The State of the Credit Markets & Current Opportunities Ryan Blute, CFA Vice President This presentation contains the current opinions of the manager and such opinions are subject to change without notice. This presentation 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. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this presentation may be reproduced in any form, or referred to in any other publication without the express written permission of PIMCO Europe Ltd PIMCO Europe Ltd (Registered in England and Wales, Company No. 264517) Registered Office, Nations House, 13 Wigmore Street, London, W1U 1QS, Tel: 44-27-872-13. Authorised and Regulated by the Financial Services Authority (25 The North Colonnade, Canary Wharf, London, E14 5HS).
Biographical Information Ryan P. Blute, CFA Mr. Blute is a Vice President and Product Manager overseeing European and UK credit products. He joined PIMCO in 2 and has nine years of investment experience, including high yield and investment grade corporate bond research. Prior to joining PIMCO, Mr. Blute was a senior accountant at Deloitte & Touche in the Assurance and Advisory practice. He holds a Bachelor's Degree in accounting and finance from the University of Arizona and an MBA in finance and economics from the University of Chicago Graduate School of Business. He is also a Certified Public Accountant. 1
Agenda I. Credit Market Turmoil Causes and Effects II. Fundamental Outlook for Credit III. Current Opportunities and Trade Ideas 2
ABX Index: An Illustration of the Subprime Problems As delinquencies and subprime credit issues began to emerge, market participants used the ABX as their primary hedging vehicle '# 1 9 8 7 6 5 ABX Prices,-.## '# 26-2 BBB 26-2 BBB- 27-1 BBB 27-1 BBB- 4 12/31 1/31 2/28 3/31 4/3 5/31 6/3 7/31 Future rate resets likely to add pressure to spreads and broader economy!"# # $ % '# )&# &# ( * ##+ 3. Refer to Appendix for additional Outlook and Strategy information. SOURCE: CSFB, LoanPerformance
Spread Levels Still Below Historical Wides As of October 18, 27 / *.#1# & &!&$ *.#1#!3.$ /.#1#!.$ &!&$ 2 % &% (% 2 % &% (% 2 % &% (% 2 % &% / *4 5 6& &!&$ *4 5 6!3.$ /4 5 6!.$ &!&$ 2 % &% (% 2 % &% (% 2 % &% (% 2 % &% SOURCE: Lehman Brothers 4
PIMCO s Outlook for Credit
Know What You Are Buying Top Down Strategies Economic factors dominate risk for high quality issuers; duration matters Duration/Curve Duration/Curve Quality Quality Sector Sector Industry Industry Investment grade trades on spread; high yield trades on dollar price Security and industry selection dominate risk for lower quality issues AAA AA A Credit Rating.95.95.9 Correlation with Treasuries* BBB BB B CCC.75.2 -.4 -.12 Industry Industry Issuer Issuer Capital Structure Capital Structure Legal & Covenant Legal & Covenant * Correlation was calculated using Total Returns for the 5 year period ending 3/31/7. SOURCE: PIMCO, Lehman Brothers 6. Refer to Appendix for additional Outlook and Strategy information. Bottom Up Strategies
Valuation: Spreads Have Historically Compensated Investors for Defaults As of October 18, 27 Breakeven Spread represents the amount of yield premium required to compensate an investor for actual default history Actual spreads* over treasuries have exceeded breakeven levels on average over the entire period Within high yield, higher quality segments offer the most compensation for default risk,#'# %'47)89 (,:5 &5;# %15&< 7 &,,, * Average month-end absolute spread over 1-Year Treasury according to Citigroup. Past performance is no guarantee of future results. The credit quality of a particular security does not ensure the stability or safety of the overall portfolio. 7 Global_HY_Review_14
