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PIMCO Tries to Get Ahead of the Next Credit Crisis

But its intriguing approach also carries risk.


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.

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.

Kevin McDevitt does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.