Viewpoint March 2013

Your Global Investment Authority

The Benefits of Active Management Are Clear, Especially in the Securitized Mortgage Market

It’s an ongoing debate: Are investors better off using passive or active strategies? On one hand, proponents of active management have argued talented managers can outperform their benchmarks over full market cycles while positioning portfolios to avoid large risks that passive managers cannot. On the other, advocates often point to limited tracking error, greater tax efficiency and lower costs.

Joshua Anderson, CFA Managing Director Since the recent financial crisis, opportunities for active management have Portfolio Manager become even more robust. Pervasive rating agency downgrades, accommodative monetary policies and re-regulation of the financial industry have led to even larger inconsistencies between asset prices and fundamental value. As a result, passive investors have been exposed to material downside risks and have been unable to capitalize on some of the most attractive risk-adjusted return opportunities across fixed income markets in recent years.

Bryan Tsu This has been especially true in the securitized mortgage market, including Senior Vice President Portfolio Analyst mortgage-backed securities issued by Fannie Mae, Freddie Mac, and Ginnie Mae (agency MBS), non-agency MBS, and commercial mortgage-backed securities. In total, securitized assets represent approximately $9 trillion and make up nearly 33% of the Barclay’s U.S. Aggregate Index, which serves as the benchmark for over $1 trillion of public assets.

Jason Mandinach Vice President Product Manager

Below, we highlight three recent examples of the value of agency downgrades, home equity ABS and manufactured active management in the securitized mortgage market, housing ABS were eliminated from the Barclay’s U.S. but PIMCO believes that dislocations in value stemming Aggregate Index in 2007 and 2009, respectively. from unprecedented central bank actions, re-regulation of As losses mounted on residential mortgages during the the financial sector and rating agency dysfunction will financial crisis, rating agencies downgraded most of the continue to present attractive opportunities for active outstanding universe of residential structured credit. At its managers for the foreseeable future. peak, the non-Agency MBS sector totaled nearly $2.1 Capitalizing on out-of-index opportunities for non- trillion. Beginning in 2007, rating agencies began to agency MBS downgrade these securities as home prices began to Non-agency MBS currently represent a $943 billion market decline and mortgage credit performance showed signs of in the U.S. and have historically been excluded from deterioration. Securities would fall out of investment grade traditional bond benchmarks. In addition, other forms of even if they took a principal loss of just $0.01. Ultimately, residential structured credit, including home equity ABS nearly 91% of originally AAA-rated non-agency MBS were and manufactured housing ABS, were once parts of the downgraded to below investment grade, decimating the Barclay’s U.S. Aggregate Index. Given widespread rating demand base for these securities and pushing prices down by as much as 70% (see Figure 1).

FIGURE 1: ABX (SYNTHETIC SUBPRIME NON-AGENCY MBS INDICES) CLOSING PRICES SINCE 2008

$100

$90 ~70% price ~140% price $80 decline increase

$70

$60

$50

Closing price $40

$30

$20

$10

$0 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Oct-08 Oct-09 Oct-10 Oct-11 Oct-12 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12

2006-2 AAA Closing Price 2007-1 AAA Closing Price

Source: PIMCO

MARCH 2013 | VIEWPOINT 2

As a result, massive forced selling of the sector by ratings- FIGURE 2: HISTORICAL PRICING OF SUBPRIME HOME constrained and levered investors brought prices to levels EQUITY ABS CONSTITUENTS OF THE BARCLAY’S U.S. that were far below fundamental value. In PIMCO’s view, AGGREGATE INDEX our expected return of principal relative to the price for $120 these securities was far more important than the credit rating that any rating agency assigned. $100

