Featured Solution November 2012

Ken Miller Your Global Investment Authority

The SSA Market: a Legitimate “Safe Spread Alternative?”

As persistent debt and deleveraging challenges impede a more robust global economic recovery, major central banks have had to apply greater doses of unconventional monetary policy (QE) to suppress the level and volatility of interest rates.

These potentially inflationary central bank asset purchases together with multiple sovereign ratings downgrades have led more investors to search beyond a shrinking universe of AAA assets for high-quality investments offering “safe spread” (incremental yield over U.S. Treasuries but with the potential for minimal additional credit risk).

Issuers in the global Supranational/Sovereign/Agency and Provincial (SSA) market have been major beneficiaries of this crowding-in effect to high-quality fixed income assets. Debt from these issuers periodically offers value for PIMCO clients, and we regularly evaluate U.S.-dollar-denominated securities in this sector versus competing Ken Miller products such as U.S. agencies or comparable debt issued in different Senior Vice President currencies. Portfolio Manager

A developing landscape

Twin financial crises in the U.S. and Europe have challenged borrowers and savers alike – the deleveraging and austerity exercised by those with unsustainable debt has been painful and recessionary, with the outcome for some large sovereign debtors still undetermined. Meanwhile on the global lender side, in addition to having to upgrade investment playbooks with sovereign credit risk capabilities, fixed income managers have grappled with a shrinking risk-free investment universe. Debt formerly perceived as “riskless” and having U.S. Treasuries as the cornerstone had included other G-10 sovereigns, agencies, and supranational organizations. Yields and spreads in the sector were then sent into disarray by successive sovereign downgrades, distortive central bank asset purchases with associated seniority uncertainty, regional bailout fund machinations, and Greek debt restructuring.

Dual debt crises rattle AAA/AA universe A look back at the U.S. experience illustrates the uncertainty and complexity of this changing landscape. Investors began to question the underlying safety of AAA and AA assets across sectors, particularly in debt which had not carried an explicit government guarantee such as agencies. As a result of the 2007–2008 mortgage crisis and failure of Lehman Brothers, the primary government-sponsored enterprises (GSEs) – Fannie Mae (FNMA) and (FHLMC) – were forced into conservatorship. These agencies reduced loan portfolios and subsequently pursued smaller issuance. Understanding SSA Issuers Meanwhile, U.S. Treasury issuance expanded amid political dispute over deficit reduction, eventually leading to S&P’s downgrade of the U.S.’s credit SSAs issue debt on a regular basis rating to AA+. to fund regional projects and More recently, and a continent away, the European debt crisis erupted, development programs, but must sparking a new series of ratings downgrades, rising market volatility and adhere to relatively conservative capital flight. Many asset managers who had held passive allocations to fixed capital requirements, balance sheet income assets for reserve diversification purposes began to direct funds away constraints and lending standards from peripheral sovereign debt into core fixed income AAA and AA written into their charters. These alternatives, with much of these destined for U.S. dollar assets. guidelines limit the type and Filling the gap: agencies wane, foreign issuers gain amount of direct lending possible, As investor demand for liquid high-quality fixed income assets grew amid this with recourse on many public turmoil, the global SSA market expanded, almost tripling in size from 2005 to sector borrowers (many of whom 2012 (see Figure 1). Much of the growth has come since 2008 as SSAs have taxing power) to mitigate expanded balance sheets, taking advantage of low interest rates, allowing ultimate exposure. issuance in the sector to supplement the loss of other formerly high-quality assets. These borrowers attempt to The SSA market now embodies traits of both government bonds and investment maintain benchmark issues grade credit, occupying a corner of the spread sector typically favored by buy- denominated in the major reserve and-hold-oriented central banks, as well as reserve and sovereign wealth fund currencies to maintain the (SWF) managers. Yields on SSA debt inhabit the range between core sovereign necessary liquidity to retain end debt and investment grade credit, and valuation at any given point can be investor interest. A similar viewed as either government or corporate surrogates (much like agencies). symbiotic relationship to that of Dollar-denominated SSAs official investors and the U.S. As shown in Figure 1, the total amount of debt outstanding in the U.S.-dollar- Treasury is in play in the SSA denominated SSA sector has increased to $650 billion as of 1 May 2012, an market, as foreign issuers benefit amount equivalent to 75% of the outstanding market value of U.S. agencies. from the ability to borrow cheaply U.S.-dollar-denominated SSAs (frequently classified as high-quality “Yankees”) in USD, while global investors account for roughly 35% of global SSA market issuance. continually need to recycle dollar The U.S. dollar SSA market in particular includes names (see Figure 2) that may funds. This dynamic perpetuates be familiar to many, such as European agencies (European Investment Bank, current reserve allocations among KFW), sovereigns and sub-sovereigns (e.g., Canadian provincials), all of which central banks/SWF. compete with FNMA and FHLMC for end investor capital. SSA investor considerations SSA issuers adhere to conservative lending standards (see details in sidebar), and the demand for such high-quality paper makes these investments generally trade at lower yields than competing spread product but still above sovereign debt from the respective country. Once SSA investors become comfortable with the underlying credit quality of any given sovereign issuer, they typically view familiar names as yield enhancers to lower-yielding core sovereign debt.

