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. Universal Index, a widely used index of U.S. high- and low-grade bonds, returned 7.97 percent for the first nine months of 2009 and 4.48 percent during the third 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. The high yield market, as represented by the Bank of America Merrill Lynch High Yield Master II Index, was up 14.82 percent for the quarter and 48.54 percent year to date.

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 Stretch for Yield Continued, Benefiting Lower Quality

• 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.
• The primary market in high yield, which started off sluggish to begin the year, has been running full steam ahead since as $52 billion was priced in the third quarter, bringing year-to-date’s total to $120.4 billion compared to the full year 2008 total of $52.9 billion.
• While the proceeds from high yield issuance was primarily of high quality deals, with BB and B-rated issues making up over 90 percent year-to-date, recent months saw a material rise in lower quality deals and generally higher risk, cyclical sectors.
• Triple-C and lower rated issues were the top performers by quality rank, up over 26 percent for the quarter, outperforming double and single-B rated bonds by approximately 1,500 basis points.
• Meanwhile, 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.
• Spreads continued to compress, ending September just shy of 800 basis points for a drop of about 260 basis points over the quarter and about 1,020 basis points lower year-to-date.
• The top performing 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, environmental services, 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.

The High Yield Fund outpeformed its benchmark, Merrill Lynch U.S. High Yield BB/B Rated Constrained Index, for the quarter. Positive contributors to relative performance included:

• An emphasis on the finance sector, where multi-line insurance companies saw material price appreciation over the quarter
• Security selection in the consumer cyclical sector, as auto-related holdings outperformed the broader category
• An emphasis on select semiconductor and other equipment manufacturers, which outperformed
• An underweight to consumer non-cyclicals, which lagged the market on lower returns from beverage and tobacco

The following strategies detracted from returns:

• Tactical exposure to investment grade bonds, which significantly underperformed the high yield market over the period
• Security selection in the finance sector, where high grade credits underperformed their lower quality counterparts
• An overweight to the utility sector, which underperformed along with most other defensive areas of the market
• Security selection in the transportation sector where higher quality securitized bonds underperformed other subordinated issues in the industry category

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.

Current 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.

With spreads today under 800 basis points, significantly lower than the beginning of the year level of about 1,800 basis points, we believe valuations today reflect a materially faster drop in defaults than are likely. Therefore, we think spreads are neutral at best for the overall asset class, but we do see attractive value in select investments.

With significant uncertainty surrounding the direction and thrust of the economy moving forward, we believe the current environment requires stringent analysis of each unique 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. Furthermore, we continue to see attractive relative value opportunities in the finance sector, where global policymakers remain supportive, among select credits.

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. Finally, looking outside of the traditional high yield market, we plan to continue to hold modest exposure to bank loans, where valuation merit, and in select emerging market currencies, in light of an expected long-run decline in the U.S. dollar.