Your Global Investment Authority Q&A April 2014 HYS PIMCO ETFs PIMCO 0 5 Year High Yield Corporate Bond Index ETF (HYS) Aims to Achieve Higher Income, Lower Sensitivity to Treasury Rates Vineer Bhansali Managing Director Portfolio Manager Vineer Bhansali, portfolio manager, and Michael Brownell, product manager, discuss the PIMCO 0 5 Year High Yield Corporate Bond Index Exchange-Traded Fund (HYS), the first ETF to capture continuous exposure to the short maturity segment of the high yield corporate bond sector. The fund aims to achieve the yield, volatility level, and low or negative correlations with other asset classes inherent in short maturity high yield. Michael Brownell Vice President Product Manager Q: What are the potential benefits of short-term high yield? Brownell: In general, the high yield market has historically demonstrated its value as part of a broader asset allocation. The primary benefit is diversification: High yield bonds have had a low correlation to most other asset classes, especially investment grade fixed income sectors such as Treasuries, where the correlation has been close to zero and even negative over the long term. This is even more pronounced in the short-term cohort of the high yield market, where interest rate duration is more of a secondary consideration (see Figure 1). In fact, high yield bonds in general (and short-term high yield bonds to a slightly smaller degree) are more correlated to stocks, as both asset classes are more sensitive to the economic outlook and corporate earnings than to day-to-day interest rate fluctuations. However, returns on short-term high yield bonds tend to be materially less volatile than
those for stocks because the income component of the total return by way of coupon payments has historically been much higher than the income from stocks by way of dividends. Correlation is a statistical measure of how two securities move in relation to each other. Duration is the measure of a bond s price sensitivity to interest rates and is expressed in years. Diversification does not guarantee a profit or protect against a loss. Q: How does short-term high yield compare to the broad high yield maturity spectrum? Brownell: Relative to the broad high yield market, the short-term cohort has a number of unique attributes that make it a compelling investment choice, especially for investors who are seeking a higher yield and less sensitivity to interest rates. As of the end of March 2014, short-term high yield bonds, as represented by the BofA Merrill Lynch 0 5 year U.S. High Yield Constrained index, had a similar yield-to-maturity and spread to those of the broad high yield market, as represented by the BofA Merrill Lynch U.S. High Yield Index, with less than half the duration (see Figure 2). FIGURE 2: SHORT-TERM HIGH YIELD HAS A SIMILAR YIELD-TO- MATURITY AND SPREAD AS BROAD HIGH YIELD Short-Term HY No. of issues 870 2,233 Face value ($MN) 428,472 1,252,767 Duration (yrs) 2.05 4.18 YTM (%) 6.01 6.16 Spread (bps) 412 377 Avg maturity (yrs) 3.43 6.62 Avg quality B1/B+ B1/B+ HY FIGURE 1: HIGH YIELD BONDS HAVE A LOW CORRELATION TO MOST ASSET CLASSES Correlation Matrix of Major Asset Class Categories (Using Monthly Returns from Jan '97 Mar '14) Short-Term HY HY 5 Yr Treas 10 Yr Treas MBS IG Corp Core Fixed Income Large Cap Equity Small Cap Equity EM Short-Term HY 1.00 HY 0.97 1.00 5 Yr Treasury -0.24-0.21 1.00 10 Yr Treasury -0.20-0.16 0.91 1.00 MBS 0.01 0.04 0.82 0.79 1.00 IG Corp 0.50 0.52 0.58 0.64 0.68 1.00 Core Fixed Income 0.15 0.19 0.86 0.88 0.90 0.88 1.00 Large Cap Equity 0.56 0.62-0.29-0.26-0.10 0.20-0.04 1.00 Small Cap Equity 0.60 0.63-0.32-0.30-0.16 0.16-0.08 0.82 1.00 EM 0.54 0.57 0.06 0.11 0.28 0.49 0.32 0.56 0.54 1.00 Performance quoted represents past performance. Past performance is not a guarantee or a reliable indicator of future results. Short-term high yield (HY) is represented by the BofA Merrill Lynch 1 5 Year U.S. High Yield Constrained Index; HY is represented by the BofA Merrill Lynch U.S. High Yield Index; Fiveyear Treasury is represented by the BofA Merrill Lynch Current 5-Year U.S. Treasury Index; 10-year Treasury is represented by the BofA Merrill Lynch Current 10-Year U.S. Treasury Index; mortgage-backed securities (MBS) are represented by the Barclays Fixed-Rate MBS Index; investment grade (IG) corporate is represented by the Barclays U.S. Credit Index; core fixed income is represented by the Barclays U.S. Aggregate Index; large cap equity is represented by the S&P 500 Index; small cap equity is represented by the Russell 2000 Index; and emerging markets (EM) is represented by the JPMorgan EMBI Global Index. 2 APRIL 2014 ETF Q&A