NOVEMBER 2012 | FEATURED SOLUTION 2

Figure 1: Amount outstanding in government-related sector subcomponents of the Barclays U.S. Aggregate Index

1,400,000

1,200,000

1,000,000

800,000

600,000 USD millions 400,000

200,000

0 Jul-08 Jan-06 Jan-11 Jun-06 Jun-11 Oct-09 Apr-07 Apr-12 Feb-08 Sep-07 Dec-08 Mar-10 Aug-05 Aug-10 Nov-06 Nov-11 May-09 Supranationals Sovereigns Foreign Local Authorities (incl Provincials) Foreign Agencies US Agencies

Source: Bloomberg, Barclays as of 31 July 2012. Note: Not included in these totals is the related covered market, which is instead classified as the securitized component of the Barclays Aggregate Indexes. Note that 98% of SSA issuance is denominated in the six major currencies of U.S. dollar (39%), the Euro (28%), British pound (4%), Japanese Yen (19%), Canadian dollar (5%) and Australian dollar (3%).

Figure 2: Top foreign SSA issues in Barclays U.S. Aggregate Index

USD debt S&P/Moody's outstanding Rating (billions)

KFW (German Development Agency) AAA/Aaa 142.8

European Investment Bank (EIB) AAA/Aaa 142.3

Ontario (Canadian Province) AA-/Aa2 42.4

CADES (French social finance AA+/Aaa 35.0 agency)

Bank Nederlandse Gemeenten AAA/Aaa 34.0 (Dutch public finance agency)

JBIC/JFM (Japan public finance agencies) AA-/Aa3 28.0

Rentenbank (German agricultural bank) AAA/Aaa 27.6

Republic of Italy BBB+/Baa2* 25.2

Quebec (Canadian Province) A+/Aa2 23.6

Source: Barclays, Bloomberg, PIMCO as of 30 Sept. 2012. * Rating would not be classified as “safe spread”.

NOVEMBER 2012 | FEATURED SOLUTION 3

SSA investors often are indifferent to duration and liability-matching sensitivities and manage without fixed income benchmarks. On the other side of the equation, typically upward-sloping yield and spread curves make shorter-dated borrowing by SSA issuers less expensive. These mutually congruent dynamics skew the average life of the sector toward shorter maturities, generally to a maximum of 10 years, fostering a symbiotic relationship. Another important characteristic of sovereign USD issuance and agency debt is the ability of investors with captive currency allocations (e.g., restricted to USD) to access country credit risk in U.S. dollar-denominated instruments (e.g., a Scandinavian country issuing in dollars). This is especially important for investors looking for an alternative to credit default swaps (CDS), which may be an eligible means of expressing a positive credit view. Returns and spreads From an annual return standpoint, SSA securities’ duration-adjusted returns (shown in Figure 3a as Government-related) have ranged between those of Treasuries and corporate bonds in all years since 2008. Over the last four years, in periods where corporates outperformed Treasuries, SSAs have also outperformed Treasuries, but by a smaller margin. Conversely, when Treasuries have outperformed corporates, SSAs also posted higher returns than their corporate counterparts.

