For some time, PIMCO has forecast that problems in subprime mortgages will lead to slower consumer spending and an eventual easing by the Federal Reserve. In our view, weakness in this sector could persist for a good while yet. Fortunately, PIMCO's mortgage-backed security (MBS) and asset-backed security (ABS) positions in PIMCO Total Return Fund currently remain unaffected by troubles in the subprime sector as our positions are very high quality. As a result of our concern about this area, we moved up in credit quality more than 18 months ago in bonds that are subject to mortgage credit risk. In our view, the extra yield that these bonds offered above Treasuries was not nearly wide enough to compensate for the risk involved.

PIMCO's substantial holdings of agency MBS, those arranged by the major mortgage agencies such as FNMA, FHLMC and GNMA, have no subprime exposure and have not been affected by the recent downturn, nor do we anticipate any significant effect since these MBS are backed by the highest quality mortgage loans. Of course, these high quality MBS still carry risk, mainly that arising from any increased volatility in interest rates. Still, these MBS should remain insulated from the troubles in the subprime sector.

In contrast with agency MBS, home equity ABS issues generally start with a pool of subprime loans, but the credit ratings and expected maturities of available issues vary significantly with their right to the current cash flows from the loans. The highest-quality ABS receive all of the mortgage pool's current cash flows - these are known as "current-pay" issues. Combined with sound credit analysis and security selection, current-pay issues are likely to be effectively insulated from default exposure, which falls on the subordinated issues that have a lower priority claim to the mortgage pool’s cash flows. In addition, ABS transactions often have several forms of credit enhancement built into their structure to help provide protection against losses. The most common form of credit enhancement is subordination. In a typical ABS structure, up to 80 percent of the bonds are subordinated to the high quality current pay issues, thereby providing a cushion against credit losses. 

In PIMCO Total Return Fund, PIMCO's modest ABS holdings are concentrated in current pay issues. These holdings are AAA-rated, 1-year floating rate bonds that we believe would be unlikely to suffer a significant loss of principal even amid a severe economic downturn.

Overall, PIMCO believes that the U.S. housing slowdown is far from over. Attempts by homebuilders to reduce heavy inventories will put downward pressure on home prices, and tighter underwriting standards at subprime mortgage lenders will make it difficult for some first-time homebuyers to secure loans. At the same time, higher mortgage rates will put further pressure on subprime borrowers. The impact of adjustable rate mortgages (ARMs) that will reset at higher rates over the next couple of years could be especially severe. However, as we have already noted, we believe it is highly unlikely that the credit problems affecting the subprime sector will spread into the Agency MBS sector given the high quality of the underlying prime loans. In fact, agency MBS may actually benefit from investors moving up-in-credit, a trend that could bode well for the high quality mortgages held in PIMCO Total Return Fund.