Pimco’s Mohamed El-Erian: The emerging markets heavyweight

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.

And indeed the stories that banks tell of their most successful deals do fit in very well with the way that El-Erian sees them. A bond will be announced, and soon the book will be twice the size it was announced at. The bond will then be upsized, and the book will grow even more. The bond might even be upsized one more time, so that a $500 million bond with a $1 billion book becomes a $1.25 billion bond with a $4 billion book. At that point, of course, the size of the book bears almost no relation to the real demand for the bond. Investors pad their orders because they know they’ll be cut back, and if the market turns out not to have been able to support a $1.25 billion bond after all, then the market in that issuer’s debt will crumble as a result. But the banks will be happy: fees on a bad $1.25 billion issue are still more than twice what they would have been on a blowout $500 million bond.

It’s important to remember, though, that it’s not just banks that can sour deals. El-Erian is more than capable of destroying bond issues and blaming broad market forces all on his own. At the beginning of July, CSFB lead managed a reverse-inquiry bond deal for Colombia. An investor had some illiquid floating-rate 2005 bonds that he wanted to swap for something more mainstream. As part of the swap, CSFB decided to reopen the country’s 2033 global bonds, as well as invite other investors to buy into the reopening too.

Unappetizing deal El-Erian was very unhappy about the deal. From his perspective at Pimco, bonds in general – and emerging-market bonds in particular – were selling off, with the emphasis at the long end of the curve. The market had no appetite for anything with a 2033 maturity, and CSFB was increasing the supply of the 2033 bonds substantially. What’s more, it was exchanging bonds with no interest-rate risk – the ’05 floaters – for plain-vanilla bonds with the maximum possible duration.

Naturally, El-Erian did not take part in the deal. But he went further than that. As soon as he heard about it, he started dumping his holdings of Colombia’s 2033 bond. CSFB, attempting to support its deal, bought some of El-Erian’s bonds, but soon got overwhelmed, and the price of the bonds plunged.

El-Erian blames CSFB for reopening a long bond when all dollar curves were steepening. But CSFB could be equally angry at El-Erian for scuppering what was meant to be a market-neutral bond swap.

With hindsight, what El-Erian did was the right thing for his own investing clients: the 2033s continued on a steady decline, and are now 15 points below where they were reopened. And his sale probably didn’t make a huge amount of difference in the long term – the 2033s haven’t done a lot worse than, say, the Russia 2030s or the Brazil 2040s. But what should have been a relatively unexceptional bond swap turned into a dog of a deal largely because of El-Erian’s unscripted involvement.

El-Erian is very clear about what he wants from investment banks in bond deals. An allocation policy that excludes hedge funds is just part of it. He also wants much more honesty and transparency in the sizing and pricing of deals. No more last-minute upsizing, no more hyping the issue so that the order book gets out of hand and it’s impossible to determine what’s real demand and what’s padding. If an issuer says clearly how much it wants to issue, what spread it wants to issue at, and how this bond fits into its pre-announced funding programme, Pimco will be interested. If it comes to market opportunistically because a Wall Street bank has shown it a deal it says it can get away, Pimco will stay on the sidelines.

One more thing El-Erian won’t budge on is that banks should give Pimco what it asks for, or give it nothing. He will not be cut back or pro-rated on his orders. A fund with a $50 million order can be given $20 million and then find another $10 million or $20 million in the secondary market, somehow, if it really wants that bond. If Pimco puts in a $500 million order, however, there’s no way it can find another few hundred million dollars’ worth of bonds upon getting cut back to $200 million.

The banks nearly always play along with this demand, because Pimco is the biggest investor in the world and because it’s known to be the safest possible place to place a large quantity of bonds. They also don’t like explaining to their issuers that they cut out El-Erian, who is very close to most of the debt teams in the countries he invests in. Besides, there are very few bond issues that can withstand the departure of a $500 million order without any knock-on effect on the price.

Most of the time, he adds to his positions in a country’s debt by doing reverse-inquiry deals where he has a lot more control over the structure of the bond and who it gets placed with. If El-Erian gets in first with exactly the kind of tenor and structure that he wants in a bond, he’ll support it with a large anchor order of, say, $750 million. It will invariably be a reopening, for liquidity reasons, and he will try his hardest to ensure that the last $250 million goes into safe hands. “We are incredibly insistent on the nature of the book,” he says.

As soon as the word gets out that “a large west coast fund” is anchoring the issue, there’s no shortage of other funds wanting in. “In every case, the curve has rallied when we’ve done this,” says El-Erian pointedly.

Once he is in a credit, El-Erian finds it relatively easy to reposition himself along that country’s yield curve. If he’s feared by syndicate desks, he’s loved by traders. He’s often the first call they make when they’re trying to put together a block trade. Often, he’ll be offered big chunks of debt at a point below the bid, or get shown swaps that need a big and liquid counterparty. Pimco has its own rocket scientists with PhDs and vast arrays of Unix workstations, and is more than capable of arbitraging Wall Street’s own bond-pricing models.

