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.

The Rally Continued in the Credit Markets, Driven by Strong Investor Demand for Risk

Amid improved market sentiment and increased appetite for risk, valuations for emerging markets U.S. dollar denominated debt continued to rise in the third quarter. In some EM countries, these gains were supported less by fundamentals than by positive technical conditions that helped push investors out of cash and toward higher yielding, riskier assets.

Emerging Market spreads decreased by 96 basis points during the quarter to finish the period at 337 basis points over U.S. Treasuries. The JPMorgan EMBIG index returned 10.21 percent for the quarter.1 In spite of their weaker fundamentals, countries such as Argentina, Pakistan, Ghana, Ecuador and Venezuela continued to benefit from the risk rally. This contrasts with countries such as Brazil, China and Poland which, despite much stronger fundamentals, lagged the market.¹

In Latin America, increased risk appetite boosted the performance of Argentina, Venezuela and Ecuador, which returned 33.53 percent, 24.67 percent and 24.22 percent, respectively. Returns for Brazil lagged its investment grade peers at 7.53 percent in spite of growth coming better than expected. Mexico returned 6.87 percent amid negative growth numbers and the government’s issuance in international capital markets.¹

In EEMEA (Emerging Europe, the Middle East and Africa), Turkey returned 7.59 percent as speculation about both the necessity and willingness of the government to secure an International Monetary Fund (IMF) program continued. Ukraine returned 16.20 percent despite the weak economic picture; second quarter gross domestic product contracted 18.0 percent year over year in the second quarter versus 20.3 percent year over year in the first quarter. Russia returned 11.16 percent as oil price remains above government budget assumption. Nevertheless, economic activity remains weak. Hungary and Poland returned 12.70 percent and 6.94 percent, respectively. In Hungary the recession continued to deepen and the IMF extended the stand by agreement.¹

In Asia, Indonesia outperformed with a 15.28 percent return amid positive rating actions and the sturdy gross domestic product. China returned only 3.69 percent amid already tight spread levels and as macro releases suggest economic growth continues.¹

Within the investment grade market spreads tightened 77 basis points, finishing the quarter at an average level of 183 basis points. As spreads tightened, the global investment grade credit market posted a 6.54 percent return².

Global investment grade financials led the third quarter rally, outpacing the index by 208 basis points to return 8.62 percent. The ongoing impact of public policy initiatives and private market capital raising helped to bolster liquidity and improve balance sheet strength within the financial system. In global investment grade financials, the life insurance sub-sector was the top performer over the third quarter, generating an excess return of 13.82 percent, outpacing the index by 927 basis points. Life insurance credits benefitted from improved credit profiles and enhanced asset coverage from higher valuations².

Utility bonds trailed the global investment grade corporate market. In general, defensive sectors have posted modest returns. For example, electric utility credits lagged the market, contributing to the utility sector’s relatively weak performance.

Finally, industrial bonds also lagged the global credit market. Within industrials, and energy credits were one of the largest drags on the sector. The energy sector, particularly the independent exploration & production sub-sector, underperformed in line with other low-beta sectors.

The global high yield market returned 12.76 percent for the quarter.³ With significant levels of cash on the sidelines to begin the year, and above average levels to start the third quarter, high yield bonds benefited from the general pursuit of yield, even at the expense of higher risk.

Inflows to retail high yield mutual funds significantly outweighed outflows, with net flows up $25.5 billion, the highest level seen since 2003 and comparatively larger than the $5.1 billion inflow this time last year.

Meanwhile, high yield defaults approached the all-time record peak set in 1991, ending the quarter at 12.0 percent and nearly three times the level to begin the year. Senior unsecured bond recoveries remained low, at 19.8 percent, compared to 33.7 percent for all of 2008 and Moody’s long-term average of 36.4 percent.

Global high yield spreads continued to compress, ending September just shy of 670 basis points for a drop of about 267 basis points over the quarter and about 835 basis points lower year-to-date.³

The top performing global high yield industry categories for the third quarter, insurance, broadcasting, and publishing/printing, were some of the worst performers of 2008. At the other end of the spectrum, the worst performing sectors were generally defensive areas of the market that remained relatively resilient through 2008, such as cable and utilities.

Although current and future portfolio holdings of the Fund are always subject to change and subject to risk, the following comments may help holders of the fund understand drivers of the Fund’s performance relative to the Fund’s benchmark.

Overall the fund outperformed its primary benchmark index, Barclays Capital Global Credit Hedged USD Index, for the quarter.

Positive contributors to relative performance included:

• An overweight allocation to the Emerging Market asset class as these issues outpaced for the quarter
• An overweight to Russian quasi-sovereign corporates, which outperformed as credit sectors continued to benefit from the return of investor risk appetite
• An underweight to China which underperformed amid already tight spread levels
• Above–index exposure to insurance issuers as the sector benefitted from the financial market rally, with improved credit profiles and enhanced asset coverage
• Security selection in the global high yield consumer cyclical sector, as auto-related holdings outperformed the broader category

The following strategies detracted from relative returns:

• An underweight allocation to the global high yield asset class, which outpaced emerging market and global investment grade corporate debt on the quarter
• An underweight to Argentina which outperformed on the back of rumors of progress in dealing with holdouts from the 2005 restructuring.
• An underweight to Venezuela, which outperformed amid increased risk appetite
• An overweight allocation to the investment grade-rated energy issuers, particularly independent exploration & production bonds, as lower-beta sectors lagged the index with modest returns

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.
• 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.

