As filed with the Securities and Exchange Commission on April 19, 2024
1933 Act File No.
1940 Act File No. 811-21601
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form
(Check appropriate box or boxes)
REGISTRATION STATEMENT
☒
UNDER
THE SECURITIES ACT OF 1933
Pre-Effective Amendment No. 1
☒
Post-Effective Amendment No.
☐
And
REGISTRATION STATEMENT
UNDER
THE INVESTMENT COMPANY ACT OF 1940
☒
Amendment No. 19
☒
PIMCO INCOME STRATEGY FUND II
(Exact Name of Registrant as Specified in Charter)
1633 Broadway
New York, New York 10019
(Address of Principal Executive Offices)
(Number, Street, City, State, Zip Code)
(888) 877-4626
(Registrant’s Telephone Number, including Area Code)
Ryan G. Leshaw
c/o Pacific Investment Management Company LLC
650 Newport Center Drive
Newport Beach, California 92660
(Name and Address (Number, Street, City, State, Zip Code) of Agent for Service)
Copies of Communications to:
| David C. Sullivan, Esq. Adam M. Schlichtmann, Esq. Ropes & Gray LLP Prudential Tower, 800 Boylston Street Boston, Massachusetts 02199 |
Douglas P. Dick, Esq. Adam T. Teufel, Esq. Dechert LLP 1900 K Street, N.W. Washington, D.C. 20006 |
Approximate Date of Proposed Public Offering:
From time to time after the effective date of this Registration Statement.
| ☐ |
Check box if the only securities being registered on this Form are being offered pursuant to dividend or interest reinvestment plans. |
☐ |
Check box if this Form is a registration statement pursuant to General Instruction B or a post-effective amendment thereto that will become effective upon filing with the Commission pursuant to Rule 462(e) under the Securities Act. |
| ☒ |
Check box if any securities being registered on this Form will be offered on a delayed or continuous basis in reliance on Rule 415 under the Securities Act of 1933 (“Securities Act”), other than securities offered in connection with a dividend reinvestment plan. |
☐ |
Check box if this Form is a post-effective amendment to a registration statement filed pursuant to General Instruction B to register additional securities or additional classes of securities pursuant to Rule 413(b) under the Securities Act. |
| ☒ |
Check box if this Form is a registration statement pursuant to General Instruction A.2 or a post-effective amendment thereto. |
|
|
| It is proposed that this filing will become effective (check appropriate box): | |
| ☐ |
when declared effective pursuant to Section 8(c), or as follows: |
The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its
effective date until the Registrant shall file a further amendment that specifically states that this Registration
Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until this
Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a),
may determine.
Subject to Completion
Preliminary Prospectus dated April 19, 2024
PIMCO Income Strategy Fund II
Base Prospectus
[], 2024
THE INFORMATION IN THIS PROSPECTUS IS NOT COMPLETE
AND MAY BE CHANGED. WE MAY NOT SELL THESE
SECURITIES UNTIL THE REGISTRATION STATEMENT FILED
WITH THE SECURITIES AND EXCHANGE COMMISSION IS
EFFECTIVE. THIS PROSPECTUS IS NOT AN OFFER TO SELL
THESE SECURITIES AND IT IS NOT SOLICITING AN OFFER TO
BUY THESE SECURITIES IN ANY JURISDICTION WHERE THE
OFFER OR SALE IS NOT PERMITTED.
PIMCO Income Strategy Fund II
$300,000,000 |
Common Shares |
PIMCO Income Strategy Fund II |
PFN |
Neither the U.S. Securities and Exchange Commission nor the U.S. Commodity
Futures Trading Commission has approved or disapproved of these securities or
determined that this prospectus is truthful or complete. Any representation to
the contrary is a criminal offense.
The Fund.
PIMCO Income Strategy Fund II (the “Fund”) is a diversified, closed-end
management investment company that commenced operations on October 29, 2004, following
the initial public offering of its common shares of beneficial interest, par value $0.00001 per
share (the “Common Shares”).
Investment Objective.
The Fund’s investment objective is to seek high current income,
consistent with the preservation of capital. The Fund cannot assure you that it will achieve its
investment objective, and you could lose all of your investment in the Fund.
Investment Strategy.
The Fund seeks to achieve its investment objective by utilizing a
dynamic asset allocation strategy that focuses on duration management, credit quality
analysis, risk management techniques and broad diversification among issuers, industries and
sectors. The Fund normally invests in a diversified portfolio of floating and/or fixed rate debt
instruments. In managing the Fund, Pacific Investment Management Company LLC, the
Fund’s investment manager (“PIMCO” or the “Investment Manager”), employs an active
approach to allocation among multiple fixed income sectors based on, among other things,
market conditions, valuation assessments, economic outlook, credit market trends and other
economic factors. The Fund focuses on seeking income generating investment ideas across
multiple fixed income sectors, with an emphasis on seeking opportunities in developed and
emerging global credit markets.
Under normal circumstances, the Fund will have a short to intermediate average portfolio duration (i.e., within a zero to eight (0 to 8) year range),
as calculated by the Investment Manager, although it may be shorter or longer at any time or from time to time depending on market conditions
and other factors.
Portfolio Contents.
The Fund seeks to achieve its investment objective by ordinarily investing in a diversified portfolio of floating- and/or
fixed-rate debt instruments. The Fund may invest a substantial portion of its floating-rate assets in floating-rate loans. Other floating-rate debt
instruments in which the Fund may invest include catastrophe and other event-linked bonds, bank capital securities, unsecured and/or secured
loans (including, but not limited to, bank and/or other syndicated loans and non-syndicated (private direct) loans), corporate bonds and other debt
securities, money market instruments and certain types of mortgage-backed and other asset-backed securities that pay interest at rates that
adjust whenever a specified interest rate changes and/or reset on predetermined dates (such as the last day of a month or calendar quarter). The
Fund also considers floating rate assets to include securities with durations of less than or equal to one year and fixed-rate securities with respect
to which the Fund has entered into derivative instruments to effectively convert the fixed-rate interest payments into floating-rate interest
payments. The Fund also may invest in a wide variety of fixed-rate debt securities, including corporate bonds and mortgage-backed and other
asset-backed securities issued on a public or private basis, including mortgage pass-through securities (e.g., securities representing interests in
“pools” of mortgage loans secured by residential or commercial real property), collateralized mortgage obligations (“CMOs”), commercial or
residential mortgage-backed securities, mortgage dollar rolls/buybacks, CMO residuals, stripped mortgage-backed securities (“SMBSs”) (e.g., a
type of mortgage-backed security that receives differing proportions of the interest and principal payments from the underlying assets) and other
securities that directly or indirectly represent a participation in, or are secured by and payable from, mortgage loans on real property. The Fund
may make use of a variety of other instruments, including collateralized bond obligations, collateralized loan obligations, collateralized debt
obligations, preferred securities, commercial paper, zero-coupon and inflation-indexed bonds, bank certificates of deposit, fixed time deposits
and bankers’ acceptances, real estate investment trusts (“REITs”), bonds, debentures, notes, and other debt securities of U.S. and foreign
(non-U.S.) corporate and other issuers; obligations of foreign governments or their sub-divisions, agencies and government sponsored
enterprises and obligations of international agencies and supranational entities; municipal securities and other debt securities issued by states or
local governments and their agencies, authorities and other government-sponsored enterprises, including taxable municipal securities (such as
Build America Bonds); inflation-indexed bonds issued by both governments and corporations; structured notes, including hybrid or indexed
securities; credit-linked notes; structured credit products; loans (including, among others, senior loans, delayed draw and delayed funding loans,
revolving credit facilities and loan participations and assignments); covenant-lite obligations, preferred securities and convertible debt securities
(i.e., debt securities that may be converted at either a stated price or stated rate into underlying shares of common stock), including synthetic
convertible debt securities (i.e., instruments created through a combination of separate securities that possess the two principal characteristics of
a traditional convertible security, such as an income producing security and the right to acquire an equity security) and contingent convertible
securities. Certain debt instruments, such as convertible bonds, also may include the right to participate in equity appreciation. The principal
and/or interest rate on some debt instruments may be determined by reference to the performance of a benchmark asset or market, such as an
index of securities, or the differential performance of two assets or markets, such as the level of exchange rates between the U.S. dollar and a
foreign currency or currencies. The Fund may invest in debt securities of stressed, distressed and defaulted issuers. Subject to the Fund’s
investment limitations, at any given time and from time to time, substantially all of the Fund’s portfolio may consist of below investment grade
securities. The Fund may invest in various levels of the capital structure of an issuer of mortgage-backed or asset-backed securities, including
the equity or “first loss” tranche. The rate of interest on an income-producing security may be fixed, floating or variable.
The Fund invests predominantly in U.S. dollar-denominated debt securities, which may include those issued by foreign corporations or
supra-national government agencies. The Fund may invest without limit in non-U.S. dollar denominated securities (of both developed and
“emerging market” countries), including obligations of non-U.S. governments and their respective sub-divisions, agencies and
government-sponsored enterprises. The Fund may invest up to 40% of its total assets in securities and instruments that are economically tied to
“emerging market” countries except the Fund may invest without limit in investment grade sovereign debt denominated in the relevant country's
local currency with less than 1 year remaining to maturity issued by emerging market issuers. The Fund may also invest directly in foreign
currencies, including local emerging market currencies.
The Fund may invest up to 20% of its total assets in common stocks and other equity securities from time to time, including those it has received
through the conversion of a convertible security held by the Fund or in connection with the restructuring of a debt security.
The Fund may, but is not required to, utilize various derivative strategies (both long and short positions) involving the purchase or sale of futures
and forward contracts (including foreign currency exchange contracts), call and put options, credit default swaps, total return swaps, basis swaps
and other swap agreements and other derivative instruments for investment purposes, leveraging purposes or in an attempt to hedge against
market, credit, interest rate, currency and other risks in the portfolio. The Fund may purchase and sell securities on a when-issued, delayed
delivery or forward commitment basis and may engage in short sales. The Fund may also seek to obtain market exposure to the securities in
which it invests by entering into a series of purchase and sale contracts. The Fund may use derivative instruments for other purposes, including
to seek to increase liquidity, provide efficient portfolio management, broaden investment opportunities (including taking short or negative
positions), implement a tax or cash management strategy, gain exposure to a particular security or segment of the market, modify the effective
duration of the Fund’s portfolio investments and/or enhance total return.
ii
The Fund has a policy not to concentrate investments in any particular industry, but may (consistent with that policy) invest up to 25% of its total
assets in any particular industry, and may invest a substantial portion of its assets in companies in related sectors, such as those in the banking
or financial services sectors, which may share common characteristics and are often subject to similar business risks and regulatory burdens.
The Fund may invest without limit in debt securities that are, at the time of purchase, rated below investment grade (commonly referred to as
“high yield” securities or “junk bonds”), and may also invest without limit in investment grade securities. However, the Fund will not normally invest
more than 20% of its total assets in debt instruments, other than mortgage-related and other asset-backed securities, that are, at the time of
purchase, rated CCC+ or lower by S&P Global Ratings (“S&P”) and Fitch Ratings, Inc. (“Fitch”) and Caa1 or lower by Moody’s Investors Service,
Inc. (“Moody's”), or that are unrated but determined by PIMCO to be of comparable quality. The Fund may invest without limit in mortgage-related
and other asset-backed securities regardless of rating—i.e., of any credit quality.
The Fund may invest in securities that have not been registered for public sale in the U.S. or relevant non-U.S. jurisdictions, including without limit
securities eligible for purchase and sale pursuant to Rule 144A under the Securities Act of 1933, as amended, or relevant provisions of applicable
non-U.S. law, and other securities issued in private placements. The Fund may invest in securities of other open- or closed-end investment
companies (including those advised by PIMCO), including, without limitation, exchange-traded funds, to the extent that such investments are
consistent with the Fund’s investment objective, strategies and policies and permissible under the Investment Company Act of 1940, as
amended. The Fund may invest in securities of companies of any market capitalization, including small and medium capitalizations.
The Fund may invest without limit in illiquid investments (i.e., investments that the Fund reasonably expects cannot be sold or disposed of in
current market conditions in seven calendar days or less without the sale or disposition significantly changing the market value of the
investment).
Leverage.
The Fund currently utilizes leverage principally through reverse repurchase agreements, and may also obtain additional leverage
through the issuance of preferred shares (the “Preferred Shares”) and the use of dollar rolls/buybacks or borrowings, such as through bank loans
or commercial paper and/or other credit facilities. The Fund may also enter into transactions other than those noted above that may give rise to a
form of leverage including, among others, selling credit default swaps, futures and forward contracts (including foreign currency exchange
contracts), total return swaps and other derivative transactions, loans of portfolio securities, short sales and when-issued, delayed delivery and
forward commitment transactions. The Fund may also determine to issue other types of preferred shares. Depending upon market conditions and
other factors, the Fund may or may not determine to add leverage following an offering to maintain or increase the total amount of leverage (as a
percentage of the Fund’s total assets) that the Fund currently maintains, taking into account the additional assets raised through the issuance of
Common Shares in such offering. The Fund utilizes certain kinds of leverage, such as reverse repurchase agreements and selling credit default
swaps, opportunistically and may choose to increase or decrease, or eliminate entirely, its use of such leverage over time and from time to time
based on PIMCO’s assessment of the yield curve environment, interest rate trends, market conditions and other factors. The Fund may also
determine to decrease the leverage it currently maintains through its outstanding Preferred Shares through Preferred Share redemptions or
tender offers and may or may not determine to replace such leverage through other sources. If the Fund determines to add leverage following an
offering, it is not possible to predict with accuracy the precise amount of leverage that would be added, in part because it is not possible to predict
the number of Common Shares that ultimately will be sold in an offering or series of offerings. To the extent that the Fund does not add additional
leverage following an offering, the Fund’s total amount of leverage as a percentage of its total assets will decrease, which could result in a
reduction of investment income available for distribution to holders of the Fund’s Common Shares (“Common Shareholders”). By using leverage,
the Fund will seek to obtain a higher return for holders of common shares than if the Fund did not use leverage. Leveraging transactions pursued
by the Fund may increase its duration and sensitivity to interest rate movements. Leveraging is a speculative technique and there are special
risks and costs involved. There can be no assurance that a leveraging strategy will be used or that it will be successful during any period in which
it is employed. See “Use of Leverage” and “Principal Risks of the Fund—Leverage Risk.”
Additional Information.
This prospectus is part of a registration statement that the Fund has filed with the U.S. Securities and Exchange
Commission (the “SEC”), using the “shelf” registration process. Under the shelf registration process, the Fund may offer, from time to time, in one
or more offerings, up to $300 million of Common Shares on terms to be determined at the time of the offering. This prospectus provides you with
a general description of the Common Shares that the Fund may offer. Each time the Fund uses this prospectus to offer Common Shares, the
Fund will provide a prospectus supplement that will contain specific information about the terms of that offering. The prospectus supplement may
also add, update or change information contained in this prospectus. You should read this prospectus and the applicable prospectus supplement,
which contain important information about the Fund, carefully before you invest in the Common Shares. Common Shares may be offered directly
to one or more purchasers, through agents designated from time to time by the Fund, or to or through underwriters or dealers. The prospectus
supplement relating to an offering will identify any agents, underwriters or dealers involved in the sale of Common Shares, and will set forth any
applicable purchase price, fee, commission or discount arrangement between the Fund and its agents or underwriters, or among the Fund’s
underwriters, or the basis upon which such amount may be calculated. See “Plan of Distribution.” The Fund may not sell any Common Shares
through agents, underwriters or dealers without delivery or deemed delivery of a prospectus supplement describing the method and terms of the
particular offering of the Common Shares.
You should retain this prospectus and any prospectus supplement for future reference. A Statement of Additional Information, dated [], 2024,
containing additional information about the Fund has been filed with the SEC and is incorporated by reference in its entirety into this prospectus.
You may request a free copy of the Statement of Additional Information, request the Fund’s most recent annual and semiannual reports, request
iii
information about the Fund and make shareholder inquiries by calling toll-free (844)-33-PIMCO (844-337-4626) or by writing to the Fund at c/o
Pacific Investment Management Company LLC, 1633 Broadway, New York, New York 10019. The Fund’s Statement of Additional Information
and most recent annual and semiannual reports are available, free of charge, on the Fund’s website (http://www.pimco.com/prospectuses). You
can obtain the same information, free of charge, from the SEC’s website (http://www.sec.gov).
The Common Shares do not represent a deposit or obligation of, and are not guaranteed or endorsed by, any bank or other insured depository
institution, and are not federally insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board or any other government
agency.
The Common Shares are listed on the New York Stock Exchange (“NYSE”) under the symbol “PFN.” The last reported sale price of the Common
Shares, as reported by the NYSE on March 28, 2024, was $7.46 per Common Share. The net asset value (“NAV”) of the Common Shares at the
close of business on March 28, 2024, was $7.15 per Common Share.
Investment in the Common Shares involves substantial risks arising from, among other strategies, the Fund’s ability to invest in debt
instruments that are, at the time of purchase, rated below investment grade (below Baa3 by Moody’s or below BBB- by either S&P or
Fitch) or unrated but determined by PIMCO to be of comparable quality, the Fund’s exposure to foreign and emerging markets
securities and currencies and to mortgage-related and other asset-backed securities, and the Fund’s use of leverage.
Debt securities of below investment grade quality are regarded as having predominantly speculative characteristics with respect to
capacity to pay interest and to repay principal, and are commonly referred to as “high yield” securities or “junk bonds.” The Fund’s
exposure to foreign securities and currencies, and particularly to emerging markets securities and currencies, involves special risks,
including foreign currency risk and the risk that the securities may decline in response to unfavorable political and legal
developments, unreliable or untimely information or economic and financial instability. Mortgage-related and other asset-backed
securities are subject to extension and prepayment risk and often have complicated structures that make them difficult to value.
Because of the risks associated with investing in high yield securities, foreign and emerging market securities (and related exposure
to foreign currencies) and mortgage-related and other asset-backed securities, and using leverage, an investment in the Fund should
be considered speculative. Before investing in the Common Shares, you should read the discussion of the principal risks of investing
in the Fund in “Principal Risks of the Fund.” Certain of these risks are summarized in “Prospectus Summary—Principal Risks of the
Fund.”
You should rely only on the information contained or incorporated by reference in this prospectus and any related prospectus
supplement. The Fund has not authorized anyone to provide you with information other than that contained or incorporated by
reference in this prospectus or any applicable prospectus supplement, and any free writing prospectus that the Fund distributes. The
Fund does not take any responsibility for, and does not provide any assurances as to the reliability of, any other information that
others may give you. The Fund is not making an offer of these securities in any jurisdiction where the offer is not permitted. You
should not assume that the information contained in this prospectus or any applicable prospectus supplement is accurate as of any
date other than the date on the front hereof or thereof. The Fund’s business, financial condition, results of operations and prospects
may have changed since that date.
iv
PIMCO Income Strategy Fund II
Prospectus Summary
This is only a summary. This summary may not contain all of the
information that you should consider before investing in PIMCO Income
Strategy Fund II’s (the “Fund”) common shares of beneficial interest,
par value $0.00001 per share (the “Common Shares”). You should
review the more detailed information contained in this prospectus and
in any related prospectus supplement and in the Statement of
Additional Information, especially the information set forth under the
heading “Principal Risks of the Fund.”
The Fund
The Fund is a diversified, closed-end management investment company.
The Fund commenced operations on October 29, 2004, following the
initial public offering of its Common Shares. Effective March 1, 2010,
the Fund changed its name from PIMCO Floating Rate Strategy Fund to
its current name, PIMCO Income Strategy Fund II.
The Common Shares are listed on the New York Stock Exchange
(“NYSE”) under the symbol “PFN.” As of March 28, 2024, the net assets
of the Fund attributable to Common Shares were $616 million and the
Fund had outstanding 86,130,947 Common Shares and 1,556 auction
rate preferred shares of beneficial interest (“ARPS” and, together with
any other preferred shares issued by the Fund, “Preferred Shares”). The
last reported sale price of the Common Shares, as reported by the NYSE
on March 28, 2024, was $7.46 per Common Share. The net asset value
(“NAV”) of the Common Shares at the close of business on March 28,
2024, was $7.15 per Common Share. See “Description of Capital
Structure.”
The Offering
The Fund may offer, from time to time, in one or more offerings, up to
$300 million of Common Shares on terms to be determined at the time
of the offering. The Common Shares may be offered at prices and on
terms to be set forth in one or more prospectus supplements. You
should read this prospectus and the applicable prospectus supplement
carefully before you invest in the Common Shares. Common Shares may
be offered directly to one or more purchasers, through agents
designated from time to time by the Fund, or to or through underwriters
or dealers. The prospectus supplement relating to an offering will
identify any agents, underwriters or dealers involved in the sale of
Common Shares, and will set forth any applicable purchase price, fee,
commission or discount arrangement between the Fund and its agents
or underwriters, or among the Fund’s underwriters, or the basis upon
which such amount may be calculated. See “Plan of Distribution.” The
Fund may not sell any Common Shares through agents, underwriters or
dealers without delivery or deemed delivery of a prospectus supplement
describing the method and terms of the particular offering of the
Common Shares.
Use of Proceeds
The net proceeds of an offering will be invested in accordance with the
Fund’s investment objective and policies as set forth below. It is
currently anticipated that the Fund will be able to invest substantially all
of the net proceeds of an offering in accordance with its investment
objective and policies within approximately 30 days of receipt by the
Fund, depending on the amount and timing of proceeds available to the
Fund as well as the availability of investments consistent with the
Fund’s investment objective and policies, and except to the extent
proceeds are held in cash to pay dividends or expenses, or for temporary
defensive purposes. See “Use of Proceeds”.
Investment Objective and Policies
When used in this prospectus, the term “invest” includes both direct
investing and indirect investing and the term “investments” includes
both direct investments and indirect investments. For example, the Fund
may invest indirectly by investing in derivatives or through its
wholly-owned subsidiaries (each, a “Subsidiary” and collectively, the
“Subsidiaries”). References herein to the Fund include, as appropriate,
Subsidiaries through which the Fund may gain exposure to investments.
The Fund may be exposed to the different types of investments
described below through its investments in its Subsidiaries. The
allocation of the Fund's assets to a Subsidiary will vary over time and
will likely not include all of the different types of investments described
herein at any given time.
The Fund’s investment objective is to seek high current income,
consistent with the preservation of capital. The Fund seeks to achieve its
investment objective by ordinarily investing in a diversified portfolio of
floating- and/or fixed-rate debt instruments. The Fund may invest a
substantial portion of its floating-rate assets in floating-rate loans.
Other floating-rate debt instruments in which the Fund may invest
include catastrophe and other event-linked bonds, bank capital
securities, unsecured and/or secured loans (including, but not limited to,
bank and/or other syndicated loans and non-syndicated (private direct)
loans), corporate bonds and other debt securities, money market
instruments and certain types of mortgage-backed and other
asset-backed securities that pay interest at rates that adjust whenever a
specified interest rate changes and/or reset on predetermined dates
(such as the last day of a month or calendar quarter). The Fund cannot
assure you that it will achieve its investment objective, and you could
lose all of your investment in the Fund.
Portfolio Management Strategies
Dynamic Allocation Strategy.
In managing the Fund, the Fund’s
investment manager, Pacific Investment Management Company LLC
(“PIMCO” or the “Investment Manager”), employs an active approach
to allocation among multiple fixed income sectors based on, among
other things, market conditions, valuation assessments, economic
outlook, credit market trends and other economic factors. With PIMCO’s
macroeconomic analysis as the basis for top-down investment
decisions, including geographic and credit sector emphasis, PIMCO
manages the Fund with a focus on seeking income generating
investment ideas across multiple fixed income sectors, with an emphasis
on seeking opportunities in developed and emerging global credit
markets. The Fund has the flexibility to allocate assets in varying
proportions among floating- and fixed-rate debt instruments, as well as
1
PIMCO Income Strategy Fund II |
Base Prospectus
Base Prospectus
among investment-grade and non-investment grade securities. It may
focus more heavily or exclusively on an asset class at any time, based on
assessments of relative values, market conditions and other factors.
PIMCO may choose to focus on particular countries/regions, asset
classes, industries and sectors to the exclusion of others at any time and
from time to time based on market conditions and other factors. The
relative value assessment within fixed-income sectors draws on
PIMCO’s regional and sector specialist insights. The Fund will observe
various investment guidelines as summarized below.
Investment Selection Strategies.
Once the Fund’s top-down,
portfolio positioning decisions have been made as described above,
PIMCO selects particular investments for the Fund by employing a
bottom-up, disciplined credit approach which is driven by fundamental,
independent research within each sector/asset class represented in the
Fund, with a focus on identifying securities and other instruments with
solid and/or improving fundamentals.
PIMCO utilizes strategies that focus on credit quality analysis, duration
management and other risk management techniques. PIMCO attempts
to identify, through fundamental research driven by independent credit
analysis and proprietary analytical tools, debt obligations and other
income-producing securities that provide current income and/or
opportunities for capital appreciation based on its analysis of the
issuer’s credit characteristics and the position of the security in the
issuer’s capital structure.
Consideration of yield is only one component of the portfolio managers’
approach in managing the Fund. PIMCO also attempts to identify
investments that may appreciate in value based on PIMCO’s assessment
of the issuer’s credit characteristics, forecast for interest rates and
outlook for particular countries/regions, currencies, industries, sectors
and the global economy and bond markets generally.
Credit Quality.
The Fund may invest without limit in debt securities
that are, at the time of purchase, rated below investment grade (below
Baa3 by Moody’s Investors Service, Inc. (“Moody’s”) or below BBB- by
either S&P Global Ratings (“S&P”) or Fitch Ratings, Inc. (“Fitch”)) or
that are unrated but judged by PIMCO to be of comparable quality
(commonly referred to as “high yield” securities or “junk bonds”).The
Fund will not normally invest more than 20% of its total assets in debt
instruments, other than mortgage-related and other asset-backed
securities, that are, at the time of purchase, rated CCC+ or lower by S&P
and Fitch and Caa1 or lower by Moody’s, or that are unrated but
determined by PIMCO to be of comparable quality. The Fund may invest
without limit in mortgage-related and other asset-backed securities
regardless of rating (i.e., of any credit quality). Subject to this 20%
restriction, the Fund may invest in issuers of any credit quality (including
bonds in the lowest ratings categories and securities that are in default
or the issuers of which are in bankruptcy). For purposes of applying the
foregoing policies, in the case of securities with split ratings (i.e., a
security receiving two different ratings from two different rating
agencies), the Fund will apply the higher of the applicable ratings.
Subject to the aforementioned investment restrictions, the Fund may
invest in securities of stressed issuers, which include securities at risk of
being in default as to the repayment of principal and/or interest at the
time of acquisition by the Fund or that are rated in the lower rating
categories by one or more nationally recognized statistical rating
organizations (for example, Ca or lower by Moody’s or CC or lower by
S&P or Fitch) or, if unrated, are determined by PIMCO to be of
comparable quality. Debt instruments of below investment grade quality
are regarded as having predominantly speculative characteristics with
respect to capacity to pay interest and to repay principal, and are
commonly referred to as “high yield” securities or “junk bonds.” Debt
instruments in the lowest investment grade category also may be
considered to possess some speculative characteristics. The Fund may,
for hedging, investment or leveraging purposes, make use of credit
default swaps, which are contracts whereby one party makes periodic
payments to a counterparty in exchange for the right to receive from the
counterparty a payment equal to the par (or other agreed-upon) value
of a referenced debt obligation in the event of a default or other credit
event by the issuer of the debt obligation.
Independent Credit Analysis.
PIMCO relies primarily on its own
analysis of the credit quality and risks associated with individual debt
instruments considered for the Fund, rather than relying exclusively on
rating agencies or third-party research. The Fund’s portfolio managers
utilize this information in an attempt to manage credit risk and/or to
identify issuers, industries or sectors that are undervalued and/or that
offer attractive yields relative to PIMCO’s assessment of their credit
characteristics. This aspect of PIMCO’s capabilities will be particularly
important to the extent that the Fund invests in floating rate loans, high
yield securities and in securities of emerging market issuers.
Duration Management.
It is expected that the Fund normally will
have a short to intermediate average portfolio duration (i.e., within a
zero to eight (0 to 8) year range), as calculated by PIMCO, although it
may be shorter or longer at any time or from time to time depending on
market conditions and other factors. For example, if the Fund has an
average portfolio duration of eight years, a 1% increase in interest rates
would tend to correspond to an 8% decrease in the value of the Fund’s
debt portfolio. While the Fund seeks to maintain a short to intermediate
average portfolio duration, there is no limit on the maturity or duration
of any individual security in which the Fund may invest. Duration is a
measure used to determine the sensitivity of a security’s price to
changes in interest rates. The Fund's duration strategy may entail
maintaining a negative average portfolio duration from time to time,
meaning the portfolio would tend to increase in value in response to an
increase in interest rates. For example, if the Fund has a negative
average portfolio duration, a 1% increase in interest rates would tend to
correspond to a 1% increase in the value of the Fund's debt portfolio for
every year of negative duration. A negative average portfolio duration
would potentially benefit the portfolio in an environment of rising
market interest rates, but would generally adversely impact the portfolio
in an environment of falling or neutral market interest rates. See
“Principal Risks of the Fund—Interest Rate Risk.” The Fund may use
various derivatives strategies to manage (increase or decrease) the
dollar-weighted average effective duration of the Fund's portfolio.
[], 2024 |
Base Prospectus
2
PIMCO Income Strategy Fund II
PIMCO may also utilize certain strategies, including without limit
investments in structured notes or interest rate futures contracts or
swap, cap, floor or collar transactions, for the purpose of reducing the
interest rate sensitivity of the Fund’s portfolio, although there is no
assurance that it will do so or that such strategies will be successful.
Portfolio Contents
The Fund seeks to achieve its investment objective by ordinarily
investing in a diversified portfolio of floating- and/or fixed-rate debt
instruments. The Fund may invest a substantial portion of its
floating-rate assets in floating-rate loans. Other floating-rate debt
instruments in which the Fund may invest include catastrophe and other
event-linked bonds, bank capital securities, unsecured and/or secured
loans (including, but not limited to, bank and/or other syndicated loans
and non-syndicated (private direct) loans), corporate bonds and other
debt securities, money market instruments and certain types of
mortgage-backed and other asset-backed securities that pay interest at
rates that adjust whenever a specified interest rate changes and/or reset
on predetermined dates (such as the last day of a month or calendar
quarter). The Fund also considers floating-rate assets to include
securities with durations of less than or equal to one year and fixed-rate
securities with respect to which the Fund has entered into derivative
instruments to effectively convert the fixed-rate interest payments into
floating-rate interest payments. The Fund also may invest in a wide
variety of fixed-rate debt securities, including corporate bonds and
mortgage-backed and other asset-backed securities issued on a public
or private basis, including mortgage pass-through securities (e.g.,
securities representing interests in “pools” of mortgage loans secured
by residential or commercial real property), collateralized mortgage
obligations (“CMOs”), commercial or residential mortgage-backed
securities, mortgage dollar rolls/buybacks, CMO residuals, stripped
mortgage-backed securities (“SMBSs”) (e.g., a type of mortgage-backed
security that receives differing proportions of the interest and principal
payments from the underlying assets) and other securities that directly
or indirectly represent a participation in, or are secured by and payable
from, mortgage loans on real property. The Fund may make use of a
variety of other instruments, including collateralized bond obligations
(“CBOs”), collateralized loan obligations (“CLOs”), collateralized debt
obligations (“CDOs”), preferred securities, commercial paper,
zero-coupon and inflation-indexed bonds, bank certificates of deposit,
fixed time deposits and bankers’ acceptances, real estate investment
trusts (“REITs”), bonds, debentures, notes, and other debt securities of
U.S. and foreign (non-U.S.) corporate and other issuers; obligations of
foreign governments or their sub-divisions, agencies and government
sponsored enterprises and obligations of international agencies and
supranational entities; municipal securities and other debt securities
issued by states or local governments and their agencies, authorities
and other government-sponsored enterprises, including taxable
municipal securities (such as Build America Bonds); inflation-indexed
bonds issued by both governments and corporations; structured notes,
including hybrid or indexed securities; credit-linked notes; structured
credit products; loans (including, among others, senior loans, delayed
draw and delayed funding loans, revolving credit facilities and loan
participations and assignments); covenant-lite obligations; preferred
securities and convertible debt securities (i.e., debt securities that may
be converted at either a stated price or stated rate into underlying
shares of common stock), including synthetic convertible debt securities
(i.e., instruments created through a combination of separate securities
that possess the two principal characteristics of a traditional convertible
security, such as an income-producing security and the right to acquire
an equity security) and contingent convertible securities. Certain debt
instruments, such as convertible bonds, also may include the right to
participate in equity appreciation. The principal and/or interest rate on
some debt instruments may be determined by reference to the
performance of a benchmark asset or market, such as an index of
securities, or the differential performance of two assets or markets, such
as the level of exchange rates between the U.S. dollar and a foreign
currency or currencies. The Fund may invest in debt securities of
stressed, distressed and defaulted issuers. Subject to the Fund’s
investment limitations, at any given time and from time to time,
substantially all of the Fund’s portfolio may consist of below investment
grade securities. The Fund may invest in various levels of the capital
structure of an issuer of mortgage-backed or asset-backed securities,
including the equity or “first loss” tranche. The Fund may invest in
unsecured loans and subordinated or mezzanine obligations, including
second and lower lien loans and the mezzanine and equity (or “first
loss”) tranches of CLO issues. For the avoidance of doubt, equity or
“first loss” tranches of mortgage-backed or asset-backed securities do
not constitute equity interests for purposes of the Fund’s 20% limit on
investments in equity interests described below. The Fund may also
invest, as a third party purchaser, in risk retention tranches of
commercial mortgage-backed securities (“CMBS”) or other eligible
securitizations, which are eligible residual interests held by the sponsors
of such securitizations pursuant to the final rules implementing the
credit risk retention requirements of Section 941 of the Dodd-Frank Act.
The rate of interest on an income-producing security may be fixed,
floating or variable.
The Fund invests predominantly in U.S. dollar-denominated debt
securities, which may include those issued by foreign corporations or
supra-national government agencies. The Fund may invest without limit
in non-U.S. dollar denominated securities (of both developed and
“emerging market” countries), including obligations of
non-U.S. governments and their respective sub-divisions, agencies and
government-sponsored enterprises. The Fund may invest up to 40% of
its total assets in securities and instruments that are economically tied
to “emerging market” countries except the Fund may invest without
limit in investment grade sovereign debt denominated in the relevant
country's local currency with less than 1 year remaining to maturity
(“short-term investment grade sovereign debt”) issued by emerging
market issuers. The Fund may also invest directly in foreign currencies,
including local emerging market currencies.
The Fund may invest up to 20% of its total assets in common stocks and
other equity securities from time to time, including those it has received
through the conversion of a convertible security held by the Fund or in
3 Base Prospectus
| PIMCO Income Strategy Fund II
Base Prospectus
connection with the restructuring of a debt security. Common stocks
include common shares and other common equity interest issued by
public or private issuers.
The Fund may, but is not required to, utilize various derivative strategies
(both long and short positions) involving the purchase or sale of futures
and forward contracts (including foreign currency exchange contracts),
call and put options, credit default swaps, total return swaps, basis
swaps and other swap agreements and other derivative instruments for
investment purposes, leveraging purposes or in an attempt to hedge
against market, credit, interest rate, currency and other risks in the
portfolio. The Fund may purchase and sell securities on a when-issued,
delayed delivery or forward commitment basis and may engage in short
sales. The Fund may also seek to obtain market exposure to the
securities in which it invests by entering into a series of purchase and
sale contracts. The Fund may use derivative instruments for other
purposes, including to seek to increase liquidity, provide efficient
portfolio management, broaden investment opportunities (including
taking short or negative positions), implement a tax or cash
management strategy, gain exposure to a particular security or segment
of the market, modify the effective duration of the Fund's portfolio
investments and/or enhance total return.
The Fund may invest without limit in debt securities that are, at the time
of purchase, rated below investment grade (commonly referred to as
“high yield” securities or “junk bonds”) and may also invest without
limit in investment grade securities. However, the Fund will not normally
invest more than 20% of its total assets in debt instruments, other than
mortgage-related and other asset-backed securities, that are, at the
time of purchase, rated CCC+ or lower by S&P and Fitch and Caa1 or
lower by Moody’s, or that are unrated but determined by PIMCO to be
of comparable quality. The Fund may invest without limit in
mortgage-related and other asset-backed securities regardless of
rating—i.e., of any credit quality.
The Fund has a policy not to concentrate investments in any particular
industry, but may (consistent with that policy) invest up to 25% of its
assets in any particular industry, and may invest a substantial portion of
its assets in companies in related sectors, such as those in the banking
or financial services sectors, which may share common characteristics
and are often subject to similar business risks and regulatory burdens.
The Fund may invest in securities that have not been registered for
public sale in the U.S. or relevant non-U.S. jurisdictions, including
without limit securities eligible for purchase and sale pursuant to
Rule 144A under the Securities Act of 1933, as amended (the
“Securities Act”), or relevant provisions of applicable non-U.S. law, and
other securities issued in private placements. The Fund may invest in
securities of other open- or closed-end investment companies (including
those advised by PIMCO), including, without limitation,
exchange-traded funds (“ETFs”), to the extent that such investments
are consistent with the Fund’s investment objective, strategies and
policies and permissible under the Investment Company Act of 1940, as
amended (the “1940 Act”). The Fund may invest in securities of
companies of any market capitalization, including small and medium
capitalizations.
The Fund may invest without limit in illiquid investments (i.e.,
investments that the Fund reasonably expects cannot be sold or
disposed of in current market conditions in seven calendar days or less
without the sale or disposition significantly changing the market value
of the investment).
The Fund may enter into repurchase agreements, in which the Fund
purchases a security from a bank or broker-dealer and the bank or
broker-dealer agrees to repurchase the security at the Fund’s cost plus
interest within a specified time.
The Fund may lend its portfolio securities to brokers, dealers or other
financial institutions provided a number of conditions are satisfied,
including that the loan is fully collateralized.
The Fund may engage in frequent and active trading of portfolio
securities to achieve its investment objective, particularly during periods
of volatile market movements.
In connection with rating the Fund’s ARPS, Moody’s and Fitch impose
asset coverage tests and other restrictions that may limit the Fund’s
ability to engage in certain of the transactions described above.
In attempting to respond to adverse market, economic, political, or other
conditions, as determined by PIMCO, when PIMCO deems it appropriate
to do so, the Fund may, for temporary defensive purposes, deviate from
its investment strategy by investing some or all of its total assets in
investments such as high grade debt securities, including high quality,
short-term debt securities, and cash and cash equivalents. The Fund may
not achieve its investment objective when it does so.
The Fund has received exemptive relief from the SEC that, to the extent
the Fund relies on such relief, permits it to (among other things)
co-invest with certain other persons, including certain affiliates of the
Investment Manager and certain public or private funds managed by the
Investment Manager and its affiliates, subject to certain terms and
conditions. The exemptive relief from the SEC with respect to co
investments imposes extensive conditions on any co-investments made
in reliance on such relief.
Use of Leverage
The Fund currently utilizes leverage principally through reverse
repurchase agreements and may also obtain additional leverage
through the issuance of Preferred Shares and the use of dollar
rolls/buybacks or borrowings, such as through bank loans or commercial
paper, other credit facilities and/or other transactions. The amount of
leverage the Fund utilizes may vary but total leverage resulting from the
issuance of Preferred Shares and senior securities representing
indebtedness of the Fund will not exceed 50% of the Fund’s total assets
less all liabilities and indebtedness not represented by senior securities.
Information regarding the terms and features of the ARPS is provided
under “Description of Capital Structure” in this Prospectus.
The Fund may also enter into transactions other than those noted above
that may give rise to a form of leverage including, among others, selling
credit default swaps, futures and forward contracts (including foreign
currency exchange contracts), total return swaps and other derivative
transactions, loans of portfolio securities, short sales and when-issued,
[], 2024 |
Base Prospectus
4
PIMCO Income Strategy Fund II
delayed delivery and forward commitment transactions. The Fund may
also determine to issue other types of preferred shares and senior
securities to add leverage to its portfolio. The Fund's Board of Trustees
may authorize the issuance of other types of preferred shares without
the approval of Common Shareholders. Leveraging transactions pursued
by the Fund may increase its duration and sensitivity to interest rate
movements.
Depending upon market conditions and other factors, the Fund may or
may not determine to add leverage following an offering to maintain or
increase the total amount of leverage (as a percentage of the Fund’s
total assets) that the Fund currently maintains, taking into account the
additional assets raised through the issuance of Common Shares in such
offering. The Fund utilizes certain kinds of leverage, such as reverse
repurchase agreements and selling credit default swaps,
opportunistically and may choose to increase or decrease, or eliminate
entirely, its use of such leverage over time and from time to time based
on PIMCO’s assessment of the yield curve environment, interest rate
trends, market conditions and other factors. The Fund may also
determine to decrease the leverage it currently maintains through its
outstanding Preferred Shares through Preferred Shares redemptions or
tender offers and may or may not determine to replace such leverage
through other sources. If the Fund determines to add leverage following
an offering, it is not possible to predict with accuracy the precise
amount of leverage that would be added, in part because it is not
possible to predict the number of Common Shares that ultimately will
be sold in an offering or series of offerings. To the extent that the Fund
does not add additional leverage following an offering, the Fund’s total
amount of leverage as a percentage of its total assets will decrease,
which could result in a reduction of investment income available for
distribution to holders of the Common Shares (“Common
Shareholders”).
The Fund’s net assets attributable to its Preferred Shares and the net
proceeds the Fund obtains from reverse repurchase agreements or other
forms of leverage utilized, if any, will be invested in accordance with the
Fund’s investment objective and policies as described in this prospectus
and any prospectus supplement. So long as the rate of return, net of
applicable Fund expenses, on the debt obligations and other
investments purchased by the Fund exceeds the dividend rates payable
on the Preferred Shares together with the costs to the Fund of other
leverage it utilizes, the investment of the Fund’s net assets attributable
to leverage will generate more income than will be needed to pay the
costs of the leverage. If so, and all other things being equal, the excess
may be used to pay higher dividends to Common Shareholders than if
the Fund were not so leveraged. There can be no assurance these
circumstances will occur.
Regarding the costs associated with the Fund’s ARPS, the terms of the
ARPS provide that they would ordinarily pay dividends at a rate set at
auctions held every seven days, normally payable on the first business
day following the end of the rate period, subject to a maximum
applicable rate calculated as a function of the ARPS’ then-current rating
and a reference interest rate. However, the weekly auctions for the
ARPS, as well as auctions for similar preferred shares of other
closed-end funds in the U.S., have failed since February 2008, and the
dividend rates on the ARPS since that time have been paid at the
maximum applicable rate (i.e., the greater of a multiple of or a spread
plus a reference rate, which is either (i) for a rate period of fewer than
365 days, the Secured Overnight Funding Rate plus spread adjustments
intended to serve as a reasonable substitute of the previously-applicable
LIBOR Rate (as defined and detailed in the Fund’s Bylaws), or (ii) for a
rate period of 365 days or more, the applicable Treasury Index Rate). In
September 2011, Moody’s, a ratings agency that provides ratings for the
Fund’s ARPS, downgraded its rating of the ARPS from “Aaa” to “Aa2,”
citing what it believed to be persistently thin asset coverage levels,
increased NAV volatility and concerns about secondary market liquidity
for some assets supporting rated obligations. In July 2012, Moody’s
downgraded its rating of the ARPS from “Aa2” to “Aa3” pursuant to a
revised ratings methodology adopted by Moody’s. In May 2020, Fitch
downgraded its rating of the ARPS from “AAA” to “AA,” indicating the
downgrades reflected recent extreme market volatility and reduced
asset liquidity, which it believed eroded asset coverage cushions for
closed-end funds and challenged fund managers’ ability to deleverage.
On December 4, 2020, Fitch published ratings criteria relating to
closed-end fund obligations, including preferred shares, which
effectively result in a rating cap of “AA” for debt and preferred stock
issued by closed-end funds and a rating cap of “A” for (i) debt and
preferred shares issued by closed-end funds exposed to corporate debt,
emerging market debt, below-investment-grade and unrated debt,
structured securities and equity, (ii) and closed-end funds with material
exposure to “BBB” category rated assets. Following the close of
business on April 30, 2021, Fitch downgraded its rating of the ARPS
from “AA” to “A” pursuant to the revised ratings methodology and
related new rating caps. In December 2022, Moody’s downgraded its
rating of the ARPS from “Aa3” to “A1,” stating that the downgrades
occurred because of, among other matters, trends in the Fund’s
risk-adjusted asset coverage metrics and the evolution of its sector
exposures. The Fund expects that the ARPS will continue to pay
dividends at the maximum applicable rate for the foreseeable future and
cannot predict whether or when the auction markets for the ARPS may
resume normal functioning. See “Use of Leverage,” “Principal Risks of
the Fund—Leverage Risk,” “Principal Risks of the Fund—Additional
Risks Associated with the Fund’s Preferred Shares” and “Description of
Capital Structure” for more information.
Under the 1940 Act, the Fund is not permitted to issue new Preferred
Shares unless, immediately after such issuance, the value of the Fund's
total assets, less the Fund’s liabilities and indebtedness not represented
by senior securities, is at least 200% of the liquidation value of any
outstanding Preferred Shares plus the aggregate amount of any senior
securities of the Fund representing indebtedness (i.e., such liquidation
value plus the aggregate amount of senior securities representing
indebtedness may not exceed 50% of the Fund's total assets, less the
Fund’s liabilities and indebtedness not represented by senior securities).
In addition, the Fund is not permitted to declare any cash dividend or
other distribution on its Common Shares unless, at the time of such
5 Base Prospectus
| PIMCO Income Strategy Fund II
Base Prospectus
declaration, the value of the Fund’s total assets, less the Fund's
liabilities and indebtedness not represented by senior securities, satisfies
the above-referenced 200% coverage requirement.
The Fund is subject to the 1940 Act requirement that an investment
company satisfy an asset coverage requirement of 300% of its senior
securities represented by indebtedness measured at the time the
investment company incurs the indebtedness. This means that at any
given time the value of the Fund's total senior securities represented
indebtedness may not exceed one-third the value of its total assets
(including assets attributable to such leverage). The Fund's issuance of
Preferred Shares and use of derivatives results in leverage, but any such
leverage is not subject to the 300% asset coverage requirement. This is
because (1) derivatives will, to the extent permitted by the Derivatives
Rule (as defined below), not be “senior securities” under the 1940 Act
and (2) under the 1940 Act, Preferred Shares are subject to the 200%
asset coverage requirement described above (not the 300% asset
coverage requirement applicable to indebtedness). The interests of
persons with whom the Fund enters into leverage arrangements will not
necessarily be aligned with the interests of the Fund's shareholders and
such persons will have claims on the Fund's assets that are senior to
those of the Fund's shareholders.
The Fund may enter into derivatives or other transactions that may
provide leverage (other than through the issuance of Preferred Shares or
bank borrowing). Rule 18f-4 under the 1940 Act (the “Derivatives
Rule”) regulates a registered investment company's use of derivatives
and certain other transactions that create future payment and/or
delivery obligations by the Fund. This rule became operative in August
2022. The Derivatives Rule prescribes specific value-at risk (“VaR”)
leverage limits that apply to the Fund (although the Fund in the future
could qualify as a limited derivatives user (as defined in the Derivatives
Rule) and would therefore not be subject to all the requirements of the
Derivatives Rule). VaR is an estimate of potential losses on an
instrument or portfolio over a specified time horizon and at a given
confidence level. The Fund may apply a relative VaR test or an absolute
VaR test (if the Fund's derivatives risk manager determines that a
designated reference portfolio would not provide an appropriate
reference portfolio for purposes of the relative VaR test). The limit under
the relative VaR test when a fund has outstanding preferred shares is
250% (or 200% when no preferred shares are outstanding) of the VaR
of a designated reference portfolio, which, very generally, may be a
designated unleveraged index or the fund's securities portfolio
excluding derivatives. If applicable, the limit under the absolute VaR test
when a fund has outstanding preferred shares is 25% (or 20% when no
preferred shares are outstanding) of the value of the fund's net assets.
The Derivatives Rule also requires the Fund to appoint a derivatives risk
manager, maintain a derivatives risk management program designed to
identify, assess, and reasonably manage the risks associated with
transactions covered by the rule, and abide by certain Board and other
reporting obligations and recordkeeping requirements. With respect to
reverse repurchase agreements or other similar financing transactions in
particular, the Derivatives Rule permits a fund to enter into such
transactions if the fund either (i) complies with the asset coverage
requirements of Section 18 of the 1940 Act, and combines the
aggregate amount of indebtedness associated with all reverse
repurchase agreements and similar financing with the aggregate
amount of any other senior securities representing indebtedness when
calculating the relevant asset coverage ratio, or (ii) treats all reverse
repurchase agreements and similar financing transactions as derivatives
transactions for all purposes under the Derivatives Rule. The Fund has
adopted procedures for investing in derivatives and other transactions in
compliance with the Derivatives Rule. Compliance with the Derivatives
Rule could adversely affect the value or performance of the Fund. Limits
or restrictions applicable to the counterparties or issuers, as applicable,
with which the Fund may engage in derivative transactions could also
limit or prevent the Fund from using certain instruments.
The Fund’s ability to utilize leverage may also be limited by asset
coverage requirements and other guidelines imposed by the terms of
the Preferred Shares and may be imposed by rating agencies that
provide ratings for the Preferred Shares, which may be more restrictive
than the limitations imposed by the 1940 Act noted above. See
“Description of Capital Structure and Shares – Preferred Shares.”
Leveraging is a speculative technique and there are special risks and
costs involved. The Fund cannot assure you that its Preferred Shares and
use of any other forms of leverage (such as the use of reverse
repurchase agreements or derivatives strategies), if any, will result in a
higher yield on your Common Shares. When leverage is used, the NAV
and market price of the Common Shares and the yield to Common
Shareholders will be more volatile. See “Principal Risks of the
Fund—Leverage Risk.” In addition, dividend, interest and other costs
and expenses borne by the Fund with respect to its Preferred Shares and
its use of any other forms of leverage are borne by the Common
Shareholders (and not by the holders of Preferred Shares) and result in a
reduction of the NAV of the Common Shares.
In addition, because the fees received by the Investment Manager are
based on the average weekly total managed assets of the Fund (“total
managed assets” includes the total assets of the Fund (including any
assets attributable to any preferred shares or other forms of leverage
that may be outstanding) minus accrued liabilities (other than liabilities
representing leverage), the Investment Manager has a financial
incentive for the Fund to use preferred shares to obtain leverage (as
opposed to other available forms), which may create a conflict of
interest between the Investment Manager, on the one hand, and the
Common Shareholders, on the other hand.
The Fund’s ability to utilize leverage is also limited by asset coverage
requirements and other guidelines imposed by rating agencies (currently
Moody’s and Fitch) that provide ratings for the Preferred Shares, which
are more restrictive than the limitations imposed by the 1940 Act noted
above. See “Description of Capital Structure” for more information.
The Fund also may borrow money in order to repurchase its shares or as
a temporary measure for extraordinary or emergency purposes,
including for the payment of dividends or the settlement of securities
transactions which otherwise might require untimely dispositions of
portfolio securities held by the Fund.
[], 2024 |
Base Prospectus
6
PIMCO Income Strategy Fund II
Investment Manager
PIMCO serves as the investment manager of the Fund. Subject to the
supervision of the Board of Trustees of the Fund (the “Board”) PIMCO is
responsible for managing the investment activities of the Fund and the
Fund’s business affairs and other administrative matters. Alfred T.
Murata, Mohit Mittal and Giang Bui are jointly and primarily responsible
for the day-to-day management of the Fund.
The Investment Manager receives an annual fee from the Fund, payable
monthly, in an amount equal to 0.830% of the Fund’s average weekly
“total managed assets.” “Total managed assets” includes the total
assets of the Fund (including any assets attributable to any preferred
shares or other forms of leverage that may be outstanding) minus
accrued liabilities (other than liabilities representing leverage). For
purposes of calculating average weekly total managed assets, the
Fund’s derivative instruments will be valued based on their market
value. PIMCO is located at 650 Newport Center Drive, Newport Beach,
CA, 92660. Organized in 1971, PIMCO provides investment
management and advisory services to private accounts of institutional
and individual clients and to registered investment companies. PIMCO is
a majority-owned indirect subsidiary of Allianz SE, a publicly traded
European insurance and financial services company. As of December 31,
2023, PIMCO had approximately $1.86 trillion in assets under
management and $1.46 trillion in third party assets under
management.
Dividends and Distributions
The Fund makes regular monthly cash distributions to Common
Shareholders at a rate based upon the past and projected net income of
the Fund. Subject to applicable law, the Fund may fund a portion of its
distributions with gains from the sale of portfolio securities and other
sources. Distributions can only be made from net investment income
after paying any accrued dividends to holders of the Preferred Shares.
The Fund’s dividend policy, as well as the dividend rate that the Fund
pays on its Common Shares, may vary as portfolio and market
conditions change, and will depend on a number of factors. There can
be no assurance that a change in market conditions or other factors will
not result in a change in the Fund distribution rate or that the rate will
be sustainable in the future.
The Fund generally distributes each year all of its net investment income
and net short-term capital gains. In addition, at least annually, the Fund
generally distributes net realized long-term capital gains not previously
distributed, if any. The Fund may distribute less than the entire amount
of net investment income earned in a particular period. The
undistributed net investment income would be available to supplement
future distributions. As a result, the distributions paid by the Fund for
any particular monthly period may be more or less than the amount of
net investment income actually earned by the Fund during the period.
The tax treatment and characterization of the Fund’s distributions may
vary significantly from time to time because of the varied nature of the
Fund’s investments.
To the extent required by the 1940 Act and other applicable laws,
absent an exemption, a notice will accompany each monthly distribution
with respect to the estimated source (as between net income, gains or
other capital source) of the distribution made. If the Fund estimates that
a portion of one of its dividend distributions may be comprised of
amounts from sources other than net investment income, in accordance
with its internal policies, accounting records and related accounting
practices, the Fund will notify shareholders of record of the estimated
composition of such distribution through a notice required by Section 19
of the 1940 Act (a “Section 19 Notice”). For these purposes, the Fund
estimates the source or sources from which a distribution is paid, to the
close of the period as of which it is paid, in reference to its internal
accounting records and related accounting practices. If, based on such
accounting records and practices, it is estimated that a particular
distribution does not include capital gains or paid-in surplus or other
capital sources, a Section 19 Notice generally would not be issued. It is
important to note that differences exist between the Fund’s daily
internal accounting records and practices, the Fund’s financial
statements presented in accordance with U.S. Generally Accepted
Accounting Principles (“U.S. GAAP”), and recordkeeping practices under
income tax regulations. Accordingly, among other consequences, it is
possible that the Fund may not issue a Section 19 Notice in situations
where the Fund’s financial statements prepared later and in accordance
with U.S. GAAP and/or the final tax character of those distributions
might later report that the sources of those distributions included
capital gains and/or a return of capital.
The tax characterization of the Fund’s distributions made in a taxable
year cannot finally be determined until at or after the end of such
taxable year. As a result, there is a possibility that the Fund may make
total distributions during a taxable year in an amount that exceeds the
Fund’s net investment income and net realized capital gains for the
relevant year (as reduced by any capital loss carry-forwards). For
example, the Fund may distribute amounts early in the year that are
derived from short-term capital gains, but incur net short-term capital
losses later in the year, thereby offsetting short-term capital gains out of
which the Fund has already made distributions. In such a situation, the
amount by which the Fund’s total distributions exceed net investment
income and net realized capital gains would generally be treated as a
tax-free return of capital up to the amount of a shareholder’s tax basis
in his or her Common Shares, with any amounts exceeding such basis
treated as gain from the sale of Common Shares. In general terms, a
return of capital would occur where the Fund distribution (or portion
thereof) represents a return of a portion of your investment, rather than
net income or capital gains generated from your investment during a
particular period. Although return of capital distributions are not
taxable, such distributions would reduce the basis of a shareholder’s
Common Shares and therefore may increase a shareholder’s capital
gains, or decrease a shareholder’s capital loss, upon a sale of Common
Shares, thereby potentially increasing a shareholder’s tax liability. The
Fund will prepare and make available to shareholders detailed tax
information with respect to the Fund’s distributions annually. See “Tax
Matters.”
7 Base Prospectus
| PIMCO Income Strategy Fund II
Base Prospectus
The 1940 Act currently limits the number of times the Fund may
distribute long-term capital gains in any tax year, which may increase
the variability of the Fund’s distributions and result in certain
distributions being comprised more or less heavily than others of
long-term capital gains currently eligible for favorable income tax rates.
The Fund, as well as several other PIMCO managed-closed end funds,
has received exemptive relief from the SEC permitting it to make a
greater number of capital gains distributions to holders of the ARPS
than would otherwise be permitted by Section 19(b) of the 1940 Act
and Rule 19b-1 under the 1940 Act.
Unless a Common Shareholder elects to receive distributions in cash, all
distributions of Common Shareholders whose shares are registered with
the plan agent under the Dividend Reinvestment Plan (the “Plan”) will
be automatically reinvested in additional Common Shares of the Fund
under the Plan. For more information on the Fund’s dividends and
distributions, see “Distributions” and “Dividend Reinvestment Plan.”
The Board may change the Fund’s distribution policy and the amount or
timing of distributions, based on a number of factors, including the
amount of the Fund’s undistributed net investment income and net
short and long-term capital gains and historical and projected net
investment income and net short- and long-term capital gains.
Custodian, Transfer Agent, Shareholder Servicing
Agent, Auction Agent and Dividend Disbursement
Agent
State Street Bank and Trust Company serves as custodian of the Fund’s
assets and also provides certain fund accounting and sub-administrative
services to the Investment Manager on behalf of the Fund. Equiniti Trust
Company, LLC serves as the Fund’s transfer agent and dividend
disbursement agent. The Investment Manager, at its own expense, has
retained Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner & Smith,
Incorporated, and UBS Securities LLC to serve as shareholder servicing
agents for the Fund. Deutsche Bank Trust Company Americas serves as
auction agent, transfer agent, registrar, dividend paying agent and
redemption agent for the Preferred Shares. See “Custodian, Transfer
Agent, Shareholder Servicing Agent, Auction Agent and Dividend
Disbursement Agent.”
Listing
The Fund’s outstanding Common Shares are listed on the NYSE under
the trading or “ticker” symbol “PFN” as will be the Common Shares
offered in this prospectus, subject to notice of issuance.
Market Price of Shares
Shares of closed-end investment companies frequently trade at prices
lower than NAV. Shares of closed-end investment companies have
during some periods traded at prices higher than NAV and during other
periods traded at prices lower than NAV. The Fund cannot assure you
that Common Shares will trade at a price equal to or higher than NAV in
the future. Proceeds from the sale of Common Shares of an offering will
be reduced by any sales load and/or commissions and the amount of
offering expenses paid or reimbursed by the Fund. See “Use of
Proceeds.” In addition to NAV, market price may be affected by factors
relating to the Fund such as dividend levels and stability (which will in
turn be affected by Fund expenses, including the costs of any leverage
used by the Fund, levels of interest payments by the Fund’s portfolio
holdings, levels of appreciation/depreciation of the Fund’s portfolio
holdings, regulation affecting the timing and character of Fund
distributions and other factors), portfolio credit quality, liquidity, call
protection, market supply and demand and similar factors relating to
the Fund’s portfolio holdings. See “Use of Leverage,” “Principal Risks of
the Fund,” “Description of Capital Structure” and “Repurchase of
Common Shares; Conversion to Open-End Fund” in this prospectus, and
see “Repurchase of Common Shares; Conversion to Open-End Fund” in
the Statement of Additional Information. The Common Shares are
designed for long-term investors and should not be treated as trading
vehicles.
Principal Risks of the Fund
The following is a summary of the principal risks associated with an
investment in Common Shares of the Fund. Investors should also refer
to “Principal Risks of the Fund” in this prospectus and “Investment
Objective and Policies” in the Statement of Additional Information for a
more detailed explanation of these and other risks associated with
investing in the Fund.
Market Discount Risk
The price of the Fund’s Common Shares will fluctuate with market
conditions and other factors. If you sell your Common Shares, the price
received may be more or less than your original investment. The
Common Shares are designed for long-term investors and should not be
treated as trading vehicles. Shares of closed-end management
investment companies frequently trade at a discount from their NAV. The
Common Shares may trade at a price that is less than the offering price
for Common Shares issued pursuant to an offering. This risk may be
greater for investors who sell their Common Shares relatively shortly
after completion of an offering. The sale of Common Shares by the Fund
(or the perception that such sales may occur), particularly if sold at a
discount to the then current market price of the Common Shares, may
have an adverse effect on the market price of the Common Shares.
Market Risk
The market price of securities owned by the Fund may go up or down,
sometimes rapidly or unpredictably. Securities may decline in value due
to factors affecting securities markets generally or particular industries
or companies represented in the securities markets. The value of a
security may decline due to general market conditions that are not
specifically related to a particular company, such as real or perceived
adverse economic conditions, changes in the general outlook for
corporate earnings, changes in interest or currency rates, adverse
changes to credit markets or adverse investor sentiment generally. The
value of a security may also decline due to factors that affect a
particular industry or industries, such as labor shortages or increased
production costs and competitive conditions within an industry. During
[], 2024 |
Base Prospectus
8
PIMCO Income Strategy Fund II
a general downturn in the securities markets, multiple asset classes may
decline in value simultaneously. Equity securities generally have greater
price volatility than fixed income securities. Credit ratings downgrades
may also negatively affect securities held by the Fund. Even when
markets perform well, there is no assurance that the investments held by
the Fund will increase in value along with the broader market.
In addition, market risk includes the risk that geopolitical and other
events will disrupt the economy on a national or global level. For
instance, war, terrorism, social unrest, recessions, supply chain
disruptions, market manipulation, government defaults, government
shutdowns, political changes, diplomatic developments or the
imposition of sanctions and other similar measures, public health
emergencies (such as the spread of infectious diseases, pandemics and
epidemics), natural/environmental disasters, climate-change and climate
related events can all negatively impact the securities markets, which
could cause the Fund to lose value. These events could reduce consumer
demand or economic output, result in market closures, changes in
interest rates, inflation/deflation, travel restrictions or quarantines, and
significantly adversely impact the economy.
As computing technology and data analytics continually advance there
has been an increasing trend towards machine driven and artificially
intelligent trading systems, particularly providing such systems with
increasing levels of autonomy in trading decisions. More recently,
advancements in the artificial intelligence sector have rapidly
developed. In light of such advancements, regulators are increasingly
focused on considering regulations and market restrictions on the
artificial intelligence sector. Such regulations may relate to algorithmic
and other machine assisted trading strategies, including efforts to
require pre-testing of such techniques, to impose automatic volume
controls and/or to impose liability for negative or manipulative market
impacts of such trading. Such restrictions may also impair the operation
of fully autonomous trading systems and technologies, either by design
or inadvertently. In addition, such technologies are relatively recent
developments and may be subject to one or more undetected errors,
defects or security vulnerabilities. Some such errors may only be
discovered after a product or service has been used by end customers or
after substantial operations in the market place. Any exploitable errors
or security vulnerabilities discovered after such products are in wide
spread operation could result in substantial loss of revenues or assets,
or material liabilities or sanctions. The potential speed of such trading
technology may exacerbate the impact of any such flaws, particularly
where such flaws are exploited by other artificially intelligent systems
and may act to impair or prevent the intervention of a human control.
The current contentious domestic political environment, as well as
political and diplomatic events within the United States and abroad,
such as presidential elections in the U.S. or abroad or the
U.S. government’s inability at times to agree on a long-term budget and
deficit reduction plan, has in the past resulted, and may in the future
result, in a government shutdown or otherwise adversely affect the
U.S. regulatory landscape, the general market environment and/or
investor sentiment, which could have an adverse impact on the Fund’s
investments and operations. Additional and/or prolonged U.S. federal
government shutdowns may affect investor and consumer confidence
and may adversely impact financial markets and the broader economy,
perhaps suddenly and to a significant degree. Governmental and
quasi-governmental authorities and regulators throughout the world
have previously responded to serious economic disruptions with a
variety of significant fiscal and monetary policy changes, including but
not limited to, direct capital infusions into companies, new monetary
programs and dramatically lower interest rates. An unexpected or
sudden reversal of these policies, or the ineffectiveness of these policies,
could increase volatility in securities markets, which could adversely
affect the Fund’s investments. Any market disruptions could also prevent
the Fund from executing advantageous investment decisions in a timely
manner. Funds that have focused their investments in a region enduring
geopolitical market disruption will face higher risks of loss. Thus,
investors should closely monitor current market conditions to determine
whether the Fund meets their individual financial needs and tolerance
for risk.
Recently, there have been inflationary price movements. As such, fixed
income securities markets may experience heightened levels of interest
rate, volatility and liquidity risk. As discussed more under “Interest Rate
Risk,” the U.S. Federal Reserve (the “Federal Reserve”) has raised
interest rates from historically low levels and may continue to raise
interest rates. Any additional interest rate increases in the future could
cause the value of any fund, such as the Fund, that invests in fixed
income securities to decrease.
Although interest rates have significantly increased since 2022 through
the date of this prospectus, the prices of real estate-related assets
generally have not decreased as much as may be expected based on
historical correlations between interest rates and prices of real
estate-related assets. This presents an increased risk of a correction or
severe downturn in real estate-related asset prices, which could
adversely impact the value of other investments as well (such as loans,
securitized debt and other fixed income securities). This risk is
particularly present with respect to commercial real estate-related asset
prices, and the value of other investments with a connection to the
commercial real estate sector. As examples of the current risks faced by
real estate-related assets: tenant vacancy rates, tenant turnover and
tenant concentration have increased; owners of real estate have faced
headwinds, delinquencies and difficulties in collecting rents and other
payments (which increases the risk of owners being unable to pay or
otherwise defaulting on their own borrowings and obligations);
property values have declined; inflation, upkeep costs and other
expenses have increased; and rents have declined for many properties.
Exchanges and securities markets may close early, close late or issue
trading halts on specific securities, which may result in, among other
things, the Fund being unable to buy or sell certain securities or financial
instruments at an advantageous time or accurately price its portfolio
investments.
9 Base Prospectus
| PIMCO Income Strategy Fund II
Base Prospectus
Asset Allocation Risk
The Fund’s investment performance depends upon how its assets are
allocated and reallocated. A principal risk of investing in the Fund is that
PIMCO may make less than optimal or poor asset allocation decisions.
PIMCO employs an active approach to allocation among multiple fixed-
income sectors, but there is no guarantee that such allocation
techniques will produce the desired results. It is possible that PIMCO
will focus on an investment that performs poorly or underperforms other
investments under various market conditions. You could lose money on
your investment in the Fund as a result of these allocation decisions.
Management Risk
The Fund is subject to management risk because it is an actively
managed investment portfolio. PIMCO and each individual portfolio
manager will apply investment techniques and risk analysis in making
investment decisions for the Fund, but there can be no guarantee that
these decisions will produce the desired results or that the due diligence
conducted by PIMCO or such other fund’s investment adviser and
individual portfolio managers will expose all material risks associated
with an investment. Additionally, PIMCO or such other fund’s
investment adviser and individual portfolio managers may not be able
to identify suitable investment opportunities and may face competition
from other investment managers when identifying and consummating
certain investments. Certain securities or other instruments in which the
Fund seeks to invest may not be available in the quantities desired,
including in circumstances where other funds for which PIMCO acts as
investment adviser, including funds with names, investment objectives
and policies, and/or portfolio management teams, similar to the Fund,
are seeking to invest in the same or similar securities or instruments. In
addition, regulatory restrictions, actual or potential conflicts of interest
or other considerations may cause PIMCO to restrict or prohibit
participation in certain investments. In such circumstances, PIMCO or
the individual portfolio managers may determine to purchase other
securities or instruments as substitutes. Such substitute securities or
instruments may not perform as intended, which could result in losses
to the Fund. To the extent the Fund employs strategies targeting
perceived pricing inefficiencies, arbitrage strategies or similar strategies,
it is subject to the risk that the pricing or valuation of the securities and
instruments involved in such strategies may change unexpectedly, which
may result in reduced returns or losses to the Fund. The Fund is also
subject to the risk that deficiencies in the internal systems or controls of
PIMCO or another service provider will cause losses for the Fund or
hinder Fund operations. For example, trading delays or errors (both
human and systemic) could prevent the Fund from purchasing a security
expected to appreciate in value. Please refer to “Investment
Manager—Conflicts of Interest” in the Statement of Additional
Information for further information. Additionally, actual or potential
conflicts of interest, legislative, regulatory, or tax restrictions, policies or
developments may affect the investment techniques available to PIMCO
and each individual portfolio manager in connection with managing the
Fund and may also adversely affect the ability of the Fund to achieve its
investment objective. There also can be no assurance that all of the
personnel of PIMCO will continue to be associated with PIMCO for any
length of time. The loss of services of one or more key employees of
PIMCO could have an adverse impact on the Fund’s ability to realize its
investment objective.
In addition, the Fund may rely on various third-party sources to calculate
its NAV. As a result, the Fund is subject to certain operational risks
associated with reliance on service providers and service providers’ data
sources. In particular, errors or systems failures and other technological
issues may adversely impact the Fund’s calculations of its NAV, and such
NAV calculation issues may result in inaccurately calculated NAV, delays
in NAV calculation and/or the inability to calculate NAV over extended
periods. The Fund may be unable to recover any losses associated with
such failures.
Issuer Risk
The value of a security may decline for a number of reasons that directly
relate to the issuer, such as management performance, major litigation,
investigations or other controversies, changes in the issuer’s financial
condition or credit rating, changes in government regulations affecting
the issuer or its competitive environment and strategic initiatives such
as mergers, acquisitions or dispositions and the market response to any
such initiatives, financial leverage, reputation or reduced demand for the
issuer’s goods or services, as well as the historical and prospective
earnings of the issuer and the value of its assets. A change in the
financial condition of a single issuer may affect one or more other
issuers or securities markets as a whole. These risks can apply to the
Common Shares issued by the Fund and to the issuers of securities and
other instruments in which the Fund invests.
Interest Rate Risk
Interest rate risk is the risk that fixed income securities and other
instruments in the Fund’s portfolio will fluctuate in value because of a
change in interest rates. For example, as nominal interest rates rise, the
value of certain fixed income securities held by the Fund is likely to
decrease. A nominal interest rate can be described as the sum of a real
interest rate and an expected inflation rate. Interest rate changes can be
sudden and unpredictable, and the Fund may lose money as a result of
movements in interest rates. The Fund may not be able to effectively
hedge against changes in interest rates or may choose not to do so for
cost or other reasons.
A wide variety of factors can cause interest rates or yields of
U.S. Treasury securities (or yields of other types of bonds) to rise,
including but not limited to central bank monetary policies, changing
inflation or real growth rates, general economic conditions, increasing
bond issuances or reduced market demand for low yielding investments.
Risks associated with rising interest rates are heightened under current
market conditions given that the Federal Reserve has raised interest
rates from historically low levels and may continue to raise interest
rates. In addition, changes in monetary policy may exacerbate the risks
associated with changing interest rates. Further, in market environments
where interest rates are rising, issuers may be less willing or able to
make principal and interest payments on fixed-income investments
when due.
[], 2024 |
Base Prospectus
10
PIMCO Income Strategy Fund II
Further, fixed income securities with longer durations tend to be more
sensitive to changes in interest rates, usually making them more volatile.
Duration is a measure used to determine the sensitivity of a security’s
price to changes in interest rates that incorporates a security’s yield,
coupon, final maturity and call features, among other characteristics.
Duration is useful primarily as a measure of the sensitivity of a fixed
income security’s market price to interest rate (i.e., yield) movements. All
other things remaining equal, for each one percentage point increase in
interest rates, the value of a portfolio of fixed income investments would
generally be expected to decline by one percent for every year of the
portfolio’s average duration above zero. For example, the value of a
portfolio of fixed income securities with an average duration of eight
years would generally be expected to decline by approximately 8% if
interest rates rose by one percentage point.
Variable and floating rate securities may decline in value if their interest
rates do not rise as much, or as quickly, as interest rates in general.
Conversely, floating rate securities will not generally increase in value if
interest rates decline. Inverse floating rate securities may decrease in
value if interest rates increase. Inverse floating rate securities may also
exhibit greater price volatility than a fixed rate obligation with similar
credit quality. When the Fund holds variable or floating rate securities, a
decrease (or, in the case of inverse floating rate securities, an increase)
in market interest rates will adversely affect the income received from
such securities and the NAV of the Fund’s shares.
During periods of very low or negative interest rates, the Fund may be
unable to maintain positive returns. Very low or negative interest rates
may magnify interest rate risk. Changing interest rates, including rates
that fall below zero, may have unpredictable effects on markets, may
result in heightened market volatility and may detract from Fund
performance to the extent the Fund is exposed to such interest rates.
Measures such as average duration may not accurately reflect the true
interest rate sensitivity of the Fund. This is especially the case if the Fund
consists of securities with widely varying durations. Therefore, if the
Fund has an average duration that suggests a certain level of interest
rate risk, the Fund may in fact be subject to greater interest rate risk
than the average would suggest. This risk is greater to the extent the
Fund uses leverage or derivatives in connection with the management
of the Fund.