Furthermore, short-term high yield bonds tend to be less volatile than the broad high yield market, especially in times of heightened volatility. Since the inception of the BofA Merrill Lynch 1 5 Year U.S. High Yield Constrained Index in 1996, short-term high yield bonds slightly outperformed the broad high yield market (annualized return of 7.9% versus 7.5%) while displaying notably lower volatility (annualized standard deviation of 7.6% vs. 9.5%), resulting in significantly better risk-adjusted returns. Furthermore, looking at just time periods when the VIX Volatility Index surpassed 30, a market standard level reflective of high volatility, short-term high yield bonds had average monthly returns of 30 basis points higher than the broad high yield market. Q: How do high yield bonds perform in a rising rate environment? Brownell: While periods of sharply rising government rates have typically been the nemesis for most fixed income sectors, the high yield market is one of the few exceptions. As previously mentioned, duration is very much a secondary consideration when investing in the high yield market, and expectations for stronger economic growth, which tend to coincide with rising rates, are usually a source of healthy returns for the asset class. Since the early 1990s, government rates have experienced 14 periods of sharp rate increases, and in each of those incidents the high yield asset class has been one of the best performing asset classes, if not the best (see Figure 3). What s more, if you compare the short-term high yield cohort to broad-based fixed income sectors, it has been the top-performing sector for half of those periods, most notably in the last episode when 10-year Treasury rates climbed over 150 basis points from July 2012 to December 2013. Stronger growth and the mitigation of sensitivity to rates, by virtue of having about half the duration of the broader high yield market, have benefited short-term high yield bonds when rates rise. Although materially strong growth and higher rates are not our base case expectation, we recognize that many investors anticipate them and are allocating their portfolios accordingly. However, should robust growth not play out, it is worth noting that performance in the high yield sector generally does not depend on great economic times a factor that plays more into the performance of the equity market. Most high yield issuers have functioned very well and continued to service their debt in even low-growth environments. Q: How has HYS behaved since inception? Bhansali: The PIMCO 0 5 Year High Yield Corporate Bond Index ETF (ticker HYS), up 7.74% on an annualized after-fee basis through March 2014, has experienced strong performance since its inception in June 2011. The shorter end of the high yield market has outperformed the longer end due to strong demand from investors seeking above-average yields in combination with less duration risk. In 2013 the shorter term BofA Merrill Lynch 0 5 Year U.S. High Yield Constrained Index outperformed the broad market index, the BofA Merrill Lynch U.S. High Yield Index, by over 100 basis points. This was most visible in late spring and summer, when rate volatility peaked. From early May through mid-august, the short-term cohort of the high yield market outperformed the broad high yield market by over 250 basis points. While this dispersion decelerated in the first three months of 2014, as government rates have fallen materially from their beginning-of-the-year peaks, we expect rate volatility to be at the forefront of obstacles for the high yield market and on the minds of investors through year-end and beyond. With still-low interest rates and the benign fundamental picture of corporate high yield issuers, especially as it relates to defaults (which, as of March 2014, are a fraction of their long-term average and expected to remain subdued for at least the next 24 months, according to Moody s), we think the case for short-term high yield bonds will be compelling for some time. ETF Q&A APRIL 2014 3
FIGURE 3: HIGH YIELD ASSET CLASS HAS PERFORMED WELL AMID SHARP RATE INCREASES 10 Year Treasury YTM (%) 8 7 6 5 1 2 3 4 5 7 8 Percent (%) 4 3 6 9 10 11 12 14 2 13 1 0 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Performance quoted represents past performance. Past performance is not a guarantee or a reliable indicator of future results. * Highlighted cells indicate best performing asset class during the respective period. 