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Pimco Makes $8.1 Billion Bet Against ‘Lost Decade’ of Deflation
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By Miles Weiss


Sept. 15 (Bloomberg) -- Bill Gross’s Pacific Investment Management Co.
made an $8.1 billion wager that the U.S. won’t suffer a decade of
deflation like the one that crippled Japan starting in the 1990s.

That’s the notional value of long-term derivative contracts tied to
the U.S.consumer price index that Pimco’s mutual funds entered into
during the first half of this year, according to a regulatory filing.
The funds received $70.5 million in up-front premiums under these
contracts, known as inflation floors, in return for agreeing to pay
investors should prices decline in the 10 years ending in 2020.

“We think the possibility that the U.S. goes 10 years with stagnant or
falling prices is remote,” Mihir Worah, the head of Pimco’s real
return portfolio management team, said in an e- mailed response to
questions. “The options were priced at rich levels to the underlying”
risk, added Worah, whose funds invest in Treasury inflation protected
securities.

The cost of protecting against deflation has doubled since January as
signs of an economic slowdown in the U.S. prompted investors including
Canadian insurer Fairfax Financial Holdings Ltd. to buy the
derivatives. James Bullard, president of the Federal Reserve Bank of
St. Louis, said the U.S. could suffer the same type of economic
malaise as Japan. Pimco Chief Executive Officer Mohamed El-Erian said
last month the chance of deflation in the U.S. is around 25 percent.

‘New Normal’

El-Erian has been among the most outspoken proponents of a theory
forecasting years of below-average economic growth, elevated
unemployment and a decreasing dominance of the U.S. in the global
economy. While falling prices are not his main scenario in that
outlook, named “new normal,” El-Erian has argued that increased fear
of deflation may have been one reason for recent sell-offs in
financial markets such as the 2.8 percent decline in the Standard &
Poor’s 500 on Aug. 11.

Pimco disclosed in a June filing that its funds began writing 10-year
inflation floors during March and reported last month that they issued
additional contracts in April. According to the Aug. 27 filing with
the U.S. Securities and Exchange Commission, 25 Pimco funds entered
into these inflation floors during this year’s first half, with
Gross’s $247.9 billion Pimco Total Return fund accounting for $6.57
billion of the $8.1 billion total.

Premiums from the contracts help boost fund income as yields on
government bonds are near record lows. Potential losses are limited
because the fixed-income securities that account for a majority of the
$1.1 trillion the Newport Beach, California, firm oversees would
probably gain in value if consumer prices had a protracted decline.

‘High-Severity Outcome’

“Falling or lower inflation than we have today on a steady basis is
the bond market’s greatest friend,” said David Ader, the head of
government bond strategy at CRT Capital Group LLC, a Stamford,
Connecticut, broker-dealer. “First and foremost, it would make
government debt very valuable, because you know they will pay you back.”

Inflation floors, structured as options on the consumer price index
for all urban consumers, are similar to insurance. The buyer of the
contract pays a premium at the outset in return for the right to
receive a payment after 10 years should the CPI decline during this
period, according to D’Arcy Miell, global head of inflation products
at BGC Partners LP, a New York-based inter-dealer broker.

The size of the payment would be calculated by multiplying the
cumulative percentage decline in the consumer price index with the
face value or ‘notional’ amount of the contracts, said Mark Greenwood,
head of inflation options in the London office of Royal Bank of
Scotland Group Plc.

Pimco’s Wager

In Pimco’s case, a cumulative 10 percent decline in the price index
over 10 years would require the funds to pay out a total of about $810
million, based on that formula. The funds would pay nothing to the
counterparties and keep the premiums if prices in 2020 are equal to or
higher than in December 2009 or January 2010, depending on the
contracts.

“This is obviously a very low-frequency, high-severity event,”
Greenwood said. “Investors fear deflation, but most ascribe a low
probability to it.”

