Introducing the PIMCO Global Advantage Bond Index (GLADI )

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3 Introducing the PIMCO Global Advantage Bond Index (GLADI ) The PIMCO Global Advantage Bond Index (GLADI ) is a new investment-grade, multi-sector fixed income benchmark. Launched in January 2009, GLADI is designed to better capture investment opportunities in a rapidly changing world. Intended to offer investors an improved benchmark for fixed income market beta, GLADI provides a building block for portfolios with the potential for higher riskadjusted returns. A New Approach to Bond Indexing The global economy is in the midst of dramatic transformations that challenge the ability of traditional investment approaches to generate sustainable returns while also managing risks. One profound change crucial to bond investing is the explosion of public debt levels in industrialized countries. Traditional bond indexes - by virtue of their market capitalization weighting methodology - have an inherent structural bias to overweight countries with high levels of debt. As concerns about sovereign creditworthiness become increasingly critical to asset allocation, there is greater urgency for an alternative to traditional approaches. Through its broader coverage and unique construction methodology, GLADI explicitly recognizes the need for investors to position their fixed income portfolios within this changing global environment. Several core features distinguish GLADI from traditional fixed income indices, including: n A global beta that evolves with the world s economic structure, providing broad exposure to a diversified basket of global currencies, especially currencies of creditor countries in the emerging world. Advantages of GDP Weighting GLADI weights index components based on gross domestic product (GDP) as an alternative to the market capitalization weights used by most existing fixed income indexes. GDP weighting offers a number of relative benefits: 1. Higher Allocation to Low-Debt Countries. Because larger stocks of debt mean higher market capitalization, market capitalization-weighted indexes are at a structural disadvantage as they have a bias to assign greater weights to highly indebted countries, even though the credit quality of those issuers may be eventually compromised by their debt load. In contrast, GLADI s GDP-weighted approach bases allocation on national income (GDP), which embodies the capacity to repay debt. The income-orientated approach produces a bond beta with an emphasis on countries with lower leverage, or lower levels of debt relative to their ability to service the debt, as illustrated in Figure 1. Figure 1: Index Distribution by Government Debt 50% GLADI (GDP-weighting) Traditional Index (Market Cap-weighting)* GDP weighting has more representation of low-debt countries......and less representation of high-debt countries n n n An innovative GDP-weighting methodology that avoids the disadvantages of traditional indexes based solely on market capitalization weighting. A continuum in coverage from developed to emerging markets, capturing the fuller set of global investment-grade opportunities and avoiding a lopsided weighting toward developed markets. Inclusion of inflation-linked bonds in addition to nominal bonds, providing a partial built-in hedge against potential inflationary pressures. Index Weights (%) 40% 30% 20% 10% 0% Above 120 Gross Government Debt (% of GDP) Source: Markit, PIMCO, Barclays, IMF (2009 Debt-to-GDP). Data values as of 10/31/2010. *Traditional Index is represented by Barclays Capital Global Aggregate Index. 1

