Ed Devlin Discusses PIMCO s Canadian CorePLUS and core plus in general. Ed Devlin Portfolio Manager Mr. Devlin is an executive vice president in the London office and head of Canadian portfolio management. As a leading authority on the Canadian fixed income market, his insights are extensively reported by the National Post, Globe and Mail, Reuters, The New York Times, and Bloomberg News. Mr. Devlin is also a frequent participant on BNN television. Prior to joining PIMCO in 2006, he gained broad global experience with Lehman Brothers and Merrill Lynch in Toronto, London, Tokyo, Hong Kong and New York where he traded fixed income derivatives. He has 15 years of investment experience and holds a bachelor s degree in business administration from Wilfrid Laurier University and an MBA from the Tuck School at Dartmouth College. Canadian Core plus strategies have delivered strong returns versus other active fixed income strategies, over the three years ending in December 2009, according to data from evestment Alliance. In the interview below, Ed Devlin, PIMCO executive vice president and head of Canadian portfolio management, discusses the success of the core plus approach in general, and the outlook for the PIMCO CorePLUS strategy. Some fixed income managers simply believe that the structural yield advantage of out of index sectors compensates for the associated risk. At PIMCO, we believe our success is our investment process of secular positioning and cyclical rotation into and out of attractively priced sectors. Our attention to detail and our strong capability in understanding the macroeconomic landscape amid an excellent quantitative and analytics framework, research and risk management are focused on consistently producing industry leading performance. Q: Core plus fixed income managers in Canada outperformed traditional Core active fixed income managers over the past three years according to evestment Alliance data (12/31/06 to 12/31/09), with the median manager returning 51 basis points over the DEX Universe Bond Index (before fees) compared with 31 bps. (Please see evestment Alliance Core and Core Plus Universe data in Figures 1&2 below). Why has the core plus approach in general outperformed? Devlin: In active management, the level of active return (or information ratio) that a manager can deliver is a function of the manager s skill and the number of active decisions the manager can make in a portfolio. Traditional Core active fixed income managers, while quite skilled, have a fairly restricted tool kit from which to make active decisions, as they are typically restricted to invest only in Canadian securities and securities contained within the benchmark, making it difficult to provide consistent alpha. By contrast, core plus approaches can invest in a wider range of securities, including out-of-index investments that, if chosen carefully, have the potential to add alpha. As a result, core plus has proven to be an effective method of active bond management in Canada, much as it has in other markets.
Alpha (%) Alpha (%) Figure 1: evestment Alliance Core Universe, Alpha (Before Fees) vs. DEX Universe Bond Index as of 12/31/09 1.5 1.3 1.1 0.9 0.7 0.5 0.3 0.1-0.1 DEX Universe Bond Index Median -0.3 Source: evestment Alliance evestment Percentiles* (Alpha Before Fees) 25th Percentile* 0.54 Median* 0.31 75th Percentile* -0.09 # of Observations 65 *% breaks as per the evestment Alliance Canadian Core Universe Figure 2: evestment Alliance Core Plus Universe, Alpha (Before Fees) vs. DEX Universe Bond Index as of 12/31/09 1.5 1.3 1.1 0.9 0.7 0.5 0.3 0.1-0.1-0.3 DEX Universe Bond Index Median Source: evestment Alliance evestment Percentiles* (Alpha Before Fees) 25th Percentile* 0.97 Median* 0.51 75th Percentile* 0.23 # of Observations 9 *% breaks as per the evestment Alliance Canadian Core Plus Universe Q: What are the different approaches to core plus fixed income management? Is PIMCO s approach to core plus investing different? Devlin: Broadly speaking, core plus approaches fall into two categories. The first can be generally described as a fund-of-funds style: The portfolio manager allocates capital to sub-funds managed by specialty managers within the firm. The second group is a traditional style bond fund: The portfolio manager is responsible for all security selection within the portfolio. We at PIMCO believe the second approach is better, and this is how we manage our Canada CorePLUS strategy. While we have specialty desks that cover virtually every sector of the global fixed income market, it is the portfolio manager who is responsible for selecting each security in the portfolio. The specialty desks are tremendously important in providing recommendations and best execution, but ultimate responsibility resides with the portfolio manager. We believe this approach allows PIMCO to be extremely precise when adding out- of-index exposures to the portfolio and is designed to eliminate the potential for unwanted tracking error that can come from submanager biases. Q: How does PIMCO choose the out-of-index exposures for Canadian CorePLUS? Devlin: To identify potential investments, both core and out-of-index, PIMCO has a unique investment process 2
that has served us well for almost four decades. We are a long-term investor and our investment process is centered around a secular, three-to-five-year view of the market. Our focus on fundamentals has helped us to identify and capitalize on market mispricing or bubbles, such as the U.S. housing market or Canadian non-bank asset-backed commercial paper. In addition to a sound investment philosophy and process, we believe the key to successful investing, especially in out-of-index securities, is strong risk management. We are experts in structured finance and derivatives. While many investors have found themselves in trouble using these tools to enhance yield in a low rate environment, we at PIMCO use these instruments most often for risk management. We use derivatives to manage default, interest rate and currency risk so that we can make prudent outof-index investments relative to our Canadian fixed income benchmarks. There