Ultimately, active management and the ability to operate $80 outside of the confines of traditional bond benchmarks and ratings constraints allowed PIMCO to increase $60 exposure to non-agency MBS at historically cheap levels. $40 Not only were investors in passive investment strategies unable to capitalize on the outsize returns available in the $20 Home Equity ABS Removed from non-agency MBS market over the past several years, but Barclay’s U.S. Aggregate Index $0 many index-tracking investment strategies exposed investors to unnecessary risks prior to the financial crisis. For example, passive strategies constructed to track the performance of the Barclay’s U.S. Aggregate Index were Sample Subprime Home Equity Bond A forced to hold exposure to both subprime home equity Sample Subprime Home Equity Bond B ABS and manufactured housing ABS, which together Sample Subprime Home Equity Bond C made up nearly 0.5% of the index at their peak. The Source: Source: PIMCO; Barclay’s Capital sectors were finally removed from the index just as prices had dropped precipitously. As a result, many passive Actively overweighting and underweighting agency investors were forced to sell holdings at the least MBS within their benchmarks opportune times, resulting in large realized losses just Agency MBS represent a $5.4 trillion market and one of before the securitized sector rebounded from record-high the most widely traded bond markets in the world. In yields (see Figure 2). addition, they represent approximately 29.7% of the Barclay’s U.S. Aggregate Index. Fannie Mae and Freddie Mac MBS represent nearly 22.3% of the index, while

Ginnie Mae MBS accounts for 7.4%.

MARCH 2013 | VIEWPOINT 3

During the depths of the financial crisis, when yields on The Fed once again reaffirmed its willingness to target the agency MBS reached record highs relative to U.S. agency MBS market in response to economic weakness in treasuries, PIMCO maintained a firm belief that the U.S. September 2011, when it announced it would be government would continue to honor the outstanding reinvesting paydowns on its agency debt and MBS obligations of Fannie Mae and Freddie Mac and that portfolios back into agency MBS. As economic conditions spreads had widened without a material change in the remained fragile during the early months of 2012, PIMCO fundamentals of these securities. As a result, active began to believe that it was highly likely the Fed would management allowed PIMCO to establish a material once again turn to the agency MBS market as a means of overweight in the agency MBS sector, which proved to be injecting liquidity into the financial system by suppressing extremely beneficial to investors as the Federal Reserve mortgage rates and forcing investors into riskier assets. announced its Agency MBS Purchase Program in

November 2008 and MBS spreads tightened by approximately 120 basis points.

FIGURE 3: SOME MBS ISSUES BENEFITED MORE FROM FED PURCHASES

7.0% 6.0% 5.0% Fed- 4.0% targeted 3.0% coupons 2.0%

1.0% Non-Fed- Price Change 0.0% targeted coupons -1.0% -2.0% -3.0%

FNMA 3.0% FNMA 3.5% FNMA 4.0% FNMA 4.5% FNMA 5.0% FNMA 5.5%

Source: JPMorgan, as of 12/31/2012

MARCH 2013 | VIEWPOINT 4

While a passive investor would have been unable to bonds and synthetic exposure for the exact same credit express this view by overweighting the agency MBS sector, risks. PIMCO was not only able to overweight the sector as a While the theoretical (and historical) relationship is for whole, but was able to employ active management to synthetic CMBS to offer lower compensation than cash target securities we believed most likely to benefit from CMBS because of the advantage that CMBX has over cash the Fed’s purchases of production agency MBS coupons. in implied funding costs, the recent cheapening in CMBX As a result of active management, PIMCO sought to relative to CMBS has created attractive relative value provide investors with exposure to securities with the opportunities for the active investor (see Figure 4). greatest risk/reward profile in the event of additional Fed purchases of agency MBS. FIGURE 4: CASH CMBS VS. CMBX (SYNTHETIC CMBS INDEX) YIELD DIFFERENTIAL Not only would a passive investor not have been able to 200 actively position a portfolio in anticipation of the Fed’s activity, but index-tracking investors also were forced to 150 hold exposure to agency MBS coupons that did not benefit 100 from Fed involvement and actually exhibited flat to slightly negative price performance in 2012. 50

Gaining access to the most efficient means of 0 CMBX (basis points) exposure to CMBS, whether in cash or synthetic form Spread Between CMBS Spread Between CMBS & -50 The CMBS market currently stands at $694 billion and constitutes approximately 1.8% of the Barclays U.S. -100 Aggregate Index. CMBS have exhibited robust spread tightening across the capital structure over the past two years, as investor demand for yield and limited new issuance have resulted in extremely high demand for a Source: PIMCO, As of 1/31/2013 limited supply. However, synthetic indexes that track An active manager had the flexibility to maintain exposure CMBS, called CMBX, have lagged the rally in cash bonds, to the CMBS sector, greatly improving the risk/reward as many investors are unable to use derivatives for profile of its positions through rotation out of CMBS cash regulatory reasons, while others receive more favorable bonds in favor of synthetic CMBX exposure. Active accounting treatment for cash bonds. In addition, a management allows investors to gain access to the most combination of natural hedgers (dealers and origination efficient means of exposure to certain sectors represented pipelines) and speculators (macro hedge funds, dealers) by a benchmark, whether in cash or synthetic form. often results in material distortions in value between cash

