It is hard to find another household finance name with a more colorful background story than Bill Gross, the original bond king, billionaire, and cofounder of the investing powerhouse Pimco.
For 43 years Gross dedicated himself to the craft of active bond trading at the fixed-income giant, which now oversees $2.2 trillion in assets under management. But since his shocking exit from Pimco in September 2014, the legendary investor has made headlines for less savory things, including his flagging performance at Janus Henderson and his acrimonious divorce from his ex-wife Sue.
So what gave? In her new book, "The Bond King: How One Man Made a Market, Built an Empire, and Lost It All," the award-winning financial journalist Mary Childs paints a vivid picture of how it all began and unraveled for the man credited with turning a once sleepy and low-risk corner of finance into an exciting casino.
Childs, now a host of NPR's "Planet Money," started covering Pimco in the spring of 2014. Earlier that year, Mohamed El-Erian, Pimco's co-CEO and co-chief investment officer, abruptly resigned after his long-simmering tensions with Gross came to a head. In a few months, Gross himself would leave the firm he'd cofounded in 1971 to join the stock-focused Janus Capital.
The dramatic events were good fodder for a compelling story, but it was also the lack of public interest in bonds that inspired Childs to write the book. Unlike stocks, which are accessible to anyone with a brokerage account, the bond market is dominated by sophisticated institutional investors who regularly make million-dollar trades. Historically, Pimco has been the biggest player among them.
"Pimco sits at this incredibly important inflection point in our economy. They have so much influence in this extremely influential market," Childs told Insider in an interview. "I felt like there just wasn't that much public understanding or even public awareness of them and what they do. To me, that seemed like a pretty big omission, like we ceded all of this power without knowing that we had done it."
The man who reinvented the bond market
The bond market has not always been where fortunes are made.
In her book, Childs recounts Gross' early days as a securities analyst clipping bond coupons in the vault of the insurance firm Pacific Mutual. It was not lucrative or intellectually stimulating work. Gross wanted to transfer to the stock division.
At the start of the 1970s, Gross persuaded his boss to let him try trading bonds. Gradually, bonds ceased to be pieces of paper that lived in vaults and became ownership of company debts that could be traded among investors.
After years of popularizing active bond trading, Gross launched the Pimco Total Return Fund in 1987. Once ranked as the world's largest bond mutual fund, the flagship strategy boasted an outstanding long-term track record during Gross' tenure.
"Total Return was the result: the culmination of Gross's carefully built rejection of the traditional, low-risk approach to bond management; his hard-won innovations and inventions mucking through the market; his creepily prescient market calls; his instinct and skill; his years of intense work hunting, scouring the markets for underpriced bonds or smart derivative plays—all of it," Childs wrote. "The fund's endurance for decades had built, was building, Gross's legendary status. That track record was why they called him 'the Bond King.'"
The trades of a bond king
While Gross was not able to replicate his success at Janus, where he managed the Global Unconstrained Bond Fund, his trading prowess was the superpower that kept him in the game for more than 40 years.
In her book, Childs breaks down the stories and technicalities behind these big, high-risk, and masterful trades.
1. The contrarian trade
Bolstered by his ability to foresee seismic shifts ahead of the competition, Gross was known for making big contrarian calls. He was right more often than he was wrong.
In 1994, Gross and his money managers put in a bid to buy one-year Mexican bonds at a yield of 19.75%. They first made the trade during the Mexican currency crisis, in which the sudden devaluation of the peso spread to other Latin American currencies. The Mexican government was teetering on the brink of default as investors fled bond auctions.
"The rumor mill churned that, with so much firepower, whoever was buying must have known something—that a bailout was coming," Childs wrote. "Pimco didn't know anything more than anybody else, but the market didn't know it was the buyer, so Pimco traders kept mum and let the speculation run rampant, boosting bond prices all the while."
Less than two weeks later, the US Treasury Department agreed to lend up to $20 billion from the Exchange Stabilization Fund to Mexico to help it stabilize the peso. Eventually, President Bill Clinton coordinated a $50 billion bailout package from the International Monetary Fund to prop up the falling peso. Gross' high-risk bet paid off handsomely.
"Though its banks would remain in crisis for years, Mexico's debt markets emerged, depressed but stable, and the bonds paid off," Childs wrote. "Once again, it seemed like Gross had seen around the corner."
2. The power trade
During the 2008 financial crisis, Gross shifted 60% of his Total Return Fund to bonds backed by government-sponsored enterprises, specifically mortgage-backed securities owned or backed by Fannie Mae and Freddie Mac. His belief was that the two entities were "too big and too important for the government to let them go bust," Childs wrote.
At first, the securities were losing money. Then Gross said in his investment outlook and TV appearances that "a mild asset bear market" could turn into "a destructive financial tsunami" if no big buyers showed up at the market.
"Bill Gross was telling the U.S. government, in no uncertain terms, that it had to buy. Fannie and Freddie were a few weeks away from the deadline to roll over $225 billion in short-term debt into fresh, new notes," Childs wrote. "Gross was warning that the market might not show up."
His gamble paid off when the government bailed out Fannie Mae and Freddie Mac. On September 7, when the treasury secretary at the time, Hank Paulson, announced the plan to put them into conservatorship, the Total Return Fund surged by 1.3% for a gain of $1.7 billion in one day.
3. The structural alpha trades
Gross likes to use a series of reliable and replicable trades that have consistently generated alpha for his fund.
"Such trades helped especially in those periods when a manager randomly lost his touch forecasting the direction of interest rates or picking the right credit over the wrong one. Which happened to everyone: it was unavoidable," Childs wrote. "So, when Gross was off, these structural trades helped provide a cushion to fall back on."
One component of the structural trades is "Lambda Cash," an internal workaround term for "leveraged cash," because fund mandates restricted how much leverage Pimco could use.
"If you have a futures contract to buy, say, $2 million in bonds at a certain date, you don't own the bond, and the market value of your contract is close to zero. But the value will move as the bond's does, and when the time is up, you'll need that $2 million to buy the bonds as promised," Childs wrote. "Pimco figured out that, in the meantime, you could take the cash backing the future and count it as part of the position."
Because one does not need to put up all the cash until the contract expires, a Pimco trader could buy futures contracts on $2 million worth of bonds and keep $1 million in cash. When required to hold cash, a trader could also hold higher-yielding cash equivalents such as short-dated corporate bonds instead of normal cash.
"Just Lambda Cash could add 0.25 percent, 0.4 percent a year—which, in fixed income, is everything. And Pimco could do it forever," Childs wrote. "In any asset class, that's how you win: if you just don't lose all your money on some big, dumb trade gone wrong; if, instead, you steady-eddy along, eventually you'll be number one in the long-term rankings."
Another favorite strategy within Gross' toolbox of structural trades is selling volatility, in which a trader sells derivative contracts to bet that prices will keep trading within a certain range.
In the summer of 2014, Pimco sold volatility across asset classes including stocks, government bonds, corporate bonds, and currencies in a bet that price swings would be muted.
Gross amassed a huge position of more than $10 billion notional in the stock market, selling 70,000 contracts tied to the S&P index and betting that stocks wouldn't move outside a certain range. He also made similar bets, known as "strangles," in interest rates and the main credit derivative index.
"That trade, so huge, so heavy it had forced the market into its own success, had succeeded by a hair: it had worked, but barely," Childs wrote. "Spikes of volatility that would come that autumn would have crushed the firm had they arrived any sooner."