are times when we use a derivative contract instead of a bond, but only when we believe there is a superior relative value. We rely on our extensive world-wide resources including our legal teams, market relationships and technological platform, that we believe are needed to take advantage of out-of-index opportunities. Q: Can you elaborate on what an investment manager needs to be successful in core plus investing? Devlin: To prudently run a core plus strategy, PIMCO believes you need to have the best-in-class infrastructure. This includes first, analytics. All risks in the portfolio need to be identified and analysed so that risks are carefully managed and to help ensure that any tracking error is providing an attractive risk/return profile. Second, you need a top-notch legal department. Banks have teams of lawyers whose sole job is to protect the banks interests. A core plus manager must have a world class legal team proficient in derivatives and structured finance. A core plus manager also needs effective operations personnel. It is not sufficient for our lawyers to negotiate favourable terms in our contracts; we need a first-class operations department that will work to ensure the contractual rights are enforced. Finally, you need research departments. A significant credit research team is required to follow the various global industries and identify the most attractive investments. A similar effort is required from quantitative research in order to stay at the leading edge of derivatives and structured finance. As an example, PIMCO has spent decades developing models that evaluate the prepayment options embedded in US mortgage-backed securities. In addition to all of this infrastructure investment, a core plus manager must be able to attract portfolio managers who understand how to construct portfolios across multiple markets using sophisticated risk management techniques. Bringing all of this together, there must be a coherent investment process that identifies opportunities and encourages the sharing of the best ideas across markets. In my experience, the hardest thing to replicate is an organizational culture that simultaneously rewards excellence and teamwork. Q: What types of investors are well suited to PIMCO s Canada CorePLUS strategy? Is it appropriate for pension plans? 3
Devlin: CorePLUS can potentially benefit a range of investors, and we believe it is especially attractive for long-term investors, such as pension plans. CorePLUS broadens the fixed income opportunity set while managing against the same Canadian fixed income benchmarks (DEX indices) as other fixed income strategies. The flexibility to invest in securities both within and outside of the benchmark has two important advantages. First, it allows the manager to incorporate securities outside of the benchmark that have similar characteristics but a superior risk/return profile to benchmark holdings. This is a compelling source of added value opportunity. In addition, it allows the manager to reduce the risk profile and work to deliver value in a more consistent fashion than a traditional fixed manager, through the use of a greater number of active decisions and fewer concentrated bets. In the long-run, an integrated portfolio with diversified exposures may also experience lower overall risk from correlations between different fixed income regions and strategies. These potential diversification benefits combined with the multiple levers at a portfolio managers disposal, helps PIMCO to reduce unrewarded risks and keep the right level of desired exposures. Q: How does CorePLUS fit for investors who use an asset-liability management framework? Devlin: Our portfolios are benchmarked to both the DEX Universe and DEX Long indices. Often our clients have spent considerable resources determining the benchmark that best fits their particular liability profile. A properly constructed core plus portfolio should respect the characteristics of the benchmark while generating additional value. Sophisticated risk management systems and processes are required to help ensure that these deviations are precise so that the tracking error of the portfolio to the benchmark is constructed with an optimized risk/return profile. Q: Given the outperformance of CorePLUS in the past three years, what is your outlook for the strategy? Devlin: PIMCO has been using the core plus style for decades. The reason is there is a large universe of strategies that can be incorporated into the portfolios. We implement both top-down macroeconomic strategies and bottom-up sector and security selection. In 2009, markets benefited from the normalization of risk premiums. In the future, we will focus on opportunities to add value from a number of sources. For example, we employ duration positioning and yield curve and volatility strategies. We seek to find value in foreign exchange positions, as well as the credit sectors, from corporate bonds and asset-backed securities to provincial, municipal and agency sectors. We can also tap non-canadian sectors and in an effort to add value through financing opportunities, such as the repo market, and assessing relative value in cash bonds versus derivatives. As of year-end 2009, PIMCO has 137 portfolio managers who spend each day searching for value in every corner of the fixed income market. Q: Rising rates may become a concern in the near future. How is Canadian CorePLUS positioned to deal with a rising rate environment? Devlin: Although we don t foresee a rate rise in the near term, the day will come. When rates do rise, we can mitigate this risk and work to add value by shortening duration of the CorePLUS portfolio and/or finding attractive duration in other markets. 4