Convexity is an additional measure used to understand a security's or
fund's interest rate sensitivity. Convexity measures the rate of change
of duration in response to changes in interest rates. With respect to a
security’s price, a larger convexity (positive or negative) may imply more
dramatic price changes in response to changing interest rates. Convexity
may be positive or negative. Negative convexity implies that interest
rate increases result in increased duration and that interest rate
decreases result in declining duration (i.e., increased sensitivity in prices
in response to rising and/or declining interest rates). Thus, securities
with negative convexity, which may include bonds with traditional call
features and certain mortgage-backed securities, may experience
greater losses in periods of rising interest rates. Accordingly, if the Fund
holds such securities, the Fund may be subject to a greater risk of losses
in periods of rising interest rates.
Rising interest rates may result in a decline in value of the Fund’s fixed
income investments and in periods of volatility. Also, when interest rates
rise, issuers are less likely to refinance existing debt securities, causing
the average life of such securities to extend. Further, while U.S. bond
markets have steadily grown over the past three decades, dealer
“market making” ability has remained relatively stagnant. As a result,
dealer inventories of certain types of bonds and similar instruments,
which provide a core indication of the ability of financial intermediaries
to “make markets,” are at or near historic lows in relation to market
size. Because market makers provide stability to a market through their
intermediary services, a significant reduction in dealer inventories could
potentially lead to decreased liquidity and increased volatility in the
fixed income markets. Such issues may be exacerbated during periods of
economic uncertainty. All of these factors, collectively and/or
individually, could cause the Fund to lose value.
Credit Risk
The Fund could lose money if the issuer or guarantor of a fixed income
security (including a security purchased with securities lending
collateral), or the counterparty to a derivatives contract, repurchase
agreement or a loan of portfolio securities is unable or unwilling, or is
perceived (whether by market participants, rating agencies, pricing
services or otherwise) as unable or unwilling, to make timely principal
and/or interest payments or to otherwise honor its obligations. The risk
that such issuer, guarantor or counterparty is less willing or able to do
so is heightened in market environments where interest rates are rising.
The downgrade of the credit of a security held by the Fund may
decrease its value. Measures such as average credit quality may not
accurately reflect the true credit risk of the Fund. This is especially the
case if the Fund consists of securities with widely varying credit ratings.
Credit risk is greater to the extent the Fund uses leverage or derivatives
in connection with the management of the Fund. Rising or high interest
rates may deteriorate the credit quality of an issuer or counterparty,
particularly if an issuer or counterparty faces challenges rolling or
refinancing its obligations.
Mortgage-Related and Other Asset-Backed Instruments Risk
Generally, rising interest rates tend to extend the duration of fixed rate
mortgage-related assets, making them more sensitive to changes in
interest rates. As a result, in a period of rising interest rates, the Fund
may exhibit additional volatility since individual mortgage holders are
less likely to exercise prepayment options, thereby putting additional
downward pressure on the value of these securities and potentially
causing the Fund to lose money. The Fund’s investments in other
asset-backed instruments are subject to risks similar to those associated
with mortgage-related assets, as well as additional risks associated with
the nature of the assets and the servicing of those assets. Payment of
principal and interest on asset-backed instruments may be largely
dependent upon the cash flows generated by the assets backing the
instruments, and asset-backed instruments may not have the benefit of
any security interest in the related assets.
11 Base Prospectus
| PIMCO Income Strategy Fund II
Base Prospectus
The Fund may also invest in the residual or equity tranches of
mortgage-related and other asset-backed instruments, which may be
referred to as subordinate mortgage-backed or asset-backed
instruments and interest-only mortgage-backed or asset-backed
instruments. The Fund expects that investments in subordinate
mortgage-backed and other asset-backed instruments will be subject to
risks arising from delinquencies and foreclosures, thereby exposing its
investment portfolio to potential losses. Subordinate securities of
mortgage-backed and other asset-backed instruments are also subject
to greater credit risk than those mortgage-backed or other asset-backed
instruments that are more highly rated.
The mortgage markets in the United States and in various foreign
countries have experienced extreme difficulties in the past that
adversely affected the performance and market value of certain
mortgage-related investments. Delinquencies and losses on residential
and commercial mortgage loans (especially subprime and second-lien
mortgage loans) may increase, and a decline in or flattening of housing
and other real property values may exacerbate such delinquencies and
losses. In addition, reduced investor demand for mortgage loans and
mortgage-related securities and increased investor yield requirements
have caused limited liquidity in the secondary market for
mortgage-related securities, which can adversely affect the market value
of mortgage-related securities. It is possible that such limited liquidity in
such secondary markets could continue or worsen.
Mortgage-Related Derivative Instruments Risk
Mortgage-related derivative instruments involve risks associated with
mortgage-related and other asset-backed instruments, privately-issued
mortgage-related securities, the mortgage market, the real estate
industry, derivatives and credit default swaps. See “Mortgage-Related
and Other Asset-Backed Instruments Risk,” “Privately-Issued
Mortgage-Related Securities Risk,” “Derivatives Risk,” and “Credit
Default Swaps Risk.”
Privately-Issued Mortgage-Related Securities Risk
There are no direct or indirect government or agency guarantees of
payments in pools created by non-governmental issuers. Privately-issued
mortgage-related securities are also not subject to the same
underwriting requirements for the underlying mortgages that are
applicable to those mortgage-related securities that have a government
or government-sponsored entity guarantee.
Privately-issued mortgage-related securities are not traded on an
exchange and there may be a limited market for the securities, especially
when there is a perceived weakness in the mortgage and real estate
market sectors. Without an active trading market, mortgage-related
securities held in the Fund’s portfolio may be particularly difficult to
value because of the complexities involved in assessing the value of the
underlying mortgage loans.
High Yield Securities Risk
To the extent that the Fund invests in high yield securities and unrated
securities of similar credit quality (commonly known as “high yield
securities” or “junk bonds”), the Fund may be subject to greater levels
of credit risk, call risk and liquidity risk than funds that do not invest in
such securities, which could have a negative effect on the NAV and
market price of the Fund’s Common Shares or Common Share
dividends. These securities are considered predominantly speculative
with respect to an issuer’s continuing ability to make principal and
interest payments, and may be more volatile than other types of
securities. An economic downturn or individual corporate developments
could adversely affect the market for these securities and reduce the
Fund’s ability to sell these securities at an advantageous time or price.
The Fund may purchase distressed securities that are in default or the
issuers of which are in bankruptcy, which involve heightened risks.
High yield securities structured as zero-coupon bonds or pay-in-kind
securities tend to be especially volatile as they are particularly sensitive
to downward pricing pressures from rising interest rates or widening
spreads and may require the Fund to make taxable distributions of
imputed income without receiving the actual cash currency. Issuers of
high yield securities may have the right to “call” or redeem the issue
prior to maturity, which may result in the Fund having to reinvest the
proceeds in other high yield securities or similar instruments that may
pay lower interest rates. The Fund may also be subject to greater levels
of liquidity risk than funds that do not invest in high yield securities.
Consequently, transactions in high yield securities may involve greater
costs than transactions in more actively traded securities. A lack of
publicly-available information, irregular trading activity and wide
bid/ask spreads among other factors, may, in certain circumstances,
make high yield debt more difficult to sell at an advantageous time or
price than other types of securities or instruments. These factors may
result in the Fund being unable to realize full value for these securities
and/or may result in the Fund not receiving the proceeds from a sale of
a high yield security for an extended period after such sale, each of
which could result in losses to the Fund. Because of the risks involved in
investing in high yield securities, an investment in the Fund should be
considered speculative.
In general, lower rated debt securities carry a greater degree of risk that
the issuer will lose its ability to make interest and principal payments,
which could have a negative effect on the Fund. Securities of below
investment grade quality are regarded as having predominantly
speculative characteristics with respect to capacity to pay interest and
repay principal and are commonly referred to as “high yield” securities
or “junk bonds.” High yield securities involve a greater risk of default
and their prices are generally more volatile and sensitive to actual or
perceived negative developments. Debt securities in the lowest
investment grade category also may be considered to possess some
speculative characteristics by certain rating agencies. The Fund may
purchase stressed or distressed securities that are in default or the
issuers of which are in bankruptcy, which involve heightened risks.
[], 2024 |
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PIMCO Income Strategy Fund II
An economic downturn could severely affect the ability of issuers
(particularly those that are highly leveraged) to service or repay their
debt obligations. Lower-rated securities are generally less liquid than
higher-rated securities, which may have an adverse effect on the Fund’s
ability to dispose of them. For example, under adverse market or
economic conditions, the secondary market for below investment grade
securities could contract further, independent of any specific adverse
changes in the condition of a particular issuer, and certain securities in
the Fund’s portfolio may become illiquid or less liquid. As a result, the
Fund could find it more difficult to sell these securities or may be able to
sell these securities only at prices lower than if such securities were
widely traded. To the extent the Fund focuses on below investment
grade debt obligations, PIMCO’s capabilities in analyzing credit quality
and associated risks will be particularly important, and there can be no
assurance that PIMCO will be successful in this regard. Due to the risks
involved in investing in high yield securities, an investment in the Fund
should be considered speculative.
The Fund’s credit quality policies apply only at the time a security is
purchased, and the Fund is not required to dispose of a security in the
event that a rating agency or PIMCO downgrades its assessment of the
credit characteristics of a particular issue. In determining whether to
retain or sell such a security, PIMCO may consider factors including, but
not limited to, PIMCO's assessment of the credit quality of the issuer of
such security, the price at which such security could be sold and the
rating, if any, assigned to such security by other rating agencies. Analysis
of creditworthiness may be more complex for issuers of high yield
securities than for issuers of higher quality debt securities.
See “Investment Objective and Policies–Portfolio Contents-High Yield
Securities” for additional information.
Distressed and Defaulted Securities Risk
Investments in the securities of financially distressed issuers involve
substantial risks, including the risk of default. Distressed securities
generally trade significantly below “par” or full value because
investments in such securities and debt of distressed issuers or issuers in
default are considered speculative and involve substantial risks in
addition to the risks of investing in high-yield bonds. Such investments
may be in default at the time of investment. In addition, these securities
may fluctuate more in price, and are typically less liquid. The Fund also
will be subject to significant uncertainty as to when, and in what
manner, and for what value obligations evidenced by securities of
financially distressed issuers will eventually be satisfied. Defaulted
obligations might be repaid only after lengthy workout or bankruptcy
proceedings, during which the issuer might not make any interest or
other payments. In any such proceeding relating to a defaulted
obligation, the Fund may lose its entire investment or may be required
to accept cash or securities with a value substantially less than its
original investment. Moreover, any securities received by the Fund upon
completion of a workout or bankruptcy proceeding may be less liquid,
speculative or restricted as to resale. Similarly, if the Fund participates in
negotiations with respect to any exchange offer or plan of
reorganization with respect to the securities of a distressed issuer, the
Fund may be restricted from disposing of such securities. To the extent
that the Fund becomes involved in such proceedings, the Fund may
have a more active participation in the affairs of the issuer than that
assumed generally by an investor. The Fund may incur additional
expenses to the extent it is required to seek recovery upon a default in
the payment of principal or interest on its portfolio holdings.
Also among the risks inherent in investments in a troubled issuer is that
it frequently may be difficult to obtain information as to the true
financial condition of such issuer. PIMCO’s judgments about the credit
quality of a financially distressed issuer and the relative value of its
securities may prove to be wrong.
Inflation-Indexed Security Risk
Inflation-indexed debt securities are subject to the effects of changes in
market interest rates caused by factors other than inflation (real interest
rates). In general, the value of an inflation-indexed security, including
Treasury Inflation-Protected Securities (“TIPS”), tends to decrease when
real interest rates increase and can increase when real interest rates
decrease. Thus generally, during periods of rising inflation, the value of
inflation-indexed securities will tend to increase and during periods of
deflation, their value will tend to decrease. Interest payments on
inflation-indexed securities are unpredictable and will fluctuate as the
principal and interest are adjusted for inflation. There can be no
assurance that the inflation index used (i.e., the Consumer Price Index
(“CPI”)) will accurately measure the real rate of inflation in the prices of
goods and services. Increases in the principal value of TIPS due to
inflation are considered taxable ordinary income for the amount of the
increase in the calendar year. Any increase in the principal amount of an
inflation-indexed debt security will be considered taxable ordinary
income, even though the Fund will not receive the principal until
maturity. Additionally, a CPI swap can potentially lose value if the
realized rate of inflation over the life of the swap is less than the fixed
market implied inflation rate (fixed breakeven rate) that the investor
agrees to pay at the initiation of the swap. With municipal
inflation-indexed securities, the inflation adjustment is integrated into
the coupon payment, which is federally tax-exempt (and may be state
tax-exempt). For municipal inflation-indexed securities, there is no
adjustment to the principal value. Because municipal inflation-indexed
securities are a small component of the municipal bond market, they
may be less liquid than conventional municipal bonds.
Loans and Other Indebtedness; Loan Acquisitions,
Participations and Assignments Risk
Loan interests may take the form of direct interests acquired during a
primary distribution or other purchase of a loan, or assignments of,
novations of or participations in all or a portion of a loan acquired in
secondary markets. In addition to credit risk and interest rate risk, the
Fund's exposure to loan interests may be subject to additional risks. For
example, purchasers of loans and other forms of direct indebtedness
depend primarily upon the creditworthiness of the borrower for
payment of principal and interest. Loans are subject to the risk that
scheduled interest or principal payments will not be made in a timely
manner or at all, either of which may adversely affect the value of the
loan. If the Fund does not receive scheduled interest or principal
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payments on such indebtedness, the Fund’s share price and yield could
be adversely affected. Loans that are fully secured may offer the Fund
more protection than an unsecured loan in the event of non-payment of
scheduled interest or principal if the Fund is able to access and
monetize the collateral. However, the collateral underlying a loan, if any,
may be unavailable or insufficient to satisfy a borrower’s obligation. If
the Fund becomes owner, whole or in part, of any collateral after a loan
is foreclosed, the Fund may incur costs associated with owning and/or
monetizing its ownership of the collateral.
Moreover, the purchaser of an assignment typically succeeds to all the
rights and obligations under the loan agreement with the same rights
and obligations as the assigning lender. Assignments may, however, be
arranged through private negotiations between potential assignees and
potential assignors, and the rights and obligations acquired by the
purchaser of an assignment may differ from, and be more limited than,
those held by the assigning lender.
Investments in loans through a purchase of a loan or a direct
assignment of a financial institution’s interests with respect to a loan
may involve additional risks to the Fund. For example, if a loan is
foreclosed, the Fund could become owner, in whole or in part, of any
collateral, which could include, among other assets, real estate or other
real or personal property, and would bear the costs and liabilities
associated with owning and holding or disposing of the collateral. The
purchaser of an assignment typically succeeds to all the rights and
obligations under the loan agreement with the same rights and
obligations as the assigning lender. Assignments may, however, be
arranged through private negotiations between potential assignees and
potential assignors, and the rights and obligations acquired by the
purchaser of an assignment may differ from, and be more limited than,
those held by the assigning lender.
In connection with purchasing loan participations, the Fund generally
will have no right to enforce compliance by the borrower with the terms
of the loan agreement relating to the loan, nor any rights
of set-off against the borrower, and the Fund may not directly benefit
from any collateral supporting the loan in which it has purchased the
loan participation. As a result, the Fund will be subject to the credit risk
of both the borrower and the lender that is selling the participation. In
the event of the insolvency of the lender selling a participation, the Fund
may be treated as a general creditor of the lender and may not benefit
from any set-off between the lender and the borrower. Certain loan
participations may be structured in a manner designed to prevent
purchasers of participations from being subject to the credit risk of the
lender, but even under such a structure, in the event of the lender’s
insolvency, the lender’s servicing of the participation may be delayed
and the assignability of the participation impaired.
The Fund may have difficulty disposing of loans and loan participations.
Because there is no liquid market for many such investments, the Fund
anticipates that such investments could be sold only to a limited number
of institutional investors. The lack of a liquid secondary market may have
an adverse impact on the value of such investments and the Fund’s
ability to dispose of particular loans and loan participations when that
would be desirable, including in response to a specific economic event
such as a deterioration in the creditworthiness of the borrower. The lack
of a liquid secondary market for loans and loan participations also may
make it more difficult for the Fund to assign a value to these securities
for purposes of valuing the Fund’s portfolio.
Investments in loans may include participations in bridge loans, which
are loans taken out by borrowers for a short period (typically less than
one year) pending arrangement of more permanent financing through,
for example, the issuance of bonds, frequently high yield bonds issued
for the purpose of acquisitions.
Investments in loans may include acquisitions of, or participation in,
delayed draw and delayed funding loans and revolving credit facilities.
These commitments may have the effect of requiring the Fund to
increase its investment in a borrower at a time when it might not
otherwise decide to do so (including at a time when the company’s
financial condition makes it unlikely that such amounts will be repaid).
Delayed draw and delayed funding loans and revolving credit facilities
may be subject to restrictions on transfer, and only limited opportunities
may exist to resell such instruments. As a result, a Fund may be unable
to sell such investments at an opportune time or may have to resell
them at less than fair market value. Further, the Fund may need to hold
liquid assets in order to provide funding for these types of
commitments, meaning the Fund may not be able to invest in other
attractive investments, or the Fund may need to liquidate existing assets
in order to provide such funding.
To the extent the Fund invests in loans (including, but not limited to,
bank loans and non-syndicated loans), the Fund may be subject to
greater levels of credit risk, call risk, settlement risk and liquidity risk.
These instruments are considered predominantly speculative with
respect to an issuer’s continuing ability to make principal and interest
payments and may be more volatile than other types of securities. The
Fund may also be subject to greater levels of liquidity risk than funds
that do not invest in loans. In addition, the loans in which the Fund
invests may not be listed on any exchange and a secondary market for
such loans may be comparatively illiquid relative to markets for other
more liquid fixed income securities. Consequently, transactions in loans
may involve greater costs than transactions in more actively traded
securities. In connection with certain loan transactions, transaction costs
that are borne by the Fund may include the expenses of third parties
that are retained to assist with reviewing and conducting diligence,
negotiating, structuring and servicing a loan transaction, and/or
providing other services in connection therewith. Furthermore, the Fund
may incur such costs in connection with loan transactions that are
pursued by the Fund but not ultimately consummated (so-called
“broken deal costs”).
Restrictions on transfers in loan agreements, a lack of publicly available
information, irregular trading activity and wide bid/ask spreads, among
other factors, may, in certain circumstances, make loans more difficult to
sell at an advantageous time or price than other types of securities or
instruments. These factors may result in the Fund being unable to realize
full value for the loans and/or may result in the Fund not receiving the
proceeds from a sale of a loan for an extended period after such sale,
each of which could result in losses to the Fund. Some loans may have
[], 2024 |
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PIMCO Income Strategy Fund II
extended trade settlement periods, including settlement periods of
greater than seven days, which may result in cash not being
immediately available to the Fund. If an issuer of a loan prepays or
redeems the loan prior to maturity, the Fund may have to reinvest the
proceeds in other loans or similar instruments that may pay lower
interest rates. Because of the risks involved in investing in loans, an
investment in the Fund should be considered speculative.
The Fund’s investments in subordinated and unsecured loans generally
are subject to similar risks as those associated with investments in
secured loans. Subordinated or unsecured loans are lower in priority of
payment to secured loans and are subject to the additional risk that the
cash flow of the borrower and property securing the loan or debt, if any,
may be insufficient to meet scheduled payments after giving effect to
the senior secured obligations of the borrower. This risk is generally
higher for subordinated unsecured loans or debt, which are not backed
by a security interest in any specific collateral. Subordinated and
unsecured loans generally have greater price volatility than secured
loans and may be less liquid. There is also a possibility that originators
will not be able to sell participations in subordinated or unsecured
loans, which would create greater credit risk exposure for the holders of
such loans. Subordinate and unsecured loans share the same risks as
other below investment grade securities.
There may be less readily available information about most loans and
the underlying borrowers than is the case for many other types of
securities. Loans may be issued by borrowers that are not subject to SEC
reporting requirements and therefore may not be required to file reports
with the SEC or may file reports that are not required to comply with
SEC form requirements. In addition, such borrowers may be subject to a
less stringent liability disclosure regime than companies subject to SEC
reporting requirements. Loans may not be considered “securities,” and
purchasers, such as the Fund, therefore may not be entitled to rely on
the anti-fraud protections of the federal securities laws. Because there is
limited public information available regarding loan investments, the
Fund is particularly dependent on the analytical abilities of the Fund’s
portfolio managers.
Economic exposure to loan interests through the use of derivative
transactions may involve greater risks than if the Fund had invested in
the loan interest directly during a primary distribution, through
assignments of, novations of or participations in a loan acquired in
secondary markets since, in addition to the risks described above,
certain derivative transactions may be subject to leverage risk and
greater illiquidity risk, counterparty risk, valuation risk and other risks.
“Covenant-lite” Obligations Risk
Covenant-lite obligations contain fewer maintenance covenants than
other obligations, or no maintenance covenants, and may not include
terms that allow the lender to monitor the performance of the borrower
and declare a default if certain criteria are breached. Covenant-lite
loans carry a risk that the borrower could transfer or encumber its
assets, which could reduce the amount of assets that can be used to
satisfy debts and result in losses for debtholders. Covenant-lite loans
may carry more risk than traditional loans as they allow individuals and
corporations to engage in activities that would otherwise be difficult or
impossible under a covenant-heavy loan agreement. In the event of
default, covenant-lite loans may exhibit diminished recovery values as
the lender may not have the opportunity to negotiate with the borrower
prior to default.
Subprime Risk
Loans, and debt instruments collateralized by loans, acquired by the
Fund may be subprime in quality, or may become subprime in quality.
Although there is no specific legal or market definition of “subprime,”
subprime loans are generally understood to refer to loans made to
borrowers that display poor credit histories and other characteristics
that correlate with a higher default risk. Accordingly, subprime loans,
and debt instruments secured by such loans have speculative
characteristics and are subject to heightened risks, including the risk of
nonpayment of interest or repayment of principal, and the risks
associated with investments in high yield securities. In addition, these
instruments could be subject to increased regulatory scrutiny. The Fund
is not restricted by any particular borrower credit risk criteria and/or
qualifications when acquiring loans or debt instruments collateralized
by loans.
Reinvestment Risk
Income from the Fund’s portfolio will decline if and when the Fund
invests the proceeds from matured, traded or called debt obligations at
market interest rates that are below the portfolio’s current earnings rate.
For instance, during periods of declining interest rates, an issuer of debt
obligations may exercise an option to redeem securities prior to
maturity, forcing the Fund to invest in lower-yielding securities. The Fund
also may choose to sell higher yielding portfolio securities and to
purchase lower yielding securities to achieve greater portfolio
diversification, because the portfolio managers believe the current
holdings are overvalued or for other investment-related reasons. A
decline in income received by the Fund from its investments is likely to
have a negative effect on dividend levels and the market price, NAV
and/or overall return of the Common Shares.
Call Risk
Call risk refers to the possibility that an issuer may exercise its right to
redeem a fixed income security earlier than expected (a call). Issuers
may call outstanding securities prior to their maturity for a number of
reasons (e.g., declining interest rates, changes in credit spreads and
improvements in the issuer's credit quality). If an issuer calls a security in
which the Fund has invested, the Fund may not recoup the full amount
of its initial investment and may be forced to reinvest in lower-yielding
securities, securities with greater credit risks or securities with other, less
favorable features.
Foreign (Non-U.S.) Investment Risk
Foreign (non-U.S.) securities may experience more rapid and extreme
changes in value than securities of U.S. issuers or securities that trade
exclusively in U.S. markets. The securities markets of many foreign
countries are relatively small, with a limited number of companies
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| PIMCO Income Strategy Fund II
Base Prospectus
representing a small number of industries. Additionally, issuers of
foreign (non-U.S.) securities are usually not subject to the same degree
of regulation as U.S. issuers. Global economies and financial markets are
becoming increasingly interconnected, and conditions and events in one
country, region or financial market may adversely impact issuers in a
different country, region or financial market.
Emerging Markets Risk
Foreign (non-U.S.) investment risk may be particularly high to the extent
that the Fund invests in securities of issuers based in or doing business
in emerging market countries or invests in securities denominated in the
currencies of emerging market countries. Investing in securities of
issuers based in or doing business in emerging markets entails all of the
risks of investing in foreign securities noted above, but to a heightened
degree.
Investments in emerging market countries pose a greater degree of
systemic risk (i.e., the risk of a cascading collapse of multiple institutions
within a country, and even multiple national economies). The
inter-relatedness of economic and financial institutions within and
among emerging market economies has deepened over the years, with
the effect that institutional failures and/or economic difficulties that are
of initially limited scope may spread throughout a country, a region or
all or most emerging market countries. This may undermine any attempt
by the Fund to reduce risk through geographic diversification of its
portfolio.
There is a heightened possibility of imposition of withholding taxes on
interest or dividend income generated from emerging market securities.
Governments of emerging market countries may engage in confiscatory
taxation or expropriation of income and/or assets to raise revenues or to
pursue a domestic political agenda. In the past, emerging market
countries have nationalized assets, companies and even entire sectors,
including the assets of foreign investors, with inadequate or no
compensation to the prior owners. There can be no assurance that the
Fund will not suffer a loss of any or all of its investments, or interest or
dividends thereon, due to adverse fiscal or other policy changes in
emerging market countries.
There is also a greater risk that an emerging market government may
take action that impedes or prevents the Fund from taking income
and/or capital gains earned in the local currency and converting into
U.S. dollars (i.e., “repatriating” local currency investments or profits).
Certain emerging market countries have sought to maintain foreign
exchange reserves and/or address the economic volatility and
dislocations caused by the large international capital flows by
controlling or restricting the conversion of the local currency into other
currencies. This risk tends to become more acute when economic
conditions otherwise worsen. There can be no assurance that if the Fund
earns income or capital gains in an emerging market currency or PIMCO
otherwise seeks to withdraw the Fund’s investments from a given
emerging market country, capital controls imposed by such country will
not prevent, or cause significant expense, or delay in, doing so.
Bankruptcy law and creditor reorganization processes may differ
substantially from those in the United States, resulting in greater
uncertainty as to the rights of creditors, the enforceability of such rights,
reorganization timing and the classification, seniority and treatment of
claims. In certain emerging market countries, although bankruptcy laws
have been enacted, the process for reorganization remains highly
uncertain. In addition, it may be impossible to seek legal redress against
an issuer that is a sovereign state.
Emerging market countries typically have less established legal,
accounting and financial reporting systems than those in more
developed markets, which may reduce the scope or quality of financial
information available to investors. Governments in emerging market
countries are often less stable and more likely to take extra-legal action
with respect to companies, industries, assets, or foreign ownership than
those in more developed markets. Moreover, it can be more difficult for
investors to bring litigation or enforce judgments against issuers in
emerging markets or for U.S. regulators to bring enforcement actions
against such issuers. The Fund may also be subject to emerging markets
risk if it invests in derivatives or other securities or instruments whose
value or return are related to the value or returns of emerging markets
securities.
The economy of some emerging markets may be particularly exposed to
or affected by a certain industry or sector, and therefore issuers and/or
securities of such emerging markets may be more affected by the
performance of such industries or sectors.
Currency Risk
If the Fund invests directly in foreign (non-U.S.) currencies or in
securities that trade in, and receive revenues in, foreign (non-U.S.)
currencies, or in derivatives or other instruments that provide exposure
to foreign (non-U.S.) currencies, it will be subject to the risk that those
currencies will decline in value relative to the U.S. dollar, or, in the case
of hedging positions, that the U.S. dollar will decline in value relative to
the currency being hedged. Although the Fund may attempt to hedge its
currency exposure into the U.S. dollar, it may not be successful in
reducing the effects of currency fluctuations. The Fund may also hedge
from one foreign currency to another. In addition, the Fund's use of
currency hedging may not be successful and the use of such strategies
may lower the Fund's potential returns.
Investments denominated in foreign (non-U.S.) currencies or that trade
in, and receive revenues in, foreign (non-U.S.) currencies, derivatives or
other investments that provide exposure to foreign (non-U.S.)
currencies, are subject to the risk that those currencies will decline in
value relative to the U.S. dollar, or, in the case of hedging positions, that
the U.S. dollar will decline in value relative to the currency being
hedged.
Currency rates in foreign (non-U.S.) countries may fluctuate significantly
over short periods of time for a number of reasons, including changes in
interest rates, rates of inflation, balance of payments and governmental
surpluses or deficits, intervention (or the failure to intervene) by U.S. or
foreign (non-U.S.) governments, central banks or supranational entities
such as the International Monetary Fund, or by the imposition of
[], 2024 |
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PIMCO Income Strategy Fund II
currency controls or other political developments in the United States or
abroad. These fluctuations may have a significant adverse impact on the
value of the Fund’s portfolio and/or the level of Fund distributions made
to Common Shareholders. There is no assurance that a hedging strategy,
if used, will be successful. Moreover, currency hedging techniques may
be unavailable with respect to emerging market currencies. As a result,
the Fund’s investments in foreign currency-denominated, and especially
emerging market-currency denominated, securities may reduce the
returns of the Fund.
U.S. Government Securities Risk
Certain U.S. government securities, such as U.S. Treasury bills, notes,
bonds, and mortgage-related securities guaranteed by the Government
National Mortgage Association (“GNMA”), are supported by the full
faith and credit of the United States; others, such as those of the Federal
Home Loan Banks (“FHLBs”) or the Federal Home Loan Mortgage
Corporation (“FHLMC”), are supported by the right of the issuer to
borrow from the U.S. Department of the Treasury (the “U.S. Treasury”);
others, such as those of the Federal National Mortgage Association
(“FNMA”), are supported by the discretionary authority of the
U.S. government to purchase the agency’s obligations; and still others
are supported only by the credit of the agency, instrumentality or
corporation. U.S. government securities are subject to market risk,
interest rate risk and credit risk. Although legislation has been enacted
to support certain government sponsored entities, including the FHLBs,
FHLMC and FNMA, there is no assurance that the obligations of such
entities will be satisfied in full, or that such obligations will not decrease
in value or default. It is difficult, if not impossible, to predict the future
political, regulatory or economic changes that could impact the
government sponsored entities and the values of their related securities
or obligations. In addition, certain governmental entities, including
FNMA and FHLMC, have been subject to regulatory scrutiny regarding
their accounting policies and practices and other concerns that may
result in legislation, changes in regulatory oversight and/or other
consequences that could adversely affect the credit quality, availability
or investment character of securities issued by these entities. Yields
available from U.S. government debt securities are generally lower than
the yields available from other debt securities. The values of
U.S. government securities change as interest rates fluctuate.
Periodically, uncertainty regarding the status of negotiations in the
U.S. government to increase the statutory debt ceiling could increase the
risk that the U.S. government may default on payments on certain
U.S. government securities, cause the credit rating of the
U.S. government to be downgraded, increase volatility in the stock and
bond markets, result in higher interest rates, reduce prices of
U.S. Treasury and other securities, and/or increase the costs of various
kinds of debt. If a government-sponsored entity is negatively impacted
by legislative or regulatory action (or lack thereof), is unable to meet its
obligations, or its creditworthiness declines, the performance of a fund
that holds securities of the entity will be adversely impacted.
Convertible Securities Risk
The market values of convertible securities may decline as interest rates
increase and, conversely, may increase as interest rates decline. A
convertible security’s market value, however, tends to reflect the market
price of the common stock of the issuing company when that stock price
approaches or is greater than the convertible security’s “conversion
price.” The conversion price is defined as the predetermined price at
which the convertible security could be exchanged for the associated
stock. As the market price of the underlying common stock declines, the
price of the convertible security tends to be influenced more by the yield
of the convertible security. Thus, it may not decline in price to the same
extent as the underlying common stock. In the event of a liquidation of
the issuing company, holders of convertible securities may be paid
before the company’s common stockholders but after holders of any
senior debt obligations of the company. Consequently, the issuer’s
convertible securities generally entail less risk than its common stock
but more risk than its other debt obligations. Convertible securities are
often rated below investment grade or not rated.
Synthetic Convertible Securities Risk
Synthetic convertible securities involve the combination of separate
securities that possess the two principal characteristics of a traditional
convertible security (i.e., an income-producing component and a right to
acquire an equity security). Synthetic convertible securities are often
achieved, in part, through investments in warrants or options to buy
common stock (or options on a stock index), and therefore are subject
to the risks associated with derivatives. The value of a synthetic
convertible security will respond differently to market fluctuations than
a traditional convertible security because a synthetic convertible is
composed of two or more separate securities or instruments, each with
its own market value. Because the convertible component is typically
achieved by investing in warrants or options to buy common stock at a
certain exercise price, or options on a stock index, synthetic convertible
securities are subject to the risks associated with derivatives. In
addition, if the value of the underlying common stock or the level of the
index involved in the convertible component falls below the exercise
price of the warrant or option, the warrant or option may lose all value.
Contingent Convertible Securities Risk
Contingent convertible securities (“CoCos”) have no stated maturity,
have fully discretionary coupons and are typically issued in the form of
subordinated debt instruments. CoCos generally either convert into
equity or have their principal written down (including potentially to
zero) upon the occurrence of certain triggering events (“triggers”)
linked to regulatory capital thresholds or regulatory actions relating to
the issuer's continued viability. As a result, an investment by the Fund in
CoCos is subject to the risk that coupon (i.e., interest) payments may be
cancelled by the issuer or a regulatory authority in order to help the
issuer absorb losses and the risk of total loss. An investment by the Fund
in CoCos is also subject to the risk that, in the event of the liquidation,
dissolution or winding-up of an issuer prior to a trigger event, the
Fund's rights and claims will generally rank junior to the claims of
holders of the issuer's other debt obligations and CoCos may also be
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| PIMCO Income Strategy Fund II
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treated as junior to an issuer's other obligations and securities. In
addition, if CoCos held by the Fund are converted into the issuer's
underlying equity securities following a trigger event, the Fund's holding
may be further subordinated due to the conversion from a debt to
equity instrument. Further, the value of an investment in CoCos is
unpredictable and will be influenced by many factors and risks,
including interest rate risk, credit risk, market risk and liquidity risk. An
investment by the Fund in CoCos may result in losses to the Fund.
Valuation Risk
Certain securities in which the Fund invests may be less liquid and more
difficult to value than other types of securities. Investments for which
market quotations are not readily available or are valued at fair value as
determined in good faith pursuant to Rule 2a-5 under the Act. Fair value
pricing may require subjective determinations about the value of a
security or other asset. As a result, there can be no assurance that fair
value pricing will result in adjustments to the prices of securities or other
assets, or that fair value pricing will reflect actual market value, and it is
possible that the fair value determined for a security or other asset will
be materially different from quoted or published prices, from the prices
used by others for the same security or other asset and/or from the
value that actually could be or is realized upon the sale of that security
or other asset.
Leverage Risk
The Fund’s use of leverage (as described under “Use of Leverage” in the
body of this prospectus) creates the opportunity for increased Common
Share net income, but also creates special risks for Common
Shareholders (including an increased risk of loss). To the extent used,
there is no assurance that the Fund’s leveraging strategies will be
successful. Leverage is a speculative technique that may expose the
Fund to greater risk and increased costs. The Fund’s assets attributable
to leverage, if any, will be invested in accordance with the Fund’s
investment objective and policies. Interest expense payable by the Fund
with respect to derivatives and other forms of leverage, and dividends
payable with respect to any preferred shares outstanding, if any, will
generally be based on shorter-term interest rates that would be
periodically reset. So long as the Fund’s portfolio investments provide a
higher rate of return (net of applicable Fund expenses) than the interest
expenses and other costs to the Fund of such leverage, the investment
of the proceeds thereof will generate more income than will be needed
to pay the costs of the leverage. If so, and all other things being equal,
the excess may be used to pay higher dividends to Common
Shareholders than if the Fund were not so leveraged. If, however,
shorter-term interest rates rise relative to the rate of return on the
Fund’s portfolio, the interest and other costs to the Fund of leverage
could exceed the rate of return on the debt obligations and other
investments held by the Fund, thereby reducing return to Common
Shareholders. Leveraging transactions pursued by the Fund may
increase its duration and sensitivity to interest rate movements. In
addition, fees and expenses of any form of leverage used by the Fund
will be borne entirely by the Common Shareholders (and not by
preferred shareholders, if any) and will reduce the investment return of
the Common Shares. Therefore, there can be no assurance that the
Fund’s use of leverage will result in a higher yield on the Common
Shares, and it may result in losses. In addition, any Preferred Shares
issued by the Fund are expected to pay cumulative dividends, which may
tend to increase leverage risk. Leverage creates several major types of
risks for Common Shareholders, including:
■
the likelihood of greater volatility of NAV and market price of
Common Shares, and of the investment return to Common
Shareholders, than a comparable portfolio without leverage;
■
the possibility either that Common Share dividends will fall if the
interest and other costs of leverage rise, or that dividends paid on
Common Shares will fluctuate because such costs vary over time;
and
■
the effects of leverage in a declining market or a rising interest
rate environment, as leverage is likely to cause a greater decline in
the NAV of the Common Shares than if the Fund were not
leveraged.
In addition, the counterparties to the Fund’s leveraging transactions and
any preferred shareholders of the Fund will have priority of payment
over the Fund’s Common Shareholders.
Reverse repurchase agreements involve the risks that the interest
income earned on the investment of the proceeds will be less than the
interest expense and Fund expenses associated with the repurchase
agreement, that the market value of the securities sold by the Fund may
decline below the price at which the Fund is obligated to repurchase
such securities and that the securities may not be returned to the Fund.
There is no assurance that reverse repurchase agreements can be
successfully employed. Dollar roll/buyback transactions involve the risk
that the market value of the securities the Fund is required to purchase
may decline below the agreed upon purchase price of those securities.
Successful use of dollar rolls/buybacks may depend upon the Investment
Manager’s ability to correctly predict interest rates and prepayments.
There is no assurance that dollar rolls/buybacks can be successfully
employed. In connection with reverse repurchase agreements and dollar
rolls/buybacks, the Fund will also be subject to counterparty risk with
respect to the purchaser of the securities. If the broker/dealer to whom
the Fund sells securities becomes insolvent, the Fund’s right to purchase
or repurchase securities may be restricted.
The Fund may engage in total return swaps, reverse repurchases, loans
of portfolio securities, short sales and when-issued, delayed delivery and
forward commitment transactions, credit default swaps, basis swaps
and other swap agreements, purchases or sales of futures and forward
contracts (including foreign currency exchange contracts), call and put
options or other derivatives. The Fund’s use of such transactions gives
rise to associated leverage risks described above, and may adversely
affect the Fund’s income, distributions and total returns to Common
Shareholders. To the extent that any offsetting positions do not behave
in relation to one another as expected, the Fund may perform as if it is
leveraged through use of these derivative strategies.
Any total return swaps, reverse repurchases, loans of portfolio securities,
short sales and when-issued, delayed delivery and forward commitment
transactions, credit default swaps, basis swaps and other swap
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PIMCO Income Strategy Fund II
agreements, purchases or sales of futures and forward contracts
(including foreign currency exchange contracts), call and put options or
other derivatives by the Fund or counterparties to the Fund’s other
leveraging transactions, if any, would have seniority over the Fund’s
Common Shares.
Because the fees received by the Investment Manager may increase
depending on the types of leverage utilized by the Fund, the Investment
Manager has a financial incentive for the Fund to use certain forms of
leverage, which may create a conflict of interest between the Investment
Manager, on the one hand, and the Common Shareholders, on the other
hand.
Derivatives Risk
The Fund may, but is not required to, utilize a variety of derivative
instruments (both long and short positions) for investment or risk
management purposes. Derivatives are financial contracts whose value
depends on, or is derived from, the value of an underlying asset,
reference rate or index. For example, the Fund may use derivative
instruments for purposes of increasing liquidity, providing efficient
portfolio management, broadening investment opportunities (including
taking short or negative positions), implementing a tax or cash
management strategy, gaining exposure to a particular security or
segment of the market, modifying the effective duration of the Fund’s
portfolio investments and/or enhancing total return.
The use of derivative instruments involves risks different from, or
possibly greater than, the risks associated with investing directly in
securities and other traditional investments. Derivatives and other
similar instruments (referred to collectively as “derivatives”), which may
increase market exposure are subject to a number of risks including
leverage risk, liquidity risk (which may be heightened for highly
customized derivatives), interest rate risk, market risk, counterparty
(including credit) risk, operational risk (such as documentation issues,
settlement issues and systems failures), legal risk (such as insufficient
documentation, insufficient capacity or authority of a counterparty, and
issues with the legality or enforceability of a contract), counterparty risk,
tax risk and management risk, as well as risks arising from changes in
applicable requirements, risks arising from margin requirements and
risks arising from mispricing or valuation complexity. They also involve
the risk that changes in the value of a derivative instrument may not
correlate perfectly with the underlying asset, rate or index. By investing
in a derivative instrument, the Fund could lose more than the initial
amount invested, and derivatives may increase the volatility of the Fund,
especially in unusual or extreme market conditions. Certain derivatives
have the potential for unlimited loss, regardless of the size of the initial
investment. The Fund may be required to hold additional cash or sell
other investments in order to obtain cash to close out a position and
changes in the value of a derivative may also create margin delivery or
settlement payment obligations for the Fund. Also, suitable derivative
transactions may not be available in all circumstances and there can be
no assurance that the Fund will engage in these transactions to reduce
exposure to other risks when that would be beneficial or that, if used,
such strategies will be successful. The Fund’s use of derivatives may
increase or accelerate the amount of taxes payable by Common
Shareholders.
Over-the-counter (“OTC”) derivatives are also subject to the risk that a
counterparty to the transaction will not fulfill its contractual obligations
to the other party, as many of the protections afforded to centrally
cleared derivative transactions might not be available for OTC
derivatives. The primary credit risk on derivatives that are
exchange-traded or traded through a central clearing counterparty
resides with the Fund’s clearing broker, or the clearinghouse itself.
Participation in the markets for derivative instruments involves
investment risks and transaction costs to which the Fund may not be
subject absent the use of these strategies. The skills needed to
successfully execute derivative strategies may be different from those
needed for other types of transactions. If the Fund incorrectly forecasts
the value and/or creditworthiness of securities, currencies, interest rates,
counterparties or other economic factors involved in a derivative
transaction, the Fund might have been in a better position if the Fund
had not entered into such derivative transaction. In evaluating the risks
and contractual obligations associated with particular derivative
instruments, it is important to consider that certain derivative
transactions may be modified or terminated only by mutual consent of
the Fund and its counterparty.
Therefore, it may not be possible for the Fund to modify, terminate, or
offset the Fund’s obligations or the Fund’s exposure to the risks
associated with a derivative transaction prior to its scheduled
termination or maturity date, which may create a possibility of increased
volatility and/or decreased liquidity to the Fund. Hedges are sometimes
subject to imperfect matching between the derivative and the
underlying instrument, and there can be no assurance that the Fund’s
hedging transactions will be effective. In such case, the Fund may lose
money.
Because the markets for certain derivative instruments (including
markets located in foreign countries) are relatively new and still
developing, appropriate derivative transactions may not be available in
all circumstances for risk management or other purposes. Upon the
expiration of a particular contract, the Fund may wish to retain the
Fund’s position in the derivative instrument by entering into a similar
contract but may be unable to do so if the counterparty to the original
contract is unwilling to enter into the new contract and no other
appropriate counterparty can be found. When such markets are
unavailable, the Fund will be subject to increased liquidity and
investment risk.
The Fund may enter into opposite sides of interest rate swap and other
derivatives for the principal purpose of generating distributable gains on
the one side (characterized as ordinary income for tax purposes) that
are not part of the Fund’s duration or yield curve management
strategies (“paired swap transactions”), and with a substantial
possibility that the Fund will experience a corresponding capital loss
and decline in NAV with respect to the opposite side transaction (to the
extent it does not have corresponding offsetting capital gains).
Consequently, Common Shareholders may receive distributions and owe
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tax on amounts that are effectively a taxable return of the shareholder’s
investment in the Fund, at a time when their investment in the Fund has
declined in value, which tax may be at ordinary income rates. The tax
treatment of certain derivatives in which the Fund invests may be
unclear and thus subject to recharacterization. Any recharacterization of
payments made or received by the Fund pursuant to derivatives
potentially could affect the amount, timing or character of Fund
distributions. In addition, the tax treatment of such investment
strategies may be changed by regulation or otherwise.
When a derivative is used as a hedge against a position that the Fund
holds, any loss generated by the derivative generally should be
substantially offset by gains on the hedged investment, and vice versa.
Although hedging can reduce or eliminate losses, it can also reduce or
eliminate gains. Hedges are sometimes subject to imperfect matching
between the derivative and the underlying instrument, and there can be
no assurance that the Fund’s hedging transactions will be effective. The
regulation of the derivatives markets has increased over the past several
years, and additional future regulation of the derivatives markets may
make derivatives more costly, may limit the availability or reduce the
liquidity of derivatives, or may otherwise adversely affect the value or
performance of derivatives. Any such adverse future developments could
impair the effectiveness or raise the costs of the Fund’s derivative
transactions, impede the employment of the Fund’s derivatives
strategies, or adversely affect the Fund’s performance.
Credit Default Swaps Risk
Credit default swap agreements may involve greater risks than if the
Fund had invested in the reference obligation directly since, in addition
to general market risks, credit default swaps are subject to leverage risk,
illiquidity risk, counterparty risk and credit risk. A buyer generally also
will lose its investment and recover nothing should no credit event occur
and the swap is held to its termination date. If a credit event were to
occur, the value of any deliverable obligation received by the seller (if
any), coupled with the upfront or periodic payments previously received,
may be less than the full notional value it pays to the buyer, resulting in
a loss of value to the seller. When the Fund acts as a seller of a credit
default swap, it is exposed to many of the same risks of leverage
described herein. As the seller, the Fund would receive a stream of
payments over the term of the swap agreement provided that no event
of default has occurred with respect to the referenced debt obligation
upon which the swap is based. The Fund would effectively add leverage
to its portfolio because, If a default occurs, the stream of payments may
stop and, in addition to its total net assets, the Fund would be subject to
investment exposure on the notional amount of the swap.
Although the Fund may seek to realize gains by selling credit default
swaps that increase in value, to realize gains on selling credit default
swaps, an active secondary market for such instruments must exist or
the Fund must otherwise be able to close out these transactions at
advantageous times. In addition to the risk of losses described above, if
no such secondary market exists or the Fund is otherwise unable to
close out these transactions at advantageous times, selling credit
default swaps may not be profitable for the Fund.
The market for credit default swaps has become more volatile as the
creditworthiness of certain counterparties has been questioned and/or
downgraded. The Fund will be subject to credit risk with respect to the
counterparties to the credit default swap contract (whether a clearing
corporation or another third party). If a counterparty’s credit becomes
significantly impaired, multiple requests for collateral posting in a short
period of time could increase the risk that the Fund may not receive
adequate collateral. The Fund may exit its obligations under a credit
default swap only by terminating the contract and paying applicable
breakage fees, or by entering into an offsetting credit default swap
position, which may cause the Fund to incur more losses.
Counterparty Risk
The Fund will be subject to credit risk with respect to the counterparties
to the derivative contracts and other instruments entered into by the
Fund or held by special purpose or structured vehicles in which the Fund
invests. In the event that the Fund enters into a derivative transaction
with a counterparty that subsequently becomes insolvent or becomes
the subject of a bankruptcy case, the derivative transaction may be
terminated in accordance with its terms and the Fund’s ability to realize
its rights under the derivative instrument and its ability to distribute the
proceeds could be adversely affected. If a counterparty becomes
bankrupt or otherwise fails to perform its obligations under a derivative
contract due to financial difficulties, the Fund may experience significant
delays in obtaining any recovery (including recovery of any collateral it
has provided to the counterparty) in a dissolution, assignment for the
benefit of creditors, liquidation, winding-up, bankruptcy or other
analogous proceeding. In addition, in the event of the insolvency of a
counterparty to a derivative transaction, the derivative transaction
would typically be terminated at its fair market value. If the Fund is
owed this fair market value in the termination of the derivative
transaction and its claim is unsecured, the Fund will be treated as a
general creditor of such counterparty and will not have any claim with
respect to any underlying security or asset. The Fund may obtain only a
limited recovery or may obtain no recovery in such circumstances. While
the Fund may seek to manage its counterparty risk by transacting with a
number of counterparties, concerns about the solvency of, or a default
by, one large market participant could lead to significant impairment of
liquidity and other adverse consequences for other counterparties.
Equity Securities and Related Market Risk
The market price of common stocks and other equity securities may go
up or down, sometimes rapidly or unpredictably. Equity securities may
decline in value due to factors affecting equity securities markets
generally, particular industries represented in those markets, or the
issuer itself. The values of equity securities may decline due to real or
perceived adverse economic conditions, changes in the general outlook
for corporate earnings, changes in interest or currency rates, adverse
changes to credit markets or adverse investor sentiment generally. They
may also decline due to labor shortages or increased production costs
and competitive conditions within an industry. Equity securities
generally have greater price volatility than bonds and other debt
securities.
[], 2024 |
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PIMCO Income Strategy Fund II
Preferred Securities Risk
In addition to equity securities risk, credit risk and possibly high yield
risk, investment in preferred securities involves certain other risks.
Certain preferred securities contain provisions that allow an issuer
under certain conditions to skip or defer distributions. If the Fund owns
a preferred security that is deferring its distribution, the Fund may be
required to include the amount of the deferred distribution in its taxable
income for tax purposes although it does not currently receive such
amount in cash. In order to receive the special treatment accorded to
regulated investment companies (“RICs”) and their shareholders under
the Internal Revenue Code of 1986, as amended (the “Code”) and to
avoid U.S. federal income and/or excise taxes at the Fund level, the Fund
may be required to distribute this income to shareholders in the tax year
in which the income is recognized (without a corresponding receipt of
cash by the Fund). Therefore, the Fund may be required to pay out as an
income distribution in any such tax year an amount greater than the
total amount of cash income the Fund actually received and to sell
portfolio securities, including at potentially disadvantageous times or
prices, to obtain cash needed for these income distributions. Preferred
securities often are subject to legal provisions that allow for redemption
in the event of certain tax or legal changes or at the issuer’s call. In the
event of redemption, the Fund may not be able to reinvest the proceeds
at comparable rates of return. Preferred securities are subordinated to
bonds and other debt securities in an issuer’s capital structure in terms
of priority for corporate income and liquidation payments, and therefore
will be subject to greater credit risk than those debt securities. Preferred
securities may trade less frequently and in a more limited volume and
may be subject to more abrupt or erratic price movements than many
other securities.
Private Placements and Restricted Securities Risk
A private placement involves the sale of securities that have not been
registered under the Securities Act or relevant provisions of applicable
non-U.S. law to certain institutional and qualified individual purchasers,
such as the Fund. In addition to the general risks to which all securities
are subject, securities received in a private placement generally are
subject to strict restrictions on resale, and there may be no liquid
secondary market or ready purchaser for such securities. See “Principal
Risks of the Fund - Liquidity Risk.” Therefore, the Fund may be unable to
dispose of such securities when it desires to do so, or at the most
favorable time or price. Private placements may also raise valuation
risks.
Restricted securities are often purchased at a discount from the market
price of unrestricted securities of the same issuer reflecting the fact that
such securities may not be readily marketable without some time delay.
Such securities are often more difficult to value and the sale of such
securities often requires more time and results in higher brokerage
charges or dealer discounts and other selling expenses than does the
sale of liquid securities trading on national securities exchanges or in
the over-the-counter markets. Until the Fund can sell such securities into
the public markets, its holdings may be less liquid and any sales will
need to be made pursuant to an exemption under the Securities Act.
Confidential Information Access Risk
In managing the Fund (and other PIMCO clients), PIMCO may from time
to time have the opportunity to receive material, non-public information
(“Confidential Information”) about the issuers of certain investments,
including, without limitation, senior floating rate loans, other loans and
related investments being considered for acquisition by the Fund or held
in the Fund’s portfolio. For example, an issuer of privately placed loans
considered by the Fund may offer to provide PIMCO with financial
information and related documentation regarding the issuer that is not
publicly available. Pursuant to applicable policies and procedures,
PIMCO may (but is not required to) seek to avoid receipt of Confidential
Information from the issuer so as to avoid possible restrictions on its
ability to purchase and sell investments on behalf of the Fund and other
clients to which such Confidential Information relates. In such
circumstances, the Fund (and other PIMCO clients) may be
disadvantaged in comparison to other investors, including with respect
to the price the Fund pays or receives when it buys or sells an
investment. Further, PIMCO’s and the Fund’s abilities to assess the
desirability of proposed consents, waivers or amendments with respect
to certain investments may be compromised if they are not privy to
available Confidential Information. PIMCO may also determine to
receive such Confidential Information in certain circumstances under its
applicable policies and procedures. If PIMCO intentionally or
unintentionally comes into possession of Confidential Information, it
may be unable, potentially for a substantial period of time, to purchase
or sell investments to which such Confidential Information relates.
Inflation/Deflation Risk
Inflation risk is the risk that the value of assets or income from the
Fund’s investments will be worth less in the future as inflation decreases
the value of payments at future dates. As inflation increases, the real
value of the Fund’s portfolio could decline. Inflation has increased and it
cannot be predicted when, if, or the degree to which it may decline.
Inflation rates may change frequently and significantly as a result of
various factors, including unexpected shifts in the domestic or global
economy or changes in fiscal or monetary policies. Deflation risk is the
risk that prices throughout the economy decline over time. Deflation
may have an adverse effect on the creditworthiness of issuers and may
make issuer default more likely, which may result in a decline in the
value of the Fund’s portfolio and Common Shares.
Regulatory Changes Risk
Financial entities, such as investment companies and investment
advisers, are generally subject to extensive government regulation and
intervention. Government regulation and/or intervention may change
the way the Fund is regulated, affect the expenses incurred directly by
the Fund and the value of its investments, and limit and /or preclude the
Fund’s ability to achieve its investment objective. Government
regulation may change frequently and may have significant adverse
consequences. The Fund and the Investment Manager have historically
been eligible for exemptions from certain regulations. However, there is
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no assurance that the Fund and the Investment Manager will continue
to be eligible for such exemptions. Actions by government entities may
also impact certain instruments in which the Fund invests.
Moreover, government regulation may have unpredictable and
unintended effects. Legislative or regulatory actions to address
perceived liquidity or other issues in fixed income markets generally, or
in particular markets such as the municipal securities market, may alter
or impair the Fund’s ability to pursue its investment objective or utilize
certain investment strategies and techniques.
While there continues to be uncertainty about the full impact of these
and other regulatory changes, it is the case that the Fund will be subject
to a more complex regulatory framework, and may incur additional
costs to comply with new requirements as well as to monitor for
compliance in the future. Actions by governmental entities may also
impact certain instruments in which the Fund invests and reduce market
liquidity and resiliency. For example, the Fund’s investments (including,
but not limited to, repurchase agreements, collateralized loan
obligations and mortgage-backed securities), payment obligations and
financing terms may rely in some fashion on LIBOR. For more
information related to the LIBOR transition, see “Principal Risks of the
Fund - Regulatory Risk - LIBOR.”
Regulatory Risk - London Interbank Offered Rate (“LIBOR”)
Certain instruments in which the Fund may invest have relied or
continue to rely in some fashion upon the London Interbank Offered
Rate (“LIBOR”). LIBOR was traditionally an average interest rate,
determined by the ICE Benchmark Administration, that banks charge
one another for the use of short-term money. On March 5, 2021, the
Financial Conduct Authority (“FCA”), the United Kingdom’s financial
regulatory body and regulator of LIBOR, publicly announced that all
U.S. Dollar LIBOR settings will either cease to be provided by any
administrator or will no longer be representative (i) immediately after
December 31, 2021 for one-week and two-month U.S. Dollar LIBOR
settings and (ii) immediately after June 30, 2023 for the remaining
U.S. Dollar LIBOR settings. As of January 1, 2022, as a result of
supervisory guidance from U.S. regulators, U.S. regulated entities have
generally ceased entering into new LIBOR contracts with limited
exceptions. Publication of all Japanese yen and the one- and six-month
sterling LIBOR settings have ceased, and while publication of the
three-month Sterling LIBOR setting will continue through at least the
end of March 2024 on the basis of a changed methodology (known as
“synthetic LIBOR”), this rate has been designated by the FCA as
unrepresentative of the underlying market that it seeks to measure and
is solely available for use in legacy transactions. Certain bank-sponsored
committees in other jurisdictions, including Europe, the United Kingdom,
Japan and Switzerland, have selected alternative reference rates
denominated in other currencies. Although the transition process away
from LIBOR for many instruments has been completed, some LIBOR use
is continuing and there are potential effects related to the transition
away from LIBOR or continued use of LIBOR on the Fund, or on certain
instruments in which the Fund invests, which can be difficult to
ascertain, and may vary depending on factors that include, but are not
limited to: (i) existing fallback or termination provisions in individual
contracts and (ii) whether, how, and when industry participants adopt
new reference rates for affected instruments. So-called “tough legacy”
contracts have LIBOR interest rate provisions with no fallback provisions
contemplating a permanent discontinuation of LIBOR, inadequate
fallback provisions or fallback provisions which may not effectively
result in a transition away from LIBOR prior to LIBOR’s planned
replacement date. On March 15, 2022, the Adjustable Interest Rate
(LIBOR) Act was signed into law. This law provides a statutory fallback
mechanism on a nationwide basis to replace LIBOR with a benchmark
rate that is selected by the Board of Governors of the Federal Reserve
System based on the Secured Overnight Financing Rate (“SOFR”) for
tough legacy contracts. On February 27, 2023, the Federal Reserve
System’s final rule in connection with this law became effective,
establishing benchmark replacements based on SOFR and Term SOFR (a
forward-looking measurement of market expectations of SOFR implied
from certain derivatives markets) for applicable tough legacy contracts
governed by U.S. law. In addition, the FCA has announced that it will
require the publication of synthetic LIBOR for the one-month,
three-month and six-month U.S. Dollar LIBOR settings after June 30,
2023 through at least September 30, 2024. Certain of the Fund’s
investments may involve individual tough legacy contracts which may
be subject to the Adjustable Interest Rate (LIBOR) Act or synthetic LIBOR
and no assurances can be given that these measures will have the
intended effects. Moreover, certain aspects of the transition from LIBOR
have relied or will continue to rely on the actions of third-party market
participants, such as clearing houses, trustees, administrative agents,
asset servicers and certain service providers; PIMCO cannot guarantee
the performance of such market participants and any failure on the part
of such market participants to manage their part of the LIBOR transition
could impact the Fund. The transition of investments from LIBOR to a
replacement rate as a result of amendment, application of existing
fallbacks, statutory requirements or otherwise may also result in a
reduction in the value of certain instruments held by the Fund or a
reduction in the effectiveness of related Fund transactions such as
hedges. In addition, an instrument’s transition to a replacement rate
could result in variations in the reported yields of the Fund that holds
such instrument. Any such effects of the transition away from LIBOR, as
well as other unforeseen effects, could result in losses to the Fund.
Regulatory Risk—Commodity Pool Operator
The CFTC has adopted regulations that subject registered investment
companies and their investment advisers to regulation by the CFTC if
the registered investment company invests more than a prescribed level
of its liquidation value in futures, options on futures or commodities,
swaps, or other financial instruments regulated under the Commodity
Exchange Act (“CEA”) and the rules thereunder (“commodity
interests”), or if the Fund markets itself as providing investment
exposure to such instruments. The Investment Manager is registered
with the CFTC as a CPO. However, with respect to the Fund, the
Investment Manager has claimed an exclusion from registration as a
CPO pursuant to CFTC Rule 4.5. For the Investment Manager to remain
eligible for this exclusion, the Fund must comply with certain limitations,
including limits on its ability to use any commodity interests and limits
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PIMCO Income Strategy Fund II
on the manner in which the Fund holds out its use of such commodity
interests. These limitations may restrict the Fund’s ability to pursue its
investment objective and strategies increase the costs of implementing
its strategies, result in higher expenses for the Fund, and/or adversely
affect the Fund’s total return. Further, in the event the Investment
Manager becomes unable to rely on the exclusion in CFTC Rule 4.5 with
respect to the Fund and is required to register as a CPO with respect to
the Fund, the Investment Manager will be subject to additional
regulation and its expenses may increase.
Liquidity Risk
Liquidity risk exists when particular investments are difficult to purchase
or sell. Illiquid investments are investments that the Fund reasonably
expects cannot be sold or disposed of in current market conditions in
seven calendar days or less without the sale or disposition significantly
changing the market value of the investment. Illiquid investments may
become harder to value, especially in changing markets. The Fund’s
investments in illiquid investments may reduce the returns of the Fund
because it may be unable to sell the illiquid investments at an
advantageous time or price or possibly require the Fund to dispose of
other investments at unfavorable times or prices in order to satisfy its
obligations, which could prevent the Fund from taking advantage of
other investment opportunities. Additionally, the market for certain
investments may become illiquid under adverse market or economic
conditions independent of any specific adverse changes in the
conditions of a particular issuer.
Further fixed income securities with longer durations until maturity face
heightened levels of liquidity risk as compared to fixed income securities
with shorter durations until maturity. The risks associated with illiquid
instruments may be particularly acute in situations in which the Fund’s
operations require cash (such as in connection with repurchase offers)
and could result in the Fund borrowing to meet its short-term needs or
incurring losses on the sale of illiquid instruments. It may also be the
case that other market participants may be attempting to liquidate fixed
income holdings at the same time as the Fund, causing increased supply
in the market and contributing to liquidity risk and downward pricing
pressure. See “Principal Risks of the Fund-Valuation Risk.”
Tax Risk
The Fund has elected to be treated as a “regulated investment
company” under the Code and intends each year to qualify and be
eligible to be treated as such, so that it generally will not be subject to
U.S. federal income tax on its net investment income or net short-term
or long-term capital gains that are distributed to shareholders. In order
to qualify and be eligible for such treatment, the Fund must meet
certain asset diversification tests, derive at least 90% of its gross
income for such year from certain types of qualifying income, and
distribute to its shareholders at least 90% of its “investment company
taxable income” as that term is defined in the Code (which includes,
among other things, dividends, taxable interest and the excess of any
net short-term capital gains over net long-term capital losses, as
reduced by certain deductible expenses).
The Fund’s investment strategy will potentially be limited by its intention
to continue qualifying for treatment as a RIC, and can limit the Fund’s
ability to continue qualifying as such. The tax treatment of certain of the
Fund’s investments under one or more of the qualification or
distribution tests applicable to RICs is uncertain. An adverse
determination or future guidance by the Internal Revenue Service
(“IRS”) or a change in law might affect the Fund’s ability to qualify or be
eligible for treatment as a RIC. Income and gains from certain of a
Fund's activities may not constitute qualifying income to a RIC for
purposes of the 90% gross income test. If a Fund were to treat income
or gain from a particular investment or activity as qualifying income and
the income or gain were later determined not to constitute qualifying
income and, together with any other nonqualifying income, caused the
Fund's nonqualifying income to exceed 10% of its gross income in any
taxable year, the Fund would fail to qualify as a RIC unless it is eligible
to and does pay a tax at the Fund level.
If, in any year, the Fund were to fail to qualify for treatment as a RIC
under the Code, and were ineligible to or did not otherwise cure such
failure, the Fund would be subject to tax on its taxable income at
corporate rates and, when such income is distributed, shareholders
would be subject to further tax on such distributions to the extent of the
Fund’s current or accumulated earnings and profits.
Portfolio Turnover Risk
The Investment Manager manages the Fund without regard generally to
restrictions on portfolio turnover. The use of futures contracts and other
derivative instruments with relatively short maturities may tend to
exaggerate the portfolio turnover rate for the Fund. Trading in fixed
income securities does not generally involve the payment of brokerage
commissions, but does involve indirect transaction costs. The use of
futures contracts and other derivative instruments may involve the
payment of commissions to futures commission merchants or other
intermediaries. Higher portfolio turnover involves correspondingly
greater expenses to the Fund, including brokerage commissions or
dealer mark-ups and other transaction costs on the sale of securities
and reinvestments in other securities. The higher the rate of portfolio
turnover of the Fund, the higher these transaction costs borne by the
Fund generally will be. Such sales may result in realization of taxable
capital gains (including short-term capital gains, which are generally
taxed to shareholders at ordinary income tax rates when distributed net
of short-term capital losses and net long-term capital losses), and may
adversely impact the Fund’s after-tax returns. See “Tax Matters.”
Operational Risk
An investment in the Fund, like any fund, can involve operational risks
arising from factors such as processing errors, human errors, inadequate
or failed internal or external processes, failures in systems and
technology, changes in personnel and errors caused by third-party
service providers. The occurrence of any of these failures, errors or
breaches could result in a loss of information, regulatory scrutiny,
reputational damage or other events, any of which could have a
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material adverse effect on the Fund. While the Fund seeks to minimize
such events through controls and oversight, there may still be failures
that could cause losses to the Fund.
Other Investment Companies Risk
When investing in an investment company, the Fund will bear its ratable
share of that investment company’s expenses and would remain subject
to payment of the Fund’s management fees and other expenses with
respect to assets so invested. Common Shareholders would therefore be
subject to duplicative expenses to the extent the Fund invests in other
investment companies. In addition, the securities of other investment
companies may also be leveraged and will therefore be subject to same
leverage risks.
Risk Retention Investment Risk
The Fund may invest in risk retention tranches of CMBS or other eligible
securitizations, if any (“risk retention tranches”), which are eligible
residual interests typically held by the sponsors of such securitizations
pursuant to the final rules implementing the credit risk retention
requirements of Section 941 of the Dodd-Frank Act (the “U.S. Risk
Retention Rules”). In the case of CMBS transactions, for example, the
U.S. Risk Retention Rules permit all or a portion of the retained credit
risk associated with certain securitizations (i.e., retained risk) to be held
by an unaffiliated “third party purchaser,” such as the Fund, if, among
other requirements, the third-party purchaser holds its retained interest,
unhedged, for at least five years following the closing of the CMBS
transaction, after which it is entitled to transfer its interest in the
securitization to another person that meets the requirements for a
third-party purchaser. Even after the required holding period has
expired, due to the generally illiquid nature of such investments, no
assurance can be given as to what, if any, exit strategies will ultimately
be available for any given position.
In addition, there is limited guidance on the application of the final
U.S. Risk Retention Rules to specific securitization structures. There can
be no assurance that the applicable federal agencies charged with the
implementation of the final U.S. Risk Retention Rules (the Federal
Deposit Insurance Corporation, the Comptroller of the Currency, the
Federal Reserve Board, the SEC, the Department of Housing and Urban
Development, and the Federal Housing Finance Agency) could not take
positions in the future that differ from the interpretation of such rules
taken or embodied in such securitizations, or that the final U.S. Risk
Retention Rules will not change.
Furthermore, in situations where the Fund invests in risk retention
tranches of securitizations structured by third parties, the Fund may be
required to execute one or more letters or other agreements, the exact
form and nature of which will vary (each, a “Risk Retention
Agreement”) under which it will make certain undertakings designed to
ensure such securitization complies with the final U.S. Risk Retention
Rules. Such Risk Retention Agreements may include a variety of
representations, warranties, covenants and other indemnities, each of
which may run to various transaction parties. If the Fund breaches any
undertakings in any Risk Retention Agreement, it will be exposed to
claims by the other parties thereto, including for any losses incurred as a
result of such breach, which could be significant and exceed the value of
the Fund’s investments.
Cyber Security Risk
As the use of technology has become more prevalent in the course of
business, the Fund has become potentially more susceptible to
operational and information security risks resulting from breaches in
cyber security. A breach in cyber security refers to both intentional and
unintentional cyber events from outside threat actors or internal
resources that may, among other things, cause the Fund to lose
proprietary information, suffer data corruption and/or destruction, lose
operational capacity, result in the unauthorized release or other misuse
of confidential information, or otherwise disrupt normal business
operations. Cyber security breaches may involve unauthorized access to
the Fund’s digital information systems (e.g., through “hacking” or
malicious software coding), and may come from multiple sources,
including outside attacks such as denial-of-service attacks (i.e., efforts to
make network services unavailable to intended users) or cyber extortion,
including exfiltration of data held for ransom and/or “ransomware”
attacks that renders systems inoperable until ransom is paid, or insider
actions. In addition, cyber security breaches involving the Fund’s third
party service providers (including but not limited to advisers,
sub-advisers, administrators, transfer agents, custodians, vendors,
suppliers, distributors and other third parties), trading counterparties or
issuers in which the Fund invests can also subject the Fund to many of
the same risks associated with direct cyber security breaches or
extortion of company data. Moreover, cyber security breaches involving
trading counterparties or issuers in which the Fund invests could
adversely impact such counterparties or issuers and cause the Fund’s
investments to lose value. In addition, work-from-home arrangements
by the Fund, the Investment Manager or their service providers could
increase all of the above risks, create additional data and information
accessibility concerns, and make the Fund, the Investment Manager or
their service providers susceptible to operational disruptions, any of
which could adversely impact their operations.
Cyber security failures or breaches may result in financial losses to the
Fund and its shareholders. These failures or breaches may also result in
disruptions to business operations, potentially resulting in financial
losses; interference with the Fund’s ability to calculate its NAV, process
shareholder transactions or otherwise transact business with
shareholders; impediments to trading; violations of applicable privacy
and other laws; regulatory fines; penalties; third party claims in
litigation; reputational damage; reimbursement or other compensation
costs; additional compliance and cyber security risk management costs
and other adverse consequences. In addition, substantial costs may be
incurred in order to prevent any cyber incidents in the future.
Like with operational risk in general, the Fund has established business
continuity plans and risk management systems designed to reduce the
risks associated with cyber security. However, there are inherent
limitations in these plans and systems, including that certain risks may
not have been identified, in large part because different or unknown
threats may emerge in the future. As such, there is no guarantee that
[], 2024 |
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PIMCO Income Strategy Fund II
such efforts will succeed, especially because the Fund does not directly
control the cyber security systems of issuers in which the Fund may
invest, trading counterparties or third party service providers to the
Fund. Such entities have experienced cyber attacks and other attempts
to gain unauthorized access to systems from time to time, and there is
no guarantee that efforts to prevent or mitigate the effects of such
attacks or other attempts to gain unauthorized access will be successful.
There is also a risk that cyber security breaches may not be detected. The
Fund and its shareholders may suffer losses as a result of a cyber
security breach related to the Fund, its service providers, trading
counterparties or the issuers in which the Fund invests.
Privacy and Data Security Risk
The Gramm-Leach-Biley Act (“GLBA”) and other laws limit the
disclosure of certain non-public personal information about a consumer
to non- affiliated third parties and require financial institutions to
disclose certain privacy policies and practices with respect to
information sharing with both affiliates and non- affiliated third parties.
Many states and a number of non-U.S. jurisdictions have enacted
privacy and data security laws requiring safeguards on the privacy and
security of consumers’ personally identifiable information. Other laws
deal with obligations to safeguard and dispose of private information in
a manner designed to avoid its dissemination. Privacy rules adopted by
the U.S. Federal Trade Commission and SEC implement GLBA and other
requirements and govern the disclosure of consumer financial
information by certain financial institutions, ranging from banks to
private investment funds. U.S. platforms following certain models
generally are required to have privacy policies that conform to these
GLBA and other requirements. In addition, such platforms typically have
policies and procedures intended to maintain platform participants’
personal information securely and dispose of it properly.
The Fund generally does not intend to obtain or hold borrowers’
non-public personal information, and the Fund has implemented
procedures reasonably designed to prevent the disclosure of borrowers’
non-public personal information to the Fund. However, service providers
to the Fund including their custodians and the platforms acting as loan
servicers for the Fund may obtain, hold or process such information. The
Fund cannot guarantee the security of non-public personal information
in the possession of such a service provider and cannot guarantee that
service providers have been and will continue to comply with the GLBA,
other data security and privacy laws and any other related regulatory
requirements. Violations of GLBA and other laws could subject the Fund
to litigation and/or fines, penalties or other regulatory action, which,
individually or in the aggregate, could have an adverse effect on the
Fund. The Fund may also face regulations related to privacy and data
security in the other jurisdictions in which the Fund invests.
Potential Conflicts of Interest Risk—Allocation of Investment
Opportunities
The Investment Manager and its affiliates are involved worldwide with a
broad spectrum of financial services and asset management activities
and may engage in the ordinary course of business in activities in which
their interests or the interests of their clients may conflict with those of
the Fund. The Investment Manager may provide investment
management services to other funds and discretionary managed
accounts that follow an investment program similar to that of the Fund.
Subject to the requirements of the 1940 Act, the Investment Manager
intends to engage in such activities and may receive compensation from
third parties for its services. The results of the Fund’s investment
activities may differ from those of the Fund’s affiliates, or another
account managed by the Investment Manager or its affiliates, and it is
possible that the Fund could sustain losses during periods in which one
or more of the Fund’s affiliates and/or other accounts managed by the
Investment Manager or its affiliates, including proprietary accounts,
achieve profits on their trading.
Repurchase Agreements Risk
The Fund may enter into repurchase agreements, in which the Fund
purchases a security from a bank or broker-dealer, which agrees to
repurchase the security at the Fund’s cost plus interest within a specified
time. If the party agreeing to repurchase should default, the Fund will
seek to sell the securities which it holds. This could involve costs or
delays in addition to a loss on the securities if their value should fall
below their repurchase price. Repurchase agreements may be or
become illiquid. These events could also trigger adverse tax
consequences for the Fund.
Structured Investments Risk
Holders of structured products, including structured notes, credit-linked
notes and other types of structured products, bear the risks of the
underlying investments, index or reference obligation and are subject to
counterparty risk. The Fund may have the right to receive payments only
from the structured product, and generally does not have direct rights
against the issuer or the entity that sold the assets to be securitized.
