Economy Continues to Stabilize; Abundant Slack Remains

Financial markets and the broader economy continued to stabilize during the third quarter after the extraordinary events of last year. The Barclays Capital U.S. Aggregate Index, a widely used index of U.S. high-grade bonds, returned 3.74 percent during the quarter. Treasury yields were less volatile than in the first half of 2009 and fell across maturities. The yield on the benchmark 10-year Treasury ended the quarter at 3.31 percent, down 23 basis points from the end of the second quarter.

Policy initiatives - such as the Federal Reserve’s purchase of mortgage and Treasury securities, the government’s support for consumer finance markets and near-zero short term rates - helped revive risk appetites and were the major factors behind enhanced stability. Two key programs were extended during the third quarter.

The Fed committed to complete its $1.25 trillion program to buy mortgage-backed bonds and extended the end date of the program to March 2010 from December 2009. Massive purchases of mortgages from this program, roughly two-thirds complete by quarter-end, helped hold down mortgage rates and supported the fragile housing market. The Fed and the Treasury also announced the extension of the Term Asset-backed Securities Loan Facility, or TALF program, which provides financing to investors buying consumer asset-backed securities (ABS). Originally set to expire in December of this year, TALF was extended through March 2010 for consumer ABS.

Manufacturing and housing data showed improvement in the third quarter, suggesting that the recession was close to an end. Even so, substantial slack remained in the economy, leading the Fed to announce that it would keep the federal funds rate near zero “for an extended period.” The unemployment rate moved closer to 10 percent, making any revival in consumer spending highly unlikely. Businesses continued to draw down inventories, albeit at a slower rate than earlier in the year. Industrial capacity utilization hovered near record lows at below 70 percent, discouraging new investment. Policymakers faced with these dismal fundamentals were in no position to contemplate withdrawal of stimulus programs any time soon.

Technicals Boost Returns in Municipals over the Quarter

For the third quarter of 2009, the municipal market experienced one of its best quarters since 1980 (the date in which the Barclays Capital Municipal Bond Index was created). Municipals returned over 7% for the quarter and 14% since the beginning of the year. The factors instrumental in this performance were: historic cash inflows into the asset class, a decrease in tax exempt new issues, contracting credit spreads, and a steep municipal yield curve through 20 years. Municipal yields as a percentage of Treasuries continued its move downward with 10 and 30 year rations ending the quarter at 77% and 94%, respectively. Specific to the municipal yield curve, rates on 2 and 10 year AAA rated municipals decreased by 30 and 66 basis points, respectively, while 20 and 30 year rates moved down by 83 and 85 basis points. Of note, the California General Obligation yield curve showed even better performance with 2 and 10 years moving down by 96 and 152 basis points, while 20 and 30 year yields decreased by 125 and 124 basis points. Cash flow into municipal bond funds has been positive for every week since the first week of the year. Following the signal by the Federal Reserve, significant assets moved out of tax free money market funds and into investments further out the curve. Year to date tax exempt mutual fund flows have totaled over $50 billion, with the greatest share going into short term funds.

On the supply side, tax exempt new issue supply for the quarter dropped 10% and 15% for the year. At the same time, the new issue supply of taxable municipals reached $35 Billion year to date; credit goes to the Obama Stimulus package that has provided a more attractive means for municipalities to issue infrastructure debt. These Build America Bonds have directly replaced issuance of longer term tax exempt municipal debt. They have also caused a flattening in the 2-30 municipal yield curve because most BABs issuance is in 20 year and longer debt. Spreads of BABs versus Treasuries and Swaps have tightened since they first came to market at the end of the first quarter. Municipal credit spreads have also tightened over the year, yet still historically wide versus AAA rated municipals. As we’ve stated earlier this year, the municipal bond market should now be viewed as a credit market, similar to corporates, not a rate market like Swaps and Treasuries.

The one component of the municipal market that has just begun to recover is the inflation protected municipal bond market (or MIPS). This niche component of the municipal bond market has seen coupons decrease as inflation drops, while at the same time their valuations have also moved lower. Analysis by our real return experts concluded that these securities, with coupons that are federally tax exempt and with coupons that adjust based on CPI-U, are depressed in value versus TIPS and other inflation protected securities.

The Fund outperformed its benchmark for the quarter.