Figure 3a: Duration-adjusted total return

16% 14% 12%

10% 8% 6% 4% Percent (%) 2% 0% -2% -4% -6% 2004 2005 2006 2007 2008 2009 2010 2011 Barclays U.S. Aggregate Treasury Government-related Corporate Securitized

Source: Barclays, PIMCO. Note: Note: All categories are unhedged USD and are represented by applicable Barclays indices.

NOVEMBER 2012 | FEATURED SOLUTION 4

However, Figure 3b shows that while the annualized return of the government- related sector over the last seven years has been just slightly lower than the Aggregate Index and comparable to Treasury returns, the volatility of the sector has been less than both.

Figure 3b: Annualized 7-year risk/return

8%

Corporate 7% Barclays U.S. Aggregate 6% Securitized Treasury Government- 5% related

4% Return(%) 3%

2%

1%

0% 0% 1% 2% 3% 4% 5% 6% 7% 8%

Standard Deviation (%)

Source: Barclays Note: All categories are unhedged USD and are represented by applicable Barclays indices.

Figure 4 shows five-year constant spreads versus U.S. Treasuries, showing ranges of various issuer spreads versus U.S. Treasuries and how SSA spreads infrequently trade below those of Treasuries. In past periods, concerns about U.S. credit quality and the overall strength of the European economy and debt ratios (e.g., EU guarantee for EIB is joint and several), along with issuer scarcity, allowed yields on EIB debt to fall below yields on U.S. Treasuries.

NOVEMBER 2012 | FEATURED SOLUTION 5

Figure 4: SSA and Provincial constant maturity spreads (USD) vs. 5-Year U.S. Treasuries

3 7 2.5

2 5

1.5 3 1

0.5 1

0 -1 -0.5 year constantyear maturity spreads - 5

-1 -3 spreads Italy maturity constant year - 5

Japan Canada EIB Germany Italy - RHS

Source: Barclays as of 28 Sept. 2012. Note: Japan is JBIC/JFM (Japan public finance agencies), Canada is Ontario (Canadian Province), EIB is European Investment Bank, Germany is KFW (German agricultural bank), Italy is Republic of Italy and shown on right hand side (RHS) scale.

From a value perspective, it also is evident in Figure 4 that SSA issuer spreads generally tend to trade in tandem, especially during flight-to-quality periods like 2008-2009. One notable exception is the trajectory of spreads for Italy in U.S. dollars, which widened to almost 700 basis points in late 2011 and have yet to recouple with other SSA issuer spreads since the advent of the European debt crisis. Investment implications The SSA market is an important sector with a dedicated investor base, and (in U.S. dollars specifically) can offer high-quality investment alternatives with yield pickup to U.S. Treasuries and agencies. SSA spreads periodically offer value for PIMCO clients, and we frequently evaluate U.S.-dollar-denominated securities in this sector against competing products such as agency and debt issued in different currencies. Will changes in the ownership of U.S. GSEs and reduced issuance generate more demand for the SSA and covered ? As the reduced rate of agency issuance exceeds the incremental rate of decline in U.S. dollar reserves, we believe allocations will continually find their way back into high-quality SSA debt. We expect that the gradual pace of reserve reallocation ensures that the SSA market will retain broad investor interest, especially among reserve managers and central banks with fixed U.S. dollar allocations. What will the effect of QE3 be on the SSA market? Local creditworthiness considerations aside, we believe the SSA market should benefit much like other issuers of spread product have as investors follow “portfolio channeling” patterns and shift exposures into higher-yielding assets out of Treasuries