4 Nominal GDP Growth 2 2. Forward-Looking. Fundamental transformations in global capital markets are reshaping the financial landscape for retail and institutional investors. Market capitalization-weighted indexes fail to capture these changes because they are inherently backward-looking, reflecting past patterns of debt issuance. Since rapid economic growth tends to precede the liberalization and deepening of capital markets, GLADI s GDP weighting is designed to capture the opportunities that exist in the world s most dynamic economies. By embedding a concept of where capital markets will be in the future rather than where they have been in the past GLADI helps investors position their portfolios to reap potential first-mover benefits. 3. Counter-Cyclical Rebalancing. Another well-known disadvantage of market capitalization-weighted indexes is that they assign progressively greater weight to securities as they go up in price, exactly the opposite of the investment maxim to buy low, sell high. GLADI not only avoids this pitfall of market capitalization weighting, but also has the potential to benefit from counter-cyclical rebalancing, since bond prices tend to move inversely to GDP growth over the business cycle, with bond prices rising as economic growth slows, and falling as economic growth accelerates. A GDP-weighted index that increases the relative weight of countries in the expansion phase of the business cycle (when bond prices are low) and reduces the relative weight of countries in the contraction phase (when bond prices are high) helps embed a buy low, sell high bias, as illustrated in Figure 2. Figure 2. Counter-cyclical Rebalancing Feature of GDP Weighting Maximum index weight as business cycle peaks... Business Cycle...and yields poised to decline as economy slows. Bonds RALLY. Minimum index weight when economy reaches trough of recession... Repeated during each business cycle....yields poised to rise as economy recovers. Bonds SELL OFF. Yields falling, bonds RALLY Methodology The construction of GLADI follows three steps: (1) regional weights are assigned based upon the relative GDP shares of the respective major regions in the global economy, (2) factor/instrument category weights are identified based upon the primary sources of fixed-income risk/return available to global investors within each region, and (3) security selection within each sub-index is guided by a set of rules and a market profile process designed to ensure that the index is investable and can be replicated In a portfolio of liquid securities. Figure 3 illustrates the process. Figure 3: Three Steps in Constructing GLADI Step 1: Assign regional weights by gross domestic product Major Regions Weighted by Share of Global GDP United States Eurozone Japan Other Industrialized Countries Emerging Markets Step 2: Assign instrument category weight by key sources of fixed-income risk and return Balance of Instruments to Represent Key Sources of Fixed Income Return Interest Rate Duration Interest rate swaps (nominal) Inflation-protected securities (real) Credit Premiums Investment-grade corporate bonds External sovereign bonds Securitized Instrument Premiums Mortgage-backed securities and covered bonds Step 3: Complete security selection for each sub-index based upon eligibility criteria and market profile Security Selection Designed for Replicability and Investibility Eligibility Criteria Credit quality Instrument type Minimum remaining maturity Minimum par outstanding Market Profile Process Select set of liquid securities to represent maturity and industry profile of broader market

5 Step 1. Regional Weights The regional classification distinguishes the major economic regions listed in Figure 3, with the weight of each region in GLADI determined by its respective share of global GDP. GDP shares are calculated as the simple average of each region s share of global GDP for the previous five years, measured in nominal U.S. dollars at market exchange rates. The GDP data come from the International Monetary Fund. GDP weights are revised annually, with the new weights becoming effective on October 31 of each year. Figure 4 displays the current regional target weights for GLADI, based on the annual review that became effective on October 31, Step 2. Instrument Weights and Sub-Index Target Weights As discussed above, market capitalization weighting has the disadvantage of increasing the weight of securities as they become more expensive. In addition, market Figure 4: Regional Weights Based on Share of Global GDP Region Target Weights United States 25.6% Eurozone % Japan 8.6% Other Industrialized Countries % Emerging Markets % 1 Includes all members of Europe s Economic and Monetary Union (EMU), which have adopted the euro as the national currency. 2 Includes Australia, Canada, Denmark, New Zealand, Norway, Sweden, Switzerland and the U.K. 3 Emerging Markets covers any markets not included in other categories. Source: Markit. Data values as of 10/31/2010. capitalization-weighted global indexes tend to be dominated by government bonds because of their large historical issuance, despite the fact that many bond managers tend to use other instruments, such as interest rate swaps, as a substitute for the interest rate duration that comes from government securities. Figure 5: Steps to Producing the Sub-Index Target Weights Regional Category United States A x B = C Regional Target Weights 25.6% Duration Factor/ Instrument Category Nominal Real Factor/ Instrument Category Weights GLADI Sub-Index Target Weights* Name of Sub-Index 22% 5.7% GLADI U.S. Interest Rate Swaps 11% 2.8% GLADI U.S. Inflation-Protected Credit 33% 8.6% GLADI U.S. Corporates Securitized 33% 8.5% GLADI U.S. Securitized Eurozone 22.1% Nominal 22% 4.9% GLADI Eurozone Interest Rate Swaps Duration Real 11% 2.5% GLADI Eurozone Inflation-Protected Credit 33% 7.4% GLADI Eurozone Corporates Nominal Japan 8.6% Duration Real Other Industrialized 11.9% Countries Emerging 31.8% Markets Securitized 33% 7.4% GLADI Eurozone Securitized Nominal Duration Real 67% 5.7% GLADI Japan Interest Rate Swaps 33% 2.9% GLADI Japan Inflation-Protected 22% 2.6% GLADI Other Industrialized Interest Rate Swaps 11% 1.3% GLADI Other Industrialized Inflation-Protected Credit 33% 4.0% GLADI Other Industrialized Corporates Securitized 33% 4.0% GLADI Other Industrialized Securitized Duration 33% 10.6% GLADI Emerging Markets Internal Bond 33% 10.6% GLADI Emerging Markets External Bond Currency 33% 10.6% GLADI Emerging Markets Currencies *Components may not sum up to aggregate due to rounding. Source: Markit. Data values as of 10/31/

