PIMCO | Global Real Return Strategy

Global Real Return Strategy

PIMCO Real Return Practice

Recognizing that their liabilities often are in real (inflation-adjusted) terms, investors are seeing the need for inflation hedges. These “real return” products can also offer important diversification for a portfolio. PIMCO offers a broad range of real return products to meet investors’ needs:

Inflation Linked Bonds (“ILBs”) – This core real return product offers liquidity, low credit risk, and a direct link to inflation

Commodity Indexes – When conservatively managed, this asset class can provide a hedge to inflation “surprises,” and historically has had strong diversification characteristics
All Asset Strategies – The Strategies allocate across a broad range of underlying strategies in an effort to produce long-term returns consistent with their benchmarks: CPI+5% for All Asset and CPI+6.5% for All Asset All Authority (CPI is the Consumer Price Index, the primary measure of U.S. inflation).
Real estate exposure as measured by a REIT index

What are Inflation Linked Bonds?

Inflation Linked Bonds, in the U.S. often called “TIPS” (Treasury Inflation Protected Securities), represent a distinct asset class in which both principal and interest payments adjust to track changes in designated inflation indices. For TIPS, the indexed principal amount is adjusted to reflect changes in the non-seasonally adjusted Consumer Price Index-All Urban Consumers (CPI-U). A fixed rate of interest (real yield) is then paid on this increasing principal amount. The principal, upon redemption, moves with changes in inflation and the cash coupon also increases or decreases with inflation. This adjustment process means that ILBs can be a hedge against inflation, especially if held to maturity. They have also historically offered portfolio diversification, since their returns have not been highly correlated with stocks and nominal bonds.

How Large are the Inflation Linked Bond Markets?

With the Treasury Department continuing to commit to future issuances of TIPS, we expect that the size and breadth of participation of the U.S. ILB market will continue to grow. For example, the Treasury Department added five-and-twenty year maturity issues to its annual auction schedule in 2004 and is planning to issue 30-year TIPS in 2010. Many other countries, such as England, Sweden, France, Canada, Japan and Australia have been active issuers of ILBs, and Germany began issuing these bonds in 2006. This new global issuance has broadened the global real return markets and has diversified real return relative value opportunities.

Applications for Real Return Products

Defined benefit pension plans have liabilities that are a function of inflation, as do property and casualty insurance companies. Individuals, funding their retirements through defined contribution plans, will need assets that provide returns in excess of inflation, which can erode the future purchasing power of their savings. Endowments and foundations have multi-year funding requirements that are in real, not nominal, terms. All of these investors can potentially benefit from higher risk-adjusted returns in their portfolios if they add diversifying assets. Real return products typically provide such diversification with historically low correlation to stocks and to nominal bonds. Because their returns have a fundamental economic relationship to inflation, they may also provide the inflation hedge needed by all of these investors. The goal of real return products is to preserve and enhance purchasing power.

PIMCO Inflation Linked Bond Management Experience

PIMCO was an early leader in analyzing global ILB issues and in working with the Treasury Department prior to the introduction of the TIPS program in early 1997.

Our ILB management extends to separate accounts having inflation-indexed benchmarks and to tactical allocations to client accounts with conventional benchmarks. Separate real return accounts include short-maturity, long-maturity, global, and leveraged assignments. Our ILB exposures also include global ILB allocations in many client separate accounts. We are able to apply our relative value framework and institutional research capabilities across the global fixed income markets in an attempt to add value through the use of ILBs. This is for strategic applications in separate real return portfolios and for tactical applications in conventional debt portfolios.

