Chances are, when you think of the repo market you think of banks and broker-dealers and the craziness that went down in 2008. This column, based on an amazing research paper by Zoltan Pozsar, suggests that’s a mistake.

(Bonus: It calls out Pimco on window-dressing its balance sheet)

Here’s an excerpt:

“Holy Cow Batman, these bonds can outperform stocks!” Bill Gross wrote back in 2003.

Then chief investment officer at Pimco, he was describing a strategy of effectively borrowing money and using financial instruments to boost returns on fixed income securities, a process better known as deploying leverage.ors to achieve the seemingly impossible; generate the kind of profits typical of stocks while enjoying the stability typical of bonds. Super hero-like indeed. But the strategy came with a significant catch: in order to juice up returns, fund managers needed to engage with the so-called shadow banking system.

The extent to which low interest rates have driven mutual funds and other asset managers to become entwined with shadow banking is laid bare in a new research paper by Zoltan Pozsar, former senior adviser at the US Treasury.

…

For example, a cursory look at the balance sheet of Pimco’s flagship Total Return Fund shows a bevy of derivatives including futures, forwards and swaps. Moreover, its repo borrowings at the end of the first quarter of 2014 stood at $1.12bn. The fund’s subsequent annual report shows repo borrowings for the period averaged $5.73bn — more than five times the amount reported at quarter-end.

Such window dressing is usually associated with big investment banks that cut back on their leverage ahead of quarter ends as they seek to flatter their funding profiles and impress their investors.

Its presence on Pimco’s balance sheet is symptomatic of a long-term trend that has seen mutual funds evolve from staid, largely “long-only” managers into very different beasts. In addition to accumulating billions of dollars’ worth of fixed income securities in recent years, the funds have reached for an alternative financial toolkit of derivatives, securities lending and other forms of leverage, to help boost returns.

Reach for returns takes funds into the shadows