By Anjani Trivedi
In the months before Pacific Investment Management Co. founder
Bill Gross quit in September, the firm had increased its bullish
bets on the Chinese economy.
The Newport Beach, Calif., money manager doubled down on its
position in the second quarter by selling insurance-like contracts
to investors that pay out when a country or a company defaults on
its debts, essentially wagering that China would continue at its
strong pace of economic growth.
Pimco benefits if the price of government debt rises, while
buyers of these contracts take the opposite view and wager on a
decline in bond prices or a default. In addition to offering a way
to take positions on Chinese debt, the contracts--called
credit-default swaps--provide a means to bet on the Chinese
economy, as foreign investors are limited on how much they can
invest in Chinese stocks and bonds. They are also used by some
investors to hedge positions in portfolios of Chinese corporate
bonds.
As of June 30, Pimco had sold $6.8 billion of credit-default
swaps on Chinese government debt, according to the most recent
securities filings that include the data. Most of the positions
were held in Pimco's flagship fund, the Total Return fund, which
had been managed by Mr. Gross and is the biggest bond fund in the
world by assets. As of June 30, the Total Return fund had sold
about $4.4 billion of these swaps, according to filings.
Representatives for Pimco and Janus Capital Group Inc., Mr.
Gross's current firm, declined to comment. Mr. Gross left to join
Janus after he found out that other executives at Pimco planned to
fire him.
As concerns have emerged about the slowing Chinese economy, the
world's second largest, the market for credit-default swaps on
China's government debt has doubled to $14.1 billion over the past
year and now ranks third in the world behind Italy and Brazil,
according to data from the Depository Trust and Clearing Corp. and
the International Swaps and Derivatives Association. Different
accounting and disclosure practices, though, make it difficult to
precisely gauge the market.
The market for Chinese government bonds denominated in foreign
currencies is small. Credit-default swaps offer a way to make
bigger bets on the debt than would otherwise be possible. Selling
credit-default swaps is appealing because returns can be much
higher than from buying the foreign-currency government debt.
Pimco's $6.8 billion bet appears to be the biggest position in
the market, dwarfing the roughly $1.5 billion in outstanding
dollar-denominated Chinese government debt. It is unclear from more
recent reports on Pimco's website whether the fund has since
changed its position.
China has never defaulted on its government debt. Investors said
the chances of the government defaulting are remote because the
country has huge reserves of foreign exchange and little foreign
debt.
The credit-default-swaps market allows investors "to take
exposure or hedge positions elsewhere beyond what would be possible
in just the relatively small physical [bond] market," said Mohammed
El-Erian, chief economic adviser of Pimco parent Allianz SE and the
former CEO of Pimco. Mr. El-Erian, Mr. Gross's former heir
apparent, left Pimco in January after butting heads with Pimco's
founder.
Mr. El-Erian declined to comment on Pimco's credit-default-swaps
positions.
Credit-default swaps are used by investors, hedge funds and
others to make bets on sovereign or corporate debt, or wager on a
company or country. Credit-default swaps on the subprime-mortgage
market were behind the 2008 bailout of insurer American
International Group Inc.
Over the past couple of months, the price of five-year contracts
for credit-default swaps on China have swung from a nine-month low
on Sept. 5 to a seven-month high on Oct. 16, making the country
appear riskier at times than Spain and other struggling economies.
At one point in October, when it cost about $87,000 a year to
insure $10 million of Chinese debt for five years, five-year
protection on Spanish debt cost $78,000 to insure the same
amount.
Credit-default swaps on China are volatile, reflecting
fast-changing sentiment as Beijing seeks to manage slowing growth,
high debt loads and a transitioning economy. From declining growth
last quarter--the slowest in five years--to falling home prices,
the past few weeks have seen a number of gloomy reports out of
China.
Pimco sold $4 billion of credit-default swaps on China in the
second quarter, as worries about China's growth prospects
intensified.
Some investors buy credit-default swaps to hedge a Chinese
corporate bond portfolio, said Arthur Lau, head of fixed income for
Asia, excluding Japan, at PineBridge Investments, which manages
$73.8 billion. "But given that China sovereign default is unlikely,
it may not make much economic sense to have a net long China
sovereign [credit-default-swaps] position for a long period of
time," he said. Mr. Lau said some of his firm's funds use
credit-default swaps to hedge their Chinese portfolio
positions.
Other investors, though, said because these swaps are designed
to insure against default of a sovereign bond, using them to hedge
positions in China's corporate debt market isn't effective.
Ken Hu, chief investment officer for Asia-Pacific fixed income
at Invesco Ltd., which has $789.6 billion under management, said,
"Sovereign [credit-default swaps are] the least attractive [hedging
option], because you're hedging for the wrong scenario." Mr. Hu
said there are many other ways to hedge risks in a China bond
portfolio, including options in stocks and buying onshore Chinese
government bonds.
Neeraj Seth, BlackRock Inc.'s head of Asian credit, said his
funds prefer to use options on stocks to hedge bond portfolios. He
said his funds will sometimes use credit-default swaps to broadly
bring down overall macroeconomic risk in their portfolios.
Write to Anjani Trivedi at anjani.trivedi@wsj.com