While certain structured products enable the investor to acquire
interests in a pool of securities without the brokerage and other
expenses associated with directly holding the same securities, investors
in structured products generally pay their share of the structured
product’s administrative and other expenses. Although it is difficult to
predict whether the prices of indices and securities underlying
structured products will rise or fall, these prices (and, therefore, the
prices of structured products) are generally influenced by the same types
of political and economic events that affect issuers of securities and
capital markets generally. If the issuer of a structured product uses
shorter term financing to purchase longer term securities, the issuer may
be forced to sell its securities at below market prices if it experiences
difficulty in obtaining such financing, which may adversely affect the
value of the structured products owned by the Fund. Structured
products generally entail risks associated with derivative instruments.
Collateralized Loan Obligations Risk
A Fund may invest in CLOs and other similarly structured investments. A
CLO is a trust typically collateralized by a pool of loans, which may
include, among others, domestic and foreign senior secured loans,
senior unsecured loans and subordinate corporate loans, including loans
that may be rated below investment grade or equivalent unrated loans.
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| PIMCO Income Strategy Fund II
Base Prospectus
A Fund’s investments in CLOs and other similarly structured investments
may expose the Fund to heightened credit risk, interest rate risk,
liquidity risk, market risk and prepayment and extension risk, as well as
the risk of default on the underlying asset. In addition, investments in
CLOs carry additional risks including, but not limited to, the risk that: (i)
distributions from the collateral may not be adequate to make interest
or other payments; (ii) the quality of the collateral may decline in value
or default; (iii) the Funds may invest in tranches of CLOs that are
subordinate to other tranches; (iv) the structure and complexity of the
transaction and the legal documents could lead to disputes among
investors regarding the characterization of proceeds; and (v) the CLO’s
manager may perform poorly CLOs may charge management and other
administrative fees, which are in addition to those of the Funds.
The cash flows from a CLO are split into two or more portions, called
tranches, varying in risk and yield. The riskiest portion is the “equity”
tranche which bears the bulk of defaults from the bonds or loans in the
trust and serves to protect the other, more senior tranches from default
in all but the most severe circumstances. Since they are partially
protected from defaults, senior tranches from a CLO typically have
higher ratings and lower yields than their underlying securities, and can
be rated investment grade. Despite the protection from the equity
tranche, CLO tranches can experience substantial losses due to actual
defaults, increased sensitivity to defaults due to collateral default and
disappearance of protecting tranches, market anticipation of defaults, as
well as aversion to CLO securities as a class. The risks of an investment
in a CLO depend largely on the type of the collateral securities and the
class of the instrument in which the Funds invests. Typically, CLOs are
privately offered and sold, and thus, are not registered under the
securities laws.
Market Disruptions Risk
The Fund is subject to investment and operational risks associated with
financial, economic and other global market developments and
disruptions, including those arising from war, terrorism, market
manipulation, government interventions, defaults and shutdowns,
political changes or diplomatic developments, public health
emergencies (such as the spread of infectious diseases, pandemics and
epidemics) and natural/environmental disasters, which can all negatively
impact the securities markets, interest rates, auctions, secondary trading,
ratings, credit risk, inflation, deflation and other factors relating to the
Fund’s investments or the Investment Manager’s operations and the
value of an investment in the Fund, its distributions and its returns.
These events can also impair the technology and other operational
systems upon which the Fund’s service providers, including PIMCO as
the Fund’s investment adviser, rely, and could otherwise disrupt the
Fund’s service providers’ ability to fulfill their obligations to the Fund.
Furthermore, events involving limited liquidity, defaults,
non-performance or other adverse developments that affect financial
institutions or the financial services industry generally, or concerns or
rumors about any events of these kinds or other similar risks, have in the
past and may in the future lead to market-wide liquidity problems.
Zero-Coupon Bond, Step-Ups and Payment-In-Kind Securities
Risk
The market prices of zero-coupon, step-ups and payment-in-kind
securities are generally more volatile than the prices of securities that
pay interest periodically and in cash, and are likely to respond to
changes in interest rates to a greater degree than other types of debt
securities with similar maturities and credit quality. Because
zero-coupon securities bear no interest, their prices are especially
volatile. And because zero-coupon bondholders do not receive interest
payments, the prices of zero-coupon securities generally fall more
dramatically than those of bonds that pay interest on a current basis
when interest rates rise. The market for zero-coupon and
payment-in-kind securities may suffer decreased liquidity. In addition, as
these securities may not pay cash interest, the Fund’s investment
exposure to these securities and their risks, including credit risk, will
increase during the time these securities are held in the Fund’s portfolio.
Further, to maintain its qualification for treatment as a RIC and to avoid
Fund-level U.S. federal income and/or excise taxes, the Fund is required
to distribute to its shareholders any income it is deemed to have
received in respect of such investments, notwithstanding that cash has
not been received currently, and the value of paid-in-kind interest.
Consequently, the Fund may have to dispose of portfolio securities
under disadvantageous circumstances to generate the cash, or may
have to leverage itself by borrowing the cash to satisfy this distribution
requirement. The required distributions, if any, would result in an
increase in the Fund’s exposure to these securities. Zero coupon bonds,
step-ups and payment-in-kind securities allow an issuer to avoid or
delay the need to generate cash to meet current interest payments and,
as a result, may involve greater credit risk than bonds that pay interest
currently or in cash. The Fund would be required to distribute the
income on these instruments as it accrues, even though the Fund will
not receive the income on a current basis or in cash. Thus, the Fund may
sell other investments, including when it may not be advisable to do so,
to make income distributions to its shareholders.
Debt Securities Risk
Debt securities are generally subject to the risks described below and
further herein:
Issuer risk.
The value of fixed income securities may decline for a
number of reasons that directly relate to the issuer, such as
management performance, financial leverage, reduced demand for the
issuer’s goods and services, historical and prospective earnings of the
issuer and the value of the assets of the issuer. A change in the financial
condition of a single issuer may affect securities markets as a whole.
These risks can apply to the Common Shares issued by the Fund and to
the issuers of securities and other instruments in which the Fund
invests.
Interest rate risk.
The market value of debt securities changes in
response to interest rate changes and other factors. Interest rate risk is
the risk that prices of debt securities will increase as interest rates fall
and decrease as interest rates rise, which would be reflected in the
Fund’s NAV. The Fund may lose money if short-term or long-term
[], 2024 |
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PIMCO Income Strategy Fund II
interest rates rise sharply in a manner not anticipated by the Fund’s
management. Moreover, because rates on certain floating rate debt
securities typically reset only periodically, changes in prevailing interest
rates (and particularly sudden and significant changes) can be expected
to cause some fluctuations in the NAV of the Fund to the extent that it
invests in floating rate debt securities.
Prepayment risk.
During periods of declining interest rates, borrowers
may prepay principal. This may force the Fund to reinvest in lower
yielding securities, resulting in a possible decline in the Fund’s income
and distributions.
Credit risk.
Credit risk is the risk that one or more debt securities in
the Fund’s portfolio will decline in price or fail to pay interest or
principal when due because the issuer of the security experiences a
decline in its financial status. Credit risk is increased when a portfolio
security is downgraded or the perceived creditworthiness of the issuer
deteriorates.
Reinvestment risk.
Reinvestment risk is the risk that income from the
Fund’s portfolio will decline if the Fund invests the proceeds from
matured, traded or called fixed income securities at market interest rates
that are below the portfolio’s current earnings rate.
Duration and maturity risk.
The Fund may seek to adjust the
duration or maturity of its investments in debt securities based on its
assessment of current and projected market conditions. The Fund may
incur costs in seeking to adjust the average duration or maturity of its
portfolio of debt securities. There can be no assurances that the Fund’s
assessment of current and projected market conditions will be correct or
that any strategy to adjust duration or maturity will be successful.
In addition, from time to time, uncertainty regarding the status of
negotiations in the U.S. government to increase the statutory debt
ceiling could impact the creditworthiness of the United States and could
impact the liquidity and value of U.S. Government and other securities
and ultimately the Fund.
Sovereign Debt Risk
In addition to the other risks applicable to debt investments, sovereign
debt (debt issued by a foreign government) may decline in value as a
result of default or other adverse credit event resulting from an issuer’s
inability or unwillingness to make principal or interest payments in a
timely fashion. A sovereign entity’s failure to make timely payments on
its debt can result from many factors, including, without limitation,
insufficient foreign (non-U.S.) currency reserves or an inability to
sufficiently manage fluctuations in relative currency valuations, an
inability or unwillingness to satisfy the demands of creditors and/or
relevant supranational entities regarding debt service or economic
reforms, the size of the debt burden relative to economic output and tax
revenues, cash flow difficulties, and other political and social
considerations. The risk of loss to the Fund in the event of a sovereign
debt default or other adverse credit event is heightened by the
unlikelihood of any formal recourse or means to enforce its rights as a
holder of the sovereign debt. In addition, sovereign debt restructurings,
which may be shaped by entities and factors beyond the Fund’s control,
may result in a loss in value of the Fund’s sovereign debt holdings.
Real Estate Risk
To the extent that the Fund invests in real estate investments, including
investments in equity or debt securities issued by private and public
REITs, real estate operating companies (“REOCs”), private or public real
estate-related loans and real estate-linked derivative instruments, it will
be subject to the risks associated with owning real estate and with the
real estate industry generally. These risks include, but are not limited to:
the burdens of ownership of real property; general and local economic
conditions(such as an oversupply of space or a reduction in demand for
space); the supply and demand for properties (including competition
based on rental rates); energy and supply shortages; fluctuations in
average occupancy and room rates; the attractiveness, type and location
of the properties and changes in the relative popularity of commercial
properties as an investment; the financial condition and resources of
tenants, buyers and sellers of properties; increased mortgage defaults;
the quality of maintenance, insurance and management services;
changes in the availability of debt financing which may render the sale
or refinancing of properties difficult or impracticable; changes in
building, environmental and other laws and/or regulations (including
those governing usage and improvements), fiscal policies and zoning
laws; changes in real property tax rates; changes in interest rates and
the availability of mortgage funds which may render the sale or
refinancing of properties difficult or impracticable; changes in operating
costs and expenses; energy and supply shortages; uninsured losses or
delays from casualties or condemnation; negative developments in the
economy that depress travel or leasing activity; environmental liabilities;
contingent liabilities on disposition of assets; uninsured or uninsurable
casualties; acts of God, including earthquakes, hurricanes and other
natural disasters; social unrest and civil disturbances, epidemics,
pandemics or other public crises; terrorist attacks and war; risks and
operating problems arising out of the presence of certain construction
materials, structural or property level latent defects, work stoppages,
shortages of labor, strikes, union relations and contracts, fluctuating
prices and supply of labor and/or other labor-related factor; and other
factors which are beyond the control of PIMCO and its affiliates.
In addition, the Fund’s investments will be subject to various risks which
could cause fluctuations in occupancy, rental rates, operating income
and expenses or which could render the sale or financing of its
properties difficult or unattractive. For example, following the
termination or expiration of a tenant’s lease, there may be a period of
time before receiving rental payments under a replacement lease.
During that period, the Fund would continue to bear fixed expenses
such as interest, real estate taxes, maintenance and other operating
expenses. In addition, declining economic conditions may impair the
ability to attract replacement tenants and achieve rental rates equal to
or greater than the rents paid under previous leases. Increased
competition for tenants may require capital improvements to properties
which would not have otherwise been planned.
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| PIMCO Income Strategy Fund II
Base Prospectus
Ultimately, to the extent it is not possible to renew leases or re-let space
as leases expire, decreased cash flow from tenants will result, which
could adversely impact the Fund’s operating results.
Real estate values have historically been cyclical. As the general
economy grows, demand for real estate increases and occupancies and
rents may increase. As occupancies and rents increase, property values
increase, and new development occurs. As development may occur,
occupancies, rents and property values may decline. Because leases are
usually entered into for long periods and development activities often
require extended times to complete, the real estate value cycle often
lags the general business cycle. Because of this cycle, real estate
companies may incur large swings in their profits and the prices of their
securities. Developments following the onset of COVID-19 have
adversely impacted certain commercial real estate markets, causing the
deferral of mortgage payments, renegotiated commercial mortgage
loans, commercial real estate vacancies or outright mortgage defaults,
and potential acceleration of macro trends such as work from home and
online shopping which may negatively impact certain industries, such as
brick-and-mortar retail.
The total returns available from investments in real estate generally
depend on the amount of income and capital appreciation generated by
the related properties. The performance of real estate, and thereby the
Fund, will be reduced by any related expenses, such as expenses paid
directly at the property level and other expenses that are capitalized or
otherwise embedded into the cost basis of the real estate.
Separately, certain service providers to the Fund and/or its subsidiaries,
as applicable, with respect to its real estate or real estate-related
investments may be owned by, employed by, or otherwise related to,
PIMCO, Allianz SE, their affiliates and/or their respective employees,
consultants and other personnel. PIMCO may, in its sole discretion,
determine to provide, or engage or recommend an affiliate of PIMCO to
provide, certain services to the Fund, instead of engaging or
recommending one or more third parties to provide such services.
Subject to the governance requirements of a particular fund and
applicable law, PIMCO or its affiliates, as applicable, will receive
compensation in connection with the provision of such services. As a
result, PIMCO faces a conflict of interest when selecting or
recommending service providers for the Fund. Fees paid to an affiliated
service provider will be determined in PIMCO’s commercially reasonable
discretion. Although PIMCO has adopted various policies and
procedures intended to mitigate or otherwise manage conflicts of
interest with respect to affiliated service providers, there can be no
guarantee that such policies and procedures (which may be modified or
terminated at any time in PIMCO’s sole discretion) will be successful.
Focused Investment Risk
To the extent that the Fund focuses its investments in a particular sector,
it may be susceptible to loss due to adverse developments affecting that
sector, including (but not limited to): governmental regulation; inflation;
rising interest rates; cost increases in raw materials, fuel and other
operating expenses; technological innovations that may render existing
products and equipment obsolete; competition from new entrants; high
research and development costs; increased costs associated with
compliance with environmental or other governmental regulations; and
other economic, business or political developments specific to that
sector. Furthermore, the Fund may invest a substantial portion of its
assets in companies in related sectors that may share common
characteristics, are often subject to similar business risks and regulatory
burdens, and whose securities may react similarly to the types of
developments described above, which will subject the Fund to greater
risk. The Fund also will be subject to focused investment risk to the
extent that it invests a substantial portion of its assets in a particular
issuer, market, asset class, country or geographic region. See “Principal
Risks of the Fund—Foreign (Non-U.S.) Investment Risk,” “Principal
Risks of the Fund—Emerging Markets Risk” and “Principal Risks of the
Fund—Currency Risk.”
Additional Risks Associated with the Fund’s Preferred Shares
Although the Fund’s ARPS ordinarily would pay dividends at rates set at
periodic auctions, the weekly auctions for the ARPS (and auctions for
similar preferred shares issued by closed-end funds in the U.S.) have
failed since 2008. The dividend rates on the ARPS since that time have
been paid, and the Fund expects that they will continue to be paid for
the foreseeable future, at the “maximum applicable rate” under the
Fund’s Bylaws (i.e., the greater of a multiple of or a spread plus a
reference rate). An increase in market interest rates generally, therefore,
could increase substantially the dividend rate required to be paid by the
Fund to the holders of ARPS, which would increase the costs associated
with the Fund’s leverage and reduce the Fund’s net income available for
distribution to Common Shareholders.
In addition, the multiple used to calculate the maximum applicable rate
is based in part on the credit rating assigned to the ARPS by the
applicable rating agency (currently, Moody’s and Fitch), with the
multiple generally increasing as the rating declines below certain levels.
In September 2011, Moody’s, a ratings agency that provides ratings for
the Fund’s ARPS, downgraded its rating of the ARPS from “Aaa” to
“Aa2,” citing what it believed to be persistently thin asset coverage
levels, increased NAV volatility and concerns about secondary market
liquidity for some assets supporting rated obligations. Under the Bylaws,
the 2011 Moody’s downgrade resulted in an increase in the dividend
rate multiplier from 1.25 to 1.50, thereby increasing the dividend rate
payable to ARPS holders and increasing the costs to Common
Shareholders associated with the Fund’s leverage. See “Use of
Leverage” and “Description of Capital Structure.” In July 2012, Moody’s
downgraded its rating of the ARPS from “Aa2” to “Aa3” pursuant to a
revised ratings methodology adopted by Moody’s. In May 2020, Fitch
downgraded its rating of the ARPS from “AAA” to “AA,” indicating the
downgrades reflected recent extreme market volatility and reduced
asset liquidity, which it believed eroded asset coverage cushions for
closed-end funds and challenged fund managers’ ability to deleverage.
Under the Bylaws, the 2020 Fitch downgrade resulted in an increase in
the applicable spread over the reference rate from 125 bps to 150 bps,
thereby increasing the dividend rate payable to ARPS holders and
increasing the costs to Common Shareholders associated with the
Fund’s leverage. On December 4, 2020, Fitch published ratings criteria
[], 2024 |
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PIMCO Income Strategy Fund II
relating to closed-end fund obligations, including preferred shares,
which effectively result in a rating cap of “AA” for debt and preferred
stock issued by closed-end funds and a rating cap of “A” for (i) debt and
preferred shares issued by closed-end funds exposed to corporate debt,
emerging market debt, below-investment-grade and unrated debt,
structured securities and equity, (ii) and closed-end funds with material
exposure to “BBB” category rated assets. Following the close of
business on April 30, 2021, Fitch downgraded its rating of the ARPS
from “AA” to “A” pursuant to the revised ratings methodology and
related new rating caps. Under the Bylaws, the April 2021 Fitch
downgrade resulted in an increase in the dividend rate multiplier from
1.50 to 2.00, which could increase the dividend rate payable to ARPS
holders should the maximum dividend rate be determined via the
multiplier in lieu of the spread noted above (the maximum dividend rate
is based on the greater of a multiple of or a spread plus a reference rate)
and, thereby, increase the expenses to Common Shareholders
associated with the Fund’s leverage. In December 2022, Moody’s
downgraded its rating of the ARPS from “Aa3” to “A1,” stating that the
downgrades occurred because of, among other matters, trends in the
Fund’s risk-adjusted asset coverage metrics and the evolution of its
sector exposures. Under the Bylaws, the 2022 Moody’s downgrade
resulted in an increase in the applicable spread over the reference rate
from 150 bps to 200 bps. As noted herein, the maximum applicable rate
actually payable to ARPS holders is based on the greater of a multiple of
or a spread plus a reference rate, which is either the applicable Secured
Overnight Funding Rate or the applicable Treasury Index Rate
depending on the rate period. The applicable spread change resulting
from the 2022 Moody’s downgrade will therefore only impact the
maximum applicable rate if the applicable spread formula is greater
than the multiplier formula. See “Description of Capital Structure –
Preferred Share Dividends.” See “Use of Leverage” and “Description of
Capital Structure.” It is possible for the ARPS to be further downgraded
in the future, possibly resulting in further increases to the maximum
applicable rate and, thereby, the expenses borne by the Fund’s Common
Shareholders.
Therefore, it is possible that a substantial rise in market interest rates
and/ or further ratings downgrades of the ARPS could, by reducing
income available for distribution to the Common Shareholders and
otherwise detracting from the Fund’s investment performance, make the
Fund’s continued use of Preferred Shares for leverage purposes less
attractive than such use is currently considered to be. In such case, the
Fund may elect to redeem some or all of the Preferred Shares
outstanding, which may require it to dispose of investments at
inopportune times and to incur losses on such dispositions. Such
dispositions may adversely affect the Fund’s investment performance
generally, and the resultant loss of leverage may materially and
adversely affect the Fund’s investment returns to Common
Shareholders. The Fund has previously been required to redeem a
portion of its ARPS due to market dislocations that caused the value of
the Fund’s portfolio securities and related asset coverage to decline and
could be required to do so again in the future.
The Fund is also subject to certain asset coverage tests associated with
the rating agencies that rate the ARPS. Failure by the Fund to maintain
the asset coverages (or to cure such failure in a timely manner) may
require the Fund to redeem ARPS. Failure to satisfy ratings agency asset
coverage tests or other guidelines could also result in the applicable
ratings agency downgrading its then-current ratings on the ARPS, as
described above. Moreover, the rating agency guidelines impose
restrictions or limitations on the Fund’s use of certain financial
instruments or investment techniques that the Fund might otherwise
utilize in order to achieve its investment objective, which may adversely
affect the Fund’s investment performance. Rating agency guidelines may
be modified by the rating agencies in the future and such modifications
may make such guidelines substantially more restrictive or otherwise
result in downgrades, which could further negatively affect the Fund’s
investment performance. The ratings agencies that have assigned
ratings to the Fund’s preferred shares may change their rating
methodologies, perhaps substantially. Such a change could adversely
affect the ratings assigned to the Fund’s Preferred Shares, the dividend
rates paid thereon, and the expenses borne by the Fund’s Common
Shareholders.
Certain Affiliations
Certain broker-dealers may be considered to be affiliated persons of the
Fund and/or the Investment Manager, or another Allianz entity. Allianz
Asset Management of America LP merged with Allianz Asset
Management, with the latter being the surviving entity, effective
January 1, 2023. Following the merger, Allianz Asset Management is
PIMCO LLC’s managing member and direct parent entity, due to their
possible affiliations with Allianz SE, the ultimate parent of the
Investment Manager. Absent an exemption from the SEC or other
regulatory relief, the Fund is generally precluded from effecting certain
principal transactions with affiliated brokers, and its ability to purchase
securities being underwritten by an affiliated broker or a syndicate
including an affiliated broker, or to utilize affiliated brokers for agency
transactions, is subject to restrictions. This could limit the Fund’s ability
to engage in securities transactions and take advantage of market
opportunities.
The Fund has received exemptive relief from the SEC that, to the extent
the Fund relies on such relief, permits it to (among other things)
co-invest with certain other persons, including certain affiliates of the
Investment Manager and certain public or private funds managed by the
Investment Manager and its affiliates, subject to certain terms and
conditions. The exemptive relief from the SEC with respect to co
investments imposes extensive conditions on any co-investments made
in reliance on such relief.
Anti-Takeover Provisions
The Fund’s Amended and Restated Agreement and Declaration of Trust
(the “Declaration”) and the Fund’s Bylaws (the “Bylaws”) include
provisions that could limit the ability of other entities or persons to
acquire control of the Fund or to convert the Fund to open-end status.
See “Anti-Takeover and Other Provisions in the Agreement and
Declaration of Trust and Bylaws.” These provisions in the Declaration
29 Base Prospectus
| PIMCO Income Strategy Fund II
Base Prospectus
and the Bylaws could have the effect of depriving the Common
Shareholders of opportunities to sell their Common Shares at a premium
over the then-current market price of the Common Shares or at NAV.
Distribution Rate Risk
Although the Fund may seek to maintain level distributions, the Fund’s
distribution rates may be affected by numerous factors, including but
not limited to changes in realized and projected market returns,
fluctuations in market interest rates, Fund performance, and other
factors. There can be no assurance that a change in market conditions or
other factors will not result in a change in the Fund’s distribution rate or
that the rate will be sustainable in the future.
For instance, during periods of low or declining interest rates, the Fund’s
distributable income and dividend levels may decline for many reasons.
For example, the Fund may have to deploy uninvested assets (whether
from sales of Fund shares, proceeds from matured, traded or called debt
obligations or other sources) in new, lower yielding instruments.
Additionally, payments from certain instruments that may be held by the
Fund (such as variable and floating rate securities) may be negatively
impacted by declining interest rates, which may also lead to a decline in
the Fund’s distributable income and dividend levels.
[], 2024 |
Base Prospectus
30
PIMCO Income Strategy Fund II
Summary of Fund Expenses
The following table is intended to assist investors in understanding the
fees and expenses (annualized) that an investor in Common Shares of
the Fund would bear, directly or indirectly, as a result of an offering. The
table reflects the use of leverage attributable to the Fund’s outstanding
Preferred Shares and reverse repurchase agreements averaged over the
period ended December 31, 2023 in an amount equal to 21.14% of the
Fund’s total average managed assets (including assets attributable to
such leverage) and 26.80% of the Fund's total average net assets
attributable to Common Shares), and shows Fund expenses as a
percentage of net assets attributable to Common Shares. The
percentages above do not reflect the Fund’s use of other forms of
economic leverage, such as credit default swaps or other derivative
instruments. The table and example below are based on the Fund’s
capital structure as of December 31, 2023. The extent of the Fund’s
assets attributable to leverage following an offering, and the Fund’s
associated expenses, are likely to vary (perhaps significantly) from these
assumptions.
Shareholder Transaction Expenses:
| Sales load (as a percentage of offering price) (1) |
[--]% |
| Offering Expenses Borne by Common Shareholders ( price) (2) |
[--]% |
| Dividend Reinvestment Plan Fees (3) |
None |
1
In the event that the Common Shares to which this prospectus relates are sold to or
through underwriters or dealer managers, a corresponding prospectus supplement will
disclose the applicable sales load and/or commission.
2
The related prospectus supplement will disclose the estimated amount of offering
expenses, the offering price and the offering expenses borne by the Fund and indirectly
by all of its Common Shareholders as a percentage of the offering price.
3
You will pay brokerage charges if you direct your broker or the plan agent to sell your
Common Shares that you acquired pursuant to a dividend reinvestment plan. You may
also pay a pro rata share of brokerage commissions incurred in connection with
open-market purchases pursuant to the Fund’s Dividend Reinvestment Plan. See
“Dividend Reinvestment Plan.”
Annual Expenses
| |
Percentage of Net Assets Attributable to Common Shares (reflecting leverage attributable to ARPS and reverse repurchase agreements) |
| Management Fees (1) |
1.09% |
| Dividend Cost on Preferred Shares (2) |
0.73% |
| Interest Payments on Borrowed Funds (3) |
1.90% |
| Other Expenses (4) |
0.08% |
| Total Annual Expenses (5) |
3.80% |
1
Management Fees include fees payable to the Investment Manager for advisory
services and for supervisory, administrative and other services. The Fund pays for the
advisory, supervisory and administrative services it requires under what is essentially
an all-in fee structure (the “unified management fee”). Pursuant to an investment
management agreement, PIMCO is paid a Management Fee of 0.83% of the Fund’s
average weekly total managed assets.
“Total managed assets” includes the total assets of the Fund (including any assets attributable to any preferred shares or other
forms of leverage that may be outstanding) minus accrued liabilities (other than
liabilities representing leverage). The Fund (and not PIMCO) will be responsible for
certain fees and expenses, which are reflected in the table above, that are not covered
by the unified management fee under the investment management agreement. Please
see “Management of the Fund — Investment Management Agreement” for an
explanation of the unified management fee.
2
Reflects the Fund’s outstanding Preferred Shares as of December 31, 2023, which
represented 5.37% of the Fund’s total average managed assets (including the
liquidation preference of outstanding Preferred Shares and assets attributable to
reverse repurchase agreements), at an estimated annual dividend rate to the Fund of
10.78% (based on the weighted average Preferred Share dividend rate during the
period ended December 31, 2023) and assumes the Fund will continue to pay
Preferred Share dividends at the “maximum applicable rate” called for under the
Fund’s Bylaws due to the ongoing failure of auctions for the ARPS. The actual dividend
rate paid on the ARPS will vary over time in accordance with variations in market
interest rates. See “Use of Leverage” and “Description of Capital Structure.”
3
Reflects the Fund’s use of leverage in the form of reverse repurchase agreements
averaged over the period ended December 31, 2023, which represented 15.76% of
the Fund’s total average managed assets (including assets attributable to reverse
repurchase agreements), at an annual interest rate cost to the Fund of 5.70%, which is
the weighted average interest rate cost during the period ended December 31, 2023.
See “Use of Leverage—Effects of Leverage”. The actual amount of interest expense
borne by the Fund will vary over time in accordance with the level of the Fund’s use of
reverse repurchase agreements, dollar rolls/buybacks and/or borrowings and variations
in market interest rates. Borrowing expense is required to be treated as an expense of
the Fund for accounting purposes. Any associated income or gains (or losses) realized
from leverage obtained through such instruments is not reflected in the Annual
Expenses table above, but would be reflected in the Fund’s performance results.
4
Other expenses are estimated for the Fund’s current fiscal year ending June 30, 2024.
5
“Dividend Cost on Preferred Shares,” including distributions on Preferred Shares, and
”Interest Payments on Borrowed Funds“ are borne by the Fund separately from
management fees paid to PIMCO. Excluding these expenses, Total Annual Fund
Operating Expenses are 1.17%. Excluding only distributions on Preferred Shares of
0.73%, Total Annual Fund Operating Expenses are 3.07%.
Example
The following example illustrates the expenses that you would pay on a
$1,000 investment in Common Shares of the Fund, assuming (1) that
the Fund’s net assets do not increase or decrease, (2) that the Fund
incurs total annual expenses of 3.80% of net assets attributable to
Common Shares in years 1 through 10 (assuming assets attributable to
Preferred Shares and assets attributable to reverse repurchase
agreements representing 21.14% of the Fund’s total managed assets)
and (3) a 5% annual return
(1)
:
| |
1 Year |
3 Years |
5 Years |
10 Years |
| Total Expenses Incurred |
$38 |
$116 |
$196 |
$404 |
(1)
The example above should not be considered a representation of future
expenses. Actual expenses may be higher or lower than those shown.
The
example assumes that the estimated Interest Payments on Borrowed Funds, Dividend
Cost on Preferred Shares and Other Expenses set forth in the Annual Expenses table
are accurate, that the rate listed under Total Annual Expenses remains the same each
year and that all dividends and distributions are reinvested at NAV. Actual expenses
may be greater or less than those assumed. Moreover, the Fund’s actual rate of return
may be greater or less than the hypothetical 5% annual return shown in the example.
The example does not include commissions or estimated offering expenses, which
would cause the expenses shown in the example to increase. In connection with an
offering of Common Shares, the prospectus supplement will set forth an example
including sales load and estimated offering costs.
31
PIMCO Income Strategy Fund II |
Base Prospectus
PIMCO Income Strategy Fund II
Financial Highlights
The information in the table below for the fiscal year ended June 30, 2023, the fiscal period ended June 30, 2022
(1)
, the fiscal years ended July 31,
2021, July 31, 2020 and July 31, 2019, the fiscal years ended July 31, 2018, July 31, 2017, July 31, 2016, July 31, 2015, July 31, 2014, and July 31,
2013 is derived from the Fund’s financial statements for the fiscal year ended June 30, 2023 audited by PricewaterhouseCoopers LLP (“PwC”), whose
report on such financial statements is contained in the Fund’s June 30, 2023 Annual Report and is incorporated by reference into the Statement of
Additional Information. The information shown for the six months ended December 31, 2023 is unaudited.
(1)
On March 25, 2022, the Board approved a change to the Fund’s fiscal year end from July 31 to June 30, effective April 1, 2022.
Investment Operations |
Less Distributions to ARPS (c) |
Less Distributions to Common Shareholders (d) | ||||||||
Selected Per Share Data for the Year or Period Ended^: |
Net Asset Value Beginning of Year or Period (a) |
Net Investment Income (Loss) (b) |
Net Realized/ Unrealized Gain (Loss) |
From Net Investment Income |
From Net Realized Capital Gains |
Net Increase (Decrease) in Net Assets Applicable to Common Shareholders Resulting from Operations |
From Net Investment Income |
From Net Realized Capital Gains |
Tax Basis Return of Capital |
Total |
PIMCO Income Strategy Fund II |
||||||||||
07/01/2023-12/31/2023 + |
$ 6.85 |
$ 0.35 |
$ 0.39 |
$ (0.04) |
$ 0.00 |
$ 0.70 |
$ (0.43) |
$ 0.00 |
$ 0.00 |
$ (0.43) |
06/30/2023 |
7.38 |
0.76 |
(0.37) |
(0.08) |
0.00 |
0.31 |
(0.86) |
0.00 |
0.00 |
(0.86) |
08/01/2021-6/30/2022 (i) |
9.42 |
0.67 |
(1.90) |
(0.02) |
0.00 |
(1.25) |
(0.80) |
0.00 |
0.00 |
(0.80) (j) |
07/31/2021 |
8.53 |
0.78 |
1.05 |
(0.02) |
0.00 |
1.81 |
(0.75) |
0.00 |
(0.21) |
(0.96) |
07/31/2020 |
9.91 |
0.86 |
(1.32) |
(0.03) |
0.00 |
(0.49) |
(0.90) |
0.00 |
(0.06) |
(0.96) |
07/31/2019 |
10.07 (h) |
0.83 |
0.04 |
(0.05) |
0.00 |
0.82 |
(1.03) |
0.00 |
0.00 |
(1.03) |
07/31/2018 |
10.33 |
0.79 |
(0.05) |
(0.04) |
0.00 |
0.70 |
(0.96) |
0.00 |
0.00 |
(0.96) |
07/31/2017 |
9.42 |
0.80 |
1.10 |
(0.03) |
0.00 |
1.87 |
(0.96) |
0.00 |
0.00 |
(0.96) |
07/31/2016 |
10.27 |
0.87 |
(0.67) |
(0.02) |
0.00 |
0.18 |
(1.03) |
0.00 |
0.00 |
(1.03) |
07/31/2015 |
10.88 |
0.70 |
(0.29) |
(0.03) |
0.00 |
0.38 |
(1.11) |
0.00 |
0.00 |
(1.11) |
07/31/2014 |
10.29 |
0.72 |
0.87 |
(0.04) |
0.00 |
1.55 |
(0.96) |
0.00 |
0.00 |
(0.96) |
07/31/2013 |
10.23 |
0.88 |
0.68 |
(0.04) |
0.00 |
1.52 |
(1.46) |
0.00 |
0.00 |
(1.46) |
33 Base Prospectus
| PIMCO Income Strategy Fund II
Base Prospectus
Common Share |
Ratios/Supplemental Data | |||||||||||
Ratios to Average Net Assets (f)(k) | ||||||||||||
Increase Resulting from Common Share Offering |
Offering Cost Charged to Paid in Capital |
Increase Resulting from Tender of ARPS (c) |
Net Asset Value End of Period (a) |
Market Price End of Year or Period |
Total Investment Return (e) |
Net Assets Applicable to Common Shareholders End of Year (000s) |
Expense (g) |
Expenses Excluding Waivers (g) |
Expenses Excluding Interest Expense |
Expenses Excluding Interest Expense and Waivers |
Net Investment Income (Loss) |
Portfolio Turnover Rate |
$ 0.00 |
$ 0.00 |
$ 0.00 |
$ 7.12 |
$ 7.23 |
6.80 % |
$ 603,305 |
3.07 %* |
3.07 %* |
1.17 %* |
1.17 %* |
10.45 %* |
9 % |
0.02 |
0.00 |
0.00 |
6.85 |
7.21 |
2.62 |
577,280 |
2.57 |
2.57 |
1.22 |
1.22 |
10.60 |
33 |
0.01 |
0.00 |
0.00 |
7.38 |
7.92 |
(21.31 ) |
581,955 |
1.54 * |
1.54 * |
1.29 * |
1.29 * |
8.32 * |
45 |
0.04 |
0.00 |
0.00 |
9.42 |
11.01 |
37.03 |
723,617 |
1.54 |
1.54 |
1.29 |
1.29 |
8.58 |
38 |
0.07 |
(0.00 ) |
0.00 |
8.53 |
8.88 |
(7.75 ) |
605,851 |
1.62 |
1.62 |
1.15 |
1.15 |
9.49 |
21 |
0.04 |
0.00 |
0.01 |
9.91 |
10.70 |
11.03 |
632,927 |
1.66 |
1.66 |
1.12 |
1.12 |
8.57 |
17 |
N/A |
N/A |
0.00 |
10.07 (h) |
10.70 |
9.19 |
600,890 |
1.41 |
1.41 |
1.10 |
1.10 |
7.79 |
18 |
N/A |
N/A |
0.00 |
10.33 |
10.76 |
26.32 |
612,310 |
1.26 |
1.26 |
1.09 |
1.09 |
8.15 |
26 |
N/A |
N/A |
0.00 |
9.42 |
9.39 |
11.92 |
556,840 |
1.14 |
1.14 |
1.07 |
1.07 |
9.25 |
38 |
N/A |
N/A |
0.12 |
10.27 |
9.41 |
(0.12 ) |
606,974 |
1.16 |
1.16 |
1.13 |
1.13 |
6.58 |
63 |
N/A |
N/A |
0.00 |
10.88 |
10.50 |
12.39 |
642,119 |
1.14 |
1.14 |
1.14 |
1.14 |
6.79 |
119 |
N/A |
N/A |
0.00 |
10.29 |
10.24 |
6.80 |
605,843 |
1.16 |
1.16 |
1.14 |
1.14 |
8.20 |
71 |
[], 2024 |
Base Prospectus
34
PIMCO Income Strategy Fund II
ARPS | ||||
Selected Per Share Data for the Year or Period Ended^: |
Total Amount Outstanding |
Asset Coverage per Preferred Share (1) |
Involuntary Liquidating Preference per Preferred Share (2) |
Average Market Value per ARPS (3) |
PIMCO Income Strategy Fund II |
||||
7/1/2023 – 12/31/2023 + |
$ 38,900,000 |
$ 411,598 |
$ 25,000 |
N/A |
6/30/2023 |
87,425,000 |
189,850 |
25,000 |
N/A |
8/1/2021 - 6/30/2022 (i) |
87,425,000 |
191,350 |
25,000 |
N/A |
7/31/2021 |
87,425,000 |
231,880 |
25,000 |
N/A |
7/31/2020 |
87,425,000 |
198,210 |
25,000 |
N/A |
7/31/2019 |
87,425,000 |
205,928 |
25,000 |
N/A |
7/31/2018 |
92,450,000 |
187,429 |
25,000 |
N/A |
7/31/2017 + |
92,450,000 |
190,527 |
25,000 |
N/A |
7/31/2016 + |
92,450,000 |
175,544 |
25,000 |
N/A |
7/31/2015 + |
92,450,000 |
189,105 |
25,000 |
N/A |
7/31/2014 + |
161,000,000 |
124,695 |
25,000 |
N/A |
7/31/2013 + |
161,000,000 |
119,060 |
25,000 |
N/A |
^
A zero balance may reflect actual amounts rounding to less than $0.01 or 0.01%.
+
Unaudited.
*
Annualized, except for organizational expense, if any.
(a)
Includes adjustments required by U.S. GAAP and may differ from net asset values and performance reported elsewhere by the Funds.
(b)
Per share amounts based on average number of common shares outstanding during the year or period.
(c)
Auction Rate Preferred Shareholders (“ARPS”).
(d)
The tax characterization of distributions is determined in accordance with Federal income tax regulations. The actual tax characterization of distributions paid is determined at the end
of the fiscal year.
(e)
Total investment return is calculated assuming a purchase of a common share at the market price on the first day and a sale of a common share at the market price on the last day of
each year or period reported. Dividends and distributions, if any, are assumed, for purposes of this calculation, to be reinvested at prices obtained under the Funds’ dividend
reinvestment plan. Total investment return does not reflect brokerage commissions in connection with the purchase or sale of Fund shares.
(f)
Calculated on the basis of income and expenses applicable to both common and preferred shares relative to the average net assets of common shareholders. The expense ratio and net
investment income do not reflect the effects of dividend payments to preferred shareholders.
(g)
Ratio includes interest expense which primarily relates to participation in borrowing and financing transactions.
(h)
The NAV presented may differ from the NAV reported for the same period in other Fund materials.
(i)
Fiscal year end changed from July 31st to June 30th.
(j)
Total distributions for the period ended June 30, 2022 may be lower than prior fiscal years due to fiscal year end change resulting in a reduction of the amount of days in the period
ended June 30, 2022.
(k)
Ratios shown do not include expenses of the investment companies in which a Fund may invest.
1
“Asset Coverage per Preferred Share” means the ratio that the value of the total assets of the Fund, less all liabilities and indebtedness not represented by ARPS, bears to the aggregate
of the involuntary liquidation preference of ARPS, expressed as a dollar amount per ARPS.
2
“Involuntary Liquidating Preference” means the amount to which a holder of ARPS would be entitled upon the involuntary liquidation of the Fund in preference to the Common
Shareholders, expressed as a dollar amount per Preferred Share.
3
The ARPS have no readily ascertainable market value. Auctions for the ARPS have failed since February 2008, there is currently no active trading market for the ARPS and the Fund is not
able to reliably estimate what their value would be in a third-party market sale. The liquidation value of the ARPS represents its liquidation preference, which approximates fair value of
the shares less any accumulated unpaid dividends.
35 Base Prospectus
| PIMCO Income Strategy Fund II
Base Prospectus
Use of Proceeds
The net proceeds of an offering will be invested in accordance with the
Fund’s investment objective and policies as set forth below. It is
currently anticipated that the Fund will be able to invest substantially all
of the net proceeds of an offering in accordance with its investment
objective and policies within approximately 30 days of receipt by the
Fund, depending on the amount and timing of proceeds available to the
Fund as well as the availability of investments consistent with the
Fund’s investment objective and policies, and except to the extent
proceeds are held in cash to pay dividends or expenses, or for temporary
defensive purposes. Pending such investment, it is anticipated that the
proceeds of an offering will be invested in high grade, short-term
securities, credit-linked trust certificates, and/or high yield securities
index futures contracts or similar derivative instruments designed to
give the Fund exposure to the securities and markets in which it intends
to invest while PIMCO selects specific investments.
The Fund
The Fund is a diversified, closed-end management investment company.
The Fund was organized as a Massachusetts business trust on June 30,
2004, pursuant to an Agreement and Declaration of Trust governed by
the laws of the Commonwealth of Massachusetts. The Fund commenced
operations on October 29, 2004, following the initial public offering of
its Common Shares. Effective March 1, 2010, the Fund changed its
name from PIMCO Floating Rate Strategy Fund to its current name,
PIMCO Income Strategy Fund II.
Investment Objective and Policies
When used in this prospectus, the term “invest” includes both direct
investing and indirect investing and the term “investments” includes
both direct investments and indirect investments. For example, the Fund
may invest indirectly by investing in derivatives or through its
Subsidiaries. References herein to the Fund include, as appropriate,
Subsidiaries through which the Fund may gain exposure to investments.
The Fund may be exposed to the different types of investments
described below through its investments in its Subsidiaries. The
allocation of the Fund's assets to a Subsidiary will vary over time and
will likely not include all of the different types of investments described
herein at any given time. The Fund does not intend to create or acquire
primary control of any entity which engages in investment activities in
securities or other assets other than entities wholly-owned by the Fund.
The Fund’s investment objective is to seek high current income,
consistent with the preservation of capital. The Fund seeks to achieve its
objective by ordinarily investing in a diversified portfolio of floating-
and/or fixed-rate debt instruments. The Fund may invest a substantial
portion of its floating-rate assets in floating-rate loans. Other
floating-rate debt instruments in which the Fund may invest include
catastrophe and other event-linked bonds, bank capital securities,
unsecured and/or secured loans (including, but not limited to, bank
and/or other syndicated loans and non-syndicated (private direct)
loans), corporate bonds and other debt securities, money market
instruments and certain types of mortgage-backed and other
asset-backed securities that pay interest at rates that adjust whenever a
specified interest rate changes and/or reset on predetermined dates
(such as the last day of a month or calendar quarter). The types of
securities and instruments in which the Fund may invest are
summarized under “Portfolio Contents” below. The Fund cannot assure
you that it will achieve its investment objective, and you could lose all of
your investment in the Fund.
The Fund cannot change its investment objective without the approval
of the holders of a “majority of the outstanding” Common Shares and
any Preferred Shares voting together as a single class, and of the
holders of a “majority of the outstanding” Preferred Shares voting as a
separate class. A “majority of the outstanding” shares (whether voting
together as a single class or voting as a separate class) means (i) 67%
or more of such shares present at a meeting, if the holders of more than
50% of those shares are present or represented by proxy, or (ii) more
than 50% of such shares, whichever is less. See “Description of
Preferred Shares—Voting Rights” for additional information with
respect to the voting rights of holders of Preferred Shares.
Portfolio Management Strategies
Dynamic Allocation Strategy.
In managing the Fund, PIMCO
employs an active approach to allocation among multiple fixed income
sectors based on, among other things, market conditions, valuation
assessments, economic outlook, credit market trends and other
economic factors. With PIMCO’s macroeconomic analysis as the basis
for top-down investment decisions, including geographic and credit
sector emphasis, PIMCO manages the Fund with a focus on seeking
income generating investment ideas across multiple fixed income
sectors, with an emphasis on seeking opportunities in developed and
emerging global credit markets. The Fund has the flexibility to allocate
assets in varying proportions among floating- and fixed-rate debt
instruments, as well as among investment-grade and non-investment
grade securities. It may focus more heavily or exclusively on an asset
class at any time, based on assessments of relative values, market
conditions and other factors. PIMCO may choose to focus on particular
countries/regions, asset classes, industries and sectors to the exclusion
of others at any time and from time to time based on market conditions
and other factors. The relative value assessment within fixed income
sectors draws on PIMCO’s regional and sector specialist insights. The
Fund will observe various investment guidelines as summarized below.
Investment Selection Strategies.
Once the Fund’s top-down,
portfolio positioning decisions have been made as described above,
PIMCO selects particular investments for the Fund by employing a
bottom-up, disciplined credit approach which is driven by fundamental,
independent research within each sector/asset class represented in the
Fund, with a focus on identifying securities and other instruments with
solid and/or improving fundamentals.
PIMCO utilizes strategies that focus on credit quality analysis, duration
management and other risk management techniques. PIMCO attempts
to identify, through fundamental research driven by independent credit
analysis and proprietary analytical tools, debt obligations and other
income-producing securities that provide current income and/or
[], 2024 |
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36
PIMCO Income Strategy Fund II
opportunities for capital appreciation based on its analysis of the
issuer’s credit characteristics and the position of the security in the
issuer’s capital structure.
Consideration of yield is only one component of the portfolio managers’
approach in managing the Fund. PIMCO also attempts to identify
investments that may appreciate in value based on PIMCO’s assessment
of the issuer’s credit characteristics, forecast for interest rates and
outlook for particular countries/regions, currencies, industries, sectors
and the global economy and bond markets generally.
In selecting investments for the Fund, PIMCO may use proprietary
quantitative models that are developed and maintained by PIMCO, and
which are subject to change over time without notice in PIMCO's
discretion.
Credit Quality.
The Fund may invest without limit in debt securities
that are, at the time of purchase, rated below investment grade or that
are unrated but judged by PIMCO to be of comparable quality
(commonly referred to as “high yield” securities or “junk bonds”). The
Fund will not normally invest more than 20% of its total assets in debt
instruments, other than mortgage-related and other asset-backed
securities, that are, at the time of purchase, rated CCC+ or lower by S&P
and Fitch and Caa1 or lower by Moody’s, or that are unrated but
determined to be of comparable quality. The Fund may invest without
limit in mortgage-related and other asset-backed securities regardless
of rating (i.e., of any credit quality). Subject to this 20% restriction, the
Fund may invest in issuers of any credit quality (including bonds in the
lowest ratings categories and securities that are in default or the issuers
of which are in bankruptcy) if PIMCO determines that the particular
obligation is undervalued or offers an attractive yield relative to its risk
profile. For purposes of applying the foregoing policies, in the case of
securities with split ratings (i.e., a security receiving two different ratings
from two different rating agencies), the Fund will apply the higher of the
applicable ratings. Subject to the aforementioned investment
restrictions, the Fund may invest in securities of stressed issuers, which
include securities at risk of being in default as to the repayment of
principal and/or interest at the time of acquisition by the Fund or that
are rated in the lower rating categories by one or more nationally
recognized statistical rating organizations (for example, Ca or lower by
Moody’s or CC or lower by S&P or Fitch) or, if unrated, are determined
by PIMCO to be of comparable quality. Debt instruments of below
investment grade quality are regarded as having predominantly
speculative characteristics with respect to capacity to pay interest and to
repay principal, and are commonly referred to as “high yield” securities
or “junk bonds.” Debt instruments in the lowest investment grade
category also may be considered to possess some speculative
characteristics. The Fund may, for hedging, investment or leveraging
purposes, make use of credit default swaps, which are contracts
whereby one party makes periodic payments to a counterparty in
exchange for the right to receive from the counterparty a payment equal
to the par (or other agreed-upon) value of a referenced debt obligation
in the event of a default or other credit event by the issuer of the debt
obligation.
Independent Credit Analysis.
PIMCO relies primarily on its own
analysis of the credit quality and risks associated with individual debt
instruments considered for the Fund, rather than relying exclusively on
rating agencies or third-party research. The Fund’s portfolio managers
utilize this information in an attempt to manage credit risk and/or to
identify issuers, industries or sectors that are undervalued and/or offer
attractive yields relative to PIMCO’s assessment of their credit
characteristics. This aspect of PIMCO’s capabilities will be particularly
important to the extent that the Fund invests in floating rate loans, high
yield securities and in securities of emerging market issuers.
Duration Management.
It is expected that the Fund normally will
have a short to intermediate average portfolio duration (i.e., within a
zero to eight (0 to 8) year range), as calculated by PIMCO, although it
may be shorter or longer at any time or from time to time depending on
market conditions and other factors. For example, if the Fund has an
average portfolio duration of eight years, a 1% increase in interest rates
would tend to correspond to an 8% decrease in the value of the Fund’s
debt portfolio. While the Fund seeks to maintain a short to intermediate
average portfolio duration, there is no limit on the maturity or duration
of any individual security in which the Fund may invest. Duration is a
measure used to determine the sensitivity of a security’s price to
changes in interest rates. The Fund’s duration strategy may entail
maintaining a negative average portfolio duration from time to time,
meaning the portfolio would tend to increase in value in response to an
increase in interest rates. For example, if the Fund has a negative
average portfolio duration, a 1% increase in interest rates would tend to
correspond to a 1% increase in the value of the Fund’s debt portfolio for
every year of negative duration. A negative average portfolio duration
would potentially benefit the portfolio in an environment of rising
market interest rates, but would generally adversely impact the portfolio
in an environment of falling or neutral market interest rates. The Fund
may use various derivatives strategies to manage (increase or decrease)
the dollar-weighted average effective duration of the Fund’s portfolio.
PIMCO may also utilize certain strategies, including without limit
investments in structured notes or interest rate futures contracts or
swap, cap, floor or collar transactions, for the purpose of reducing the
interest rate sensitivity of the Fund’s portfolio, although there is no
assurance that it will do so or that such strategies will be successful. See
“Principal Risks of the Fund—Interest Rate Risk.”
Portfolio Contents
Principal Investment Techniques
The Fund seeks to achieve its investment objective by ordinarily
investing in a diversified portfolio of floating- and/or fixed-rate debt
instruments. The Fund may invest a substantial portion of its
floating-rate assets in floating-rate loans. Other floating-rate debt
instruments in which the Fund may invest include catastrophe and other
event-linked bonds, bank capital securities, unsecured and/or secured
loans (including, but not limited to, bank and/or other syndicated loans
and non-syndicated (private direct) loans), corporate bonds and other
debt securities, money market instruments and certain types of
mortgage-backed and other asset-backed securities that pay interest at
37 Base Prospectus
| PIMCO Income Strategy Fund II
Base Prospectus
rates that adjust whenever a specified interest rate changes and/or reset
on predetermined dates (such as the last day of a month or calendar
quarter). The Fund also considers floating-rate assets to include
securities with durations of less than or equal to one year and fixed-rate
securities with respect to which the Fund has entered into derivative
instruments to effectively convert the fixed-rate interest payments into
floating-rate interest payments. The Fund also may invest in a wide
variety of fixed-rate debt securities, including corporate bonds and
mortgage-backed and other asset-backed securities issued on a public
or private basis, including mortgage pass-through securities, CMOs,
commercial or residential mortgage-backed securities, mortgage dollar
rolls/buybacks, CMO residuals, SMBSs and other securities that directly
or indirectly represent a participation in, or are secured by and payable
from, mortgage loans on real property. The Fund may make use of a
variety of other instruments, including CBOs, CLOs, CDOs, preferred
securities, commercial paper, zero-coupon and inflation-indexed bonds,
bank certificates of deposit, fixed time deposits and bankers’
acceptances, real estate investment trusts (“REITs”), bonds, debentures,
notes, and other debt securities of U.S. and foreign (non-U.S.) corporate
and other issuers; obligations of foreign governments or their
sub-divisions, agencies and government sponsored enterprises and
obligations of international agencies and supranational entities;
municipal securities and other debt securities issued by states or local
governments and their agencies, authorities and other
government-sponsored enterprises, including taxable municipal
securities (such as Build America Bonds); inflation-indexed bonds issued
by both governments and corporations; structured notes, including
hybrid or indexed securities; credit-linked notes; structured credit
products; loans (including, among others, senior loans, delayed draw
and delayed funding loans, revolving credit facilities and loan
participations and assignments); covenant-lite obligations; preferred
securities and convertible debt securities (i.e., debt securities that may
be converted at either a stated price or stated rate into underlying
shares of common stock), including synthetic convertible debt securities
(i.e., instruments created through a combination of separate securities
that possess the two principal characteristics of a traditional convertible
security, such as an income-producing security and the right to acquire
an equity security) and CoCos. Certain debt instruments, such as
convertible bonds, also may include the right to participate in equity
appreciation. The principal and/or interest rate on some debt
instruments may be determined by reference to the performance of a
benchmark asset or market, such as an index of securities, or the
differential performance of two assets or markets, such as the level of
exchange rates between the U.S. dollar and a foreign currency or
currencies. The Fund may invest in debt securities of stressed, distressed
and defaulted issuers. Subject to the Fund’s investment limitations, at
any given time and from time to time, substantially all of the Fund’s
portfolio may consist of below investment grade securities. The Fund
may invest in various levels of the capital structure of an issuer of
mortgage-backed or asset-backed securities, including the equity or
“first loss” tranche. The Fund may invest in unsecured loans and
subordinated or mezzanine obligations, including second and lower lien
loans and the mezzanine and equity (or “first loss”) tranches of CLO
issues. For the avoidance of doubt, equity or “first loss” tranches of
mortgage-backed or asset-backed securities do not constitute equity
interests for purposes of the Fund’s 20% limit on investments in equity
interests described below. The Fund may also invest, as a third party
purchaser, in risk retention tranches of CMBS or other eligible
securitizations, which are eligible residual interests held by the sponsors
of such securitizations pursuant to the final rules implementing the
credit risk retention requirements of Section 941 of the Dodd-Frank Act.
The rate of interest on an income-producing security may be fixed,
floating or variable.
The Fund invests predominantly in U.S. dollar-denominated debt
securities, which may include those issued by foreign corporations or
supra-national government agencies. The Fund may invest without limit
in non-U.S. dollar denominated securities (of both developed and
“emerging market” countries), including obligations of
non-U.S. governments and their respective sub-divisions, agencies and
government-sponsored enterprises. The Fund may invest up to 40% of
its total assets in securities and instruments that are economically tied
to “emerging market” countries, except the Fund may invest without
limit in investments in short-term investment grade sovereign debt
issued by emerging market issuers. The Fund may also invest directly in
foreign currencies, including local emerging market currencies.
The Fund may invest up to 20% of its total assets in common stocks and
other equity securities from time to time, including those it has received
through the conversion of a convertible security held by the Fund or in
connection with the restructuring of a debt security. Common stocks
include common shares and other common equity interest issued by
public or private issuers.
The Fund may, but is not required to, utilize various derivative strategies
(both long and short positions) involving the purchase or sale of futures
and forward contracts (including foreign currency exchange contracts),
call and put options, credit default swaps, total return swaps, basis
swaps and other swap agreements and other derivative instruments for
investment purposes, leveraging purposes or in an attempt to hedge
against market, credit, interest rate, currency and other risks in the
portfolio. The Fund may purchase and sell securities on a when-issued,
delayed delivery or forward commitment basis and may engage in short
sales. The Fund may also seek to obtain market exposure to the
securities in which it invests by entering into a series of purchase and
sale contracts. The Fund may use derivative instruments for other
purposes, including to seek to increase liquidity, provide efficient
portfolio management, broaden investment opportunities (including
taking short or negative positions), implement a tax or cash
management strategy, gain exposure to a particular security or segment
of the market, modify the effective duration of the Fund's portfolio
investments and/or enhance total return.
The Fund has a policy not to concentrate investments in any particular
industry, but may (consistent with that policy) invest up to 25% of its
assets in any particular industry, and may invest a substantial portion of
its assets in companies in related sectors, such as those in the banking
or financial services sectors, which may share common characteristics
and are often subject to similar business risks and regulatory burdens.
[], 2024 |
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PIMCO Income Strategy Fund II
The Fund may invest without limit in debt securities that are, at the time
of purchase, rated below investment grade (commonly referred to as
“high yield” securities or “junk bonds”) and may also invest without
limit in investment grade securities. However, the Fund will not normally
invest more than 20% of its total assets in debt instruments, other than
mortgage-related and other asset-backed securities, that are, at the
time of purchase, rated CCC+ or lower by S&P and Fitch and Caa1 or
lower by Moody’s, or that are unrated but determined by PIMCO to be
of comparable quality. The Fund may invest without limit in
mortgage-related and other asset-backed securities regardless of
rating—i.e., of any credit quality.
The Fund may invest in securities that have not been registered for
public sale in the U.S. or relevant non-U.S. jurisdictions, including
without limit securities eligible for purchase and sale pursuant to
Rule 144A under the 1933 Act, or relevant provisions of applicable
non-U.S. law, and other securities issued in private placements. The
Fund may invest in securities of other open- or closed-end investment
companies (including those advised by PIMCO), including, without
limitation, ETFs, to the extent that such investments are consistent with
the Fund’s investment objective, strategies and policies and permissible
under the 1940 Act. The Fund may invest in REITs. The Fund may invest
in securities of companies of any market capitalization, including small
and medium capitalizations.
The Fund may invest without limit in illiquid investments (i.e.,
investments that the Fund reasonably expects cannot be sold or
disposed of in current market conditions in seven calendar days or less
without the sale or disposition significantly changing the market value
of the investment). The Fund may enter into repurchase agreements, in
which the Fund purchases a security from a bank or broker-dealer and
the bank or broker-dealer agrees to repurchase the security at the
Fund’s cost plus interest within a specified time.
The Fund may lend its portfolio securities to brokers, dealers or other
financial institutions provided a number of conditions are satisfied,
including that the loan is fully collateralized.
The Fund may engage in frequent and active trading of portfolio
securities to achieve its investment objective, particularly during periods
of volatile market movements.
In connection with rating the Fund’s outstanding auction rate preferred
shares of beneficial interest (“ARPS” and, together with any other
preferred shares the Fund may have outstanding, “Preferred Shares”),
Moody’s and Fitch impose asset coverage tests and other restrictions
that may limit the Fund’s ability to engage in certain of the transactions
described above.
The Fund cannot change its investment objective without the approval
(a) of the holders of a “majority of the outstanding” common shares
and any Preferred Shares voting together as a single class, and (b) of the
holders of a “majority of the outstanding” preferred shares (including
the Preferred Shares) voting as a separate class. A “majority of the
outstanding” shares (whether voting together as a single class or voting
as a separate class) means (i) 67% or more of such shares present at a
meeting, if the holders of more than 50% of those shares are present or
represented by proxy, or (ii) more than 50% of such shares, whichever is
less.
The Fund has received exemptive relief from the SEC that, to the extent
the Fund relies on such relief, permits it to (among other things)
co-invest with certain other persons, including certain affiliates of the
Investment Manager and certain public or private funds managed by the
Investment Manager and its affiliates, subject to certain terms and
conditions. The exemptive relief from the SEC with respect to co
investments imposes extensive conditions on any co-investments made
in reliance on such relief.
High Yield Securities
As noted above, the Fund will not normally invest more than 20% of its
total assets in debt instruments, other than mortgage-related and other
asset-backed instruments, that are, at the time of purchase, rated CCC+
or lower by S&P and Fitch and Caa1 or lower by Moody’s, or that are
unrated but determined to be of comparable quality to securities so
rated. The Fund may invest without limit in mortgage-related and other
asset-backed securities regardless of rating (i.e., of any credit quality).
For purposes of applying the foregoing policies, in the case of securities
with split ratings (i.e., a security receiving two different ratings from two
different rating agencies), the Fund will apply the higher of the
applicable ratings. Subject to the aforementioned investment
restrictions, the Fund may invest in securities of stressed or distressed
issuers, which include securities at risk of being in default as to the
repayment of principal and/or interest at the time of acquisition by the
Fund or that are rated in the lower rating categories by one or more
nationally recognized statistical rating organizations (for example, Ca or
lower by Moody’s or CC or lower by S&P or Fitch) or, if unrated, are
determined to be of comparable quality. The Fund may also invest in
defaulted securities and debtor-in-possession financings. Below
investment grade securities are commonly referred to as “high yield”
securities or “junk bonds.” High yield securities involve a greater degree
of risk (in particular, a greater risk of default) than, and special risks in
addition to the risks associated with, investment grade debt obligations.
While offering a greater potential opportunity for capital appreciation
and higher yields, high yield securities typically entail greater potential
price volatility and may be less liquid than higher-rated securities. High
yield securities may be regarded as predominantly speculative with
respect to the issuer’s continuing ability to make timely principal and
interest payments. They also may be more susceptible to real or
perceived adverse economic and competitive industry conditions than
higher-rated securities. Debt securities in the lowest investment grade
category also may be considered to possess some speculative
characteristics by certain ratings agencies.
The market values of high yield securities tend to reflect individual
developments of the issuer to a greater extent than do higher-quality
securities, which tend to react mainly to fluctuations in the general level
of interest rates. In addition, lower-quality debt securities tend to be
more sensitive to general economic conditions. Certain emerging market
governments that issue high yield securities in which the Fund may
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| PIMCO Income Strategy Fund II
Base Prospectus
invest are among the largest debtors to commercial banks, foreign
governments and supranational organizations, such as the World Bank,
and may not be able or willing to make principal and/or interest
payments as they come due.
Credit ratings and unrated securities.
Rating agencies are private
services that provide ratings of the credit quality of debt obligations.
Appendix A to this prospectus describes the various ratings assigned to
debt obligations by Moody’s, S&P and Fitch. As noted in Appendix A,
Moody’s, S&P and Fitch may modify their ratings of securities to show
relative standing within a rating category, with the addition of
numerical modifiers (1, 2 or 3) in the case of Moody’s, and with the
addition of a plus (+) or minus (-) sign in the case of S&P and Fitch.
Ratings assigned by a rating agency are not absolute standards of credit
quality and do not evaluate market risks. Rating agencies may fail to
make timely changes in credit ratings and an issuer’s current financial
condition may be better or worse than a rating indicates. The Fund will
not necessarily sell a security when its rating is reduced below its rating
at the time of purchase. The ratings of a debt security may change over
time. Moody’s, S&P and Fitch monitor and evaluate the ratings assigned
to securities on an ongoing basis. As a result, debt instruments held by
the Fund could receive a higher rating (which would tend to increase
their value) or a lower rating (which would tend to decrease their value)
during the period in which they are held by the Fund.
The Fund may purchase unrated securities (which are not rated by a
rating agency) if PIMCO determines, in its sole discretion, that the
security is of comparable quality to a rated security that the Fund may
purchase. In making these determinations, PIMCO may take into
account different factors than those taken into account by rating
agencies, and PIMCO’s rating of a security may differ from the rating
that a rating agency may have given the same security. Unrated
securities may be less liquid than comparable rated securities and
involve the risk that the portfolio manager may not accurately evaluate
the security’s comparative credit rating. Analysis of the creditworthiness
of issuers of high yield securities may be more complex than for issuers
of higher-quality fixed income securities. The Fund’s success in achieving
its investment objective may depend more heavily on PIMCO’s credit
analysis to the extent that the Fund invests in below investment grade
quality and unrated securities.
Corporate Bonds
The Fund may invest in a wide variety of bonds of varying maturities
issued by U.S. and foreign corporations and other business entities.
Bonds are fixed or variable rate debt obligations, including bills, notes,
debentures, money market instruments and similar instruments and
securities. Bonds generally are used by corporations as well as
governments and other issuers to borrow money from investors. The
issuer pays the investor a fixed or variable rate of interest and normally
must repay the amount borrowed on or before maturity. Certain bonds
are “perpetual” in that they have no maturity date.
Variable- and Floating-Rate Securities
Variable- and floating-rate instruments are instruments that pay interest
at rates that adjust whenever a specified interest rate changes and/or
that reset on predetermined dates (such as the last day of a month or
calendar quarter). In addition to loans, variable- and floating-rate
instruments may include, without limitation, instruments such as
catastrophe and other event-linked bonds, bank capital securities,
unsecured and/or secured loans (including, but not limited to, bank
and/or other syndicated loans and non-syndicated (private direct)
loans), corporate bonds, money market instruments and certain types of
mortgage-related and other asset-backed securities. Due to their
variable- or floating-rate features, these instruments will generally pay
higher levels of income in a rising interest rate environment and lower
levels of income as interest rates decline. For the same reason, the
market value of a variable- or floating-rate instrument is generally
expected to have less sensitivity to fluctuations in market interest rates
than a fixed-rate instrument, although the value of a variable- or
floating-rate instrument may nonetheless decline as interest rates rise
and due to other factors, such as changes in credit quality.
The Fund may invest in floating rate debt instruments (“floaters”) and
engage in credit spread trades. The interest rate on a floater is a variable
rate which is tied to another interest rate, such as a money-market index
or U.S. Treasury bill rate. The interest rate on a floater resets periodically,
typically every six months. Due to the interest rate reset feature, floaters
provide the Fund with a certain degree of protection against rises in
interest rates, although the Fund will participate in any declines in
interest rates as well. A credit spread trade is an investment position
relating to a difference in the prices or interest rates of two bonds or
other securities, in which the value of the investment position is
determined by changes in the difference between the prices or interest
rates, as the case may be, of the respective securities.
Loans and Other Indebtedness; Loan Acquisitions,
Participations and Assignments
The Fund may purchase indebtedness and participations in loans held
and/or originated by private financial institutions, including commercial
and residential mortgage loans, corporate loans and consumer loans, as
well as interests and/or servicing or similar rights in such loans. Such
instruments may be secured or unsecured and may be newly-originated
(and may be specifically designed for the Fund). Indebtedness is
different from traditional debt securities in that debt securities are part
of a large issue of securities to the public whereas indebtedness may
not be a security, and may represent a specific commercial loan to a
borrower. Loan participations typically represent direct participation,
together with other parties, in a loan to a borrower, and generally are
offered by banks or other financial institutions or lending syndicates. The
Fund may participate in such syndications, or can buy part of a loan,
becoming a part lender. When purchasing indebtedness and loan
participations, the Fund assumes the credit risk associated with the
borrower and may assume the credit risk associated with an interposed
bank or other financial intermediary. The indebtedness and loan
participations that the Fund may acquire may not be rated by any
nationally recognized rating service.
[], 2024 |
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PIMCO Income Strategy Fund II
A loan is often administered by an agent bank acting as agent for all
holders. The agent bank administers the terms of the loan, as specified
in the loan agreement. In addition, the agent bank is normally
responsible for the collection of principal and interest payments from
the borrower and the apportionment of these payments to the credit of
all institutions which are parties to the loan agreement. Unless, under
the terms of the loan or other indebtedness, the Fund has direct
recourse against the borrower, the Fund may have to rely on the agent
bank or other financial intermediary to apply appropriate credit
remedies against a borrower.
A financial institution’s employment as agent bank might be terminated
in the event that it fails to observe a requisite standard of care or
becomes insolvent. A successor agent bank would generally be
appointed to replace the terminated agent bank, and assets held by the
agent bank under the loan agreement would likely remain available to
holders of such indebtedness. However, if assets held by the agent bank
for the benefit of the Fund were determined to be subject to the claims
of the agent bank’s general creditors, the Fund might incur certain costs
and delays in realizing payment on a loan or loan participation and
could suffer a loss of principal and/or interest. In situations involving
other interposed financial institutions (e.g., an insurance company or
governmental agency) similar risks may arise.
Purchasers of loans and other forms of direct indebtedness depend
primarily upon the creditworthiness of the borrower for payment of
principal and interest. If the Fund does not receive scheduled interest or
principal payments on such indebtedness, the NAV, market share price
and/or yield of the Common Shares could be adversely affected. Loans
that are fully secured offer the Fund more protection than an unsecured
loan in the event of non-payment of scheduled interest or principal.
However, there is no assurance that the liquidation of collateral from a
secured loan would satisfy the borrower’s obligation, or that the
collateral could be liquidated. In the event of the bankruptcy of a
borrower, the Fund could experience delays or limitations in its ability to
realize the benefits of any collateral securing a loan.
The Fund may acquire loans and loan participations with credit quality
comparable to that of issuers of its securities investments. Indebtedness
of companies whose creditworthiness is poor and/or subprime in quality
involves substantially greater risks, and may be highly speculative. Some
companies may never pay off their indebtedness, or may pay only a
small fraction of the amount owed. Consequently, when acquiring
indebtedness of companies with poor credit, the Fund bears a
substantial risk of losing the entire amount invested of the instrument
acquired. The Fund may make purchases of indebtedness and loan
participations to achieve income and/or capital appreciation, rather than
to seek income.
The Fund will limit the amount of its total assets that it will invest in any
one issuer and the Fund will limit the amount of its total assets that it
will invest in issuers within the same industry. For purposes of this limit,
the Fund generally will treat the borrower as the “issuer” of
indebtedness held by the Fund. In the case of loan participations where
a bank or other lending institution serves as a financial intermediary
between the Fund and the borrower, if the participation does not shift
to the Fund the direct debtor-creditor relationship with the borrower,
the Fund will treat both the lending bank or other lending institution
and the borrower as “issuers.” Treating a financial intermediary as an
issuer of indebtedness may restrict the Fund’s ability to invest in
indebtedness related to a single financial intermediary, or a group of
intermediaries engaged in the same industry, even if the underlying
borrowers represent many different companies and industries.
Loans and other types of direct indebtedness (which the Fund may
purchase or otherwise gain exposure to) may not be readily marketable
and may be subject to restrictions on resale. In connection with certain
loan transactions, transaction costs that are borne by the Fund may
include the expenses of third parties that are retained to assist with
reviewing and conducting diligence, negotiating, structuring and
servicing a loan transaction, and/or providing other services in
connection therewith. Furthermore, the Fund may incur such costs in
connection with loan transactions that are pursued by the Fund but not
ultimately consummated (so-called “broken deal costs”). In some cases,
negotiations involved in disposing of indebtedness may require weeks
to complete. Consequently, some indebtedness may be difficult or
impossible to dispose of readily at what PIMCO believes to be a fair
price. In addition, valuation of illiquid indebtedness involves a greater
degree of judgment in determining the Fund’s net asset value than if
that value were based on available market quotations, and could result
in significant variations in the Fund’s daily share price. At the same time,
some loan interests are traded among certain financial institutions and
accordingly may be deemed liquid. As the market for different types of
indebtedness develops, the liquidity of these instruments may improve.
Acquisitions of loan participations are considered to be debt obligations
for purposes of the Fund’s investment restriction relating to the lending
of funds or assets by the Fund.
Acquisition of loans through a purchase of a loan or direct assignment
of a financial institution’s interests with respect to a loan may involve
additional risks to the Fund. The purchaser of an assignment typically
succeeds to all the rights and obligations under the loan agreement
with the same rights and obligations as the assigning lender.
Assignments may, however, be arranged through private negotiations
between potential assignees and potential assignors, and the rights and
obligations acquired by the purchaser of an assignment may differ from,
and be more limited than, those held by the assigning lender. If a loan is
foreclosed, the Fund could become part owner of any collateral, and
would bear the costs and liabilities associated with owning and
disposing of the collateral. In addition, it is conceivable that under
emerging legal theories of lender liability, the Fund could be held liable
as co-lender. It is unclear whether loans and other forms of direct
indebtedness offer securities law protections against fraud and
misrepresentation.
The purchaser of an assignment typically succeeds to all the rights and
obligations under the loan agreement with the same rights and
obligations as the assigning lender. Assignments may, however, be
arranged through private negotiations between potential assignees and
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Base Prospectus
potential assignors, and the rights and obligations acquired by the
purchaser of an assignment may differ from, and be more limited than,
those held by the assigning lender.
The Fund may make, participate in or acquire debtor-in-possession
financings (commonly known as “DIP financings”). DIP financings are
arranged when an entity seeks the protections of the bankruptcy court
under Chapter 11 of the U.S. Bankruptcy Code. These financings allow
the entity to continue its business operations while reorganizing under
Chapter 11. Such financings constitute senior liens on unencumbered
security (i.e., security not subject to other creditors’ claims). There is a
risk that the entity will not emerge from Chapter 11 and be forced to
liquidate its assets under Chapter 7 of the U.S. Bankruptcy Code. In the
event of liquidation, the Fund’s only recourse will be against the
property securing the DIP financing. Various state licensing requirements
could apply to the Fund with respect to the acquisition, holding,
servicing, foreclosure and/or disposition of loans and similar assets. The
licensing requirements could apply depending on the location of the
borrower, the location of the collateral securing the loan, or the location
where the Fund or PIMCO operates or has offices. In states in which it is
licensed, the Fund or PIMCO will be required to comply with applicable
laws and regulations, including consumer protection and anti-fraud
laws, which could impose restrictions on the Fund’s or PIMCO’s ability
to take certain actions to protect the value of its holdings in such assets
and impose compliance costs. Failure to comply with such laws and
regulations could lead to, among other penalties, a loss of the Fund’s or
PIMCO’s license, which in turn could require the Fund to divest assets
located in or secured by real property located in that state. These risks
will also apply to issuers and entities in which the Fund invests that hold
similar assets, as well as any origination company or servicer in which
the Fund owns an interest.
