructed as a sum of the Sharpe ratio – deviations from the mean divided by volatility – of various market factors, such as equity volatilities, Treasury rates, swap spreads, corporate bond swaption-implied volatilities, and structured credit spreads. Citi will make the CLX tradable by using fixed historical values for the mean and volatility parameters, eliminating the need for costly recomputation from lengthy time series.

Although the design of the index serves as a proxy measure for liquidity, Terry Benzschawel, a managing director of quantitative credit trading strategy at Citi in New York and head of the team researching the product, says it also tracks more traditional measures such as bid-ask spreads, trading volumes and the USRLI. He compares the potential impact of CLX to that of the interest rate swaps market.

"The great thing about the index is that it hedges your funding costs while being very simple to trade. I believe it will reduce the systemic risk in the industry, akin to how the advent of swaps means people don't worry about interest-rate exposures any more – they just pay a fee to hedge it," he says.

Like a swap, the contracts envisaged by Citi would be entered into without an up-front premium, with money changing hands according to the index's movements around a fair strike value.

The team is in talks with multi-dealer platforms over distribution rights, although Benzschawel expects most large banks, including Citi, to move into the market eventually. He has also drawn up a hedging strategy for sellers of the index, although he would not comment on the details.

"We are focused on viewing it from a brokers' perspective – we want to get natural buyers and sellers of liquidity together. But we do have an explicit hedging programme, based on the underlying assets in the index. There is a basis risk, but the beauty is that as this widens, the strategy involves buying up assets whose prices are falling, thereby providing liquidity to the market," he says.

However, there is concern from academic circles that the counterparty risks involved in such a product could create moral hazard. Chris Rogers, chair of statistical science at Cambridge University, said the only participants able to sell CLX-based products would probably be those who are too big to fail.

"This is basically a kind of insurance product. The main issue is: how good is the party issuing it? If it's going to be paying out huge numbers in the event of a crisis, will it be able to meet it obligations? Insurers can buy reinsurance for their liabilities, but the buck has to stop somewhere – there's a limit to how much a private insurer can pay out. Only the government can cover unlimited losses," he says.