Why Asset Managers Shouldn’t Ignore the SEC’s PIMCO Probe

Bond market illiquidity and mega-manager leverage foster compliance issues—and not just for PIMCO, Morningstar argues.

The US Securities and Exchange Commission’s (SEC) Wells notice to PIMCO over valuations points to market-wide problems with fixed-income valuations, according to Morningstar’s top specialist. 

The Newport Beach-based bond house revealed Monday that SEC staff intend to recommend action against the firm for allegedly inflating mortgage bond values in its Total Return Active ETF. 

“The broader fixed-income pricing issues at hand are neither unique to PIMCO nor intrinsic to ETFs.” —Michael Herbst, MorningstarWhatever the investigation reveals about PIMCO, Morningstar’s head of fixed-income manager research has argued that it shows the potential consequences of market illiquidity, manager leverage, and standard bond trading practices. 

“Without more information, we can’t speculate whether PIMCO acted appropriately or inappropriately,” wrote Michael Herbst in an analysis published Thursday. “But we do know that the broader fixed-income pricing issues at hand are neither unique to PIMCO nor intrinsic to ETFs.”

The daily value of an ETF like Total Return Active—a tracker to PIMCO’s flagship fund—partly depends on assets vastly less liquid than their vehicle, Herbst pointed out. 

When PIMCO’s traders bought the small batches of mortgage-backed securities they’re under scrutiny for, the price may have reflected the awkward lot size and seller’s circumstances as much as the underlying value of the assets. Repacked by PIMCO (or any other large bond manager or asset owner) and free of external pressure to sell, Herbst noted that the same securities would be worth more. 

Finding those opportunities is part of what makes a great fixed-income manager. But in his view, it also makes for hazy valuations and compliance vulnerabilities. 

“It’s very plausible that an asset management firm with any bargaining power (and PIMCO by reputation is a fierce negotiator) could offer to take odd lots of less liquid nonagency mortgage-backed securities off a dealer’s hands for a discounted price, or that a dealer looking to get those securities off its books or curry favor with PIMCO could make those securities available to the firm at a discount,” Herbst wrote. 

Whether those factors were or weren’t at play in the Total Return ETF transactions has not yet been revealed. Either way, he argued, trading and pricing in the fixed-income market are such that they certainly could have been. 

And while the SEC has (for now) singled out PIMCO for scrutiny, its competitors have faced the same confluence of illiquidity and lot-dependent pricing that invites flexible valuations into a rigidly regulated sector. 

Herbst and his colleagues haven’t changed their view on PIMCO, which Morningstar last rated neutral overall, with a C for stewardship. 

“There is nothing definitive about a Wells notice,” he concluded. But for managers playing in the same market, there is definitive reason to watch how the SEC views their behavior. 

Read Michael Herbst’s entire post: “PIMCO Put on Notice.”

Related: SEC Warns PIMCO Over Potential Legal Action

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