Loan origination and servicing companies are routinely involved in legal
proceedings concerning matters that arise in the ordinary course of their
business. These legal proceedings range from actions involving a single
plaintiff to class action lawsuits with potentially tens of thousands of
class members. In addition, a number of participants in the loan
origination and servicing industry (including control persons of industry
participants) have been the subject of regulatory actions by state
regulators, including state Attorneys General, and by the federal
government. Governmental investigations, examinations or regulatory
actions, or private lawsuits, including purported class action lawsuits,
may adversely affect such companies’ financial results. To the extent the
Fund seeks to engage in servicing directly, or has a financial interest in,
or is otherwise affiliated with, an origination or servicing company, the
Fund will be subject to enhanced risks of litigation, regulatory actions
and other proceedings. As a result, the Fund may be required to pay
legal fees, settlement costs, damages, penalties or other charges, any or
all of which could materially adversely affect the Fund and its holdings.
Delayed Draw and Delayed Funding Loans and Revolving
Credit Facilities
The Fund may enter into, or acquire participations in, delayed draw and
delayed funding loans and revolving credit facilities, in which a bank or
other lender agrees to make loans up to a maximum amount upon
demand by the borrower during a specified term. These commitments
may have the effect of requiring the Fund to increase its investment in a
company at a time when it might not be desirable to do so (including at
a time when the company’s financial condition makes it unlikely that
such amounts will be repaid). Delayed draw and delayed funding loans
and revolving credit facilities are subject to credit, interest rate and
liquidity risk and the risks of being a lender.
Bank Capital Securities and Bank Obligations
The Fund may invest in bank capital securities of both non-U.S. (foreign)
and U.S. issuers. Bank capital securities are issued by banks to help fulfill
their regulatory capital requirements. There are three common types of
bank capital: Lower Tier II, Upper Tier II and Tier I. Upper Tier II securities
are commonly thought of as hybrids of debt and preferred securities.
Upper Tier II securities are often perpetual (with no maturity date),
callable and have a cumulative interest deferral feature. This means that
under certain conditions, the issuer bank can withhold payment of
interest until a later date. However, such deferred interest payments
generally earn interest. Tier I securities often take the form of trust
preferred securities.
The Fund may also invest in other bank obligations including, without
limitation, CoCos, certificates of deposit, bankers’ acceptances and fixed
time deposits. CoCos have no stated maturity, have fully discretionary
coupons and are typically issued in the form of subordinated debt
instruments. CoCos generally either convert into equity or have their
principal written down (including potentially to zero) upon the
occurrence of certain triggering events (“triggers”) linked to regulatory
capital thresholds or regulatory actions relating to the issuer’s continued
viability. Certificates of deposit are negotiable certificates that are
issued against funds deposited in a commercial bank for a definite
period of time and that earn a specified return. Bankers’ acceptances
are negotiable drafts or bills of exchange, normally drawn by an
importer or exporter to pay for specific merchandise, which are
“accepted” by a bank, meaning, in effect, that the bank unconditionally
agrees to pay the face value of the instrument on maturity. Fixed time
deposits are bank obligations payable at a stated maturity date and
bearing interest at a fixed rate. Fixed time deposits may be withdrawn
on demand by the investor, but may be subject to early withdrawal
penalties which vary depending upon market conditions and the
remaining maturity of the obligation. There are generally no contractual
restrictions on the right to transfer a beneficial interest in a fixed time
deposit to a third party, although there is generally no market for such
deposits. The Fund may also hold funds on deposit with its custodian
bank in an interest-bearing account for temporary purposes.
Bonds
The Fund may invest in a wide variety of bonds of varying maturities
issued by non-U.S. (foreign) and U.S. corporations and other business
entities, governments and quasi-governmental entities and
municipalities and other issuers. Bonds may include, among other
things, fixed or variable/floating-rate debt obligations, including bills,
notes, debentures, money market instruments and similar instruments
and securities. Bonds generally are used by corporations as well as
[], 2024 |
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PIMCO Income Strategy Fund II
governments and other issuers to borrow money from investors. The
issuer pays the investor a fixed or variable rate of interest and normally
must repay the amount borrowed on or before maturity. Certain bonds
are “perpetual” in that they have no maturity date.
Preferred Securities
Preferred securities represent an equity interest in a company that
generally entitles the holder to receive, in preference to the holders of
other stocks such as common stocks, dividends and a fixed share of the
proceeds resulting from liquidation of the company. Unlike common
stocks, preferred securities usually do not have voting rights. Preferred
securities in some instances are convertible into common stock. Some
preferred securities also entitle their holders to receive additional
liquidation proceeds on the same basis as holders of a company’s
common stock, and thus also represent an ownership interest in the
company. Some preferred securities offer a fixed rate of return with no
maturity date. Because they never mature, these preferred securities
may act like long-term bonds, can be more volatile than other types of
preferred securities and may have heightened sensitivity to changes in
interest rates. Other preferred securities have a variable dividend,
generally determined on a quarterly or other periodic basis, either
according to a formula based upon a specified premium or discount to
the yield on particular U.S. Treasury securities or based on an auction
process, involving bids submitted by holders and prospective purchasers
of such securities. Although they are equity securities, preferred
securities have certain characteristics of both debt securities and
common stock. They are like debt securities in that their stated income is
generally contractually fixed. They are like common stocks in that they
do not have rights to precipitate bankruptcy proceedings or collection
activities in the event of missed payments. Furthermore, preferred
securities have many of the key characteristics of equity due to their
subordinated position in an issuer’s capital structure and because their
quality and value are heavily dependent on the profitability of the issuer
rather than on any legal claims to specific assets or cash flows. Because
preferred securities represent an equity ownership interest in a
company, their value usually will react more strongly than bonds and
other debt instruments to actual or perceived changes in a company’s
financial condition or prospects, or to fluctuations in the equity markets.
In order to be payable, dividends on preferred securities must be
declared by the issuer’s board of directors. In addition, distributions on
preferred securities may be subject to deferral and thus may not be
automatically payable. Income payments on some preferred securities
are cumulative, causing dividends and distributions to accrue even if
they are not declared by the board of directors of the issuer or otherwise
made payable. Other preferred securities are non-cumulative, meaning
that skipped dividends and distributions do not continue to accrue.
There is no assurance that dividends on preferred securities in which the
Fund invests will be declared or otherwise made payable.
Preferred securities have a liquidation value that generally equals their
original purchase price at the date of issuance. The market values of
preferred securities may be affected by favorable and unfavorable
changes affecting the issuers’ industries or sectors. They also may be
affected by actual and anticipated changes or ambiguities in the tax
status of the security and by actual and anticipated changes or
ambiguities in tax laws, such as changes in corporate and individual
income tax rates or the rates applicable to dividends. The dividends paid
on the preferred securities in which the Fund invests might not be
eligible for the favorable tax treated accorded to “qualified dividend
income.” See “Taxation” in the Statement of Additional Information.
Because the claim on an issuer’s earnings represented by preferred
securities may become disproportionately large when interest rates fall
below the rate payable on the securities or for other reasons, the issuer
may redeem preferred securities, generally after an initial period of call
protection in which the security is not redeemable. Thus, in declining
interest rate environments in particular, the Fund’s holdings of higher
dividend-paying preferred securities may be reduced and the Fund may
be unable to acquire securities paying comparable rates with the
redemption proceeds.
Convertible Securities and Synthetic Convertible Securities
Convertible securities (i.e., debt securities that may be converted at
either a stated price or stated rate into underlying shares of common
stock) have general characteristics similar to both debt securities and
equity securities. Although to a lesser extent than with debt obligations,
the market value of convertible securities tends to decline as interest
rates increase and, conversely, tends to increase as interest rates
decline. In addition, because of the conversion feature, the market value
of convertible securities tends to vary with fluctuations in the market
value of the underlying common stocks and, therefore, also will react to
variations in the general market for equity securities.
Convertible securities are investments that provide for a level stream of
income with generally higher yields than common stocks. There can be
no assurance of current income because the issuers of the convertible
securities may default on their obligations. Convertible securities,
however, generally offer lower interest or dividend yields than
non-convertible debt securities of similar credit quality because of the
potential for equity-related capital appreciation. A convertible security,
in addition to providing current income, offers the potential for capital
appreciation through the conversion feature, which enables the holder
to benefit from increases in the market price of the underlying common
stock.
The Fund may invest in synthetic convertible securities, which are
created through a combination of separate securities that possess the
two principal characteristics of a traditional convertible security, that is,
an income-producing component and the right to acquire a convertible
component. The income-producing component is achieved by investing
in non-convertible, income-producing securities such as bonds, preferred
stocks and money market instruments. The convertible component is
achieved by purchasing warrants or options to buy common stock at a
certain exercise price, or options on a stock index. The Fund may also
purchase synthetic securities created by other parties, typically
investment banks, including convertible structured notes. The
income-producing and convertible components of a synthetic
convertible security may be issued separately by different issuers and at
different times. The values of synthetic convertible securities will respond
differently to market fluctuations than a traditional convertible security
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| PIMCO Income Strategy Fund II
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because a synthetic convertible is composed of two or more separate
securities or instruments, each with its own market value. Synthetic
convertible securities are also subject to the risks associated with
derivatives. See “Principal Risks of the Fund—Derivatives Risk.” In
addition, if the value of the underlying common stock or the level of the
index involved in the convertible element falls below the strike price of
the warrant or option, the warrant or option may lose all value.
Contingent Convertible Securities
CoCos are a form of hybrid debt security that is structured to either
convert into equity or have their principal written down upon the
occurrence of certain “triggers.” The triggers are generally linked to
regulatory capital thresholds or regulatory actions calling into question
the issuing banking institution’s continued viability as a going-concern.
CoCos’ unique equity conversion or principal write-down features are
tailored to the issuing banking institution and its regulatory
requirements.
Some additional risks associated with CoCos include, but are not limited
to:
Loss absorption risk.
CoCos may be subject to an automatic
write-down (i.e., the automatic write-down of the principal amount or
value of the securities, potentially to zero, and the cancellation of the
securities) under certain circumstances, which could result in the Fund
losing a portion or all of its investment in such securities. In addition, the
Fund may not have any rights with respect to repayment of the principal
amount of the securities that has not become due or the payment of
interest or dividends on such securities for any period from (and
including) the interest or dividend payment date falling immediately
prior to the occurrence of such automatic write-down. An automatic
write-down could also result in a reduced income rate if the dividend or
interest payment is based on the security’s par value. In addition, CoCos
have fully discretionary coupons. This means coupons can potentially be
cancelled at the issuer’s discretion or at the request of the relevant
regulatory authority in order to help the issuer absorb losses and may be
suspended in the event there are insufficient distributable reserves.
Subordinated instruments.
CoCos will, in the majority of circumstances,
be issued in the form of subordinated debt instruments in order to
provide the appropriate regulatory capital treatment prior to a
conversion. Accordingly, in the event of liquidation, dissolution or
winding-up of an issuer prior to a conversion having occurred, the rights
and claims of the holders of the CoCos, such as the Fund, against the
issuer in respect of or arising under the terms of the CoCos shall
generally rank junior to the claims of all holders of unsubordinated
obligations of the issuer. In addition, if the CoCos are converted into the
issuer’s underlying equity securities following a conversion event (i.e., a
“trigger”), each holder will be subordinated due to their conversion
from being the holder of a debt instrument to being the holder of an
equity instrument.
Market value will fluctuate based on unpredictable factors.
The trading
behavior of a given issuer’s CoCos may be strongly impacted by the
trading behavior of other issuers’ CoCos, such that negative information
from an unrelated CoCo may cause a decline in value of one or more
CoCos held by the Fund. Accordingly, the trading behavior of CoCos
may not follow the trading behavior of other similarly structured
securities. The value of CoCos is unpredictable and could be influenced
by many factors including, without limitation: (i) the creditworthiness of
the issuer and/or fluctuations in such issuer’s applicable capital ratios;
(ii) supply and demand for the CoCos; (iii) general market conditions
and available liquidity; and (iv) economic, financial and political events
that affect the issuer, its particular market or the financial markets in
general.
“Covenant-lite” Obligations
The Fund may invest in, or obtain exposure to, obligations that may be
“covenant-lite,” which means such obligations lack, or possess fewer,
financial covenants that protect lenders. Covenant-lite agreements
feature incurrence covenants, as opposed to the more restrictive
maintenance covenants. Under a maintenance covenant, the borrower
would need to meet regular, specific financial tests, while under an
incurrence covenant, the borrower only would be required to comply
with the financial tests at the time it takes certain actions (e.g., issuing
additional debt, paying a dividend, making an acquisition). A
covenant-lite obligation contains fewer maintenance covenants than
other obligations, or no maintenance covenants, and may not include
terms that allow the lender to monitor the performance of the borrower
and declare a default if certain criteria are breached.
Zero-Coupon Bonds, Step-Ups and Payment-In-Kind Securities
Zero-coupon bonds pay interest only at maturity rather than at intervals
during the life of the security. Like zero-coupon bonds, “step up” bonds
pay no interest initially but eventually begin to pay a coupon rate prior
to maturity, which rate may increase at stated intervals during the life of
the security. Partial payment in kind loans and bonds (“PIKs”) are debt
obligations that pay “interest” in the form of other debt obligations,
instead of in cash. Each of these instruments is normally issued and
traded at a deep discount from face value. Zero-coupon bonds, step-ups
and PIKs allow an issuer to avoid or delay the need to generate cash to
meet current interest payments and, as a result, may involve greater
credit risk than bonds that pay interest currently or in cash.
Foreign (Non-U.S.) Investments
Subject to the limit described elsewhere in this prospectus on
investments in securities and instruments that are economically tied to
“emerging market” countries, the Fund may invest some or all of its
assets in U.S. dollar-denominated debt obligations of foreign corporate
issuers and of supranational government entities. Subject to the
limitations set forth in this prospectus, including the limit on
investments in emerging market securities and instruments, the Fund
may invest without limit in non-U.S. dollar denominated securities (of
both developed and “emerging market” countries), including
obligations of non-U.S. governments and their respective sub-divisions,
agencies and government-sponsored enterprises. Supranational entities
include international organizations that are organized or supported by
one or more government entities to promote economic reconstruction or
[], 2024 |
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PIMCO Income Strategy Fund II
development and by international banking institutions and related
governmental agencies. As a holder of such debt securities, the Fund
may be requested to participate in the rescheduling of such debt and to
extend further loans to governmental entities. In addition, there are
generally no bankruptcy proceedings similar to those in the
United States by which defaulted foreign debt securities may be
collected. Investing in foreign securities involves special risks and
considerations not typically associated with investing in U.S. securities.
See “Principal Risks of the Fund—Foreign (Non-U.S.) Investment Risk.”
PIMCO generally considers an instrument to be economically tied to a
non- U.S. country if the issuer is a foreign (non-U.S.) government (or any
political subdivision, agency, authority or instrumentality of such
government), or if the issuer is organized under the laws of a
non-U.S. country. In the case of money market instruments, other than
commercial paper and certificates of deposit, such instruments will be
considered economically tied to a non-U.S. country if the issuer of such
money market instrument is organized under the laws of a
non-U.S. country. In the case of commercial paper and certificates of
deposit, instruments will be considered economically tied to a
non-U.S. country if the “country of exposure” of such instrument is a
non-U.S. country, as determined by the criteria set forth below. With
respect to derivative instruments, PIMCO generally considers such
instruments to be economically tied to non-U.S. countries if the
underlying assets are foreign currencies (or baskets or indexes of such
currencies), or instruments or securities that are issued by foreign
governments or issuers organized under the laws of a non-U.S. country
(or if the underlying assets are money market instruments, other than
commercial paper and certificates of deposit, the issuer of such money
market instrument is organized under the laws of a non-U.S. country or,
in the case of underlying assets that are commercial paper or certificates
of deposit, if the “country of exposure” of such money market
instrument is a non-U.S. country). A security’s “country of exposure” is
determined by PIMCO using certain factors provided by a third-party
analytical service provider. The factors are applied in order such that the
first factor to result in the assignment of a country determines the
“country of exposure.” Both the factors and the order in which they are
applied may change in the discretion of PIMCO. The current factors,
listed in the order in which they are applied, are: (i) if an asset-backed or
other collateralized security, the country in which the collateral backing
the security is located; (ii) the “country of risk” of the issuer; (iii) if the
security is guaranteed by the government of a country (or any political
subdivision, agency, authority or instrumentality of such government),
the country of the government or instrumentality providing the
guarantee; (iv) the “country of risk” of the issuer’s ultimate parent; or (v)
the country where the issuer is organized or incorporated under the
laws thereof. “Country of risk” is a separate four-part test determined
by the following factors, listed in order of importance: (i) management
location; (ii) country of primary listing; (iii) sales or revenue attributable
to the country; and (iv) reporting currency of the issuer.
The Fund may invest in Brady Bonds, which are securities created
through the exchange of existing commercial bank loans to sovereign
entities for new obligations in connection with a debt restructuring.
Investments in Brady Bonds may be viewed as speculative. Brady Bonds
acquired by the Fund may be subject to restructuring arrangements or
to requests for new credit, which may cause the Fund to realize a loss of
interest or principal on any of its portfolio holdings.
The foreign securities in which the Fund may invest include, without
limitation, Eurodollar obligations and “Yankee Dollar” obligations.
Eurodollar obligations are U.S. dollar-denominated certificates of
deposit and time deposits issued outside the U.S. capital markets by
foreign branches of U.S. banks and by foreign banks. Yankee Dollar
obligations are U.S. dollar-denominated obligations issued in the
U.S. capital markets by foreign banks. Eurodollar and Yankee Dollar
obligations are generally subject to the same risks that apply to
domestic debt issues, notably credit risk, interest rate risk, market risk
and liquidity risk. Additionally, Eurodollar (and to a limited extent,
Yankee Dollar) obligations are subject to certain sovereign risks. One
such risk is the possibility that a sovereign country might prevent
capital, in the form of U.S. dollars, from flowing across its borders. Other
risks include adverse political and economic developments; the extent
and quality of government regulation of financial markets and
institutions; the imposition of foreign withholding or other taxes; and
the expropriation or nationalization of foreign issuers.
Emerging Markets Investments
The Fund may invest up to 40% of its total assets in securities and
instruments that are economically tied to “emerging market” countries,
except the Fund may invest without limit in short-term investment grade
sovereign debt issued by emerging market issuers. PIMCO generally
considers an instrument to be economically tied to an emerging market
country if: the issuer is organized under the laws of an emerging market
country; the currency of settlement of the security is a currency of an
emerging market country; the security is guaranteed by the government
of an emerging market country (or any political subdivision, agency,
authority or instrumentality of such government); for an asset-backed or
other collateralized security, the country in which the collateral backing
the security is located is an emerging market country; or the security’s
“country of exposure” is an emerging market country, as determined by
the criteria set forth below. With respect to derivative instruments,
PIMCO generally considers such instruments to be economically tied to
emerging market countries if the underlying assets are currencies of
emerging market countries (or baskets or indexes of such currencies), or
instruments or securities that are issued or guaranteed by governments
of emerging market countries or by entities organized under the laws of
emerging market countries or an instrument’s “country of exposure” is
an emerging market country. A security’s “country of exposure” is
determined by PIMCO using certain factors provided by a third-party
analytical service provider. The factors are applied in order such that the
first factor to result in the assignment of a country determines the
“country of exposure.” Both the factors and the order in which they are
applied may change in the discretion of PIMCO. The current factors,
listed in the order in which they are applied, are: (i) if an asset-backed or
other collateralized security, the country in which the collateral backing
the security is located; (ii) the “country of risk” of the issuer; (iii) if the
security is guaranteed by the government of a country (or any political
subdivision, agency, authority or instrumentality of such government),
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| PIMCO Income Strategy Fund II
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the country of the government or instrumentality providing the
guarantee; (iv) the “country of risk” of the issuer’s ultimate parent; or (v)
the country where the issuer is organized or incorporated under the
laws thereof. “Country of risk” is a separate four-part test determined
by the following factors, listed in order of importance: (i) management
location; (ii) country of primary listing; (iii) sales or revenue attributable
to the country; and (iv) reporting currency of the issuer. In making
investments in emerging market securities, the Fund emphasizes those
countries with relatively low gross national product per capita and with
the potential for rapid economic growth. Emerging market countries are
generally located in Asia, Africa, the Middle East, Latin America and
Eastern Europe. PIMCO will select the country and currency composition
based on its evaluation of relative interest rates, inflation rates,
exchange rates, monetary and fiscal policies, trade and current account
balances, legal and political developments and any other specific factors
it believes to be relevant.
Investing in emerging market securities imposes risks different from, or
greater than, risks of investing in domestic securities or in foreign
developed countries. The securities and currency markets of emerging
market countries are generally smaller, less developed, less liquid, and
more volatile than the securities and currency markets of the
United States and other developed markets and disclosure and
regulatory standards in many respects are less stringent. There also may
be a lower level of monitoring and regulation of securities markets in
emerging market countries and the activities of investors in such
markets and enforcement of existing regulations may be extremely
limited. Government enforcement of existing securities regulations is
limited, and any enforcement may be arbitrary and the results may be
difficult to predict. In addition, reporting requirements of emerging
market countries with respect to the ownership of securities are more
likely to be subject to interpretation or changes without prior notice to
investors than more developed countries.
Many emerging market countries have experienced substantial, and in
some periods extremely high, rates of inflation for many years. Inflation
and rapid fluctuations in inflation rates have had and may continue to
have negative effects on such countries’ economies and securities
markets.
Economies of emerging market countries generally are heavily
dependent upon international trade and, accordingly, have been and
may continue to be affected adversely by trade barriers, exchange
controls, managed adjustments in relative currency values, and other
protectionist measures imposed or negotiated by the countries with
which they trade. The economies of emerging market countries also
have been and may continue to be adversely affected by economic
conditions in the countries with which they trade. The economies of
emerging market countries may also be predominantly based on only a
few industries or dependent on revenues from particular commodities.
In addition, custodial services and other investment-related costs may
be more expensive in emerging markets than in many developed
markets, which could reduce the Fund’s income from securities or debt
instruments of emerging market country issuers. Governments of many
emerging market countries have exercised and continue to exercise
substantial influence over many aspects of the private sector. In some
cases, the government owns or controls many companies, including
some of the largest in the country. Accordingly, government actions
could have a significant effect on economic conditions in an emerging
market country and on market conditions, prices and yields of securities
in the Fund’s portfolio.
Emerging market countries are more likely than developed market
countries to experience political uncertainty and instability, including
the risk of war, terrorism, nationalization, limitations on the removal of
funds or other assets, or diplomatic developments that affect
investments in these countries. No assurance can be given that adverse
political changes will not cause the Fund to suffer a loss of any or all of
its investments in emerging market countries or interest/dividend
income thereon.
Foreign investment in certain emerging market country securities is
restricted or controlled to varying degrees. These restrictions or controls
may at times limit or preclude foreign investment in certain emerging
market country securities and increase the costs and expenses of the
Fund. Certain emerging market countries require governmental approval
prior to investments by foreign persons, limit the amount of investment
by foreign persons in a particular issuer, limit the investment by foreign
persons only to a specific class of securities of an issuer that may have
less advantageous rights than the classes available for purchase by
domiciliaries of the countries and/or impose additional taxes on foreign
investors. Certain emerging market countries may also restrict
investment opportunities in issuers in industries deemed important to
national interests. Emerging market countries may require governmental
approval for the repatriation of investment income, capital or the
proceeds of sales of securities by foreign investors.
Also, because publicly traded debt instruments of emerging market
issuers represent a relatively recent innovation in the world debt
markets, there is little historical data or related market experience
concerning the attributes of such instruments under all economic,
market and political conditions.
As reflected in the above discussion, investments in emerging market
securities involve a greater degree of risk than, and special risks in
addition to the risks associated with, investments in domestic securities
or in securities of foreign developed countries. See “Principal Risks of
the Fund—Emerging Markets Risk.”
Foreign Currencies and Related Transactions
The Fund’s Common Shares are priced in U.S. dollars and the
distributions paid by the Fund to Common Shareholders are paid in
U.S. dollars. However, a significant portion of the Fund’s assets may be
denominated in foreign (non-U.S.) currencies and the income received
by the Fund from many foreign debt obligations will be paid in foreign
currencies. The Fund also may invest in or gain exposure to foreign
currencies themselves for investment or hedging purposes. The Fund’s
investments in securities that trade in, or receive revenues in, foreign
currencies will be subject to currency risk, which is the risk that
fluctuations in the exchange rates between the U.S. dollar and foreign
currencies may negatively affect the value of an investment. See
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PIMCO Income Strategy Fund II
“Principal Risks of the Fund—Currency Risk.” The Fund may (but is not
required to) hedge some or all of its exposure to foreign currencies
through the use of derivative strategies. For instance, the Fund may
enter into forward foreign currency exchange contracts, and may buy
and sell foreign currency futures contracts and options on foreign
currencies and foreign currency futures. A forward foreign currency
exchange contract, which involves an obligation to purchase or sell a
specific currency at a future date at a price set at the time of the
contract, may reduce the Fund’s exposure to changes in the value of the
currency it will deliver and increase its exposure to changes in the value
of the currency it will receive for the duration of the contract. The effect
on the value of the Fund’s assets is similar to selling securities
denominated in one currency and purchasing securities denominated in
another currency. Foreign currency transactions, like currency exchange
rates, can be affected unpredictably by intervention (or the failure to
intervene) by U.S. or foreign governments or central banks, or by
currency controls or political developments. Such events may prevent or
restrict the Fund’s ability to enter into foreign currency transactions,
force the Fund to exit a foreign currency transaction at a
disadvantageous time or price or result in penalties for the Fund, any of
which may result in a loss to the Fund.
Contracts to sell foreign currency would limit any potential gain that
might be realized by the Fund if the value of the hedged currency
increases. The Fund may enter into these contracts to hedge against
foreign exchange risk arising from the Fund’s investment or anticipated
investment in securities denominated in foreign currencies. Suitable
hedging transactions may not be available in all circumstances and
there can be no assurance that the Fund will engage in such
transactions at any given time or from time to time when they would be
beneficial. Although PIMCO has the flexibility to engage in such
transactions for the Fund, it may determine not to do so or to do so only
in unusual circumstances or market conditions. Also, these transactions
may not be successful and may eliminate any chance for the Fund to
benefit from favorable fluctuations in relevant foreign currencies.
The Fund may also use derivatives contracts for purposes of increasing
exposure to a foreign currency or to shift exposure to foreign currency
fluctuations from one currency to another. To the extent that it does so,
the Fund will be subject to the additional risk that the relative value of
currencies will be different than anticipated by PIMCO.
Please see “Investment Objective and Policies—Non-U.S. Securities,”
“Investment Objective and Policies— Foreign Currency Transactions”
and “Investment Objective and Policies—Foreign Currency
Exchange-Related Securities” in the Statement of Additional
Information for a more detailed description of the types of foreign
investments and foreign currency transactions in which the Fund may
invest or engage and their related risks.
Derivatives
The Fund may, but is not required to, utilize various derivative strategies
(both long and short positions) for investment purposes, leveraging
purposes, or in an attempt to hedge against market, credit, interest rate,
currency and other risks in the portfolio. The Fund may use various
derivatives transactions to add leverage to its portfolio. See “Use of
Leverage.” Generally, derivatives are financial contracts whose value
depends upon, or is derived from, the value of an underlying asset,
reference rate or index, and may relate to, among others, individual debt
instruments, interest rates, currencies or currency exchange rates,
commodities and related indexes. Examples of derivative instruments
that the Fund may use include, without limit, futures and forward
contracts (including foreign currency exchange contracts), call and put
options (including options on futures contracts), credit default swaps,
total return swaps, basis swaps and other swap agreements. The Fund’s
use of derivative instruments involves risks different from, or possibly
greater than, the risks associated with investment directly in securities
and other more traditional investments. See “Principal Risks of the
Fund—Derivatives Risk.” Certain types of derivative instruments that
the Fund may utilize are described elsewhere in this section, including
those described under “—Certain interest rate transactions,” “—Hybrid
instruments,” “—Credit default swaps” and “— Structured notes and
related instruments.” Please see “Investment Objective and
Policies—Derivative Instruments” in the Statement of Additional
Information for additional information about these and other derivative
instruments that the Fund may use and the risks associated with such
instruments. There is no assurance that these derivative strategies will
be available at any time or that PIMCO will determine to use them for
the Fund or, if used, that the strategies will be successful. In addition,
the Fund may be subject to certain restrictions on its use of derivative
strategies imposed by guidelines of Moody’s and Fitch, each of which
issues ratings for the ARPS.
Credit Default Swaps
The Fund may enter into credit default swaps for both investment and
risk management purposes, as well as to add leverage to the Fund’s
portfolio. A credit default swap may have as reference obligations one
or more securities that are not currently held by the Fund. The protection
“buyer” in a credit default swap is generally obligated to pay the
protection “seller” an upfront or a periodic stream of payments over the
term of the contract provided that no credit event, such as a default, on
a reference obligation has occurred. If a credit event occurs, the seller
generally must pay the buyer the “par value” (full notional value) of the
swap in exchange for an equal face amount of deliverable obligations of
the reference entity described in the swap, or the seller may be required
to deliver the related net cash amount, if the swap is cash settled.
Rather than exchange the bonds for par value, a single cash payment
may be due from the protection seller representing the difference
between the par value of the bonds and the current market value of the
bonds (which may be determined through an auction). The Fund may be
either the buyer or seller in the transaction. If the Fund is a buyer and no
credit event occurs, the Fund may recover nothing if the swap is held
through its termination date. However, if a credit event occurs, the buyer
generally may elect to receive the full notional value of the swap from
the seller, who, in turn, generally will recover an amount significantly
lower than the equivalent face amount of the obligations of the
reference entity, whose value may have significantly decreased, through
(i) physical delivery of such obligations by the buyer, (ii) cash settlement
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or (iii) an auction process. As a seller, the Fund generally receives an
upfront payment or a fixed rate of income throughout the term of the
swap provided that there is no credit event. As the seller, the Fund
would effectively add leverage to its portfolio because, in addition to its
total net assets, the Fund would be subject to investment exposure on
the notional amount of the swap.
The spread of a credit default swap is the annual amount the protection
buyer must pay the protection seller over the length of the contract,
expressed as a percentage of the notional amount. When spreads rise,
market perceived credit risk rises and when spreads fall, market
perceived credit risk falls. Wider credit spreads and decreasing market
values, when compared to the notional amount of the swap, represent a
deterioration of the referenced entity’s credit soundness and a greater
likelihood or risk of default or other credit event occurring as defined
under the terms of the agreement. For credit default swaps on
asset-backed securities and credit indexes, the quoted market prices and
resulting values, as well as the annual payment rate, serve as an
indication of the current status of the payment/performance risk.
Credit default swaps involve greater risks than if the Fund had invested
in the reference obligation directly since, in addition to general market
risks, credit default swaps are subject to illiquidity risk, counterparty risk
and credit risk, among other risks associated with derivative
instruments. A buyer generally also will lose the upfront and/or periodic
payments it made for the swap and recover nothing should no credit
event occur and the swap is held to its termination date. If a credit event
were to occur, the value of any deliverable obligation received by the
seller, coupled with the upfront or periodic payments previously
received, may be less than the full notional value it pays to the buyer,
resulting in a loss of value to the seller. The Fund's obligations under a
credit default swap will be accrued daily (offset against any amounts
owing to the Fund) See “Principal Risks of the Fund - Regulatory Risk -
Commodity Pool Operator.”
Hybrid Instruments
A hybrid instrument is a type of potentially high-risk derivative that
combines a traditional bond, stock or commodity with an option or
forward contract. Generally, the principal amount, amount payable upon
maturity or redemption, or interest rate of a hybrid is tied (positively or
negatively) to the price of some commodity, currency or securities index
or another interest rate or some other economic factor (each a
“benchmark”). The interest rate or (unlike most fixed income securities)
the principal amount payable at maturity of a hybrid security may be
increased or decreased, depending on changes in the value of the
benchmark. An example of a hybrid could be a bond issued by an oil
company that pays a small base level of interest with additional interest
that accrues in correlation to the extent to which oil prices exceed a
certain predetermined level. Such a hybrid instrument would be a
combination of a bond and a call option on oil.
Hybrids can be used as an efficient means of pursuing a variety of
investment goals, including currency hedging, duration management
and increased total return. Hybrids may not bear interest or pay
dividends. The value of a hybrid or its interest rate may be a multiple of a
benchmark and, as a result, may be leveraged and move (up or down)
more steeply and rapidly than the benchmark. These benchmarks may
be sensitive to economic and political events, such as commodity
shortages and currency devaluations, which cannot be readily foreseen
by the purchaser of a hybrid. Under certain conditions, the redemption
value of a hybrid could be zero. Thus, an investment in a hybrid may
entail significant market risks that are not associated with a similar
investment in a traditional, U.S. dollar-denominated bond that has a
fixed principal amount and pays a fixed rate or floating rate of interest.
The purchase of hybrids also exposes the Fund to the credit risk of the
issuer of the hybrids. These risks may cause significant fluctuations in
the NAV of the Common Shares if the Fund invests in hybrid
instruments.
Certain hybrid instruments may provide exposure to the commodities
markets. These are derivative securities with one or more
commodity-linked components that have payment features similar to
commodity futures contracts, commodity options or similar instruments.
Commodity-linked hybrid instruments may be either equity or debt
securities, leveraged or unleveraged, and are considered hybrid
instruments because they have both security and commodity-like
characteristics. A portion of the value of these instruments may be
derived from the value of a commodity, futures contract, index or other
economic variable.
Certain issuers of structured products such as hybrid instruments may
be deemed to be investment companies as defined in the 1940 Act. As a
result, the Fund’s investments in these products may be subject to limits
applicable to investments in investment companies and may be subject
to restrictions contained in the 1940 Act.
The Fund’s use of commodity-linked instruments may be limited by the
Fund’s intention to qualify as a regulated investment company (“RIC”)
and may limit the Fund’s ability to so qualify. In order to qualify for the
favorable tax treatment accorded RICs and their shareholders, the Fund
must, among other things, derive at least 90% of its income from
certain specified sources (qualifying income). Income from certain
commodity-linked instruments does not constitute qualifying income to
the Fund. The tax treatment of certain other commodity-linked
instruments in which the Fund might invest is not certain, in particular
with respect to whether income and gains from such instruments
constitute qualifying income. If the Fund were to treat income from a
particular instrument as qualifying income and the income were later
determined not to constitute qualifying income and, together with any
other nonqualifying income, caused the Fund’s nonqualifying income to
exceed 10% of its gross income in any taxable year, the Fund would fail
to qualify as a RIC unless it is eligible to and does pay a tax at the Fund
level. See “Tax Matters.”
Structured Notes and Related Instruments
The Fund may invest in “structured” notes and other related
instruments, which are privately negotiated debt obligations in which
the principal and/or interest is determined by reference to the
performance of a benchmark asset, market or interest rate (an
“embedded index”), such as selected securities, an index of securities or
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specified interest rates, or the differential performance of two assets or
markets, such as indexes reflecting bonds. Structured instruments may
be issued by corporations, including banks, as well as by governmental
agencies. Structured instruments frequently are assembled in the form
of medium-term notes, but a variety of forms are available and may be
used in particular circumstances. The terms of such structured
instruments normally provide that their principal and/or interest
payments are to be adjusted upwards or downwards (but ordinarily not
below zero) to reflect changes in the embedded index while the
structured instruments are outstanding. As a result, the interest and/or
principal payments that may be made on a structured product may vary
widely, depending on a variety of factors, including the volatility of the
embedded index and the effect of changes in the embedded index on
principal and/or interest payments. The rate of return on structured
notes may be determined by applying a multiplier to the performance or
differential performance of the referenced index(es) or other asset(s).
Application of a multiplier involves leverage that will serve to magnify
the potential for gain and the risk of loss.
The Fund may use structured instruments for investment purposes and
also for risk management purposes, such as to reduce the duration and
interest rate sensitivity of the Fund’s portfolio, and for leveraging
purposes. While structured instruments may offer the potential for a
favorable rate of return from time to time, they also entail certain risks.
Structured instruments may be less liquid than other debt securities, and
the price of structured instruments may be more volatile. In some cases,
depending on the terms of the embedded index, a structured instrument
may provide that the principal and/or interest payments may be
adjusted below zero. Structured instruments also may involve significant
credit risk and risk of default by the counterparty. Structured
instruments may also be illiquid. Like other sophisticated strategies, the
Fund’s use of structured instruments may not work as intended. If the
value of the embedded index changes in a manner other than that
expected by PIMCO, principal and/or interest payments received on the
structured instrument may be substantially less than expected. Also, if
PIMCO chooses to use structured instruments to reduce the duration of
the Fund’s portfolio, this may limit the Fund’s return when having a
longer duration would be beneficial (for instance, when interest rates
decline).
Mortgage-Related and Other Asset-Backed Instruments
The Fund may invest in a variety of mortgage-related and other
asset-backed instruments issued by government agencies or other
governmental entities or by private originators or issuers.
Mortgage-related securities include mortgage pass-through securities,
CMOs, CBOs, CLOs, CDOs, CMBS, mortgage dollar rolls/buybacks, CMO
residuals, adjustable rate mortgage-backed securities (“ARMs”), SMBSs
and other securities that directly or indirectly represent a participation
in, or are secured by and payable from, mortgage loans on real property.
Mortgage Pass-Through Securities.
Interests in pools of
mortgage-related securities differ from other forms of debt securities,
which normally provide for periodic payment of interest in fixed
amounts with principal payments at maturity or specified call dates.
Instead, these securities provide a monthly payment which consists of
both interest and principal payments. In effect, these payments are a
“pass through” of the monthly payments made by the individual
borrowers on their residential or commercial mortgage loans, net of any
fees paid to the issuer, or guarantor of such securities. Additional
payments are caused by repayments of principal resulting from the sale
of the underlying property, refinancing or foreclosure, net of fees or
costs that may be incurred. Some mortgage-related securities (such as
securities issued by GNMA) are described as “modified pass-through.”
These securities entitle the holder to receive all interest and principal
payments owed on the mortgage pool, net of certain fees, at the
scheduled payment dates regardless of whether or not the mortgagor
actually makes the payment.
The rate of pre-payments on underlying mortgages will affect the price
and volatility of a mortgage-related security, and may have the effect of
shortening or extending the effective duration of the security relative to
what was anticipated at the time of purchase. To the extent that
unanticipated rates of pre-payment on underlying mortgages increase
the effective duration of a mortgage-related security, the volatility of
such security can be expected to increase. The residential mortgage
market in the United States has experienced in the past, and could
experience in the future, difficulties that may adversely affect the
performance and market value of certain of the Fund’s mortgage-related
investments. Delinquencies, defaults and losses on residential mortgage
loans may increase substantially over certain periods. A decline in or
flattening of housing values may exacerbate such delinquencies and
losses on residential mortgages. Borrowers with adjustable rate
mortgage loans are more sensitive to changes in interest rates, which
affect their monthly mortgage payments, and may be unable to secure
replacement mortgages at comparably low interest rates. As a result of
the 2008 financial crisis, a number of residential mortgage loan
originators experienced serious financial difficulties or bankruptcy.
Owing largely to the foregoing, reduced investor demand for mortgage
loans and mortgage-related securities and increased investor yield
requirements caused limited liquidity in the secondary market for certain
mortgage-related securities, which adversely affected the market value
of mortgage-related securities. It is possible that such limited liquidity in
such secondary markets could recur or worsen in the future.
The principal U.S. governmental guarantor of mortgage-related
securities is GNMA. GNMA is a wholly owned U.S. Government
corporation within the Department of Housing and Urban Development.
GNMA is authorized to guarantee, with the full faith and credit of the
U.S. Government, the timely payment of principal and interest on
securities issued by institutions approved by GNMA (such as savings
and loan institutions, commercial banks and mortgage bankers) and
backed by pools of mortgages insured by the Federal Housing
Administration (the “FHA”), or guaranteed by the Department of
Veterans Affairs (the “VA”). Government-related guarantors (i.e., not
backed by the full faith and credit of the U.S. Government) include
FNMA and FHLMC. FNMA is a government-sponsored corporation the
common stock of which is owned entirely by private stockholders.
FNMA purchases conventional (i.e., not insured or guaranteed by any
government agency) residential mortgages from a list of approved
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seller/servicers which include state and federally chartered savings and
loan associations, mutual savings banks, commercial banks and credit
unions and mortgage bankers. Pass-through securities issued by FNMA
are guaranteed as to timely payment of principal and interest by FNMA,
but are not backed by the full faith and credit of the U.S. Government.
FHLMC was created by Congress in 1970 for the purpose of increasing
the availability of mortgage credit for residential housing. It is a
government-sponsored corporation that issues Participation Certificates
(“PCs”), which are pass-through securities, each representing an
undivided interest in a pool of residential mortgages. FHLMC
guarantees the timely payment of interest and ultimate collection of
principal, but PCs are not backed by the full faith and credit of the
U.S. Government. Instead, they are supported only by the discretionary
authority of the U.S. Government to purchase the agency’s obligations.
On September 6, 2008, the Federal Housing Finance Agency (“FHFA”)
placed FNMA and FHLMC into conservatorship. As the conservator,
FHFA succeeded to all rights, titles, powers and privileges of FNMA and
FHLMC and of any stockholder, officer or director of FNMA and FHLMC
with respect to FNMA and FHLMC and the assets of FNMA and FHLMC.
FHFA selected a new chief executive officer and chairman of the board
of directors for each of FNMA and FHLMC. In connection with the
conservatorship, the U.S. Treasury entered into a Senior Preferred Stock
Purchase Agreement with each of FNMA and FHLMC pursuant to which
the U.S. Treasury will purchase up to an aggregate of $100 billion of
each of FNMA and FHLMC to maintain a positive net worth in each
enterprise. This agreement contains various covenants that severely limit
each enterprise’s operations. In exchange for entering into these
agreements, the U.S. Treasury received $1 billion of each enterprise’s
senior preferred stock and warrants to purchase 79.9% of each
enterprise’s common stock. In 2009, the U.S. Treasury announced that it
was doubling the size of its commitment to each enterprise under the
Senior Preferred Stock Program to $200 billion. The U.S. Treasury’s
obligations under the Senior Preferred Stock Program are for an
indefinite period of time for a maximum amount of $200 billion per
enterprise. On December 24, 2009, the U.S. Treasury announced further
amendments to the Senior Preferred Stock Purchase Agreements which
included additional financial support to certain governmentally
supported entities, including the FHLBs, FNMA and FHLMC. There is no
assurance that the obligations of such entities will be satisfied in full, or
that such obligations will not decrease in value or default. It is difficult,
if not impossible, to predict the future political, regulatory or economic
changes that could impact the FNMA, FHLMC and the FHLBs, and the
values of their related securities or obligations.
FNMA and FHLMC are continuing to operate as going concerns while in
conservatorship and each remain liable for all of its obligations,
including its guaranty obligations, associated with its mortgage-backed
securities. Under the Federal Housing Finance Regulatory Reform Act of
2008 (the “Reform Act”), which was included as part of the Housing
and Economic Recovery Act of 2008, FHFA, as conservator or receiver,
has the power to repudiate any contract entered into by FNMA or
FHLMC prior to FHFA’s appointment as conservator or receiver, as
applicable, if FHFA determines, in its sole discretion, that performance of
the contract is burdensome and that repudiation of the contract
promotes the orderly administration of FNMA’s or FHLMC’s affairs. The
Reform Act requires FHFA to exercise its right to repudiate any contract
within a reasonable period of time after its appointment as conservator
or receiver. FHFA, in its capacity as conservator, has indicated that it has
no intention to repudiate the guaranty obligations of FNMA or FHLMC
because FHFA views repudiation as incompatible with the goals of the
conservatorship. However, in the event that FHFA, as conservator or if it
is later appointed as receiver for FNMA or FHLMC, were to repudiate
any such guaranty obligation, the conservatorship or receivership estate,
as applicable, would be liable for actual direct compensatory damages
in accordance with the provisions of the Reform Act. Any such liability
could be satisfied only to the extent of FNMA’s or FHLMC’s assets
available therefor. In the event of repudiation, the payments of interest
to holders of FNMA or FHLMC mortgage-backed securities would be
reduced if payments on the mortgage loans represented in the
mortgage loan groups related to such mortgage-backed securities are
not made by the borrowers or advanced by the servicer. Any actual
direct compensatory damages for repudiating these guaranty
obligations may not be sufficient to offset any shortfalls experienced by
such mortgage-backed security holders. Further, in its capacity as
conservator or receiver, FHFA has the right to transfer or sell any asset or
liability of FNMA or FHLMC without any approval, assignment or
consent. Although FHFA has stated that it has no present intention to
do so, if FHFA, as conservator or receiver, were to transfer any such
guaranty obligation to another party, holders of FNMA or FHLMC
mortgage-backed securities would have to rely on that party for
satisfaction of the guaranty obligation and would be exposed to the
credit risk of that party. In addition, certain rights provided to holders of
mortgage-backed securities issued by FNMA and FHLMC under the
operative documents related to such securities may not be enforced
against FHFA, or enforcement of such rights may be delayed, during the
conservatorship or any future receivership. The operative documents for
FNMA and FHLMC mortgage-backed securities may provide (or with
respect to securities issued prior to the date of the appointment of the
conservator may have provided) that upon the occurrence of an event of
default on the part of FNMA or FHLMC, in its capacity as guarantor,
which includes the appointment of a conservator or receiver, holders of
such mortgage-backed securities have the right to replace FNMA or
FHLMC as trustee if the requisite percentage of mortgage-backed
securities holders consent. The Reform Act prevents mortgage-backed
security holders from enforcing such rights if the event of default arises
solely because a conservator or receiver has been appointed. The
Reform Act also provides that no person may exercise any right or
power to terminate, accelerate or declare an event of default under
certain contracts to which FNMA or FHLMC is a party, or obtain
possession of or exercise control over any property of FNMA or FHLMC,
or affect any contractual rights of FNMA or FHLMC, without the
approval of FHFA, as conservator or receiver, for a period of 45 or
90 days following the appointment of FHFA as conservator or receiver,
respectively.
FHFA and the White House have made public statements regarding
plans to consider ending the conservatorships of FNMA and FHLMC. In
the event that FNMA and FHLMC are taken out of conservatorship, it is
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PIMCO Income Strategy Fund II
unclear how the capital structure of FNMA and FHLMC would be
constructed and what effects, if any, there may be on FNMA’s and
FHLMC’s creditworthiness and guarantees of certain mortgage-backed
securities. It is also unclear whether the U.S. Treasury would continue to
enforce its rights or perform its obligations under the Senior Preferred
Stock Programs. Should FNMA’s and FHLMC’s conservatorship end,
there could be an adverse impact on the value of their securities, which
could cause losses to the Fund.
Commercial banks, savings and loan institutions, private mortgage
insurance companies, mortgage bankers and other secondary market
issuers also create pass-through pools of conventional residential
mortgage loans. Such issuers may be the originators and/or servicers of
the underlying mortgage loans as well as the guarantors of the
mortgage-related securities. Pools created by such non-governmental
issuers generally offer a higher rate of interest than government and
government-related pools because there are no direct or indirect
government or agency guarantees of payments in the former pools.
However, timely payment of interest and principal of these pools may be
supported by various forms of insurance or guarantees, including
individual loan, title, pool and hazard insurance and letters of credit,
which may be issued by governmental entities or private insurers. Such
insurance and guarantees and the creditworthiness of the issuers
thereof will be considered in determining whether a mortgage-related
security should be purchased for the Fund. There can be no assurance
that the private insurers or guarantors can meet their obligations under
the insurance policies or guarantee arrangements. The Fund may,
however, invest in mortgage-related securities without insurance or
guarantees if PIMCO believes that the securities will help to achieve the
Fund’s investment objective. Securities issued by certain private
organizations may not be readily marketable.
Privately-Issued Mortgage-Related Securities.
Commercial
banks, savings and loan institutions, private mortgage insurance
companies, mortgage bankers and other secondary market issuers also
create pass-through pools of conventional residential mortgage loans.
Such issuers may be the originators and/or servicers of the underlying
mortgage loans as well as the guarantors of the mortgage-related
securities. Pools created by such non-governmental issuers generally
offer a higher rate of interest than government and government-related
pools because there are no direct or indirect government or agency
guarantees of payments in the former pools. However, timely payment
of interest and principal of these pools may be supported by various
forms of insurance or guarantees, including individual loan, title, pool
and hazard insurance and letters of credit, which may be issued by
governmental entities or private insurers. Such insurance and
guarantees and the creditworthiness of the issuers thereof will be
considered in determining whether a mortgage-related security meets
the Fund’s investment quality standards. There can be no assurance that
insurers or guarantors can meet their obligations under the insurance
policies or guarantee arrangements. The Fund may buy
mortgage-related securities without insurance or guarantees if, through
an examination of the loan experience and practices of the
originators/servicers and poolers, PIMCO determines that the securities
meet the Fund’s quality standards. Securities issued by certain private
organizations may not be readily marketable.
Privately-issued mortgage-related securities are not subject to the same
underwriting requirements for the underlying mortgages that are
applicable to those mortgage-related securities that have a government
or government-sponsored entity guarantee. As a result, the mortgage
loans underlying privately-issued mortgage-related securities may, and
frequently do, have less favorable collateral, credit risk or other
underwriting characteristics than government or government-sponsored
mortgage-related securities and have wider variances in a number of
terms including interest rate, term, size, purpose and borrower
characteristics. Mortgage pools underlying privately-issued
mortgage-related securities more frequently include second mortgages,
high loan-to-value ratio mortgages and manufactured housing loans, in
addition to commercial mortgages and other types of mortgages where
a government or government-sponsored entity guarantee is not
available. The coupon rates and maturities of the underlying mortgage
loans in a privately-issued mortgage-related securities pool may vary to
a greater extent than those included in a government guaranteed pool,
and the pool may include subprime mortgage loans. Subprime loans are
loans made to borrowers with weakened credit histories or with a lower
capacity to make timely payments on their loans. For these reasons, the
loans underlying these securities have had in many cases higher default
rates than those loans that meet government underwriting
requirements.
The risk of non-payment is greater for mortgage-related securities that
are backed by loans that were originated under weak underwriting
standards, including loans made to borrowers with limited means to
make repayment. A level of risk exists for all loans, although, historically,
the poorest performing loans have been those classified as subprime.
Other types of privately-issued mortgage-related securities, such as
those classified as pay-option adjustable rate or Alt-A have also
performed poorly. Even loans classified as prime have experienced
higher levels of delinquencies and defaults. The substantial decline in
real property values across the U.S. has exacerbated the level of losses
that investors in privately-issued mortgage-related securities have
experienced. It is not certain when these trends may reverse. Market
factors that may adversely affect mortgage loan repayment include
adverse economic conditions, unemployment, a decline in the value of
real property, or an increase in interest rates.
Privately-issued mortgage-related securities are not traded on an
exchange and there may be a limited market for the securities, especially
when there is a perceived weakness in the mortgage and real estate
market sectors. Without an active trading market, mortgage-related
securities held in the Fund’s portfolio may be particularly difficult to
value because of the complexities involved in assessing the value of the
underlying mortgage loans.
The Fund may purchase privately-issued mortgage-related securities
that are originated, packaged and serviced by third party entities. It is
possible these third parties could have interests that are in conflict with
the holders of mortgage-related securities, and such holders (such as
the Fund) could have rights against the third parties or their affiliates.
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For example, if a loan originator, servicer or its affiliates engaged in
negligence or willful misconduct in carrying out its duties, then a holder
of the mortgage-related security could seek recourse against the
originator/servicer or its affiliates, as applicable. Also, as a loan
originator/servicer, the originator/servicer or its affiliates may make
certain representations and warranties regarding the quality of the
mortgages and properties underlying a mortgage-related security. If one
or more of those representations or warranties is false, then the holders
of the mortgage-related securities (such as the Fund) could trigger an
obligation of the originator/servicer or its affiliates, as applicable, to
repurchase the mortgages from the issuing trust.
Notwithstanding the foregoing, many of the third parties that are legally
bound by trust and other documents have failed to perform their
respective duties, as stipulated in such trust and other documents, and
investors have had limited success in enforcing terms. To the extent third
party entities involved with privately issued mortgage-related securities
are involved in litigation relating to the securities, actions may be taken
that are adverse to the interests of holders of the mortgage-related
securities, including the Fund. For example, third parties may seek to
withhold proceeds due to holders of the mortgage-related securities,
including the Fund, to cover legal or related costs. Any such action could
result in losses to the Fund.
Collateralized Mortgage Obligations.
A CMO is a debt obligation
of a legal entity that is collateralized by mortgages and divided into
classes. Similar to a bond, interest and prepaid principal is paid, in most
cases, on a monthly basis. CMOs may be collateralized by whole
mortgage loans or private mortgage bonds, but are generally
collateralized by portfolios of mortgage pass-through securities
guaranteed by GNMA, FHLMC or FNMA and their income streams.
CMOs are structured into multiple classes, often referred to as
“tranches,” with each class bearing a different stated maturity and
entitled to a different schedule for payments of principal and interest,
including prepayments. The riskiest portion is the “equity” tranche
which bears the bulk of defaults and serves to protect the other, more
senior tranches from default in all but the most severe circumstances.
Actual maturity and average life will depend upon the pre-payment
experience of the collateral. In the case of certain CMOs (known as
“sequential pay” CMOs), payments of principal received from the pool
of underlying mortgages, including prepayments, are applied to the
classes of CMOs in the order of their respective final distribution dates.
Thus, no payment of principal will be made to any class of sequential
pay CMOs until all other classes having an earlier final distribution date
have been paid in full. CMOs may be less liquid and may exhibit greater
price volatility than other types of mortgage- or asset-backed securities.
Commercial Mortgage-Backed Securities.
CMBS include securities
that reflect an interest in, and are secured by, mortgage loans on
commercial real property. Many of the risks of investing in commercial
mortgage-backed securities reflect the risks of investing in the real
estate securing the underlying mortgage loans. These risks reflect the
effects of local and other economic conditions on real estate markets,
the ability of tenants to make loan payments and the ability of a
property to attract and retain tenants. Commercial mortgage-backed
securities may be less liquid and exhibit greater price volatility than
other types of mortgage- or asset-backed securities. The Fund may also
invest in swaps the reference obligation for which is a mortgage-related
index, such as the TRX Index (a tradeable index referencing total return
swaps based on CMBS).
CMO Residuals.
CMO residuals are mortgage securities issued by
agencies or instrumentalities of the U.S. Government or by private
originators of, or investors in, mortgage loans, including savings and
loan associations, homebuilders, mortgage banks, commercial banks,
investment banks and special purpose entities of the foregoing. The
cash flow generated by the mortgage assets underlying a series of a
CMO is applied first to make required payments of principal and interest
on the CMO and second to pay the related administrative expenses and
any management fee of the issuer. The residual in a CMO structure
generally represents the interest in any excess cash flow remaining after
making the foregoing payments. Each payment of such excess cash flow
to a holder of the related CMO residual represents income and/or a
return of capital. The amount of residual cash flow resulting from a CMO
will depend on, among other things, the characteristics of the mortgage
assets, the coupon rate of each class of CMO, prevailing interest rates,
the amount of administrative expenses and the prepayment experience
on the mortgage assets. In particular, the yield to maturity on CMO
residuals is extremely sensitive to prepayments on the related
underlying mortgage assets, in the same manner as an interest-only (or
IO) class of stripped mortgage-backed securities (described below). In
addition, if a series of a CMO includes a class that bears interest at an
adjustable rate, the yield to maturity on the related CMO residual will
also be extremely sensitive to changes in the level of the index upon
which interest rate adjustments are based. As described below with
respect to stripped mortgage-backed securities, in certain circumstances
the Fund may fail to recoup fully its initial investment in a CMO residual.
CMO residuals are generally purchased and sold by institutional
investors through several investment banking firms acting as brokers or
dealers. CMO residuals may, or pursuant to an exemption therefrom,
may not, have been registered under the 1933 Act. CMO residuals,
whether or not registered under the 1933 Act, may be subject to certain
restrictions on transferability.
Adjustable Rate Mortgage-Backed Securities.
ARMs have
interest rates that reset at periodic intervals. Acquiring ARMs permits the
Fund to participate in increases in prevailing current interest rates
through periodic adjustments in the coupons of mortgages underlying
the pool on which ARMs are based. Such ARMs generally have higher
current yield and lower price fluctuations than is the case with more
traditional fixed income debt securities of comparable rating and
maturity. In addition, when prepayments of principal are made on the
underlying mortgages during periods of rising interest rates, the Fund
can reinvest the proceeds of such prepayments at rates higher than
those at which they were previously invested. Mortgages underlying
most ARMs, however, have limits on the allowable annual or lifetime
increases that can be made in the interest rate that the mortgagor pays.
Therefore, if current interest rates rise above such limits over the period
of the limitation, the Fund, when holding an ARM, does not benefit from
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PIMCO Income Strategy Fund II
further increases in interest rates. Moreover, when interest rates are in
excess of coupon rates (i.e., the rates being paid by mortgagors) of the
mortgages, ARMs behave more like fixed income securities and less like
adjustable-rate securities and are subject to the risks associated with
fixed income securities. In addition, during periods of rising interest
rates, increases in the coupon rate of adjustable-rate mortgages
generally lag current market interest rates slightly, thereby creating the
potential for capital depreciation on such securities.
Stripped Mortgage-Backed Securities.
SMBSs are derivative
multi-class mortgage securities. SMBSs may be issued by agencies or
instrumentalities of the U.S. Government, or by private originators of, or
investors in, mortgage loans, including savings and loan associations,
mortgage banks, commercial banks, investment banks and special
purpose entities of the foregoing. SMBSs are usually structured with two
classes that receive different proportions of the interest and principal
distributions on a pool of mortgage assets. A common type of SMBS will
have one class receiving some of the interest and most of the principal
from the mortgage assets, while the other class will receive most of the
interest and the remainder of the principal. In the most extreme case,
one class will receive all of the interest (the IO class), while the other
class will receive all of the principal (the principal-only or PO class). The
yield to maturity on an IO class is extremely sensitive to the rate of
principal payments (including prepayments) on the related underlying
mortgage assets, and a rapid rate of principal payments may have a
material adverse effect on the Fund’s yield to maturity from these
securities. If the underlying mortgage assets experience greater than
anticipated prepayments of principal, the Fund may fail to recoup some
or all of its initial investment in these securities even if the security is in
one of the highest rating categories.
Collateralized Bond Obligations, Collateralized Loan
Obligations and other Collateralized Debt Obligations.
The
Fund may invest in each of CBOs, CLOs, other CDOs and other similarly
structured securities. CBOs, CLOs and CDOs are types of asset-backed
securities. A CBO is a trust which is often backed by a diversified pool of
high risk, below investment grade fixed income securities. The collateral
can be from many different types of fixed income securities such as
high-yield debt, residential privately-issued mortgage-related securities,
commercial privately-issued mortgage-related securities, trust preferred
securities and emerging market debt. A CLO is a trust typically
collateralized by a pool of loans, which may include, among others,
domestic and foreign senior secured loans, senior unsecured loans and
subordinate corporate loans, including loans that may be rated below
investment grade or equivalent unrated loans. Other CDOs are trusts
backed by other types of assets representing obligations of various
parties. CBOs, CLOs and other CDOs may charge management fees and
administrative expenses. For CBOs, CLOs and CDOs, the cash flows from
the trust are split into two or more portions, called tranches, varying in
risk and yield. The riskiest portion is the “equity” tranche which bears
the bulk of defaults from the bonds or loans in the trust and serves to
protect the other, more senior tranches from default in all but the most
severe circumstances. Since they are partially protected from defaults,
senior tranches from a CBO trust, CLO trust or trust of another CDO
typically have higher ratings and lower yields than their underlying
securities, and can be rated investment grade. Despite the protection
from the equity tranche, CBO, CLO or other CDO tranches can
experience substantial losses due to actual defaults, increased sensitivity
to defaults due to collateral default and disappearance of protecting
tranches, market anticipation of defaults, as well as aversion to CBO,
CLO or other CDO securities as a class. The Fund may invest in any
tranche, including the equity tranche, of a CBO, CLO or other CDO. The
risks of an investment in a CBO, CLO or other CDO depend largely on
the type of the collateral securities and the class of the instrument in
which the Fund invests. Normally, CBOs, CLOs and other CDOs are
privately offered and sold, and thus are not registered under the
securities laws. As a result, investments in CBOs, CLOs and other CDOs
may be characterized by the Fund as illiquid investments; however, an
active dealer market may exist for CBOs, CLOs and other CDOs allowing
them to qualify for Rule 144A under the 1933 Act. In addition to the
normal risks associated with debt instruments discussed elsewhere in
this prospectus and in the Statement of Additional Information (e.g.,
prepayment risk, credit risk, liquidity risk, market risk, structural risk,
legal risk, interest rate risk (which may be exacerbated if the interest
rate payable on a structured financing changes based on multiples of
changes in interest rates or inversely to changes in interest rates) and
default risk), CBOs, CLOs and other CDOs carry additional risks
including, but not limited to: (i) the possibility that distributions from
collateral securities will not be adequate to make interest or other
payments; (ii) the quality of the collateral may decline in value or
default; (iii) the risk that the Fund may invest in CBOs, CLOs and other
CDOs that are subordinate to other classes; and (iv) the complex
structure of the security may not be fully understood at the time of
investment and may produce disputes with the issuer or unexpected
investment results.
Asset-Backed Securities.
Asset-backed securities (“ABS”) are bonds
backed by pools of loans or other receivables. ABS are created from
many types of assets, including auto loans, credit card receivables, home
equity loans and student loans. ABS are typically issued through special
purpose vehicles that are bankruptcy remote from the issuer of the
collateral. The credit quality of an ABS transaction depends on the
performance of the underlying assets. To protect ABS investors from the
possibility that some borrowers could miss payments or even default on
their loans, ABS may include various forms of credit enhancement. Some
ABS, particularly home equity loan ABS, are subject to interest rate risk
and prepayment risk. A change in interest can affect the pace of
payments on the underlying loans, which in turn affects total return on
the securities. ABS also carry credit or default risk. If many borrowers on
the underlying loans default, losses could exceed the credit
enhancement level and result in losses to investors in an ABS. In
addition, ABS have structural risk due to a unique characteristic known
as early amortization, or early payout, risk. Built into the structure of
most ABS are triggers for early payout, designed to protect investors
from losses. These triggers are unique to each transaction and can
include a big rise in defaults on the underlying loans, a sharp drop in the
credit enhancement level or even the bankruptcy of the originator. Once
early amortization begins, all incoming loan payments (after expenses
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are paid) are used to pay investors as quickly as possible based upon a
predetermined priority of payment. The Fund may invest in any tranche,
including the equity tranche, of an ABS.
The Fund may invest in other types of asset-backed securities that are
offered in the marketplace, including Enhanced Equipment Trust
Certificates (“EETCs”). EETCs are typically issued by specially-created
trusts established by airlines, railroads, or other transportation
corporations. The proceeds of EETCs are used to purchase equipment,
such as airplanes, railroad cars, or other equipment, which in turn serve
as collateral for the related issue of the EETCs. The equipment generally
is leased by the airline, railroad or other corporation, which makes rental
payments to provide the projected cash flow for payments to EETC
holders. Holders of EETCs must look to the collateral securing the
certificates, typically together with a guarantee provided by the lessee
corporation or its parent company for the payment of lease obligations,
in the case of default in the payment of principal and interest on the
EETCs. However, because principal and interest payments on EETCs are
funded in the ordinary course by the lessee corporation, the Fund treats
EETCs as corporate bonds/obligations for purposes of compliance
testing and related classifications.
Please see “Investment Objective and Policies—Mortgage-Related and
Other Asset-Backed Instruments” in the Statement of Additional
Information and “Principal Risks of the Fund—Mortgage-Related and
Asset-Backed Instruments Risk” in this prospectus for a more detailed
description of the types of mortgage-related and other asset-backed
instruments in which the Fund may invest and their related risks.
Real Estate Assets and Related Derivatives
The Fund may generally gain exposure to the real estate sector by
investing in real-estate linked derivatives, real estate investment trusts
(“REITs”) and common, preferred and convertible securities of issuers in
real estate- related industries. The Fund may also invest in loans or other
investments secured by real estate (other than mortgage-backed
securities) and may, as a result of default, foreclosure or otherwise, take
possession of and hold real estate as a direct owner (see “Loans and
Other Indebtedness; Loan Participations and Assignments” below). Each
of these types of investments are subject, directly or indirectly, to risks
associated with ownership of real estate, including changes in the
general economic climate or local conditions (such as an oversupply of
space or a reduction in demand for space), loss to casualty or
condemnation, increases in property taxes and operating expenses,
zoning law amendments, changes in interest rates, overbuilding and
increased competition, including competition based on rental rates,
variations in market value, changes in the financial condition of tenants,
changes in operating costs, attractiveness and location of the properties,
adverse changes in the real estate markets generally or in specific
sectors of the real estate industry and possible environmental liabilities.
Real estate-related investments may entail leverage and may be highly
volatile.
REITs are pooled investment vehicles that own, and typically operate,
income-producing real estate. If a REIT meets certain requirements,
including distributing to shareholders substantially all of its taxable
income (other than net capital gains), then it is not generally taxed on
the income distributed to shareholders. REITs are subject to
management fees and other expenses, and so the Fund would bear its
proportionate share of the costs of the REITs’ operations if it invests in
REITs.
There are three general categories of REITs: Equity REITs, Mortgage
REITs and Hybrid REITs. Equity REITs invest primarily in direct fee
ownership or leasehold ownership of real property; they derive most of
their income from rents. Mortgage REITs invest mostly in mortgages on
real estate, which may secure construction, development or long-term
loans, and the main source of their income is mortgage interest
payments. Hybrid REITs hold both ownership and mortgage interests in
real estate.
Along with the risks common to different types of real estate related
securities, REITs, no matter the type, involve additional risk factors.
These include poor performance by the REIT’s manager, adverse
changes to the tax laws, and failure by the REIT to qualify for tax-free
distribution of income or exemption under 1940 Act or tax-free
pass-through of income under the Code. In addition, some REITS have
limited diversification because they invest in a limited number of
properties, a narrow geographic area, or a single type of property. Also,
the organizational documents of a REIT may contain provisions that
make changes in control of the REIT difficult and time-consuming.
Finally, private REITs are not traded on a national securities exchange.
As such, these products are generally illiquid. This reduces the ability of
the Fund to redeem its investment early. Private REITS are also generally
harder to value and may bear higher fees than public REITs.
Some of the REITs in which the Fund may invest may be permitted to
hold senior or residual interests in real estate mortgage investment
conduits (“REMICs”) or debt or equity interests in taxable mortgage
pools (“TMPs”). The Fund may also hold interests in “Re-REMICs”,
which are interests in securitizations formed by the contribution of asset
backed or other similar securities into a trust which then issues
securities in various tranches. The Fund may participate in the creation
of a Re-REMIC by contributing assets to the trust and receiving junior
and/or senior securities in return. An interest in a Re-REMIC security
may be riskier than the securities originally held by and contributed to
the trust, and the holders of the Re-REMIC securities will bear the costs
associated with the securitization.
Inverse Floaters
An inverse floater is a type of debt instrument that bears a floating or
variable interest rate that moves in the opposite direction to interest
rates generally or the interest rate on another security or index. Changes
in interest rates generally, or the interest rate of the other security or
index, inversely affect the interest rate paid on the inverse floater, with
the result that the inverse floater’s price will be considerably more
volatile than that of a fixed-rate bond. The Fund may invest without
limitation in inverse floaters, which brokers typically create by depositing
an income-producing instrument, which may be a mortgage-related
security, in a trust. The trust in turn issues a variable rate security and
inverse floaters. The interest rate for the variable rate security is typically
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PIMCO Income Strategy Fund II
determined by an index or an auction process, while the inverse floater
holder receives the balance of the income from the underlying
income-producing instrument less an auction fee. The market prices of
inverse floaters may be highly sensitive to changes in interest rates and
prepayment rates on the underlying securities, and may decrease
significantly when interest rates increase or prepayment rates change. In
a transaction in which the Fund purchases an inverse floater from a
trust, and the underlying bond was held by the Fund prior to being
deposited into the trust, the Fund typically treats the transaction as a
secured borrowing for financial reporting purposes. As a result, for
financial reporting purposes, the Fund will generally incur a non-cash
interest expense with respect to interest paid by the trust on the
variable rate securities, and will recognize additional interest income in
an amount directly corresponding to the non-cash interest expense.
Therefore, the Fund’s NAV per Common Share and performance are not
affected by the non-cash interest expense. This accounting treatment
does not apply to inverse floaters acquired by the Fund when the Fund
did not previously own the underlying bond.
Certain Interest Rate Transactions
In order to reduce the interest rate risk inherent in the Fund’s underlying
investments and capital structure, the Fund may (but is not required to)
enter into interest rate swap transactions. Interest rate swaps involve
the exchange by the Fund with a counterparty of their respective
commitments to pay or receive interest, such as an exchange of fixed
rate payments for floating rate payments. These transactions generally
involve an agreement with the swap counterparty to pay a fixed or
variable rate payment in exchange for the counterparty paying the Fund
the other type of payment stream (i.e., variable or fixed). The payment
obligation would be based on the notional amount of the swap. Other
forms of interest rate swap agreements in which the Fund may invest
include without limitation interest rate caps, under which, in return for a
premium, one party agrees to make payments to the other to the extent
that interest rates exceed a specified rate, or “cap;” interest rate floors,
under which, in return for a premium, one party agrees to make
payments to the other to the extent that interest rates fall below a
specified rate, or “floor;” and interest rate “collars,” under which a
party sells a cap and purchases a floor or vice versa in an attempt to
protect itself against interest rate movements exceeding given minimum
or maximum levels. The Fund may (but is not required to) use interest
rate swap transactions with the intent to reduce or eliminate the risk
that an increase in short-term interest rates could pose for the
performance of the Fund’s Common Shares as a result of leverage, and
also may use these instruments for other hedging or investment
purposes. The Fund may choose or be required to redeem some or all of
the ARPS. This redemption would likely result in the Fund seeking to
terminate early all or a portion of any swap or cap transaction. Such
early termination of an interest rate swap transaction could result in a
termination payment by or to the Fund. Any termination of a cap could
result in a termination payment to the Fund.
Reverse Repurchase Agreements and Dollar Rolls/Buybacks
As described under “Use of Leverage,” the Fund may use, among other
things, reverse repurchase agreements and/or dollar rolls/buybacks to
add leverage to its portfolio. Under a reverse repurchase agreement, the
Fund sells securities to a bank or broker dealer and agrees to repurchase
the securities at a mutually agreed future date and price. A dollar
roll/buyback is similar to a reverse repurchase agreement except that
the counterparty with which the Fund enters into a dollar roll/buyback
transaction is not obligated to return the same securities as those
originally sold by the Fund, but only securities that are “substantially
identical.” Generally, the effect of a reverse repurchase agreement or
dollar roll/buyback transaction is that the Fund can recover and reinvest
all or most of the cash invested in the portfolio securities involved
during the term of the agreement and still be entitled to the returns
associated with those portfolio securities, thereby resulting in a
transaction similar to a borrowing and giving rise to leverage for the
Fund. The Fund will incur interest expense as a cost of utilizing reverse
repurchase agreements and dollar rolls/buybacks. In the event the buyer
of securities under a reverse repurchase agreement or dollar
roll/buyback files for bankruptcy or becomes insolvent, the Fund’s use of
the proceeds of the agreement may be restricted pending a
determination by the other party, or its trustee or receiver, whether to
enforce the Fund’s obligation to repurchase the securities.
Repurchase Agreements
The Fund may enter into repurchase agreements, in which the Fund
purchases a security from a bank or broker-dealer and the bank or
broker-dealer agrees to repurchase the security at the Fund’s cost plus
interest within a specified time. If the party agreeing to repurchase
should default, the Fund would seek to sell the securities which it holds.
This could involve costs or delays in addition to a loss on the securities if
their value should fall below their repurchase price. Repurchase
agreements maturing in more than seven days are considered to be
illiquid investments.
U.S. Government Securities
U.S. government securities are obligations of and, in certain cases,
guaranteed by, the U.S. government, its agencies or instrumentalities.
The U.S. government does not guarantee the NAV of the Common
Shares. Some U.S. government securities, such as Treasury bills, notes
and bonds, and securities guaranteed by GNMA, are supported by the
full faith and credit of the United States; others, such as those of the
FHLBs or the FHLMC, are supported by the right of the issuer to borrow
from the U.S. Treasury; others, such as those of FNMA, are supported by
the discretionary authority of the U.S. government to purchase the
agency’s obligations; and still others are supported only by the credit of
the instrumentality. U.S. government securities may include zero coupon
securities, which do not distribute interest on a current basis and tend to
be subject to greater risk than interest-paying securities of similar
maturities.
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When-Issued, Delayed Delivery and Forward Commitment
Transactions
The Fund may purchase securities that it is eligible to purchase on a
when-issued basis, may purchase such securities for delayed delivery
and may make contracts to purchase such securities for a fixed price at a
future date beyond normal settlement time (forward commitments).
