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.

Riskier Assets Extend Gains Despite Fragile Economy

Valuations of corporate bonds, mortgages and asset–backed securities continued to richen in the third quarter. These gains were supported less by fundamentals than by positive technical conditions and government policies that helped push investors out of cash and toward higher yielding, riskier assets. The following summarizes fixed income sector returns:

• Agency mortgage-backed securities (MBS) continued their powerful rally during the third quarter, outperforming like-duration Treasuries. The success of the Fed’s MBS Purchase Program compressed mortgage yield premiums to the narrowest levels ever seen when measured versus interest rate swaps. Non-Agency mortgages also rallied. A lack of new issuance over the last two years and anticipation of demand from the Public Private Investment Program drove non-Agency prices higher. Consumer ABS enjoyed strong gains versus like-duration Treasuries, owing to robust demand for TALF assets and the re-emergence of unleveraged cash investors such as pension funds and insurance companies.
• Corporate bonds, especially high yield credits, were among the best performing fixed income assets during the quarter, buoyed by highly favorable market technicals. Credit premiums continued to tighten and approached levels last seen in 2007 as fund flows into corporate credit were very strong and the supply of available bonds began to contract slightly after years of growth. These circumstances benefitted lower-rated credits the most. Performance was strongest in the financial sector, which gained from improved asset valuations, a continued steep yield curve and increased fee-based income as capital markets revived.
• Municipal bonds outperformed Treasuries by a wide margin during the quarter. Municipal yield ratios relative to Treasuries moved closer to historical averages after widening dramatically last year. As with corporate bonds, technical factors were positive in the municipal market. Inflows into municipal funds remained strong amid heightened expectations for future tax increases. Municipal new issue supply was relatively modest as issuance was diverted into taxable Build America Bonds.
• Treasury Inflation-Protected Securities (TIPS) outperformed their nominal counterparts during the third quarter, supported by positive inflation accruals and lower real yields across most of the maturity spectrum.
• The rally in emerging market (EM) bonds continued in the third quarter. EM bonds denominated in U.S. dollars outperformed Treasuries as credit premiums tightened on most bonds amid an increase in risk appetites and positive flows into the EM sector. EM assets denominated in local currencies also had strong returns, led by monetary stimulus in most EM countries. EM currency appreciation also helped boost returns of EM local assets.
• Yields on government bonds fell modestly in most developed markets during the quarter as concerns about the extent of global economic recovery lingered. Interest rate volatility generally decreased from recent periods. Among developed markets, U.S., U.K. and Eurozone bonds fared the best.

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, respectively.

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.

Overall, PIMCO’s emphasis on attractively priced high quality assets, especially those with government support, was beneficial for performance for the quarter. The following strategies helped returns in the quarter:

• Above-index duration as yields fell
• Money market futures in the U.S., Europe and the U.K, which gained as central banks indicated short maturity rates would remain low longer than markets had expected
• An emphasis on Agency mortgage pass-through securities for some of the quarter; valuations of these bonds benefitted from continued purchases by the Fed
• An overweight to bonds of financial companies, which continued to outperform the broader corporate market
• An emphasis to municipal bonds; inflows into municipals funds remained strong and new issue supply was relatively light leading to the municipal market outperforming treasuries over the period
• Holdings of real return bonds, which outperformed their nominal counterparts due to positive inflation accruals

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.

Tactically Scale Back Risk as Valuations Richen

PIMCO will tactically reduce risk exposures in portfolios following powerful rallies in non-Treasury sectors driven primarily by favorable technicals and government policy. We believe this approach will protect portfolios in the event the economy slips back into a recession and should allow PIMCO to reinvest at more attractive valuations later.

• Interest Rate Strategies – We will plan to provide a moderate exposure to interest rate duration. While shorter maturity yields are unlikely to move much from current lows, there could be downward pressure on longer maturity yields should the economy weaken over the next year.
• Move Toward Neutral in Agency Mortgages – PIMCO’s significant emphasis in high quality Agency mortgage-backed securities (MBS) has recently been strongly positive for returns. With MBS valuations having richened substantially and the Fed’s mortgage purchase program slated to end in March of next year, PIMCO will move to an underweight in an effort to benefit from an expected cheapening of Agency MBS.
• Reduce Corporate Bond Holdings – We also will look to trim corporate bond positions into the current rally, especially those that have appreciated most such as senior bonds of high quality banks.
• Emerging Markets and Currency – PIMCO will take exposure to high quality EM credits such as Mexico, Brazil, Korea and Russia, which have relatively little debt coming due in the near future and a high level of reserves. We will take similar positions in EM currencies, with the exception of Russia, and also take exposure to the Chinese yuan, anticipating that faster growth in these economies should allow their currencies to gain versus the U.S. dollar.