Back in September, following the shocking news that after building Pimco from the ground up, Bill Gross would depart the world's then biggest bond fund after some terminal office politics, there were concerns that as a result of a surge in redemptions and liquidation sales at the Gross-controlled Total Return Fund, the already illiquid bond market would suffer and potentially go bidless across various CUSIPs in order to extract the best price from the forced seller.

This did not happen even as said surge in redemptions, which has seen PIMCO's AUM tumble by 60% from its peak holdings of $293 billion in April 2013, took place just as expected. Why not?

According to Bloomberg, the reason is that while the TRF did indeed sell tens of billions in Treasurys and TIPS, it rarely actually faced the outside market. Instead, the fund’s clearance sale was held in-house.

"The firm sold about $18 billion of Total Return’s assets to other Pimco funds and accounts between October and March, helping it meet more than $100 billion of redemptions that followed Gross’s surprise exit."

Wait, is a fund allow to reallocate securities in an arms-length transaction without ever touching (and roiling) an already turbulent market? Turns out the answer is yes, thanks to a provision in the Investment Company Act of 1940 allowing funds within the same family to trade with one another under limited circumstances.

Such cross trades are tightly regulated because they pose potential conflicts of interest, and can only be done if they’re beneficial to the buyer and seller. In this case, their use may also have limited the fallout in areas of the bond market where the fund traditionally held large chunks of debt, such as Treasury Inflation Protected Securities, or TIPS.

And since Pimco holds over a trillion in fixed income exposure across all of its funds, and since a plunge in said asset class would result in far more pain in Newport Beach, it was clear that conflicts of interest or no, both the buyer, Pimco, and the seller, Pimco, would find such a cross-trade beneficial. As a result, yet another discounting function of the market failed not because participants were wrong but because of yet another regulatory loophole which allowed a massively concentrated position to be transferred without anyone ever being the wiser.

“There was this perception that Pimco would have to dump stuff on the marketplace and that just kind of tanked prices,” said Claude Erb, a former fund manager at TCW Group. “Pimco’s forced selling did not materialize,” though, “so things recovered fairly quickly.”

One wonders then why instead of bailing out LTCM a few firms didn't simply create a well-funded subsidiary within the same fund, and offload the impacted holdings into a better capitalized entity. Perhaps the bailout culture that LTCM's rescue unleashed would never have appeared and capitalism would still be alive today instead of the centrally planned crony-klepto-socialist-fascism that passes for "markets" today.

Bloomberg continues:

Cross-selling helps funds cut transaction costs, including mark-ups charged by dealers, and also allows them to keep hard-to-find bonds within the firm. The U.S. Securities and Exchange Commission requires that the transactions occur at market prices and be advantageous to both parties, to avoid that one fund dumps unwanted assets on another, or sells them at inflated prices to artificially boost its own returns.

It's great that the transactions take place at a market price. But how is the market price set when the biggest holder of marketable bonds (aside from the Fed of course) is allowed to bypass price formation via a bid/ask process and trade at an "implied" price? To wit:

“It saves money on transaction costs and it also allows you to dispose of securities without going into the market and impacting the price,” Diana McCarthy, a partner in the investment management group of Drinker Biddle & Reath in Philadelphia, said in an interview.

Which is surely a great loophole to have, however one that merely exacerbates the market's already profound illiquidity because instead of testing the market depth with what would have been the post-crisis world's first real liquidation, stress was completely avoided and as a result nobody knows just how much can be sold without crashing the bond market.

As Bloomberg adds, the "regulatory documents don’t disclose which securities were sold through related-party transactions or which Pimco funds were engaged in the deals. But the filings do show that some Pimco funds were buying the same securities that the firm was selling during last year’s fourth quarter."

For example, Pimco Total Return Fund sold almost $3.8 billion of its inflation-linked Treasuries maturing in July 2021, with a coupon of 0.625 percent, and about $1.6 billion of 2.375 percent TIPS that come due in January 2025, according to holdings reports published on Pimco’s website.

So if Gross' former fund was selling to satisfy redemptions who was buying?  

The Pimco Income Fund, run by Daniel Ivascyn, acquired 2021 TIPS and 2025 TIPS with face values of $527 million and $984 million respectively during the same quarter. The 2025 TIPS ranked as Pimco Income Fund’s largest holding at the end of March, according to data compiled by Bloomberg.

Ivascyn’s fund, which seeks to maximize current income, previously held little or no TIPS since the middle of 2012, according to regulatory filings.

Pimco Total Return, by contrast, owned a big chunk of that market before Gross’s exit. The fund held about 13.9 percent of outstanding TIPS of an issue maturing in 2021 and 19.2 percent another maturing in 2025, excluding securities owned by the U.S. Federal Reserve, according to data compiled by Bloomberg.

“If you want to unload a position in TIPS, it’s going to be extraordinarily problematic and visible to everyone out there” said David Ader, the head of government bond strategy at CRT Capital Group.

One outstanding question is if net liquidity was being withdrawn from Pimco, just where did the internal "buyers" find the cash to buy what TRF was selling: did they merely lever up even more in repo and extract that much more equity (cash_) from existing holdings, or did they personally fund such purchases out of pocket?

This is indeed an interested conundrum because it puts into a different the recent rout in the commodity market which has resulted in few if any casualties, and brings up the question if Pimco was able to engage in such "loopholes" to avoid liquidation prices (and potentially far worse), are there other SEC "loopholes" that allow a third party to quietly fund banks, prop desks and hedge funds that find themselves in times of illiquid trouble. 

A conundrum that will not be answered until whatever "loophole" is being used no longer works.