Fundamentals Remain Sound and Significant Deterioration Does Not Look Imminent As of September 3, 27 Defaults fall near lowest level while recovery rates remain wellabove their historical average 89!?$.189 =5( 5(!?$.189 5( 1;8 > Default projections continue to over-exaggerate actual defaults Moody's now forecasts a 221 basis point increase in defaults over the next 12 months 89!?$ # 89 '# 2 & 8 2 & 8 2 & % 2 % @5% % 2 % @5% % 2 %@5%% SOURCE: Merrill Lynch; Moody s. Opinion is subject to change without notice. 8 Global_HY_Review_14
Fundamentals Remain Sound and Significant Deterioration Does Not Look Imminent, continued As of September 3, 27 Cyclically high margins and relatively solid earnings expectations for 27 reflect constructive fundamental conditions at US companies '!?$ 7&'9## /,4;8A! # $ /,4;8A!B%9# # $ 58 #& 937&3,)3 %C< Leverage continues to creep higher, with bank debt being the preferred financing vehicle #& B B B B 1;8 > D#3# 3 A/,4;8 3# 3 A/,4;8 )8A/,4;8 8A/,4;8 * EBITDA adjusted for prospective cost savings or synergies. SOURCE: Citigroup, S&P, Merrill Lynch. Opinion is subject to change without notice. 9 Global_HY_Review_14
Current Opportunities
NUGGETTAG:userName=null&plotName=null Opportunity Bank Loans vs. High Yield As of October 18, 27.## 89, :8 Trade: Long LCDX vs. short position in CDX Rationale: Bank loans are senior in capital structure; receive payment priority in bankruptcy Yield premium on LCDX compensates investors for potential increase in default rates Recovery rates in bank loans have historically been higher (75% vs. 4%) Spread widening has been more pronounced in LCDX, distorting the relationship with CDX Yield Ratio: Loans to High Yield????????? 3;"89 A) # % 3;E94# 9 A ; 4%?.7.65.6.55.5.45.4 Source: LehmanLive.com Loans vs. High Yield Jun-7 Jul-7 Aug-7 Sep-7 Oct-7 KeyAxisName Last Minimum Maximum Mean SD SD Chang Sample trade for illustrative purposes only. Refer to Appendix for additional chart and securities information. SOURCE: Moodys, Lehman Brothers 11 Left Ratio: LCDX / CDX Relative.565.398 6/7/2.74 7/31/2.565.84.22
Opportunity Bank Loans, continued Current forward pipeline represents 4% of outstanding loan market CLOs accounted for 6% of market demand New funds being raised are unlikely to offset supply-demand imbalance Wall Street has been very disciplined in bringing new supply to the market over the last few weeks allowing loan prices to stabilize But, will they be as disciplined over the next 6 18 months? 8 Par Amount of Leveraged Loans Outstanding ($ in billions) 7 6 5 4 3 2 1 Current forward pipeline Loans outstanding as of September. 1996 1997 1998 1999 2 21 22 23 24 25 26 27YTD SOURCE: S&P Leveraged Commentary and Data, Goldman Sachs Research 12
Recent Trend of Covenant Lites has Begun to Reverse As of September 3, 27 5@975!B 5 % # $ @9 75 C% C C F 975 %3#3 ",# # C% C C SOURCE: Standard and Poor s 13 Global_HY_Review_14
Opportunity Bank Loans, continued Terms have shifted from in favour of the borrower to in favour of the lender! Analysis of XYZ Finance Co. Bank Loan Transaction 7( )## ;' '47),( -1GD# 7 D# @#; Pricing L + 275 at par L + 4 purchase price at a 5 point discount (95) Call Provisions Restricted Payments Covenant $12 in Year 1 $11 in Year 2 Par thereafter Restricted payments basket grew by 5% of Net Income each year $13 in Year 1 $12 in Year 2 $11 in Year 3 Par thereafter No dividends, stock repurchases or capital repatriation until 1st lieu load has been paid in full Total Debt to Net Worth Ratio Company wanted 6x Maximum 2x Sample trade for illustrative purposes only. Refer to Appendix for additional chart and securities information. SOURCE: PIMCO 14
Opportunity Bank Capital As of October 18, 27 Trade: Long Financials and Bank Capital Rationale: Financials usually have lower spreads than Industrials; relationship changed this summer Cannot persist that Industrials fund themselves at lower rates than the banks which provide the financing Spread (bps) D# # @ %D# # &;# D# # @ %9# # 8% 2 % D% % &% (% 2 % 2 % % &% Bank capital, which is a regulatory requirement, offers attractive value Spread between Tier 1 and Lower Tier 2 has widened dramatically &!&$ 8#9 H;%3; ;#!/*$ 3I;#!/*$, :7&# H;#53I;# 8% 2 % D% % &% (% 2 % 2 % % &% Sample trade for illustrative purposes only. Refer to Appendix for additional chart and securities information. SOURCE: PIMCO analysis, Merrill Lynch 15