Investment Philosophy for Real Return Management

All of PIMCO’s real return products rely on our core competency in fixed income management, with the objective of maximizing real return while seeking preservation of the real capital of a portfolio. In ILB management, our full authority approach incorporates an active management philosophy, using multiple strategies involving real return and conventional debt sectors in our efforts to add value above the benchmark. We also manage return volatility relative to a designated benchmark. Our limited authority approach seeks to add value above the benchmark returns but control return volatility relative to the benchmark more closely than that targeted under full authority assignments. We believe that an active approach works in managing ILB portfolios, just as active management can add value in other sectors of the bond market. Many of the same strategies apply. It is our intention to maintain relatively high exposures (above 80%) to ILBs, a high average credit quality (AA or higher), and limited duration differentials between real return accounts and their benchmarks. Our other real return products also take advantage of PIMCO’s active bond management capabilities. Commodity index portfolios gain commodity exposure through derivatives linked to the benchmark index. The collateral that backs these derivatives is then actively managed in an attempt to provide returns higher than the interest rate embedded in the commodity index. In the case of many of PIMCO’s commodity strategies, this collateral is typically heavily invested in TIPS, which provides a “Double Real®” strategy. The RealEstateRealReturn strategy likewise uses TIPS to back derivatives that are linked to a REIT index. The All Asset strategy also takes advantage of PIMCO’s bond management by investing in several different PIMCO products managed by our portfolio specialists. To add value through active allocation among those products, the strategy engages a sub-advisor with long and specific experience in asset class allocation.

Sources of Added Value Performance

We have committed substantial analytical resources to valuing global ILBs and to assessing relative values between ILBs and conventional debt. In our efforts to achieve value-added results, we actively apply the following strategies:

Real and conventional debt durations
Real and conventional yield curve structure
Inflation-related strategies, such as “break-even” and “inflation capture”
Country rotation across ILB issuers in an effort to capture cyclical relative value
Tactical use of non-real return debt sectors, such as, mortgage-backed securities, corporate, agency or non-U.S. sovereign issues
Security selection among real return issues based on relative value factors
Cash-backing strategies

In analyzing non-U.S. real return issues, we use our global real return debt valuation models, incorporating currency-hedging costs, inflation expectations and forecasted monetary policy effectiveness. We have used limited allocations to U.S. corporate and agency ILBs, non-U.S. ILBs, and shorter-duration conventional debt in an attempt to enhance returns and manage duration for client portfolios.

Real Return Products: Improving Asset Allocations
ILBs, commodities, and real estate have displayed the characteristics of a distinct asset class:

Fundamentally distinct drivers of economic value
Low, even negative, return correlations with other asset classes

These characteristics have provided opportunities for an improved efficient frontier.

ILBs have had relatively small return correlations across various asset classes. Thus, real return portfolios have the potential to enhance the risk-return trade-off for equity-debt portfolios. ILBs can be used effectively within a portfolio containing equities due to low absolute return volatility, small return correlations with equities, and the possibility of an active manager adding value.

ILBs have exhibited smaller return volatilities than similar maturity sovereign nominal debt. The smaller ILB return volatility is a result of lower real yield volatilities. In turn, lower ILB return volatilities require the use of effective duration as the standard of comparison between ILBs and similarly rated conventional debt. We derive ILB effective durations by adjusting real yield durations by a “yield beta,” which incorporates the expected relationship between real yield and conventional yield movements. This yield beta will vary depending on where we are in the business cycle, but it is less than 1.0. This means that longer-term ILBs can be substituted for shorter-term sovereign nominal debt without changing the effective duration of the portfolio.

Low effective durations and price hedging through inflation adjustments make ILBs a valuable asset class within a portfolio context. ILBs can be used more effectively than conventional bonds in customizing portfolio risk-return profiles.

Common portfolio risks and objectives may be actively and effectively managed using ILB investments:

The need to fund requirements that are inflation-sensitive or are stated in real terms
The desire to narrow return dispersion over an investment horizon or lock in an existing surplus
The risk-to-equity returns and volatility in an inflationary environment

Risk Management / Controls

As with all of our specialized strategies, our real return portfolios are managed within our core investment philosophies and within the general portfolio guidelines established by our clients or Investment Committee. The effective duration of a real return portfolio will be maintained within a moderate range (mostly within ±1 year) of its benchmark in order to limit potential tracking errors. Additionally, we continuously measure potential price effects from yield curve movements, premium spread changes, and yield volatility shifts. We manage portfolio characteristics carefully so as to avoid large tracking errors in an effort to limit underperformance.

How To Invest

Separate Accounts

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor there is no assurance that the guarantor will meet its obligations. Investing in foreign 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. PIMCO strategies utilize derivatives which 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 could lose more than the amount invested. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Diversification does not ensure against loss.

The Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time. It is not possible to invest directly in an unmanaged index.

This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.

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