PIMCO’s Cyclical Outlook: A W-Shaped Recovery

Monetary and fiscal stimulus, along with a rebuilding of inventories will be tailwinds for the U.S. economy for the rest of 2009. These positive effects will begin to fade in 2010 at the same time as consumer spending is constrained by high debt levels. A W-shaped recovery will set in, consistent with the muted growth rates PIMCO expects for developed economies over a secular time frame. Federal Reserve tightening is unlikely before the summer of 2010 given this forecast.

In the “New Normal” Emerging Economies to Grow Faster than the Developed World

As emerging economies overall are showing signs of a rebound, we believe that emerging economies should continue to grow faster than the developed world. In the cyclical horizon, 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. In aggregate, emerging economies should continue to grow at a faster pace, helped by aggressive stimulus policies.

In this “New Normal”, those Emerging Market countries which are in sound fiscal health and are of systemic importance to the global economy have shown some signs of economic rebound due to stronger domestic demand. These economies should continue to find internal and external support easiest to access.

The outlook though, does not apply equally to every country. The ability to delineate strong from weak sovereigns remains paramount. Not all countries have used the favorable growth environment leading up to 2007 to prepare their economies for tougher times. Some will face challenges in the New Normal, wherein capital is not handed out indiscriminately. PIMCO’s focus remains on sovereigns who—through a combination of strong initial conditions, a demonstrated ability to respond to the crisis, and access to external sources of financing—are likely to emerge from the crisis in better shape than they entered.

Selective Opportunities to Persist within Global Investment Grade

We find that there are still attractive opportunities within the investment grade credit market. However, as in global high yield, we are being more selective and encouraging a more cautious approach toward credit, relying on comprehensive analysis of each credit and the associated risks.

We continue to favor sectors that have attractive risk/reward potential in sectors such as healthcare, telecom and cable. These industries are further supported from relatively high margins, revenue generation from non-discretionary spending and pricing power.

Current Global High Yield Environment Requires Stringent Analysis of Each Unique Credit

Given the unprecedented surge in high yield performance year-to-date following the worst year of performance and unparalleled difficulties of 2008, there is a wide dispersion of views as to where the high yield market is heading from here. Throughout this period, technicals have been the focal point of investors and in recent months have driven returns higher as large sums of cash on the sidelines made their way into riskier investments. With still a significant amount of assets in money market funds and bank deposits, well above average levels, the potential for technicals to remain positive over the near term is highly probable.

Although defaults have just passed the peaks seen in 2001/2002 and are approaching the record level seen back in 1991, they are decelerating and look to plateau over the next several months. We expect defaults to begin falling from their peaks in the late fourth quarter 2009/early first quarter 2010 period, but remain elevated and above their long-term average throughout 2010, given expectations for weak economic growth.

Within emerging markets we will continue to make tactical use of local currency opportunities where local curves remain steep and our analysis points to favorable risk-reward dynamics, such as in Brazil and Mexico. We will also seek opportunities to add value by substituting quasi sovereign and EM corporate credits related to key infrastructure investment for sovereign issuers. Finally, we plan to make tactical use of select EM currency opportunities when fundamental factors suggest that currencies are undervalued.

Within global credits we will maintain an overweight to select economically-vital “National Champion” banking institutions that will continue to benefit from policy response, a global asset base, diversified revenue sources and strong capital ratios. With monetary and fiscal stimulus measures intended to support the financial markets and the economy, we intend to continue to overweight industries such as metals & mining and energy, which should benefit the most from aggressive spending. Direct government support through stimulus and infrastructure spending continue to make opportunities in these industries attractive. We intend to continue to underweight credits that are highly exposed to discretionary spending by the consumer. We believe that the consumer, particularly in the United States, is likely still in the early stages of de-leveraging. These sectors took advantage of easy credit standards over the past several years and have leveraged themselves to unsustainable levels. As lending remains tight and selective, these companies will remain under pressure until the economy stabilizes.

With significant uncertainty surrounding the direction and thrust of the economy moving forward, we believe the current environment requires stringent analysis of each unique global high yield credit, and the associated risks, on a case-by-case basis. We still favor utilities, where strong balance sheets and high quality assets make the sector attractive. We intend to maintain our focus on the healthcare sector, which benefits from positive demographics, reasonably stable cash flow, and valuations that appear attractive over a secular horizon. Within the energy sector, we plan to emphasize exposure to pipelines, where strong collateral and supportive technicals make the industry category appealing. With consumers constrained by high debt levels, low savings, poor income growth, and weak employment prospects, it should be no surprise that we remain guarded on sectors tied to the consumer. Cyclicals such as retail, in particular, appear vulnerable to a slowing economy and coming off technically driven spread compression year-to-date. Similarly, we plan to continue to underweight homebuilding credits, given excess capacity, tighter lending standards, and given weakening valuations amid the recent flight to risk