Opportunity Banks & Brokerages As of October 18, 27 Trade: Long (sell protection) on high quality banks and brokerages Rationale: Spreads widened to levels not seen in almost five years Brokers policy is to maintain adequate liquidity to meet unsecured debt maturing within one year Though spreads have narrowed, opportunities persist 12 1 8 6 4 2 NUGGETTAG:userName=null&plotName=null Source: LehmanLive.com Banks and Brokers (A): 5yr Spread 22 23 24 25 26 27 Key Axis Name Last Minimum Maximum Mean SD SD Chang Left Banks & Brokerage (A Rated): 8.262 2.281 2/25/2 121.78 9/14/2 42.45522.869 1.88 Sample trade for illustrative purposes only. Refer to Appendix for additional chart and securities information. SOURCE: PIMCO, Lehman Brothers 16
Opportunity New Issue Concessions Following the credit market turmoil, issuers have been forced to pay higher yields when raising cash Spreads on many recent issues have tightened relative to overall index 4 #(A 7 8 # 7 ( (: &4 @I4 & @I4'#: & E.ON International Finance (EOAGR) 1/2/12 A2 / A EUR L+3 L+6 +3 bps Royal Bank of Scotland (RBS) 1/29/17 Aa3 / A EUR L+192 L+235 +43 bps American Express Credit Co (AXP) 9/24/12 Aa3 / A+ GBP L+62 L+9 +28 bps Santander (SANTAN) 1/24/17 Aa2 / AA- GBP L+36 L+85 +49 bps GE Capital Corp (GECC) 9/15/17 Aa1 / AA+ GBP L+6 L+1 +4 bps Bear Stearns (BSC) 8/1/12 A1/A+ USD L+12 L+18 +6 bps Sample trade for illustrative purposes only. Refer to Appendix for additional chart and securities information. SOURCE: PIMCO 17
Opportunity Negative Basis Trades J 7#89 I& 7, Credit default swaps have grown significantly and are now larger than the entire global bond universe CDS are primary hedging vehicles for banks and hedge funds *8,# # J J J J J J 8 8 8 8 8 8 8 8 8 ( # 7, &34,) During summer credit crunch, the basis widened as market participants bid up the price of insurance As market began rallying, basis became negative, presenting new opportunities &!&$ #;BB178 3 17&4 B % &% (% 2 % 2 % % &% Sample trade for illustrative purposes only. Refer to Appendix for additional chart and securities information. SOURCE: PIMCO, Lehman Brother, BIS 18
Opportunity Negative Basis Trades, continued Trade: Buy Bertelsmann AG Cash Bond and Buy Protection Using Credit Default Swap Rationale: Cost of insurance (CDS spread) is lower than yield on Bertelsmann s cash bond Maturity Bond Sept 26, 216 Credit Default Swap Sept 2, 216 Results in positive carry without underlying exposure to the Bertelsmann credit Coupon Spread 4.75% +74 bps.% Cost of CDS -56bps Negative Basis +18 bps Sample trade for illustrative purposes only. Refer to Appendix for additional chart and securities information. SOURCE: PIMCO analysis, Lehman Brothers 19
Summary & Conclusions Fundamentals remain fairly sound, but recent spread widening provides opportunities to add value in actively managed portfolios: Relative value between loans and bonds Focused sector selection such as financials Negative basis trades Yields have historically compensated credit investors for default risk; best opportunities may lie in lower tier investment grade/upper tier high yield Defaults can only go up from here, but will not increase significantly over the next 12 months 2. Refer to Appendix for additional Outlook and Strategy Information.
Appendix Chart Performance results for certain charts and graphs may be limited by date ranges specified on those charts and graphs; different time periods may produce different results Outlook and Strategy Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. Securities PIMCO may or may not own the securities referenced and, if such securities are owned, no representation is being made that such securities will continue to be held.. 21