6 To avoid these issues, GLADI takes a different approach, employing a proportional weighting system based on the key sources of fixed-income risk and return. Of particular importance are: (1) interest rate duration, reflecting the sensitivity of bond prices to changes in nominal and real yields; (2) credit premiums, reflecting the higher yields available on securities with credit risk; and (3) securitized instrument premiums, reflecting embedded pre-payment options and other premiums associated with mortgagebacked securities. In the absence of a robust theoretical or empirical rationale for departing from a parsimonious equal weighting of each of these factors, this is adopted as the preferred weighting scheme. The implementation of Steps 1 and 2 is illustrated in Figure 5, where each respective region s GDP weight (Column A) is multiplied by the proportional instrument category weight (Column B) to produce the 17 sub-index target weights (Column C). For the United States, the eurozone, and other industrialized countries, the application of this framework is straightforward: the 1 /3 interest rate duration component is represented by a mix of two parts interest rate swaps and one part inflation-protected securities; the 1 /3 credit premium component is represented by fixed-rate corporate bonds; and the 1 /3 securitized instrument premium component is represented by U.S. Agency mortgage-backed security TBAs, mortgage-backed bonds in Canada and Denmark, and covered bonds and Pfandbriefe in the eurozone, Sweden, Switzerland and the United Kingdom. In other markets, adjustments to this methodology are incorporated to reflect the availability of certain categories of instruments. For Japan, where liquidity in the corporate bond market is highly limited and there is no substantial securitized market, only the interest rate duration component is included. For emerging markets, the lack of liquid interest rate swap markets means that internal local currency- 4 denominated government bonds are used to represent the interest rate duration risk factor, while U.S. dollar- and euro-denominated external sovereign bonds are used to represent credit premiums. Due to the lack of widespread securitized markets at this time, this category is not represented for emerging markets. However, because short-duration local currency investments have become a staple of global investment in these markets, currency represented by short-dated foreign exchange derivatives is included as a separate category. Step 3. Security Selection The final step is to determine the specific securities that will be included in each of the sub-indexes. The universe of potential securities is defined by a series of eligibility criteria. In order to preserve replicability and investability, the number of securities selected within each market is limited, depending on the size of the market and liquidity considerations. When the actual number of securities in the market exceeds the limit, a market profile process is applied to select the securities that will be included in the index. The market profile process refines the universe of eligible securities to identify the most representative and liquid securities, producing an index that is replicable and investable. A. Eligibility Criteria There are four eligibility criteria that define the universe of instruments: n Credit Quality. Eligible instruments must be investment grade (BBB- or higher). The average rating from Moody s, S&P and Fitch is considered when available. Instruments downgraded to below investment grade are removed from the index upon monthly reconstitution. n Instrument Type. Outside of derivatives instruments, only fixed-rate, non-callable (except for mortgage-backed securities) bullet bonds or sinking funds issued by developed and emerging governments, corporations and securitization entities are eligible.

