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.

Investment Grade Credit Maintains Positive Momentum

Spreads in the investment grade credit market tightened 77 basis points, finishing the quarter at an average level of 198 basis points. High grade credit spreads maintained their positive momentum as greater risk appetite boosted investor demand relative to lower yielding U.S. Treasury securities. The Barclays Capital U.S. Credit Index has outperformed Treasuries for six consecutive months¹. As spreads tightened, the investment grade credit market posted a 4.98 percent return¹.

Financials led the third quarter rally, outpacing the index by 223 basis points to return 7.21%¹. 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. Since June 30, financials’ spreads have tightened 127 basis points to end the quarter at 288 basis points.

The life insurance sub-sector was the top performer over the third quarter, generating an excess return of 14.78 percent and outpacing the index by 980 basis points¹. Life insurance credits outperformed all sectors on the quarter, benefitting from improved credit profiles, and enhanced asset coverage from higher valuations. During the middle of the second quarter, Troubled Asset Relief Program (TARP) funds were made available which supplied the sector with much needed access to capital and provided issuers with liquidity and stability after suffering from substantial declines at the height of the financial crisis. Credit investors were afforded additional support after the successful capital raising efforts in the debt and equity markets during the second quarter. Additionally, there were relatively few downside surprises from the second quarter earnings season, which provided improved confidence in the general state of financial markets.

Financials were further supported by credits in the banking sub-sector. Government aid has greatly reduced default and liquidity risk for financial institutions that received support, including in some situations, direct recapitalization of systemically vital institutions. Banks have also demonstrated the ability to call on the capital markets, de-leveraging their balance sheets in the process through new debt and equity issuance and preferred exchange offers to raise tangible common equity ratios. Along with improved market conditions, banks have benefitted from a deceleration in the deterioration of asset quality. Financial institutions that are able to access private sector capital have begun to separate themselves from weaker firms as they possess healthier balance sheets and ample liquidity without depending on government support. Better earnings performance was a continuing trend and drove spread compression during the quarter as the financial landscape showed modest improvement. As a result, credits in the banking industry advanced 6.76 percent¹.

Real estate investment trust (REIT) credits returned 8.95 percent on the quarter, outpacing the index by 397 basis points. REIT credits achieved gains from strong investor demand, recapitalization efforts and active real estate portfolio management. Many investment-grade REIT issuers are well positioned to meet capital needs in the near-term through debt and equity issuances, cost cutting initiatives and the possession of large amounts of unencumbered assets. Brokerage and finance companies returned 8.42 percent and 5.20 percent, respectively, to round out the financials sector.

All other sectors also outpaced Treasuries on the quarter. Supranationals, the worst performing group, surpassed Treasuries by 107 basis points¹. This performance paralleled all non-corporate credits except for sovereigns. For example, foreign local governments and foreign agencies, which often offer less compelling absolute compensation than corporate bonds, soundly outpaced Treasuries yet underperformed the credit market by 170 basis points and 309 basis points, respectively¹.

Utility bonds trailed the investment grade market by 8 basis points, gaining 4.90 percent. Within utilities, natural gas pipelines returned 6.06 percent¹. Defensive sectors that are asset-rich or that have stable and predictable cash flows have posted modest returns as they are low in volatility. Yet, pipeline valuations were enhanced by investor demand for credits with hard assets, modest leverage and ample liquidity. Electric utility credits also slightly lagged the market, contributing to the utility sector’s overall moderate performance.

Industrials, while posting a gain of 4.62 percent, lagged the market by 36 basis points¹. Within industrials, consumer non-cyclical, energy and other utility credits were the largest drags on the sector. Non-cyclical consumer companies lagged the index as consumer confidence continued to show signs of instability. The energy sector, particularly the independent exploration & production sub-sector, underperformed in line with other low-beta sectors that generated modest returns during the third quarter.

Elsewhere, refining sector credits underperformed the index by 251 basis points, generating a return of 2.47 percent¹. Pharmaceutical and wireline bonds also underperformed as demand for defensive credits declined amidst an increased market appetite for risk.

BBB-rated bonds outperformed all investment grade quality tiers with an excess return of 6.59 percent, while AA-rated and A-rated bonds gained 3.31 percent and 5.18 percent, respectively. The positive momentum of lower quality names was due to increased risk appetite among investors¹.

