dangerous side effect of 2nd wave of turmoil

Pimco Says World Economic Crisis Faces ‘Second Wave’

By Wes Goodman

Feb. 11 (Bloomberg) -- Pacific Investment Management Co., which runs the world’s biggest bond fund, said the global economy faces a “second wave” of turmoil unless governments adopt larger spending plans.

“The economic setback is still in its early stages,” Koyo Ozeki, head of Asia-Pacific credit research at Pimco’s Tokyo office, wrote in a report published today on the company’s Web site. “Any further decline in housing prices could accelerate the downturn, intensifying the pernicious feedback loop and possibly leading to a second wave in the financial crisis in the next six to 12 months.”

The lack of specifics in U.S. Treasury Secretary Timothy Geithner’s financial-system rescue plan triggered a 4.9 percent slide in the Standard & Poor’s 500 Index yesterday, the steepest since President Barack Obama’s inauguration. Advanced economies are in a “depression” that may get worse, Dominique Strauss- Kahn, Managing Director of the International Monetary Fund, said on Feb. 7.

Ozeki this month said investors may want to hold off buying Japanese corporate debt until yields rise to reflect the full extent of the slump. Pimco is also avoiding longer-maturity bonds elsewhere in Asia as governments increase spending, Douglas Hodge, managing director for the region, said in an interview yesterday. Bill Gross, Pimco’s co-chief investment officer, said on Feb. 5 the Federal Reserve will have to buy Treasuries to curb yields as debt sales increase.

‘Second Wave’

“To overcome that second wave, governments worldwide would have to spend vast quantities,” Ozeki wrote. “The resulting erosion in their finances would increase the risk of dangerous side effects.”

Trading was closed today in Japan for a holiday, and Ozeki could not be reached at his office.

The cost of protecting Asia-Pacific bonds from default rose on speculation Geithner’s bank plan won’t be enough to revive the world’s largest economy.

The Markit iTraxx Asia index of 50 investment-grade borrowers outside Japan increased 10 basis points to 355 as of 9:14 a.m. in Singapore, according to Barclays Capital. Japan’s corporate bond risk climbed to a record yesterday.

Credit-default swap indexes are benchmarks for protecting bonds against default and traders use them to speculate on changes in credit quality. The swaps pay the buyer face value in exchange for the underlying securities if a borrower fails to adhere to its debt agreements. A basis point, or 0.01 percentage point, is worth $1,000 on a swap protecting $10 million of debt.

Toxic Assets

Geithner pledged government financing for as much as $2 trillion to spur new lending and address banks’ toxic assets, seeking to end the credit crunch hobbling the economy. He said he is still “exploring a range of different structures” to implement the plan, outlined in Washington yesterday.

“The worst cannot be ruled out,” Strauss-Kahn said in Kuala Lumpur, where he was attending a gathering of central bankers from Southeast Asia. “There’s a lot of downside risk.”

Investors will demand a greater yield premium to hold longer-dated Asian bonds over short-term securities as the supply of government debt increases, Pimco’s Hodge said in an interview with Bloomberg Television yesterday in Kuala Lumpur.

Corporate bonds have trounced Treasuries so far this year as government efforts to spur economic growth led some investors to favor higher-yielding assets.

Extra Yield

U.S. company debt rated A by Standard & Poor’s returned 0.8 percent so far in 2009, according to Merrill Lynch & Co.’s Corporate Master index. Government securities fell 2.7 percent, based on the company’s Treasury Master index.

Investors demand 4.74 percentage points of extra yield to buy the A rated bonds instead of Treasuries. While the spread has narrowed from 6.49 percentage points in December, it is still up from 2.30 percentage points a year ago, the Merrill indexes show.

In Japan, A rated corporates yield 1.74 percentage points more than government bonds, widening from 0.58 percentage point 12 months ago, according to Merrill’s Japan Corporate Index. Company debt fell 0.5 percent so far this year and government securities dropped 0.7 percent, the indexes show.

Japan’s struggle to revive growth in the 1990s, the so- called Lost Decade, offers lessons on how the world economy will develop, Ozeki wrote in his report.

The government has limited ability to keep prices for real estate and other assets from falling, he said.

‘Downside Risks’

“In a situation where the economy continues to retreat amid a financial crisis, demand for real estate will not recover until a severe enough drop in prices significantly reduces the downside risk of holding property,” he wrote. “In Japan’s case, it took 15 years for real estate prices to hit bottom.”

Pimco, based in Newport Beach, California, is a unit of Munich-based Allianz SE, Europe’s biggest insurer. It’s Total Return Fund is the largest bond fund with $136 billion in assets. It returned 2.7 percent in the past year, beating 89 percent of its competitors, according to data compiled by Bloomberg.

Gross said in his Feb. 5 interview on Bloomberg Television that he recommends high-rated company and bank bonds because they offer higher yields than Treasuries.

To contact the reporter on this story: Wes Goodman in Singapore at wgoodman@bloomberg.net.

Last Updated: February 11, 2009 04:16 EST