10 Yr Treasury Rate (%) Total Return (%) Period # Period Start Period End Start End Ch (%) STHY HY 10 Yr Treasury MBS IG Corp EM Pre-Financial Crisis Periods 1 Sep 93 Nov 94 5.39 7.91 2.53 5.46 1.37-10.83-1.51-4.86 NA 2 Dec 95 Aug 96 5.58 6.94 1.37 8.45 4.81-5.48 0.72-2.26 22.21 3 Nov 96 Mar 97 6.05 6.91 0.86 2.17 1.73-4.23-0.40-2.37 1.99 4 Sep 98 Jan 00 4.42 6.67 2.25 5.18 4.93-10.06 1.78-1.71 35.75 5 Oct 01 Mar 02 4.27 5.41 1.14 6.04 4.48-6.83-0.32-1.81 6.27 6 May 03 Aug 03 3.35 4.45 1.10 3.34 2.70-7.20-1.01-3.75-1.10 7 Mar 04 May 04 3.84 4.66 0.82-1.09-2.22-5.48-2.00-3.83-7.37 8 Jun 05 Jun 06 3.95 5.14 1.20 5.41 4.70-5.79 0.39-2.06 5.24 Financial Crisis and Post-Crisis Periods 9 Mar 08 May 08 3.43 4.05 0.62 3.72 4.61-4.35-0.58-0.38 1.35 10 Dec 08 Jun 09 2.25 3.52 1.27 28.95 29.37-8.74 2.76 6.87 12.71 11 Nov 09 Mar 10 3.20 3.83 0.63 7.61 8.11-3.94 0.11 1.25 3.82 12 Aug 10 Mar 11 2.48 3.45 0.97 9.31 10.27-6.04 0.43-0.34 0.20 13 Jan 12 Mar 12 1.80 2.22 0.42 2.62 2.18-3.03 0.15-0.04 2.53 14 Jul 12 Dec 13 1.49 3.01 1.52 14.64 13.77-8.69-1.35-0.20-3.06 Short-term high yield (HY) is represented by the BofA Merrill Lynch 1 5 Year U.S. High Yield Constrained Index; HY is represented by The BofA Merrill Lynch U.S. High Yield Index; 10-year Treasury is represented by The BofA Merrill Lynch Current 10-Year U.S. Treasury Index; mortgage-backed securities (MBS) are represented by Barclays Fixed-Rate MBS Index; investment grade (IG) corporate is represented by the Barclays U.S. Credit Index; and emerging markets (EM) is represented by the JPMorgan EMBI Global Index. 4 APRIL 2014 ETF Q&A
PIMCO 0 5 Year High Yield Bond Index ETF (HYS) Performance as of 31 December 2013 3 Mo 6 Mo 1 Yr 2 Yr Since Inception (6/16/2011) NAV Before fee (%) 3.12 6.47 8.86 10.83 8.53 NAV After Fee (%) 2.98 6.18 8.26 10.22 7.93 Share Price (%) 2.86 6.07 7.81 9.57 7.96 Benchmark (%) 2.78 5.78 8.49 11.02 8.43 Performance quoted represents past performance. Past performance is not a guarantee or a reliable indicator of future results. Current performance may be lower or higher than performance shown. Investment return and principal value will fluctuate, so that Fund shares may be worth more or less than their original cost when sold. Performance data current to the most recent month-end is available at pimcoetfs.com or call 888.400.4ETF. The fund s expense ratio is 55 basis points. All periods longer than one year are annualized. Benchmark: BofA Merril Lynch 0 5 Year U.S. High Yield Constrained Index Q: What key trends are you seeing in the space? Brownell: Within the broader leverage finance universe, a number of trends have been underway in recent years. Fundamentals have been improving ever since the end of the most recent financial crisis in 2008 2009. This has been most identifiable by way of tracking defaults, where today the Moody s U.S. speculative default rate is just 0.4% by volume and 1.7% by issuer, compared with a longterm average default rate closer to 4.5% 5.0%. While this may leave little room for material improvement, PIMCO and most agencies, such as Moody s, expect defaults to remain low and relatively stable over the foreseeable future, given the significant amount of refinancing in recent years, which has effectively cleared the path of maturities through 2016. Where the D in high yield has typically stood for defaults, today it has represented duration. This concern has grown considerably since early 2013 and most significantly when government rates soared in late spring/early summer, and it was clearly reflected by flows out of traditional fixed income sectors and into either equities or other low-duration products. The broad high yield market, which typically is relatively immune to rates, began 2013 with strong inflows, then witnessed record outflows alongside intensifying rate volatility midyear. The market saw a recovery of flows later in the year but remained in the red for the full year. Short-term high yield strategies, which have shown very little rate sensitivity, saw very strong and consistent flows throughout 2013 and so far this year. Short-term high yield ETFs as a whole have experienced close to $2.5 billion in net inflows year-to-date, of which HYS accounted for about half those flows, in contrast to net outflows from traditional high yield ETFs of $1.3 billion. Moreover, in 2013 when rising rate concerns were at the forefront, short-term high yield ETFs witnessed almost $6.5 billion in net inflows compared with outflows of $2.9 billion for broad high yield ETFs a clear reflection of a growing trend of investors focusing on striking a balance between yield and duration. Q: How are clients using HYS? Bhansali: With low yields across fixed income sectors, most investors have been drawn to HYS for the higher income and lower sensitivity to Treasury rates. The intraday liquidity of HYS has been a strong benefit as well, as investors rebalance and adjust their asset allocation. Yield and duration have played a key role in the allocation of the broader portfolios, and many advisors are focused on fixed income products where the yield exceeds the duration. Furthermore, amid supportive fundamentals, interest rate risk is being prioritized ahead of credit risk. Finally, we have also received feedback from clients that HYS has complemented their existing broader exposures to high yield. As high yield bonds trade over the counter, and at times at considerable bid/ask spreads, an advantage of high yield ETFs such as HYS is the tighter spreads that the secondary market of ETFs provides, thereby resulting in greater liquidity. Only roughly 10% -15% of the bonds in the high yield sector actually trade daily, so price discovery is another potential benefit of the ETF. ETF Q&A APRIL 2014 5