7 n Remaining Maturity. All emerging market, inflationprotected, corporate and securitized bonds must have at least 12 months remaining until maturity. Securities with maturities of less than 12 months upon monthly reconstitution are excluded from the index. n Minimum Par Amount Outstanding. Eligible instruments must have a current par amount outstanding greater than or equal to a minimum amount that differs by instrument and is currency specific. Minimum par for inflation-protected bonds is 2 billion USD or the approximate foreign currency equivalent. For corporate bonds the minimum is 500 million USD, 100 million GBP or 300 million CAD, EUR, AUD or CHF. Securitized bonds must have minimum par of 1 billion CAD or EUR, 100 million GBP, 300 million CHF, 2 billion SEK or 3 billion DKK. For emerging markets, the minimum for external bonds is 500 million USD or EUR, while local bonds must have a minimum local currency equivalent of 100 million USD. B. Market Profile The market profile process is used for the corporate, securitized, and emerging market local bond subindexes of GLADI. The objective of the process is to create an index that is replicable and investable by identifying the most representative and liquid bonds in each sector of the market. Figure 6: Market Profile Example: U.S. Corporates (1) For U.S. Corporates, the relevant factors are industry sector and maturity. Bonds are assigned to cells in the matrix based on their sector (senior financial, subordinated financial, non-financial consumer and non-financial industrial) and maturity band (1-7 years, 7-15 years, 15+ years). In this example, 6% of the total market value of the U.S. Corporate universe is in the cell corresponding to financials with 7-15 years maturity. Industry Sector Senior Financial Subordinated Financial Non-financial Consumer Maturity Band 1 7 Years 7 15 Years 15 + Years 20% 8% 3% 7% 6% 4% 13% 6% 7% (2) Calculate the number of bonds to be selected for the market profile for each cell by multiplying the cell s market share by the overall target number of bonds for the sub-index. The overall target number of bonds for the U.S. corporate sub-index is 500. Using the example above where financial sector bonds of 7-15 year maturity represent 6% of the universe, 30 bonds should be selected for this cell (500 x 6% = 30). (3) For this example, bonds issued within the last five years would be the first considered for index inclusion, with these bonds ranked based on 1) the amount outstanding, 2) time since issue, 3) remaining time to maturity and 4) issuer size. Non-financial Industrial # of Bonds (subordinated financial, 7 15 years) = Market Share (subordinated financial, 7 15 years) Ranking Criteria for Corporate Bond Bond issued within the last five years (yes/no) Amount outstanding (descending) Age (descending) 10% Time to maturity (descending) Issuer size (descending) 8% x Total Target # of Bonds 8% 5

8 The market profile process for each sub-index varies depending on the particular attributes of that sector, but the basic process involves three steps, illustrated below in Figure 6 with an example from the U.S. Corporates sub-index. (1) Create a market structure matrix, which classifies all bonds according to the most relevant factors in that market. (2) Calculate the number of bonds to be selected for the market profile for each cell by multiplying the cell s market share by the overall target number of bonds for the sub-index. (3) Select the highest-ranked individual securities (based on a set of ranking criteria see box), until the target number of bonds per cell is satisfied. Only one bond per issuer is considered in each cell until one bond from each issuer represented in that cell has been selected. If the number of bonds required is larger than the number of issuers, a second bond is selected from each issuer according to the rank until the required number of bonds has been selected. Streamlined market profiles are also used for the interest rate swap and emerging market foreign exchange components of the index. A basket of 2-year, 5-year, 10-year, and 30-year swaps are used to represent the interest rate swap sub-indexes, while a basket of 1-month, 2-month, and 3-month foreign exchange forwards are used to represent the emerging market currency sub-index. Index Attributes The index methodology described above produces an index that is broadly diversified across instruments, regions, currencies and maturities. Key attributes of the GLADI overall index and sub-indexes are presented in the accompanying figures. Figures 7 through 11 show index data as of October 31, Figure 7: PIMCO GLADI and Sub-index Statistics Regional Category PIMCO GLADI Sub-Indexes Weights (%) Duration (Years) Yield (%) Average Quality GLADI U.S. Interest Rate Swaps 5.7% AA- United States GLADI U.S. Inflation-Protected 2.8% AAA GLADI U.S. Corporates 8.6% A GLADI U.S. Securitized 8.5% AAA GLADI Eurozone Interest Rate Swaps 4.9% AA- Eurozone GLADI Eurozone Inflation-Protected 2.5% AA+ GLADI Eurozone Corporates 7.4% A+ GLADI Eurozone Securitized 7.4% AAA Japan Other Industrialized Countries Emerging Markets GLADI Japan Interest Rate Swaps 5.7% AA- GLADI Japan Inflation-Protected 2.9% AA- GLADI Other Industrialized Interest Rate Swaps 2.6% AA- GLADI Other Industrialized Inflation-Protected 1.3% AAA GLADI Other Industrialized Corporates 4.0% AA- GLADI Other Industrialized Securitized 4.0% AAA GLADI Emerging Markets Internal Bond 10.6% A GLADI Emerging Markets External Bond 10.6% BBB+ GLADI Emerging Markets Currencies 10.6% A+ PIMCO Global Advantage Bond Index 100% AA- 6 Source: Markit. Data values as of 10/31/2010.

