Pacific Investment Management Company LLC (PIMCO) has been managing long-term assets as a part of our core Total Return portfolios since the firm's inception in 1971. In 1983, we began managing specialty Long Duration portfolios.

What Is Duration?
Before describing our Long Duration strategy in detail, it is important to understand the concept of duration. Duration measures the price sensitivity of cash flows to changes in interest rates. This is demonstrated by the adjacent diagram. The blue boxes show the price changes that result from a one percent move in interest rates. If interest rates rise from 8 percent to 9 percent (or fall from 8 to 7 percent), a bond, or portfolio of bonds, with a duration of 2 years will decrease (or increase) in principal value by 2 percent. If the portfolio's duration is 5 years, its value will fluctuate by 5 percent; a higher, or longer, duration indicates that the portfolio has a greater price sensitivity to interest rate movements. The green boxes represent a more volatile interest rate environment, with rates changing by 2 percent, or 200 basis points; a larger change in rates produces a greater change in prices. In short, duration is simply a method of measuring interest rate risk.

Uses Of Long Duration Portfolios
Clients use Long Duration bond portfolios for various purposes. Several clients invest in Long Duration assets as a tool to increase their exposure to interest rate movements. These clients assume greater than average interest rate risk for the potential to achieve greater than average expected returns. Other investors view high quality, long duration, fixed income assets as a hedge against deflation, or disinflation, within their broad asset allocation framework. In either case, a Long Duration portfolio will be structured according to PIMCO's broad fixed income philosophy. This conservative philosophy and expertise guides all of our Total Return portfolios; therefore, our Long Duration portfolios can be viewed, simply, as Total Return portfolios with longer absolute durations.

Alternatively, many of our clients use Long Duration separate accounts to partially or fully match, or "immunize," their pension liabilities. Immunization, as defined by one of its earliest proponents, is "the investment of the assets in such a way that the existing business is immune to a general change in the rate of interest."

After PIMCO provides a thorough analysis of the costs and benefits of numerous immunization strategies, these clients choose among several methods to hedge their liability risks. Depending upon the optimal solution, these strategies can range from managing a portfolio versus an index which shares key characteristics with the liabilities to full immunization of the liabilities.

PIMCO's Long Duration Investment Philosophy
Similar to the core Total Return approach we have practiced for over twenty-five years, PIMCO's Long Duration investment philosophy can be summarized as follows:

PIMCO is guided by several key principles which embrace many methods of adding value: First, major shifts in portfolio strategy are driven by longer-term trends. Our annually updated secular outlook, based upon predicted trends over the next 3 to 5 years, determines a general duration range for the portfolio in relation to the market or to the client's specific benchmark. Short-term, cyclical economic considerations determine duration targets within this range. For example, if we are bullish on interest rates, then the durations of our portfolios will be longer than the durations of their respective benchmarks. Whereas the absolute durations of portfolios will differ, their relative positioning to their respective indexes will be similar.

Our second key principle is the belief that consistent above-market returns are produced by diversifying risk across a broad range of investment parameters, including duration, yield curve positioning, sector allocation, credit and issue selection. We believe that yield curve exposure, or maturity structure, should be actively managed to maximize expected return given a forecast for the future shape of the curve, as well as an understanding of the trade-offs inherent to repositioning the portfolio.

An interest rate volatility forecast is crucial to the management of a bond portfolio since volatility impacts the relative performance of bond market sectors and of portfolio structures. Given a duration target, a portfolio consisting of a mixture of long and short bonds will perform differently than a pure intermediate portfolio, depending on volatility and changes in the shape of the yield curve. Furthermore, we utilize all sectors of the fixed income market, including governments, corporates, mortgages, and hedged international, making sector shifts depending upon changes in relative valuations and yield spreads. Sophisticated proprietary software assists in the evaluation of sector opportunities and in the pricing of specific securities.

Additionally, from a "bottom-up", or micro perspective, PIMCO utilizes proprietary analytics, in-house credit research, and cost-effective trading to add additional value. Our proprietary analytics help us to understand the inherent risks of a given security as well as the relative values in the market. PIMCO's credit research is essential to the corporate security selection process. Effective analysis of financial statements, combined with knowledge of capital structures and corporate management, increases the probability of buying bonds that may be upgraded, while avoiding those that may be downgraded or default. Cost-effective trading takes on added importance in a brokered market, where bid/ask spreads and other transaction costs can vary greatly. Size and clout in the marketplace allows large participants, like PIMCO, the power to regularly negotiate the best possible executions.

Our typical Long Duration portfolios have averaged Aaa, the highest rating category, over the past several years, although this may vary depending upon our outlook for the economy, interest rates, and quality spreads. In general, we do not believe it is appropriate to expose Long Duration portfolios to significant credit risk because most investors view these portfolios as a vehicle to maximize return or safeguard principal in a falling rate environment. Such periods would normally be associated with recessionary, or even depressionary, conditions in which default risk rises and credit spreads can widen dramatically. Thus, the portfolio's performance would be hindered by this credit risk at exactly the same time as investors are depending on it as a hedge.