Emerging-market debt is an asset class where size and sophistication pay off: the best-performing funds tend to be the largest. Pimco’s emerging-markets bond fund is the best-performing fixed-income mutual fund in the US over three and five years, with annual returns of 20.22% and 18.93% respectively. It has beaten the EMBI index in every 36-month period since inception, as well as remaining comfortably above the average emerging-markets bond fund over one, three and five years.

Much of the reason for Pimco’s outperformance can be put down to its size and sophistication. It can make money by repoing out bonds it has no intention of selling; it can play the credit default swap market to get country exposure at durations where there aren’t any bonds; and it can get paid to provide liquidity to an asset class that often suffers from gappy markets.

All the same, a lot more of the reason for Pimco’s outperformance can be put down to Mohamed El-Erian personally. Stanley Fischer, president of Citigroup International, says that El-Erian “has extraordinary ability” – something he knows at first hand, since he was El-Erian’s boss when he was first deputy managing director of the IMF. “He was my first chief of staff at the IMF, and was superb in that role,” recalls Fischer. “He really understood the issues and the institution. You couldn’t ask for more.”

El-Erian arrived at the Fund already a polished and cosmopolitan economist. The son of a French mother and an Egyptian diplomat father, he was born in New York and raised in Egypt, growing up trilingual in French, Arabic and English. When he tired of the peripatetic life of a diplomat’s son, he asked to go to boarding school. The US was too far from Egypt, so his second choice, sight unseen, was England.

Once in England, he settled into a successful academic career. His A-levels were maths, further maths (“awful, absolutely awful,” he recalls), physics and chemistry. He dropped the latter for economics, which he went on to read at Cambridge and then Oxford, where he got his doctorate.

At the IMF, El-Erian worked on the economics of Middle East peace before joining Fischer’s office. He went on to work mainly in the Middle East department, but also spent a lot of time on the Brady plan, for which he had to learn Spanish. Most of the present officials in Latin central banks and finance ministries were already in key positions at that time, and El-Erian won the friendship and respect of many of the people whose debt he is buying today.

After gaining an intimate understanding of the official sector, El-Erian moved to London for what would prove to be an intense, if short, stint as head of emerging-markets economic research at Salomon Smith Barney. He was there for little more than a year, but it was a key role: he got to understand the markets from the inside.

When Pimco came calling, the decision was quickly made.

Pimco was switching, at the time, from a model of generalists to one of specialists. Although the chief investment officer, Bill Gross, remains a jack of all trades, Pimco has appointed individuals to cover such markets as mortgages and municipals.

In a sense, the job of emerging-markets head was the most important appointment of all. For one thing, the market is vastly more volatile than any of the others in which Pimco invests. For another, the drivers of emerging-market debt are very different to the things that move fixed-income markets more generally, and the two have, at lower credit ratings, almost zero correlation.

Best in the world “Mohamed has the premier speciality area,” says Paul McCulley, head of the short-term desk at Pimco and the other big star – below Bill Gross, of course – of the firm. “He’s the best in the world at what he does, and nobody has more discretion at this firm within his field than Mohamed.”

Most important, however, El-Erian provides crucial emerging-market macroeconomic insights for Pimco as a whole. Three days a week, at noon, El-Erian, McCulley, and others meet for the investment committee, which is chaired by Gross. There, they build a consensus by bouncing ideas off each other. A typical topic of concern might be China, and its effects on US interest rates. On the one hand, competition in the manufacturing sector from China keeps US inflation low and bond yields down. On the other, China’s enormous current-account surplus means that it is one of the world’s largest buyers of treasury bonds – and it won’t simply accumulate reserves for ever. If a key source of demand for US debt were to dry up, that could affect the treasury market adversely.

El-Erian has no Chinese debt in his portfolio, yet he is the first person to whom the investment committee looks for answers to such questions.

In fact, Pimco is encouraging El-Erian to branch out. He’s one of half a dozen or so fund managers who has been given his own total-return fund – in his case it’s about $1.6 billion – to manage across all of the asset classes in which Pimco invests. The benchmark is the Lehman Aggregate, which has less than 1.5% emerging markets, and that composed overwhelmingly of low-yielding investment-grade credits such as Mexico and state-owned Mexican oil company Pemex. El-Erian’s fund – like all the others – is overweight emerging markets, since it’s an excellent source of outsize returns. But even El-Erian limits his emerging-market exposure to less than 4% of his fund.

Bill Thompson, Pimco’s CEO, says that El-Erian’s fund “is a great growth opportunity for him and for the firm. We try to increase people’s breadth of knowledge: it gives more depth and balance.”

