PIMCO is repositioning the PIMCO CommodityRealReturn Strategy Fund from an emphasis on commodity index swaps to an emphasis on commodity structured notes, while maintaining the unique "double real^TM" investment approach that is a hallmark of the Fund. This paper addresses two questions relative to that process.

What is a Commodity Structured Note ("CSN")?
A typical CSN has an interest rate component and a component of return that is related to a commodity index. There are many variations of such notes, but the basic economics are as follows:

• The note often provides levered exposure to the commodity index, often 3-to-1.
• The note provides for a set rate of interest (often related to the London Interbank Offered Rate, or LIBOR, a benchmark for short-term rates) on the face amount, in addition to the commodity index exposure.
• The note usually has a prepayment provision which means that it will be prepaid if the face amount drops below a certain level. That level is typically above 50%.
• The tenor of the notes varies depending on negotiations between issuer and purchaser.

For simplicity, let’s assume that a CSN of $100MM face amount pays the note holder (LIBOR-Discount) on the face, plus pays (+/-) three times (the return of the commodity index minus a negotiated transaction cost). This transaction cost is comparable to the swap costs currently incurred when the fund directly has used index swaps. The "Discount" referenced above means that the note would pay a certain number of basis points below LIBOR on the $100MM face amount. (A reasonable question would be to ask how the issuer hedges its commodity index exposure. If that issuer had a commodity desk, such as the current swap counterparties of the fund, then it could hedge its commodity exposure internally, just as it currently hedges its risk on a book of commodity swaps. If the counterparty does not have a commodity desk, then it can execute a swap with one of the major counterparties, where it buys $300MM of commodity index exposure to offset the commitment to pay $300MM of commodity index exposure on the CSN that it has just issued.)

How can PIMCO use the CSN to Maintain Double Real^TM exposure?
Within the fund, the portfolio manager can conceptually "pair up" the CSN with another $200MM of Treasury Inflation-Protected Securities (TIPS). Now the fund has $300MM of securities backing $300MM of commodity index exposure. But, as noted above, one-third of these securities are generating a LIBOR-based return. Therefore the portfolio manager has multiple choices to gain TIPS exposure for the $100MM in our example:

• Negotiate a CSN that pays a TIPS-based return rather than LIBOR-based return on the face amount
• Purchase interest rate swaps, where the fund pays LIBOR and receives TIPS returns
• Buy $100MM of TIPS forward in the dealer market.

In any of these cases, the fund is now receiving a TIPS-based return on $300MM of securities along with the index return on $300MM. Let’s assume that the portfolio manager buys TIPS forward. Further, assume that the financing rate with the dealer on the buyforward is LIBOR. (This simplifies the math.) The buyforward generates a return of (TIPS-LIBOR), while the CSN generates a return of (LIBOR-Discount). These two returns reduce to a "cost" which equals "Discount," which would be the net cost compared to the alternative of owning a swap that is completely backed by TIPS. But note that this net cost applies to only $100MM of the total of $300MM of securities that are owned.

Therefore, the net impact on returns of the $300MM is simply (Discount/3). So, for instance, if the original CSN paid LIBOR-45 basis points (bps) on the $100MM, then the net cost would be 15 bps in this example. If the CSN paid LIBOR-15 bps, then the net cost would be 5 bps. Finally, note that this simplified calculation of net cost would be affected positively if the TIPS buyforwards were financed at less than LIBOR, and would be affected negatively if the TIPS buyforwards were financed at more than LIBOR.

Conclusion
Structured notes are a solution which has been used in the past to provide qualifying income to commodity mutual funds, and that is an approach which is being implemented by PIMCO. However PIMCO continues to consider other solutions which may be even more efficient for providing to investors the Double Real^TM exposure which they have sought since the inception of the fund.

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A note about risk: Commodities are volatile investments and should only form a small part of a diversified portfolio. Commodities may not be suitable for all investors. The use of derivative instruments may add additional risk. Consult your financial advisor to help you determine whether an investment in this Fund is right for you.