PIMCO Comments

Implications for investors

Anticipate volatility over the short term but in the long term, the outlook for bond returns as "bonds mature" remains positive. Overtime we will have the advantage of higher spread margins over risk assets. PIMCO has an underweight allocation to the long end of the US curve, recognizing the now realized downgrade potential and longer term structural funding issues for the US Treasury. Whilst over the past quarter we have been reducing these short positions and whilst we still believe that rates are likely to trend upwards, we recognize that contagion in market sentiment and the 'risk off’ mode around the very fragile state of global capital markets needs to be taken into consideration.

PIMCO's New Normal thesis speaks directly to these imbalances both across and within economies, thus our secular baseline portfolio positioning has been to minimise exposure to the negative impact of financial repression, hedge against higher inflation and currency depreciation and exploit the heightened differentiation in balance sheets and growth potentials. Balance sheets, both across and within economies, being out of equilibrium. We continue to expect that advanced economies will face sluggish growth and persistently high unemployment over the secular (3 to 5year) horizon. Emerging economies will achieve higher growth but face recurrent inflationary concerns.

PIMCO thoughts

We have spent the last few weeks stress testing PIMCO portfolios around the possibility of a change in ratings. This was an important exercise as the ratings change will not only impact US government bonds, it will also impact agencies backed by the full faith and credit of the U.S. or those that receive indirect backing, such as Fannie Mae and Freddie Mac and other government-related securities. Globally we have also spoken to and received guideline amendments from our clients to ensure we do not sell as a result of negative ratings actions affecting US government related issuers. We have recommended that clients hold their positions and provide waivers for relevant quality limits (e.g., min issuer and average quality) that have been breached by a downgrade event. We anticipate continued market uncertainty which could be adverse for those who are forced to sell exposure and potential opportunity for investors who are able to capitalise on dislocations.

This was also important from the standpoint of portfolio positioning and liquidity/collateral risk management. US government securities are the main form of accepted collateral for OTC derivatives, repos, and futures initial/variation margin. In the event of the downgrade, we expect an increase in the haircut on US government related securities posted as collateral (which we had already seen with the Chicago Mercantile Exchange). Most Credit Support Annex's (CSAs) do not explicitly draw a link between the eligibility of US Treasuries as collateral and their AAA rating. In addition, given that major US banks are several notches below AAA, a single-notch downgrade should not lead to downgrades in the credit ratings of banks. Even if that were to occur, additional collateral requirements would be manageable in our view. At this point, we believe that the potential for some exchanges and/or brokers to no longer allow US government related securities as collateral is remote. Liquidity overall is a focus, and we will continue as we have for the past several years to invest cash directly.