Bill Gross turned to derivatives to make a big bet on emerging-market debt after taking the helm of a Janus Capital Group Inc. fund more than a year ago. One thing he didn’t let stop him: regulatory guidelines that lay out how much fund managers should use them.
Gross wagered in his Janus Global Unconstrained Bond Fund that sovereign debt from countries including Mexico and Brazil, as well as corporate bonds, would outperform. He structured his positions by entering into swaps contracts in which he agreed to insure against default almost $1.7 billion of bonds as of the end of June, the most recent data available show. While most funds limit their exposure to just a small percent of assets, Gross’s use exceeded the market value of his fund’s holdings, which were $1.46 billion at the time.
In order to write this much insurance, Gross took advantage of a gray area under U.S. securities rules in determining how much collateral to set aside to cover potential losses on the swaps contracts. It’s an approach that runs counter to what has been directed -- but not legally required -- by the U.S. Securities and Exchange Commission. The swaps positions also go beyond what was initially permitted in the fund’s disclosure documents after Gross joined Janus in September 2014. Those documents have since been updated to allow him to have unlimited swaps exposure.
“We believe that our procedures are consistent with existing SEC guidelines,” said Erin Passan, a spokeswoman for Denver-based Janus.
The credit default swaps in Gross’s portfolio are low risk and have a low probability of default, reducing the possibility that they would have to be unwound, she said. Not one of the credit default swap positions have posted a loss since Gross started running the fund and they’ve contributed more than 0.5 percent to fund performance, according to Passan. She said Gross wasn’t available for an interview.
Soros Redemption
Gross’s insurance writing is part of a broader strategy in which he has said he’s more focused on generating income as a 30-year bull market that led to rising bond prices nears an end. But the strategy requires the Janus fund to load up on derivatives. That can trigger losses for funds when markets don’t perform as expected, which happened during the credit crisis in 2008.
“There is as much interest rate risk and as much credit risk in the credit default swaps as in the rest of the $1 billion portfolio combined,” said Craig McCann, an economist at Securities Litigation & Consulting Group, who reviewed Gross’s fund holdings.
So far Gross’s use of derivatives hasn’t led to outperformance. Since he took over management of the Janus fund, it’s lost about 1.7 percent, a stark drop off from his former run as manager of the Pimco Total Return Fund. He built that fund into the world’s biggest bond fund by consistently generating market-beating gains.
It was disclosed earlier this month that one of Gross’s biggest individual backers, billionaire George Soros’s investment firm, pulled $490 million from a separately managed account that followed the same strategy as the Janus unconstrained mutual fund. If more investors flee, the 71-year-old Gross could be forced to unwind positions.
‘Extreme Outlier’
Many fixed-income funds use swaps to make bets on bonds without actually buying them, but they generally represent a small portion of holdings. That held true for Gross when he managed Pimco Total Return.
Less than 5 percent of U.S. mutual funds wrote credit default swaps whose value exceeded 12 percent of net assets, according to an academic paper published last year by Wei Jiang, a finance and economics professor at Columbia University, and Zhongyan Zhu of the Chinese University of Hong Kong. The study looked at 309 mutual funds with exposure to credit default swaps.
“It’s very, very rare to have such a high percentage of CDS,” Jiang said in an interview when asked about Gross’s fund. “It’s an extreme outlier.”
Because managers who write, or sell, credit default swaps can increase their exposure to certain bonds with only a small down payment, holding these derivatives is like using borrowed money to make investments. To limit fund leverage, the SEC requires that managers set aside, or earmark, securities that can be sold to meet potential losses stemming from derivatives. Mutual funds generally note which securities have been earmarked to meet the collateral requirements rather than putting them into a separate account.
Up until the financial crisis, the SEC allowed mutual funds to reserve only enough cash or easy-to-sell securities to cover the daily gain or loss on a swaps contract. But the agency took a stricter stance on credit default swaps after global insurer American International Group Inc. almost went bankrupt on its losses from those contracts and needed a $182 billion bailout.
Starting around 2011, the SEC began telling mutual funds in public letters that they should set aside a dollar of physical assets such as cash, stocks or bonds for each dollar of bonds that they agreed to insure. In effect, funds were advised to assume that every bond they insured would default. If adhered to, the recommendation would cap the amount of swaps funds can write to the net value of assets they can post as collateral. Gross’s fund isn’t following those guidelines, with the value of his insurance contracts exceeding the net asset value of his holdings by about 16 percent as of June 30, according to the most recent data available.
“Almost all mutual funds follow the SEC’s position,” said Robert Plaze, a former SEC attorney who now helps represent about 850 registered funds at law firm Stroock & Stroock & Lavan LLP. “But those who choose to follow a different methodology aren’t breaking the law because the SEC has never put its position into any actual regulation.”
Disclosure Changes
Gross doesn’t have much in the way of cash or super-safe securities, such as Treasuries, to set aside as collateral against the credit swaps that his fund has written. Instead, he’s mostly earmarked corporate bonds that are rated just above or below junk status, filings show.
Janus sent a letter to the SEC on March 9 telling the regulator Gross’s fund would protect against losses differently. The agency hasn’t yet responded to it, according to a person with knowledge of the situation who wasn’t authorized to speak publicly.
What Janus proposed is to set aside the estimated recovery value for some of its swaps, rather than the full face value, according to the letter. Recovery value refers to the amount that investors have historically recouped when a bond issuer defaults -- the average is 40 percent for corporate bonds, according to generally accepted industry standards, and 25 percent for Mexican and Brazilian sovereign debt, according to information provider Markit Group Ltd.
Several weeks after Gross took over management of the unconstrained fund, Janus filed a prospectus with the SEC saying that the face value of its credit default swap exposure would be capped at 10 percent of assets. In November 2014, the fund made another filing that removed the reference to the 10 percent cap. By the end of December, the fund’s swaps exposure to corporate and sovereign debt was 42 percent of net assets.
By June 30, the credit default swaps exposure was $1.69 billion relative to fund assets of $1.46 billion. At that time, the fund had set aside $1.32 billion of securities to cover SEC earmarking and broker margin requirements on derivatives and transactions such as short sales, according to its annual report.
Last month, Janus updated its prospectus to say that Gross’s fund could enter into various credit default swaps “without limit” to add leverage to the portfolio.
SEC Changes
Funds that use derivatives can reduce their earmarking obligations by entering into offsetting transactions. It isn’t clear whether any of the Janus fund’s other derivatives would offset some of the exposure Gross has taken on by writing credit default swaps.
The SEC plans to vote Dec. 11 on the first set of comprehensive rules on mutual funds’ use of derivatives, according to two people familiar with the matter. The agency would have to solicit public comment on the plan and later take a separate vote to approve formal regulations. Approaches the agency is considering could lead to formal regulations on swaps collateral that force Gross to change his ways, according to a separate person with direct knowledge of the regulator’s thinking.
Judith Burns, a spokeswoman for the SEC, declined to comment.
The SEC so far has made its view on credit swaps collateral known through the routine letters it sends to mutual funds when reviewing their disclosure documents, such as annual and semi- annual reports. In addition to Gross, there are several investment funds that have told the SEC they would use different criteria when setting collateral aside for some of their credit default swaps.
Big asset managers, such as Pacific Investment Management Co. and Fidelity Investments, have agreed to follow the SEC’s preferred protocol. KKR & Co. and Credit Suisse Group AG weren’t able to start new funds until they revised their collateral policies to adhere to the SEC’s guidelines, according to public comment letters. This year, the agency has continued to stipulate that funds should earmark enough securities to cover the full value of the bond insurance they write.