Since we never rely solely on any one strategy to generate excess returns, we are capable of outperforming the market even if some of our strategies are not successful. For instance, PIMCO constrains interest rate risk by confining the portfolio's duration within a moderate range around the duration of the index or the liabilities. Operating within a moderate duration range allows a consistent opportunity to achieve above-benchmark returns while ensuring that duration is not the sole determinant of performance.

The Pitfalls Of Passive Portfolio Immunization
Many pension funds naively immunize their liabilities via passive portfolio strategies. These strategies can be successful under the right circumstances, but many practitioners do not completely understand the inherent costs and risks of such approaches.

The simplest form of immunization, known as "cash flow matching" or "dedication," involves the purchasing of assets that generate cash flows which exactly offset each liability at each due date. This passive strategy is only feasible when the future liabilities are known with certainty. In most cases, however, liabilities do not remain constant and dedication is not risk free. Additionally, dedicated strategies are extremely constrained since they must purchase assets which generate specific cash flows on specific dates. They can not, therefore, effectively search for value and are often forced to accept lower expected returns. This is a hidden cost of dedication, as it leads to a greater initial funding requirement. Although the initial matching of the durations of the asset portfolio to its accompanying liability stream is a key step in hedging investment risk, it does not guarantee success. One must allow for the fact that durations change as yields change. Convexity risk results when this effect is not properly accounted for, as illustrated in the accompanying diagram. The solid line represents the value of the assets as rates change, while the dotted line represents the value of the liabilities. Convexity measures the curvature of this price-yield line and this curvature is the source of risk. For example, assume the asset and liability portfolios begin at point A, where the durations are matched. If yields move significantly, in either direction, durations will not remain matched because their values will change at different rates and a deficit may result. In this case, active management is the only way to ensure proper results.

In order to simplify our analysis up to this point, we have assumed that rates have changed by an equal amount for every available maturity. This is known as a "parallel" shift of the yield curve. In reality, this is not usually the case. The yields on longer maturity issues may rise more than the yields on shorter issues this is known as a "steepening" of the yield curve. The curve may also "flatten" or change shapes in an infinite amount of other ways. Yield curve risk arises when the maturity structures of the assets and liabilities are different and a "non-parallel" shift occurs. This shift will have a disproportionate affect on the asset and liability values and may result in a mismatch.

A strategy which includes callable bonds is subject to call risk during periods of declining interest rates or increasing volatility. Issuers may choose to exercise their option to call these bonds away from their holders at a previously agreed upon price. Even if durations are initially matched, a call will change the interest rate sensitivity of the portfolio, creating a severe risk of underperforming the liability stream. Similarly, passive strategies are subject to the sinking fund effect. Sinking fund provisions require the issuer to retire a certain amount of the outstanding debt each year. Again, even if durations are initially matched, the retirement of bonds from the portfolio will alter the portfolio's interest rate sensitivity and lead to a risk of underperformance.

Finally, many pension funds rely upon equity investments to hedge their risks. Several in-depth studies conducted by leading investment banks have concluded that this method, by itself, is usually not effective. Equities have a surprisingly low duration while pension liabilities tend to have very large durations. Therefore, when interest rates change, the values of the assets and the liabilities do not move in tandem, resulting in a mismatch. These studies conclude that the most effective hedge, in the broadest terms, is a portfolio of long duration fixed income securities.

PIMCO's Asset/Liability Matching Methodology
Even if passive strategies are feasible, they are usually not ideal. Active management, in some form, can offer a solution. In order to reach an optimal structure, assets and liabilities must initially be analyzed individually. Since its founding, PIMCO has consistently demonstrated superior ability in understanding fixed income securities. The same proprietary expertise that we have built to analyze bonds is precisely relevant to the analysis of pension liabilities.

PIMCO begins by systematically analyzing each liability cash flow, using several valuation techniques and subjecting each valuation to a series of simulations to understand how the liabilities react under a broad range of interest rate scenarios. Through the analytic process, we gain a full understanding of the risks inherent to the liability stream and how these risks affect value. The next step is to construct a portfolio of assets to offset these risks as efficiently and cost-effectively as possible. The construction of this portfolio relies upon our Long Duration philosophy, as previously highlighted. Finally, both the assets and the liabilities are actively monitored to ensure that the hedge remains effective through time and that the value added remains maximized within the appropriate risk constraints.

Summary
By utilizing PIMCO's core expertise, Long Duration has proven itself a useful and consistently successful strategy. PIMCO's active management of Long Duration portfolios offers a solution for increasing exposure to interest rate movements, for hedging against deflation, or for immunizing liabilities.