Strategy OverviewMunicipal bonds are debt securities issued by or on behalf of state and local governments, their agencies and authorities, and other instrumentalities. The interest income of most municipal issues is exempt from Federal income taxes. Additionally, the interest income of municipal issues of a specific state will generally not be taxable for state income tax purposes for residents of that state.
The PIMCO Short Duration Municipal Bond strategy is designed to be appropriate for investors seeking tax-exempt income. The strategy consists of a diversified portfolio of primarily short duration, high credit quality municipal bonds that carry interest income that is exempt from federal tax and in some cases state tax.
In the municipal bond market, issuer-specific credit analysis is critical. Unlike passive strategies that typically rely solely on a rating agency for credit analysis, PIMCO applies extensive research on each municipal bond we purchase. We believe it is imperative to analyze each issuer, both at purchase and on an ongoing basis, to avoid what we feel are municipalities of deteriorating credit quality in our efforts to protect investors’ capital. Active management not only enables the strategy to invest in only the issuers and securities we endorse, but also allows us to change the portfolio structure should credit conditions change. In addition, active management allows for management of capital gains and losses, working to minimize the tax effect of gains, while harvesting losses when available.
Our strategic objectives are to consistently add value over benchmark total returns and to maintain return volatilities similar to those of the selected benchmark. We use the following portfolio strategies in attempting to achieve consistent above-benchmark returns:
Most municipal bonds have call options. Callability introduces duration uncertainty as duration can be extended or shortened dramatically, depending upon changes in interest rates. For example, as yields drop, the likelihood of a bond getting called away well before its stated maturity date may increase substantially. Under such a circumstance, the bond’s duration could be dramatically shortened, thereby limiting the potential price appreciation resulting from falling yields. We carefully measure the added yield from accepting call risks and will structure our portfolios to provide for appropriate call protection. Similarly, we use our extensive internal analytics to gauge the potential price effects of yield curve movements and sector yield premium shifts.
We closely track potential tax liabilities of market discount bonds, which may be trading near their safe harbor limits, or the price at which any further price increases to par are not taxable. Such market discount bonds will experience price volatilities differently than their stated duration calculations. For discount bonds near or below the safe harbor limits, market discounts would be taxed at ordinary income tax rates upon disposal, call, or maturity. Due to this potential tax liability, a market discount bond can sustain adverse price movements as the de minimis safe harbor limit is approached.
As one of the largest bond managers in the U.S., we have available trading economies of scale, permitting us to manage trading costs to as low a level as possible. Trading costs are reflected in bid-ask spreads, which can be substantial in the municipal market due to the absence of sufficient trading liquidity, the very large number of different issues, and the relatively small average issue amount. Our trading volumes provide us with continuous access to all of the major market makers, allowing us to assess broker inventories and current market conditions. Trading costs, including tax effects, are factored into all of our analyses to help ensure that the relative value benefits of a trade outweigh the transaction costs.
We are unique among municipal managers in that we integrate our municipal bond managers with our other sector specialist and generalist portfolio managers. Through this integration, our municipal managers acquire a relative value perspective among all debt sectors, enabling them to assess how relative sector and issue valuations may shift under changing circumstances and how relative portfolio performance may be affected.
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. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. 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 an overall portfolio. There is no guarantee that this investment strategy will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. Diversification does not ensure against loss. Please consult your tax and/or legal counsel for specific tax questions and concerns.
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.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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