Pimco is putting all their chips on the table, betting that low interest rates, along with lower and more stable global growth, will last for the next 3 to 5 years; an economic condition it is referring to as the “new neutral”.
In fact, the company is so convinced of this “sure thing”, it’s placing a straight bet–selling insurance against price fluctuations on their $230bn flagship bond fund Pimco Total Return. That means it is offering investors price stability in the bond portfolio, in return for a premium.
Instead of just simply investing clients’ money in a normal bond strategy, it is upping the ante by applying a derivatives trading scheme. To this fact, Mr. Gross asserts that Pimco is one of the biggest sellers of insurance against market volatility.
Selling volatility typically involves selling options, which would pay out if a particular market moved by more than a pre-agreed amount. For example, the Volatility index, also known as the VIX, is based on the price of a combination of options on the S&P 500. The more investors are willing to pay to protect themselves, the higher the index goes. The index is said to measure fear in the market place.
Sellers of these types of security derivatives have profited lately from the lack of volatility in the market. This has allowed Pimco to sit back and collect premiums, without having to pay out on market volatility.
Sound familiar? That’s because back in the early 2000’s, insurer AIG placed a similar seemingly riskless bet. They offered banks a way to get around the Basel rules, via insurance contracts, known as credit default swaps. They insured sub-prime securities for a premium.  At the time, I’m sure it seemed like easy money–after all, the historical loss rates on American mortgages was close to nothing. They employed extremely bright people who created incredibly sophisticated computer models and assured them that this bet was a sure thing. They wagered big on what appeared to be a lock. And for a period of time, they too sat back and collected premiums without having to pay out.