The following strategies helped quarterly returns:

• Above-benchmark duration was positive for performance as California yields moved lower over the period
• Limited exposure to tobacco-related municipals helped performance as this sector had strong positive performance as high yield fund flows were strong, leading to money being put to work in this sector
• Exposure to hospital, corporate backed, and power related municipals was positive while exposure to resource recovery bonds detracted from performance as this sector underperformed

The following strategies detracted from quarterly returns:

• Underweight exposure to State of California General Obligation bonds was negative for performance as the State’s bonds saw a strong rebound as investors reached for yield in the municipal market
• Exposure to high quality variable rate demand notes hurt performance due to their low rates versus rates further out the yield curve
• Exposure to pre-refunded bonds was negative for performance as investors continued to move away from this sector to take advantage of higher yields elsewhere in the market

Recovery To Be Weak in 2010 After Temporary Boost

PIMCO believes that the most likely outcome for the U.S. economy will be a weak recovery in 2010 after a temporary boost in the latter half of this year. On the downside, the U.S. could slip back into recession sometime next year. Emerging economies, especially China, should continue to grow at a faster pace than the developed world, helped by aggressive stimulus policies. The rationale for our forecast is outlined below:

• Limits to U.S. Growth – A slower pace of inventory drawdown by businesses and positive effects from stimulus programs should support growth in the third and fourth quarter of this year, but this boost will not be sustainable. The reasons include: excessive levels of consumer debt and an expected increase in savings to work these levels down; a stubbornly high unemployment rate; and weak business investment in the face of record lows in capacity utilization.
• Muted Monetary Policy – PIMCO expects the Federal Reserve to retain near-zero policy rates for some time. Even so, the impact of low rates and the Fed’s huge liquidity injections may be largely muted by overleveraged consumers’ reluctance to borrow.
• Weak Recoveries in Europe, U.K. and Japan – The rest of the developed world is expected to face similar challenges with the sustainability of demand into 2010. In Europe, large public debts and economic linkages to the U.S. and U.K. are likely to impose constraints on recovery. Japan’s recovery will face limits arising from its reliance on U.S. demand for its exports, especially autos, and weak capital spending as capacity utilization rates remain low.
• China to Grow Faster – China is likely to grow far faster than more developed economies. Its fiscal stimulus has been especially large to compensate for a decline in exports. A surge in infrastructure investment has readjusted China’s GDP back toward its critical growth target of 8 percent.
• Bifurcated Emerging Markets – Emerging economies overall are showing signs of a rebound. PIMCO believes that EM economies that are more reliant on external demand – such as Korea, Mexico and Russia – will face greater headwinds for sustained recovery. Countries driven more by internal demand – including Brazil and India – would appear to be more resilient.
• Tame Inflation – Substantial excess capacity in labor and product markets should keep inflation low over a cyclical time frame. Over the longer run, inflation risk may be heightened by the massive liquidity the Fed has injected into the financial system. For now though, transmission of that liquidity into the broader economy will continue to be constrained by strong demand for cash among financial institutions and consumers eager to pay down debt.

Expect Higher Taxes and an Increase in New Issue Supply

Higher federal and state tax rates bode well for municipal bond performance even after record returns for the quarter and year. At the same time, credit issues continue to dog major municipalities such as California, New York, Illinois, and New Jersey, just to name a few. One should expect federal tax rates in 2010 to increase to 39.6% from 35% for individuals. On the state level, many have already added another, higher tax bracket for the highest income producers. These increases may not be enough to satisfy the double digit decreases in revenues experienced by many states and local municipalities across the country. In recent years, California, Connecticut, Hawaii, New Jersey, New York, Oregon, and Wisconsin have added a new state income tax, while some of them added an additional new bracket or higher rates in 2009.

From a supply perspective, there are mixed views on the size of new issues through the fourth quarter. On the one hand, we expect additional Build America Bonds (BABs) in maturities of 20 years and longer, after adding $35 Billion in supply for the year through the third quarter. These taxable municipals should result in lower new issue tax exempt supply in longer maturities. On the other hand, longer rates on high quality municipals are at historic lows, with AAA rated bonds yielding less than 4 percent. One should expect municipal finance bankers to crunch numbers to determine whether an advance refunding on older, higher cost debt makes sense for many issuers. In years past, when refunding issues are cost effective, the amount of new issue refunding supply can comprise as much as 25 percent of total new issue volume. As long as Treasury and tax exempt rates remain low, one should expect new issue supply of both taxable and tax exempt municipals to reach record levels in 2009. As tax rates continue their move upward and the economic environment remains weak, municipals will be the asset class of choice for investments of taxable dollars. As a result, the supply should be easily manageable.

The following is a summary of PIMCO’s major portfolio strategies:

• Target an overweight to duration as interest rates could trend downward from current levels while the economy remains weak
• Continue to favor high quality, yield-oriented securities in an environment of low growth and political uncertainty
• Although the municipal yield curve is steep, it flattens further out the curve. As such, we will provide more emphasis on intermediate maturities where we believe the return per unit of duration is most attractive
• Focus on Build America Bond supply, as it will have a strong effect on the supply pressures for the remainder of 2009
• Monitor budget situations of states across the nation as the economic crisis continues to be felt due to significantly reduced revenues resulting in potential deficits
• Focus portfolio structure on providing clients with attractive tax free income while working to minimize performance volatility
• Manage net capital gain recognition to control tax liabilities