Pimco mutual funds entered into long term derivative contracts with a notional value of $8.1 billion during the first six months of 2010 that will require Pimco to pay investors should prices decline over the ten year period ending in 2020. For their trouble Pimco received $70.5mil in premiums.
I had written before about the bet Mr. Watsa and Fairfax made on deflation:
The relevant part being….
“Yes. So we’ve put a little more than a $180 million to the CPI linked derivative contracts. So obviously the maximum we can lose, we bought them for $180 million, and the maximum we can lose over 10 years is $180 million. The notional amount that we disclosed is about $23 billion and they fluctuate, Jeff. They fluctuate up and down and on a daily basis, it’s difficult to determine, but it does give us significant amount of protection.”
Watsa has bought some protection against a long term deflationary environment. If his hunch is correct he can make a bundle (note the notional contract value of $23 billion), and the most he can lose is $180 million. This is very similar to his bet on contract default swaps that were an incredible homerun.
It could very well be that Pimco is the actual counterparty to the Fairfax investment.
Bloomberg quoted Pimco as saying the following:
“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.
These contracts are spread across 25 different Pimco funds.
While getting a small premium against huge notional potential liabilities frightens me, as it is not hard to recall what writing CDS contracts did to AIG it doesn’t seem to be a bad idea for Pimco. The reason of course being that if such deflation were to occur the value of Pimco’s huge $1.1 trillion fixed income portfolio would more than offset any losses incurred.
Bloomberg estimated that a cumulative 10% decline in the price index over the period of the contract would require the funds to pay out roughly $800 million. If consumer prices were to stay even flat the funds would pay out nothing. It does seem like a pretty good bet to me although I will happily put such decisions in my too hard pile and move on to things that I think I am more capable of understanding.
What I do find absolutely amazing is the huge differences in opinion between some of the finest investors over the past few decades. On one hand you have Watsa guarding against deflation and on the other you have someone like Jim Rogers warning against hyperinflation. These are two extremely smart, extremely successful investors taking the exact same information and reaching completely opposite conclusions.
What is an investor to do ? My answer is stay within your circle of competence and don’t fool yourself into thinking that you are smarter than you really are. Pay attention to what people like Watsa and Rogers are saying, but don’t act on anything you don’t fully understand.
Here is the link to the full Bloomberg article: