October 2, 2014 / 8:54 PM / 3 years ago

As Gross exit sank in, traders saw confusion, then opportunity

(Reuters) - As bond traders began what they thought would be a quiet day last Friday, a simple headline crossed their screens: “William H. Gross joins Janus Capital.”

The headquarters of investment firm PIMCO is shown in this photo taken in Newport Beach, California January 26, 2012. REUTERS/Lori Shepler

Confusion ensued. Several asset managers and traders wondered whether the news was about Pimco’s co-founder, known to most on Wall Street simply as Bill Gross, or someone else with the same name.

“The question was, ‘Is it THAT William H. Gross?'” said Lou Brien, a veteran market strategist at DRW Trading, a 22-year-old trading firm in Chicago active in futures markets.

It was indeed. The 70-year-old fund manager had quit as chief investment officer of the $2 trillion asset manager and portfolio manager of the world’s largest bond fund, the Pimco Total Return Fund, after more than four decades amid tensions with management.

As the news sank in, fixed income traders jumped. Several said they first tried to figure out the biggest holdings of the Total Return Fund, which had $222 billion under management before Gross bolted.

Then, they began selling assets that they believed to be the biggest holdings of the fund, including U.S. Treasuries, Treasury Inflation-Protected Securities (TIPS) and high-yield bonds, anticipating massive redemptions. Clients immediately started withdrawing funds, sending assets in the direction of rivals TCW, DoubleLine Capital, BlackRock Inc and Western Asset Management Co.

The Total Return Fund saw $23 billion in outflows in September, with its worst day of withdrawals in its history on Friday. Pimco declined to comment for this story.

“People scrambled to see what their positions were. People were trying to front-run any liquidation,” DRW’s Brien said.

The reaction across financial markets to news of a job change by one man was unprecedented, and the ripples still flow through the bond market. It will also feed into a months-long debate over whether massive asset managers are systemically important, like the global banks, and, therefore, should be regulated more tightly.

Interviews with more than a dozen bond traders and managers about what went on in their minds and in the markets after the news of Gross’s departure broke, paint the fullest picture yet of what happened in various markets in its aftermath.

“This event will go down as the single-largest movement of capital as a result of one person’s move from one firm to another,” said David Barse, chief executive of New York-based Third Avenue Management, which had about $13 billion under management at July 31.

The shock at Pimco rocked a market that was already nervous. Several traders said it may spark a deeper analysis of the depth and liquidity in fixed income markets, especially after financial reforms took away the incentive for large banks to hold inventory of fixed income assets that could have acted as a shock absorber.

Regulators are watching, sources familiar with the situation said. The U.S. Federal Reserve and Treasury Department are talking to market participants about Pimco, but they have not warned investors against pulling their funds, they said. The U.S. Securities and Exchange Commission, which regulates the fixed income market, is also monitoring developments, another person said.

“We are obviously trying to understand the outflows and what is going on. I think it is a natural consequence when you have somebody so high profile like Bill Gross moving out of a firm,” Daniel Gallagher, a Republican member of the SEC, told Reuters on Tuesday. “But I hope and expect it won’t become too much of a concern as the market soaks up the information about his departure.”

To be sure, Gross’s exit doesn’t appear sufficient to threaten the stability of the entire financial system. While the reaction in the markets was swift and some of its effects linger even now, these market sources said, it appears to have been largely contained.

“Markets have had a more shaky feel to them over the past few days,” said Jason Brady, a portfolio manager of Thornburg Investment Management in Santa Fe, New Mexico, which has $88 billion in assets under management. Brady said while markets started to move a bit before the Gross announcement, they have gotten more volatile since Friday. 

   

KNEE-JERK REACTION

In the minutes following the news of Gross’s exit on Friday, the reaction across financial markets was clear.

The news was released at 8:28 a.m. Eastern time. CBOT U.S. 10-year T-note futures, one of the most popularly traded U.S. futures contracts, saw volume quadruple in the minutes that followed because Pimco has a large position in Treasuries. More than 200,000 contracts traded between 8:35 a.m. and 9 a.m. as prices dropped and bond yields rose.

The benchmark 10-year Treasury’s yield rose to 2.55 percent from 2.50. Investors also sold TIPs, causing those yields to spike. Risk premiums on junk bonds rose broadly as well in anticipation of more selling and spreads widened out sharply. Eurodollar <0#ED:> contracts, arguably the world’s most widely traded futures, saw the two and three-year part of the curve cheapen.

Shares of Allianz SE, Pimco’s German parent fell more than 6 percent Friday, while those of Janus Capital Group soared 43 percent.

On desks, traders said they smelled panic. “I felt that dealer desks got defensive,” said one loan trader, who declined to be named because he was not authorized to speak publicly. “It was a tough day to get a bid.”

Another loan trader said some people saw a buying opportunity, thinking, “Let’s get out of here and let’s buy something else, probably better.”

Several of Pimco’s rivals said they saw immediate inflows as investors made that trade. “We have definitely had institutional assets in (our) direction,” said Chris Orndorff, senior portfolio manager at Western Asset Management Co. in Pasadena, California which manages $470 billion.

Jeffrey Gundlach, Gross’s arch-rival, said on Monday his investment firm, DoubleLine Capital, saw between $400 million and $500 million of net inflows on Friday.

“There has been a significant amount of fixed income assets in motion based on recent news,” Ron Redell, president of DoubleLine Funds, told Reuters. “We believe DoubleLine, as well as other asset managers, are receiving an increase in interest.”

Sources close to BlackRock Inc said the world’s largest asset manager was also seeing inflows. It has been buying Treasuries and other fixed income instruments as it is trying to win market share, one of the sources said.

“Given strong performance across our fixed income franchise, we’ve been seeing solid flows all year. In recent days, conversations with clients, particularly around our Total Return and Strategic Income Opportunities funds have increased greatly,” a BlackRock spokeswoman said.

     

EXACERBATING FEAR

Several traders said Gross’s departure came at a time when risk assets, such as stocks and high yield bonds and loans, were already trading off. Concerns about weak European growth, protests in Hong Kong and the first Ebola case in the United States have contributed to safe-haven buying in Treasuries. High yield spreads were under pressure as well because of ongoing concerns about economic growth prospects worldwide and as many investors see that market as overvalued.

Still, traders said there was no mistaking the Gross effect.

The nervousness triggered by his exit seeped into this week, and much of it has lingered. New issues of corporate bonds effectively stopped on Monday. Now, while the selling in bonds has tapered off and primary markets have bounced back, the stress is continuing elsewhere.

The bid-offer yield spreads in riskier bonds including junk bonds, non-agency mortgage-backed securities, commercial mortgage-backed securities and TIPs have remained wider than usual, according to Western Asset’s Orndorff.

If redemptions at Pimco were to increase, Orndoff said, “this could be the beginning of a pretty ugly move” in the bond market. “They could be coming in successive waves,” Orndoff said.

Additional reporting by Lisa Lee, Billy Cheung, Jennifer Ablan, David Gaffen in New York, Ross Kerber in Boston and Sarah Lynch in Washington; Writing by Paritosh Bansal; Editing by John Pickering

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