Pimco explains how frogs make butter out of government debt

You may remember Bill Gross’ sage advice to “buy cheap bonds” and his amphibious explainer:

All right fellow frogs, so we’re being repressed and shortchanged in order to allow Uncle Sam to balance its books. Whatta we gonna do about it? “Frogs of the world unite,” as Lenin might have said, and so here’s where I harken back to Mark Twain and my second lesser-told frog story. There was this other frog who instead of being tossed into a pot of hot water was left to cool its heels in a pitcher of cold milk. Unable to jump out, he churned and churned those frog legs until eventually the milk turned into butter and the hardened butter allowed him the platform to leap to froggy freedom! Well, let’s get churnin’, fellow frogs.

Well, courtesy of Pimco’s latest statistical release, here’s the recipe:

Spot the difference between the breakdown at the end of May and that at the end of February, when we first learned Pimco had “dumped” its US government debt.

“Government related” debt is now disaggregated as US Treasuries, agency securities and “swaps and liquid rates”. The footnotes to the table have a bit more detail:

Of course, this “long-short-long position” (H/T Paul Kedrosky) using derivatives is Gross’s way to retain his negative position on interest rates — he’s assuming yields will rise when the Fed stops buying US Treasuries. Bloomberg’s Susanne Walker hastaken a look at recent Pimco filings and crunched the numbers:

Gross has been betting against U.S. debt through short sales, in which the Total Return Fund would borrow and then sell government bonds, hoping to profit by repurchasing the securities at a lower price in the future. The fund’s annual report showed that, as of March 31, it had sold short about $2.2 billion of Treasuries that mature in about 10 years and $5.8 billion of agency debt that comes due in 2041.

In addition, the fund also entered into 10- and 30-year interest-rate swaps with a face value of about $15.2 billion during the fourth quarter of 2010 and first quarter of 2011, according to filings. Based on the terms disclosed in Pimco Total Return’s annual report, the 10-year and 30-year swaps held by the fund have lost about $1 billion in market value since March 31, according to Bloomberg calculations.

In order to obtain the contracts, which are the equivalent of betting against Treasuries, the Total Return Fund paid upfront premiums totaling about $331 million to 12 Wall Street banks, the filing shows.

Not that the strategy has worked out quite yet. According to Bloomberg, the TRF beat 98 per cent of competitors the last five years but only 33 percent in May, due to the decline in Treasury yields.

More margarine than butter, for now.