When-issued transactions, delayed delivery purchases and forward
commitments involve a risk of loss if the value of the securities declines
prior to the settlement date. This risk is in addition to the risk that the
Fund’s other assets will decline in value. Therefore, these transactions
may result in a form of leverage and increase the Fund’s overall
investment exposure. Typically, no income accrues on securities the Fund
has committed to purchase prior to the time delivery of the securities is
made. When the Fund has sold a security on a when-issued,
delayed-delivery or forward commitment basis, the Fund does not
participate in future gains or losses with respect to the security. If the
other party to a transaction fails to pay for the securities, the Fund could
suffer a loss. Additionally, when selling a security on a when-issued,
delayed-delivery or forward commitment basis without owning the
security, the Fund will incur a loss if the security’s price appreciates in
value such that the security’s price is above the agreed-upon price on
the settlement date.
Inflation-Indexed Bonds
Inflation-indexed bonds (other than municipal inflation-indexed bonds
and certain corporate inflation-indexed bonds) are fixed income
securities the principal value of which is periodically adjusted according
to the rate of inflation. If the index measuring inflation falls, the
principal value of inflation-indexed bonds (other than municipal
inflation-indexed bonds and certain corporate inflation-indexed bonds)
will be adjusted downward, and consequently the interest payable on
these securities (calculated with respect to a smaller principal amount)
will be reduced. Repayment of the original bond principal upon maturity
(as adjusted for inflation) is guaranteed in the case of Treasury Inflation
Protected Securities (“TIPS”). For bonds that do not provide a similar
guarantee, the adjusted principal value of the bond repaid at maturity
may be less than the original principal. TIPS may also be divided into
individual zero-coupon instruments for each coupon or principal
payment (known as “iSTRIPS”). An iSTRIP of the principal component of
a TIPS issue will retain the embedded deflation floor that will allow the
holder of the security to receive the greater of the original principal or
inflation-adjusted principal value at maturity. iSTRIPS may be less liquid
than conventional TIPS because they are a small component of the TIPS
market. Municipal inflation-indexed securities are municipal bonds that
pay coupons based on a fixed rate plus CPI. With regard to municipal
inflation-indexed bonds and certain corporate inflation-indexed bonds,
the inflation adjustment is typically reflected in the semi-annual coupon
payment. As a result, the principal value of municipal inflation-indexed
bonds and such corporate inflation-indexed bonds does not adjust
according to the rate of inflation. At the same time, the value of
municipal inflation-indexed securities and such corporate
inflation-indexed securities generally will not increase if the rate of
inflation decreases. Because municipal inflation-indexed securities and
corporate inflation-indexed securities are a small component of the
municipal bond and corporate bond markets, respectively, they may be
less liquid than conventional municipal and corporate bonds.
The value of inflation-indexed bonds is expected to change in response
to changes in real interest rates. Real interest rates are tied to the
relationship between nominal interest rates and the rate of inflation. If
nominal interest rates increase at a faster rate than inflation, real
interest rates may rise, leading to a decrease in value of
inflation-indexed bonds. Any increase in the principal amount of an
inflation-indexed bond will be considered taxable ordinary income, even
though investors do not receive their principal until maturity. See “Tax
Matters“ in this prospectus and “Taxation” in the Statement of
Additional Information.
Event-Linked Instruments
The Fund may obtain event-linked exposure by investing in
“event-linked bonds” or “event-linked swaps” or by implementing
“event-linked strategies.” Event-linked exposure results in gains or
losses that typically are contingent upon, or formulaically related to,
defined trigger events. Examples of trigger events include hurricanes,
earthquakes, weather-related phenomena or statistics relating to such
events. Some event-linked bonds are commonly referred to as
“catastrophe bonds.” If a trigger event occurs, the Fund may lose a
portion or its entire principal invested in the bond or notional amount
on a swap. Event-linked exposures often provide for an extension of
maturity to process and audit loss claims when a trigger event has, or
possibly has, occurred. An extension of maturity may increase volatility.
Event-linked exposure may also expose the Fund to certain other risks
including credit risk, counterparty risk, adverse regulatory or
jurisdictional interpretations and adverse tax consequences.
Event-linked exposures may also be subject to liquidity risk.
Credit-Linked Trust Certificates
The Fund may invest in credit-linked trust certificates, which are
investments in a limited purpose trust or other vehicle which, in turn,
invests in a basket of derivative instruments, such as credit default
swaps, total return swaps, interest rate swaps or other securities, in
order to provide exposure to the high yield or another debt securities
market. Like an investment in a bond, investments in credit-linked trust
certificates represent the right to receive periodic income payments (in
the form of distributions) and payment of principal at the end of the
term of the certificate. However, these payments are conditioned on the
trust’s receipt of payments from, and the trust’s potential obligations to,
the counterparties to the derivative instruments and other securities in
which the trust invests. For instance, the trust may sell one or more
credit default swaps, under which the trust would receive a stream of
payments over the term of the swap agreements provided that no event
of default has occurred with respect to the referenced debt obligation
upon which the swap is based. If a default occurs, the stream of
payments may stop and the trust would be obligated to pay to the
counterparty the par (or other agreed upon value) of the referenced
debt obligation. This, in turn, would reduce the amount of income and
principal that the Fund would receive as an investor in the trust. The
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Fund’s investments in these instruments are indirectly subject to the
risks associated with derivative instruments, including, among others,
credit risk, default or similar event risk, counterparty risk, interest rate
risk, leverage risk, valuation risk and management risk. It is expected
that the trusts that issue credit-linked trust certificates will constitute
“private” investment companies, exempt from registration under the
1940 Act. Therefore, the certificates will not be subject to applicable
investment limitations and other regulation imposed by the 1940 Act
(although the Fund will remain subject to such limitations and
regulation, including with respect to its investments in the certificates).
Although the trusts are typically private investment companies, they
generally are not actively managed such as a “hedge fund” might be. It
also is expected that the certificates will be exempt from registration
under the 1933 Act. Accordingly, there may be no established trading
market for the certificates and they may constitute illiquid investments.
See “Principal Risks of the Fund—Liquidity Risk.” If market quotations
are not readily available for the certificates, they will be valued by the
Valuation Designee (as defined below) at fair value as determined by
the Board or persons acting at its direction. See “Net Asset Value.” The
Fund may lose its entire investment in a credit-linked trust certificate.
Other Investment Companies
The Fund may invest in securities of other open- or closed-end
investment companies (including those advised by PIMCO), including,
without limitation, ETFs, to the extent that such investments are
consistent with the Fund’s investment objective, strategies and policies
and permissible under the 1940 Act. The Fund may invest in other
investment companies (including those advised by PIMCO) to gain
broad market or sector exposure or for cash management purposes,
including during periods when it has large amounts of uninvested cash
(such as the period shortly after the Fund receives the proceeds of the
offering of its Common Shares) or when PIMCO believes share prices of
other investment companies offer attractive values. The Fund may invest
in certain money market funds and/or short-term bond funds (“Central
Funds”), to the extent permitted by the 1940 Act, the rules thereunder
or exemptive relief therefrom. The Central Funds are registered
investment companies created for use by certain registered investment
companies advised by PIMCO in connection with their cash
management activities. The Fund treats its investments in other
investment companies that invest primarily in types of securities in
which the Fund may invest directly as investments in such types of
securities for purposes of the Fund’s investment policies (e.g., the Fund’s
investment in an investment company that invests primarily in debt
securities will be treated by the Fund as an investment in a debt
security). As a shareholder in an investment company, the Fund would
bear its ratable share of that investment company’s expenses and would
remain subject to payment of the Fund’s management fees and other
expenses with respect to assets so invested. Common Shareholders
would therefore be subject to duplicative expenses to the extent the
Fund invests in other investment companies. The securities of other
investment companies may be leveraged, in which case the NAV and/or
market value of the investment company’s shares will be more volatile
than unleveraged investments. See “Principal Risks of the
Fund—Leverage Risk.”
Regulatory changes adopted by the SEC concerning investments by
registered investment companies in the securities of other registered
investment companies may, among other things, limit investment
flexibility and could affect the Fund’s ability to utilize the Central Funds.
This could adversely impact the Fund’s investment strategies and
operations. The “Investment Objective and Policies - Regulatory Risk”
section in the Statement of Additional Information discusses these
changes in further detail.
Short Sales
A short sale is a transaction in which the Fund sells a security or other
instrument that it does not own in anticipation that the market price will
decline. The Fund may use short sales for investment purposes or for
hedging and risk management purposes. The Fund may also take short
positions with respect to the performance of securities, indexes, interest
rates, currencies and other assets or markets through the use of
derivative or forward instruments. When the Fund engages in a short
sale of a security, it must borrow the security sold short and deliver it to
the counterparty. The Fund may have to pay a fee to borrow particular
securities and would often be obligated to pay over any payments
received on such borrowed securities. The Fund’s obligation to replace
the borrowed security will be secured by collateral deposited with the
Fund’s custodian in the name of the lender. The Fund may not receive
any payments (including interest) on its collateral. Short sales expose the
Fund to the risk that it will be required to cover its short position at a
time when the securities have appreciated in value, thus resulting in a
loss to the Fund. The Fund may engage in so-called “naked” short sales
when it does not own or have the immediate right to acquire the
security sold short at no additional cost, in which case the Fund’s losses
theoretically could be unlimited. If the price of the security sold short
increases between the time of the short sale and the time that the Fund
replaces the borrowed security, the Fund will incur a loss; conversely, if
the price declines, the Fund will realize a gain. Any gain will be
decreased, and any loss increased, by the transaction costs described
above. The successful use of short selling may be adversely affected by
imperfect correlation between movements in the price of the security
sold short and securities being hedged if the short sale is being used for
hedging purposes. See “Principal Risks of the Fund—Derivatives” and
“Principal Risks of the Fund—Short Sales Risk.” See also “Principal
Risks of the Fund—Leverage Risk.” The Fund may engage in short
selling to the extent permitted by the 1940 Act and other federal
securities laws.
Portfolio Turnover
The length of time the Fund has held a particular security is not
generally a consideration in investment decisions. A change in the
securities held by the Fund is known as “portfolio turnover.” The Fund
may engage in frequent and active trading of portfolio securities to
achieve its investment objective, particularly during periods of volatile
market movements. High portfolio turnover (e.g., over 100%) generally
57 Base Prospectus
| PIMCO Income Strategy Fund II
Base Prospectus
involves correspondingly greater expenses to the Fund, including
brokerage commissions or dealer mark-ups and other transaction costs
on the sale of securities and reinvestments in other securities. Sales of
portfolio securities may also result in realization of taxable capital gains
(including short-term capital gains which are generally treated as
ordinary income upon distribution in the form of dividends). The trading
costs and tax effects associated with portfolio turnover may adversely
affect the Fund’s performance.
Other Investment Techniques
The following provides additional information regarding the types of
securities and other instruments in which the Fund will ordinarily invest.
A more detailed discussion of these and other instruments and
investment techniques that may be used by the Fund is provided under
“Investment Objective and Policies” in the Statement of Additional
Information.
Temporary Defensive Investments
The Fund may make short-term investments when attempting to
respond to adverse market, economic, political, or other conditions, as
determined by PIMCO. When PIMCO deems it appropriate to do so, the
Fund may, for temporary defensive purposes, deviate from its
investment strategy by investing some or all of its total assets in
investments such as high grade debt securities, including high quality,
short-term debt securities, and cash and cash equivalents. The Fund may
not achieve its investment objective when it does so.
Commercial Paper
Commercial paper represents short-term unsecured promissory notes
issued in bearer form by corporations such as banks or bank holding
companies and finance companies. The rate of return on commercial
paper may be linked or indexed to the level of exchange rates between
the U.S. dollar and a foreign currency or currencies.
Common Stocks and Other Equity Securities
The Fund will not normally invest directly in common stocks of operating
companies. However, the Fund may own and hold common stocks of
operating companies in its portfolio from time to time in connection
with a corporate action, or the restructuring of a debt instrument or
through the conversion of a convertible security held by the Fund. For
instance, in connection with the restructuring of a debt instrument,
either outside of bankruptcy court or in the context of bankruptcy court
proceedings, the Fund may determine or be required to accept common
stocks or other equity securities in exchange for all or a portion of the
debt instrument. Depending upon, among other things, PIMCO’s
evaluation of the potential value of such securities in relation to the
price that could be obtained by the Fund at any given time upon sale
thereof, the Fund may determine to hold these equity securities in its
portfolio. For these purposes, operating companies do not include
holding companies or companies or other entities whose primary
business is to own and manage investment assets such as securities,
commodities or real estate.
Although common stocks and other equity securities have historically
generated higher average returns than debt securities over the long
term, they also have experienced significantly more volatility in those
returns and in certain years have significantly underperformed relative
to debt securities. An adverse event, such as an unfavorable earnings
report, may depress the value of a particular equity security held by the
Fund. Also, prices of common stocks and other equity securities are
sensitive to general movements in the equity markets and a decline in
those markets may depress the prices of the equity securities held by the
Fund. The prices of equity securities fluctuate for many different reasons,
including changes in investors’ perceptions of the financial condition of
an issuer or the general condition of the relevant stock market or when
political or economic events affecting the issuer occur. In addition, prices
of equity securities may be particularly sensitive to rising interest rates,
as the cost of capital rises and borrowing costs increase. The Fund may
invest in common shares of pooled vehicles, such as those of other
investment companies, and in common shares of REITs..
Lending of Portfolio Securities
For the purpose of achieving income, the Fund may lend its portfolio
securities to brokers, dealers or other financial institutions provided a
number of conditions are satisfied, including that the loan is fully
collateralized. See “Investment Objective and Policies—Loans of
Portfolio Securities” in the Statement of Additional Information for
details. When the Fund lends portfolio securities, its investment
performance will continue to reflect changes in the value of the
securities loaned. The Fund will also receive a fee or interest on the
collateral. Securities lending involves the risk of loss of rights in the
collateral or delay in recovery of the collateral if the borrower fails to
return the security loaned or becomes insolvent, or the risk of loss due
to the investment performance of the collateral. The Fund may pay
lending fees to the party arranging the loan. See “Principal Risks of the
Fund—Securities Lending Risk.”
As a shareholder of an investment company or other pooled vehicle, the
Fund may indirectly bear investment advisory fees, supervisory and
administrative fees, service fees and other fees which are in addition to
the fees the Fund pays its service providers. To the extent such cash
collateral is invested in an affiliated money market or short-term mutual
fund, such fees generally will not be waived, and PIMCO expects to
select such an investment without considering or canvassing the
universe of available unaffiliated investment companies.
Rating Agency Requirements
In connection with rating the ARPS, Moody’s and Fitch will impose asset
coverage tests and other restrictions that may limit the Fund’s ability to
engage in certain of the transactions described above. See “Description
of Capital Structure.”
Please see “Investment Objective and Policies” in the Statement of
Additional Information for additional information regarding the
investments of the Fund and their related risks.
[], 2024 |
Base Prospectus
58
PIMCO Income Strategy Fund II
Use of Leverage
The Fund currently utilizes leverage principally through reverse
repurchase agreements and may also obtain additional leverage
through the issuance of Preferred Shares and the use of dollar
rolls/buybacks or borrowings, such as through bank loans or commercial
paper and/or other credit facilities. Information regarding the terms and
features of the ARPS is provided under “Description of Capital
Structure” in this prospectus.
The Fund may also enter into transactions other than those noted above
that may give rise to a form of leverage including, among others, selling
credit default swaps, futures and forward contracts (including foreign
currency exchange contracts), total return swaps and other derivative
transactions, loans of portfolio securities, short sales and when-issued,
delayed delivery and forward commitment transactions. The Fund may
also determine to issue other types of preferred shares. Leveraging
transactions pursued by the Fund may increase its duration and
sensitivity to interest rate movements.
Depending upon market conditions and other factors, the Fund may or
may not determine to add leverage following an offering to maintain or
increase the total amount of leverage (as a percentage of the Fund’s
total assets) that the Fund currently maintains, taking into account the
additional assets raised through the issuance of Common Shares in such
offering. The Fund utilizes certain kinds of leverage, such as reverse
repurchase agreements and credit default swaps, opportunistically and
may choose to increase or decrease, or eliminate entirely, its use of such
leverage over time and from time to time based on PIMCO’s assessment
of the yield curve environment, interest rate trends, market conditions
and other factors. The Fund may also determine to decrease the
leverage it currently maintains through its outstanding Preferred Shares
through Preferred Shares redemptions or tender offers and may or may
not determine to replace such leverage through other sources. If the
Fund determines to add leverage following an offering, it is not possible
to predict with accuracy the precise amount of leverage that would be
added, in part because it is not possible to predict the number of
Common Shares that ultimately will be sold in an offering or series of
offerings. To the extent that the Fund does not add additional leverage
following an offering, the Fund’s total amount of leverage as a
percentage of its total assets will decrease, which could result in a
reduction of investment income available for distribution to Common
Shareholders.
The Fund’s net assets attributable to its Preferred Shares and the net
proceeds the Fund obtains from reverse repurchase agreements or other
forms of leverage utilized, if any, will be invested in accordance with the
Fund’s investment objective and policies as described in this prospectus
and any prospectus supplement. So long as the rate of return, net of
applicable Fund expenses, on the debt obligations and other
investments purchased by the Fund exceeds the dividend rates payable
on the Preferred Shares together with the costs to the Fund of other
leverage it utilizes, the investment of the Fund’s net assets attributable
to leverage will generate more income than will be needed to pay the
costs of the leverage. If so, and all other things being equal, the excess
may be used to pay higher dividends to Common Shareholders than if
the Fund were not so leveraged.
Regarding the costs associated with the Fund’s ARPS, the terms of the
ARPS provide that they would ordinarily pay dividends at a rate set at
auctions held every seven days, normally payable on the first business
day following the end of the rate period, subject to a maximum
applicable rate calculated as a function of the ARPS’ then-current rating
and a reference interest rate as described below. However, the weekly
auctions for the ARPS, as well as auctions for similar preferred shares of
other closed-end funds in the U.S., have failed since February 2008, and
the dividend rates on the ARPS since that time have been paid at the
maximum applicable rate (i.e., the greater of a multiple of or a spread
plus a reference rate, which is either (i) for a rate period of fewer than
365 days, the Secured Overnight Funding Rate plus spread adjustments
intended to serve as a reasonable substitute of the previously-applicable
LIBOR Rate (as defined and detailed in the Fund’s Bylaws), or (ii) for a
rate period of 365 days or more, the applicable Treasury Index Rate). In
September 2011, Moody’s, a ratings agency that provides ratings for the
Fund’s ARPS, downgraded its rating of the ARPS from “Aaa” to “Aa2,”
citing what it believed to be persistently thin asset coverage levels,
increased NAV volatility and concerns about secondary market liquidity
for some assets supporting rated obligations. In July 2012, Moody’s
downgraded its rating of the ARPS from “Aa2” to “Aa3” pursuant to a
revised ratings methodology adopted by Moody’s. In May 2020, Fitch
downgraded its rating of the ARPS from “AAA” to “AA,” indicating the
downgrades reflected recent extreme market volatility and reduced
asset liquidity, which it believed eroded asset coverage cushions for
closed-end funds and challenged fund managers’ ability to deleverage.
On December 4, 2020, Fitch published ratings criteria relating to
closed-end fund obligations, including preferred shares, which
effectively result in a rating cap of “AA” for debt and preferred stock
issued by closed-end funds and a rating cap of “A” for (i) debt and
preferred shares issued by closed-end funds exposed to corporate debt,
emerging market debt, below-investment-grade and unrated debt,
structured securities and equity, (ii) and closed-end funds with material
exposure to “BBB” category rated assets. Following the close of
business on April 30, 2021, Fitch downgraded its rating of the ARPS
from “AA” to “A” pursuant to the revised ratings methodology and
related new rating caps. In December 2022, Moody’s downgraded its
rating of the ARPS from “Aa3” to “A1,” stating that the downgrades
occurred because of, among other matters, trends in the Fund’s
risk-adjusted asset coverage metrics and the evolution of its sector
exposures. See “Use of Leverage” and “Description of Capital
Structure.” The Fund expects that the ARPS will continue to pay
dividends at the maximum applicable rate for the foreseeable future and
cannot predict whether or when the auction markets for the ARPS may
resume normal functioning. See “Principal Risks of the Fund—Leverage
Risk,” “Principal Risks of the Fund—Additional Risks Associated with
the Fund’s Preferred Shares” and “Description of Capital Structure” for
more information.
59 Base Prospectus
| PIMCO Income Strategy Fund II
Base Prospectus
Under the 1940 Act, the Fund is not permitted to issue new Preferred
Shares unless immediately after such issuance the value of the Fund’s
total net assets (as defined below) is at least 200% of the liquidation
value of the outstanding Preferred Shares and the newly issued
preferred shares plus the aggregate amount of any senior securities of
the Fund representing indebtedness (i.e., such liquidation value plus the
aggregate amount of senior securities representing indebtedness may
not exceed 50% of the Fund’s total net assets). In addition, the Fund is
not permitted to declare any cash dividend or other distribution on its
Common Shares unless, at the time of such declaration, the value of the
Fund’s total net assets satisfies the above-referenced 200% coverage
requirement.
The Fund is subject to the 1940 Act requirement that an investment
company satisfy an asset coverage requirement of 300% of its senior
securities represented by indebtedness measured at the time the
investment company incurs the indebtedness. This means that at any
given time the value of the Fund's total senior securities represented
indebtedness may not exceed one-third the value of its total assets
(including assets attributable to such leverage). The Fund's issuance of
Preferred Shares and use of derivatives results in leverage, but any such
leverage is not subject to the 300% asset coverage requirement. This is
because (1) derivatives will, to the extent permitted by the Derivatives
Rule, not be “senior securities” under the 1940 Act and (2) under the
1940 Act, Preferred Shares are subject to the 200% asset coverage
requirement described above (not the 300% asset coverage
requirement applicable to indebtedness). The interests of persons with
whom the Fund enters into leverage arrangements will not necessarily
be aligned with the interests of the Fund's shareholders and such
persons will have claims on the Fund's assets that are senior to those of
the Fund's shareholders.
The Fund may enter into derivatives or other transactions that may
provide leverage (other than through the issuance of Preferred Shares or
bank borrowing). The Derivatives Rule regulates a registered investment
company's use of derivatives and certain other transactions that create
future payment and/or delivery obligations by the Fund. This rule
became operative in August 2022. The Derivatives Rule prescribes
specific VaR leverage limits that apply to the Fund (although the Fund in
the future could qualify as a limited derivatives user (as defined in the
Derivatives Rule) and would therefore not be subject to all the
requirements of the Derivatives Rule). VaR is an estimate of potential
losses on an instrument or portfolio over a specified time horizon and at
a given confidence level. The Fund may apply a relative VaR test or an
absolute VaR test (if the Fund's derivatives risk manager determines that
a designated reference portfolio would not provide an appropriate
reference portfolio for purposes of the relative VaR test). The limit under
the relative VaR test when a fund has outstanding preferred shares is
250% (or 200% when no preferred shares are outstanding) of the VaR
of a designated reference portfolio, which, very generally, may be a
designated unleveraged index or the fund's securities portfolio
excluding derivatives. If applicable, the limit under the absolute VaR test
when a fund has outstanding preferred shares is 25% (or 20% when no
preferred shares are outstanding) of the value of the fund's net assets.
The Derivatives Rule also requires the Fund to appoint a derivatives risk
manager, maintain a derivatives risk management program designed to
identify, assess, and reasonably manage the risks associated with
transactions covered by the rule, and abide by certain Board and other
reporting obligations and recordkeeping requirements. With respect to
reverse repurchase agreements or other similar financing transactions
in particular, the Derivatives Rule permits a fund to enter into such
transactions if the fund either (i) complies with the asset coverage
requirements of Section 18 of the 1940 Act, and combines the
aggregate amount of indebtedness associated with all reverse
repurchase agreements and similar financing with the aggregate
amount of any other senior securities representing indebtedness when
calculating the relevant asset coverage ratio, or (ii) treats all reverse
repurchase agreements and similar financing transactions as
derivatives transactions for all purposes under the Derivatives Rule. The
Fund has adopted procedures for investing in derivatives and other
transactions in compliance with the Derivatives Rule. Compliance with
the Derivatives Rule could adversely affect the value or performance of
the Fund. Limits or restrictions applicable to the counterparties or
issuers, as applicable, with which the Fund may engage in derivative
transactions could also limit or prevent the Fund from using certain
instruments. The Fund’s ability to utilize leverage is also limited by asset
coverage requirements and other guidelines imposed by rating agencies
(currently Moody’s and Fitch) that provide ratings for the Preferred
Shares, which are more restrictive than the limitations imposed by the
1940 Act noted above. See “Description of Capital Structure” for more
information.
Leveraging is a speculative technique and there are special risks and
costs involved. The Fund cannot assure you that its Preferred Shares and
use of any other forms of leverage (such as the use of reverse
repurchase agreements or derivatives strategies), if any, will result in a
higher yield on your Common Shares. When leverage is used, the NAV
and market price of the Common Shares and the yield to Common
Shareholders will be more volatile. See “Principal Risks of the
Fund—Leverage Risk.” In addition, dividend, interest and other costs
and expenses borne by the Fund with respect to its Preferred Shares and
its use of any other forms of leverage are borne by the Common
Shareholders (and not by the holders of Preferred Shares) and result in a
reduction of the NAV of the Common Shares. In addition, because the
fees received by the Investment Manager are based on the average
weekly “total managed assets” (“total managed assets” includes the
total assets of the Fund (including any assets attributable to any
preferred shares or other forms of leverage that may be outstanding)
minus accrued liabilities (other than liabilities representing leverage)),
the Investment Manager has a financial incentive for the Fund to use
preferred shares and other forms of leverage, which may create a
conflict of interest between the Investment Manager, on the one hand,
and the Common Shareholders, on the other hand. See “Principal Risks
of the Fund—Leverage Risk” in this prospectus for additional
information regarding leverage and related risks.
[], 2024 |
Base Prospectus
60
PIMCO Income Strategy Fund II
The Fund also may borrow money in order to repurchase its shares or as
a temporary measure for extraordinary or emergency purposes,
including for the payment of dividends or the settlement of securities
transactions which otherwise might require untimely dispositions of
portfolio securities held by the Fund.
Effects of Leverage
The following table is furnished in response to requirements of the SEC.
It is designed to illustrate the effects of leverage through the use of
senior securities, as that term is defined under Section 18 of the 1940
Act, on Common Share total return, assuming investment portfolio total
returns (consisting of income and changes in the value of investments
held in the Fund’s portfolio) of -10%, -5%, 0%, 5% and 10%. The table
below assumes the Fund’s continued use of Preferred Shares averaged
over the period ended December 31, 2023, representing approximately
5.37% of the Fund’s total average managed assets, and, although not
senior securities under the 1940 Act, covered reverse repurchase
agreements averaged over the period ended December 31, 2023,
representing approximately 15.76% of the Fund’s total average
managed assets. The table below also assumes that the Fund will pay
dividends on Preferred Shares at an estimated annual effective Preferred
Share dividend rate of 10.78% (based on the weighted average
Preferred Share dividend rate during the period ended December 31,
2023) and interest on reverse repurchase agreements at an estimated
annual effective interest expense rate of 5.70% (based on weighted
average interest rate during the period ended December 31, 2023).
Based on such estimates, the annual return that the Fund’s portfolio
must experience (net of expenses) in order to cover such costs is 1.48%
The information below does not reflect the Fund’s use of certain other
forms of economic leverage achieved through the use of other
instruments or transactions not considered to be senior securities under
the 1940 Act, such as covered credit default swaps or other derivative
instruments.
These assumed investment portfolio returns in the table below are
hypothetical figures and are not necessarily indicative of the investment
portfolio returns experienced or expected to be experienced by the
Fund. Your actual returns may be greater or less than those appearing
below. In addition, actual borrowing expenses associated with reverse
repurchase agreements (or dollar rolls/buybacks or borrowings, if any)
used by the Fund may vary frequently and may be significantly higher or
lower than the rate used for the example below.
Assumed Return on Portfolio (Net of Expenses) |
( 10.00 )% |
(5.00)% |
0.00% |
5.00% |
10.00% |
Corresponding Return to Common Shareholders |
(14.55)% |
(8.21)% |
(1.87)% |
4.47% |
10.81% |
Common Share total return is composed of two elements — the
Common Share dividends paid by the Fund (the amount of which is
largely determined by the net investment income of the Fund after
paying dividends on Preferred Shares and expenses on any forms of
leverage outstanding) and gains or losses on the value of the securities
and other instruments the Fund owns. As required by SEC rules, the
table assumes that the Fund is more likely to suffer capital losses than
to enjoy capital appreciation. For example, to assume a total return of
0%, the Fund must assume that the income it receives on its
investments is entirely offset by losses in the value of those investments.
This table reflects hypothetical performance of the Fund’s portfolio and
not the actual performance of the Fund’s Common Shares, the value of
which is determined by market forces and other factors.
Should the Fund elect to add additional leverage to its portfolio, any
benefits of such additional leverage cannot be fully achieved until the
proceeds resulting from the use of such leverage have been received by
the Fund and invested in accordance with the Fund’s investment
objective and policies. As noted above, the Fund’s willingness to use
additional leverage, and the extent to which leverage is used at any
time, will depend on many factors, including, among other things,
PIMCO’s assessment of the yield curve environment, interest rate trends,
market conditions and other factors.
Principal Risks of the Fund
The Fund is subject to the principal risks noted below, whether through
the Fund’s direct investments or derivatives positions.
Market Discount Risk
The price of the Fund’s Common Shares will fluctuate with market
conditions and other factors. If you sell your Common Shares, the price
received may be more or less than your original investment. The
Common Shares are designed for long-term investors and should not be
treated as trading vehicles. Shares of closed-end management
investment companies frequently trade at a discount from their NAV. The
Common Shares may trade at a price that is less than the offering price
for Common Shares issued pursuant to an offering. This risk may be
greater for investors who sell their Common Shares relatively shortly
after completion of an offering. The sale of Common Shares by the Fund
(or the perception that such sales may occur), particularly if sold at a
discount to the then current market price of the Common Shares, may
have an adverse effect on the market price of the Common Shares.
Market Risk
The market price of securities owned by the Fund may go up or down,
sometimes rapidly or unpredictably. Securities may decline in value due
to factors affecting securities markets generally or particular industries
or companies represented in the securities markets. The value of a
security may decline due to general market conditions that are not
specifically related to a particular company, such as real or perceived
adverse economic conditions, changes in the general outlook for
corporate earnings, changes in interest or currency rates, adverse
changes to credit markets or adverse investor sentiment generally. The
value of a security may also decline due to factors that affect a
particular industry or industries, such as labor shortages or increased
production costs and competitive conditions within an industry. During
a general downturn in the securities markets, multiple asset classes may
decline in value simultaneously. Equity securities generally have greater
price volatility than fixed income securities. Credit ratings downgrades
61 Base Prospectus
| PIMCO Income Strategy Fund II
Base Prospectus
may also negatively affect securities held by the Fund. Even when
markets perform well, there is no assurance that the investments held by
the Fund will increase in value along with the broader market.
In addition, market risk includes the risk that geopolitical and other
events will disrupt the economy on a national or global level. For
instance, war, terrorism, social unrest, recessions, supply chain
disruptions, market manipulation, government defaults, government
shutdowns, political changes, diplomatic developments or the
imposition of sanctions and other similar measures, public health
emergencies (such as the spread of infectious diseases, pandemics and
epidemics) and natural/environmental disasters can all negatively
impact the securities markets, which could cause the Fund to lose value.
These events could reduce consumer demand or economic output, result
in market closures, changes in interest rates, inflation/deflation, travel
restrictions or quarantines, and significantly adversely impact the
economy.
The current contentious domestic political environment, as well as
political and diplomatic events within the United States and abroad,
such as presidential elections in the U.S. or abroad or the
U.S. government's inability at times to agree on a long-term budget and
deficit reduction plan, has in the past resulted, and may in the future
result, in a government shutdown or otherwise adversely affect the
U.S. regulatory landscape, the general market environment and/or
investor sentiment, which could have an adverse impact on the Fund's
investments and operations. Additional and/or prolonged U.S. federal
government shutdowns may affect investor and consumer confidence
and may adversely impact financial markets and the broader economy,
perhaps suddenly and to a significant degree. Governmental and
quasi-governmental authorities and regulators throughout the world
have previously responded to serious economic disruptions with a
variety of significant fiscal and monetary policy changes, including but
not limited to, direct capital infusions into companies, new monetary
programs and dramatically lower interest rates. An unexpected or
sudden reversal of these policies, or the ineffectiveness of these policies,
could increase volatility in securities markets, which could adversely
affect the Fund's investments. Any market disruptions could also prevent
the Fund from executing advantageous investment decisions in a timely
manner. Funds that have focused their investments in a region enduring
geopolitical market disruption will face higher risks of loss. Thus,
investors should closely monitor current market conditions to determine
whether the Fund meets their individual financial needs and tolerance
for risk.
Recently, there have been inflationary price movements. As such, fixed
income securities markets may experience heightened levels of interest
rate, volatility and liquidity risk. As discussed more under “Interest Rate
Risk,” the Federal Reserve has raised interest rates from historically low
levels and may continue to raise interest rates. Any additional interest
rate increases in the future could cause the value of any fund, such as
the Fund that invests in fixed income securities to decrease.
Although interest rates have significantly increased since 2022 through
the date of this prospectus, the prices of real estate-related assets
generally have not decreased as much as may be expected based on
historical correlations between interest rates and prices of real
estate-related assets. This presents an increased risk of a correction or
severe downturn in real estate-related asset prices, which could
adversely impact the value of other investments as well (such as loans,
securitized debt and other fixed income securities). This risk is
particularly present with respect to commercial real estate-related asset
prices, and the value of other investments with a connection to the
commercial real estate sector. As examples of the current risks faced by
real estate-related assets: tenant vacancy rates, tenant turnover and
tenant concentration have increased; owners of real estate have faced
headwinds, delinquencies and difficulties in collecting rents and other
payments (which increases the risk of owners being unable to pay or
otherwise defaulting on their own borrowings and obligations);
property values have declined; inflation, upkeep costs and other
expenses have increased; and rents have declined for many properties.
Exchanges and securities markets may close early, close late or issue
trading halts on specific securities, which may result in, among other
things, the Fund being unable to buy or sell certain securities or financial
instruments at an advantageous time or accurately price its portfolio
investments.
Asset Allocation Risk
The Fund’s investment performance depends upon how its assets are
allocated and reallocated. A principal risk of investing in the Fund is that
PIMCO may make less than optimal or poor asset allocation decisions.
PIMCO employs an active approach to allocation among multiple
fixed-income sectors, but there is no guarantee that such allocation
techniques will produce the desired results. It is possible that PIMCO
will focus on an investment that performs poorly or underperforms other
investments under various market conditions. You could lose money on
your investment in the Fund as a result of these allocation decisions.
Management Risk
The Fund is subject to management risk because it is an actively
managed investment portfolio. PIMCO and each individual portfolio
manager will apply investment techniques and risk analysis in making
investment decisions for the Fund, but there can be no guarantee that
these decisions will produce the desired results or that the due diligence
conducted by PIMCO or such other fund’s investment adviser and
individual portfolio managers will expose all material risks associated
with an investment. Additionally, PIMCO or such other fund’s
investment adviser and individual portfolio managers may not be able
to identify suitable investment opportunities and may face competition
from other investment managers when identifying and consummating
certain investments. Certain securities or other instruments in which the
Fund seeks to invest may not be available in the quantities desired,
including in circumstances where other funds for which PIMCO acts as
investment adviser, including funds with names, investment objectives
and policies, and/or portfolio management teams, similar to the Fund,
are seeking to invest in the same or similar securities or instruments. In
addition, regulatory restrictions, actual or potential conflicts of interest
or other considerations may cause PIMCO to restrict or prohibit
participation in certain investments. In such circumstances, PIMCO or
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PIMCO Income Strategy Fund II
the individual portfolio managers may determine to purchase other
securities or instruments as substitutes. Such substitute securities or
instruments may not perform as intended, which could result in losses
to the Fund. To the extent the Fund employs strategies targeting
perceived pricing inefficiencies, arbitrage strategies or similar strategies,
it is subject to the risk that the pricing or valuation of the securities and
instruments involved in such strategies may change unexpectedly, which
may result in reduced returns or losses to the Fund. The Fund is also
subject to the risk that deficiencies in the internal systems or controls of
PIMCO or another service provider will cause losses for the Fund or
hinder Fund operations. For example, trading delays or errors (both
human and systemic) could prevent the Fund from purchasing a security
expected to appreciate in value. Please refer to “Investment
Manager—Conflicts of Interest” in the Statement of Additional
Information for further information. Additionally, actual or potential
conflicts of interest, legislative, regulatory, or tax restrictions, policies or
developments may affect the investment techniques available to PIMCO
and each individual portfolio manager in connection with managing the
Fund and may also adversely affect the ability of the Fund to achieve its
investment objective. There also can be no assurance that all of the
personnel of PIMCO will continue to be associated with PIMCO for any
length of time. The loss of services of one or more key employees of
PIMCO could have an adverse impact on the Fund’s ability to realize its
investment objective.
In addition, the Fund may rely on various third-party sources to calculate
its net asset value. As a result, the Fund is subject to certain operational
risks associated with reliance on service providers and service providers’
data sources. In particular, errors or systems failures and other
technological issues may adversely impact the Fund’s calculations of its
net asset value, and such net asset value calculation issues may result in
inaccurately calculated net asset value, delays in net asset value
calculation and/or the inability to calculate net asset value over
extended periods. The Fund may be unable to recover any losses
associated with such failures.
Issuer Risk
The value of a security may decline for a number of reasons that directly
relate to the issuer, such as management performance, major litigation,
investigations or other controversies, changes in the issuer’s financial
condition or credit rating, changes in government regulations affecting
the issuer or its competitive environment and strategic initiatives such
as mergers, acquisitions or dispositions and the market response to any
such initiatives, financial leverage, reputation or reduced demand for the
issuer’s goods or services, as well as the historical and prospective
earnings of the issuer and the value of its assets. A change in the
financial condition of a single issuer may affect one or more other
issuers or securities markets as a whole. These risks can apply to the
Common Shares issued by the Fund and to the issuers of securities and
other instruments in which the Fund invests.
Interest Rate Risk
Interest rate risk is the risk that fixed income securities and other
instruments in the Fund’s portfolio will fluctuate in value because of a
change in interest rates. For example, as nominal interest rates rise, the
value of certain fixed income securities held by the Fund is likely to
decrease. A nominal interest rate can be described as the sum of a real
interest rate and an expected inflation rate. Interest rate changes can be
sudden and unpredictable, and the Fund may lose money as a result of
movements in interest rates. The Fund may not be able to effectively
hedge against changes in interest rates or may choose not to do so for
cost or other reasons.
A wide variety of factors can cause interest rates or yields of
U.S. Treasury securities (or yields of other types of bonds) to rise,
including but not limited to central bank monetary policies, changing
inflation or real growth rates, general economic conditions, increasing
bond issuances or reduced market demand for low yielding investments.
Risks associated with rising interest rates are heightened under current
market conditions given that the Federal Reserve has raised interest
rates from historically low levels and may continue to raise interest
rates. In addition, changes in monetary policy may exacerbate the risks
associated with changing interest rates. Further, in market environments
where interest rates are rising, issuers may be less willing or able to
make principal and interest payments on fixed-income investments
when due.
Further, fixed income securities with longer durations tend to be more
sensitive to changes in interest rates, usually making them more volatile.
Duration is a measure used to determine the sensitivity of a security’s
price to changes in interest rates that incorporates a security’s yield,
coupon, final maturity and call features, among other characteristics.
Duration is useful primarily as a measure of the sensitivity of a fixed
income security’s market price to interest rate (i.e., yield) movements. All
other things remaining equal, for each one percentage point increase in
interest rates, the value of a portfolio of fixed income investments would
generally be expected to decline by one percent for every year of the
portfolio’s average duration above zero. For example, the value of a
portfolio of fixed income securities with an average duration of eight
years would generally be expected to decline by approximately 8% if
interest rates rose by one percentage point.
Variable and floating rate securities may decline in value if their interest
rates do not rise as much, or as quickly, as interest rates in general.
Conversely, floating rate securities will not generally increase in value if
interest rates decline. Inverse floating rate securities may decrease in
value if interest rates increase. Inverse floating rate securities may also
exhibit greater price volatility than a fixed rate obligation with similar
credit quality. When the Fund holds variable or floating rate securities, a
decrease (or, in the case of inverse floating rate securities, an increase)
in market interest rates will adversely affect the income received from
such securities and the NAV of the Fund’s shares.
During periods of very low or negative interest rates, the Fund may be
unable to maintain positive returns. Very low or negative interest rates
may magnify interest rate risk. Changing interest rates, including rates
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that fall below zero, may have unpredictable effects on markets, may
result in heightened market volatility and may detract from Fund
performance to the extent the Fund is exposed to such interest rates.
Measures such as average duration may not accurately reflect the true
interest rate sensitivity of the Fund. This is especially the case if the Fund
consists of securities with widely varying durations. Therefore, if the
Fund has an average duration that suggests a certain level of interest
rate risk, the Fund may in fact be subject to greater interest rate risk
than the average would suggest. This risk is greater to the extent the
Fund uses leverage or derivatives in connection with the management
of the Fund.
Convexity is an additional measure used to understand a security's or
fund's interest rate sensitivity. Convexity measures the rate of change
of duration in response to changes in interest rates. With respect to a
security’s price, a larger convexity (positive or negative) may imply more
dramatic price changes in response to changing interest rates. Convexity
may be positive or negative. Negative convexity implies that interest
rate increases result in increased duration and that interest rate
decreases result in declining duration (i.e., increased sensitivity in prices
in response to rising and/or declining interest rates). Thus, securities
with negative convexity, which may include bonds with traditional call
features and certain mortgage-backed securities, may experience
greater losses in periods of rising interest rates. Accordingly, if the Fund
holds such securities, the Fund may be subject to a greater risk of losses
in periods of rising interest rates.
Rising interest rates may result in a decline in value of the Fund’s fixed
income investments and in periods of volatility. Also, when interest rates
rise, issuers are less likely to refinance existing debt securities, causing
the average life of such securities to extend. Further, while U.S. bond
markets have steadily grown over the past three decades, dealer
“market making” ability has remained relatively stagnant. As a result,
dealer inventories of certain types of bonds and similar instruments,
which provide a core indication of the ability of financial intermediaries
to “make markets,” are at or near historic lows in relation to market
size. Because market makers provide stability to a market through their
intermediary services, a significant reduction in dealer inventories could
potentially lead to decreased liquidity and increased volatility in the
fixed income markets. Such issues may be exacerbated during periods of
economic uncertainty. All of these factors, collectively and/or
individually, could cause the Fund to lose value.
Credit Risk
The Fund could lose money if the issuer or guarantor of a fixed income
security (including a security purchased with securities lending
collateral), or the counterparty to a derivatives contract, repurchase
agreement or a loan of portfolio securities is unable or unwilling, or is
perceived (whether by market participants, rating agencies, pricing
services or otherwise) as unable or unwilling, to make timely principal
and/or interest payments or to otherwise honor its obligations. The risk
that such issuer, guarantor or counterparty is less willing or able to do
so is heightened in market environments where interest rates are rising.
The downgrade of the credit of a security held by the Fund may
decrease its value. Measures such as average credit quality may not
accurately reflect the true credit risk of the Fund. This is especially the
case if the Fund consists of securities with widely varying credit ratings.
Securities are subject to varying degrees of credit risk, which are often
reflected in credit ratings. Credit risk is greater to the extent the Fund
uses leverage or derivatives. Rising or high interest rates may deteriorate
the credit quality of an issuer or counterparty, particularly if an issuer or
counterparty faces challenges rolling or refinancing its obligations.
Mortgage-Related and Other Asset-Backed Instruments Risk
The mortgage-related assets in which the Fund may invest include, but
are not limited to, any security, instrument or other asset that is related
to U.S. or non-U.S. mortgages, including those issued by private
originators or issuers, or issued or guaranteed as to principal or interest
by the U.S. government or its agencies or instrumentalities or by
non-U.S. governments or authorities, such as, without limitation, assets
representing interests in, collateralized or backed by, or whose values
are determined in whole or in part by reference to any number of
mortgages or pools of mortgages or the payment experience of such
mortgages or pools of mortgages, including REMICs, which could
include Re-REMICs, mortgage pass-through securities, inverse floaters,
CMOs, CLOs, multiclass pass-through securities, private mortgage
pass-through securities, stripped mortgage securities (generally
interest-only and principal-only securities), mortgage-related asset
backed securities and mortgage-related loans (including through
participations, assignments, originations and whole loans), including
commercial and residential mortgage loans. Exposures to
mortgage-related assets through derivatives or other financial
instruments will be considered investments in mortgage-related assets.
The Fund may also invest in other types of ABS, including CDOs, CBOs
and CLOs and other similarly structured securities See “Investment
Objective and Policies–Portfolio Contents–Mortgage-Related and Other
Asset-Backed Instruments” in this prospectus and “Investment
Objectives and Policies-Mortgage-Related and Other Asset-Backed
Instruments” in the Statement of Additional Information for a
description of the various mortgage-related and other asset-backed
instruments in which the Fund may invest and their related risks.
Mortgage-related and other asset-backed instruments represent
interests in “pools” of mortgages or other assets such as consumer
loans or receivables held in trust and often involve risks that are
different from or possibly more acute than risks associated with other
types of debt instruments.
Generally, rising interest rates tend to extend the duration of fixed rate
mortgage-related assets, making them more sensitive to changes in
interest rates. Compared to other fixed income investments with similar
maturity and credit, mortgage-related securities may increase in value to
a lesser extent when interest rates decline and may decline in value to a
similar or greater extent when interest rates rise. As a result, in a period
of rising interest rates, the Fund may exhibit additional volatility since
individual mortgage holders are less likely to exercise prepayment
options, thereby putting additional downward pressure on the value of
these securities and potentially causing the Fund to lose money. This is
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PIMCO Income Strategy Fund II
known as extension risk. Mortgage-backed securities can be highly
sensitive to rising interest rates, such that even small movements can
cause the Fund to lose value. Mortgage-backed securities, and in
particular those not backed by a government guarantee, are subject to
credit risk. When interest rates decline, borrowers may pay off their
mortgages sooner than expected. This can reduce the returns of the
Fund because the Fund may have to reinvest that money at the lower
prevailing interest rates. The Fund’s investments in other asset-backed
instruments are subject to risks similar to those associated with
mortgage-related assets, as well as additional risks associated with the
nature of the assets and the servicing of those assets. Payment of
principal and interest on asset-backed instruments may be largely
dependent upon the cash flows generated by the assets backing the
instruments, and asset-backed instruments may not have the benefit of
any security interest in the related assets.
Subordinate mortgage-backed or asset-backed instruments are paid
interest only to the extent that there are funds available to make
payments. To the extent the collateral pool includes a large percentage
of delinquent loans, there is a risk that interest payment on subordinate
mortgage-backed or asset-backed instruments will not be fully paid.
There are multiple tranches of mortgage-backed and asset-backed
instruments, offering investors various maturity and credit risk
characteristics. Tranches are categorized as senior, mezzanine, and
subordinated/equity or “first loss,” according to their degree of risk. The
most senior tranche of a mortgage-backed or asset-backed instrument
has the greatest collateralization and pays the lowest interest rate. If
there are defaults or the collateral otherwise underperforms, scheduled
payments to senior tranches take precedence over those of mezzanine
tranches, and scheduled payments to mezzanine tranches take
precedence over those to subordinated/equity tranches. Lower tranches
represent lower degrees of credit quality and pay higher interest rates
intended to compensate for the attendant risks. The return on the lower
tranches is especially sensitive to the rate of defaults in the collateral
pool. The lowest tranche (i.e., the “equity” or “residual” tranche)
specifically receives the residual interest payments (i.e., money that is
left over after the higher tranches have been paid and expenses of the
issuing entities have been paid) rather than a fixed interest rate. The
Fund may also invest in the residual or equity tranches of
mortgage-related and other asset-backed instruments, which may be
referred to as subordinate mortgage-backed or asset-backed
instruments and interest-only mortgage-backed or asset-backed
instruments. The Fund expects that investments in subordinate
mortgage-backed and other asset-backed instruments will be subject to
risks arising from delinquencies and foreclosures, thereby exposing its
investment portfolio to potential losses. Subordinate securities of
mortgage-backed and other asset-backed instruments are also subject
to greater credit risk than those mortgage-backed or other asset-backed
instruments that are more highly rated.
The mortgage markets in the United States and in various foreign
countries have experienced extreme difficulties in the past that
adversely affected the performance and market value of certain of the
Fund’s mortgage-related investments. Delinquencies and losses on
residential and commercial mortgage loans (especially subprime and
second-lien mortgage loans) may increase, and a decline in or flattening
of housing and other real property values may exacerbate such
delinquencies and losses. In addition, reduced investor demand for
mortgage loans and mortgage-related securities and increased investor
yield requirements have caused limited liquidity in the secondary market
for mortgage-related securities, which can adversely affect the market
value of mortgage-related securities. It is possible that such limited
liquidity in such secondary markets could continue or worsen.
Mortgage-Related Derivative Instruments Risk
The Fund may engage in derivative transactions related to
mortgage-backed securities, including purchasing and selling
exchange-listed and OTC put and call options, futures and forwards on
mortgages and mortgage-backed securities. The Fund may also invest in
mortgage-backed securities credit default swaps, which include swaps
the reference obligation for which is a mortgage-backed security or
related index, such as the CMBX Index (a tradeable index referencing a
basket of commercial mortgage-backed securities) or the ABX (a
tradeable index referencing a basket of sub-prime mortgage-backed
securities). The Fund may invest in newly developed mortgage related
derivatives that may hereafter become available.
Derivative mortgage-backed securities (such as principal-only (“POs”),
interest-only (“IOs”) or inverse floating rate securities) are particularly
exposed to call and extension risks. Small changes in mortgage
prepayments can significantly impact the cash flows and the market
value of these derivative instruments. In general, the risk of faster than
anticipated prepayments adversely affects IOs, super floaters and
premium priced mortgage-backed securities. The risk of slower than
anticipated prepayments generally affects POs, floating-rate securities
subject to interest rate caps, support tranches and discount priced
mortgage-backed securities. In addition, particular derivative
instruments may be leveraged such that their exposure (i.e., price
sensitivity) to interest rate and/or prepayment risk is magnified.
Mortgage-related derivative instruments involve risks associated with
mortgage-related and other asset-backed instruments, privately-issued
mortgage-related securities, the mortgage market, the real estate
industry, derivatives and credit default swaps. See “Mortgage-Related
and Other Asset-Backed Instruments Risk,” “Privately-Issued
Mortgage-Related Securities Risk,” “Derivatives Risk,” and “Credit
Default Swaps Risk.”
High Yield Securities Risk
To the extent that the Fund invests in high yield securities and unrated
securities of similar credit quality (commonly known as “high yield
securities” or “junk bonds”), the Fund may be subject to greater levels
of credit risk, call risk and liquidity risk than funds that do not invest in
such securities, which could have a negative effect on the NAV and
market price of the Fund’s Common Shares or Common Share
dividends. These securities are considered predominantly speculative
with respect to an issuer’s continuing ability to make principal and
interest payments, and may be more volatile than other types of
securities. An economic downturn or individual corporate developments
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could adversely affect the market for these securities and reduce the
Fund’s ability to sell these securities at an advantageous time or price.
The Fund may purchase distressed securities that are in default or the
issuers of which are in bankruptcy, which involve heightened risks.
High yield securities structured as zero-coupon bonds or pay-in-kind
securities tend to be especially volatile as they are particularly sensitive
to downward pricing pressures from rising interest rates or widening
spreads and may require the Fund to make taxable distributions of
imputed income without receiving the actual cash currency. Issuers of
high yield securities may have the right to “call” or redeem the issue
prior to maturity, which may result in the Fund having to reinvest the
proceeds in other high yield securities or similar instruments that may
pay lower interest rates. The Fund may also be subject to greater levels
of liquidity risk than funds that do not invest in high yield securities.
Consequently, transactions in high yield securities may involve greater
costs than transactions in more actively traded securities. A lack of
publicly-available information, irregular trading activity and wide
bid/ask spreads among other factors, may, in certain circumstances,
make high yield debt more difficult to sell at an advantageous time or
price than other types of securities or instruments. These factors may
result in the Fund being unable to realize full value for these securities
and/or may result in the Fund not receiving the proceeds from a sale of
a high yield security for an extended period after such sale, each of
which could result in losses to the Fund. Because of the risks involved in
investing in high yield securities, an investment in the Fund should be
considered speculative.
In general, lower rated debt securities carry a greater degree of risk that
the issuer will lose its ability to make interest and principal payments,
which could have a negative effect on the Fund. Securities of below
investment grade quality are regarded as having predominantly
speculative characteristics with respect to capacity to pay interest and
repay principal and are commonly referred to as “high yield” securities
or “junk bonds.” High yield securities involve a greater risk of default
and their prices are generally more volatile and sensitive to actual or
perceived negative developments. Debt securities in the lowest
investment grade category also may be considered to possess some
speculative characteristics by certain rating agencies. The Fund may
purchase stressed or distressed securities that are in default or the
issuers of which are in bankruptcy, which involve heightened risks.
An economic downturn could severely affect the ability of issuers
(particularly those that are highly leveraged) to service or repay their
debt obligations. Lower-rated securities are generally less liquid than
higher-rated securities, which may have an adverse effect on the Fund’s
ability to dispose of them. For example, under adverse market or
economic conditions, the secondary market for below investment grade
securities could contract further, independent of any specific adverse
changes in the condition of a particular issuer, and certain securities in
the Fund’s portfolio may become illiquid or less liquid. As a result, the
Fund could find it more difficult to sell these securities or may be able to
sell these securities only at prices lower than if such securities were
widely traded. To the extent the Fund focuses on below investment
grade debt obligations, PIMCO’s capabilities in analyzing credit quality
and associated risks will be particularly important, and there can be no
assurance that PIMCO will be successful in this regard. Due to the risks
involved in investing in high yield securities, an investment in the Fund
should be considered speculative.
The Fund’s credit quality policies apply only at the time a security is
purchased, and the Fund is not required to dispose of a security in the
event that a rating agency or PIMCO downgrades its assessment of the
credit characteristics of a particular issue. In determining whether to
retain or sell such a security, PIMCO may consider factors including, but
not limited to, PIMCO's assessment of the credit quality of the issuer of
such security, the price at which such security could be sold and the
rating, if any, assigned to such security by other rating agencies. Analysis
of creditworthiness may be more complex for issuers of high yield
securities than for issuers of higher quality debt securities.
See “Investment Objective and Policies–Portfolio Contents–High Yield
Securities” for additional information.
Distressed and Defaulted Securities Risk
Investments in the securities of financially distressed issuers involve
substantial risks, including the risk of default. Distressed securities
generally trade significantly below “par” or full value because
investments in such securities and debt of distressed issuers or issuers in
default are considered speculative and involve substantial risks in
addition to the risks of investing in high-yield bonds. Such investments
may be in default at the time of investment. In addition, these securities
may fluctuate more in price, and are typically less liquid. The Fund also
will be subject to significant uncertainty as to when, and in what
manner, and for what value obligations evidenced by securities of
financially distressed issuers will eventually be satisfied. Defaulted
obligations might be repaid only after lengthy workout or bankruptcy
proceedings, during which the issuer might not make any interest or
other payments. In any such proceeding relating to a defaulted
obligation, the Fund may lose its entire investment or may be required
to accept cash or securities with a value substantially less than its
original investment. Moreover, any securities received by the Fund upon
completion of a workout or bankruptcy proceeding may be less liquid,
speculative or restricted as to resale. Similarly, if the Fund participates in
negotiations with respect to any exchange offer or plan of
reorganization with respect to the securities of a distressed issuer, the
Fund may be restricted from disposing of such securities. To the extent
that the Fund becomes involved in such proceedings, the Fund may
have a more active participation in the affairs of the issuer than that
assumed generally by an investor. The Fund may incur additional
expenses to the extent it is required to seek recovery upon a default in
the payment of principal or interest on its portfolio holdings.
Also among the risks inherent in investments in a troubled issuer is that
it frequently may be difficult to obtain information as to the true
financial condition of such issuer. PIMCO's judgments about the credit
quality of a financially distressed issuer and the relative value of its
securities may prove to be wrong.
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Inflation-Indexed Security Risk
Inflation-indexed debt securities are subject to the effects of changes in
market interest rates caused by factors other than inflation (real interest
rates). In general, the value of an inflation-indexed security, including
Treasury Inflation-Protected Securities (“TIPS”), tends to decrease when
real interest rates increase and can increase when real interest rates
decrease. Thus generally, during periods of rising inflation, the value of
inflation-indexed securities will tend to increase and during periods of
deflation, their value will tend to decrease. Interest payments on
inflation-indexed securities are unpredictable and will fluctuate as the
principal and interest are adjusted for inflation. There can be no
assurance that the inflation index used (
i.e.,
the Consumer Price Index
(“CPI”) will accurately measure the real rate of inflation in the prices of
goods and services. Increases in the principal value of TIPS due to
inflation are considered taxable ordinary income for the amount of the
increase in the calendar year. Any increase in the principal amount of an
inflation-indexed debt security will be considered taxable ordinary
income, even though the Fund will not receive the principal until
maturity. Additionally, a CPI swap can potentially lose value if the
realized rate of inflation over the life of the swap is less than the fixed
market implied inflation rate (fixed breakeven rate) that the investor
agrees to pay at the initiation of the swap. With municipal
inflation-indexed securities, the inflation adjustment is integrated into
the coupon payment, which is federally tax exempt (and may be state
tax exempt). For municipal inflation-indexed securities, there is no
adjustment to the principal value. Because municipal inflation-indexed
securities are a small component of the municipal bond market, they
may be less liquid than conventional municipal bonds.
Loans and Other Indebtedness; Loan Acquisitions,
Participations and Assignments Risk
Loan interests may take the form of direct interests acquired during a
primary distribution or other purchase of a loan, or assignments of,
novations of or participations in all or a portion of a loan acquired in
secondary markets. In addition to credit risk and interest rate risk, the
Fund's exposure to loan interests may be subject to additional risks. For
example, purchasers of loans and other forms of direct indebtedness
depend primarily upon the creditworthiness of the borrower for
payment of principal and interest. Loans are subject to the risk that
scheduled interest or principal payments will not be made in a timely
manner or at all, either of which may adversely affect the value of the
loan. If the Fund does not receive scheduled interest or principal
payments on such indebtedness, the Fund’s share price and yield could
be adversely affected. Loans that are fully secured may offer the Fund
more protection than an unsecured loan in the event of non-payment of
scheduled interest or principal if the Fund is able to access and
monetize the collateral. However, the collateral underlying a loan, if any,
may be unavailable or insufficient to satisfy a borrower’s obligation. If
the Fund becomes owner, whole or in part, of any collateral after a loan
is foreclosed, the Fund may incur costs associated with owning and/or
monetizing its ownership of the collateral.
Moreover, the purchaser of an assignment typically succeeds to all the
rights and obligations under the loan agreement with the same rights
and obligations as the assigning lender. Assignments may, however, be
arranged through private negotiations between potential assignees and
potential assignors, and the rights and obligations acquired by the
purchaser of an assignment may differ from, and be more limited than,
those held by the assigning lender.
Investments in loans through a purchase of a loan or a direct
assignment of a financial institution’s interests with respect to a loan
may involve additional risks to the Fund. For example, if a loan is
foreclosed, the Fund could become owner, in whole or in part, of any
collateral, which could include, among other assets, real estate or other
real or personal property, and would bear the costs and liabilities
associated with owning and holding or disposing of the collateral. The
purchaser of an assignment typically succeeds to all the rights and
obligations under the loan agreement with the same rights and
obligations as the assigning lender. Assignments may, however, be
arranged through private negotiations between potential assignees and
potential assignors, and the rights and obligations acquired by the
purchaser of an assignment may differ from, and be more limited than,
those held by the assigning lender.
In connection with purchasing loan participations, the Fund generally
will have no right to enforce compliance by the borrower with the terms
of the loan agreement relating to the loan, nor any rights
of set-off against the borrower, and the Fund may not directly benefit
from any collateral supporting the loan in which it has purchased the
loan participation. As a result, the Fund will be subject to the credit risk
of both the borrower and the lender that is selling the participation. In
the event of the insolvency of the lender selling a participation, the Fund
may be treated as a general creditor of the lender and may not benefit
from any set-off between the lender and the borrower. Certain loan
participations may be structured in a manner designed to prevent
purchasers of participations from being subject to the credit risk of the
lender, but even under such a structure, in the event of the lender’s
insolvency, the lender’s servicing of the participation may be delayed
and the assignability of the participation impaired.
The Fund may have difficulty disposing of loans and loan participations.
Because there is no liquid market for many such investments, the Fund
anticipates that such investments could be sold only to a limited number
of institutional investors. The lack of a liquid secondary market may have
an adverse impact on the value of such investments and the Fund’s
ability to dispose of particular loans and loan participations when that
would be desirable, including in response to a specific economic event
such as a deterioration in the creditworthiness of the borrower. The lack
of a liquid secondary market for loans and loan participations also may
make it more difficult for the Fund to assign a value to these securities
for purposes of valuing the Fund’s portfolio.
Investments in loans may include participations in bridge loans, which
are loans taken out by borrowers for a short period (typically less than
one year) pending arrangement of more permanent financing through,
for example, the issuance of bonds, frequently high yield bonds issued
for the purpose of acquisitions.
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Investments in loans may include acquisitions of, or participation in,
delayed draw and delayed funding loans and revolving credit facilities.
These commitments may have the effect of requiring the Fund to
increase its investment in a borrower at a time when it might not
otherwise decide to do so (including at a time when the company’s
financial condition makes it unlikely that such amounts will be repaid).
Delayed draw and delayed funding loans and revolving credit facilities
may be subject to restrictions on transfer, and only limited opportunities
may exist to resell such instruments. As a result, a Fund may be unable
to sell such investments at an opportune time or may have to resell
them at less than fair market value. Further, the Fund may need to hold
liquid assets in order to provide funding for these types of
commitments, meaning the Fund may not be able to invest in other
attractive investments, or the Fund may need to liquidate existing assets
in order to provide such funding.
To the extent the Fund invests in loans (including, but not limited to,
bank loans and non-syndicated loans), the Fund may be subject to
greater levels of credit risk, call risk, settlement risk and liquidity risk.
These instruments are considered predominantly speculative with
respect to an issuer’s continuing ability to make principal and interest
payments and may be more volatile than other types of securities. The
Fund may also be subject to greater levels of liquidity risk than funds
that do not invest in loans. In addition, the loans in which the Fund
invests may not be listed on any exchange and a secondary market for
such loans may be comparatively illiquid relative to markets for other
more liquid fixed income securities. Consequently, transactions in loans
may involve greater costs than transactions in more actively traded
securities. In connection with certain loan transactions, transaction costs
that are borne by the Fund may include the expenses of third parties
that are retained to assist with reviewing and conducting diligence,
negotiating, structuring and servicing a loan transaction, and/or
providing other services in connection therewith. Furthermore, the Fund
may incur such costs in connection with loan transactions that are
pursued by the Fund but not ultimately consummated (so-called
“broken deal costs”).
Restrictions on transfers in loan agreements, a lack of publicly available
information, irregular trading activity and wide bid/ask spreads, among
other factors, may, in certain circumstances, make loans more difficult to
sell at an advantageous time or price than other types of securities or
instruments. These factors may result in the Fund being unable to realize
full value for the loans and/or may result in the Fund not receiving the
proceeds from a sale of a loan for an extended period after such sale,
each of which could result in losses to the Fund. Some loans may have
extended trade settlement periods, including settlement periods of
greater than seven days, which may result in cash not being
immediately available to the Fund. If an issuer of a loan prepays or
redeems the loan prior to maturity, the Fund may have to reinvest the
proceeds in other loans or similar instruments that may pay lower
interest rates. Because of the risks involved in investing in loans, an
investment in the Fund should be considered speculative.
The Fund’s investments in subordinated and unsecured loans generally
are subject to similar risks as those associated with investments in
secured loans. Subordinated or unsecured loans are lower in priority of
payment to secured loans and are subject to the additional risk that the
cash flow of the borrower and property securing the loan or debt, if any,
may be insufficient to meet scheduled payments after giving effect to
the senior secured obligations of the borrower. This risk is generally
higher for subordinated unsecured loans or debt, which are not backed
by a security interest in any specific collateral. Subordinated and
unsecured loans generally have greater price volatility than secured
loans and may be less liquid. There is also a possibility that originators
will not be able to sell participations in subordinated or unsecured
loans, which would create greater credit risk exposure for the holders of
such loans. Subordinate and unsecured loans share the same risks as
other below investment grade securities.
There may be less readily available information about most loans and
the underlying borrowers than is the case for many other types of
securities. Loans may be issued by borrowers that are not subject to SEC
reporting requirements and therefore may not be required to file reports
with the SEC or may file reports that are not required to comply with
SEC form requirements. In addition, such borrowers may be subject to a
less stringent liability disclosure regime than companies subject to SEC
reporting requirements. Loans may not be considered “securities,” and
purchasers, such as the Fund, therefore may not be entitled to rely on
the anti-fraud protections of the federal securities laws. Because there is
limited public information available regarding loan investments, the
Fund is particularly dependent on the analytical abilities of the Fund’s
portfolio managers.
Economic exposure to loan interests through the use of derivative
transactions may involve greater risks than if the Fund had invested in
the loan interest directly during a primary distribution, through
assignments of, novations of or participations in a loan acquired in
secondary markets since, in addition to the risks described above,
certain derivative transactions may be subject to leverage risk and
greater illiquidity risk, counterparty risk, valuation risk and other risks.
“Covenant-lite” Obligations Risk
Covenant-lite obligations contain fewer maintenance covenants than
other obligations, or no maintenance covenants, and may not include
terms that allow the lender to monitor the performance of the borrower
and declare a default if certain criteria are breached. Covenant-lite
loans carry a risk that the borrower could transfer or encumber its
assets, which could reduce the amount of assets that can be used to
satisfy debts and result in losses for debtholders. Covenant-lite loans
may carry more risk than traditional loans as they allow individuals and
corporations to engage in activities that would otherwise be difficult or
impossible under a covenant-heavy loan agreement. In the event of
default, covenant-lite loans may exhibit diminished recovery values as
the lender may not have the opportunity to negotiate with the borrower
prior to default.
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Subprime Risk
Loans, and debt instruments collateralized by loans, acquired by the
Fund may be subprime in quality, or may become subprime in quality.
Although there is no specific legal or market definition of “subprime,”
subprime loans are generally understood to refer to loans made to
borrowers that display poor credit histories and other characteristics
that correlate with a higher default risk. Accordingly, subprime loans,
and debt instruments secured by such loans, have speculative
characteristics and are subject to heightened risks, including the risk of
nonpayment of interest or repayment of principal, and the risks
associated with investments in high yield securities. In addition, these
instruments could be subject to increased regulatory scrutiny. The Fund
is not restricted by any particular borrower credit risk criteria and/or
qualifications when acquiring loans or debt instruments collateralized
by loans.
Reinvestment Risk
Income from the Fund’s portfolio will decline if and when the Fund
invests the proceeds from matured, traded or called debt obligations at
market interest rates that are below the portfolio’s current earnings rate.
For instance, during periods of declining interest rates, an issuer of debt
obligations may exercise an option to redeem securities prior to
maturity, forcing the Fund to invest in lower-yielding securities. The Fund
also may choose to sell higher yielding portfolio securities and to
purchase lower yielding securities to achieve greater portfolio
diversification, because the portfolio managers believe the current
holdings are overvalued or for other investment-related reasons. A
decline in income received by the Fund from its investments is likely to
have a negative effect on dividend levels and the market price, NAV
and/or overall return of the Common Shares.
Securities Lending Risk
For the purpose of achieving income, the Fund may lend its portfolio
securities to brokers, dealers, and other financial institutions provided a
number of conditions are satisfied, including that the loan is fully
collateralized. Please see “Investment Objective and Policies—Loans of
Portfolio Securities” in the Statement of Additional Information for more
details. When the Fund lends portfolio securities, its investment
performance will continue to reflect changes in the value of the
securities loaned, and the Fund will also receive a fee or interest on the
collateral. Securities lending involves the risk of loss of rights in the
collateral or delay in recovery of the collateral if the borrower fails to
return the security loaned or becomes insolvent. The Fund may pay
lending fees to a party arranging the loan, which may be an affiliate of
the Fund. Cash collateral received by the Fund in securities lending
transactions may be invested in short-term liquid fixed income
instruments or in money market or short-term mutual funds, or similar
investment vehicles, including affiliated money market or short-term
mutual funds. The Fund bears the risk of such investments.
Call Risk
Call risk refers to the possibility that an issuer may exercise its right to
redeem a fixed income security earlier than expected (a call). Issuers
may call outstanding securities prior to their maturity for a number of
reasons (e.g., declining interest rates, changes in credit spreads and
improvements in the issuer's credit quality). If an issuer calls a security in
which the Fund has invested, the Fund may not recoup the full amount
of its initial investment and may be forced to reinvest in lower-yielding
securities, securities with greater credit risks or securities with other, less
favorable features.
Foreign (Non-U.S.) Investment Risk
Foreign (non-U.S.) securities may experience more rapid and extreme
changes in value than securities of U.S. issuers or securities that trade
exclusively in U.S. markets. The securities markets of many foreign
countries are relatively small, with a limited number of companies
representing a small number of industries. Additionally, issuers of
foreign (non-U.S.) securities are usually not subject to the same degree
of regulation as U.S. issuers. Reporting, accounting, auditing and
custody standards of foreign countries differ, in some cases significantly,
from U.S. standards. Global economies and financial markets are
becoming increasingly interconnected, and conditions and events in one
country, region or financial market may adversely impact issuers in a
different country, region or financial market. Foreign (non-U.S.) market
trading hours, clearance and settlement procedures, and holiday
schedules may limit the Fund’s ability to buy and sell securities.
Investments in foreign (non-U.S.) markets may also be adversely
affected by governmental actions such as the imposition of capital
controls, nationalization of companies or industries, expropriation of
assets or the imposition of punitive taxes. The governments of certain
countries may prohibit or impose substantial restrictions on foreign
(non-U.S.) investing in their capital markets or in certain sectors or
industries. In addition, a foreign (non-U.S.) government may limit or
cause delay in the convertibility or repatriation of its currency which
would adversely affect the U.S. dollar value and/or liquidity of
investments denominated in that currency. Certain foreign (non-U.S.)
investments may become less liquid in response to market
developments or adverse investor perceptions, or become illiquid after
purchase by the Fund, particularly during periods of market turmoil. A
reduction in trading in securities of issuers located in countries whose
economies are heavily dependent upon trading with key partners may
have an adverse impact on a Fund’s investments.
Also, nationalization, expropriation or confiscatory taxation, unstable
governments, decreased market liquidity, currency blockage, market
disruptions, political changes, security suspensions or diplomatic
developments or the imposition of sanctions or other similar measures
could adversely affect the Fund’s investments in a foreign (non-U.S.)
country. In the event of nationalization, expropriation or other
confiscation, the Fund could lose its entire investment in foreign
(non-U.S.) securities. The type and severity of sanctions and other similar
measures, including counter sanctions and other retaliatory actions, that
may be imposed could vary broadly in scope, and their impact is difficult
to ascertain. These types of measures may include, but are not limited
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to, banning a sanctioned country or certain persons or entities
associated with such country from global payment systems that
facilitate cross-border payments, restricting the settlement of securities
transactions by certain investors, and freezing the assets of particular
countries, entities or persons. The imposition of sanctions and other
similar measures could, among other things, result in a decline in the
value and/or liquidity of securities issued by the sanctioned country or
companies located in or economically tied to the sanctioned country,
downgrades in the credit ratings of the sanctioned country's securities
or those of companies located in or economically tied to the sanctioned
country, currency devaluation or volatility, and increased market
volatility and disruption in the sanctioned country and throughout the
world. Sanctions and other similar measures could directly or indirectly
limit or prevent a Fund from buying and selling securities (in the
sanctioned country and other markets), significantly delay or prevent the
settlement of securities transactions, and adversely impact a Fund's
liquidity and performance. Adverse conditions in a certain region can
adversely affect securities of other countries whose economies appear
to be unrelated. To the extent that the Fund invests a significant portion
of its assets in a specific geographic region or in securities denominated
in a particular foreign (non-U.S.) currency, the Fund will generally have
more exposure to regional economic risks, including weather
emergencies and natural disasters, associated with foreign (non-U.S.)
investments. Foreign (non-U.S.) securities may also be less liquid
(particularly during market closures due to local holidays or other
reasons) and more difficult to value than securities of U.S. issuers.
The Fund may invest in securities and instruments that are economically
tied to Russia. Investments in Russia are subject to various risks such as,
but not limited to political, economic, legal, market and currency risks.
The risks include uncertain political and economic policies, short term
market volatility, poor accounting standards, corruption and crime, an
inadequate regulatory system, regional armed conflict and
unpredictable taxation. Investments in Russia are particularly subject to
the risk that further economic sanctions, export and import controls, and
other similar measures may be imposed by the United States and/or
other countries. Other similar measures may include, but are not limited
to, banning or expanding bans on Russia or certain persons or entities
associated with Russia from global payment systems that facilitate
cross-border payments, restricting the settlement of securities
transactions by certain investors, and freezing Russian assets or those of
particular countries, entities or persons with ties to Russia (e.g. Belarus).
