Five key principles make up the foundation of Pacific Investment Management Company LLC's (PIMCO's) international fixed income philosophy. First, like in our domestically benchmarked accounts, we limit our volatility with respect to our assigned index. Our clients have typically spent considerable resources determining the proper asset allocation. To ignore tracking error and create a portfolio with very different volatility to the index and correlation with other asset classes would render this decision meaningless.

Secondly, we believe that consistent above index performance is best produced by using multiple sources of value added. In contrast to some managers which prefer to take a few large exposures, PIMCO makes a number of small departures from the benchmark, all of which together should produce tracking error of 200 - 300 basis points to the index.

Third, we separate the portfolio's bond and currency decisions. The factors which influence bond markets are often different than those which influence currencies. Given the number of efficient hedging tools, there is no reason why the decision to buy a particular bond should obligate us to own that currency as well.

Fourth, our country bond allocation process focuses on economic and credit fundamentals as the key determinants of value in fixed income markets. Analysis of economic data, real yields, and country risk modeling serve to identify in which countries we invest.

Finally, PIMCO uses advanced proprietary quantitative tools to measure and monitor risk. This is crucial in monitoring the impact of specific positions in the total portfolio as well as for analyzing performance to understand what strategies have systematically added value and which have not.

It's important to note that investing in foreign securities which can entail special risks, including the effects of foreign economic, political and legal developments, as well as currency exchange rate changes. These risks can be enhanced when investing in emerging market securities.

Volatility And Correlation
As with PIMCO's domestic fixed income style, our international investment philosophy is that of a core manager. Given our responsibility for the core international bond holdings, we understand that this necessitates a style of management which produces a small amount of tracking error to the benchmark index. As a result, we are extremely conscious of volatility and correlation, both at the individual security and portfolio levels.

Our goal is to produce investment results which have similar to index volatility but with additional return or alpha. This ensures that our segment of the portfolio will conform to the original asset allocation, both in terms of risk and correlation with other asset classes. Our tracking error target of 200 - 300 basis points effectively constitutes a "risk budget" which is spent across the variety of opportunities that we find in the world's fixed income markets. Although we often find excellent opportunities to earn additional returns, if our analysis shows that these portfolio statements would cause excessive volatility to the index, we limit the exposures to stay within our budget.

Multiple Sources Of Value Added
Value added strategies can be divided into two groups, macro or top down strategies and micro or security specific strategies. Unlike many boutique international investment managers which may focus on one particular area (e.g. currencies or country selection), PIMCO utilizes its expertise in each of these areas in attempting to add value to its benchmark index.

This is important because international markets will often offer substantial opportunities in one area and very few in another. The ability to use a variety of tools may increase returns as well as diversifies risk, lessening the need to press any one area for the majority of the portfolio's outperformance.

Separation of Country Bond And Currency Decisions
PIMCO sees an international bond mandate as the management of two distinct entities, a bond portfolio and a currency portfolio. While the same macroeconomic forecast is used for both portfolios, the factors which impact bond returns are different than those which affect currency movements. Bonds resonate to a business cycle, increasing in value as economic growth and inflation decline and decreasing as these indicators pick-up. Conversely, currencies show little correlation with the business cycle and tend to be more dominated by the level of short-term yields, market trend or technical factors and fundamentals associated with their relative purchasing power.

There are only two areas where the bond and currency decisions overlap. First, the same macroeconomic forecast is used to come to conclusions about each area. Second, we carefully consider the extent to which a bond and currency market might be correlated in order to ensure that the overall volatility target or risk budget is not violated.

Country Bond Allocation
The overriding principal of our country allocation process is that the real yields of a particular market must be commensurate with the risk in that market. The first step in our process is to determine the real yield of a particular security. While the nominal yield is simply the market interest rate, the relevant inflation rate to deduct in finding the real yield is a subjective judgment. We believe that the consensus inflation forecasts are the best available predictor of future inflation. These predictions become the basis for comparing similar instruments across different country markets. These yields must then be considered in light of the risk associated with a particular market.

In order to rank the markets by their relevant country risk, we rely on our own proprietary credit model. This model considers quantitative factors such as GDP per capita, GDP growth, net debt/exports and short-term liability coverage as well as qualitative variables including economic policy, openness to capital flows and corruption measures. These country risk rankings are then compared to the real yields to determine which countries have the best risk adjusted yield. Our goal is to invest in countries which appear to strike the best balance between attractive real yields and low economic risk ratings.

Currency Allocations
There are three basic criteria by which PIMCO decides its currency allocations; short-term yields, market trend or technical factors, and fundamental analysis focused on measures of relative purchasing power. Unlike with bonds, there is much evidence that currencies with high short-term yields have higher returns than those with lower yields. Markets seem to persistently over-estimate the amount of depreciation that will take place with these high yield currencies.

The other major anomaly which exists in the currency markets is that they appear to exhibit trend following behavior. Unlike bonds where empirical research is unable to discern a technical pattern, currencies often go into over-shoot or undershoot, enabling technicians to produce abnormal returns. Explanations of this phenomenon tend to focus on central bank intervention as the main source of this price action. As a result, we include past market trends as an important variable in our analysis.

Finally, PIMCO focuses on relative purchasing power models as a source of fundamental analysis in this market. While purchasing power parity tests of currencies exhibit little predictive power of returns in the short run, most academic evidence points to this as an effective tool over a longer time horizon. When examined over three or more years, those currencies which purchase a larger basket of goods tend to rise relative to those currencies which purchase less.