9 Figure 8: PIMCO GLADI Instrument Exposure* (%) Figure 10: PIMCO GLADI Maturity Exposure* (%) External Debt 10.6% Currencies 10.6% Interest Rate Swaps 19.0% Years 7.9% > 15 Years 9.1% 1 3 Years 40.6% Internal Debt 10.6% Inflation Protected 9.5% 7 10 Years 12.4% Securitized 19.8% Corporates 19.9% 5 7 Years 15.8% 3 5 Years 14.3% Figure 9: PIMCO GLADI Credit Quality Exposure* (%) Figure 11: PIMCO GLADI Currency Exposure* (%) BBB 15.3% AAA 25.6% Other Industralized Currencies 11.9% U.S. Dollar 32.8% A 16.4% Asia ex-japan: 7.7% Emerging Europe, Middle East and Africa: 7.0% Latin America: 6.5% Emerging Market Currencies 21.2% AA 42.8% Japanese Yen 8.6% Euro 25.6% *Source: Markit. Data values as of 10/31/

10 Reweighting and Rebalancing Target Regional weights for GLADI will be revised in an annual review, with the new weights becoming effective on October 31 of each year. Under most circumstances, year-to-year changes in the sub-index target weights will come only from changes in the regional weights, which will shift as relative shares of global GDP shift. On occasion, the instrument category weights may also be changed at the annual review to reflect the development of new instrument categories and other innovations in global capital markets. The actual weights of the GLADI sub-indexes on a daily basis will deviate from their target weights, reflecting changes in the prices of the underlying instruments in the index. On a quarterly basis (October 31, January 31, April 30, July 31), the GLADI will be rebalanced to restore the actual sub-index weights to their targeted levels. On a monthly basis, securities within each sub-index will be added and removed at month-end according to the eligibility criteria and market profile process described above. Figure 12: PIMCO GLADI Rebalancing Schedule Review of Target Weights Rebalancing to Target Weights Security Selection Update Index Administration and Data GLADI will be administered and calculated independently from PIMCO by Markit, an unaffiliated leading global index provider. Markit will be responsible for the ongoing application of the index methodology, identification of index constituents and all other technical matters connected to the calculation and provision of index data. Additional information and access to data can be found at: GLADI data is available on Bloomberg: PGLATR Index <GO> PGLAYD Index <GO> Annual Quarterly Monthly Total Return in USD Unhedged Yield PGLAMD Index <GO> Modified Duration 8

11 Past performance is not a guarantee or a reliable indicator of future results. Back-testing and other statistical analysis material that is provided in connection with the explanation of the mechanics and/or potential yield of GLADI or a GLADI sub-index use simulated analysis and hypothetical circumstances to estimate how the index or sub-index may have performed prior to its actual existence for the period shown. No representation is being made that any investment will achieve results similar to those shown. The information provided is not intended for trading purposes, and should not be considered investment advice. Yield and other information are derived from data provided by Markit LLC. While PIMCO believes the data to be accurate, no warranty is given regarding the accuracy of the data. The performance shown does not include transaction costs, fees of any kind, or any other costs which could have materially reduced the performance shown. GLADI IS AN INDEX AND YOU CANNOT INVEST DIRECTLY IN GLADI OR ANY SUB-INDEX. The Use of Third Party Information: GLADI relies on information from an unaffiliated third party provider, Markit LLC. PIMCO does not make any warranty or representation as to the accuracy and/or completeness of that information and takes no responsibility for the impact of any inaccuracy of such data. This material contains the current opinions of PIMCO 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. There is no guarantee that this investment methodology will work under all market conditions. Certain features of the PIMCO Global Advantage Bond Index (GLADI) are patent pending. GLOBAL ADVANTAGE and GLADI are trademarks of Pacific Investment Management Company LLC. Registered trademarks or trademarks contained herein are the property of Pacific Investment Management Company LLC and/or Allianz Global Investors of America L.P. in the United States and/or other countries. 9

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