Q: How is HYS differentiated? Bhansali: We manage all of our index ETFs, including HYS, using our smart index methodologies, which consist of three prongs: smart index construction, smart optimization and smart execution. Unlike many ETF managers, we do not replicate the index simply through stratified sampling. We aim to reduce true economic tracking error to the index while maintaining the attractive carry in this sector and believe PIMCO s internal credit screening process is instrumental in achieving that goal. We have more than 50 credit analysts at PIMCO contributing to the screening process, assigning a green-, yellow- or red-light designation to each high yield issuer, independent of any credit agency ratings. We define red-light credits as issuers whose viability as a going concern is in serious question; these generally represent a relatively small percentage of the high yield universe. We seek to exclude red-light credits from our ETF portfolios when we construct them, while maintaining the fund s objective of closely tracking the index, which can be a meaningful benefit during certain time periods when select challenged credits find themselves within the short-term cohort as a result of difficulty accessing the capital markets and refinancing existing debt. Our high yield ETF also has some transactional advantages. PIMCO may accept cash instead of in-kind contributions from our authorized participants; creating ETF shares with cash potentially reduces the risk and cost to authorized participants, thereby leading to market prices that tend to trade closer to net asset value (NAV). Finally, using PIMCO s established credit desks, we attempt to minimize transaction costs by getting the most efficient execution. Carry is the rate of interest earned by holding the respective securities. 6 APRIL 2014 ETF Q&A
ETF Q&A APRIL 2014 7
For more information, please contact your advisor, call 888.400.4ETF (888.400.4383) or visit pimcoetfs.com Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information are contained in the Fund s prospectus, which may be obtained by contacting your PIMCO representative. Please read the prospectus carefully before you invest. A word about risk: An investment in an ETF involves risk, including the loss of principal. Investment return, price, yield and net asset value (NAV) will fluctuate with changes in market conditions. Investments may be worth more or less than the original cost when redeemed. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. High yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. 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. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. 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. The use of leverage may cause a portfolio to liquidate positions when it may not be advantageous to do so to satisfy its obligations or to meet segregation requirements. Leverage, including borrowing, may cause a portfolio to be more volatile than if the portfolio had not been leveraged. The Fund is non-diversified, which means that it may concentrate its assets in a smaller number of issuers than a diversified fund. Exchange-Traded Funds ( ETF ) are afforded certain exemptions from the Investment Company Act. The exemptions allow, among other things, for individual shares to trade on the secondary market. Individual shares cannot be directly purchased from or redeemed by the ETF. Purchases and redemptions directly with ETFs are only accomplished through creation unit aggregations or baskets of shares. Shares of an ETF are bought and sold at market price (not NAV). Brokerage commissions will reduce returns. Investment policies, management fees and other information can be found in the individual ETF s prospectus. The NAV of the Fund s shares is determined by dividing the total value of the Fund s portfolio investments and other assets, less any liabilities, by the total number of shares outstanding. Fund shares are valued as of the close of regular trading (normally 4:00 p.m., Eastern time) (the NYSE Close ) on each business day. The price used to calculate market returns ( Market Price ) of the Fund generally is determined using the midpoint between the highest bid and the lowest offer on the national securities exchange on which shares of the Fund will be primarily listed for trading, as of the time that the Fund s NAV is calculated. The Fund s Market Price may be at, above or below its NAV. The NAV of the Fund will fluctuate with changes in the market value of its portfolio holdings. The Market Price of the Fund will fluctuate in accordance with changes in its NAV, as well as market supply and demand. The Fund uses an indexing approach and may be affected by a general decline in market segments or asset classes relating to its Underlying Index. The Fund invests in securities and instruments included in, or representative of, its Underlying Index regardless of the investment merits of the Underlying Index. Barclays U.S. Credit Index is an unmanaged index composed of publicly issued U.S. corporate and specified non-u.s. debentures and secured notes that meet the specified maturity, liquidity and quality requirements. To qualify, bonds must be SEC-registered. Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable and dollar denominated. The index covers the U.S. investment grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indexes that are calculated and reported on a regular basis. The BofA Merrill Lynch 0 5 Year US High Yield Constrained Index tracks the performance of short-term U.S. dollar-denominated below-investment-grade corporate debt issued in the U.S. domestic market with less than five years remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $100 million, issued publicly. Allocations to an individual issuer will not exceed 2%. The BofA Merrill Lynch Current 5-Year US Treasury Index is a one-security index composed of the most recently issued 5-year US Treasury note. The index is rebalanced monthly. In order to qualify for inclusion, a 5-year note must be auctioned on or before the third business day before the last business day of the month. The BofA Merrill Lynch Current 10-Year US Treasury Index is a one-security index composed of the most recently issued 10-year US Treasury note. The index is rebalanced monthly. In order to qualify for inclusion, a 10-year note must be auctioned on or before the third business day before the last business day of the month. The BofA Merrill Lynch High Yield Index is an unmanaged index consisting of bonds that are issued in U.S. Domestic markets with at least one year remaining until maturity. All bonds must have a credit rating below investment grade but not in default. The JPMorgan Emerging Markets Bond Index Global is an unmanaged index which tracks the total return of U.S.-dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady Bonds, loans, Eurobonds and local market instruments. The Barclays U.S. MBS Fixed Rate Index covers the mortgage-backed pass through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC). The MBS Index is formed by grouping the universe of over 600,000 individual fixed-rate MBS pools into approximately 3,500 generic aggregates. The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the large cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index. BofA Merrill Lynch and The BofA Merrill Lynch 0 5 Year U.S. High Yield Constrained Index SM are reprinted with permission. Copyright 2014 Merrill Lynch, Pierce, Fenner & Smith Incorporated ( BofA Merrill Lynch ). All rights reserved. BofA Merrill Lynch and The BofA Merrill Lynch 0 5 Year U.S. High Yield Constrained Index SM are service marks of BofA Merrill Lynch and/ or its affiliates and have been licensed for use for certain purposes by PIMCO on behalf of the PIMCO 0 5 Year High Yield Corporate Bond Index ETF that is based on The BofA Merrill Lynch 0 5 Year U.S. High Yield Constrained Index SM, and is not issued, sponsored, endorsed or promoted by BofA Merrill Lynch and/or BofA Merrill Lynch s affiliates nor is BofA Merrill Lynch and/or BofA Merrill Lynch s affiliates an adviser to the PIMCO 0 5 Year High Yield Corporate Bond Index ETF. BofA Merrill Lynch and BofA Merrill Lynch s affiliates make no representation, express or implied, regarding the advisability of investing in the PIMCO 0 5 Year High Yield Corporate Bond Index ETF or The BofA Merrill Lynch 0 5 Year U.S. High Yield Constrained Index SM and do not guarantee the quality, accuracy, timeliness or completeness of The BofA Merrill Lynch 0 5 Year U.S. High Yield Constrained Index SM, index values or any index related data included herein, provided herewith or derived therefrom and assume no liability in connection with their use. As the index provider, BofA Merrill Lynch is licensing certain trademarks, The BofA Merrill Lynch 0 5 Year U.S. High Yield Constrained Index SM and trade names which are composed by BofA Merrill Lynch without regard to PIMCO, the PIMCO 0 5 Year High Yield Corporate Bond Index ETF or any investor. BofA Merrill Lynch and BofA Merrill Lynch s affiliates do not provide investment advice to PIMCO or the PIMCO 0 5 Year High Yield Corporate Bond Index ETF and are not responsible for the performance of the PIMCO 0 5 Year High Yield Corporate Bond Index ETF. This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. 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. 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. 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