El-Erian has only been running his total-return fund for about a year; thus far it’s been somewhere in the middle of the pack. Bill Gross is normally top, although he sometimes slips to number two; there’s a lot of competition among the other money managers to approach his performance. Thompson likens it to a horse race, although he hastens to add that “we like to have all the horses running in the same direction”.

Even more recently, at the beginning of August, El-Erian started up a new global income fund, which gives him wide latitude to invest between emerging markets, high-yield corporates and investment-grade corporates.

It’s clear that Pimco is going to continue to throw more on his plate: Thompson says that “he’ll probably have more to come”.

It’s not as if El-Erian is underworked. His day starts at the unholy hour of 3.15am, when he makes a phone call from his Bloomberg-equipped home in Newport Beach to the trading desk in London. After dealing with the needs of the two most recent additions to his family – a newborn daughter and a puppy – he gets in to the office between 4.30am and 4.45am, and spends his first hour putting together a daily emerging-markets briefing note that is distributed throughout the company.

Once a week, there’s a global conference call, during which the three professionals in Newport Beach, two in Munich and one in Singapore talk first about global macroeconomic themes, second about risk issues and the way their funds are positioned, and third about fund flows in and out of the asset class. The results appear in a weekly newsletter, which complements the daily one.

From 5.45am to noon, El-Erian gets the meatiest part of his job done – sitting at his trading desk, he enters and exits positions and reads the market. At noon, there’s the investment committee meeting, and at 1pm California time the New York markets close. From 2pm to 4pm there are administrative meetings, and El-Erian normally heads home – which, of course, is a very different thing from stopping working – between 4pm and 4.30pm.

And once every six weeks, El-Erian takes a trip abroad, meeting with everybody from finance ministers and senior bankers to academics and reporters.

El-Erian’s investment style is bold. Investors used to looking at investment banks’ model portfolios would be shocked by the large bets he takes. While banks go overweight or underweight a few tenths of a percentage point here or there, El-Erian puts his money where his convictions are.

A snapshot of his fund at the beginning of August shows 32 members of the EMBI+, the index against which El-Erian is judged. Pimco has a zero weighting in no fewer than 12 of them: Argentina, China, Côte d’Ivoire, Hungary, Lebanon, Nigeria, Philippines, Poland, Thailand, Turkey, Uruguay and Venezuela. These are huge underweights: Venezuela accounts for 3.7% of the benchmark, while Turkey is 5.2%.

“We have an obsession with black-hole risk,” says El-Erian, who got rid of all his Argentine debt long before most other fund managers, and who did so comprehensively, not timidly.

Being short Venezuela and Turkey has not been such a smart move during the huge run-up in emerging-market debt, but El-Erian is a long-term investor: he buys good macroeconomic stories, rather than trying to time the market and ride a rally in bond prices from 50 to 60 which is backed up by the hope that the official community will step in if necessary. “Mohamed will bet improving fundamentals which are backstopped by moral hazard,” says McCulley. “He’s willing to let someone else make the pure moral-hazard money.”

Naturally, if El-Erian is short so many countries, he must have some large overweights as well. He is famously overweight Brazil, a bet that has paid off in spades, but in fact his 22.9% holding is not vastly greater than the Brazil’s 17.7% weight in the index. And most of that holding is in short-dated EI bonds, with an average maturity of 18 months: El-Erian could be out of Brazil faster than most people think.

Perhaps the most surprising overweight is tiny Tunisia, a country with a mere 0.3% weight in the index but which El-Erian has put 6.2% of his money in. In total, El-Erian is overweight just 11 of the 32 countries: he picks carefully, and then bets big. The full list of his favourites: Brazil, Chile, Croatia, Ecuador, Guatemala, Mexico, Panama, Peru, Russia, South Africa, and Tunisia.

El-Erian’s total funds under management has risen so far now that many observers wonder whether he’s capable of exiting such a large position without destroying his own portfolio. “When you have a relatively illiquid market you have to run it like a supertanker, changing direction miles in advance,” says Gross. For liquidity reasons alone, he says, “I don’t think our allocation to emerging markets could be that much greater than it is now.”

What’s certain is that El-Erian will remain a very public figure, popping up all over the world to harangue and advise both the public and the private sectors. “More than anybody else here, Mohamed’s an ambassador,” says Gross. “It’s not our function to be a banker, but he’s more of a banker than anybody here.” After all, El-Erian lends billions of dollars to countries worldwide that desperately need the cash.

In the Pimco lobby, a well-preserved piece of paper is framed for waiting visitors to admire. It’s a 50-year bond, issued in 1906 by the State of the Amazon in Brazil, and paying 5% interest. Back then, emerging markets were growing fast, fuelled by large capital flows from the developed world. The optimism of the investors of 100 years ago, however, was sorely misplaced.

Part of Mohamed El-Erian’s job is to try to create a world where Brazilian states might once again be able to issue long-dated bonds at 5% interest. And if he’s going to do that, he’s going to have to throw his weight around a little bit.