Such sanctions and other similar measures — which may impact
companies in many sectors, including energy, financial services,
technology, accounting, quantum computing, shipping, aviation, metals
and mining, defense, architecture, engineering, construction,
manufacturing and transportation, among others — and Russia’s
countermeasures may negatively impact the Fund’s performance and/or
ability to achieve its investment objective. For example, certain
investments may be prohibited and/or existing investments may become
illiquid (e.g., in the event that transacting in certain existing investments
is prohibited, securities markets close, or market participants cease
transacting in certain investments in light of geopolitical events,
sanctions or related considerations), which could render any such
securities held by the Fund unmarketable for an indefinite period of time
and/or cause the Fund to sell other portfolio holdings at a
disadvantageous time or price or to continue to hold investments that
the Fund no longer seeks to hold. In addition, such sanctions or other
similar measures, and the Russian government's response, could result
in a downgrade of Russia's credit rating or of securities of issuers
located in or economically tied to Russia, devaluation of Russia's
currency and/or increased volatility with respect to Russian securities
and the ruble. Moreover, disruptions caused by Russian military action
or other actions (including cyberattacks, espionage or other asymmetric
measures) or resulting actual or threatened responses to such activity
may impact Russia's economy and Russian and other issuers of
securities in which the Fund is invested. Such resulting actual or
threatened responses may include, but are not limited to, purchasing
and financing restrictions, withdrawal of financial intermediaries,
boycotts or changes in consumer or purchaser preferences, sanctions,
export and import controls, tariffs or cyberattacks on the Russian
government, Russian companies or Russian individuals, including
politicians. Any actions by Russia made in response to such sanctions or
retaliatory measures could further impair the value and liquidity of Fund
investments. Sanctions and other similar measures have resulted in
defaults on debt obligations by certain corporate issuers and the
Russian Federation that could lead to cross-defaults or
cross-accelerations on other obligations of these issuers.
The Russian securities market is characterized by limited volume of
trading, resulting in difficulty in obtaining accurate prices and trading.
These issues can be magnified as a result of sanctions and other similar
measures that may be imposed and the Russian government's response.
The Russian securities market, as compared to U.S. markets, has
significant price volatility, less liquidity, a smaller market capitalization
and a smaller number of traded securities. There may be little publicly
available information about issuers. Settlement, clearing and
registration of securities transactions are subject to risks. Prior to the
implementation of the National Settlement Depository (“NSD”), a
recognized central securities depository, there was no central
registration system for equity share registration in Russia, and
registration was carried out by either the issuers themselves or by
registrars located throughout Russia. Title to Russian equities held
through the NSD is now based on the records of the NSD and not the
registrars. Although the implementation of the NSD has enhanced the
efficiency and transparency of the Russian securities market, issues
resulting in loss can still occur. In addition, sanctions by the European
Union against the NSD, as well as the potential for sanctions by other
governments, could make it more difficult to conduct or confirm
transactions involving Russian securities. Ownership of securities issued
by Russian companies that are not held through depositories such as
the NSD may be recorded by companies themselves and by registrars. In
such cases, the risk is increased that the Fund could lose ownership
rights through fraud, negligence or oversight. While applicable Russian
regulations impose liability on registrars for losses resulting from their
errors, it may be difficult for the Fund to enforce any rights it may have
against the registrar or issuer of the securities in the event of loss of
share registration. In addition, issuers and registrars are still prominent
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in the validation and approval of documentation requirements for
corporate action processing in Russia. Because the documentation
requirements and approval criteria vary between registrars and issuers,
there remain unclear and inconsistent market standards in the Russian
market with respect to the completion and submission of corporate
action elections. In addition, sanctions or Russian countermeasures may
prohibit or limit a Fund’s ability to participate in corporate actions, and
therefore require the Fund to forego voting on or receiving funds that
would otherwise be beneficial to the Fund. To the extent that the Fund
suffers a loss relating to title or corporate actions relating to its portfolio
securities, it may be difficult for the Fund to enforce its rights or
otherwise remedy the loss. Russian securities laws may not recognize
foreign nominee accounts held with a custodian bank, and therefore the
custodian may be considered the ultimate owner of securities they hold
for their clients. Adverse currency exchange rates are a risk and there
may be a lack of available currency hedging instruments. Investments in
Russia may be subject to the risk of nationalization or expropriation of
assets. Oil, natural gas, metals, minerals and timber account for a
significant portion of Russia’s exports, leaving the country vulnerable to
swings in world prices and to sanctions or other actions that may be
directed at the Russian economy as a whole or at Russian oil, natural
gas, metals, minerals or timber industries.
Emerging Markets Risk
Foreign (non-U.S.) investment risk may be particularly high to the extent
that the Fund invests in securities of issuers based in or doing business
in emerging market countries or invests in securities denominated in the
currencies of emerging market countries. Investing in securities of
issuers based in or doing business in emerging markets entails all of the
risks of investing in foreign securities noted above, but to a heightened
degree.
Investments in emerging market countries pose a greater degree of
systemic risk (i.e., the risk of a cascading collapse of multiple institutions
within a country, and even multiple national economies). The
inter-relatedness of economic and financial institutions within and
among emerging market economies has deepened over the years, with
the effect that institutional failures and/or economic difficulties that are
of initially limited scope may spread throughout a country, a region or
all or most emerging market countries. This may undermine any attempt
by the Fund to reduce risk through geographic diversification of its
portfolio.
There is a heightened possibility of imposition of withholding taxes on
interest or dividend income generated from emerging market securities.
Governments of emerging market countries may engage in confiscatory
taxation or expropriation of income and/or assets to raise revenues or to
pursue a domestic political agenda. In the past, emerging market
countries have nationalized assets, companies and even entire sectors,
including the assets of foreign investors, with inadequate or no
compensation to the prior owners. There can be no assurance that the
Fund will not suffer a loss of any or all of its investments, or interest or
dividends thereon, due to adverse fiscal or other policy changes in
emerging market countries.
There is also a greater risk that an emerging market government may
take action that impedes or prevents the Fund from taking income
and/or capital gains earned in the local currency and converting into
U.S. dollars (i.e., “repatriating” local currency investments or profits).
Certain emerging market countries have sought to maintain foreign
exchange reserves and/or address the economic volatility and
dislocations caused by the large international capital flows by
controlling or restricting the conversion of the local currency into other
currencies. This risk tends to become more acute when economic
conditions otherwise worsen. There can be no assurance that if the Fund
earns income or capital gains in an emerging market currency or PIMCO
otherwise seeks to withdraw the Fund’s investments from a given
emerging market country, capital controls imposed by such country will
not prevent, or cause significant expense, or delay in, doing so.
Bankruptcy law and creditor reorganization processes may differ
substantially from those in the United States, resulting in greater
uncertainty as to the rights of creditors, the enforceability of such rights,
reorganization timing and the classification, seniority and treatment of
claims. In certain emerging market countries, although bankruptcy laws
have been enacted, the process for reorganization remains highly
uncertain. In addition, it may be impossible to seek legal redress against
an issuer that is a sovereign state.
Emerging market countries typically have less established legal,
accounting and financial reporting systems than those in more
developed markets, which may reduce the scope or quality of financial
information available to investors. Governments in emerging market
countries are often less stable and more likely to take extra-legal action
with respect to companies, industries, assets, or foreign ownership than
those in more developed markets. Moreover, it can be more difficult for
investors to bring litigation or enforce judgments against issuers in
emerging markets or for U.S. regulators to bring enforcement actions
against such issuers. The Fund may also be subject to emerging markets
risk if it invests in derivatives or other securities or instruments whose
value or return are related to the value or returns of emerging markets
securities.
Other heightened risks associated with emerging markets investments
include without limitation (i) risks due to less social, political and
economic stability; (ii) the smaller size of the market for such securities
and a lower volume of trading, resulting in a lack of liquidity and in
price volatility; (iii) certain national policies which may restrict the Fund’s
investment opportunities, including sanctions and restrictions on
investing in issuers or industries deemed sensitive to relevant national
interests and requirements that government approval be obtained prior
to investment by foreign persons; (iv) certain national policies that may
restrict the Fund’s repatriation of investment income, capital or the
proceeds of sales of securities, including temporary restrictions on
foreign capital remittances; (v) the lack of uniform accounting and
auditing standards and/or standards that may be significantly different
from the standards required in the United States; (vi) less publicly
available financial and other information regarding issuers; (vii)
potential difficulties in enforcing contractual obligations; and (viii)
higher rates of inflation, higher interest rates and other economic
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concerns. The Fund may invest to a substantial extent in emerging
market securities that are denominated in local currencies, subjecting
the Fund to a greater degree of foreign currency risk. Also, investing in
emerging market countries may entail purchases of securities of issuers
that are insolvent, bankrupt or otherwise of questionable ability to
satisfy their payment obligations as they become due, subjecting the
Fund to a greater amount of credit risk and/or high yield risk. The
economy of some emerging markets may be particularly exposed to or
affected by a certain industry or sector, and therefore issuers and/or
securities of such emerging markets may be more affected by the
performance of such industries or sectors.
Currency Risk
If the Fund invests directly in foreign (non-U.S.) currencies or in
securities that trade in, and receive revenues in, foreign (non-U.S.)
currencies, or in derivatives or other instruments that provide exposure
to foreign (non-U.S.) currencies, it will be subject to the risk that those
currencies will decline in value relative to the U.S. dollar, or, in the case
of hedging positions, that the U.S. dollar will decline in value relative to
the currency being hedged. Although the Fund may attempt to hedge its
currency exposure into the U.S. dollar, it may not be successful in
reducing the effects of currency fluctuations. The Fund may also hedge
from one foreign currency to another. In addition, the Fund's use of
currency hedging may not be successful and the use of such strategies
may lower the Fund's potential returns.
Investments denominated in foreign (non-U.S.) currencies or that trade
in and receive revenues in, foreign (non-U.S.) currencies or derivatives
that provide exposure to foreign (non-U.S.) currencies, are subject to the
risk that those currencies will decline in value relative to the U.S. dollar,
or, in the case of hedging positions, that the U.S. dollar will decline in
value relative to the currency being hedged.
Currency rates in foreign (non-U.S.) countries may fluctuate significantly
over short periods of time for a number of reasons, including changes in
interest rates, rates of inflation, balance of payments and governmental
surpluses or deficits, intervention (or the failure to intervene) by U.S. or
foreign (non-U.S.) governments, central banks or supranational entities
such as the International Monetary Fund, or by the imposition of
currency controls or other political developments in the United States or
abroad. These fluctuations may have a significant adverse impact on the
value of the Fund’s portfolio and/or the level of Fund distributions made
to Common Shareholders. There is no assurance that a hedging strategy,
if used, will be successful. Moreover, currency hedging techniques may
be unavailable with respect to emerging market currencies. As a result,
the Fund’s investments in foreign currency-denominated, and especially
emerging market-currency denominated, securities may reduce the
returns of the Fund. As a result, the Fund’s investments in foreign
currency-denominated”, and especially emerging market-currency
denominated,” securities may reduce the returns of the Fund.
The local emerging market currencies in which the Fund may be
invested from time to time may experience substantially greater
volatility against the U.S. dollar than the major convertible currencies of
developed countries. Some of the local currencies in which the Fund
may invest are neither freely convertible into one of the major currencies
nor internationally traded. The local currencies may be convertible into
other currencies only inside the relevant emerging market where the
limited availability of such other currencies may tend to inflate their
values relative to the local currency in question. Such internal exchange
markets can therefore be said to be neither liquid nor competitive. In
addition, many of the currencies of emerging market countries in which
the Fund may invest have experienced steady devaluation relative to
freely convertible currencies.
Continuing uncertainty as to the status of the euro and the European
Monetary Union (“EMU”) has created significant volatility in currency
and financial markets generally. Any partial or complete dissolution of
the EMU could have significant adverse effects on currency and financial
markets, and on the values of the Fund’s portfolio investments. If one or
more EMU countries were to stop using the euro as its primary currency,
the Fund’s investments in such countries may be redenominated into a
different or newly adopted currency. As a result, the value of those
investments could decline significantly and unpredictably. In addition,
securities or other investments that are redenominated may be subject
to foreign currency risk, liquidity risk and valuation risk to a greater
extent than similar investments currently denominated in euros. To the
extent a currency used for redenomination purposes is not specified in
respect of certain EMU-related investments, or should the euro cease to
be used entirely, the currency in which such investments are
denominated may be unclear, making such investments particularly
difficult to value or dispose of. The Fund may incur additional expenses
to the extent it is required to seek judicial or other clarification of the
denomination or value of such securities.
There can be no assurance that if the Fund earns income or capital gains
in a non-U.S. country or PIMCO otherwise seeks to withdraw the Fund’s
investments from a given country, capital controls imposed by such
country will not prevent, or cause significant expense in, doing so.
U.S. Government Securities Risk
Certain U.S. government securities, such as U.S. Treasury bills, notes,
bonds, and mortgage-related securities guaranteed by the GNMA, are
supported by the full faith and credit of the United States; others, such
as those of the FHLBs or the FHLMC, are supported by the right of the
issuer to borrow from the U.S. Treasury; others, such as those of the
FNMA, are supported by the discretionary authority of the
U.S. government to purchase the agency’s obligations; and still others
are supported only by the credit of the agency, instrumentality or
corporation. U.S. government securities are subject to market risk,
interest rate risk and credit risk. Although legislation has been enacted
to support certain government sponsored entities, including the FHLBs,
FHLMC and FNMA, there is no assurance that the obligations of such
entities will be satisfied in full, or that such obligations will not decrease
in value or default. It is difficult, if not impossible, to predict the future
political, regulatory or economic changes that could impact the
government sponsored entities and the values of their related securities
or obligations. In addition, certain governmental entities, including
FNMA and FHLMC, have been subject to regulatory scrutiny regarding
their accounting policies and practices and other concerns that may
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result in legislation, changes in regulatory oversight and/or other
consequences that could adversely affect the credit quality, availability
or investment character of securities issued by these entities. Yields
available from U.S. government debt securities are generally lower than
the yields available from other debt securities. The values of
U.S. government securities change as interest rates fluctuate.
Periodically, uncertainty regarding the status of negotiations in the
U.S. government to increase the statutory debt ceiling could increase the
risk that the U.S. government may default on payments on certain
U.S. government securities, cause the credit rating of the
U.S. government to be downgraded, increase volatility in the stock and
bond markets, result in higher interest rates, reduce prices of
U.S. Treasury and other securities, and/or increase the costs of various
kinds of debt. If a government-sponsored entity is negatively impacted
by legislative or regulatory action (or lack thereof), is unable to meet its
obligations, or its creditworthiness declines, the performance of a fund
that holds securities of the entity will be adversely impacted.
Convertible Securities Risk
The market values of convertible securities may decline as interest rates
increase and, conversely, may increase as interest rates decline. A
convertible security’s market value, however, tends to reflect the market
price of the common stock of the issuing company when that stock price
approaches or is greater than the convertible security’s “conversion
price.” The conversion price is defined as the predetermined price at
which the convertible security could be exchanged for the associated
stock. As the market price of the underlying common stock declines, the
price of the convertible security tends to be influenced more by the yield
of the convertible security. Thus, it may not decline in price to the same
extent as the underlying common stock. In the event of a liquidation of
the issuing company, holders of convertible securities may be paid
before the company’s common stockholders but after holders of any
senior debt obligations of the company. Consequently, the issuer’s
convertible securities generally entail less risk than its common stock
but more risk than its other debt obligations. Convertible securities are
often rated below investment grade or not rated.
Synthetic Convertible Securities Risk
Synthetic convertible securities involve the combination of separate
securities that possess the two principal characteristics of a traditional
convertible security (i.e., an income-producing component and a right to
acquire an equity security). Synthetic convertible securities are often
achieved, in part, through investments in warrants or options to buy
common stock (or options on a stock index), and therefore are subject
to the risks associated with derivatives. The value of a synthetic
convertible security will respond differently to market fluctuations than
a traditional convertible security because a synthetic convertible is
composed of two or more separate securities or instruments, each with
its own market value. Because the convertible component is typically
achieved by investing in warrants or options to buy common stock at a
certain exercise price, or options on a stock index, synthetic convertible
securities are subject to the risks associated with derivatives. In
addition, if the value of the underlying common stock or the level of the
index involved in the convertible component falls below the exercise
price of the warrant or option, the warrant or option may lose all value.
Contingent Convertible Securities Risk
CoCos have no stated maturity, have fully discretionary coupons and are
typically issued in the form of subordinated debt instruments. CoCos
generally either convert into equity or have their principal written down
(including potentially to zero) upon the occurrence of certain triggering
events (“triggers”) linked to regulatory capital thresholds or regulatory
actions relating to the issuer's continued viability. As a result, an
investment by the Fund in CoCos is subject to the risk that coupon (i.e.,
interest) payments may be cancelled by the issuer or a regulatory
authority in order to help the issuer absorb losses and the risk of total
loss. An investment by the Fund in CoCos is also subject to the risk that,
in the event of the liquidation, dissolution or winding-up of an issuer
prior to a trigger event, the Fund's rights and claims will generally rank
junior to the claims of holders of the issuer's other debt obligations and
CoCos may also be treated as junior to an issuer's other obligations and
securities. In addition, if CoCos held by the Fund are converted into the
issuer's underlying equity securities following a trigger event, the Fund's
holding may be further subordinated due to the conversion from a debt
to equity instrument. Further, the value of an investment in CoCos is
unpredictable and will be influenced by many factors and risks,
including interest rate risk, credit risk, market risk and liquidity risk. An
investment by the Fund in CoCos may result in losses to the Fund.
Valuation Risk
Certain securities in which the Fund invests may be less liquid and more
difficult to value than other types of securities. Investments for which
market quotations are not readily available are valued at fair value as
determined in good faith pursuant to Rule 2a-5 under the 1940 Act. Fair
value pricing may require subjective determinations about the value of a
security or other asset. As a result, there can be no assurance that fair
value pricing will result in adjustments to the prices of securities or other
assets or that fair value pricing will reflect actual market value, and it is
possible that the fair value determined for a security or other asset will
be materially different from quoted or published prices, from the prices
used by others for the same security or other asset and/or from the
value that actually could be or is realized upon the sale of that security
or other asset.
Leverage Risk
The Fund’s use of leverage (as described under “Use of Leverage” in the
body of this prospectus) creates the opportunity for increased Common
Share net income, but also creates special risks for Common
Shareholders (including an increased risk of loss). To the extent used,
there is no assurance that the Fund’s leveraging strategies will be
successful. Leverage is a speculative technique that may expose the
Fund to greater risk and increased costs. The Fund’s assets attributable
to leverage, if any, will be invested in accordance with the Fund’s
investment objective and policies. Interest expense payable by the Fund
with respect to derivatives and other forms of leverage, and dividends
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payable with respect to any preferred shares outstanding, if any, will
generally be based on shorter-term interest rates that would be
periodically reset. So long as the Fund’s portfolio investments provide a
higher rate of return (net of applicable Fund expenses) than the interest
expenses and other costs to the Fund of such leverage, the investment
of the proceeds thereof will generate more income than will be needed
to pay the costs of the leverage. If so, and all other things being equal,
the excess may be used to pay higher dividends to Common
Shareholders than if the Fund were not so leveraged. If, however,
shorter-term interest rates rise relative to the rate of return on the
Fund’s portfolio, the interest and other costs to the Fund of leverage
could exceed the rate of return on the debt obligations and other
investments held by the Fund, thereby reducing return to Common
Shareholders. Leveraging transactions pursued by the Fund may
increase its duration and sensitivity to interest rate movements. In
addition, fees and expenses of any form of leverage used by the Fund
will be borne entirely by the Common Shareholders (and not by
preferred shareholders, if any) and will reduce the investment return of
the Common Shares. Therefore, there can be no assurance that the
Fund’s use of leverage will result in a higher yield on the Common
Shares, and it may result in losses. In addition, any Preferred Shares
issued by the Fund are expected to pay cumulative dividends, which may
tend to increase leverage risk. Leverage creates several major types of
risks for Common Shareholders, including:
■
the likelihood of greater volatility of NAV and market price of
Common Shares, and of the investment return to Common
Shareholders, than a comparable portfolio without leverage;
■
the possibility either that Common Share dividends will fall if the
interest and other costs of leverage rise, or that dividends paid on
Common Shares will fluctuate because such costs vary over time;
and
■
the effects of leverage in a declining market or a rising interest
rate environment, as leverage is likely to cause a greater decline in
the NAV of the Common Shares than if the Fund were not
leveraged.
In addition, the counterparties to the Fund’s leveraging transactions and
any preferred shareholders of the Fund will have priority of payment
over the Fund’s Common Shareholders.
Reverse repurchase agreements involve the risks that the interest
income earned on the investment of the proceeds will be less than the
interest expense and Fund expenses associated with the repurchase
agreement, that the market value of the securities sold by the Fund may
decline below the price at which the Fund is obligated to repurchase
such securities and that the securities may not be returned to the Fund.
There is no assurance that reverse repurchase agreements can be
successfully employed. Dollar roll/buyback transactions involve the risk
that the market value of the securities the Fund is required to purchase
may decline below the agreed upon purchase price of those securities.
Successful use of dollar rolls/buybacks may depend upon the Investment
Manager’s ability to correctly predict interest rates and prepayments.
There is no assurance that dollar rolls/buybacks can be successfully
employed. In connection with reverse repurchase agreements and dollar
rolls/buybacks, the Fund will also be subject to counterparty risk with
respect to the purchaser of the securities. If the broker/dealer to whom
the Fund sells securities becomes insolvent, the Fund’s right to purchase
or repurchase securities may be restricted.
The Fund may engage in total return swaps, reverse repurchases, loans
of portfolio securities, short sales and when-issued, delayed delivery and
forward commitment transactions, credit default swaps, basis swaps
and other swap agreements, purchases or sales of futures and forward
contracts (including foreign currency exchange contracts), call and put
options or other derivatives. The Fund’s use of such transactions gives
rise to associated leverage risks described above, and may adversely
affect the Fund’s income, distributions and total returns to Common
Shareholders. To the extent that any offsetting positions do not behave
in relation to one another as expected, the Fund may perform as if it is
leveraged through use of these derivative strategies.
Any total return swaps, reverse repurchases, loans of portfolio securities,
short sales and when-issued, delayed delivery and forward commitment
transactions, credit default swaps, basis swaps and other swap
agreements, purchases or sales of futures and forward contracts
(including foreign currency exchange contracts), call and put options or
other derivatives by the Fund or counterparties to the Fund’s other
leveraging transactions, if any, would have seniority over the Fund’s
Common Shares.
Because the fees received by the Investment Manager may increase
depending on the types of leverage utilized by the Fund, the Investment
Manager has a financial incentive for the Fund to use certain forms of
leverage, which may create a conflict of interest between the Investment
Manager, on the one hand, and the Common Shareholders, on the other
hand.
Derivatives Risk
The Fund may, but is not required to, utilize a variety of derivative
instruments (both long and short positions) for investment or risk
management purposes. Derivatives are financial contracts whose value
depends on, or is derived from, the value of an underlying asset,
reference rate or index. For example, the Fund may use derivative
instruments for purposes of increasing liquidity, providing efficient
portfolio management, broadening investment opportunities (including
taking short or negative positions), implementing a tax or cash
management strategy, gaining exposure to a particular security or
segment of the market, modifying the effective duration of the Fund’s
portfolio investments and/or enhancing total return.
The use of derivative instruments involves risks different from, or
possibly greater than, the risks associated with investing directly in
securities and other traditional investments. Derivatives and other
similar instruments (referred to collectively as “derivatives”), which may
increase market exposure are subject to a number of risks including
leverage risk, liquidity risk (which may be heightened for highly
customized derivatives), interest rate risk, market risk, counterparty
(including credit) risk, operational risk (such as documentation issues,
settlement issues and systems failures), legal risk (such as insufficient
documentation, insufficient capacity or authority of a counterparty, and
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PIMCO Income Strategy Fund II
issues with the legality or enforceability of a contract), counterparty risk,
tax risk and management risk, as well as risks arising from changes in
applicable requirements, risks arising from margin requirements and
risks arising from mispricing or valuation complexity. They also involve
the risk that changes in the value of a derivative instrument may not
correlate perfectly with the underlying asset, rate or index. By investing
in a derivative instrument, the Fund could lose more than the initial
amount invested, and derivatives may increase the volatility of the Fund,
especially in unusual or extreme market conditions. Certain derivatives
have the potential for unlimited loss, regardless of the size of the initial
investment. The Fund may be required to hold additional cash or sell
other investments in order to obtain cash to close out a position and
changes in the value of a derivative may also create margin delivery or
settlement payment obligations for the Fund. Also, suitable derivative
transactions may not be available in all circumstances and there can be
no assurance that the Fund will engage in these transactions to reduce
exposure to other risks when that would be beneficial or that, if used,
such strategies will be successful. The Fund’s use of derivatives may
increase or accelerate the amount of taxes payable by Common
Shareholders.
Over-the-counter (“OTC”) derivatives are also subject to the risk that a
counterparty to the transaction will not fulfill its contractual obligations
to the other party, as many of the protections afforded to centrally
cleared derivative transactions might not be available for OTC
derivatives. The primary credit risk on derivatives that are
exchange-traded or traded through a central clearing counterparty
resides with the Fund’s clearing broker, or the clearinghouse itself.
Participation in the markets for derivative instruments involves
investment risks and transaction costs to which the Fund may not be
subject absent the use of these strategies. The skills needed to
successfully execute derivative strategies may be different from those
needed for other types of transactions. If the Fund incorrectly forecasts
the value and/or creditworthiness of securities, currencies, interest rates,
counterparties or other economic factors involved in a derivative
transaction, the Fund might have been in a better position if the Fund
had not entered into such derivative transaction. In evaluating the risks
and contractual obligations associated with particular derivative
instruments, it is important to consider that certain derivative
transactions may be modified or terminated only by mutual consent of
the Fund and its counterparty.
Therefore, it may not be possible for the Fund to modify, terminate, or
offset the Fund’s obligations or the Fund’s exposure to the risks
associated with a derivative transaction prior to its scheduled
termination or maturity date, which may create a possibility of increased
volatility and/or decreased liquidity to the Fund. Hedges are sometimes
subject to imperfect matching between the derivative and the
underlying instrument, and there can be no assurance that the Fund’s
hedging transactions will be effective. In such case, the Fund may lose
money.
Because the markets for certain derivative instruments (including
markets located in foreign countries) are relatively new and still
developing, appropriate derivative transactions may not be available in
all circumstances for risk management or other purposes. Upon the
expiration of a particular contract, the Fund may wish to retain the
Fund’s position in the derivative instrument by entering into a similar
contract but may be unable to do so if the counterparty to the original
contract is unwilling to enter into the new contract and no other
appropriate counterparty can be found. When such markets are
unavailable, the Fund will be subject to increased liquidity and
investment risk.
The Fund may enter into opposite sides of interest rate swap and other
derivatives for the principal purpose of generating distributable gains on
the one side (characterized as ordinary income for tax purposes) that
are not part of the Fund’s duration or yield curve management
strategies (“paired swap transactions”), and with a substantial
possibility that the Fund will experience a corresponding capital loss
and decline in NAV with respect to the opposite side transaction (to the
extent it does not have corresponding offsetting capital gains).
Consequently, Common Shareholders may receive distributions and owe
tax on amounts that are effectively a taxable return of the shareholder’s
investment in the Fund, at a time when their investment in the Fund has
declined in value, which tax may be at ordinary income rates. The tax
treatment of certain derivatives in which the Fund invests may be
unclear and thus subject to recharacterization. Any recharacterization of
payments made or received by the Fund pursuant to derivatives
potentially could affect the amount, timing or character of Fund
distributions. In addition, the tax treatment of such investment
strategies may be changed by regulation or otherwise.
When a derivative is used as a hedge against a position that the Fund
holds, any loss generated by the derivative generally should be
substantially offset by gains on the hedged investment, and vice versa.
Although hedging can reduce or eliminate losses, it can also reduce or
eliminate gains. Hedges are sometimes subject to imperfect matching
between the derivative and the underlying instrument, and there can be
no assurance that the Fund’s hedging transactions will be effective. The
regulation of the derivatives markets has increased over the past several
years, and additional future regulation of the derivatives markets may
make derivatives more costly, may limit the availability or reduce the
liquidity of derivatives, or may otherwise adversely affect the value or
performance of derivatives. Any such adverse future developments could
impair the effectiveness or raise the costs of the Fund’s derivative
transactions, impede the employment of the Fund’s derivatives
strategies, or adversely affect the Fund’s performance.
Credit Default Swaps Risk
Credit default swap agreements may involve greater risks than if the
Fund had invested in the reference obligation directly since, in addition
to general market risks, credit default swaps are subject to leverage risk,
illiquidity risk, counterparty risk and credit risk. A buyer generally also
will lose its investment and recover nothing should no credit event occur
and the swap is held to its termination date. If a credit event were to
occur, the value of any deliverable obligation received by the seller (if
any), coupled with the upfront or periodic payments previously received,
may be less than the full notional value it pays to the buyer, resulting in
a loss of value to the seller. When the Fund acts as a seller of a credit
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default swap, it is exposed to many of the same risks of leverage
described herein. As the seller, the Fund would receive a stream of
payments over the term of the swap agreement provided that no event
of default has occurred with respect to the referenced debt obligation
upon which the swap is based. The Fund would effectively add leverage
to its portfolio because, if a default occurs, the stream of payments may
stop and, in addition to its total net assets, the Fund would be subject to
investment exposure on the notional amount of the swap.
Although the Fund may seek to realize gains by selling credit default
swaps that increase in value, to realize gains on selling credit default
swaps, an active secondary market for such instruments must exist or
the Fund must otherwise be able to close out these transactions at
advantageous times. In addition to the risk of losses described above, if
no such secondary market exists or the Fund is otherwise unable to
close out these transactions at advantageous times, selling credit
default swaps may not be profitable for the Fund.
The market for credit default swaps has become more volatile as the
creditworthiness of certain counterparties has been questioned and/or
downgraded. The Fund will be subject to credit risk with respect to the
counterparties to the credit default swap contract (whether a clearing
corporation or another third party). If a counterparty’s credit becomes
significantly impaired, multiple requests for collateral posting in a short
period of time could increase the risk that the Fund may not receive
adequate collateral. The Fund may exit its obligations under a credit
default swap only by terminating the contract and paying applicable
breakage fees, or by entering into an offsetting credit default swap
position, which may cause the Fund to incur more losses.
Counterparty Risk
The Fund will be subject to credit risk with respect to the counterparties
to the derivative contracts and other instruments entered into by the
Fund or held by special purpose or structured vehicles in which the Fund
invests. In the event that the Fund enters into a derivative transaction
with a counterparty that subsequently becomes insolvent or becomes
the subject of a bankruptcy case, the derivative transaction may be
terminated in accordance with its terms and the Fund’s ability to realize
its rights under the derivative instrument and its ability to distribute the
proceeds could be adversely affected. If a counterparty becomes
bankrupt or otherwise fails to perform its obligations under a derivative
contract due to financial difficulties, the Fund may experience significant
delays in obtaining any recovery (including recovery of any collateral it
has provided to the counterparty) in a dissolution, assignment for the
benefit of creditors, liquidation, winding-up, bankruptcy or other
analogous proceeding. In addition, in the event of the insolvency of a
counterparty to a derivative transaction, the derivative transaction
would typically be terminated at its fair market value. If the Fund is
owed this fair market value in the termination of the derivative
transaction and its claim is unsecured, the Fund will be treated as a
general creditor of such counterparty and will not have any claim with
respect to any underlying security or asset. The Fund may obtain only a
limited recovery or may obtain no recovery in such circumstances. While
the Fund may seek to manage its counterparty risk by transacting with a
number of counterparties, concerns about the solvency of, or a default
by, one large market participant could lead to significant impairment of
liquidity and other adverse consequences for other counterparties.
Equity Securities and Related Market Risk
The market price of common stocks and other equity securities may go
up or down, sometimes rapidly or unpredictably. Equity securities may
decline in value due to factors affecting equity securities markets
generally, particular industries represented in those markets, or the
issuer itself. The values of equity securities may decline due to real or
perceived adverse economic conditions, changes in the general outlook
for corporate earnings, changes in interest or currency rates or adverse
investor sentiment generally. They may also decline due to labor
shortages or increased production costs and competitive conditions
within an industry. Equity securities generally have greater price
volatility than bonds and other debt securities.
Different types of equity securities provide different voting and dividend
rights and priority in the event of the bankruptcy and/or insolvency of
the issuer. In addition to common stock, equity securities may include
preferred securities, convertible securities and warrants. Equity securities
other than common stock are subject to many of the same risks as
common stock, although possibly to different degrees. The risks of
equity securities are generally magnified in the case of equity
investments in distressed companies.
Preferred Securities Risk
In addition to equity securities risk, credit risk and possibly high yield
risk, investment in preferred securities involves certain other risks.
Certain preferred securities contain provisions that allow an issuer
under certain conditions to skip or defer distributions. If the Fund owns
a preferred security that is deferring its distribution, the Fund may be
required to include the amount of the deferred distribution in its taxable
income for tax purposes although it does not currently receive such
amount in cash. In order to receive the special treatment accorded to
RICs and their shareholders under the Code and to avoid U.S. federal
income and/or excise taxes at the Fund level, the Fund may be required
to distribute this income to shareholders in the tax year in which the
income is recognized (without a corresponding receipt of cash by the
Fund). Therefore, the Fund may be required to pay out as an income
distribution in any such tax year an amount greater than the total
amount of cash income the Fund actually received and to sell portfolio
securities, including at potentially disadvantageous times or prices, to
obtain cash needed for these income distributions. Preferred securities
often are subject to legal provisions that allow for redemption in the
event of certain tax or legal changes or at the issuer’s call. In the event
of redemption, the Fund may not be able to reinvest the proceeds at
comparable rates of return. Preferred securities are subordinated to
bonds and other debt securities in an issuer’s capital structure in terms
of priority for corporate income and liquidation payments, and therefore
will be subject to greater credit risk than those debt securities. Preferred
securities may trade less frequently and in a more limited volume and
may be subject to more abrupt or erratic price movements than many
other securities.
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PIMCO Income Strategy Fund II
Private Placements and Restricted Securities Risk
A private placement involves the sale of securities that have not been
registered under the Securities Act or relevant provisions of applicable
non-U.S. law to certain institutional and qualified individual purchasers,
such as the Fund. In addition to the general risks to which all securities
are subject, securities received in a private placement generally are
subject to strict restrictions on resale, and there may be no liquid
secondary market or ready purchaser for such securities. See ”Principal
Risks of the Fund - Liquidity Risk.“ Therefore, the Fund may be unable to
dispose of such securities when it desires to do so, or at the most
favorable time or price. Private placements may also raise valuation
risks.
Restricted securities are often purchased at a discount from the market
price of unrestricted securities of the same issuer reflecting the fact that
such securities may not be readily marketable without some time delay.
Such securities are often more difficult to value and the sale of such
securities often requires more time and results in higher brokerage
charges or dealer discounts and other selling expenses than does the
sale of liquid securities trading on national securities exchanges or in
the over-the-counter markets. Until the Fund can sell such securities into
the public markets, its holdings may be less liquid and any sales will
need to be made pursuant to an exemption under the Securities Act.
Confidential Information Access Risk
In managing the Fund (and other PIMCO clients), PIMCO may from time
to time have the opportunity to receive material, non-public information
(“Confidential Information”) about the issuers of certain investments,
including, without limitation, senior floating rate loans, other loans and
related investments being considered for acquisition by the Fund or held
in the Fund’s portfolio. For example, an issuer of privately placed loans
considered by the Fund may offer to provide PIMCO with financial
information and related documentation regarding the issuer that is not
publicly available. Pursuant to applicable policies and procedures,
PIMCO may (but is not required to) seek to avoid receipt of Confidential
Information from the issuer so as to avoid possible restrictions on its
ability to purchase and sell investments on behalf of the Fund and other
clients to which such Confidential Information relates. In such
circumstances, the Fund (and other PIMCO clients) may be
disadvantaged in comparison to other investors, including with respect
to the price the Fund pays or receives when it buys or sells an
investment. Further, PIMCO’s and the Fund’s abilities to assess the
desirability of proposed consents, waivers or amendments with respect
to certain investments may be compromised if they are not privy to
available Confidential Information. PIMCO may also determine to
receive such Confidential Information in certain circumstances under its
applicable policies and procedures. If PIMCO intentionally or
unintentionally comes into possession of Confidential Information, it
may be unable, potentially for a substantial period of time, to purchase
or sell investments to which such Confidential Information relates.
Inflation/Deflation Risk
Inflation risk is the risk that the value of assets or income from the
Fund’s investments will be worth less in the future as inflation decreases
the value of payments at future dates. As inflation increases, the real
value of the Fund’s portfolio could decline. Inflation has increased and it
cannot be predicted when, if, or the degree to which it may decline.
Inflation rates may change frequently and significantly as a result of
various factors, including unexpected shifts in the domestic or global
economy or changes in fiscal or monetary policies. Deflation risk is the
risk that prices throughout the economy decline over time. Deflation
may have an adverse effect on the creditworthiness of issuers and may
make issuer default more likely, which may result in a decline in the
value of the Fund’s portfolio and Common Shares.
Regulatory Changes Risk
Financial entities, such as investment companies and investment
advisers, are generally subject to extensive government regulation and
intervention. Government regulation and/or intervention may change
the way the Fund is regulated, affect the expenses incurred directly by
the Fund and the value of its investments, and limit and /or preclude the
Fund’s ability to achieve its investment objective. Government
regulation may change frequently and may have significant adverse
consequences. The Fund and the Investment Manager have historically
been eligible for exemptions from certain regulations. However, there is
no assurance that the Fund and the Investment Manager will continue
to be eligible for such exemptions. Actions by governmental entities may
also impact certain instruments in which the Fund invests.
Moreover, government regulation may have unpredictable and
unintended effects. Legislative or regulatory actions to address
perceived liquidity or other issues in fixed income markets generally, or
in particular markets such as the municipal securities market, may alter
or impair the Fund’s ability to pursue its investment objective or utilize
certain investment strategies and techniques.
While there continues to be uncertainty about the full impact of these
and other regulatory changes, it is the case that the Fund will be subject
to a more complex regulatory framework, and may incur additional
costs to comply with new requirements as well as to monitor for
compliance in the future. Actions by governmental entities may also
impact certain instruments in which the Fund invests and reduce market
liquidity and resiliency. For example, the Fund’s investments (including,
but not limited to, repurchase agreements, collateralized loan
obligations and mortgage-backed securities), payment obligations and
financing terms may rely in some fashion on LIBOR. For more
information related to the LIBOR transition, see “Principal Risks of the
Fund - Regulatory Risk - LIBOR.”
Regulatory Risk—LIBOR
Certain instruments in which the Fund may invest have relied or
continue to rely in some fashion upon the London Interbank Offered
Rate (“LIBOR”). LIBOR was traditionally an average interest rate,
determined by the ICE Benchmark Administration, that banks charge
one another for the use of short-term money. On March 5, 2021, the
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Financial Conduct Authority (“FCA”), the United Kingdom’s financial
regulatory body and regulator of LIBOR, publicly announced that all
U.S. Dollar LIBOR settings will either cease to be provided by any
administrator or will no longer be representative (i) immediately after
December 31, 2021 for one-week and two-month U.S. Dollar LIBOR
settings and (ii) immediately after June 30, 2023 for the remaining
U.S. Dollar LIBOR settings. As of January 1, 2022, as a result of
supervisory guidance from U.S. regulators, U.S. regulated entities have
generally ceased entering into new LIBOR contracts with limited
exceptions. Publication of all Japanese yen and the one- and six-month
sterling LIBOR settings have ceased, and while publication of the
three-month Sterling LIBOR setting will continue through at least the
end of March 2024 on the basis of a changed methodology (known as
“synthetic LIBOR”), this rate has been designated by the FCA as
unrepresentative of the underlying market that it seeks to measure and
is solely available for use in legacy transactions. Certain bank-sponsored
committees in other jurisdictions, including Europe, the United Kingdom,
Japan and Switzerland, have selected alternative reference rates
denominated in other currencies. Although the transition process away
from LIBOR for many instruments has been completed, some LIBOR use
is continuing and there are potential effects related to the transition
away from LIBOR on continued use of LIBOR on the Fund, or on certain
instruments in which the Fund invests can be difficult to ascertain, and
may vary depending on factors that include, but are not limited to: (i)
existing fallback or termination provisions in individual contracts and (ii)
whether, how, and when industry participants adopt new reference
rates for affected instruments. So-called “tough legacy” contracts have
LIBOR interest rate provisions with no fallback provisions contemplating
a permanent discontinuation of LIBOR, inadequate fallback provisions
or fallback provisions which may not effectively result in a transition
away from LIBOR prior to LIBOR’s planned replacement date. On
March 15, 2022, the Adjustable Interest Rate (LIBOR) Act was signed
into law. This law provides a statutory fallback mechanism on a
nationwide basis to replace LIBOR with a benchmark rate that is
selected by the Board of Governors of the Federal Reserve System based
on the Secured Overnight Financing Rate (“SOFR”) for tough legacy
contracts. On February 27, 2023, the Federal Reserve System’s final rule
in connection with this law became effective, establishing benchmark
replacements based on SOFR and Term SOFR (a forward-looking
measurement of market expectations of SOFR implied from certain
derivatives markets) for applicable tough legacy contracts governed by
U.S. law. In addition, the FCA has announced that it will require the
publication of synthetic LIBOR for the one-month, three-month and
six-month U.S. Dollar LIBOR settings after June 30, 2023 through at
least September 30, 2024. Certain of the Fund’s investments may
involve individual tough legacy contracts which may be subject to the
Adjustable Interest Rate (LIBOR) Act or synthetic LIBOR and no
assurances can be given that these measures will have the intended
effects. Moreover, certain aspects of the transition from LIBOR have
relied or will continue to rely on the actions of third-party market
participants, such as clearing houses, trustees, administrative agents,
asset servicers and certain service providers; PIMCO cannot guarantee
the performance of such market participants and any failure on the part
of such market participants to manage their part of the LIBOR transition
could impact the Fund. The transition of investments from LIBOR to a
replacement rate as a result of amendment, application of existing
fallbacks, statutory requirements or otherwise may also result in a
reduction in the value of certain instruments held by the Fund or a
reduction in the effectiveness of related Fund transactions such as
hedges. In addition, an instrument’s transition to a replacement rate
could result in variations in the reported yields of the Fund that holds
such instrument. Any such effects of the transition away from LIBOR, as
well as other unforeseen effects, could result in losses to the Fund.
Regulatory Risk—Commodity Pool Operator
The CFTC has adopted regulations that subject registered investment
companies and their investment advisers to regulation by the CFTC if
the registered investment company invests more than a prescribed level
of its liquidation value in futures, options on futures or commodities,
swaps, or other financial instruments regulated under the CEA and the
rules thereunder (“commodity interests”), or if the Fund markets itself
as providing investment exposure to such instruments. The Investment
Manager is registered with the CFTC as a CPO. However, with respect to
the Fund, the Investment Manager has claimed an exclusion from
registration as a CPO pursuant to CFTC Rule 4.5. For the Investment
Manager to remain eligible for this exclusion, the Fund must comply
with certain limitations, including limits on its ability to use any
commodity interests and limits on the manner in which the Fund holds
out its use of such commodity interests. These limitations may restrict
the Fund’s ability to pursue its investment objective and strategies,
increase the costs of implementing its strategies, result in higher
expenses for the Fund, and/or adversely affect the Fund’s total return.
Further, in the event the Investment Manager becomes unable to rely on
the exclusion in CFTC Rule 4.5 with respect to the Fund and is required
to register as a CPO with respect to the Fund, the Investment Manager
will be subject to additional regulation and its expenses may increase.
Liquidity Risk
Liquidity risk exists when particular investments are difficult to purchase
or sell. Illiquid investments are investments that the Fund reasonably
expects cannot be sold or disposed of in current market conditions in
seven calendar days or less without the sale or disposition significantly
changing the market value of the investment. Illiquid investments may
become harder to value, especially in changing markets. The Fund’s
investments in illiquid investments may reduce the returns of the Fund
because it may be unable to sell the illiquid investments at an
advantageous time or price or possibly require the Fund to dispose of
other investments at unfavorable times or prices in order to satisfy its
obligations, which could prevent the Fund from taking advantage of
other investment opportunities. Additionally, the market for certain
investments may become illiquid under adverse market or economic
conditions independent of any specific adverse changes in the
conditions of a particular issuer. Bond markets have consistently grown
over the past three decades while the capacity for traditional dealer
counterparties to engage in fixed income trading has not kept pace and
in some cases has decreased. As a result, dealer inventories of corporate
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PIMCO Income Strategy Fund II
bonds, which provide a core indication of the ability of financial
intermediaries to “make markets,” are at or near historic lows in
relation to market size. Because market makers seek to provide stability
to a market through their intermediary services, a significant reduction
in dealer inventories could potentially lead to decreased liquidity and
increased volatility in the fixed income markets. Such issues may be
exacerbated during periods of economic uncertainty. To the extent that
the Fund’s principal investment strategies involve securities of
companies with smaller market capitalizations, foreign (non-U.S.)
securities, Rule 144A securities, illiquid sectors of fixed income
securities, derivatives or securities with substantial market and/or credit
risk, the Fund will tend to have the greatest exposure to liquidity risk.
Further fixed income securities with longer durations until maturity face
heightened levels of liquidity risk as compared to fixed income securities
with shorter durations until maturity. The risks associated with illiquid
instruments may be particularly acute in situations in which the Fund’s
operations require cash (such as in connection with repurchase offers)
and could result in the Fund borrowing to meet its short-term needs or
incurring losses on the sale of illiquid instruments. It may also be the
case that other market participants may be attempting to liquidate fixed
income holdings at the same time as the Fund, causing increased supply
in the market and contributing to liquidity risk and downward pricing
pressure. See ”Principal Risks of the Fund - Valuation Risk.“
Liquidity risk also refers to the risk that the Fund may be required to
hold additional cash or sell other investments in order to obtain cash to
close out derivatives or meet the liquidity demands that derivatives can
create to make payments of margin, collateral, or settlement payments
to counterparties. The Fund may have to sell a security at a
disadvantageous time or price to meet such obligations.
The current direction of governments and regulators may have the effect
of reducing market liquidity, market resiliency and money supply, such
as through higher rates, tighter financial regulations and proposals
related to open-end fund liquidity that may prevent mutual funds and
exchange-traded funds from participating in certain markets.
Tax Risk
The Fund has elected to be treated as a RIC under the Code and intends
each year to qualify and be eligible to be treated as such, so that it
generally will not be subject to U.S. federal income tax on its net
investment income or net short-term or long-term capital gains that are
distributed (or deemed distributed, as described below) to shareholders.
In order to qualify and be eligible for such treatment, the Fund must
meet certain asset diversification tests, derive at least 90% of its gross
income for such year from certain types of qualifying income, and
distribute to its shareholders at least 90% of its “investment company
taxable income” as that term is defined in the Code (which includes,
among other things, dividends, taxable interest and the excess of any
net short-term capital gains over net long-term capital losses, as
reduced by certain deductible expenses).
The Fund’s investment strategy will potentially be limited by its intention
to continue qualifying for treatment as a RIC, and can limit the Fund’s
ability to continue qualifying as such. The tax treatment of certain of the
Fund’s investments under one or more of the qualification or
distribution tests applicable to regulated investment companies is
uncertain. An adverse determination or future guidance by the IRS or a
change in law might affect the Fund’s ability to qualify or be eligible for
treatment as a RIC. Income and gains from certain of the Fund’s
activities may not constitute qualifying income to a RIC for purposes of
the 90% gross income test. If the Fund were to treat income or gain
from a particular investment or activity as qualifying income and the
income or gain were later determined not to constitute qualifying
income and, together with any other nonqualifying income, caused the
Fund’s nonqualifying income to exceed 10% of its gross income in any
taxable year, the Fund would fail to qualify as a RIC unless it is eligible
to and does pay a tax at the Fund level.
If, in any year, the Fund were to fail to qualify for treatment as a RIC
under the Code, and were ineligible to or did not otherwise cure such
failure, the Fund would be subject to tax on its taxable income at
corporate rates and, when such income is distributed, shareholders
would be subject to further tax, on such distributions to the extent of
the Fund’s current or accumulated earnings and profits.
Portfolio Turnover Risk
The Investment Manager manages the Fund without regard generally to
restrictions on portfolio turnover. The use of futures contracts and other
derivative instruments with relatively short maturities may tend to
exaggerate the portfolio turnover rate for the Fund. Trading in fixed
income securities does not generally involve the payment of brokerage
commissions, but does involve indirect transaction costs. The use of
futures contracts and other derivative instruments may involve the
payment of commissions to futures commission merchants or other
intermediaries. Higher portfolio turnover involves correspondingly
greater expenses to the Fund, including brokerage commissions or
dealer mark-ups and other transaction costs on the sale of securities
and reinvestments in other securities. The higher the rate of portfolio
turnover of the Fund, the higher these transaction costs borne by the
Fund generally will be. Such sales may result in realization of taxable
capital gains (including short-term capital gains, which are generally
taxed to shareholders at ordinary income tax rates when distributed net
of short-term capital losses and net long-term capital losses), and may
adversely impact the Fund’s after-tax returns. See “Tax Matters.”
Operational Risk
An investment in the Fund, like any fund, can involve operational risks
arising from factors such as processing errors, human errors, inadequate
or failed internal or external processes, failures in systems and
technology, changes in personnel and errors caused by third-party
service providers. The occurrence of any of these failures, errors or
breaches could result in a loss of information, regulatory scrutiny,
reputational damage or other events, any of which could have a
material adverse effect on the Fund. While the Fund seeks to minimize
such events through controls and oversight, there may still be failures
that could cause losses to the Fund.
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Other Investment Companies Risk
When investing in an investment company, the Fund will generally bear
its ratable share of that investment company's expenses, and would
remain subject to payment of the Fund's investment management fees
with respect to the assets so invested. Common Shareholders would
therefore be subject to duplicative expenses to the extent the Fund
invests in other investment companies. In addition, these other
investment companies may utilize leverage, in which case an investment
would subject the Fund to additional risks associated with leverage. Due
to its own financial interest or other business considerations, the
Investment Manager may choose to invest a portion of the Fund's
assets in investment companies sponsored or managed by the
Investment Manager or its related parties in lieu of investments by the
Fund directly in portfolio securities, or may choose to invest in such
investment companies over investment companies sponsored or
managed by others. Applicable law may limit the Fund's ability to invest
in other investment companies. See “Principal Risks of the
Fund-Leverage Risk.”
Risk Retention Investment Risk
The Fund may invest in risk retention tranches, which are eligible
residual interests typically held by the sponsors of such securitizations
pursuant to the final rules implementing the credit risk retention
requirements of the U.S. Risk Retention Rules. In the case of CMBS
transactions, for example, the U.S. Risk Retention Rules permit all or a
portion of the retained credit risk associated with certain securitizations
(i.e., retained risk) to be held by an unaffiliated “third party purchaser,”
such as the Fund, if, among other requirements, the third-party
purchaser holds its retained interest, unhedged, for at least five years
following the closing of the CMBS transaction, after which it is entitled
to transfer its interest in the securitization to another person that meets
the requirements for a third-party purchaser. Even after the required
holding period has expired, due to the generally illiquid nature of such
investments, no assurance can be given as to what, if any, exit strategies
will ultimately be available for any given position.
In addition, there is limited guidance on the application of the final
U.S. Risk Retention Rules to specific securitization structures. There can
be no assurance that the applicable federal agencies charged with the
implementation of the final U.S. Risk Retention Rules (the Federal
Deposit Insurance Corporation, the Comptroller of the Currency, the
Federal Reserve Board, the SEC, the Department of Housing and Urban
Development, and the Federal Housing Finance Agency) could not take
positions in the future that differ from the interpretation of such rules
taken or embodied in such securitizations, or that the final U.S. Risk
Retention Rules will not change.
Furthermore, in situations where the Fund invests in risk retention
tranches of securitizations structured by third parties, the Fund may be
required to execute one or more Risk Retention Agreements under
which it will make certain undertakings designed to ensure such
securitization complies with the final U.S. Risk Retention Rules. Such
Risk Retention Agreements may include a variety of representations,
warranties, covenants and other indemnities, each of which may run to
various transaction parties. If the Fund breaches any undertakings in any
Risk Retention Agreement, it will be exposed to claims by the other
parties thereto, including for any losses incurred as a result of such
breach, which could be significant and exceed the value of the Fund’s
investments.
Cyber Security Risk
As the use of technology, including cloud-based technology, has
become more prevalent in the course of business, the Fund is potentially
more susceptible to operational and information security risks resulting
from breaches in cyber security. A breach in cyber security refers to both
intentional and unintentional cyber events from outside threat actors or
internal resources that may, among other things, cause the Fund to lose
proprietary information, suffer data corruption and/or destruction, lose
operational capacity, result in the unauthorized release or other misuse
of confidential information, or otherwise disrupt normal business
operations. Cyber security breaches may involve unauthorized access to
the Fund’s digital information systems (e.g., through “hacking” or
malicious software coding), and may come from multiple sources,
including outside attacks such as denial-of-service attacks (i.e., efforts to
make network services unavailable to intended users) or cyber extortion,
including exfiltration of data held for ransom and/or “ransomware”
attacks that renders systems inoperable until ransom is paid, or insider
actions (e.g., intentionally or unintentionally harmful acts of PIMCO
personnel). In addition, cyber security breaches involving the Fund’s
third party service providers (including but not limited to advisers,
subadvisers, administrators, transfer agents, custodians, vendors,
suppliers, distributors and other third parties), trading counterparties or
issuers in which the Fund invests can also subject the Fund to many of
the same risks associated with direct cyber security breaches or
extortion of company data. PIMCO's use of cloud-based service
providers could heighten or change these risks. In addition,
work-from-home arrangements by the Fund, the Investment Manager or
their service providers could increase all of the above risks, create
additional data and information accessibility concerns, and make the
Fund, the Investment Manager or their service providers susceptible to
operational disruptions, any of which could adversely impact their
operations.
Cyber security failures or breaches may result in financial losses to the
Fund and its shareholders. For example, cyber security failures or
breaches involving trading counterparties or issuers in which the Fund
invests could adversely impact such counterparties or issuers and cause
the Fund’s investment to lose value. These failures or breaches may also
result in disruptions to business operations, potentially resulting in
financial losses; interference with the Fund’s ability to calculate its NAV,
process shareholder transactions or otherwise transact business with
shareholders; impediments to trading; violations of applicable privacy
and other laws; regulatory fines; penalties; third-party claims in
litigation; reputational damage; reimbursement or other compensation
costs; additional compliance and cyber security risk management costs
and other adverse consequences. In addition, substantial costs may be
incurred in order to prevent any cyber incidents in the future.
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Like with operational risk in general, the Fund has established business
continuity plans and risk management systems designed to reduce the
risks associated with cyber security. However, there are inherent
limitations in these plans and systems, including that certain risks may
not have been identified, in large part because different or unknown
threats may emerge in the future. As such, there is no guarantee that
such efforts will succeed, especially because the Fund does not directly
control the cyber security systems of issuers in which the Fund may
invest, trading counterparties or third-party service providers to the
Fund. Such entities have experienced cyber attacks and other attempts
to gain unauthorized access to systems from time to time, and there is
no guarantee that efforts to prevent or mitigate the effects of such
attacks or other attempts to gain unauthorized access will be successful.
There is also a risk that cyber security breaches may not be detected. The
Fund and its shareholders may suffer losses as a result of a cyber
security breach related to the Fund, its service providers, trading
counterparties or the issuers in which the Fund invests.
Privacy and Data Security Risk
The GLBA and other laws limit the disclosure of certain non-public
personal information about a consumer to non- affiliated third parties
and require financial institutions to disclose certain privacy policies and
practices with respect to information sharing with both affiliates and
non- affiliated third parties. Many states and a number of
non-U.S. jurisdictions have enacted privacy and data security laws
requiring safeguards on the privacy and security of consumers’
personally identifiable information. Other laws deal with obligations to
safeguard and dispose of private information in a manner designed to
avoid its dissemination. Privacy rules adopted by the U.S. Federal Trade
Commission and SEC implement GLBA and other requirements and
govern the disclosure of consumer financial information by certain
financial institutions, ranging from banks to private investment funds.
U.S. platforms following certain models generally are required to have
privacy policies that conform to these GLBA and other requirements. In
addition, such platforms typically have policies and procedures intended
to maintain platform participants’ personal information securely and
dispose of it properly.
The Fund generally does not intend to obtain or hold borrowers’
non-public personal information, and the Fund has implemented
procedures reasonably designed to prevent the disclosure of borrowers’
non-public personal information to the Fund. However, service providers
to the Fund including their custodians and the platforms acting as loan
servicers for the Fund may obtain, hold or process such information. The
Fund cannot guarantee the security of non-public personal information
in the possession of such a service provider and cannot guarantee that
service providers have been and will continue to comply with the GLBA,
other data security and privacy laws and any other related regulatory
requirements. Violations of GLBA and other laws could subject the Fund
to litigation and/or fines, penalties or other regulatory action, which,
individually or in the aggregate, could have an adverse effect on the
Fund. The Fund may also face regulations related to privacy and data
security in the other jurisdictions in which the Fund invests.
Potential Conflicts of Interest Risk—Allocation of Investment
Opportunities
The Investment Manager and its affiliates are involved worldwide with a
broad spectrum of financial services and asset management activities
and may engage in the ordinary course of business in activities in which
their interests or the interests of their clients may conflict with those of
the Fund. The Investment Manager may provide investment
management services to other funds and discretionary managed
accounts that follow an investment program similar to that of the Fund.
Subject to the requirements of the 1940 Act, the Investment Manager
intends to engage in such activities and may receive compensation from
third parties for its services. The results of the Fund’s investment
activities may differ from those of the Fund’s affiliates, or another
account managed by the Investment Manager or its affiliates, and it is
possible that the Fund could sustain losses during periods in which one
or more of the Fund’s affiliates and/or other accounts managed by the
Investment Manager or its affiliates, including proprietary accounts,
achieve profits on their trading.
Repurchase Agreements Risk
The Fund may enter into repurchase agreements, in which the Fund
purchases a security from a bank or broker-dealer, which agrees to
repurchase the security at the Fund’s cost plus interest within a specified
time. If the party agreeing to repurchase should default, the Fund will
seek to sell the securities which it holds. This could involve procedural
costs or delays in addition to a loss on the securities if their value should
fall below their repurchase price. Repurchase agreements may be or
become illiquid. These events could also trigger adverse tax
consequences for the Fund.
Structured Investments Risk
Holders of structured products, including structured notes, credit-linked
notes and other types of structured products, bear the risks of the
underlying investments, index or reference obligation and are subject to
counterparty risk. The Fund may have the right to receive payments only
from the structured product, and generally does not have direct rights
against the issuer or the entity that sold the assets to be securitized.
While certain structured products enable the investor to acquire
interests in a pool of securities without the brokerage and other
expenses associated with directly holding the same securities, investors
in structured products generally pay their share of the structured
product’s administrative and other expenses. Although it is difficult to
predict whether the prices of indices and securities underlying
structured products will rise or fall, these prices (and, therefore, the
prices of structured products) are generally influenced by the same types
of political and economic events that affect issuers of securities and
capital markets generally. If the issuer of a structured product uses
shorter term financing to purchase longer term securities, the issuer may
be forced to sell its securities at below market prices if it experiences
difficulty in obtaining such financing, which may adversely affect the
value of the structured products owned by the Fund. Structured
products generally entail risks associated with derivative instruments.
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Base Prospectus
Collateralized Loan Obligations Risk
CLOs may charge management fees and administrative expenses. The
cash flows from a CLO trust are split into two or more portions, called
tranches, varying in risk and yield. The riskiest portion is the equity
tranche which generally bears losses in connection with the first
defaults, if any, on the bonds or loans in the trust. A senior tranche from
a CLO trust typically has higher credit ratings and lower yields than the
underlying securities. CLO tranches, even senior ones, can experience
substantial losses due to actual defaults, increased sensitivity to defaults
due to collateral default and disappearance of protecting tranches,
market anticipation of defaults and aversion to CLO securities. The risks
of an investment in a CLO depend largely on the type of the collateral
securities and the class/tranche of the CLO in which the Fund invests.
Normally, CLOs are privately offered and sold, and thus are not
registered under the securities laws. Investments in CLOs may be or
become illiquid. In addition to the normal risks associated with debt
instruments (e.g., interest rate risk and credit risk), CLOs carry additional
risks including, but not limited to: (i) the possibility that distributions
from the collateral will not be adequate to make interest or other
payments; (ii) the risk that the quality of the collateral may decline in
value or default; (iii) the risk that the Fund may invest in CBOs, CLOs or
other CDOs that are subordinate to other classes; and (iv) the risk that
the complex structure of the security may not be fully understood at the
time of investment and may produce disputes with the issuer or others
and may produce unexpected investment results.
Market Disruptions Risk
The Fund is subject to investment and operational risks associated with
financial, economic and other global market developments and
disruptions, including those arising from war, terrorism, market
manipulation, government interventions, defaults and shutdowns,
political changes or diplomatic developments, public health
emergencies (such as the spread of infectious diseases, pandemics and
epidemics) and natural/environmental disasters, which can all negatively
impact the securities markets, interest rates, auctions, secondary trading,
ratings, credit risk, inflation, deflation, other factors relating to the
Fund’s investments or the Investment Manager’s operations and the
value of an investment in the Fund, its distributions and its returns.
These events can also impair the technology and other operational
systems upon which the Fund’s service providers, including PIMCO as
the Fund’s investment adviser, rely, and could otherwise disrupt the
Fund’s service providers’ ability to fulfill their obligations to the Fund.
Furthermore, events involving limited liquidity, defaults,
non-performance or other adverse developments that affect financial
institutions or the financial services industry generally, or concerns or
rumors about any events of these kinds or other similar risks, have in the
past and may in the future lead to market-wide liquidity problems.
Debt Securities Risk
Debt securities are generally subject to the risks described below and
further herein:
Issuer risk.
The value of fixed income securities may decline for a
number of reasons that directly relate to the issuer, such as
management performance, financial leverage, reduced demand for the
issuer’s goods and services, historical and prospective earnings of the
issuer and the value of the assets of the issuer. A change in the financial
condition of a single issuer may affect securities markets as a whole.
These risks can apply to the Common Shares issued by the Fund and to
the issuers of securities and other instruments in which the Fund
invests.
Interest rate risk.
The market value of debt securities changes in
response to interest rate changes and other factors. Interest rate risk is
the risk that prices of debt securities will increase as interest rates fall
and decrease as interest rates rise, which would be reflected in the
Fund’s NAV. The Fund may lose money if short-term or long-term
interest rates rise sharply in a manner not anticipated by the Fund’s
management. Moreover, because rates on certain floating rate debt
securities typically reset only periodically, changes in prevailing interest
rates (and particularly sudden and significant changes) can be expected
to cause some fluctuations in the NAV of the Fund to the extent that it
invests in floating rate debt securities.
Prepayment risk.
During periods of declining interest rates, borrowers
may prepay principal. This may force the Fund to reinvest in lower
yielding securities, resulting in a possible decline in the Fund’s income
and distributions.
Credit risk.
Credit risk is the risk that one or more debt securities in
the Fund’s portfolio will decline in price or fail to pay interest or
principal when due because the issuer of the security experiences a
decline in its financial status. Credit risk is increased when a portfolio
security is downgraded or the perceived creditworthiness of the issuer
deteriorates.
Reinvestment risk.
Reinvestment risk is the risk that income from the
Fund’s portfolio will decline if the Fund invests the proceeds from
matured, traded or called fixed income securities at market interest rates
that are below the portfolio’s current earnings rate.
Duration and maturity risk.
The Fund may seek to adjust the
duration or maturity of its investments in debt securities based on its
assessment of current and projected market conditions. The Fund may
incur costs in seeking to adjust the average duration or maturity of its
portfolio of debt securities. There can be no assurances that the Fund’s
assessment of current and projected market conditions will be correct or
that any strategy to adjust duration or maturity will be successful.
In addition, from time to time, uncertainty regarding the status of
negotiations in the U.S. government to increase the statutory debt
ceiling could impact the creditworthiness of the United States and could
impact the liquidity and value of U.S. Government and other securities
and ultimately the Fund.
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Restricted Securities Risk
A private placement involves the sale of securities that have not been
registered under the Securities Act or relevant provisions of applicable
non-U.S. law to certain institutional and qualified individual purchasers,
such as the Fund. In addition to the general risks to which all securities
are subject, securities received in a private placement generally are
subject to strict restrictions on resale, and there may be no liquid
secondary market or ready purchaser for such securities. Therefore, the
Fund may be unable to dispose of such securities when it desires to do
so, or at the most favorable time or price. Private placements may also
raise valuation risks. Restricted securities are often purchased at a
discount from the market price of unrestricted securities of the same
issuer reflecting the fact that such securities may not be readily
marketable without some time delay. Such securities are often more
difficult to value and the sale of such securities often requires more time
and results in higher brokerage charges or dealer discounts and other
selling expenses than does the sale of liquid securities trading on
national securities exchanges or in the over-the-counter markets. Until
the Fund can sell such securities into the public markets, its holdings will
be less liquid and any sales will need to be made pursuant to an
exemption under the Securities Act.
Sovereign Debt Risk
In addition to the other risks applicable to debt investments, sovereign
debt may decline in value as a result of default or other adverse credit
event resulting from an issuer’s inability or unwillingness to make
principal or interest payments in a timely fashion. A sovereign entity’s
failure to make timely payments on its debt can result from many
factors, including, without limitation, insufficient foreign (non-U.S.)
currency reserves or an inability to sufficiently manage fluctuations in
relative currency valuations, an inability or unwillingness to satisfy the
demands of creditors and/or relevant supranational entities regarding
debt service or economic reforms, the size of the debt burden relative to
economic output and tax revenues, cash flow difficulties, and other
political and social considerations. The risk of loss to the Fund in the
event of a sovereign debt default or other adverse credit event is
heightened by the unlikelihood of any formal recourse or means to
enforce its rights as a holder of the sovereign debt. In addition,
sovereign debt restructurings, which may be shaped by entities and
factors beyond the Fund’s control, may result in a loss in value of the
Fund’s sovereign debt holdings.
Zero-Coupon Bond, Step-Ups and Payment-In-Kind Securities
Risk
The market prices of zero-coupon, step-ups and payment-in-kind
securities are generally more volatile than the prices of securities that
pay interest periodically and in cash, and are likely to respond to
changes in interest rates to a greater degree than other types of debt
securities with similar maturities and credit quality. Because
zero-coupon securities bear no interest, their prices are especially
volatile. And because zero-coupon bondholders do not receive interest
payments, the prices of zero-coupon securities generally fall more
dramatically than those of bonds that pay interest on a current basis
when interest rates rise. The market for zero-coupon and
payment-in-kind securities may suffer decreased liquidity. In addition, as
these securities may not pay cash interest, the Fund’s investment
exposure to these securities and their risks, including credit risk, will
increase during the time these securities are held in the Fund’s portfolio.
Further, to maintain its qualification for treatment as a RIC and to avoid
Fund-level U.S. federal income and/or excise taxes, the Fund is required
to distribute to its shareholders any income it is deemed to have
received in respect of such investments, notwithstanding that cash has
not been received currently, and the value of paid-in-kind interest.
Consequently, the Fund may have to dispose of portfolio securities
under disadvantageous circumstances to generate the cash, or may
have to leverage itself by borrowing the cash to satisfy this distribution
requirement. The required distributions, if any, would result in an
increase in the Fund’s exposure to these securities. Zero coupon bonds,
step-ups and payment-in-kind securities allow an issuer to avoid or
delay the need to generate cash to meet current interest payments and,
as a result, may involve greater credit risk than bonds that pay interest
currently or in cash. The Fund would be required to distribute the
income on these instruments as it accrues, even though the Fund will
not receive the income on a current basis or in cash. Thus, the Fund may
sell other investments, including when it may not be advisable to do so,
to make income distributions to its shareholders.
Real Estate Risk
To the extent that the Fund invests in real estate investments, including
investments in equity or debt securities issued by private and public
REITs, REOCs, private or public real estate-related loans and real
estate-linked derivative instruments, it will be subject to the risks
associated with owning real estate and with the real estate industry
generally. These risks include, but are not limited to: the burdens of
ownership of real property; general and local economic conditions(such
as an oversupply of space or a reduction in demand for space); the
supply and demand for properties (including competition based on
rental rates); energy and supply shortages; fluctuations in average
occupancy and room rates; the attractiveness, type and location of the
properties and changes in the relative popularity of commercial
properties as an investment; the financial condition and resources of
tenants, buyers and sellers of properties; increased mortgage defaults;
the quality of maintenance, insurance and management services;
changes in the availability of debt financing which may render the sale
or refinancing of properties difficult or impracticable; changes in
building, environmental and other laws and/or regulations (including
those governing usage and improvements), fiscal policies and zoning
laws; changes in real property tax rates; changes in interest rates and
the availability of mortgage funds which may render the sale or
refinancing of properties difficult or impracticable; changes in operating
costs and expenses; energy and supply shortages; uninsured losses or
delays from casualties or condemnation; negative developments in the
economy that depress travel or leasing activity; environmental liabilities;
contingent liabilities on disposition of assets; uninsured or uninsurable
casualties; acts of God, including earthquakes, hurricanes and other
natural disasters; social unrest and civil disturbances, epidemics,
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pandemics or other public crises; terrorist attacks and war; risks and
operating problems arising out of the presence of certain construction
materials, structural or property level latent defects, work stoppages,
shortages of labor, strikes, union relations and contracts, fluctuating
prices and supply of labor and/or other labor-related factor; and other
factors which are beyond the control of PIMCO and its affiliates.
In addition, the Fund’s investments will be subject to various risks which
could cause fluctuations in occupancy, rental rates, operating income
and expenses or which could render the sale or financing of its
properties difficult or unattractive. For example, following the
termination or expiration of a tenant’s lease, there may be a period of
time before receiving rental payments under a replacement lease.
During that period, the Fund would continue to bear fixed expenses
such as interest, real estate taxes, maintenance and other operating
expenses. In addition, declining economic conditions may impair the
ability to attract replacement tenants and achieve rental rates equal to
or greater than the rents paid under previous leases. Increased
competition for tenants may require capital improvements to properties
which would not have otherwise been planned.
Ultimately, to the extent it is not possible to renew leases or re-let space
as leases expire, decreased cash flow from tenants will result, which
could adversely impact the Fund’s operating results.
Real estate values have historically been cyclical. As the general
economy grows, demand for real estate increases and occupancies and
rents may increase. As occupancies and rents increase, property values
increase, and new development occurs. As development may occur,
occupancies, rents and property values may decline. Because leases are
usually entered into for long periods and development activities often
require extended times to complete, the real estate value cycle often
lags the general business cycle. Because of this cycle, real estate
companies may incur large swings in their profits and the prices of their
securities. Developments following the onset of COVID-19 have
adversely impacted certain commercial real estate markets, causing the
deferral of mortgage payments, renegotiated commercial mortgage
loans, commercial real estate vacancies or outright mortgage defaults,
and potential acceleration of macro trends such as work from home and
online shopping which may negatively impact certain industries, such as
brick-and-mortar retail.
The total returns available from investments in real estate generally
depend on the amount of income and capital appreciation generated by
the related properties. The performance of real estate, and thereby the
Fund, will be reduced by any related expenses, such as expenses paid
directly at the property level and other expenses that are capitalized or
otherwise embedded into the cost basis of the real estate.
Separately, certain service providers to the Fund and/or its subsidiaries,
as applicable, with respect to its real estate or real estate-related
investments may be owned by, employed by, or otherwise related to,
PIMCO, Allianz SE, their affiliates and/or their respective employees,
consultants and other personnel. PIMCO may, in its sole discretion,
determine to provide, or engage or recommend an affiliate of PIMCO to
provide, certain services to the Fund, instead of engaging or
recommending one or more third parties to provide such services.
Subject to the governance requirements of a particular fund and
applicable law, PIMCO or its affiliates, as applicable, will receive
compensation in connection with the provision of such services. As a
result, PIMCO faces a conflict of interest when selecting or
recommending service providers for the Fund. Fees paid to an affiliated
service provider will be determined in PIMCO’s commercially reasonable
discretion. Although PIMCO has adopted various policies and
procedures intended to mitigate or otherwise manage conflicts of
interest with respect to affiliated service providers, there can be no
guarantee that such policies and procedures (which may be modified or
terminated at any time in PIMCO’s sole discretion) will be successful.
Focused Investment Risk
To the extent that the Fund focuses its investments in a particular sector,
it may be susceptible to loss due to adverse developments affecting that
sector, including (but not limited to): governmental regulation; inflation;
rising interest rates; cost increases in raw materials, fuel and other
operating expenses; technological innovations that may render existing
products and equipment obsolete; competition from new entrants; high
research and development costs; increased costs associated with
compliance with environmental or other governmental regulations; and
other economic, business or political developments specific to that
sector. Furthermore, the Fund may invest a substantial portion of its
assets in companies in related sectors that may share common
characteristics, are often subject to similar business risks and regulatory
burdens, and whose securities may react similarly to the types of
developments described above, which will subject the Fund to greater
risk. The Fund also will be subject to focused investment risk to the
extent that it invests a substantial portion of its assets in a particular
issuer, market, asset class, country or geographic region. See “Principal
Risks of the Fund—Foreign (Non-U.S.) Investment Risk,” “Principal
Risks of the Fund—Emerging Markets Risk” and “Principal Risks of the
Fund—Currency Risk.”