Worah said Pimco’s inflation floors are “analogous” to the $36 billion
of equity index put options that Warren Buffett’s Berkshire Hathaway
Inc. has on major stock market indexes, including the S&P 500.
Berkshire received $4.9 billion in derivative premiums in return for
agreeing to make payments to the counterparties, starting in 2018, if
the stock indexes are lower than when the contracts were signed.

Deflation Fear

With U.S. unemployment stuck near 10 percent and consumer prices
rising just 1.2 percent for the 12 months ended in July, investors
have been seeking financial products that would protect their holdings
from deflation. Canadian insurer Fairfax Financial Holdings said in
July that it bought 10-year contracts tied to consumer price indexes
with a face value of $21.5 billion in this year’s first half.

The price of 10-year inflation floors has risen to 146 basis points,
or 1.46 percent of the face value of each contract, from an average of
78 basis points in March and as little as 42 basis points in October,
according to data compiled by Bloomberg.

Pimco on average received about 87 basis points, according to the
premiums reported in its filing. Premiums on 10-year inflation floors
equaled about 108 basis points at June 30.

“We have seen tremendous growth since the end of last year, less so in
inflation caps and more so in floors,” said Allan Levin, head of
structured rates for North America at Deutsche Bank Securities Inc. in
New York. “It reflects an increasing fear of deflation.”

‘Lost Decade’

As recently as April, Pimco’s Worah wrote that inflation, not
deflation, was the primary long-term concern in the U.S., given that
the federal government could choose to address widening budget
deficits by devaluing the dollar. Scott Mather, Pimco’s head of global
portfolio management, wrote in August that the odds had increased of
the U.S. suffering a Japanese- style “lost decade.”

“If you have inflation going down toward zero, you enter a new regime
where expectations can become a self-fulfilling prophecy,” Mather said
in an interview. “That is what we saw in Japan as well,” he said,
referring to an era of declining real estate and equity prices that
began in the early 1990s.

While the derivative contracts suggest that deflation fears have
increased, the risk of deflation in the U.S. is lower than it was in
Japan because the two countries have different currency policies, said
Donald Ratajczak, an economic consultant and former director of the
Economic Forecasting Center at Georgia State University.

‘Bad Bet’

Japanese deflation stems from government policies to maintain the
value of the yen that depleted the money supply there, said Ratajczak,
who won acclaim from the Boston Federal Reserve Bank for his inflation
forecast in the 1990s.

“We don’t care as much about our dollar,” said Ratajczak. “People who
are betting on ten years of deflation are making a bad bet.”

Wall Street dealers write derivative contracts for clients that want
to bet on or protect their holdings from changes in interest rates,
commodities, stock prices and other financial markets. The dealers can
then keep the contracts, sell some of them to other Wall Street firms
through the inter-dealer market, or find counterparties such as Pimco
that will take the other side of the trade.

The value of inflation floors traded between dealers doubled to $3
billion in the first half of this year, from $1.5 billion for all of
2009, according to Miell at BGC Partners. That’s a fraction of the
$21.5 billion Fairfax Financial bought.

Buffett’s Model

Fairfax, based in Toronto, sells insurance and invests the premiums it
receives in out-of-favor securities, similar to Buffett’s investment
model. Equities are more at risk from deflation than fixed income
securities such as the Treasury bonds Pimco holds in its funds, and
which gain in value as interest rates decline.

Given the size of the inflation floors bought by Fairfax Financial,
Pimco may have taken the other side on some of them, said Greenwood.

Paul Rivett, Fairfax Financial’s chief legal officer, declined to
comment on the counterparties to the contracts.

“We are very concerned about deflation and have put this trade on to
hedge some of what we see as a not insignificant risk,” Rivett said in
an e-mail. “Unfortunately, we have not publicly disclosed the inner
mechanics of the trade.”

To contact the reporter on this story: Miles Weiss in Washington atmweiss@bloomberg.net