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| Pimco's Mohamed El-Erian is the world's biggest buyer of emerging market debt |
MOHAMED EL-ERIAN, the chief emerging-market bond investor at Pimco in California, likes to tell the story of a trip to Asia at the beginning of 2002. A large investor there was dipping its toes into El-Erian's market. Brazil was doing what it tries to do every January - issuing a 10-year bond. The Asian investor put in an order, received an allocation, and watched as the new bond immediately fell off a cliff, dropping three points in one day.
The fund manager reported this development red-facedly to his superior, the shell-shocked company sold the bond taking a large hit, and an important investor was lost to the asset class for the foreseeable future.
El-Erian was furious: this kind of deal gave emerging-market debt a bad name and kept large numbers of investors on the sidelines. The asset class has delivered stunning returns in recent years, but bond investors don't like to invest in Wild West markets. If emerging-market debt was ever to mature, deals like this simply could not keep on coming to market.
What's more, the deal soured the market for Brazilian debt for months, making the country's fiscal situation much more tenuous than it might otherwise have been.
"I was very marked by the Brazil 12s," says El-Erian. "A bad capital markets transaction will contaminate the fundamentals."
El-Erian himself has had a stellar time since then. He was an important fund manager at the beginning of 2002, with $121 million in his flagship dedicated fund, slightly under $1 billion in total dedicated money, and just over $4 billion under management overall. Now, however, he's simply enormous: his headline fund reached $1.08 billion at one point, his dedicated funds are slightly under $4 billion, and his total funds under management are around $11 billion, more than three times the sum of his closest competitor.
El-Erian is the 800-pound gorilla of the buy side - by far the world's largest emerging-market bond investor, and the man who, rumour has it, was single-handedly responsible for much of Salomon Smith Barney's plunge down the emerging-market league tables in 2002.
For not only is El-Erian big, he is also not shy about throwing his weight around. He took no part in the Brazil 2012 deal, but that didn't stop him from placing Salomon Smith Barney - a co-lead of the bond, along with JPMorgan - in what's known as the "penalty box" for most of the subsequent year.
When an investment bank does something that upsets El-Erian - and they all do from time to time - he's prone to express his displeasure by boycotting all of their deals for a period commensurate with the severity of the offence. He will also tell any issuers that care to ask that he won't be buying any of their bonds if they use a certain house. Given the amount of competition between investment banks for sovereign mandates, it's hardly surprising that a long-standing presence on El-Erian's hit list might begin to have an adverse effect on league-table performance.
El-Erian has a very clear idea of how investment banks should behave. Essentially, he tells them what to do and how to do it. He's the man with the money, while they're ultimately no more than middlemen, so he should have at least as much influence on how deals are structured as they do.
What's good for El-Erian...
Of course, the people running the debt capital markets desks at the large investment banks do not much appreciate being told how to do their jobs, especially when they see no discernible difference between what El-Erian wants from them and what would maximize the value of his own portfolio. The bankers have many other clients to serve, from issuers to hedge-fund managers.
Most of the acrimony centres on El-Erian's notions of the kind of investors who should and shouldn't be allowed to participate in bond deals. Look at those Brazil 12s, he says: 30% of the deal went to one hedge fund, which immediately flipped the bond and sent it - along with the rest of the Brazilian curve - plunging. Hedge funds typically short a sovereign before they buy its new bonds, which means that they aren't hurt - indeed, they can benefit - if the issue damages the credit in the markets. El-Erian points to countries like Colombia and Panama falling as much as five points in the days leading up to a new issue - a clear sign that hedge funds have got wind of the forthcoming bond, and are positioning themselves for it by going short.
The banks, of course, say that they are very careful about whom they sell to, and that they would never let word of a new bond leak out days in advance, would never sell large chunks of a new issue into the hands of flippers, and are well aware of which hedge funds are good for the asset class and which are bad. If a bond issue goes wrong, they say, there's a reason for it: the treasury bond market suddenly moved, or the Dow plunged, or a key tax reform got found unconstitutional by the country's supreme court.
But the fact is that the banks, squeezed by fee compression and low levels of bond issuance, have an incentive to work for their own short-term gain rather than for the long-term well-being of the asset class. "They're fighting each other while fees are coming down," says El-Erian. "In the old days, reputation was really important. Now your ability to get the next deal is much reduced, so you maximize your fees from the transaction - you overhype the deal and you upsize."
Not all banks are equally bad: the key culprits in the eyes of El-Erian are those with large emerging-market desks that need a steady deal flow just to cover their fixed costs. El-Erian won't give names on the record. He doesn't need to. The big banks in emerging markets are Citigroup, JPMorgan, and Deutsche. Those houses in turn create a highly competitive market in which such banks as CSFB, UBS, Goldman Sachs, Merrill Lynch and Morgan Stanley all end up playing much the same game, if for slightly smaller stakes.