NOVEMBER 2012 | FEATURED SOLUTION 6

(“portfolio channeling” is a term used by some Fed officials for an ancillary effect of QE, enticing investors to move out the credit spectrum). Also, as central banks provide reflationary impetus in the form of low base rates, cheap financing, and direct asset purchase and credit easing, a continuous recycling of G-10 currency purchases by reserve managers may sustain demand for SSA product. Given that the Fed has announced it will purchase $40 billion of mortgage-backed securities per month in QE3, other comparable asset classes also may benefit at the expense of Treasuries. Less supply and differentiation among GSE debentures should add a scarcity premium for SSA debt. We believe that SSA spreads and returns are likely to follow patterns similar to those observed in the past but are not expected to trade at yields lower than those of U.S. Treasuries – mainly due to liquidity, issuer size and idiosyncratic issuer differentiation related to credit concerns. When the SSA market offers value for our clients, PIMCO will utilize this market as another tool to complement investor portfolios.

NOVEMBER 2012 | FEATURED SOLUTION 7

“Safe spread” is defined as investment sectors that we believe are most likely to withstand the vicissitudes of a wide Newport Beach Headquarters range of possible economic scenarios. 840 Newport Center Drive Newport Beach, CA 92660 Asset proxies for figures 3a and 3b: Barclays U.S. Aggregate is total return value. Treasuries represented by Barclays +1 949.720.6000 U.S. Aggregate Total Treasury. Government-related represented by Barclays U.S. Aggregate Government-Related. Corporate represented by Barclays U.S. Aggregate Corporate. Securitized represented by Barclays U.S. MBS Index. Amsterdam Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign Hong Kong denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing London government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Credit default swap (CDS) is an over-the-counter (OTC) agreement between Milan two parties to transfer the credit exposure of fixed income securities; CDS is the most widely used instrument. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management Munich and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. A "risk free" asset refers to an asset which in theory has a certain future return. U.S. New York Treasuries are typically perceived to be the "risk free" asset because they are backed by the U.S. government. All investments contain risk and may lose value. Singapore The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The Quality ratings of individual issues/issuers are provided to indicate the credit worthiness of such Sydney issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively. The issuers referenced are examples of issuers PIMCO considers to be well known and that may fall into Tokyo the stated sectors. PIMCO may or may not own any securities of the issuers referenced and, if such securities are owned, no representation is being made that such securities will continue to be held. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these Toronto investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Outlook and Zurich strategies are subject to change without notice. Barclays U.S. Aggregate Index represents securities that are SEC- registered, taxable, and dollar denominated. The index covers the U.S. investment grade market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed pimco.com securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The Barclays U.S. Fixed Rate Mortgage-Backed Securities Index is composed of all fixed-rate securitized mortgage pools by GNMA, FNMA, and the FHLMC, including GNMA Graduated Payment Mortgages. It is not possible to invest directly in an unmanaged index.

This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Munich Branch (Company No. 157591), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Services Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam, Italy and Munich Branches are additionally regulated by the AFM, CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, and BaFin in accordance with Section Newport Beach Headquarters 53b of the German Banking Act, respectively. PIMCO Europe Ltd services and products are available only to 840 Newport Center Drive professional clients as defined in the Financial Services Authority's Handbook and are not available to individual Newport Beach, CA 92660 investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. +1 949.720.6000 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to Amsterdam professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO Asia Pte Ltd (501 Orchard Road #08-03, Hong Kong Wheelock Place, Singapore 238880, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. PIMCO Asia Pte Ltd London services and products are available only to accredited investors, expert investors and institutional investors as defined th in the Securities and Futures Act. | PIMCO Asia Limited (24 Floor, Units 2402, 2403 & 2405 Nine Queen’s Road Milan Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd (Level 19, 363 Munich George Street, Sydney, NSW 2000, Australia), AFSL 246862 and ABN 54084280508, offers services to wholesale clients as defined in the Corporations Act 2001. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, New York Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Singapore Advisers Association and Investment Trusts Association. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where Sydney provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is Tokyo no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and Toronto calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets Zurich and thus such fees and expenses cannot be set forth herein. | PIMCO Canada Corp. (120 Adelaide Street West, Suite 1901, Toronto, Ontario, Canada M5H 1T1) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | No part of this publication may be pimco.com reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. © 2012 PIMCO