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 Investment Grade Corporate Bond Fund outperformed its benchmark, Barclays Capital U.S. Credit Index, for the quarter. Positive contributors to relative performance included:

• Above-benchmark exposure to select systemically vital financial institutions enhanced returns as these securities continued to benefit from relative asset quality improvement, enhanced asset coverage and easing market conditions
• An overweight to natural gas pipeline credits that benefitted from stable, fee-based and non-cyclical cash flows, capital raises, and infrastructure spending contributed to returns. These issues also have consistent access to the capital markets to fund capital expenditures
• The portfolio’s underweight to non-corporate credits (foreign agencies and supranationals) enhanced relative returns, as these credits offered less compelling compensation than corporate bonds, and lagged the index
• An underweight allocation to non-cyclical consumer industries, including the food & beverage and consumer products sub-sectors added to performance as defensive credits rallied less than higher-beta sectors
• An average overweight to duration contributed to relative performance as yields fell across the term structure during the quarter

The following strategies detracted from returns:

• An overweight allocation to the energy sector, particularly the independent exploration & production sub-sector, detracted from returns as lower-beta sectors lagged the index with modest returns
• Below–index exposure to insurance issuers hindered performance as the sector benefitted from the financial-market rally, with improved credit profiles and enhanced asset coverage
• An underweight allocation to BBB-rated bonds detracted from performance as lower quality credits outperformed higher quality tiers as risk appetite boosted investor demand
• Modest exposure to mortgage agency pass-throughs detracted from relative returns as these bonds lagged behind the rally in the investment grade credit market
• A below-index position in the real estate investment trust (REITs) group dampened demand, as REITS benefitted from strong investor demand, recapitalization efforts and active real estate portfolio management

Recovery To Be Weak in 2010 After Temporary Boost

PIMCO believes that secular economic, social and political trends exert the most powerful and sustained influences on bond markets. We define “secular” as the next three to five years. The key assumption of our Secular Outlook is that following the severe shocks to the global economy in the second half of 2008, the world embarked upon a journey of change not likely to be reversed over the next few years. This journey, which is expected to be characterized by starts, stops and volatility, will end at a destination that can be described as a “New Normal”. Some of its features are 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.

Selective Opportunities to Persist within Investment Grade

• We find that there are still attractive opportunities within the investment grade credit market. However, 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.
• Unprecedented global fiscal and monetary support has helped to stabilize the economy, and in some cases, improved the near-term fundamentals for some companies. Longer-term, we expect that industries with ties to growth in developing markets will benefit most from this trend as we anticipate emerging market countries will look to stimulate internal demand.
• We 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.
• We still emphasize exposure to natural gas pipelines which are supported by hard assets, long term contracts and modest leverage. In addition, these issues are essential to the national infrastructure. The industry also has consistent access to the capital markets to fund capital expenditures and boost liquidity. Their stable, fee-based, non-cyclical cash flows make them attractive credits when considering debt service and the ability to weather the economic storm.
• 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.
• Despite recent richening in certain credits, we also favor select utilities, particularly those with some regulatory oversight. Further, there has rarely been a loss of principal on utility first mortgage bonds. In a worst case scenario, utility credits tend to benefit from their difficult-to-replace assets. These assets serve to generate much higher recovery values than other less asset-rich issuers, such as retailers and technology corporations.
• 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.
• Uncertainty in the labor market and elevated debt levels should have a negative impact on discretionary spending and asset prices going forward into the near future. We do not expect a sustained rapid recovery in the economy and we expect to see weak real economic growth. Therefore, we continue to maintain our bias away from consumer related industries such as retailers, gaming and home construction and other cyclical issuers.
• Weak income growth and high unemployment have caused companies in cyclical industries to remain cautious in both hiring and capital spending and to hoard cash until there is more visibility in the economy. While significant cost-cutting measures may have a positive impact on near-term corporate fundamentals, long-term profitability and free cash flow generation may be compromised in the absence of meaningful top-line revenue growth.
• In the near-term, inflows into the credit markets are likely to remain robust as credit spreads are still wide by historical standards. Financial market conditions have improved and companies are finding it easier to access the debt and equity capital markets to boost liquidity and repair balance sheets and reduce near-term default risk. However, we remain cautious about increasing risk in line with our outlook for increased supply and eventual softer demand for risk assets.