MARCH 2013 | VIEWPOINT 5

Over the past year, PIMCO has opportunistically added The importance of active management in today’s CMBX exposure across a variety of strategies versus sales mortgage market of equivalent cash securities that have rallied to levels that PIMCO believes that active management can help investors no longer justify the downside risks. In addition to cash navigate the dislocations in value across the securitized versus synthetic exposure, active managers can also mortgage market, particularly in an investment landscape employ detailed selection across the CMBS sector which continues to be heavily influenced by ongoing policy to identify opportunities that are not included in traditional initiatives, rating agency dysfunction and structural bond benchmarks. For example, interest-only and floating- changes to the mortgage finance system. As valuations rate CMBS have historically not been included in the and fundamentals change, active managers can adjust Barclay’s U.S. Aggregate Index. their portfolios accordingly.

MARCH 2013 | VIEWPOINT 6 Biography Mr. Anderson is a managing director and portfolio manager in the Newport Beach office, focusing on global structured credit investments. Prior to joining PIMCO in 2003, he was an analyst at Merrill Lynch covering both the residential ABS and collateralized debt obligation sectors and was ranked as one of the top analysts by magazine. He was previously a portfolio manager at Merrill Lynch Investment Managers. He has 17 years of investment experience and holds an MBA from the State University of New York, Buffalo. Mr. Tsu is a senior vice president and portfolio analyst in the Newport Beach office, focusing on commercial mortgage-backed securities (CMBS) and collateralized loan obligations (CLOs). Prior to joining PIMCO in 2008, he worked at Bear Stearns in New York, syndicating collateralized loan and collateralized debt obligations and other asset-backed transactions. He has seven years of investment experience and holds a bachelor's degree in economics and operations research from Columbia University. Mr. Mandinach is a vice president and product manager in the Newport Beach office, responsible for mortgage-related strategies. Prior to joining PIMCO in 2010, he was a business development associate at the Chicago Climate Futures Exchange. Previously, he was a vice president on the agency CMO desk at Bear Stearns. He has six years of investment experience and holds an undergraduate degree from the University of Delaware.

Newport Beach Headquarters 840 Newport Center Drive Newport Beach, CA 92660 +1 949.720.6000

Amsterdam

Hong Kong

London

Milan

Munich

New York

Rio de Janeiro

Singapore

Sydney Past performance is not a guarantee or a reliable indicator of future results. A word about risk: Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation Tokyo risk; investments may be worth more or less than the original cost when redeemed. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may Toronto fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some Zurich form of government or private guarantee there is no assurance that private guarantors will meet their obligations. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives .com could lose more than the amount invested. Diversification does not ensure against loss.

This material contains the current opinions of the manager 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 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 53b of the German Banking Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Services Authority's Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 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 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, Wheelock Place, Newport Beach Headquarters Singapore 238880, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a 840 Newport Center Drive holder of a capital markets services licence and an exempt financial adviser. PIMCO Asia Pte Ltd services and Newport Beach, CA 92660 +1 949.720.6000 products are available only to accredited investors, expert investors and institutional investors as defined in the Securities and Futures Act. | PIMCO Asia Limited (24th Floor, Units 2402, 2403 & 2405 Nine Queen’s Road Amsterdam 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 Hong Kong are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd (Level 19, 363 George Street, Sydney, NSW 2000, Australia), AFSL 246862 and ABN 54084280508, London offers services to wholesale clients as defined in the Corporations Act 2001. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Milan Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and Investment Trusts Association. Investment Munich 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 provision of such products or services is unauthorized. New York Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the Rio de Janeiro 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 no guarantee that the principal amount Singapore 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 calculation methodologies of Sydney each type of fee and expense and their total amounts will vary depending on the , the status of investment performance, period of management and outstanding balance of assets and thus such fees and Tokyo 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 Toronto Canada and only through dealers authorized for that purpose. | PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1o andar, Rio de Janeiro – RJ Brasil 22210-030. | No part of this publication may be Zurich 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 pimco.com States and throughout the world. © 2013, PIMCO.