Pimco has become a major force in global emerging-market debt (EMD), but indirectly, as it seeks to profit from writing insurance on the bonds of sovereigns with large foreign-exchange reserves, says Emanuele Ravano, managing director in London.
He says the firm has tripled its exposure to emerging markets since the 2008 crisis to around $170 billion. “We have the biggest relative position to emerging markets ever, relative to developed markets,” Ravano says. “Emerging markets have better fundamentals.”
But he describes Pimco’s positions to EMD as “risks that are self-liquidating”.
Instead of investing directly in long-dated securities that could be illiquid in the event of a market panic, Pimco is selling credit default swaps (CDS) against the debt of big emerging markets with substantial cushions of foreign reserves.
It's a strategy that, before the financial crisis, was dominated by AIG. To some extent, Pimco has become a leading writer of CDS, but against a different range of debt securities. The buyers of insurance are banks and other financial institutions that, for regulatory or risk-management reasons, need to reduce their balance sheets.
Pimco has to be careful about the government bonds it is insuring, because EMD can be volatile and it needs to be able to ride out such swings. That’s why it looks for emerging markets with sound fundamentals, including large pools of reserves; and when it writes CDS contracts, it does not use leverage.
Pimco also derives a lot of its EMD exposure via currency forwards and other plays, mostly betting on emerging-market currencies to appreciate against the dollar.
It does take some direct positions by owning emerging-market bonds, such as Brazilian sovereign debt, but is concerned about having to mark these to market, says Ravano. That’s because many of the investors that have moved into EMD this year are new to these assets.
“Many European investors have moved into emerging-market debt, but they are not natural holders of volatility,” Ravano explains. These pension funds and other investors are likely to sell if there’s a geopolitical surprise. “New players don’t know the cost of exiting in a moment of panic,” he says. “You have to manage your tail risks very carefully.”