The press focuses on policy rates of 0.25% (as of 12/31/09) in Canada, but the fact is that 30-year government yields in Canada have traded between 4.0% and 4.25% in the first weeks of 2010. The range over the past five years, (2005-2009) has been 3.45% to 4.85%, which means we are now at the five-year average. Even while the Bank of Canada hiked rates from 2.5% to 4.5% and then slashed rates to 0.25% during this same period, long yields stayed generally range-bound [shown in the graph below]. So looking forward, we do not expect a substantial rise in long yields as the Bank of Canada (BoC) removes its extraordinary monetary policy stimulus. We believe the market will likely maintain confidence in the BoC s inflation targeting regime, and this should provide the basis for bond market returns in the future. Q: At this time last year, liquidity was a major issue in the market. How does PIMCO deal with liquidity concerns in the Canadian CorePLUS strategy? Devlin: We monitor liquidity very carefully to help ensure we can meet client requests while responding to market conditions. The key to our liquidity management is the proprietary systems we have developed over a number of years. These systems incorporate exposures to unsettled trades, futures and swaps, and then test, or shock, these exposures for various rate environments. Armed with this information, PIMCO portfolio managers can then make judgments regarding the types of liquid instruments to keep in the portfolio. Q: Finally, can you tell us about your current views on the market and how Canadian CorePLUS is positioned to reflect those views? Devlin: We at PIMCO believe the events of the past two years are not just another economic downturn and market correction; we believe this has been a crisis of the financial system with profound implications for the real economy. We have entered a new financial environment, which we at PIMCO have dubbed the New Normal, and we believe the coming years will be characterised by several ongoing developments. First, massive de-leveraging of the financial system and by Yield 6 5 4 3 2 1 0 Figure 3: 1/28/05 5/28/05 Source: Bloomberg Canada 30-Year Government Bond vs. Bank of Canada Overnight Rate 30-Year Yield Overnight Rate 9/28/05 1/28/06 5/28/06 9/28/06 1/28/07 5/28/07 9/28/07 1/28/08 5/28/08 9/28/08 1/28/09 5/28/09 9/28/09 1/22/10 over-extended consumers in many developed markets will translate into lower global growth. We also expect increased market volatility as non-traditional public policies are implemented and withdrawn. In addition, investment returns will likely not match those seen in the days of the credit bubble. Canada and Australia are the two developed countries that have best weathered the financial storm. Both countries had prudent fiscal policies before the crisis, and neither banking system had significant exposure to the US property market. While the Reserve Bank of Australia has already started to hike policy rates, we do not believe the Bank of Canada will raise rates until at least the second half of this year, and even if they do hike rates this year, we do not believe it will be any more than 25-50 basis points. The main reason we expect a more muted response from the Bank of Canada is the weakness of the US economic recovery. We believe the external sector will be a drag 5
on Canadian growth. Also, as the loonie [Canadian dollar] soars beyond 97 cents against the US dollar, financial conditions are likely to tighten in Canada, particularly with exports, and will put downward pressure on inflation. If the Bank of Canada hikes policy rates significantly more than the US Federal Reserve, it will fuel an unwanted rise in the value of the loonie. We see value in duration exposure in Canada; with an extremely steep yield curve, the value is in the 10- to 15-year part of the curve. We are turning cautious on US and UK duration as their central banks are looking to end massive quantitative easing programs early this year. We think European duration exposure also has some value because the European Central Bank, like the BoC, is not encumbered with the task of ending a significant quantitative easing program. After the massive rally in corporate bonds in 2009, we are becoming a bit more cautious in that sector. Corporate spreads in Canada are tight relative to spreads in other corporate bond markets. While planning to maintain an underweight to Canadian credits, we currently have modest exposures to US and European corporate bond markets. Given our secular concern about growth in the New Normal, we prefer to hold selected high-quality credits, particularly in bank and non-bank financials and non-cyclical sectors, such as utilities and healthcare. In high yield and emerging markets, we currently have very small exposures concentrated in the highest quality names. Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. 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. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Swaps are a type of privately negotiated derivative; there is no central exchange or market for swap transactions and therefore they are less liquid than exchange-traded instruments. 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 could lose more than the amount invested. Diversification does not ensure against loss. The DEX Universe index covers all marketable Canadian bonds with term to maturity of more than 1 year. History dates from December 1979. The Universe contains over 900 marketable Canadian bonds. The average term is 9 years and the average duration is 5.5 years. The purpose of this index is to reflect performance of the broad Canadian bond market in a manner similar to the way the TSE 300 represents the Canadian equity market. It is not possible to directly invest into an unmanaged index. The products and services provided by PIMCO Canada Corp. are only available in provinces or territories of Canada to investors who are accredited investors within the meaning of the relevant provincial or territorial legislation or rules and in certain provinces, only through dealers authorized for that purpose. 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. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. 2010, PIMCO. PIMCO Canada Corp., 120 Adelaide Street West, Suite 1901, Toronto, ON MSH 1T1, 416-368-3350, 866-341-3350 While we do not expect to repeat the returns of 2009, we do foresee a good environment for active investing. 6
PIMCO Canada Corp. 120 Adelaide Street West Suite 1901 Toronto, Ontario M5H 1T1 416-368-3350 www.pimco.ca