Privately-Issued Mortgage-Related Securities Risk
There are no direct or indirect government or agency guarantees of
payments in pools created by non-governmental issuers. Privately-issued
mortgage-related securities are also not subject to the same
underwriting requirements for the underlying mortgages that are
applicable to those mortgage-related securities that have a government
or government sponsored entity guarantee.
Privately-issued mortgage-related securities are not traded on an
exchange and there may be a limited market for the securities, especially
when there is a perceived weakness in the mortgage and real estate
market sectors. Without an active trading market, mortgage-related
securities held in the Fund’s portfolio may be particularly difficult to
value because of the complexities involved in assessing the value of the
underlying mortgage loans.
Additional Risks Associated with the Fund’s Preferred Shares
Although the Fund’s ARPS ordinarily would pay dividends at rates set at
periodic auctions, the weekly auctions for the ARPS (and auctions for
similar preferred shares issued by closed-end funds in the U.S.) have
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failed since 2008. The dividend rates on the ARPS since that time have
been paid, and the Fund expects that they will continue to be paid for
the foreseeable future, at the “maximum applicable rate” under the
Fund’s Bylaws (i.e., the greater of a multiple of or a spread plus a
reference rate). An increase in market interest rates generally, therefore,
could increase substantially the dividend rate required to be paid by the
Fund to the holders of ARPS, which would increase the costs associated
with the Fund’s leverage and reduce the Fund’s net income available for
distribution to Common Shareholders.
In addition, the multiple used to calculate the maximum applicable rate
is based in part on the credit rating assigned to the ARPS by the
applicable rating agency (currently, Moody’s and Fitch), with the
multiple generally increasing as the rating declines below certain levels.
In September 2011, Moody’s, a ratings agency that provides ratings for
the Fund’s ARPS, downgraded its rating of the ARPS from “Aaa” to
“Aa2,” citing what it believed to be persistently thin asset coverage
levels, increased NAV volatility and concerns about secondary market
liquidity for some assets supporting rated obligations. Under the Bylaws,
the 2011 Moody’s downgrade resulted in an increase in the dividend
rate multiplier from 1.25 to 1.50, thereby increasing the dividend rate
payable to ARPS holders and increasing the costs to Common
Shareholders associated with the Fund’s leverage. See “Use of
Leverage” and “Description of Capital Structure.” In July 2012, Moody’s
downgraded its rating of the ARPS from “Aa2” to “Aa3” pursuant to a
revised ratings methodology adopted by Moody’s. In May 2020, Fitch
downgraded its rating of the ARPS from “AAA” to “AA,” indicating the
downgrades reflected recent extreme market volatility and reduced
asset liquidity, which it believed eroded asset coverage cushions for
closed-end funds and challenged fund managers’ ability to deleverage.
Under the Bylaws, the 2020 Fitch downgrade resulted in an increase in
the applicable spread over the reference rate from 125 bps to 150 bps,
thereby increasing the dividend rate payable to ARPS holders and
increasing the costs to Common Shareholders associated with the
Fund’s leverage. On December 4, 2020, Fitch published ratings criteria
relating to closed-end fund obligations, including preferred shares,
which effectively result in a rating cap of “AA” for debt and preferred
stock issued by closed-end funds and a rating cap of “A” for (i) debt and
preferred shares issued by closed-end funds exposed to corporate debt,
emerging market debt, below-investment-grade and unrated debt,
structured securities and equity, (ii) and closed-end funds with material
exposure to “BBB” category rated assets. Following the close of
business on April 30, 2021, Fitch downgraded its rating of the ARPS
from “AA” to “A” pursuant to the revised ratings methodology and
related new rating caps. Under the Bylaws, the April 2021 Fitch
downgrade resulted in an increase in the dividend rate multiplier from
1.50 to 2.00, which could increase the dividend rate payable to ARPS
holders should the maximum dividend rate be determined via the
multiplier in lieu of the spread noted above (the maximum dividend rate
is based on the greater of a multiple of or a spread plus a reference rate)
and, thereby, increase the expenses to Common Shareholders
associated with the Fund’s leverage. In December 2022, Moody’s
downgraded its rating of the ARPS from “Aa3” to “A1,” stating that the
downgrades occurred because of, among other matters, trends in the
Fund’s risk-adjusted asset coverage metrics and the evolution of its
sector exposures. Under the Bylaws, the 2022 Moody’s downgrade
resulted in an increase in the applicable spread over the reference rate
from 150 bps to 200 bps. As noted herein, the maximum applicable rate
actually payable to ARPS holders is based on the greater of a multiple of
or a spread plus a reference rate, which is either the applicable Secured
Overnight Funding Rate or the applicable Treasury Index Rate
depending on the rate period. The applicable spread change resulting
from the 2022 Moody’s downgrade will therefore only impact the
maximum applicable rate if the applicable spread formula is greater
than the multiplier formula. See “Description of Capital Structure –
Preferred Share Dividends.” See “Use of Leverage” and “Description of
Capital Structure.” It is possible for the ARPS to be further downgraded
in the future, possibly resulting in further increases to the maximum
applicable rate and, thereby, the expenses borne by the Fund’s Common
Shareholders.
Therefore, it is possible that a substantial rise in market interest rates
and/ or further ratings downgrades of the ARPS could, by reducing
income available for distribution to the Common Shareholders and
otherwise detracting from the Fund’s investment performance, make the
Fund’s continued use of Preferred Shares for leverage purposes less
attractive than such use is currently considered to be. In such case, the
Fund may elect to redeem some or all of the Preferred Shares
outstanding, which may require it to dispose of investments at
inopportune times and to incur losses on such dispositions. Such
dispositions may adversely affect the Fund’s investment performance
generally, and the resultant loss of leverage may materially and
adversely affect the Fund’s investment returns to Common
Shareholders. The Fund has previously been required to redeem a
portion of its ARPS due to market dislocations that caused the value of
the Fund’s portfolio securities and related asset coverage to decline and
could be required to do so again in the future.
The Fund is also subject to certain asset coverage tests associated with
the rating agencies that rate the ARPS. Failure by the Fund to maintain
the asset coverages (or to cure such failure in a timely manner) may
require the Fund to redeem ARPS. Failure to satisfy ratings agency asset
coverage tests or other guidelines could also result in the applicable
ratings agency downgrading its then-current ratings on the ARPS, as
described above. Moreover, the rating agency guidelines impose
restrictions or limitations on the Fund’s use of certain financial
instruments or investment techniques that the Fund might otherwise
utilize in order to achieve its investment objective, which may adversely
affect the Fund’s investment performance. Rating agency guidelines may
be modified by the rating agencies in the future and such modifications
may make such guidelines substantially more restrictive or otherwise
result in downgrades, which could further negatively affect the Fund’s
investment performance. The ratings agencies that have assigned
ratings to the Fund’s preferred shares may change their rating
methodologies, perhaps substantially. Such a change could adversely
affect the ratings assigned to the Fund’s Preferred Shares, the dividend
rates paid thereon, and the expenses borne by the Fund’s Common
Shareholders.
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Certain Affiliations
Certain broker-dealers may be considered to be affiliated persons of the
Fund and/or the Investment Manager due to their possible affiliations
with Allianz SE, the ultimate parent of the Investment Manager, or
another Allianz entity. Allianz Asset Management of America LP merged
with Allianz Asset Management of America LLC, with the latter being
the surviving entity, effective January 1, 2023. Following the merger,
Allianz Asset Management of America LLC is PIMCO LLC’s managing
member and direct parent entity. Absent an exemption from the SEC or
other regulatory relief, the Fund is generally precluded from effecting
certain principal transactions with affiliated brokers, and its ability to
purchase securities being underwritten by an affiliated broker or a
syndicate including an affiliated broker, or to utilize affiliated brokers for
agency transactions, is subject to restrictions. This could limit the Fund’s
ability to engage in securities transactions and take advantage of
market opportunities.
The Fund has received exemptive relief from the SEC that, to the extent
the Fund relies on such relief, permits it to (among other things)
co-invest with certain other persons, including certain affiliates of the
Investment Manager and certain public or private funds managed by the
Investment Manager and its affiliates, subject to certain terms and
conditions. The exemptive relief from the SEC with respect to
co-investments imposes extensive conditions on any co-investments
made in reliance on such relief.
Anti-Takeover Provisions
The Fund’s Declaration and Bylaws include provisions that could limit
the ability of other entities or persons to acquire control of the Fund or
to convert the Fund to open-end status. See “Anti-Takeover and Other
Provisions in the Agreement and Declaration of Trust and Bylaws.” These
provisions in the Declaration and the Bylaws could have the effect of
depriving the Common Shareholders of opportunities to sell their
Common Shares at a premium over the then-current market price of the
Common Shares or at NAV.
Distribution Rate Risk
Although the Fund may seek to maintain level distributions, the Fund’s
distribution rates may be affected by numerous factors, including but
not limited to changes in realized and projected market returns,
fluctuations in market interest rates, Fund performance, and other
factors. There can be no assurance that a change in market conditions or
other factors will not result in a change in the Fund’s distribution rate or
that the rate will be sustainable in the future.
For instance, during periods of low or declining interest rates, the Fund’s
distributable income and dividend levels may decline for many reasons.
For example, the Fund may have to deploy uninvested assets (whether
from sales of Fund shares, proceeds from matured, traded or called debt
obligations or other sources) in new, lower yielding instruments.
Additionally, payments from certain instruments that may be held by the
Fund (such as variable and floating rate securities) may be negatively
impacted by declining interest rates, which may also lead to a decline in
the Fund’s distributable income and dividend levels.
How the Fund Manages Risk
Investment Limitations
The Fund has adopted certain investment limitations designed to limit
investment risk and maintain portfolio diversification. These limitations
are fundamental and may not be changed without the approval of the
holders of a majority of the outstanding Common Shares and Preferred
Shares voting together as a single class, and of the Preferred Shares
voting as a separate class. The Fund may not:
1.
Concentrate its investments in a particular “industry,” as that
term is used in the 1940 Act, and as interpreted, modified, or
otherwise permitted by regulatory authority having jurisdiction,
from time to time.
2.
With respect to 75% of the Fund’s total assets, purchase the
securities of any issuer, except securities issued or guaranteed by
the U.S. Government or any of its agencies or instrumentalities or
securities issued by other investment companies, if, as a result, (i)
more than 5% of the Fund’s total assets would be invested in the
securities of that issuer, or (ii) the Fund would hold more than
10% of the outstanding voting securities of that issuer.
3.
Purchase or sell real estate, although it may purchase securities
secured by real estate or interests therein, or securities issued by
companies which invest in real estate, or interests therein.
4.
Purchase or sell commodities or commodities contracts or oil, gas
or mineral programs. This restriction shall not prohibit the Fund,
subject to restrictions described in the Prospectus and elsewhere
in this Statement of Additional Information, from purchasing,
selling or entering into futures contracts, options on futures
contracts, forward contracts, or any interest rate, securities related
or other hedging instrument, including swap agreements and
other derivative instruments, subject to compliance with any
applicable provisions of the federal securities or commodities
laws.
5.
Borrow money or issue any senior security, except to the extent
permitted under the 1940 Act and as interpreted, modified, or
otherwise permitted by regulatory authority having jurisdiction,
from time to time.
6.
Make loans, except to the extent permitted under the 1940 Act,
and as interpreted, modified, or otherwise permitted by
regulatory authority having jurisdiction, from time to time.
7.
Act as an underwriter of securities of other issuers, except to the
extent that in connection with the disposition of portfolio
securities, it may be deemed to be an underwriter under the
federal securities laws.
The Fund would be deemed to “concentrate” its investments in a
particular industry if it invested more than 25% of its total assets in that
industry. The Fund’s industry concentration policy does not preclude it
from focusing investments in issuers in a group of related industrial
sectors (such as different types of utilities). The Fund interprets its
industry concentration policy to apply to direct investments in the
securities of issuers in a particular industry, as defined by the Fund. For
purposes of this restriction, a foreign government is considered to be an
industry. Currency positions are not considered to be an investment in a
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PIMCO Income Strategy Fund II
foreign government for industry concentration purposes.
Mortgage-backed securities that are issued or guaranteed by the
U.S. Government, its agencies or instrumentalities are not subject to the
Fund’s industry concentration restrictions, by virtue of the exclusion from
that test available to all U.S. Government securities. Similarly,
tax-exempt municipal bonds issued by states, municipalities and other
political subdivisions, agencies, authorities and instrumentalities of
states and multi state agencies and authorities are not subject to the
Fund’s industry concentration restrictions.
See “Investment Objective and Policies” and “Investment Restrictions”
in the Statement of Additional Information for a complete list of the
fundamental investment policies of the Fund.
The Fund is subject to asset coverage and other guidelines which are
more limiting than the investment restrictions set forth above and other
restrictions set forth in the Statement of Additional Information in order
to obtain and maintain a rating or ratings from Moody’s on the ARPS.
See “Description of Capital Structure.” See also “Investment Objective
and Policies” and “Investment Restrictions” in the Statement of
Additional Information for a complete list of the fundamental
investment policies of the Fund.
From time to time, the Fund may voluntarily participate in actions (for
example, rights offerings, conversion privileges, exchange offers, credit
event settlements, etc.) where the issuer or counterparty offers
securities or instruments to holders or counterparties, such as the Fund,
and the acquisition is determined to be beneficial to Fund shareholders
(“Voluntary Action”). Notwithstanding any percentage investment
limitation listed under this “Investment Restrictions” section or any
percentage investment limitation of the 1940 Act or rules thereunder, if
a Fund has the opportunity to acquire a permitted security or instrument
through a Voluntary Action, and the Fund will exceed a percentage
investment limitation following the acquisition, it will not constitute a
violation if, prior to the receipt of the securities or instruments and after
announcement of the offering, the Fund sells an offsetting amount of
assets that are subject to the investment limitation in question at a price
at least equal to the value of the securities or instruments to be
acquired.
Unless otherwise indicated, all percentage limitations on Fund
investments (as stated herein) that are not: (i) specifically included in
this “Investment Restrictions” section; or (ii) imposed by the 1940 Act,
rules thereunder, the Code or related regulations (the “Elective
Investment Restrictions”), will apply only at the time of investment
unless the acquisition is a Voluntary Action. The percentage limitations
and absolute prohibitions with respect to Elective Investment
Restrictions are not applicable to the Fund’s acquisition of securities or
instruments through a Voluntary Action.
The Fund may engage in roll-timing strategies where the Fund seeks to
extend the expiration or maturity of a position, such as a forward
contract, futures contract or to-be-announced (“TBA”) transaction, on
an underlying asset by closing out the position before expiration and
contemporaneously opening a new position with respect to the same
underlying asset that has substantially similar terms except for a later
expiration date. Such “rolls” enable the Fund to maintain continuous
investment exposure to an underlying asset beyond the expiration of the
initial position without delivery of the underlying asset. Similarly, as
certain standardized swap agreements transition from OTC trading to
mandatory exchange-trading and clearing due to the implementation of
Dodd-Frank Act regulatory requirements, the Fund may “roll” an
existing OTC swap agreement by closing out the position before
expiration and contemporaneously entering into a new exchange-traded
and cleared swap agreement on the same underlying asset with
substantially similar terms except for a later expiration date. These types
of new positions opened contemporaneous with the closing of an
existing position on the same underlying asset with substantially similar
terms are collectively referred to as “Roll Transactions.” Elective
Investment Restrictions (defined in the preceding paragraph), which
normally apply at the time of investment, do not apply to Roll
Transactions (although Elective Investment Restrictions will apply to the
Fund’s entry into the initial position). In addition and notwithstanding
the foregoing, for purposes of this policy, those Non-Fundamental
Investment Restrictions that are considered Elective Investment
Restrictions for purposes of the policy on Voluntary Actions (described in
the preceding paragraph) are also Elective Investment Restrictions for
purposes of this policy on Roll Transactions. The Fund will test for
compliance with Elective Investment Restrictions at the time of the
Fund’s initial entry into a position, but the percentage limitations and
absolute prohibitions set forth in the Elective Investment Restrictions
are not applicable to the Fund’s subsequent acquisition of securities or
instruments through a Roll Transaction.
Management of Investment Portfolio and Capital Structure to
Limit Leverage Risk
The Fund may take certain actions if short-term interest rates increase or
market conditions otherwise change (or the Fund anticipates such an
increase or change) and the Fund’s leverage begins (or is expected) to
adversely affect Common Shareholders. In order to attempt to offset
such a negative impact of leverage on Common Shareholders, the Fund
may shorten the average maturity or duration of its investment portfolio
(by investing in short-term, high quality securities or implementing
certain hedging strategies). The Fund also may attempt to reduce
leverage by redeeming or otherwise purchasing preferred shares
(subject to any restrictions discussed under “Description of Capital
Structure–Preferred Shares Redemption”) or by reducing any holdings in
other instruments that create leverage. As explained above under
“Principal Risks of the Fund—Leverage Risk,” the success of any such
attempt to limit leverage risk depends on PIMCO’s ability to accurately
predict interest rate or other market changes. Because of the difficulty of
making such predictions, the Fund may not be successful in managing
its interest rate exposure in the manner described above. If market
conditions suggest that additional leverage would be beneficial, the
Fund may issue additional preferred shares or utilize other forms of
leverage, such as reverse repurchase agreements, dollar rolls/buybacks,
credit default swaps and other derivative instruments. See “Investment
Objective and Policies—Portfolio Contents” and “Principal Risks of the
Fund—Liquidity Risk.”
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Use of Derivatives
The Fund may use derivative instruments for other purposes, including
to seek to increase liquidity, provide efficient portfolio management,
broaden investment opportunities (including taking short or negative
positions), implement a tax or cash management strategy, gain
exposure to a particular security or segment of the market, modify the
effective duration of the Fund's portfolio investments and/or enhance
total return.
Related Strategies
The Fund may (but is not required to) use various investment strategies
to attempt to hedge exposure to reduce the risk of price fluctuations of
its portfolio securities, the risk of loss, and to preserve capital.
Derivatives strategies and instruments that the Fund may use include,
among others, reverse repurchase agreements; interest rate swaps; total
return swaps; credit default swaps; basis swaps; other types of swap
agreements or options thereon; dollar rolls/buybacks; futures and
forward contracts (including foreign currency exchange contracts); short
sales; options on financial futures; options based on either an index of
municipal securities or taxable debt securities whose prices, PIMCO
believes, correlate with the prices of the Fund’s investments; other
derivative transactions; loans of portfolio securities and when-issued,
delayed delivery and forward commitment transactions. Income earned
by the Fund from its hedging and related transactions may be subject to
one or more special U.S. federal income tax rules that can affect the
amount, timing and/or character of distributions to Common
Shareholders. For instance, many hedging activities will be treated as
capital gain and, if not offset by net realized capital loss, will be
distributed to Common Shareholders in taxable distributions. If
effectively used, hedging strategies will offset in varying percentages
losses incurred on the Fund’s investments due to adverse interest rate
changes. There is no assurance that these hedging strategies will be
available at any time or that PIMCO will determine to use them for the
Fund or, if used, that the strategies will be successful. PIMCO may
determine not to engage in hedging strategies or to do so only in
unusual circumstances or market conditions. In addition, the Fund may
be subject to certain restrictions on its use of hedging strategies
imposed by guidelines of one or more ratings agencies that may issue
ratings on any preferred shares issued by the Fund.
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PIMCO Income Strategy Fund II
Management of the Fund
Trustees and Officers
The business of the Fund is managed under the direction of the Fund’s Board, including supervision of the duties performed by the Investment
Manager. The Board is currently composed of eight Trustees of the Fund (“Trustees”), six of whom are not “interested persons” of the Fund (as that
term is defined by Section 2(a)(19) of the 1940 Act). The Trustees meet periodically throughout the year to discuss and consider matters concerning
the Fund and to oversee the Fund’s activities, including its investment performance, compliance program and risks associated with its activities. The
names and business addresses of the Trustees and officers of the Fund and their principal occupations and other affiliations during the past five years
are set forth under “Management of the Fund” in the Statement of Additional Information.
Investment Manager
PIMCO serves as the investment manager of the Fund. Subject to the supervision of the Board. PIMCO is responsible for managing the investment
activities of the Fund and the Fund’s business affairs and other administrative matters.
PIMCO is located at 650 Newport Center Drive, Newport Beach, CA, 92660. Organized in 1971, PIMCO provides investment management and
advisory services to private accounts of institutional and individual clients and to registered investment companies. PIMCO is a majority-owned
indirect subsidiary of Allianz SE, a publicly traded European insurance and financial services company. As of December 31, 2023, PIMCO had
approximately $1.86 trillion in assets under management and $1.46 trillion in third party assets under management.
Alfred T. Murata, Mohit Mittal and Giang Bui are jointly and primarily responsible for the day-to-day management of the Fund.
Portfolio Manager |
Since |
Title |
Recent Professional Experience |
Alfred T. Murata |
2014 |
Portfolio Manager and Managing Director |
Mr. Murata is a managing director and portfolio manager in the Newport Beach office, managing income-oriented, multisector credit, opportunistic and securitized strategies. Morningstar named him Fixed- Income Fund Manager of the Year (U.S.) for 2013. Prior to joining PIMCO in 2001, he researched and implemented exotic equity and interest rate derivatives at Nikko Financial Technologies. He has 21 years of investment experience and holds a Ph.D. in engineering-economic systems and operations research from Stanford University. He also earned a J.D. from Stanford Law School and is a member of the State Bar of California. |
Mohit Mittal |
2014 |
Portfolio Manager and Managing Director |
Mr. Mittal is a managing director and portfolio manager in the Newport Beach office, and a senior member of the liability driven investment and credit portfolio management teams. He manages multi-sector portfolios with added specialization in long credit, investment grade credit, and unconstrained bond portfolios. In addition, he is the head of U.S. investment grade trading desk. Previously, he was a specialist on PIMCO’s interest rates and derivatives desk. Mr. Mittal joined the firm in 2007 and holds an MBA in finance from the Wharton School of the University of Pennsylvania and an undergraduate degree in computer science from Indian Institute of Technology (IIT) in Delhi, India. |
Giang Bui |
2023 |
Portfolio Manager and Executive Vice President |
Ms. Bui is an executive vice president in the Newport Beach office and a portfolio manager and trader of securitized debt instruments, focusing on collateralized loan obligations (CLOs), asset-backed collateralized debt obligations, and off-the-run sectors within structured products. Ms. Bui joined PIMCO in 2000 and was previously a member of the bank loan portfolio management team, responsible for bank loan investments and the management of PIMCO-issued CLOs. She has 24 years of investment experience and holds an MBA from the Anderson School of Management at the University of California, Los Angeles and an undergraduate degree from the University of California, San Diego. |
Please see the Statement of Additional Information for additional information about other accounts managed by the portfolio managers, the portfolio
managers' compensation and the portfolio managers’ ownership of shares of the Fund.
Control Persons
A control person is a person who owns, either directly or indirectly, beneficially more than 25% of the voting securities of a company. As of April 9,
2024, the Fund did not know of any person or entity who “controlled” the Fund.
Additional Information
The Trustees are responsible generally for overseeing the management of the Fund. The Trustees authorize the Fund to enter into service agreements
with the Investment Manager and other service providers in order to provide, and in some cases authorize service providers to procure through other
parties, necessary or desirable services on behalf of the Fund. Shareholders are not intended to be third-party beneficiaries of such service
agreements.
Neither this prospectus, the Fund’s Statement of Additional Information, any contracts filed as exhibits to the Fund’s registration statement, nor any
other communications or disclosure documents from or on behalf of the Fund creates a contract between a shareholder of the Fund and the Fund, a
service provider to the Fund, and/or the Trustees or officers of the Fund. The Trustees may amend this prospectus, the Statement of Additional
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Information, and any other contracts to which the Fund is a party, and interpret the investment objective, policies, restrictions and contractual
provisions applicable to the Fund without shareholder input or approval, except in circumstances in which shareholder approval is specifically required
by law (such changes to fundamental investment policies) or where a shareholder approval requirement is specifically disclosed in the Fund's
prospectus or Statement of Additional Information.
Investment Management Agreement
Pursuant to an investment management agreement between the Investment Manager and the Fund (the “Investment Management Agreement”), the
Fund has agreed to pay the Investment Manager an annual fee, payable monthly, in an amount equal to 0.830% of the Fund’s average weekly total
managed assets. Total managed assets includes the total assets of the Fund (including any assets attributable to any preferred shares or other forms
of leverage that may be outstanding) minus accrued liabilities (other than liabilities representing leverage).
Pursuant to the Investment Management Agreement, PIMCO shall provide to the Fund investment guidance and policy direction in connection with
the management of the Fund, including oral and written research, analysis, advice and statistical and economic data and information. In addition,
under the terms of the Investment Management Agreement, subject to the general supervision of the Board, PIMCO shall provide or cause to be
furnished all supervisory and administrative and other services reasonably necessary for the operation of the Fund under the unified management fee
structure, including but not limited to the supervision and coordination of matters relating to the operation of the Fund, including any necessary
coordination among the custodian, transfer agent, dividend disbursing agent, and recordkeeping agent (including pricing and valuation of the Fund),
accountants, attorneys, auction agents and other parties performing services or operational functions for the Fund; the provision of adequate
personnel, office space, communications facilities, and other facilities necessary for the effective supervision and administration of the Fund, as well as
the services of a sufficient number of persons competent to perform such supervisory and administrative and clerical functions as are necessary for
compliance with federal securities laws and other applicable laws; the maintenance of the books and records of the Fund; the preparation of all
federal, state, local and foreign tax returns and reports for the Fund; the provision of administrative services to shareholders for the Fund including the
maintenance of a shareholder information telephone number, the provision of certain statistical information and performance of the Fund, an internet
website (if requested), and maintenance of privacy protection systems and procedures; the preparation and filing of such registration statements and
other documents with such authorities as may be required to register and maintain the listing of the shares of the Fund; the taking of other such
actions as may be required by applicable law (including establishment and maintenance of a compliance program for the Fund); and the preparation,
filing and distribution of proxy materials, periodic reports to shareholders and other regulatory filings.
In addition, under the Investment Management Agreement, PIMCO will procure, at its own expense, the following services, and will bear expenses
associated with the following for the Fund: a custodian or custodians for the Fund to provide for the safekeeping of the Fund’s assets; a
recordkeeping agent to maintain the portfolio accounting records for the Fund; a transfer agent for the Fund; a dividend disbursing agent and/or
registrar for the Fund; all audits by the Fund’s independent public accountant (except fees to auditors associated with satisfying rating agency
requirements for preferred shares or other securities issued by the Fund and other related requirements in the Fund’s organizational documents);
valuation services; maintaining the Fund’s tax records; all costs and/or fees incident to meetings of the Fund’s shareholders, the preparation, printing
and mailing of the Fund’s prospectuses (although the Fund will bear such expenses in connection with the offerings made pursuant to this prospectus
as noted below), notices and proxy statements, press releases and reports to its Shareholders, the filing of reports with regulatory bodies, the
maintenance of the Fund’s existence and qualification to do business, the expense of issuing, redeeming, registering and qualifying for sale, Common
Shares with the federal and state securities authorities, and the expense of qualifying and listing Shares with any securities exchange or other trading
system; legal services (except for extraordinary legal expenses); costs of printing certificates representing Shares of the Fund; the Fund’s pro rata
portion of its fidelity bond and other insurance premiums; and association membership dues.
The Fund (and not PIMCO) will be responsible for certain fees and expenses that are not covered by the unified fee under the Investment
Management Agreement. These include fees and expenses, including travel expenses, and fees and expenses of legal counsel retained for their
benefit, of Trustees who are not officers, employees, partners, shareholders or members of PIMCO or its subsidiaries or affiliates; the salaries and other
compensation or expenses, including travel expenses, of any of the Fund’s executive officers and employees, if any, who are not officers, directors,
shareholders, members, partners or employees of PIMCO or its subsidiaries or affiliates; taxes and governmental fees, if any, levied against the Fund;
brokerage fees and commissions, and other portfolio transaction expenses incurred by or for the Fund (including, without limitation, fees and
expenses of outside legal counsel or third-party consultants retained in connection with reviewing, negotiating and structuring specialized loans and
other investments made by the Fund, and subject to specific or general authorization by the Fund’s Board of Trustees (for example, so-called
“broken-deal costs” (e.g., fees, costs, expenses and liabilities, including, for example, due diligence-related fees, costs, expenses and liabilities, with
respect to unconsummated investments))); expenses of the Fund’s securities lending (if any), including any securities lending agent fees, as governed
by a separate securities lending agreement; costs, including interest expenses, of borrowing money or engaging in other types of leverage financing
(including, without limitation, through the use by the Fund of reverse repurchase agreements, tender option bonds, bank borrowings and credit
facilities); costs, including dividend and/or interest expenses and other costs (including, without limitation, offering and related legal costs, fees to
brokers, fees to auction agents, fees to transfer agents, fees to ratings agencies and fees to auditors associated with satisfying ratings agency
[], 2024 |
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PIMCO Income Strategy Fund II
requirements for Preferred Shares or other securities issued by the Fund and other related requirements in the Fund’s organizational documents)
associated with the Fund’s issuance, offering, redemption and maintenance of Preferred Shares, commercial paper or other senior securities for the
purpose of incurring leverage; fees and expenses of any underlying funds or other pooled vehicles in which the Fund invests; dividend and interest
expenses on short positions taken by the Fund; organizational and offering expenses of the Fund, including with respect to share offerings following
the Fund’s initial offering, such as rights and shelf offerings (including expenses associated with offerings made pursuant to this prospectus), and
expenses associated with tender offers and other share repurchases and redemptions; extraordinary expenses, including extraordinary legal expenses
as may arise, including expenses incurred in connection with litigation, proceedings, other claims, and the legal obligations of the Fund to indemnify
its Trustees, officers, employees, shareholders, distributors, and agents with respect thereto; and expenses of the Fund which are capitalized in
accordance with generally accepted accounting principles.
Because the fees received by the Investment Manager are based on the average weekly total managed assets of the Fund (“total managed assets”
includes the total assets of the Fund (including any assets attributable to any Preferred Shares or other forms of leverage that may be outstanding)
minus accrued liabilities (other than liabilities representing leverage)), the Investment Manager has a financial incentive for the Fund to utilize
leverage and to maintain and utilize preferred shares, which may create a conflict of interest between the Investment Manager, on the one hand, and
the Common Shareholders, on the other hand.
A discussion regarding the basis for the Board’s most recent continuation of the Investment Management Agreement is available in the Fund’s annual
report to shareholders for the fiscal year ended June 30, 2023.
Net Asset Value
The NAV of the Fund’s Common 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 common shares outstanding.
On each day that the NYSE is open, Fund shares are ordinarily valued as of the close of regular trading (normally 4:00 p.m. Eastern time) (“NYSE
Close”). Information that becomes known to the Fund or its agents after the time as of which NAV has been calculated on a particular day will not
generally be used to retroactively adjust the price of a security or the NAV determined earlier that day. If regular trading on the NYSE closes earlier
than scheduled, the Fund may calculate its NAV as of the earlier closing time or calculate its NAV as of the normally scheduled close of regular trading
on the NYSE for that day. The Fund generally does not calculate its NAV on days on which the NYSE is not open for business. If the NYSE is closed on a
day it would normally be open for business, the Fund may calculate its NAV as of the normally scheduled NYSE Close or such other time that the Fund
may determine. If regular trading on the NYSE closes earlier than scheduled, the Fund reserves the right to either (i) calculate its NAV as of the earlier
closing time or (ii) calculate its NAV as of the normally scheduled close of regular trading on the NYSE for that day. The Fund generally does not
calculate its NAV on days during which the NYSE is closed. However, if the NYSE is closed on a day it would normally be open for business, the Fund
reserves the right to calculate its NAV as of the normally scheduled close of regular trading on the NYSE for that day or such other time that the Fund
may determine.
For purposes of calculating NAV, portfolio securities and other assets for which market quotations are readily available are valued at market value. A
market quotation is readily available only when that quotation is a quoted price (unadjusted) in active markets for identical investments that the Fund
can access at the measurement date, provided that a quotation will not be readily available if it is not reliable. Market value is generally determined
on the basis of official closing prices or the last reported sales prices. The Fund will normally use pricing data for domestic equity securities received
shortly after the NYSE Close and does not normally take into account trading, clearances or settlements that take place after the NYSE Close. A
foreign (non-U.S.) equity security traded on a foreign exchange or on more than one exchange is typically valued using pricing information from the
exchange considered by PIMCO to be the primary exchange. If market value pricing is used, a foreign (non-U.S.) equity security will be valued as of
the close of trading on the foreign exchange, or the NYSE Close, if the NYSE Close occurs before the end of trading on the foreign exchange.
Investments for which market quotations are not readily available are valued at fair value as determined in good faith pursuant to Rule 2a-5 under
the 1940 Act. As a general principle, the fair value of a security or other asset is the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date. Pursuant to Rule 2a-5, the Board has designated PIMCO as
the valuation designee (“Valuation Designee”) for the Fund to perform the fair value determination relating to all Fund investments. PIMCO may carry
out its designated responsibilities as Valuation Designee through various teams and committees. The Valuation Designee’s policies and procedures
govern the Valuation Designee’s selection and application of methodologies for determining and calculating the fair value of Fund investments. The
Valuation Designee may value Fund portfolio securities for which market quotations are not readily available and other Fund assets utilizing inputs
from pricing services, quotation reporting systems, valuation agents and other third-party sources (together, “Pricing Sources”). Domestic and
foreign (non-U.S.) fixed income securities, non-exchange traded derivatives, and equity options are normally valued on the basis of quotes obtained
from brokers and dealers or Pricing Sources using data reflecting the earlier closing of the principal markets for those securities. Prices obtained from
Pricing Sources may be based on, among other things, information provided by market makers or estimates of market values obtained from yield data
relating to investments or securities with similar characteristics. Certain fixed income securities purchased on a delayed-delivery basis are marked to
market daily until settlement at the forward settlement date. Exchange-traded options, except equity options, futures and options on futures are
91 Base Prospectus
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valued at the settlement price determined by the relevant exchange. Swap agreements are valued on the basis of bid quotes obtained from brokers
and dealers or market-based prices supplied by Pricing Sources. With respect to any portion of the Fund’s assets that are invested in one or
more open-end management investment companies (including those advised by PIMCO) (other than ETFs), the Fund’s NAV will be calculated based
upon the NAVs of such investments.
If a foreign (non-U.S.) equity security’s value has materially changed after the close of the security’s primary exchange or principal market but before
the NYSE Close, the security may be valued at fair value. Foreign (non-U.S.) equity securities that do not trade when the NYSE is open are also valued
at fair value. With respect to foreign (non-U.S.) equity securities, the Fund may determine the fair value of investments based on information provided
by Pricing Sources and other third-party vendors, which may recommend fair value or adjustments with reference to other securities, indexes or
assets. In considering whether fair valuation is required and in determining fair values, the Valuation Designee may, among other things, consider
significant events (which may be considered to include changes in the value of U.S. securities or securities indexes) that occur after the close of the
relevant market and before the NYSE Close. The Fund may utilize modeling tools provided by third-party vendors to determine fair values
of non-U.S. securities. For these purposes, unless otherwise determined by the Valuation Designee, any movement in the applicable reference index or
instrument (“zero trigger”) between the earlier close of the applicable foreign market and the NYSE Close may be deemed to be a significant event,
prompting the application of the pricing model (effectively resulting in daily fair valuations.) Foreign (non-U.S.) exchanges may permit trading in
foreign (non-U.S.) equity securities on days when the Fund is not open for business, which may result in the Fund’s portfolio investments being
affected when shareholders are unable to buy or sell shares.
Senior secured floating rate loans for which an active secondary market exists to a reliable degree will be valued at the mean of the last available
bid/ask prices in the market for such loans, as provided by a Pricing Source. Senior secured floating rate loans for which an active secondary market
does not exist to a reliable degree will be valued at fair value, which is intended to approximate market value. In valuing a senior secured floating rate
loan at fair value, the factors considered may include, but are not limited to, the following: (a) the creditworthiness of the borrower and any
intermediate participants, (b) the terms of the loan, (c) recent prices in the market for similar loans, if any, and (d) recent prices in the market for
instruments of similar quality, rate, period until next interest rate reset and maturity.
Investments valued in currencies other than the U.S. dollar are converted to the U.S. dollar using exchange rates obtained from Pricing Services. As a
result, the value of such investments and, in turn, the NAV of the Fund’s shares may be affected by changes in the value of currencies in relation to
the U.S. dollar. The value of investments traded in markets outside the United States or denominated in currencies other than the U.S. dollar may be
affected significantly on a day that the Fund is not open for business. As a result, to the extent that the Fund holds foreign (non-U.S.) investments, the
value of those investments may change at times when shareholders are unable to buy or sell shares and the value of such investments will be
reflected in the Fund’s next calculated NAV.
Whole loans may be fair valued using inputs that take into account borrower- or loan-level data (e.g., credit risk of the borrower) that is updated
periodically throughout the life of each individual loan; any new borrower- or loan-level data received in written reports periodically by the Fund
normally will be taken into account in calculating the NAV.
Fair valuation may require subjective determinations about the value of a security. While the Fund’s policy and Valuation Designee’s policies and
procedures are intended to result in a calculation of the Fund’s NAV that fairly reflects security values as of the time of pricing, the Fund cannot
ensure that fair values accurately reflect the price that the Fund could obtain for a security if it were to dispose of that security as of the time of pricing
(for instance, in a forced or distressed sale). The prices used by the Fund may differ from the value that would be realized if the securities were sold.
Distributions
The Fund makes regular monthly cash distributions to Common Shareholders at a rate based upon the past and projected net income of the Fund.
Subject to applicable law, the Fund may fund a portion of its distributions with gains from the sale of portfolio securities and other sources.
Distributions can only be made from net investment income after paying any accrued dividends to holders of the Preferred Shares. The dividend rate
that the Fund pays on its Common Shares may vary as portfolio and market conditions change, and will depend on a number of factors, including
without limit the amount of the Fund’s undistributed net investment income and net short- and long-term capital gains, as well as the costs of any
leverage obtained by the Fund (including the amount of the costs and dividend rates on the outstanding ARPS (and any other preferred shares issued
by the Fund) and interest or other expenses on any reverse repurchase agreements, credit default swaps, dollar rolls/buybacks and borrowings). As
portfolio and market conditions change, the rate of distributions on the Common Shares and the Fund’s dividend policy could change. There can be no
assurance that a change in market conditions or other factors will not result in a change in the Fund distribution rate or that the rate will be
sustainable in the future. See “Principal Risks of the Fund—Distribution Rate Risk.” For a discussion of factors that may cause the Fund’s income and
capital gains (and therefore the dividend) to vary, see “Principal Risks of the Fund”. The Fund generally distributes each year all of its net investment
income and net short-term capital gains. In addition, at least annually, the Fund generally distributes net realized long-term capital gains not
previously distributed, if any. The net investment income of the Fund consists of all income (other than net short-term and long-term capital gains)
less all expenses of the Fund (after it pays accrued dividends on the outstanding Preferred Shares).
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PIMCO Income Strategy Fund II
To permit the Fund to maintain a more level monthly distribution, the Fund may distribute less than the entire amount of net investment income
earned in a particular period. The undistributed net investment income would be available to supplement future distributions. As a result, the
distributions paid by the Fund for any particular monthly period may be more or less than the amount of net investment income actually earned by
the Fund during the period. Undistributed net investment income will be additive to the Fund’s NAV and, correspondingly, distributions from
undistributed net investment income will be deducted from the Fund’s NAV.
The tax treatment and characterization of the Fund’s distributions may vary significantly from time to time because of the varied nature of the Fund’s
investments. For example, the Fund may enter into opposite sides of multiple interest rate swaps or other derivatives with respect to the same
underlying reference instrument (e.g., a 10-year U.S. treasury) that have different effective dates with respect to interest accrual time periods for the
principal purpose of generating distributable gains (characterized as ordinary income for tax purposes) that are not part of the Fund’s duration or yield
curve management strategies. In such a “paired swap transaction”, the Fund would generally enter into one or more interest rate swap agreements
whereby the Fund agrees to make regular payments starting at the time the Fund enters into the agreements equal to a floating interest rate in return
for payments equal to a fixed interest rate (the “initial leg”). The Fund would also enter into one or more interest rate swap agreements on the same
underlying instrument, but take the opposite position (i.e., in this example, the Fund would make regular payments equal to a fixed interest rate in
return for receiving payments equal to a floating interest rate) with respect to a contract whereby the payment obligations do not commence until a
date following the commencement of the initial leg (the “forward leg”). The Fund may engage in investment strategies, including those that employ
the use of derivatives, to, among other things, seek to generate current, distributable income, even if such strategies could potentially result in
declines in the Fund’s NAV. The Fund’s income and gain-generating strategies, including certain derivatives strategies, may generate current income
and gains taxable as ordinary income sufficient to support monthly distributions even in situations when the Fund has experienced a decline in net
assets due to, for example, adverse changes in the broad U.S. or non-U.S. equity markets or the Fund’s debt investments, or arising from its use of
derivatives. Because some or all of these transactions may generate capital losses without corresponding offsetting capital gains, portions of the
Fund’s distributions recognized as ordinary income for tax purposes (such as from paired swap transactions) may be economically similar to a taxable
return of capital when considered together with such capital losses. The tax treatment of certain derivatives in which the Fund invests may be unclear
and thus subject to recharacterization. Any recharacterization of payments made or received by the Fund pursuant to derivatives potentially could
affect the amount, timing or character of Fund distributions. In addition, the tax treatment of such investment strategies may be changed by
regulation or otherwise.
To the extent required by the 1940 Act and other applicable laws, absent an exemption, a notice will accompany each monthly distribution with
respect to the estimated source (as between net income, gains or other capital source) of the distribution made. If the Fund estimates that a portion
of one of its dividend distributions may be comprised of amounts from sources other than net investment income, in accordance with its internal
policies and accounting records and related accounting practices, the Fund will notify shareholders of record of the estimated composition of such
distribution through a Section 19 Notice. For these purposes, the Fund estimates the source or sources from which a distribution is paid, to the close
of the period as of which it is paid, in reference to its internal accounting records and related accounting practices. If, based on such accounting
records and practices, it is estimated that a particular distribution does not include capital gains or paid-in surplus or other capital sources, a
Section 19 Notice generally would not be issued. It is important to note that differences exist between the Fund’s daily internal accounting records
and practices, the Fund’s financial statements presented in accordance with U.S. GAAP, and recordkeeping practices under income tax regulations. For
instance, the Fund’s internal accounting records and practices may take into account, among other factors, tax-related characteristics of certain
sources of distributions that differ from treatment under U.S. GAAP. Examples of such differences may include, among others, the treatment of
paydowns on mortgage-backed securities purchased at a discount and periodic payments under interest rate swap contracts. Accordingly, among
other consequences, it is possible that the Fund may not issue a Section 19 Notice in situations where the Fund’s financial statements prepared later
and in accordance with U.S. GAAP and/or the final tax character of those distributions might later report that the sources of those distributions
included capital gains and/or a return of capital.
The tax characterization of the Fund’s distributions made in a taxable year cannot finally be determined until at or after the end of such taxable year.
As a result, there is a possibility that the Fund may make total distributions during a taxable year in an amount that exceeds the Fund’s net
investment income and net realized capital gains (as reduced by any capital loss carry-forwards) for the relevant year. For example, the Fund may
distribute amounts early in the year that are derived from short-term capital gains, but incur net short-term capital losses later in the year, thereby
offsetting short-term capital gains out of which the Fund has already made distributions. In such a situation, the amount by which the Fund’s total
distributions exceed net investment income and net realized capital gains would generally be treated as a tax-free return of capital up to the amount
of a shareholder’s tax basis in his or her Common Shares, with any amounts exceeding such basis treated as gain from the sale of Common Shares. In
general terms, a return of capital would occur where the Fund distribution (or portion thereof) represents a return of a portion of your investment,
rather than net income or capital gains generated from your investment during a particular period. A return of capital distribution is not taxable, but it
reduces a shareholder's tax basis in the Common Shares, thus reducing any loss or increasing any gain on a subsequent taxable disposition by the
shareholder of the Common Shares, thereby potentially increasing a shareholder’s tax liability. The Fund will prepare and make available to
shareholders detailed tax information with respect to the Fund’s distributions annually. See “Tax Matters.”
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| PIMCO Income Strategy Fund II
Base Prospectus
The 1940 Act currently limits the number of times the Fund may distribute long-term capital gains in any tax year, which may increase the variability
of the Fund’s distributions and result in certain distributions being comprised more or less heavily than others of long-term capital gains currently
eligible for favorable income tax rates. The Fund, as well as several other PIMCO managed closed end funds, has received exemptive relief from the
SEC permitting it to make a greater number of capital gains distributions to holders of the ARPS than would otherwise be permitted by Section 19(b)
of the 1940 Act and Rule 19b-1 under the 1940 Act.
Unless a Common Shareholder elects to receive distributions in cash, all distributions of Common Shareholders whose shares are registered with the
plan agent will be automatically reinvested in additional Common Shares of the Fund under the Fund’s Dividend Reinvestment Plan.
Dividend Reinvestment Plan
The information contained under the heading “Dividend Reinvestment Plan” in the Fund's annual report to shareholders for the fiscal year ended
June 30, 2023, is incorporated
herein by reference
.
Description of Capital Structure
The following is a brief description of the capital structure of the Fund. This description does not purport to be complete and is subject to and qualified
in its entirety by reference to the Declaration and the Bylaws. The Declaration and Bylaws are each exhibits to the registration statement of which this
prospectus is a part.
The Fund is an unincorporated voluntary association with transferable shares of beneficial interest (commonly referred to as a “Massachusetts
business trust”) established under the laws of the Commonwealth of Massachusetts by the Declaration. The Declaration provides that the Trustees of
the Fund may authorize separate classes of shares of beneficial interest. Preferred shares (such as the ARPS) are permitted to be issued in one or more
series, with such par value and with such rights as determined by the Board, by action of the Board without the approval of the Common
Shareholders.
The following table shows, for each class of authorized securities of the Fund, the amount of (i) shares authorized and (ii) shares outstanding, each as
of March 28, 2024.
Title of Class |
Amount Authorized |
Amount Outstanding (Exclusive of Amount Held by the Fund) |
Amount Outstanding |
Common Shares |
Unlimited |
0 |
86,130,947 |
Preferred Shares—ARPS |
0 |
||
Class M |
3,840 |
0 |
209 |
Class T |
3,840 |
0 |
394 |
Class W |
3,840 |
0 |
272 |
Class TH |
3,840 |
0 |
387 |
Class F |
3,840 |
0 |
294 |
The Common Shares of the Fund commenced trading on the NYSE on October 29, 2004, under the trading or “ticker” symbol “PFN.” As of the close
of trading on the NYSE on March 28, 2024, the NAV per Common Share was $7.15, and the closing price per Common Share on the NYSE was $7.46
representing a premium to NAV of 4.34%.
Common Shareholders are entitled to share equally in dividends declared by the Board to Common Shareholders and in the net assets of the Fund
available for distribution to Common Shareholders after payment of the preferential amounts payable to holders of Preferred Shares and any other
outstanding preferred shares of beneficial interest. See “Preferred Shares Dividends” below. All Common Shares of the Fund have equal rights to the
payment of dividends and the distribution of assets upon liquidation.
Common Shares of the Fund are fully paid and, subject to matters discussed in “Anti-Takeover and Other Provisions in the Agreement and Declaration
of Trust,” non-assessable, and have no pre-emptive or conversion rights or rights to cumulative voting, and have no right to cause the Fund to redeem
their shares. Upon liquidation of the Fund, after paying or adequately providing for the payment of all liabilities of the Fund and the liquidation
preference with respect to the holders of any outstanding preferred shares (including the ARPS), and upon receipt of such releases, indemnities and
refunding agreements as they deem necessary for their protection, the Trustees may distribute the remaining assets of the Fund among the Fund’s
Common Shareholders.
For so long as any ARPS are outstanding, the Fund generally may not declare, pay or set apart for payment any dividend or other distribution (other
than a dividend or distribution paid in shares of additional Common Shares or options, warrants or rights to subscribe for or purchase Common
Shares or other shares ranking junior to the ARPS as to dividends or upon liquidation) in respect of Common Shares or any other shares of the Fund
ranking junior to or on a parity with the ARPS as to dividends or upon liquidation, or call for redemption, redeem, purchase or otherwise acquire for
consideration any Common Shares or any other such junior shares (except by conversion into or exchange for shares of beneficial interest of the Fund
ranking junior to ARPS as to dividends and upon liquidation) or any such parity shares (except by conversion into or exchange for shares of beneficial
[], 2024 |
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PIMCO Income Strategy Fund II
interest of the Fund ranking junior to or on a parity with ARPS as to dividends and upon liquidation), unless and only if: (i) immediately after such
transaction, the Fund would satisfy Moody’s Ratings Agency Preferred Shares Asset Coverage, Fitch Ratings Agency Preferred Shares Asset Coverage
and 1940 Act Preferred Shares Asset Coverage (each as defined and described under “—Rating Agency Guidelines and Asset Coverage”); (ii) full
cumulative dividends on the ARPS due on or prior to the date of the transaction have been declared and paid or shall have been declared and
sufficient funds for the payment thereof deposited with the auction agent for the ARPS; and (iii) the Fund has redeemed the full number of ARPS
required to be redeemed by any provision for mandatory redemption contained in the Bylaws. See “Preferred Shares Redemption.” Further, so long as
any ARPS are outstanding, the Fund generally may not declare, pay or set apart for payment any dividend or other distribution on any parity shares
other than the ARPS unless the Fund contemporaneously declares, pays or sets apart for payment, as the case may be, the same proportionate share
of dividends on the ARPS. The Fund expects that similar restrictions would apply to any other classes of preferred shares that the Fund might choose
to issue in the future. In addition, if the Fund has outstanding any senior security representing indebtedness, the 1940 Act prohibits the Fund from
declaring any dividend or distribution on the Fund’s Common Shares (other than a dividend or distribution paid in shares of additional Common
Shares) unless such senior securities representing indebtedness have, at the time of the declaration, asset coverage of at least 300% after deducting
the amount of such dividend or distribution. See “Use of Leverage.”
Shareholders of each class are entitled to one vote for each share held. Common Shareholders will vote with the holders of any outstanding Preferred
Shares or other preferred shares as a single class on each matter submitted to a vote of holders of Common Shares, except as otherwise provided by
the Declaration, the Bylaws or applicable law. Except as otherwise provided by the Declaration, the Bylaws or applicable law, holders of Preferred
Shares, voting as a separate class, are entitled to elect two of the Fund’s Trustees. The remaining Trustees are elected by Common Shareholders and
holders of Preferred Shares, voting together as a single class. In the unlikely event that two full years of accrued dividends are unpaid on the Preferred
Shares, the holders of all outstanding Preferred Shares, voting as a separate class, will be entitled to elect a majority of the Fund’s Trustees until all
dividends in arrears have been paid or declared and set apart for payment. The holders of Preferred Shares also have the right to elect a majority of
the Fund’s Trustees as may be required under the 1940 Act.
Additional Information Regarding The Preferred Shares
The Fund initially issued ARPS in five series (Series M, Series T, Series W, Series TH and Series F) in December 2004, in the amount of 3,840 shares per
series. The ARPS have a par value of $0.00001 and liquidation value of $25,000 per share. The ARPS have various rights determined by action of the
Board without the approval of Common Shareholders, most of which are specified in Article 11 of the Bylaws.
In 2008 and 2009, the Fund was effectively required to redeem a portion of its ARPS due to market dislocations that caused the value of the Fund’s
portfolio securities and related asset coverage to decline. In order to increase and maintain the Fund’s asset coverage above the requisite 200% level,
in December 2008 and March and April 2009, the Fund redeemed 2,552 shares ($63,800,000) of each series of its outstanding ARPS, in each case at
face value (i.e., a total of 12,760 shares ($319,000,000) across all series). On September 19, 2014, the Fund commenced a voluntary tender offer for
up to 100% of its outstanding ARPS at a price equal to 90% of the ARPS’ per share liquidation preference of $25,000. The Fund accepted 2,742
ARPS for payment, representing approximately 43% of its outstanding ARPS, such that on October 31, 2014, the expiration of the tender offer, the
Fund had a total of 3,698 ARPS outstanding (721 shares of Series M, 881 shares of Series T, 671 shares of Series W, 753 shares of Series TH, and 672
shares of Series F) with a total liquidation value of $92,450,000. On June 25, 2019, the Fund commenced a voluntary tender offer for up to 100% of
its outstanding ARPS at a price equal to 87% of the ARPS’ per share liquidation preference of $25,000. The Fund accepted 201 ARPS for payment,
representing approximately 5.44% of its outstanding ARPS, such that on July 26, 2019, the expiration of the tender offer, the Fund had a total of
3,497 ARPS outstanding 671 shares of Series M, 855 shares of Series T, 627 shares of Series W, 706 shares of Series TH, and 638 shares of Series F)
with a total liquidation value of $87,425,000. On September 20, 2023, the Fund announced the results of the tender offer, which expired on
September 18, 2023. The Fund accepted 1,941 ARPS for payment, representing approximately 55.50% of its outstanding ARPS, such that on
September 19, 2023, the Fund had a total of 1,556 ARPS outstanding (209 shares of Series M, 394 shares of Series T, 272 shares of Series W, 387
shares of Series TH, and 294 shares of Series F) with a total liquidation value of $38,900,000. On March 12, 2024, the Fund commenced a voluntary
tender offer for up to 100% of its outstanding ARPS at a price equal to 96% of the ARPS' per share liquidation preference of $25,000. On April 15,
2024, the Fund announced the results of the tender offer, which expired on April 12, 2024. The Fund accepted 1,426 ARPS for payment, representing
approximately 91.65% of its outstanding ARPS, such that on April 15, 2024, the Fund had a total of 130 ARPS outstanding (7 shares of Series M, 1
share of Series T, 5 shares of Series W, 95 shares of Series TH, and 22 shares of Series F) with a total liquidation value of $3,250,000.
Under the 1940 Act, the Fund is permitted to have outstanding more than one series of preferred shares of beneficial interest as long as no single
series has priority over another series as to the distribution of assets of the Fund or the payment of dividends. Neither Common Shareholders nor
holders of Preferred Shares have preemptive rights to purchase any Preferred Shares or any other preferred shares that might be issued by the Fund.
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Preferred share dividends
The Preferred Shares have complete priority over the common shares as to distribution of assets. The terms of the Preferred Shares provide that they
would ordinarily pay dividends at a rate set at auctions held every seven days, normally payable on the first business day following the end of the rate
period, subject to a “maximum applicable rate” calculated as a function of the ARPS’ then-current ratings and a reference interest rate as described
below. However, the weekly auctions for the ARPS, as well as auctions for similar preferred shares of other closed-end funds across the U.S. industry,
have failed since February 2008, and the dividend rates on the Preferred Shares since that time have been paid at the maximum applicable rate. The
Fund expects that the Preferred Shares will continue to pay dividends at the maximum applicable rate for the foreseeable future and cannot predict
whether or when the auction markets for the ARPS may resume normal functioning.
As noted, the “maximum applicable rate” for each series of ARPS depends on the credit ratings assigned to such shares (currently by Fitch and
Moody’s) and on the duration of the rate period. The maximum applicable rate for any regular rate period (i.e., any rate period other than a
non-payment period) will be the higher of the applicable percentage of the reference rate, or the applicable spread plus the reference rate. The
reference rate is the Secured Overnight Funding Rate plus spread adjustments intended to serve as a reasonable substitute of the
previously-applicable LIBOR Rate (as defined and detailed in the Fund’s Bylaws). (for a rate period of fewer than 365 days) or the Treasury Index Rate
(as defined below) (for a rate period of 365 days or more). The applicable percentage and applicable spread for any regular rate period will generally
be determined based on the credit ratings assigned to the ARPS by Fitch and Moody’s on the auction date for such period (as set forth in the table
below).
Aaa |
AAA |
125% |
125 bps |
Aa3 to Aa1 |
AA- to AA+ |
150% |
150 bps |
A3 to A1 |
A- to A+ |
200% |
200 bps |
Baa3 to Baa1 |
BBB- to BBB+ |
250% |
250 bps |
Ba1 and below |
BB+ and below |
300% |
300 bps |
Rating Agency Guidelines and Asset Coverage
The Fund is required to satisfy various asset maintenance requirements with respect to its ARPS under the terms of the Bylaws, which are summarized
below.
1940 Act preferred shares asset coverage
The Fund is required under the Bylaws to maintain, with respect to the ARPS, as of the last business day of each month in which any Preferred Shares
are outstanding, 1940 Act Preferred Shares Asset Coverage (as defined below) of at least 200% with respect to senior securities that are equity
securities, including the Preferred Shares. If the Fund fails to maintain 1940 Act Preferred Shares Asset Coverage and such failure is not cured as of
the last business day of the following month (the “1940 Act Cure Date”), the Fund will be required under certain circumstances to redeem certain of
the Preferred Shares. See “Preferred Shares Redemption.”
The “1940 Act Preferred Shares Asset Coverage” with respect to the Fund’s currently outstanding ARPS is equal to the following ratio, which as of
March 28, 2024 was as follows:
Value of the Fund's total assets less all liabilities and indebtedness not represented by senior securities |
||
= |
1,683.73% | |
Senior securities representing indebtedness plus liquidation value of the ARPS |
Ratings Agency Preferred Shares Asset Coverage
The Fund is required under the Bylaws to satisfy separate asset coverage tests specific to each rating agency (the “Ratings Agency Preferred Shares
Asset Coverage”).
Moody’s Preferred Shares Asset Coverage
Satisfaction of Moody’s Ratings Agency Preferred Shares Asset Coverage generally requires the Fund to have eligible assets having in the aggregate a
discounted value equal to or in excess of a “Preferred Shares Basic Maintenance Amount.” Generally, the Preferred Shares Basic Maintenance
Amount includes the sum of (a) the aggregate liquidation preference of the Fund’s preferred shares then outstanding (including the ARPS) and (b)
certain accrued and projected payment obligations of the Fund, including without limit any accrued and projected dividends on its preferred shares
then outstanding (including the ARPS).
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Article 11 of the Bylaws includes Moody’s-specific guidelines for calculating discounted value for purposes of determining whether the Moody’s
Ratings Agency Preferred Shares Asset Coverage test is satisfied. These guidelines specify discount factors that the Fund must apply to various types
of securities in its portfolio for purposes of calculating whether the discounted value of the Fund’s eligible assets is at least equal to the Preferred
Shares Basic Maintenance Amount (with the level of discount generally becoming greater as the credit quality of a security becomes lower). In
addition, under the Moody’s guidelines, certain types of securities (including securities in which the Fund may otherwise invest) are not eligible for
inclusion in the calculation of the discounted value of the Fund’s portfolio. Such ineligible securities may include, for example, certain privately placed
debt securities (other than Rule 144A securities) and debt securities of certain non-U.S. issuers. The Moody’s guidelines for calculating discounted
value do not impose any limitations on the percentage of the Fund’s assets that may be invested in ineligible assets, and the amount of ineligible
assets included in the Fund’s portfolio at any time may vary depending upon the rating, diversification and other characteristics of the Moody’s
eligible assets included in the portfolio.
Fitch Preferred Shares Asset Coverage
Satisfaction of Fitch Preferred Shares Asset Coverage requires that the Fund satisfy both a “Fitch Total Overcollateralization Test (“Fitch Total OC”)
and a “Fitch Net Over Collateralization Test (“Fitch Net OC”), in each case to be consistent with then-current rating assigned to the Preferred Shares
by Fitch pursuant to the Fitch Criteria (as defined below). Under the Bylaws, Fitch Preferred Shares Asset Coverage is satisfied if, as of a particular date
or time, the Fund has sufficient asset coverage with respect to the Preferred Shares such that the Fund satisfies both the (i) Fitch Total OC test and the
(ii) Fitch Net OC test as of such date or time. The Fitch Total OC test and the Fitch Net OC test are satisfied if the Fund has Fitch Total OC or Fitch Net
OC, as the case may be, in excess of one-hundred percent (100%) pursuant to the applicable formula below.
The Fund’s Bylaws incorporate by reference the Closed-End Fund Criteria Report issued by Fitch entitled “Rating Closed –End Fund Debt and
Preferred Stock” most recently published by Fitch and approved for use by the Trust by resolution of the Board of Trustees of the Trust (the “Fitch
Criteria”). The Fitch Criteria include, among other things, the current formulations for satisfaction of the Fitch Total OC test and the Fitch Net OC test,
asset discount factors (used in part to calculate Fitch Total OC and Fitch Net OC), issuer and industry diversification and concentration thresholds and
guidelines and a description of other rating considerations.
The Fitch Criteria define Fitch Total OC and Fitch Net OC as follows:
Total Net Discounted Assets at MV* |
||
= |
Fitch Total OC | |
Fitch Rated Liability + Other Liabilities Pari Passu and Senior to Rated Liability |
*
Total net discounted assets at market value (MV) equal total portfolio assets at MV and accrued income, including assets held as collateral for other Fund liabilities, less nonleverage
liabilities that are not part of a rolling leverage strategy (such as to-be-announced, or TBA, securities, futures and forwards, among others), then discounted pursuant to the Fitch
discount factors specified in the Fitch Criteria and adjusted per Fitch’s criteria discussed in the Fitch Criteria.
Value of the Fund's total assets less all liabilities and indebtedness not represented by senior securities |
||
= |
127.10% | |
Senior securities representing indebtedness plus liquidation value of the ARPS |
*
Available net discounted assets equals total portfolio assets at market value and accrued income minus all assets that are either held as collateral for other Fund liabilities and/or
subject to a first claim of a senior liability in the capital structure minus nonleverage liabilities that are not part of a rolling leverage strategy (such as TBA security rolls, futures and
forwards, among others), then discounted pursuant to the Fitch discount factors specified in the Fitch Criteria and adjusted per Fitch’s criteria discussed in the Fitch Criteria.
In the event the Fund does not timely cure a failure to maintain (a) both Moody’s Preferred Shares Asset Coverage and Fitch Preferred Shares Asset
Coverage or (b) 1940 Act Preferred Shares Asset Coverage, in each case in accordance with the requirements of the rating agency or agencies then
rating the ARPS, the Fund will be required to redeem ARPS as described under “Preferred Shares Redemption”.
In addition to the requirements described above, the rating agency guidelines impose restrictions or limitations on the Fund’s use of certain financial
instruments or investment techniques that the Fund might otherwise utilize in order to obtain and maintain a rating from Moody’s and Fitch on the
ARPS. It is not currently anticipated that these guidelines will materially impede PIMCO from managing the Fund’s portfolio in accordance with the
Fund’s investment objective and policies.
The Fund may, but is not required to, adopt any modifications to the guidelines that may be established by Moody’s and/or Fitch with respect to their
ratings of the ARPS. Failure to adopt any such modifications, however, may result in a reduction in the ratings described above or a withdrawal of
ratings altogether. In addition, any rating agency providing a rating for the ARP may, at any time, change or withdraw any such rating. The Board may,
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without shareholder approval, amend, alter or repeal various definitions and related provisions that have been adopted by the Fund pursuant to the
rating agency guidelines in the event the Fund receives written confirmation from Moody’s or Fitch (or any substitute rating agency) that any such
amendment, alteration or repeal would not impair the rating then assigned by the rating agency to the Preferred Shares.
The ratings of the ARPS are based on current information furnished to Moody’s and Fitch by the Fund, the Investment Manager or information
obtained from other sources. The ratings may be changed, suspended or withdrawn as a result of changes in, or the unavailability of, such
information. The Fund’s common shares have not been rated by a nationally recognized statistical rating organization. A rating agency’s guidelines
will apply to the ARPS only so long as the rating agency is rating the shares. The Fund pays certain fees to Moody’s and Fitch for rating the ARPS.
The foregoing description of the rating agency guidelines and asset coverage requirements applicable to the ARPS is intended only as a summary and
is qualified in its entirety by reference to the actual terms of Article 11 and other relevant provisions of the Bylaws and Exhibit 1 thereto.
Liquidation Preference
Subject to the rights of holders of any series or class or classes of shares ranking on a parity with the ARPS with respect to the distribution of assets
upon liquidation of the Fund, upon a liquidation of the Fund (whether voluntary or involuntary), the holders of the ARPS then outstanding would be
entitled to receive and to be paid, out of the assets of the Fund available for distribution to its shareholders, before any payment or distribution would
be made on the Fund’s common shares or any other class of shares of the Fund ranking junior in right of payment upon liquidation to the ARPS, an
amount equal to the liquidation preference with respect to such ARPS ($25,000 per share), plus an amount equal to all dividends thereon (whether or
not earned or declared by the Fund, but excluding the interest thereon) accumulated but unpaid to (but not including) the date of final distribution in
same-day funds in connection with the liquidation of the Fund. If such assets of the Fund are insufficient to make the full liquidation payment on
outstanding ARPS and liquidation payments on any other outstanding class or series of preferred shares of the Fund ranking on parity with the ARPS
as to payment upon liquidation, then such assets will be distributed among the holders of ARPS and the holders of shares of such other class or series
ratably in proportion to the respective preferential amounts to which they are entitled. After the payment to the holders of ARPS of the full
preferential amounts provided for as described herein, the holders of ARPS as such would have no right or claim to any of the remaining assets of the
Fund. For these purposes, a liquidation of the Fund does not include the sale of all or any portion of the assets of the Fund or the merger,
consolidation or statutory share exchange of the Fund into or with any trust or other entity.
As used in this prospectus, unless otherwise noted, the Fund’s “net assets” include assets of the Fund attributable to any outstanding ARPS, with no
deduction for the liquidation preference of the Preferred Shares. Solely for financial reporting purposes, however, the Fund is required to exclude the
liquidation preference of Preferred Shares from “net assets,” so long as the Preferred Shares have redemption features that are not solely within the
control of the Fund. For all regulatory and tax purposes, the Fund’s ARPS will be treated as stock (rather than indebtedness).
Preferred Shares Redemption
As noted above, the Fund is required under the Bylaws to maintain (a) both Moody’s Ratings Agency Preferred Shares Asset Coverage and Fitch
Ratings Agency Preferred Shares Asset Coverage and (b) 1940 Act Preferred Shares Asset Coverage. Eligible portfolio securities for the purposes of (a)
above will be determined from time to time by the rating agency then rating the then outstanding ARPS. If the Fund fails to maintain such asset
coverage amounts and does not timely cure such failure in accordance with the Bylaws, the Fund would be required to redeem all or a portion of the
ARPS. This mandatory redemption would take place on a date that the Board specifies out of legally available funds in accordance with the
Declaration, the Bylaws and applicable law, at the redemption price of $25,000 per share, plus accumulated but unpaid dividends (whether or not
earned or declared) to (but not including) the date fixed for redemption. In determining the number of ARPS required to be redeemed in accordance
with the foregoing, the Fund would redeem the lesser of (a) the minimum number of ARPS necessary to satisfy the applicable Ratings Agency
Preferred Shares Asset Coverage or 1940 Act Preferred Shares Asset Coverage, as the case may be, and (b) the maximum number of ARPS and any
other preferred shares of the Fund subject to redemption or retirement that can be redeemed out of funds expected to be legally available therefor at
the time of redemption, and in any case will redeem such Preferred Shares pro rata among the ARPS and any other preferred shares of the Fund
subject to redemption or retirement. The mandatory redemption will be limited to the number of Preferred Shares and any other preferred shares
necessary to restore the required Ratings Agency Preferred Shares Asset Coverage or 1940 Act Preferred Shares Asset Coverage, as the case may be.
Optional Redemption
To the extent permitted under the 1940 Act and under Massachusetts law, upon giving notice of redemption, as provided below, the Fund, at its
option, may redeem Preferred Shares, in whole or in part, out of funds legally available therefore, at the Optional Redemption Price (as defined below)
per share on any dividend payment date, provided that no Preferred Shares may be redeemed at the option of the Fund during (a) the initial rate
period with respect to the Preferred Shares or (b) a non-call period to which such shares are subject. “Optional Redemption Price” means $25,000
per Preferred Share plus an amount equal to accumulated but unpaid dividends (whether or not earned or declared) to (but not including) the date
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PIMCO Income Strategy Fund II
fixed for redemption plus the applicable redemption premium, if any. The Fund has the authority to redeem Preferred Shares for any reason and may
redeem all or part of the outstanding Preferred Shares if it anticipates that the Fund’s leveraged capital structure will result, for a significant period of
time, in a lower rate of return to Common Shareholders than that obtainable if the Common Shares were not so leveraged.
Although the Preferred Shares are subject to redemption under certain circumstances as described above, unlike the shares of an open-end mutual
fund, the Preferred Shares may not be redeemed at a shareholder’s option at NAV or otherwise.
Plan of Distribution
The Fund may sell Common Shares through underwriters or dealers, directly to one or more purchasers (including existing shareholders in a rights
offering), through agents, to or through underwriters or dealers, or through a combination of any such methods of sale. The applicable prospectus
supplement will identify any underwriter or agent involved in the offer and sale of the Common Shares, any sales loads, discounts, commissions, fees
or other compensation paid to any underwriter, dealer or agent, the offering price, net proceeds and use of proceeds and the terms of any sale.
The distribution of the Common Shares may be effected from time to time in one or more transactions at a fixed price or prices, which may be
changed, at prevailing market prices at the time of sale, at prices related to such prevailing market prices, or at negotiated prices. The sale of Common
Shares by the Fund (or the perception that such sales may occur),particularly if sold at a discount to the then-current market price of the Common
Shares, may have an adverse effect on the market price of the Common Shares.
The Fund may sell the Common Shares directly to, and solicit offers from, institutional investors or others who may be deemed to be underwriters as
defined in the Securities Act for any resales of the securities. In this case, no underwriters or agents would be involved. The Fund may use electronic
media, including the Internet, to sell offered securities directly.
In connection with the sale of the Common Shares, underwriters or agents may receive compensation from the Fund or from PIMCO or its affiliates in
the form of discounts, concessions or commissions. Underwriters may sell Common Shares to or through dealers, and such dealers may receive
compensation in the form of discounts, concessions or commissions from the underwriters and/or commissions from the purchasers for whom they
may act as agents. Underwriters, dealers and agents that participate in the distribution of the Common Shares may be deemed to be underwriters
under the Securities Act, and any discounts and commissions they receive from the Fund and any profit realized by them on the resale of the Common
Shares may be deemed to be underwriting discounts and commissions under the Securities Act. Any such underwriter or agent will be identified and
any such compensation received from the Fund will be described in the applicable prospectus supplement. The maximum amount of compensation to
be received by any Financial Industry Regulatory Authority member or independent broker-dealer will not exceed 8% for the sale of any securities
being registered pursuant to Rule 415 under the Securities Act. The Fund will not pay any compensation to any underwriter or agent in the form of
warrants, options, consulting or structuring fees or similar arrangements.
If a prospectus supplement so indicates, the Fund may grant the underwriters an option to purchase additional Common Shares at the public offering
price, less the underwriting discounts and commissions, within a certain number of days (often 30 to 45 days) from the date of the prospectus
supplement, to cover any over-allotments.
Under agreements into which the Fund may enter, underwriters, dealers and agents who participate in the distribution of the Common Shares may be
entitled to indemnification by the Fund against certain liabilities, including liabilities under the Securities Act. Underwriters, dealers and agents may
engage in transactions with the Fund, or perform services for the Fund, in the ordinary course of business.
If so indicated in the applicable prospectus supplement, the Fund will, or will authorize underwriters or other persons acting as its agents to, solicit
offers by certain institutions to purchase Common Shares from the Fund pursuant to contracts providing for payment and delivery on a future date.
Institutions with which such contracts may be made include commercial and savings banks, insurance companies, pension funds, investment
companies, educational and charitable institutions and others, but in all cases such institutions must be approved by the Fund. The obligation of any
purchaser under any such contract will be subject to the condition that the purchase of the Common Shares shall not at the time of delivery be
prohibited under the laws of the jurisdiction to which such purchaser is subject. The underwriters and such other agents will not have any
responsibility in respect of the validity or performance of such contracts. Such contracts will be subject only to those conditions set forth in the
prospectus supplement, and the prospectus supplement will set forth the commission payable for solicitation of such contracts.
To the extent permitted under the 1940 Act and the rules and regulations promulgated thereunder, the underwriters may from time to time act as
brokers or dealers and receive fees in connection with the execution of the Fund’s portfolio transactions after the underwriters have ceased to be
underwriters and, subject to certain restrictions, each may act as a broker while it is an underwriter.
A prospectus and accompanying prospectus supplement in electronic form may be made available on the websites maintained by underwriters. The
underwriters may agree to allocate a number of securities for sale to their online brokerage account holders. Such allocations of securities for Internet
distributions will be made on the same basis as other allocations. In addition, securities may be sold by the underwriters to securities dealers who
resell securities to online brokerage account holders.
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In order to comply with the securities laws of certain states, if applicable, Common Shares offered hereby will be sold in such jurisdictions only
through registered or licensed brokers or dealers.
Information Regarding State Escheatment Laws
Closed-end fund accounts can be considered abandoned property. States increasingly are looking at inactive closed-end fund accounts as possible
abandoned or unclaimed property. Under certain circumstances, the Fund may be legally obligated to escheat (or transfer) an investor's account to
the appropriate state's unclaimed property administrator. The Fund will not be liable to investors or their representatives for good faith compliance
with state unclaimed or abandoned property (escheatment) laws.
Escheatment laws vary by state, and states have different criteria for defining inactivity and abandoned property. Generally, a closed-end account may
be subject to “escheatment” (i.e., considered to be abandoned or unclaimed property) if the account owner has not initiated any activity in the
account or contacted the fund for an “inactivity period” as specified in applicable state laws. Typically, an investor's last known address of record
determines the state that has jurisdiction.