These three factors determine our view of expected returns for the various world currencies. These views are then combined with volatilities and correlations to show the weighting in a portfolio context. Because currency movements tend to impart more volatility, careful management of currency risk is especially important. We believe that to get the fullest perspective of currency tracking error risk, both historical and implied market volatilities should be used.

Use Of Advanced Proprietary Analytical Tools
Fundamental to the process of risk control is the analytical tools which are available to measure and monitor volatility in the portfolio. PIMCO has invested considerable resources in developing its own proprietary models to help in this analysis. These models include our Bonds Under Management report which gives extensive summary information of portfolio holdings, a Risk Optimizer which indicates for a set of expected returns, volatilities, and correlations an optimum portfolio structure, and our own proprietary Level, Slope and Curvature model which gives a more accurate measure of individual security and portfolio risk than traditional duration and convexity analysis would allow.

Extensive use of analytical models provides the additional benefits of allowing us to better leverage our investment professionals and provide a dispassionate check on the various investment decisions we make in the portfolio. It also gives us the ability to do attribution analysis to determine which strategies are consistently adding value and which need to be altered in the future.

Investment Process
PIMCO's investment decision process utilizes a top-down approach. All investment professionals participate in the Investment Strategy Group (ISG) which determines the overall risk level (duration) of our fixed income accounts. Annually, the ISG gathers for a one week Secular Forum in which important long-term forces that can influence the global economy and financial markets are discussed. Selected members of the investment staff are assigned specific areas to monitor throughout the year, including monetary and fiscal policy, demographics, international trade, inflation, productivity trends, etc. The purpose of this forum is to arrive at a three to five year outlook for the direction of domestic and foreign interest rates and the U.S. dollar. Every three months shorter-term or cyclical international trends are discussed in the ISG's Economic Forum. At these sessions, the investment professionals at PIMCO refine and update the forecast for shorter-term (two to four quarters) trends in interest rate and currencies.

With the firm's secular and cyclical analysis as a foundation, the International Portfolio Management Group (IPMG) meets weekly to discuss those issues uniquely relevant to adding value in our international portfolios. We examine opportunities in four key areas: international bonds, currencies, cash management, and relative value strategies. Within the IPMG, particular individuals are assigned ongoing responsibilities for certain areas, but the ultimate decisions are a result of the group's consensus. These decisions translate into portfolio statements versus our benchmark indices.

Duration Management
Overall portfolio duration is the result of our secular and cyclical forecasting processes described above. Broad portfolio duration targets are then set by geographic region, depending on our view for regional, long-term economic trends, coupled with local cyclical forecasts for economic activity and inflation. Country-specific targets are determined so that weighted portfolio duration is +/-2.0 years of the benchmark. Our top-down process ensures that portfolio duration is shifted in a measured fashion consistent with our long-term focus.

Yield Curve Exposures
Yield curve or slope exposures in particular countries often present outstanding opportunities. Our group's goal is to identify not only which countries to overweight or underweight but where on each country's yield curve we want to take our exposure. A particularly attractive yield curve opportunity can also support the impetus for an overweighted country exposure. Aside from outright underweight or overweight statements on one part of a country's yield curve, we also evaluate from a duration neutral perspective whether within a particular country we wish to be in a barbelled mix of long and short maturities or a bulleted intermediate maturity structure. These structures can produce dramatically different returns given changes in the shape of a country yield curve. Specifically, during the periods where short-term interest rates are falling relative to longer rates, a bullet portfolio provides superior total return. PIMCO uses the full spectrum of maturities to build portfolio structures that maximize returns given our expectation for relative changes in rates.

Sector And Security Selection
Sector strategies tend to be most important within the U.S.component of a global portfolio. This is because the U.S. fixed income market has by far the most developed corporate and mortgage markets. The non-dollar portion of our portfolios has largely been in government holdings, as most international non-government securities markets are relatively small and illiquid. There are however selected opportunities abroad in the corporate and mortgage area which require sector specific relative value analysis.

We rely on resources in other parts of our firm for analysis of these sectors. First, we rely on our macroeconomic analysis to set our broad view of particular sectors given that corporate bond outperformance tends to be linked to the improved corporate cash flows and profitability associated with stronger economic growth, while mortgages outperform in a more stable economic and interest rate environment. Estimates of economic growth and volatility as well as historical spread relationships determine the relative weights of these sectors compared to government securities.

Second, at the security selection level, bottoms up credit research which stresses fundamental analysis of company prospects is performed on all of the corporate credits that we own. Similarly, each mortgage security purchased is rigorously tested using our proprietary models in order to determine accurate duration and convexity characteristics. The call features and pre-payment options in mortgage securities make these instruments extremely sensitive to changes in market volatility making their duration and convexity characteristics unstable.

Cash Management
Active cash management is an often overlooked avenue to adding value to an international fixed income portfolio. Cash strategies are used when exposure to a market is gained through the use of futures or options as well as when securities are lent out for specific periods of time. In each instance, cash is created with an interest rate which is close to and sometimes below a short-term risk-free rate. Within our portfolio management team, short-term specialists exploit opportunities in higher-yielding cash equivalents in the U.S. market by actively managing the underlying pool of assets used to back the futures, options, and forward obligations. In this manner, we also avoid leverage in the portfolio through the use of these derivative instruments.

This strategy has been highly effective in contributing substantial rates of return without adding material risk. This is due to the inherent term and liquidity premiums available by investing slightly further out on the yield curve from these shortest assets. We have also been able to exploit an expanded opportunity set which includes instruments such as adjustable-rate and high-coupon mortgages, floating-rate notes, commercial paper, and near maturity corporate bonds. Each of these offers substantial return relative to the financing rates embedded in futures, options, and forward obligations.