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PIMCO: Villain or Hero?

At this stage of the investigation, it's anybody's guess.

Bad Service

On Monday, PIMCO disclosed that the SEC had served the company with a "Wells Notice" for alleged infractions in pricing bonds for

That is all we know, on the record. As Wells Notices are private matters, the SEC has no filing to peruse, nor has PIMCO publicly revealed further information. Off the record, though, somebody has been talking, as various articles report that the matter involves the pricing of "odd-lot" securities. Odd lots, meaning small volumes of securities (as opposed to "round lots," which in institutional bond circles often means $1 million), tend to carry lower prices. If BOND had purchased odd lots at their discounted prices, then marked them at prices quoted by pricing services without regard to lot size, it could have generated quick accounting profits to jump-start its new, high-profile exchange-traded fund.

Perhaps that is what occurred, as the ETF dramatically beat its older mutual fund sibling coming out of the gate. However, we are already firmly into speculation, as neither PIMCO nor the SEC has offered up further information. (For the latest and greatest details, see Michael Herbst's Fund Spy, "PIMCO Put on Notice.")

Bonds Versus Stocks What we do know is that in policing bond-fund pricing, the SEC is walking a delicate line.

Bond-fund pricing is unlike stock-fund pricing. Stocks typically boast a single, centrally reported price, which makes valuing stock funds a snap. Locate the closing quote, find the last trade price of the day, and voila!, there exists one consistent price that all funds can use. (This gets complicated for foreign stocks that trade in other time zones, but we'll set that issue aside.) Bonds, on the other hand, can have many values. Call a dealer, get a quote, that is a bond price. Call a second dealer, get a second quote, now there's second bond price--which may or may not match the first.

There are many reasons for these discrepancies. Different dealers own different amounts of the securities, have different perceptions of the market's demand, and face different internal dynamics. (That is, one dealer might be shrinking its book of business, while another dealer is looking to grow.) In those aspects, bond dealers resemble stock traders, who also are heterogeneous. But bond dealers' preferences play out differently, due to the bond market's over-the-counter structure. This marketplace structure has a profound effect on how bond managers go about their businesses.

Bond managers have two ways to add value (or "capture alpha" as the jargon goes). One is to grab at dollars by betting on major risk factors, such as the direction of interest rates, the shape of the yield curve, movement in credit spreads, or changes in currencies. The danger of that approach, of course, is that the bet goes wrong and the fund loses dollars by the fistful rather than gains them. The other is the safer, albeit more modest, course of picking up nickels by finding cheap bonds, one security at a time.

Once again, that parallels stock funds, which also may grab for dollars or scoop up nickels. And once again, there is a difference. Stock-fund managers, by and large, aren't hunting for a favorable quote. If they collect a nickel, it is not because they find a better price for the security. It is because they make a correct decision while paying the market price. (Or they got lucky and credited their good fortune as insight.) Bond-fund managers have the additional tool of price discovery at their disposal. They may operate as a stock-fund manager does and purchase a security that has tightly clustered price quotes. Or they may not. They may instead create value by finding a security that is variously priced, buying the low quote, and then waiting for that quote to rise.

What Color Is Your Hat? When playing that role, bond-fund managers (and other informed, security-by-security buyers) would seem to be heroes rather than villains. Their actions of price discovery serve to tighten the quotes offered by dealers, and they improve liquidity. In short, those managers would be performing a classic role of taking advantage of market arbitrage. For example, had PIMCO bought several odd lots of the same bond at a discount, then bundled those odds and ends to form a round lot that could theoretically be more easily sold at a higher price, that would have been a textbook case of arbitrage. If that were the case, it surely would be blameless.

Presumably, that is not the SEC accusation, the claim instead being that PIMCO valued odd lots at round-lot prices while they were still odd lots. But let's think about this issue more generally. A bond is offered by several dealers, one of whom quotes a price lower than other quotes. A fund takes up that offer and buys out that dealer's position. Perhaps the remaining dealers will adjust their quotes accordingly. But if they do not, how should the fund value its new stake? As a registered fund, it is required to mark its securities to market. As we have seen, the notion of marking to market can be difficult with bonds. That's a key reason that mutual fund firms, as a matter of standard practice, almost always use prices provided by third-party services, which arrive at them by collecting information, most commonly from the aforementioned dealers. However the task is conducted, though, the market price for this new bundle of bonds would seem to be higher than their purchase price, since all dealers quote a higher price.

So the fund quotes a higher price when the day ends, to match what exists in the market. Instant gain! Villain or hero?

To look at the issue another way, one of the goals of the SEC's recent mutual fund modernization proposal is to ensure consistent pricing. By requiring all funds to file quarterly electronic portfolios, using the same data structure, the SEC will for the first time be able to scour the fund universe to find security prices that are discrepant. If two funds hold the same security on the same day at different values, it's possible that one fund is overstating its net asset value--and thus its fund performance. Thus, the SEC hopes to see one price for every discrete CUSIP.

Well that's ironic--because it appears that PIMCO's infraction, from the SEC's perspective, may be that it used a single price for one CUSIP without adjusting for the odd lot. Perhaps this single price for one CUSIP goal could be modified in the case of odd lots. But that quickly gets tricky. Which securities would have volume adjustments and which would not? At what level would the trigger go off? Would it be a two-step function, or would there be multiple pricing levels? How large would the discount(s) be?

None of this is to profess PIMCO's innocence, nor to suggest any certainty about what the SEC is trying to uncover. As I wrote at the beginning of this column, the facts are far too scanty to permit judgment. At the same time, the matter is murkier than if PIMCO were served for carrying incorrect stock prices. It's the bond market. It's complicated.

Thanks to Morningstar senior analyst Eric Jacobson for his assistance with this column.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

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