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.

Mortgage Rates Rebound Amid Fed MBS Purchases

Mortgage-backed securities, as measured by the Barclays Fixed-Rate MBS Index, outperformed like-duration Treasuries by 111 basis points in the third quarter. Mortgages outperformed Treasuries for the tenth straight month and returned 2.35 percent for the quarter on an absolute basis.

The Fed's Agency MBS purchase program has now been in operation for nine months and has purchased $905 billion Agency MBS year to date. In September the Fed extended the length of the purchase program to help mitigate potentially adverse effects as the Fed withdraws from the market. The par mortgage rate dropped 36 basis points to 4.25 percent during the third quarter. To date, over 80 percent of the Fed’s purchases have been focused in 30-year Fannie Mae and Freddie Mac 4.0%, 4.5% and 5.0% mortgage coupons.

Overall, conventional prepayment speeds continued to slow over the quarter as limited origination capacity and tighter mortgage underwriting standards resulted in a lower level of refinancing and housing turnover. GNMA prepayment speeds were slightly faster than FNMA and FHLMC due to the streamlined refinancing programs of FHA and VA and servicer buyouts in a high delinquency environment.

The following is a summary of mortgage sector performance in the third quarter:

• Agency mortgage-backed securities (MBS) outperformed Treasuries on a like-duration basis for the quarter. The success of the Fed MBS Purchase Program has compressed par mortgage spreads through pre-crisis levels
• Similar to the second quarter, higher coupon Agency MBS outperformed lower coupons with superior carry and slower prepays
• Agency MBS liquidity decreased towards the end of the quarter as significant Fed buying distorted coupon valuations and the resulting volatile technicals drove away relative value market participants
• Over the quarter, non-agency mortgages continued to rally from their March lows as the lack of supply over the last two years and technical buying ahead of the PPIP (Public-Private Investment Program) Fund launches drove up prices
• Spreads on consumer asset-backed securities (ABS) collateralized by credit card receivables, student loans and auto loans continued to tighten as the TALF program successfully reinvigorated demand for issuance as well as increased trading activity in the secondary market. The resurgence of unlevered cash investors (pension funds, money managers, insurance companies etc.) has driven many of the shorter-dated tranches below TALF-eligible financing levels
• While commercial mortgage-backed securities (CMBS) performance varied significantly from security to security, overall spreads tightened over the quarter as senior tranches benefitted from inclusion in the TALF program and from the anticipated demand from the launch of the PPIP funds. Despite strong technicals, commercial real estate fundamentals continued to deteriorate as delinquencies rose and commercial real estate prices fell

While government programs such as the Agency MBS Purchase Program have helped stabilize portions of the securitized markets, the continued orderly functioning of those sectors will depend on the ongoing implementation and eventual unwind of those programs. PIMCO will seek to position its portfolios defensively against policy uncertainty and reduce the magnitude of risk portfolios until more compelling opportunities based on fundamentals arise.

The PIMCO Mortgage-Backed Securities Fund outperformed its benchmark, the Barclays Capital Mortgage Index, during the third quarter and year to date. PIMCO’s emphasis on attractively priced high quality assets, especially those with government support, was beneficial for performance for the quarter and year to date.

The following strategies were positive for quarterly returns:

• Senior Non-Agency MBS positions as the sector rallied on strong technicals. A lack of supply and expected demand from PPIP drove up prices across collateral types
• An allocation to super senior CMBS as spreads tightened on continued technical support from TALF and PPIP
• An overweight to higher coupons for most of the quarter, as they outperformed lower coupons with superior carry and slowing prepays

An overweight to duration as rates fell The following strategies were negative for quarterly returns:

• Exposure to high-quality consumer ABS as traditional, unlevered buyers of short-dated consumer ABS returned to the market in search of high quality yield
• A curve steepening bias detracted from returns as long end rates rallied relative to the shorter end

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

Mortgage Outlook: Policy Initiatives Meet Partial Success

Third quarter 2009 was marked by the continued deployment of government programs launched earlier in the year and subsequent spread tightening across sectors. The Federal Reserve MBS Purchase Program has now purchased more than $900 billion in Agency MBS year to date. Aggressive Fed buying over the third quarter has tightened spreads but has caused relative coupon values to become dominated by Fed-related technicals. Given the outsized effects of Fed purchases, the importance of an orderly exit from the market becomes even more important.

While government programs targeting the securities markets have been successful in tightening spreads (TALF, Fed MBS Purchase Program, Commercial Paper Funding Facility), housing policy continues to face challenges. In particular, the Home Affordable Modification Program (HAMP), designed to keep borrowers in their homes through loan modifications, has yet to prove effective in stemming the pace of ultimate foreclosures. Aggressive, blanket loan modifications are unlikely to generate large numbers of successfully modified loans. Many loan modifications will likely result in high re-default rates, thereby restarting the liquidation process and extending the time frame of distressed selling pressures on home prices. The timing and volume of re-defaults remains key to determining the duration of the housing bottom. Therefore, the government’s ability to manage the outstanding supply of distressed inventory through future policy initiatives will be essential to stemming the rate of price declines and foreclosures.

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

• Fed Buying Dominates Agency MBS Valuations – PIMCO will maintain a flat to underweight position in mortgages as Fed purchases have driven Agency MBS to their near richest levels ever. We will look to re-enter the market when valuations are more compelling.
• Reduce Size of Agency MBS Coupon Relative Value Trades – Significant Fed buying has distorted coupon valuations and driven away relative value market participants. Technically-driven changes in coupon relative values have less attractive risk/reward profiles and we will seek to scale up trades when opportunities based on fundamentals re-emerge.
• Prepayment Speeds Faster than Consensus – PIMCO will position portfolios to reflect higher than expected prepayment speeds. The Street has recalibrated models to reflect reduced prepayment speed projections, however, loan modifications through the Home Affordable Modification Program will likely increase speeds as the modifications become permanent.
• Government Balance Sheet to Support Securitized Assets – The Term Asset-Backed Securities Loan Facility and the Public-Private Investment Program (PPIP) should serve to further improve liquidity and pricing for eligible sectors (Consumer ABS, Commercial MBS, Non-Agency MBS.) PPIP managers will begin deploying capital near the start of the fourth quarter.
• Cautiously Add CMBS Where Appropriate – The Term Asset-Backed Securities Loan Facility (TALF) has improved CMBS spreads overall and has in particular, benefited TALF-able CMBS. We will look to move out of TALF-eligible CMBS and replace exposure with substantially similar non-TALF-eligible CMBS positions at wider spreads.