The process described above, and the application of state escheatment laws, may vary depending on how shareholders hold their shares in the Fund.
Market and Net Asset Value Information
The Fund’s Common Shares are listed on the NYSE under the trading or “ticker” symbol “PFN”. The Fund’s Common Shares commenced trading on
the NYSE in October 2004. The Fund cannot predict whether its Common Shares will trade in the future at a premium or discount to NAV. The conduct
of any offering and the issuance of additional Common Shares pursuant to any offering may have an adverse effect on prices in the secondary market
for the Fund’s Common Shares by increasing the number of shares available, which may put downward pressure on the market price for the Common
Shares. The NAV of the Fund’s Common Shares will be reduced immediately following an offering by the sales load, commissions and offering
expenses paid or reimbursed by the Fund in connection with such offering. The completion of an offering may result in an immediate dilution of the
NAV per Common Share for all existing Common Shareholders.
The following table sets forth, for each of the periods indicated, the high and low closing market prices of the Fund’s Common Shares on the NYSE,
the high and low NAV per Common Share and the high and low premium/discount to NAV per Common Share. See “Net Asset Value” for information
as to how the Fund’s NAV is determined.
1
Such prices reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.
2
Effective April 1, 2022, the end of the Fund’s fiscal year changed from July 31 to June 30.
The Fund’s NAV per Common Share at the close of business on March 28, 2024 was $7.15 and the last reported sale price of a Common Share on
the NYSE on that day was $7.46, representing a 4.34% premium to such NAV.
Anti-Takeover and Other Provisions in the Agreement and Declaration of Trust and Bylaws
The Declaration and the Bylaws include provisions that could limit the ability of other entities or persons to acquire control of the Fund or to convert
the Fund to open-end status. The Fund’s Trustees are divided into three classes. At each annual meeting of shareholders, the term of one class will
expire and each Trustee elected to that class will hold office until the third annual meeting thereafter. The classification of the Board of Trustees in this
manner could delay for an additional year the replacement of a majority of the Board of Trustees. In addition, the Declaration provides that a Trustee
may be removed only for cause and only (i) by action of at least seventy-five percent (75%) of the outstanding shares of the classes or series of shares
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PIMCO Income Strategy Fund II
entitled to vote for the election of such Trustee, or (ii) by written instrument, signed by at least seventy-five percent (75%) of the remaining Trustees,
specifying the date when such removal shall become effective. Cause for these purposes shall require willful misconduct, dishonesty or fraud on the
part of the Trustee in the conduct of his or her office or such Trustee being convicted of a felony.
As described below, the Declaration grants special approval rights with respect to certain matters to members of the Board who qualify as
“Continuing Trustees,” which term means a Trustee who either (i) has been a member of the Board for a period of at least thirty-six months (or since
the commencement of the Fund’s operations, if less than thirty-six months) or (ii) was nominated to serve as a member of the Board of Trustees by a
majority of the Continuing Trustees then members of the Board.
The Declaration requires the affirmative vote or consent of at least seventy-five percent (75%) of the Board and holders of at least seventy-five
percent (75%) of the Fund’s shares to authorize certain Fund transactions not in the ordinary course of business, including a merger or consolidation
or share exchange, issuance or transfer by the Fund of the Fund’s shares having an aggregate fair market value of $1,000,000 or more (except as may
be made pursuant to a public offering, the Fund’s dividend reinvestment plan or upon exercise of any stock subscription rights), a sale, lease,
exchange, mortgage, pledge, transfer or other disposition of Fund assets, having an aggregated fair market value of $1,000,000 or more, or any
shareholder proposal regarding specific investment decisions, unless the transaction is authorized by both a majority of the Trustees and seventy-five
percent (75%) of the Continuing Trustees (in which case no shareholder authorization would be required by the Declaration, but may be required in
certain cases under the 1940 Act). The Declaration also requires the affirmative vote or consent of holders of at least seventy-five percent (75%) of
the Fund’s shares entitled to vote on the matter to authorize a conversion of the Fund from a closed-end to an open-end investment company, unless
the conversion is authorized by both a majority of the Trustees and seventy-five percent (75%) of the Continuing Trustees (in which case shareholders
would have only the minimum voting rights required by the 1940 Act with respect to the conversion). Also, the Declaration provides that the Fund
may be terminated at any time by vote or consent of at least seventy-five percent (75%) of the Fund’s shares or, alternatively, by vote or consent of
both a majority of the Trustees and seventy-five percent (75%) of the Continuing Trustees. See “Anti-Takeover and Other Provisions in the Declaration
of Trust” in the Statement of Additional Information for a more detailed summary of these provisions. The Trustees may from time to time grant other
voting rights to shareholders with respect to these and other matters in the Bylaws, certain of which are required by the 1940 Act.
The overall effect of these provisions is to render more difficult the accomplishment of a merger or the assumption of control of the Fund by a third
party. These provisions also provide, however, the advantage of potentially requiring persons seeking control of the Fund to negotiate with its
management regarding the price to be paid and facilitating the continuity of the Fund’s investment objective and policies. The provisions of the
Declaration and Bylaws described above could have the effect of depriving the Common Shareholders of opportunities to sell their Common Shares at
a premium over the then current market price of the Common Shares by discouraging a third party from seeking to obtain control of the Fund in a
tender offer or similar transaction. The Board has considered the foregoing anti-takeover provisions and concluded that they are in the best interests
of the Fund and its shareholders, including Common Shareholders.
The foregoing is intended only as a summary and is qualified in its entirety by reference to the full text of the Declaration and the Bylaws, both of
which are on file with the SEC.
Shareholder Liability
Under Massachusetts law, shareholders could, in certain circumstances, be held personally liable for the obligations of the Fund. However, the
Declaration contains an express disclaimer of shareholder liability for debts or obligations of the Fund and requires that notice of such limited liability
be given in each agreement, obligation or instrument entered into or executed by the Fund or the Trustees. The Declaration further provides for
indemnification out of the assets and property of the Fund for all loss and expense of any shareholder held personally liable for the obligations of the
Fund. Thus, the risk of a shareholder incurring financial loss on account of shareholder liability is limited to circumstances in which the Fund would be
unable to meet its obligations. The Fund believes that the likelihood of such circumstances is remote.
Derivative and Direct Claims of Shareholders
A shareholder may not bring or maintain any court action, proceeding or claim on behalf of the Fund or any series or class of shares without first
making demand on the Trustees requesting the Trustees to bring or maintain such action, proceeding or claim. Such demand shall not be excused
under any circumstances, including claims of alleged interest on the part of the Trustees, unless the plaintiff makes a specific showing that irreparable
nonmonetary injury to the Trust or series or class of shares would otherwise result. The Trustees shall consider such demand within 45 days of its
receipt by the Fund. In their sole discretion, the Trustees may submit the matter to a vote of shareholders of the Fund or a series or class of shares, as
appropriate. Any decision by the Trustees to bring, maintain or settle (or not to bring, maintain or settle) such court action, proceeding or claim, or to
submit the matter to a vote of shareholders shall be made by the Trustees in their business judgment and shall be binding upon the shareholders.
A shareholder or group of shareholders may not bring or maintain a direct action or claim for monetary damages against the Fund or the Trustees
predicated upon an express or implied right of action under the Declaration or the 1940 Act (excepting rights of action permitted under Section 36(b)
of the 1940 Act) , nor shall any single shareholder, who is similarly situated to one or more other shareholders with respect to the alleged injury, have
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the right to bring such an action, unless such group of shareholders or shareholder has obtained authorization from the Trustees to bring the action.
The requirement of authorization shall not be excused under any circumstances, including claims of alleged interest on the part of the Trustees. The
Trustees shall consider such request within 45 days of its receipt by the Fund. In their sole discretion, the Trustees may submit the matter to a vote of
shareholders of the Fund or series or class of shares, as appropriate. Any decision by the Trustees to settle or to authorize (or not to settle or to
authorize) such court action, proceeding or claim, or to submit the matter to a vote of shareholders, shall be made in their business judgment and
shall be binding on all shareholders. Any person purchasing or otherwise acquiring or holding any interest in shares of beneficial interest of the Fund
will be deemed to have notice of and consented to the foregoing provisions. These provisions may limit a shareholder's ability to bring a claim against
the Trustees, officers or other agents of the Fund and its service providers, which may discourage such lawsuits with respect to such claims.
These provisions in the Declaration regarding derivative and direct claims of shareholders shall not apply to claims made under federal securities laws.
Repurchase of Common Shares; Conversion to Open-End Fund
The Fund is a closed-end investment company and as such its shareholders will not have the right to cause the Fund to redeem their shares. Instead,
the Common Shares will trade in the open market at a price that will be a function of factors relating to the Fund such as dividend levels and stability
(which will in turn be affected by Fund expenses, including the costs of reverse repurchase agreements, dollar rolls/buybacks, borrowings and other
leverage used by the Fund, levels of dividend and interest payments by the Fund’s portfolio holdings, levels of appreciation/depreciation of the Fund’s
portfolio holdings, regulation affecting the timing and character of the Fund’s distributions and other factors), portfolio credit quality, liquidity, call
protection, market supply and demand and similar factors relating to the Fund’s portfolio holdings. The market price of the Common Shares may also
be affected by general market or economic conditions, including market trends affecting securities values generally or values of closed-end fund
shares more specifically. Shares of a closed-end investment company may frequently trade at prices lower than NAV. The Fund’s Board of Trustees
regularly monitors the relationship between the market price and NAV of the Common Shares. If the Common Shares were to trade at a substantial
discount to NAV for an extended period of time, the Board of Trustees may consider the repurchase of its Common Shares on the open market or in
private transactions, the making of a tender offer for such shares or the conversion of the Fund to an open-end investment company. The Fund cannot
assure you that its Board of Trustees will decide to take or propose any of these actions, or that share repurchases or tender offers will actually reduce
any market discount. See “Tax Matters” in the Statement of Additional Information for a discussion of the tax implications of a tender offer by the
Fund.
If the Fund were to convert to an open-end company, it would be required to repurchase all Preferred Shares then outstanding (requiring in turn that
it liquidate a portion of its investment portfolio), the Common Shares likely would no longer be listed on the NYSE. In contrast to a closed-end
investment company, shareholders of an open-end investment company may require the company to redeem their shares at any time (except in
certain circumstances as authorized by or under the 1940 Act) at their NAV, less any redemption charge that is in effect at the time of redemption.
Before deciding whether to take any action to convert the Fund to an open-end investment company, the Board of Trustees would consider all
relevant factors, including the extent and duration of the discount, the liquidity of the Fund’s portfolio, the impact of any action that might be taken
on the Fund or its shareholders, and market considerations. Based on these considerations, even if the Common Shares should trade at a discount, the
Board of Trustees may determine that, in the interest of the Fund and its shareholders, no action should be taken. See the Statement of Additional
Information under “Repurchase of Common Shares; Conversion to Open-End Fund” for a further discussion of possible action to reduce or eliminate
any such discount to NAV.
Tax Matters
This section summarizes some of the U.S. federal income tax consequences to U.S. persons of investing in the Fund; the consequences under other tax
laws and to non-U.S. shareholders may differ. Shareholders should consult their tax advisors as to the possible application of federal, state, local or
non-U.S. income tax laws. This summary is based on the Code, U.S. Treasury regulations, and other applicable authority, all as of the date of this
prospectus. Please see the Statement of Additional Information for additional information regarding the tax aspects of investing in the Fund.
Taxation of the Fund
The Fund has elected to be treated, and intends each year to qualify and be eligible to be treated, as a RIC under Subchapter M of the Code. A RIC is
not subject to U.S. federal income tax at the corporate level on income and gains from investments that are distributed in a timely manner to
shareholders in the form of dividends. The Fund’s failure to qualify as a RIC would result in corporate-level taxation, thereby reducing the return on
your investment.
As described under “Use of Leverage” above, if at any time when preferred shares or other senior securities are outstanding the Fund does not meet
applicable asset coverage requirements, it will be required to suspend distributions to Common Shareholders until the requisite asset coverage is
restored. Any such suspension may cause the Fund to pay a U.S. federal income and excise tax on undistributed income or gains and may, in certain
circumstances, prevent the Fund from qualifying for treatment as a RIC. The Fund may repurchase or otherwise retire preferred shares or other senior
securities, as applicable, in an effort to comply with the distribution requirement applicable to RICs.
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PIMCO Income Strategy Fund II
Distributions
The Fund intends to make monthly distributions of net investment income. A shareholder subject to U.S. federal income tax will generally be subject to
tax on Fund distributions. A RIC may report certain dividends as derived from “qualified dividend income,” which, when received by a non-corporate
shareholder, will be taxed at the rates applicable to net capital gain, provided holding period and other requirements are met at both the shareholder
and fund levels. The Fund does not expect a significant portion of distributions to be derived from qualified dividend income. For U.S. federal income
tax purposes, Fund distributions will generally be taxable to a shareholder as either ordinary income or capital gains. Fund dividends consisting of
distributions of investment income generally are taxable to shareholders as ordinary income. Federal taxes on Fund distributions of capital gains are
determined by how long the Fund owned or is deemed to have owned the investments that generated the capital gains, rather than how long a
shareholder has owned its shares of the Fund. Distributions of net capital gains (that is, the excess of net long-term capital gains over net short-term
capital losses, in each case determined with reference to any loss carryforwards) that are properly reported by the Fund as capital gain dividends
(“Capital Gain Dividends”) generally will be treated as long-term capital gains includible in a shareholder’s net capital gains and taxed to individuals
at reduced rates. The Fund does not expect a significant portion of its distributions to be treated as long-term capital gains. Distributions of net
short-term capital gains in excess of net long-term capital losses generally will be taxable to shareholders as ordinary income.
Section 1411 of the Code generally imposes a 3.8% Medicare contribution tax on the “net investment income” of certain individuals, trusts and
estates to the extent their modified adjusted gross income exceeds certain threshold amounts. Net investment income generally includes for this
purpose dividends paid by the Fund, including any capital gain dividends and including any net capital gains recognized on the sale, redemption or
exchange of shares of the Fund. Shareholders are advised to consult their tax advisors regarding the possible implications of this additional tax on
their investment in the Fund.
Distributions by the Fund to its shareholders that the Fund properly reports as “section 199A dividends,” as defined and subject to certain conditions
described in the Statement of Additional Information, are treated as qualified REIT dividends in the hands of non-corporate shareholders, for which a
deduction may be available. See “Fund Distributions” in the Statement of Additional Information for further details.
The ultimate tax characterization of the Fund’s distributions made in a taxable year cannot be determined finally until after the end of that taxable
year. As a result, there is a possibility that the Fund may make total distributions during a taxable year in an amount that exceeds the Fund’s current
and accumulated earnings and profits. In that case, the excess generally would be treated as return of capital and would reduce the shareholders’ tax
basis in the applicable shares, with any amounts exceeding such basis treated as gain from the sale of such shares. A return of capital is not taxable,
but it reduces a shareholder’s tax basis in the shares, thus reducing any loss or increasing any gain on a subsequent taxable disposition by the
shareholder of the shares.
Fund distributions are taxable to shareholders as described above even if they are paid from income or gains earned by the Fund before a
shareholder’s investment (and thus were included in the price the shareholder paid).
A shareholder whose distributions are reinvested in Common Shares of the Fund under the Plan will be treated as having received a dividend equal to
either (i) if newly issued Common Shares are issued under the Plan, generally the fair market value of the newly issued Common Shares issued to the
Common Shareholder or (ii) if reinvestment is made through open-market purchases under the Plan, the amount of cash allocated to the Common
Shareholder for the purchase of Common Shares on its behalf in the open market. See “Dividend Reinvestment Plan” above.
The IRS currently requires a RIC that the IRS recognizes as having two or more “classes” of stock for U.S. federal income tax purposes to allocate to
each such class proportionate amounts of each type of its income (such as ordinary income and capital gains) based upon the percentage of total
dividends distributed to each class for the tax year. Accordingly, as and when applicable, the Fund intends each tax year to allocate capital gain
dividends between and among its Common Shares and each series of its preferred shares in proportion to the total dividends paid to each class with
respect to such tax year. Dividends qualifying and not qualifying for the dividends received deduction or as qualified dividend income will similarly be
allocated between and among Common Shares and each series of Preferred Shares, then outstanding.
Taxes When You Dispose of Your Shares
Any gain resulting from the sale or other disposition of Fund shares that is treated as a sale or exchange for U.S. federal income tax purposes
generally will be taxable to shareholders as capital gains for U.S. federal income tax purposes.
In the event that the Fund repurchases a shareholder’s Common Shares (as described above), shareholders who offer, and are able to sell all of the
shares they hold or are deemed to hold in response to such repurchase offer generally will be treated as having sold their shares and generally will
recognize a capital gain or loss. In the case of shareholders who tender or are able to sell fewer than all of their shares, it is possible that any amounts
that the shareholder receives in such repurchase will be taxable as a dividend to such shareholder. Shares actually owned, as well as shares
constructively owned under Section 318 of the Code, will generally be taken into account for purposes of the foregoing rules. In addition, there is a
risk that shareholders who do not tender any of their shares for repurchase, or whose percentage interest in the Fund otherwise increases as a result
of the tender offer, will be treated for U.S. federal income tax purposes as having received a taxable dividend distribution as a result of their
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| PIMCO Income Strategy Fund II
Base Prospectus
proportionate increase in the ownership of the Fund. The Fund’s use of cash to repurchase shares could adversely affect its ability to satisfy the
distribution requirements for treatment as a regulated investment company. The Fund could also recognize income in connection with its liquidation
of portfolio securities to fund share repurchases. Any such income would be taken into account in determining whether such distribution requirements
are satisfied.
Foreign (Non-U.S.) Taxes
Income received by the Fund from sources within foreign countries may be subject to withholding and other taxes imposed by such countries, which
will reduce the return on those investments. If, at the close of its taxable year, more than 50% of the value of the Fund’s total assets consists of
securities of foreign corporations including for this purpose foreign governments, the Fund will be permitted to make an election under the Code that
would allow shareholders to claim a deduction or credit on their income returns for their pro rata portions of qualified foreign taxes paid by the Fund.
If the Fund does not qualify for or chooses not to make such an election, shareholders generally will not be entitled separately to claim a credit or
deduction for U.S. federal income tax purposes with respect to foreign taxes paid by the Fund; in that case the foreign tax will nonetheless reduce the
Fund’s taxable income. Even if the Fund elects to pass through to its shareholders foreign tax credits or deductions, tax-exempt shareholders and
those who invest in the Fund through tax-advantaged accounts such as IRAs will not benefit from any such tax credit or deduction. In addition, the
Fund’s investments in non-U.S. securities (other than equity securities) or foreign currencies may increase or accelerate the Fund’s recognition of
ordinary income and may affect the timing or amount of the Fund’s distributions.
Certain Fund Investments
The Fund’s transactions in foreign currencies, foreign-currency denominated debt obligations, derivatives, short sales, or similar or related transactions
could affect the amount, timing, or character of distributions from the Fund, and could increase the amount and accelerate the timing for payment of
taxes payable by shareholders. The Fund’s investments in certain debt instruments could cause the Fund to recognize taxable income in excess of the
cash generated by such investments (which may require the Fund to sell other investments in order to make required distributions, including when it
is not advantageous to do so).
Backup Withholding
The Fund is generally required to withhold and remit to the U.S. Treasury a percentage of the taxable distributions and redemption proceeds, if any,
paid to any shareholder who fails to properly furnish the Fund with a correct taxpayer identification number, who has under-reported dividend or
interest income, or who fails to certify to the Fund that he, she or it is not subject to such withholding. The backup withholding rules may also apply to
distributions that are properly reported as exempt-interest dividends.
Shares Purchased Through Tax-Advantaged Plans
Special tax rules apply to investments through defined contribution plans and other tax-advantaged plans. Common Shareholders should consult
their tax advisors to determine the suitability of the Fund’s Common Shares as an investment through such plans and the precise effect of an
investment on their particular tax situation.
General
The foregoing discussion relates solely to U.S. federal income tax laws. Dividends and distributions also may be subject to state and local taxes.
Common Shareholders are urged to consult their tax advisors regarding specific questions as to federal, state, local, and, where applicable, foreign
taxes. Foreign investors should consult their tax advisors concerning the tax consequences of ownership of Common Shares of the Fund.
The foregoing is a general and abbreviated summary of the applicable provisions of the Code and related regulations currently in effect. For the
complete provisions, reference should be made to the pertinent Code sections and regulations. The Code and regulations are subject to change by
legislative or administrative actions.
Please see “Taxation” in the Statement of Additional Information for additional information regarding the tax aspects of investing in Common Shares
of the Fund.
Custodian, Transfer Agent, Shareholder Servicing Agent, Auction Agent and Dividend Disbursement Agent
The custodian of the assets of the Fund is State Street Bank and Trust Company, 801 Pennsylvania Avenue, Kansas City, Missouri 64105. The
custodian performs custodial and fund accounting services as well as sub-administrative services on behalf of the Fund.
Equiniti Trust Company, LLC, 48 Wall Street, Floor 23, New York, New York 10005, serves as the Fund’s transfer agent, registrar, dividend
disbursement agent and shareholder servicing agent, as well as agent for the Fund’s Dividend Reinvestment Plan.
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PIMCO Income Strategy Fund II
The Investment Manager, at its own expense, has retained Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner & Smith Incorporated and UBS Securities
LLC to serve as shareholder servicing agents for the Fund.
Deutsche Bank Trust Company Americas, 60 Wall Street, New York, New York 10005, serves as auction agent, transfer agent, registrar, dividend
paying agent and redemption agent for the Preferred Shares.
Independent Registered Public Accounting Firm
PwC, 1100 Walnut Street, Suite 1300, Kansas City, MO 64106, serves as independent registered public accounting firm for the Fund. PwC provides
audit services, tax and other audit related services to the Fund.
Legal Matters
Certain legal matters will be passed on for the Fund by Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, Massachusetts 02199.
Incorporation by Reference
As noted above, this prospectus is part of a registration statement filed with the SEC. The Fund is permitted to “incorporate by reference” the
information filed with the SEC, which means that the Fund can disclose important information to you by referring you to those documents. In
addition, all documents subsequently filed by the Fund pursuant to Sections 13(a), 13(c), 14 or 15(d) of the Securities Exchange Act of 1934, as
amended (the “Exchange Act”), (excluding any information furnished rather than filed) prior to the termination of the offering shall be deemed to be
incorporated by reference into the prospectus and the Statement of Additional Information. The information incorporated by reference is an important
part of this prospectus. Any statement in a document incorporated by reference into this prospectus will be deemed to be automatically modified or
superseded to the extent a statement contained in (1) this prospectus or (2) any other subsequently filed document that is incorporated by reference
into this prospectus modifies or supersedes such statement. The documents incorporated by reference herein include:
■
the Fund’s Statement of Additional Information, dated [ ], 2024, filed with this Prospectus;
■
the Fund's Semi-Annual Report on
Form N-CSRS
, filed on March 5, 2024;
■
■
You may obtain copies of any information incorporated by reference into this prospectus, at no charge, by calling toll-free (844) 33-PIMCO
(844-337-4626) or by writing to the Fund at c/o Pacific Investment Management Company LLC, 1633 Broadway, New York, New York 10019. The
Fund’s periodic reports filed pursuant to Section 30(b)(2) of the 1940 Act and Sections 13 and 15(d) of the Exchange Act, as well as this prospectus
and the Statement of Additional Information, are available on the Fund’s website http://www.pimco.com/prospectuses. In addition, the SEC maintains
a website at www.sec.gov, free of charge that contains these reports, the Fund’s proxy and information statements, and other information relating to
the Fund.
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Appendix A
Description of Securities Ratings
The Fund’s investments may range in quality from securities rated in the
lowest category in which the Fund is permitted to invest to securities
rated in the highest category (as rated by Moody’s, Standard & Poor’s or
Fitch, or, if unrated, determined by PIMCO to be of comparable quality).
The percentage of the Fund’s assets invested in securities in a particular
rating category will vary. The following terms are generally used to
describe the credit quality of fixed income securities:
High Quality Debt Securities
are those rated in one of the two highest
rating categories (the highest category for commercial paper) or, if
unrated, deemed comparable by PIMCO.
Investment Grade Debt Securities
are those rated in one of the four
highest rating categories, or, if unrated, deemed comparable by PIMCO.
Below Investment Grade High Yield Securities (“Junk Bonds”),
are
those rated lower than Baa by Moody’s, BBB by Standard & Poor’s or
Fitch, and comparable securities. They are deemed predominantly
speculative with respect to the issuer’s ability to repay principal and
interest.
The following is a description of Moody’s, Standard & Poor’s and Fitch’s
rating categories applicable to fixed income securities.
Moody’s Investors Service, Inc.
Global Long-Term Rating Scale
Ratings assigned on Moody’s global long-term rating scales are
forward-looking opinions of the relative credit risks of financial
obligations issued by non-financial corporates, financial institutions,
structured finance vehicles, project finance vehicles, and public sector
entities. Long-term ratings are assigned to issuers or obligations with an
original maturity of eleven months or more and reflect both on the
likelihood of a default or impairment on contractual financial
obligations and the expected financial loss suffered in the event of
default or impairment.
Aaa: Obligations rated Aaa are judged to be of the highest quality,
subject to the lowest level of credit risk.
Aa: Obligations rated Aa are judged to be of high quality and are
subject to very low credit risk.
A: Obligations rated A are judged to be upper-medium grade and are
subject to low credit risk.
Baa: Obligations rated Baa are judged to be medium-grade and subject
to moderate credit risk and as such may possess certain speculative
characteristics.
Ba: Obligations rated Ba are judged to be speculative and are subject to
substantial credit risk.
B: Obligations rated B are considered speculative and are subject to
high credit risk.
Caa: Obligations rated Caa are judged to be speculative of poor
standing and are subject to very high credit risk.
Ca: Obligations rated Ca are highly speculative and are likely in, or very
near, default, with some prospect of recovery of principal and interest.
C: Obligations rated C are the lowest rated and are typically in default,
with little prospect for recovery of principal or interest.
Moody’s appends numerical modifiers 1, 2, and 3 to each generic rating
classification from Aa through Caa. The modifier 1 indicates that the
obligation ranks in the higher end of its generic rating category; the
modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a
ranking in the lower end of that generic rating category. Additionally, a
“(hyb)” indicator is appended to all ratings of hybrid securities issued by
banks, insurers, finance companies, and securities firms.*
* By their terms, hybrid securities allow for the omission of scheduled
dividends, interest, or principal payments, which can potentially result in
impairment if such an omission occurs. Hybrid securities may also be
subject to contractually allowable write-downs of principal that could
result in impairment. Together with the hybrid indicator, the long-term
obligation rating assigned to a hybrid security is an expression of the
relative credit risk associated with that security.
Medium-Term Note Program Ratings
Moody’s assigns provisional ratings to medium-term note (MTN) or
similar programs and definitive ratings to the individual debt securities
issued from them (referred to as drawdowns or notes).
MTN program ratings are intended to reflect the ratings likely to be
assigned to drawdowns issued from the program with the specified
priority of claim (
e.g.
, senior or subordinated). To capture the contingent
nature of a program rating, Moody’s assigns provisional ratings to MTN
programs. A provisional rating is denoted by a (P) in front of the rating.
The rating assigned to a drawdown from a rated MTN or bank/deposit
note program is definitive in nature, and may differ from the program
rating if the drawdown is exposed to additional credit risks besides the
issuer’s default, such as links to the defaults of other issuers, or has
other structural features that warrant a different rating. In some
circumstances, no rating may be assigned to a drawdown.
Moody’s encourages market participants to contact Moody’s Ratings
Desks or visit www.moodys.com directly if they have questions
regarding ratings for specific notes issued under a medium-term note
program. Unrated notes issued under an MTN program may be assigned
an NR (not rated) symbol.
Global Short-Term Rating Scale
Ratings assigned on Moody’s global short-term rating scales are
forward-looking opinions of the relative credit risks of financial
obligations issued by non-financial corporates, financial institutions,
structured finance vehicles, project finance vehicles, and public sector
entities. Short-term ratings are assigned to obligations with an original
maturity of thirteen months or less and reflect both on the likelihood of
a default or impairment on contractual financial obligations and the
expected financial loss suffered in the event of default or impairment.
Moody’s employs the following designations to indicate the relative
repayment ability of rated issuers:
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PIMCO Income Strategy Fund II
P-1: Ratings of Prime-1 reflect a superior ability to repay short-term
obligations.
P-2: Ratings of Prime-2 reflect a strong ability to repay short-term
obligations.
P-3: Ratings of Prime-3 reflect an acceptable ability to repay short-term
obligations.
NP: Issuers (or supporting institutions) rated Not Prime do not fall within
any of the Prime rating categories.
National Scale Long-Term Ratings
Moody’s long-term National Scale Ratings (NSRs) are opinions of the
relative creditworthiness of issuers and financial obligations within a
particular country. NSRs are not designed to be compared among
countries; rather, they address relative credit risk within a given country.
Moody’s assigns national scale ratings in certain local capital markets in
which investors have found the global rating scale provides inadequate
differentiation among credits or is inconsistent with a rating scale
already in common use in the country.
In each specific country, the last two characters of the rating indicate
the country in which the issuer is located or the financial obligation was
issued (
e.g.,
Aaa.ke for Kenya).
Aaa.n: Issuers or issues rated Aaa.n demonstrate the strongest
creditworthiness relative to other domestic issuers and issuances.
Aa.n: Issuers or issues rated Aa.n demonstrate very strong
creditworthiness relative to other domestic issuers and issuances.
A.n: Issuers or issues rated A.n present above-average creditworthiness
relative to other domestic issuers and issuances.
Baa.n: Issuers or issues rated Baa.n represent average creditworthiness
relative to other domestic issuers and issuances.
Ba.n: Issuers or issues rated Ba.n demonstrate below-average
creditworthiness relative to other domestic issuers and issuances.
B.n: Issuers or issues rated B.n demonstrate weak creditworthiness
relative to other domestic issuers and issuances.
Caa.n: Issuers or issues rated Caa.n demonstrate very weak
creditworthiness relative to other domestic issuers and issuances.
Ca.n: Issuers or issues rated Ca.n demonstrate extremely weak
creditworthiness relative to other domestic issuers and issuances.
C.n: Issuers or issues rated C.n demonstrate the weakest
creditworthiness relative to other domestic issuers and issuances.
Moody’s appends numerical modifiers 1, 2, and 3 to each generic rating
classification from Aa through Caa. The modifier 1 indicates that the
obligation ranks in the higher end of its generic rating category; the
modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a
ranking in the lower end of that generic rating category.
National Scale Short-Term Ratings
Moody’s short-term NSRs are opinions of the ability of issuers or
issuances in a given country, relative to other domestic issuers or
issuances, to repay debt obligations that have an original maturity not
exceeding thirteen months. Short-term NSRs in one country should not
be compared with short-term NSRs in another country, or with Moody’s
global ratings. There are four categories of short-term national scale
ratings, generically denoted N-1 through N-4 as defined below.
In each specific country, the first two letters indicate the country in
which the issuer is located (
e.g.
, KE-1 through KE-4 for Kenya).
N-1: N-1 issuers or issuances represent the strongest likelihood of
repayment of short-term debt obligations relative to other domestic
issuers or issuances.
N-2: N-2 issuers or issuances represent an above average likelihood of
repayment of short-term debt obligations relative to other domestic
issuers or issuances.
N-3: N-3 issuers or issuances represent an average likelihood of
repayment of short-term debt obligations relative to other domestic
issuers or issuances.
N-4: N-4 issuers or issuances represent a below average likelihood of
repayment of short-term debt obligations relative to other domestic
issuers or issuances.
The short-term rating symbols P-1.za, P-2.za, P-3.za and NP.za are used
in South Africa.
Short-Term Obligation Ratings
The Municipal Investment Grade (MIG) scale is used for US municipal
cash flow notes, bond anticipation notes and certain other short-term
obligations, which typically mature in three years or less. Under certain
circumstances, the MIG scale is used for bond anticipation notes with
maturities of up to five years.
MIG 1: This designation denotes superior credit quality. Excellent
protection is afforded by established cash flows, highly reliable liquidity
support, or demonstrated broad-based access to the market for
refinancing.
MIG 2: This designation denotes strong credit quality. Margins of
protection are ample, although not as large as in the preceding group.
MIG 3: This designation denotes acceptable credit quality. Liquidity and
cash-flow protection may be narrow, and market access for refinancing
is likely to be less well-established.
SG: This designation denotes speculative-grade credit quality. Debt
instruments in this category may lack sufficient margins of protection.
Demand Obligation Ratings
In the case of variable rate demand obligations (VRDOs), a
two-component rating is assigned. The components are a long-term
rating and a short-term demand obligation rating. The long-term rating
addresses the issuer’s ability to meet scheduled principal and interest
payments. The short-term demand obligation rating addresses the ability
of the issuer or the liquidity provider to make payments associated with
the purchase-price-upon-demand feature (“demand feature”) of the
VRDO. The short-term demand obligation rating uses the Variable
Municipal Investment Grade (VMIG) scale.
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| PIMCO Income Strategy Fund II
Base Prospectus
VMIG 1: This designation denotes superior credit quality. Excellent
protection is afforded by the superior short-term credit strength of the
liquidity provider and structural and legal protections.
VMIG 2: This designation denotes strong credit quality. Good protection
is afforded by the strong short-term credit strength of the liquidity
provider and structural and legal protections.
VMIG 3: This designation denotes acceptable credit quality. Adequate
protection is afforded by the satisfactory short-term credit strength of
the liquidity provider and structural and legal protections.
SG: This designation denotes speculative-grade credit quality. Demand
features rated in this category may be supported by a liquidity provider
that does not have a sufficiently strong short-term rating or may lack
the structural or legal protections.
Standard & Poor’s Ratings Services
Long-Term Issue Credit Ratings
Issue credit ratings are based, in varying degrees, on S&P Global
Ratings’ (“S&P”) analysis of the following considerations:
■
Likelihood of payment—capacity and willingness of the obligor to
meet its financial commitments on an obligation in accordance
with the terms of the obligation;
■
Nature and provisions of the financial obligation and the promise
S&P imputes; and
■
Protection afforded by, and relative position of, the financial
obligation in the event of a bankruptcy, reorganization, or other
arrangement under the laws of bankruptcy and other laws
affecting creditors’ rights.
Issue ratings are an assessment of default risk, but may incorporate an
assessment of relative seniority or ultimate recovery in the event of
default. Junior obligations are typically rated lower than senior
obligations, to reflect lower priority in bankruptcy, as noted above. (Such
differentiation may apply when an entity has both senior and
subordinated obligations, secured and unsecured obligations, or
operating company and holding company obligations.)
Investment Grade
AAA: An obligation rated ‘AAA’ has the highest rating assigned by S&P.
The obligor’s capacity to meet its financial commitments on the
obligation is extremely strong.
AA: An obligation rated ‘AA’ differs from the highest-rated obligations
only to a small degree. The obligor’s capacity to meet its financial
commitments on the obligation is very strong.
A: An obligation rated ‘A’ is somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than
obligations in higher-rated categories. However, the obligor’s capacity to
meet its financial commitments on the obligation is still strong.
BBB: An obligation rated ‘BBB’ exhibits adequate protection parameters.
However, adverse economic conditions or changing circumstances are
more likely to weaken the obligor’s capacity to meet its financial
commitments on the obligation.
Speculative Grade
Obligations rated ‘BB’, ‘B’, ‘CCC’, ‘CC’, and ‘C’ are regarded as having
significant speculative characteristics. ‘BB’ indicates the least degree of
speculation and ‘C’ the highest. While such obligations will likely have
some quality and protective characteristics, these may be outweighed by
large uncertainties or major exposure to adverse conditions.
BB: An obligation rated ‘BB’ is less vulnerable to nonpayment than other
speculative issues. However, it faces major ongoing uncertainties or
exposure to adverse business, financial, or economic conditions that
could lead to the obligor’s inadequate capacity to meet its financial
commitments on the obligation.
B: An obligation rated ‘B’ is more vulnerable to nonpayment than
obligations rated ‘BB’, but the obligor currently has the capacity to meet
its financial commitments on the obligation. Adverse business, financial,
or economic conditions will likely impair the obligor’s capacity or
willingness to meet its financial commitments on the obligation.
CCC: An obligation rated ‘CCC’ is currently vulnerable to nonpayment,
and is dependent upon favorable business, financial, and economic
conditions for the obligor to meet its financial commitments on the
obligation. In the event of adverse business, financial, or economic
conditions, the obligor is not likely to have the capacity to meet its
financial commitments on the obligation.
CC: An obligation rated ‘CC’ is currently highly vulnerable to
nonpayment. The ‘CC’ rating is used when a default has not yet
occurred, but S&P expects default to be a virtual certainty, regardless of
the anticipated time to default.
C: An obligation rated ‘C’ is currently highly vulnerable to nonpayment,
and the obligation is expected to have lower relative seniority or lower
ultimate recovery compared with obligations that are rated higher.
D: An obligation rated ‘D’ is in default or in breach of an imputed
promise. For non-hybrid capital instruments, the ‘D’ rating category is
used when payments on an obligation are not made on the date due,
unless S&P believes that such payments will be made within the next
five business days in the absence of a stated grace period or within the
earlier of the stated grace period or the next 30 calendar days. The ‘D’
rating also will be used upon the filing of a bankruptcy petition or the
taking of similar action and where default on an obligation is a virtual
certainty, for example due to automatic stay provisions. A rating on an
obligation is lowered to ‘D’ if it is subject to a distressed debt
restructuring.
NR: This indicates that a rating has not been assigned or is no longer
assigned.
Plus (+) or minus (-): The ratings from ‘AA’ to ‘CCC’ may be modified by
the addition of a plus (+) or minus (-) sign to show relative standing
within the rating categories.
[], 2024 |
Base Prospectus
A-3
PIMCO Income Strategy Fund II
Short-Term Issue Credit Ratings
A-1: A short-term obligation rated ‘A-1’ is rated in the highest category
by S&P. The obligor’s capacity to meet its financial commitments on the
obligation is strong. Within this category, certain obligations are
designated with a plus sign (+). This indicates that the obligor’s capacity
to meet its financial commitments on these obligations is extremely
strong.
A-2: A short-term obligation rated ‘A-2’ is somewhat more susceptible
to the adverse effects of changes in circumstances and economic
conditions than obligations in higher rating categories. However, the
obligor’s capacity to meet its financial commitments on the obligation is
satisfactory.
A-3: A short-term obligation rated ‘A-3’ exhibits adequate protection
parameters. However, adverse economic conditions or changing
circumstances are more likely to weaken an obligor’s capacity to meet
its financial commitments on the obligation.
B: A short-term obligation rated ‘B’ is regarded as vulnerable and has
significant speculative characteristics. The obligor currently has the
capacity to meet its financial commitments; however, it faces major
ongoing uncertainties that could lead to the obligor’s inadequate
capacity to meet its financial commitments.
C: A short-term obligation rated ‘C’ is currently vulnerable to
nonpayment and is dependent upon favorable business, financial, and
economic conditions for the obligor to meet its financial commitments
on the obligation.
D: A short-term obligation rated ‘D’ is in default or in breach of an
imputed promise. For non-hybrid capital instruments, the ‘D’ rating
category is used when payments on an obligation are not made on the
date due, unless S&P believes that such payments will be made within
any stated grace period. However, any stated grace period longer than
five business days will be treated as five business days. The ‘D’ rating
also will be used upon the filing of a bankruptcy petition or the taking
of a similar action and where default on an obligation is a virtual
certainty, for example due to automatic stay provisions. A rating on an
obligation is lowered to ‘D’ if it is subject to a distressed debt
restructuring.
Dual Ratings: Dual ratings may be assigned to debt issues that have a
put option or demand feature. The first component of the rating
addresses the likelihood of repayment of principal and interest as due,
and the second component of the rating addresses only the demand
feature. The first component of the rating can relate to either a
short-term or long-term transaction and accordingly use either
short-term or long-term rating symbols. The second component of the
rating relates to the put option and is assigned a short-term rating
symbol (for example, ‘AAA/A-1+‘ or ‘A-1+/ A-1’). With U.S. municipal
short-term demand debt, the U.S. municipal short-term note rating
symbols are used for the first component of the rating (for example,
‘SP-1+/A-1+‘).
Active Qualifiers
S&P uses the following qualifiers that limit the scope of a rating. The
structure of the transaction can require the use of a qualifier such as a
‘p’ qualifier, which indicates the rating addresses the principal portion of
the obligation only. A qualifier appears as a suffix and is part of the
rating.
L: Ratings qualified with ‘L’ apply only to amounts invested up to federal
deposit insurance limits.
p: This suffix is used for issues in which the credit factors, the terms, or
both, that determine the likelihood of receipt of payment of principal are
different from the credit factors, terms or both that determine the
likelihood of receipt of interest on the obligation. The ‘p’ suffix indicates
that the rating addresses the principal portion of the obligation only and
that the interest is not rated.
prelim: Preliminary ratings, with the ‘prelim’ suffix, may be assigned to
obligors or obligations, including financial programs, in the
circumstances described below. Assignment of a final rating is
conditional on the receipt by S&P of appropriate documentation. S&P
reserves the right not to issue a final rating. Moreover, if a final rating is
issued, it may differ from the preliminary rating.
■
Preliminary ratings may be assigned to obligations, most
commonly structured and project finance issues, pending receipt
of final documentation and legal opinions.
■
Preliminary ratings may be assigned to obligations that will likely
be issued upon the obligor’s emergence from bankruptcy or
similar reorganization, based on late-stage reorganization plans,
documentation, and discussions with the obligor. Preliminary
ratings may also be assigned to the obligors. These ratings
consider the anticipated general credit quality of the reorganized
or post-bankruptcy issuer as well as attributes of the anticipated
obligation(s).
■
Preliminary ratings may be assigned to entities that are being
formed or that are in the process of being independently
established when, in S&P’s opinion, documentation is close to
final. Preliminary ratings may also be assigned to the obligations
of these entities.
■
Preliminary ratings may be assigned when a previously unrated
entity is undergoing a well-formulated restructuring,
recapitalization, significant financing or other transformative
event, generally at the point that investor or lender commitments
are invited. The preliminary rating may be assigned to the entity
and to its proposed obligation(s). These preliminary ratings
consider the anticipated general credit quality of the obligor, as
well as attributes of the anticipated obligation(s), assuming
successful completion of the transformative event. Should the
transformative event not occur, S&P would likely withdraw these
preliminary ratings.
■
A preliminary recovery rating may be assigned to an obligation
that has a preliminary issue credit rating.
A-4 Base Prospectus
| PIMCO Income Strategy Fund II
Base Prospectus
t: This symbol indicates termination structures that are designed to
honor their contracts to full maturity or, should certain events occur, to
terminate and cash settle all their contracts before their final maturity
date.
cir: This symbol indicates a Counterparty Instrument Rating (CIR), which
is a forward-looking opinion about the creditworthiness of an issuer in a
securitization structure with respect to a specific financial obligation to
a counterparty (including interest rate swaps, currency swaps, and
liquidity facilities). The CIR is determined on an ultimate payment basis;
these opinions do not take into account timeliness of payment.
Inactive Qualifiers (no longer applied or outstanding)
*: This symbol indicated that the rating was contingent upon S&P
receipt of an executed copy of the escrow agreement or closing
documentation confirming investments and cash flows. Discontinued
use in August 1998.
c: This qualifier was used to provide additional information to investors
that the bank may terminate its obligation to purchase tendered bonds
if the long-term credit rating of the issuer was lowered to below an
investment-grade level and/or the issuer’s bonds were deemed taxable.
Discontinued use in January 2001.
G: The letter ‘G’ followed the rating symbol when a fund’s portfolio
consisted primarily of direct U.S. government securities.
i: This suffix was used for issues in which the credit factors, terms, or
both that determine the likelihood of receipt of payment of interest are
different from the credit factors, terms, or both that determine the
likelihood of receipt of principal on the obligation. The 'i' suffix indicated
that the rating addressed the interest portion of the obligation only. The
'i' suffix was always used in conjunction with the 'p' suffix, which
addresses likelihood of receipt of principal. For example, a rated
obligation could have been assigned a rating of 'AAApNRi' indicating
that the principal portion was rated 'AAA' and the interest portion of
the obligation was not rated.
pi: This qualifier was used to indicate ratings that were based on an
analysis of an issuer’s published financial information, as well as
additional information in the public domain. Such ratings did not,
however, reflect in-depth meetings with an issuer’s management and
therefore, could have been based on less comprehensive information
than ratings without a ‘pi’ suffix. Discontinued use as of December 2014
and as of August 2015 for Lloyd’s Syndicate Assessments.
pr: The letters ‘pr’ indicate that the rating was provisional. A provisional
rating assumed the successful completion of a project financed by the
debt being rated and indicates that payment of debt service
requirements was largely or entirely dependent upon the successful,
timely completion of the project. This rating, however, while addressing
credit quality subsequent to completion of the project, made no
comment on the likelihood of or the risk of default upon failure of such
completion.
q: A ‘q’ subscript indicates that the rating is based solely on quantitative
analysis of publicly available information. Discontinued use in April
2001.
r: The ‘r’ modifier was assigned to securities containing extraordinary
risks, particularly market risks, that are not covered in the credit rating.
The absence of an ‘r’ modifier should not be taken as an indication that
an obligation would not exhibit extraordinary noncredit-related risks.
S&P discontinued the use of the ‘r’ modifier for most obligations in June
2000 and for the balance of obligations (mainly structured finance
transactions) in November 2002.
Fitch Ratings
Long-Term Credit Ratings
Investment Grade
Rated entities in a number of sectors, including financial and
non-financial corporations, sovereigns, insurance companies and certain
sectors within public finance, are generally assigned Issuer Default
Ratings (“IDRs”). IDRs are also assigned to certain entities or
enterprises in global infrastructure, project finance, and public finance.
IDRs opine on an entity’s relative vulnerability to default (including by
way of a distressed debt exchange) on financial obligations. The
threshold default risk addressed by the IDR is generally that of the
financial obligations whose non-payment would best reflect the
uncured failure of that entity. As such, IDRs also address relative
vulnerability to bankruptcy, administrative receivership or similar
concepts.
In aggregate, IDRs provide an ordinal ranking of issuers based on the
agency’s view of their relative vulnerability to default, rather than a
prediction of a specific percentage likelihood of default.
AAA: Highest credit quality. ‘AAA’ ratings denote the lowest expectation
of default risk. They are assigned only in cases of exceptionally strong
capacity for payment of financial commitments. This capacity is highly
unlikely to be adversely affected by foreseeable events.
AA: Very high credit quality. ‘AA’ ratings denote expectations of very low
default risk. They indicate very strong capacity for payment of financial
commitments. This capacity is not significantly vulnerable to foreseeable
events.
A: High credit quality. ‘A’ ratings denote expectations of low default risk.
The capacity for payment of financial commitments is considered strong.
This capacity may, nevertheless, be more vulnerable to adverse business
or economic conditions than is the case for higher ratings.
BBB: Good credit quality. ‘BBB’ ratings indicate that expectations of
default risk are currently low. The capacity for payment of financial
commitments is considered adequate, but adverse business or economic
conditions are more likely to impair this capacity.
Speculative Grade
BB: Speculative. ‘BB’ ratings indicate an elevated vulnerability to default
risk, particularly in the event of adverse changes in business or
economic conditions over time; however, business or financial flexibility
exists that supports the servicing of financial commitments.
[], 2024 |
Base Prospectus
A-5
PIMCO Income Strategy Fund II
B: Highly speculative. ‘B’ ratings indicate that material default risk is
present, but a limited margin of safety remains. Financial commitments
are currently being met; however, capacity for continued payment is
vulnerable to deterioration in the business and economic environment.
CCC: Substantial credit risk. Very low margin for safety. Default is a real
possibility.
CC: Very high levels of credit risk. Default of some kind appears
probable.
C: Near default.
A default or default-like process has begun, or the issuer is in standstill,
or for a closed funding vehicle, payment capacity is irrevocably impaired.
Conditions that are indicative of a ‘C’ category rating for an issuer
include:
a. the issuer has entered into a grace or cure period following
non-payment of a material financial obligation;
b. the issuer has entered into a temporary negotiated waiver or
standstill agreement following a payment default on a material financial
obligation;
c. the formal announcement by the issuer or their agent of a distressed
debt exchange;
d. a closed financing vehicle where payment capacity is irrevocably
impaired such that it is not expected to pay interest and/or principal in
full during the life of the transaction, but where no payment default is
imminent
RD: Restricted default. ‘RD’ ratings indicate an issuer that in Fitch’s
opinion has experienced an uncured payment default or distressed debt
exchange on a bond, loan or other material financial obligation but has
not entered into bankruptcy filings, administration, receivership,
liquidation or other formal winding-up procedure, and has not
otherwise ceased operating. This would include:
i. the selective payment default on a specific class or currency of debt;
ii. the uncured expiry of any applicable grace period, cure period or
default forbearance period following a payment default on a bank loan,
capital markets security or other material financial obligation;
iii. the extension of multiple waivers or forbearance periods upon a
payment default on one or more material financial obligations, either in
series or in parallel; ordinary execution of a distressed debt exchange on
one or more material financial obligations.
D: Default. ‘D’ ratings indicate an issuer that in Fitch’s opinion has
entered into bankruptcy filings, administration, receivership, liquidation
or other formal winding-up procedure or that has otherwise ceased
business. Default ratings are not assigned prospectively to entities or
their obligations; within this context, non-payment on an instrument
that contains a deferral feature or grace period will generally not be
considered a default until after the expiration of the deferral or grace
period, unless a default is otherwise driven by bankruptcy or other
similar circumstance, or by a distressed debt exchange.
In all cases, the assignment of a default rating reflects the agency’s
opinion as to the most appropriate rating category consistent with the
rest of its universe of ratings, and may differ from the definition of
default under the terms of an issuer’s financial obligations or local
commercial practice.
The modifiers “+” or “-” may be appended to a rating to denote
relative status within major rating categories. For example, the rating
category ‘AA’ has three notch-specific rating levels (’AA+‘; ’AA’; ‘AA-’;
each a rating level). Such suffixes are not added to ‘AAA’ ratings and
ratings below the ‘CCC’ category.
Recovery Ratings
Recovery Ratings are assigned to selected individual securities and
obligations, most frequently for individual obligations of corporate
finance issuers with IDRs in speculative grade categories.
Among the factors that affect recovery rates for securities are the
collateral, the seniority relative to other obligations in the capital
structure (where appropriate), and the expected value of the company
or underlying collateral in distress.
The Recovery Rating scale is based on the expected relative recovery
characteristics of an obligation upon the curing of a default, emergence
from insolvency or following the liquidation or termination of the
obligor or its associated collateral.
Recovery Ratings are an ordinal scale and do not attempt to precisely
predict a given level of recovery. As a guideline in developing the rating
assessments, the agency employs broad theoretical recovery bands in its
ratings approach based on historical averages and analytical judgment,
but actual recoveries for a given security may deviate materially from
historical averages.
RR1:
Outstanding recovery prospects given default.
‘RR1’ rated
securities have characteristics consistent with securities historically
recovering 91%-100% of current principal and related interest.
RR2:
Superior recovery prospects given default.
‘RR2’ rated securities
have characteristics consistent with securities historically recovering
71%-90% of current principal and related interest.
RR3:
Good recovery prospects given default.
‘RR3’ rated securities have
characteristics consistent with securities historically recovering
51%-70% of current principal and related interest.
RR4:
Average recovery prospects given default.
‘RR4’ rated securities
have characteristics consistent with securities historically recovering
31%-50% of current principal and related interest.
RR5:
Below average recovery prospects given default.
‘RR5’ rated
securities have characteristics consistent with securities historically
recovering 11%-30% of current principal and related interest.
RR6:
Poor recovery prospects given default.
‘RR6’ rated securities have
characteristics consistent with securities historically recovering 0%-10%
of current principal and related interest.
A-6 Base Prospectus
| PIMCO Income Strategy Fund II
Base Prospectus
Short-Term Credit Ratings
A short-term issuer or obligation rating is based in all cases on the
short-term vulnerability to default of the rated entity and relates to the
capacity to meet financial obligations in accordance with the
documentation governing the relevant obligation. Short-term deposit
ratings may be adjusted for loss severity. Short-Term Ratings are
assigned to obligations whose initial maturity is viewed as “short term”
based on market convention (a long-term rating can also be used to rate
an issue with short maturity). Typically, this means up to 13 months for
corporate, sovereign, and structured obligations, and up to 36 months
for obligations in U.S. public finance markets.
F1:
Highest short-term credit quality.
Indicates the strongest intrinsic
capacity for timely payment of financial commitments; may have an
added “+” to denote any exceptionally strong credit feature.
F2:
Good short-term credit quality.
Good intrinsic capacity for timely
payment of financial commitments.
F3:
Fair short-term credit quality.
The intrinsic capacity for timely
payment of financial commitments is adequate.
B:
Speculative short-term credit quality.
Minimal capacity for timely
payment of financial commitments, plus heightened vulnerability to near
term adverse changes in financial and economic conditions.
C:
High short-term default risk.
Default is a real possibility.
RD:
Restricted default.
Indicates an entity that has defaulted on one or
more of its financial commitments, although it continues to meet other
financial obligations. Typically applicable to entity ratings only.
D:
Default.
Indicates a broad-based default event for an entity, or the
default of a short-term obligation.
[], 2024 |
Base Prospectus
A-7
The information in this Statement of Additional Information is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This Statement of Additional Information, which is not a prospectus, is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state or jurisdiction where the offer or sale is not permitted.
Subject to completion, dated April 19, 2024
PIMCO INCOME STRATEGY FUND II
Statement of Additional Information
[ ], 2024
PIMCO Income Strategy Fund II (the “Fund”) is a diversified, closed-end management investment company.
Pacific Investment Management Company LLC (“PIMCO” or the “Investment Manager”), 650 Newport Center Drive, Newport Beach, California 92660, is the investment manager to the Fund.
This Statement of Additional Information relating to the common shares of beneficial interest, par value $0.00001 per share, of the Fund (the “Common Shares”) is not a prospectus, and should be read in conjunction with the Fund’s prospectus relating thereto dated [ ], 2024 (the “Prospectus”) and any related prospectus supplement. This Statement of Additional Information does not include all information that a prospective investor should consider before purchasing Common Shares, and investors should obtain and read the Prospectus and any related prospectus supplement prior to purchasing such shares. A copy of the Prospectus and any related prospectus supplement or the annual or semi-annual reports for the Fund may be obtained without charge by calling (844) 33-PIMCO (844-337-4626). You may also obtain a copy of the Prospectus or any related prospectus supplement on the website of the Securities and Exchange Commission (the “SEC”) at http://www.sec.gov. Capitalized terms used but not defined in this Statement of Additional Information have the meanings ascribed to them in the Prospectus and any related prospectus supplement.
THE FUND
The Fund commenced operations on October 29, 2004, following the initial public offering of its common shares. Effective March 1, 2010, the Fund changed its name from PIMCO Floating Rate Strategy Fund to PIMCO Income Strategy Fund II. The Fund was organized as a Massachusetts business trust on June 30, 2004. Prior to commencing operations on October 29, 2004, the Fund had no operations other than matters relating to its organization and registration as a diversified, closed-end management company registered under the Investment Company Act of 1940, as amended (the “1940 Act”).
INVESTMENT OBJECTIVE AND POLICIES
The investment objective and general investment policies of the Fund are described in the Prospectus. Additional information concerning the characteristics of certain of the Fund’s investments strategies and risks is set forth below. Unless a strategy or policy described below is specifically prohibited by the investment restrictions listed in the Prospectus, by the investment restrictions under “Investment Restrictions” in this Statement of Additional Information, or by applicable law, the Fund may engage in each of the practices described below. However, the Fund is not required to engage in any particular transaction or purchase any particular type of securities or investment even if to do so might benefit the Fund. Unless otherwise stated herein, all investment policies of the Fund may be changed by the Board of Trustees (the “Board”) without shareholder approval. In addition, the Fund may be subject to restrictions on its ability to utilize certain investments or investment techniques. Unless otherwise stated herein, these additional restrictions may be changed with the consent of the Board but without approval by or notice to shareholders.
High Yield Securities (“Junk Bonds”) and Securities of Distressed Companies
The Fund may invest without limitation in debt instruments that are, at the time of purchase, rated below investment grade (below Baa3 by Moody’s Investors Service, Inc. (“Moody’s”) or below BBB- by either S&P Global Ratings (“S&P”), or Fitch Ratings, Inc. (“Fitch”)), or unrated but determined by PIMCO to be of comparable quality, and may also invest without limit in investment grade securities. However, the Fund will not normally invest more than 20% of its total assets in debt instruments, other than mortgage-related and other asset-backed securities (“ABS”), that are, at the time of purchase, rated CCC+ or lower by S&P and Fitch and Caa1 or lower by Moody’s, or that are unrated but determined by PIMCO to be of comparable quality to securities so rated. Subject to this 20% restriction, the Fund may invest in issuers of any credit quality (including bonds in the lowest ratings categories and securities that are in default or the issuers of which are in bankruptcy). The Fund may invest without limit in mortgage-related and other ABS regardless of rating—i.e., of any credit quality. For purposes of applying the foregoing policies, in the case of securities with split ratings (i.e., a security receiving two different ratings from two different rating agencies), the Fund will apply the higher of the applicable ratings. Subject to the aforementioned investment restrictions, the Fund may invest in securities of stressed, distressed and/or defaulted issuers, which include securities in default or at risk of being in default as to the repayment of principal and/or interest at the time of acquisition by the Fund or that are rated in the lower rating categories by one or more nationally recognized statistical rating organizations (“NRSROs”) (for example, Ca or lower by Moody’s or CC or lower by S&P or Fitch) or, if unrated, are determined by PIMCO to be of comparable quality. Debt instruments of below investment grade quality are regarded as having predominantly speculative characteristics with respect to capacity to pay interest and to repay principal, and are commonly referred to as “high yield” securities or “junk bonds.” Debt instruments in the lowest investment grade category also may be considered to possess some speculative characteristics. A description of the ratings categories used is set forth in Appendix A to the Prospectus.
A security is considered to be below “investment grade” quality if it is either (1) not rated in one of the four highest rating categories by one of the NRSROs (i.e., rated Ba or below by Moody’s, BB or below by S&P or BB or below by Fitch) or (2) if unrated, determined by PIMCO to be of comparable quality. Investments in securities rated below investment grade are described as “speculative” by Moody’s, S&P and Fitch, and are commonly referred to as “high yield” securities or “junk bonds.” Additional information about Moody’s, S&P’s and Fitch’s securities ratings is included in Appendix A to the Prospectus.
Investment in lower rated corporate debt securities (“high yield” securities or “junk bonds”) and securities of distressed companies generally provides greater income and increased opportunity for capital appreciation than investments in higher quality securities, but it also typically entails greater price volatility and principal and income risk. Securities of distressed companies include both debt and equity securities. High yield securities and debt
1
securities of distressed companies are regarded as predominantly speculative with respect to the issuer’s continuing ability to make timely principal and interest payments. Issuers of high yield and distressed company securities may be involved in restructurings or bankruptcy proceedings that may not be successful. Analysis of the creditworthiness of issuers of debt securities that are high yield or debt securities of distressed companies may be more complex than for issuers of higher quality debt.
High yield securities and debt securities of distressed companies may be more susceptible to real or perceived adverse economic and competitive industry conditions than investment grade securities. The prices of these securities have been found to be more sensitive to adverse economic downturns or individual corporate developments.
A projection of an economic downturn, for example, could cause a decline in prices of high yield securities and debt securities of distressed companies because the advent of a recession could lessen the ability of a highly leveraged company to make principal and interest payments on its debt securities, and a high yield security may lose significant market value before a default occurs. If an issuer defaults, in addition to risking payment of all or a portion of interest and principal, the Fund, by investing in such securities, may incur additional expenses to seek recovery of their respective investments. In the case of securities structured as zero-coupon or pay-in-kind securities, their market prices are affected to a greater extent by interest rate changes, and therefore tend to be more volatile than securities which pay interest periodically and in cash.
High yield and distressed company securities may have the right to “call” or redeem the issue prior to maturity, which may result in the Fund having to reinvest the proceeds in other high yield securities that may pay lower interest rates. The Fund may also be subject to greater levels of liquidity risk than funds that do not invest in these securities. In addition, the high yield securities and securities of distressed companies in which the Fund invests may not be listed on any exchange and a secondary market for such securities may be comparatively less liquid relative to markets for other more liquid fixed income securities. Consequently, transactions in high yield and distressed company securities may involve greater costs than transactions in more actively traded securities, which could adversely affect the price at which the Fund could sell a high yield or distressed company security, and could adversely affect the daily net asset value of the shares. A lack of publicly-available information, irregular trading activity and wide bid/ask spreads among other factors, may, in certain circumstances, make high yield and distressed company debt more difficult to sell at an advantageous time or price than other types of securities or instruments. These factors may result in the Fund being unable to realize full value for these securities and/or may result in the Fund not receiving the proceeds from a sale of a high yield or distressed company security for an extended period after such sale, each of which could result in losses to the Fund. Because of the risks involved in investing in high yield securities and securities of distressed companies, an investment in the Fund should be considered speculative.
Analysis of the creditworthiness of issuers of high yield securities and distressed company securities may be more complex than for issuers of higher quality debt securities, and achievement of the Fund’s investment objectives may, to the extent of its investments in high yield and distressed company securities, depend more heavily on PIMCO’s creditworthiness analysis than would be the case if the Fund were investing in higher quality securities.
High yield securities structured as “zero-coupon” bonds or “payment-in-kind” securities (“PIKs”) tend to be especially volatile as they are particularly sensitive to downward pricing pressures from rising interest rates or widening spreads and may require the Fund to make taxable distributions of income greater than the total amount of cash interest the Fund has actually received. Even though such securities do not pay current interest in cash, the Fund nonetheless is required to accrue interest income on these investments and to distribute the interest income on a current basis. Thus, the Fund could be required at times to sell other investments in order to satisfy its distribution requirements (including when it is not advantageous to do so).
The secondary market on which high yield securities are traded may be less liquid than the market for higher grade securities. Less liquidity in the secondary trading market could adversely affect the price at which the Fund could sell a high yield security, and could adversely affect the daily net asset value of the shares. Lower liquidity in secondary markets could adversely affect the value of high yield/high risk securities held by the Fund. While lower rated securities typically are less sensitive to interest rate changes than higher rated securities, the market prices of high yield/high risk securities structured as zero coupon bonds or PIKs may be affected to a greater extent by interest rate changes. In addition, adverse publicity and investor perceptions, whether or not based on fundamental analysis, may decrease the values and liquidity of high yield securities, especially in a thinly traded market. When secondary markets for high yield and distressed company securities are less liquid than the market for other types of securities, it
2
may be more difficult to value the securities because such valuation may require more research, and elements of judgment may play a greater role in the valuation because there is less reliable, objective data available.
The use of credit ratings as the sole method of evaluating high yield securities and debt securities of distressed companies can involve certain risks. For example, credit ratings evaluate the safety of principal and interest payments of a debt security, not the market value risk of the security. Also, credit rating agencies may fail to change credit ratings in a timely fashion to reflect events since the security was last rated. PIMCO does not rely solely on credit ratings when selecting debt securities for the Fund. If a credit rating agency changes the rating of a debt security held by the Fund, the Fund may retain the security.
Securities Lending
For the purpose of achieving income, the Fund may lend its portfolio securities to brokers, dealers, and other financial institutions provided a number of conditions are satisfied, including that the loan is fully collateralized. Please see “Investment Objectives and Policies-Loans of Portfolio Securities” in the Statement of Additional Information for more details. When the Fund lends portfolio securities, its investment performance will continue to reflect changes in the value of the securities loaned, and the Fund will also receive a fee or interest on the collateral.
Securities lending involves the risk of loss of rights in the collateral or delay in recovery of the collateral if the borrower fails to return the security loaned or becomes insolvent. The Fund may pay lending fees to a party arranging the loan, which may be an affiliate of the Fund. Cash collateral received by the Fund in securities lending transactions may be invested in short-term liquid fixed-income instruments or in money market or short-term mutual funds, or similar investment vehicles, including affiliated money market or short-term mutual funds. The Fund bears the risk of such investments.
Mortgage-Related and Other Asset-Backed Instruments
The Fund may invest in a variety of mortgage-related and other asset-backed instruments issued by government agencies or other governmental entities or by private originators or issuers.
Mortgage-related assets include, but are not limited to, any security, instrument or other asset that is related to U.S. or non U.S. mortgages, including those issued by private originators or issuers, or guaranteed as to principal or interest by the U.S. government or its agencies or instrumentalities or by non-U.S. governments or authorities, such as, without limitation, assets representing interests in, collateralized or backed by, or whose values are determined in whole or in part by reference to any number of mortgages or pools of mortgages or the payment experience of such mortgages or pools of mortgages, including real estate mortgage investment conduits (“REMICs”), which could include resecuritizations of REMICs (“Re-REMICs”), mortgage pass-through securities, inverse floaters, collateralized mortgage obligations (“CMOs”), collateralized loan obligations, multiclass pass-through securities, private mortgage pass-through securities, and stripped mortgage securities (generally interest-only and principal-only securities), mortgage-related asset backed securities and mortgage-related loans (including through participations, assignments, originations and whole loans), including commercial and residential mortgage loans. Such mortgage loans may include non-performing loans, which may include (but not be limited to) loans where a borrower is delinquent in payments or loans that are in or close to default, and reperforming loans (“RPLs”), which are loans that have previously been delinquent but are current at the time securitized.
The value of some mortgage-related or other asset-backed securities (“ABS”) in which the Fund invests may be particularly sensitive to changes in prevailing interest rates, and, like other fixed income investments, the ability of the Fund to utilize these instruments successfully may depend in part upon the ability of PIMCO to forecast interest rates and other economic factors correctly. See “–Mortgage Pass-Through Securities” below. The Fund may also invest in debt securities which are secured with collateral consisting of mortgage-related assets, and in other types of mortgage-related assets and ABS. See “–Collateralized Mortgage Obligations (“CMOs”)” below.
The financial downturn of the late 2000s adversely affected the market for mortgage-related securities. The downturn saw dramatic declines in the housing market, with falling home prices and increasing foreclosures and unemployment, and significant asset write-downs by financial institutions. Between 2008 and 2009, the market for mortgage-related securities (and other ABS) was particularly adversely impacted by, among other factors, the failure of certain large financial institutions and the events leading to the conservatorship and the control by the U.S. government
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of the Federal National Mortgage Association (“FNMA”) and the Federal Home Loan Mortgage Corporation (“FHLMC”), as described below. These events, coupled with the general economic downturn, resulted in a substantial level of uncertainty in the financial markets, particularly with respect to mortgage-related investments. There is no assurance that the U.S. government would take similar or further action to support the mortgage-related securities industry, as it has in the past, should the economy experience another downturn. Further, any future government actions may significantly alter the manner in which the mortgage-related securities market functions. Each of these factors could ultimately increase the risk that the Fund could realize losses on mortgage-related securities. The mortgage-related assets in which the Fund may invest may pay variable or fixed rates of interest.
Through investments in mortgage-related assets, including those that are issued by private issuers, the Fund may have some exposure to subprime loans as well as to the mortgage and credit markets generally. Private issuers include commercial banks, savings associations, mortgage companies, investment banking firms, finance companies and special purpose finance entities (called special purpose vehicles or SPVs) and other entities that acquire and package mortgage loans for resale as mortgage-related assets.
Mortgage Pass-Through Securities. Mortgage pass-through securities are securities representing interests in “pools” of mortgage loans secured by residential or commercial real property. Interests in pools of mortgage-related securities differ from other forms of debt securities, which normally provide for periodic payment of interest in fixed or variable amounts with principal payments at maturity or specified call dates. Instead, these securities provide a monthly payment which consists of both interest and principal payments. In effect, these payments are a “pass-through” of the monthly payments made by the individual borrowers on their residential or commercial mortgage loans, net of any fees paid to the issuer or guarantor of such securities. Additional payments are caused by repayments of principal resulting from the sale of the underlying property, refinancing or foreclosure, net of fees or costs which may be incurred. Some mortgage-related securities (such as securities issued by the Government National Mortgage Association (“GNMA”)) are described as “modified pass-through.” These securities entitle the holder to receive all interest and principal payments owed on the mortgage pool, net of certain fees, at the scheduled payment dates regardless of whether or not the mortgagor actually makes the payment.
The rate of pre-payments on underlying mortgages will affect the price and volatility of a mortgage-related security, and may have the effect of shortening or extending the effective duration of the security relative to what was anticipated at the time of purchase. Early repayment of principal on some mortgage-related securities (arising from prepayments of principal due to the sale of the underlying property, refinancing, or foreclosure, net of fees and costs that may be incurred) may expose the Fund to a lower rate of return upon reinvestment of principal. Also, if a security subject to prepayment has been purchased at a premium, the value of the premium would be lost in the event of prepayment. Like other fixed income securities, when interest rates rise, the value of a mortgage-related security generally will decline; however, when interest rates are declining, the value of mortgage-related securities with prepayment features may not increase as much as other fixed income securities. Adjustable rate mortgage-related and other ABS are also subject to some interest rate risk. For example, because interest rates on most adjustable rate mortgage- and other ABS only reset periodically (e.g., monthly or quarterly), changes in prevailing interest rates (and particularly sudden and significant changes) can be expected to cause some fluctuations in the market value of these securities, including declines in value as interest rates rise. In addition, to the extent that unanticipated rates of pre-payment on underlying mortgages increase the effective duration of a mortgage-related security, the volatility of such security can be expected to increase.
The residential mortgage market in the United States has experienced in the past, and could experience in the future, difficulties that may adversely affect the performance and market value of certain of the Fund’s mortgage-related investments. Delinquencies, defaults and losses on residential mortgage loans may increase substantially over certain periods. A decline in or flattening of housing values may exacerbate such delinquencies and losses on residential mortgages. Borrowers with adjustable rate mortgage loans are more sensitive to changes in interest rates, which affect their monthly mortgage payments, and may be unable to secure replacement mortgages at comparably low interest rates. As a result of the 2008 financial crisis, a number of residential mortgage loan originators experienced serious financial difficulties or bankruptcy. Owing largely to the foregoing, reduced investor demand for mortgage loans and mortgage-related securities and increased investor yield requirements caused limited liquidity in the secondary market for certain mortgage-related securities, which adversely affected the market value of mortgage-related securities. It is possible that such limited liquidity in such secondary markets could recur or worsen in the future.
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Mortgage-related securities that are issued or guaranteed as to principal or interest by the U.S. government or its agencies or instrumentalities are not subject to the Fund’s industry concentration restrictions (see “Investment Restrictions”) by virtue of the exclusion from that test available to all U.S. government securities.
Agency Mortgage-Related Securities. Payment of principal and interest on some mortgage pass-through securities (but not the market value of the securities themselves) may be guaranteed by the full faith and credit of the U.S. government (in the case of securities guaranteed by GNMA) or guaranteed by agencies or instrumentalities of the U.S. government (in the case of securities guaranteed by the Federal National Mortgage Association (“FNMA”) or the Federal Home Loan Mortgage Corporation (“FHLMC”)). The principal governmental guarantor of mortgage-related securities is GNMA. GNMA is a wholly-owned U.S. government corporation within the U.S. Department of Housing and Urban Development (the “Department of Housing and Urban Development” or “HUD”). GNMA is authorized to guarantee, with the full faith and credit of the U.S. government, the timely payment of principal and interest on securities issued by institutions approved by GNMA (such as savings and loan institutions, commercial banks and mortgage bankers) and backed by pools of mortgages insured by the Federal Housing Administration (the “FHA”), or guaranteed by the Department of Veterans Affairs (the “VA”).
Government-related guarantors (i.e., not backed by the full faith and credit of the U.S. government) include FNMA and FHLMC. FNMA is a government-sponsored corporation. FNMA purchases conventional (i.e., not insured or guaranteed by any government agency) residential mortgages from a list of approved seller/servicers, which includes state and federally chartered savings and loan associations, mutual savings banks, commercial banks, credit unions and mortgage bankers. Pass-through securities issued by FNMA are guaranteed as to timely payment of principal and interest by FNMA, but are not backed by the full faith and credit of the U.S. government.
FHLMC was created by Congress in 1970 for the purpose of increasing the availability of mortgage credit for residential housing. It is a government-sponsored corporation that issues participation certificates (“PCs”) which are pass-through securities, each representing an undivided interest in a pool of residential mortgages. FHLMC guarantees the timely payment of interest and ultimate collection of principal, but PCs are not backed by the full faith and credit of the U.S. government.
FNMA and FHLMC also securitize RPLs. For example, in FNMA’s case, the RPLs are single-family, fixed rate reperforming loans that generally were previously placed in an MBS trust guaranteed by FNMA, purchased from the trust by FNMA and held as a distressed asset after four or more months of delinquency, and subsequently became current (i.e. performing) again. Such RPLs may have exited delinquency through efforts at reducing defaults (e.g., loan modification). In selecting RPLs for securitization, FNMA follows certain criteria related to length of time the loan has been performing, the type of loan (single-family, fixed rate), and the status of the loan as first lien, among other things. FNMA may include different loan structures and modification programs in the future.
Since September 6, 2008, FNMA and FHLMC have operated under a conservatorship administered by the Federal Housing Finance Agency (“FHFA”). As the conservator, the FHFA succeeded to all rights, titles, powers and privileges of FNMA and FHLMC and of any stockholder, officer or director of FNMA and FHLMC with respect to FNMA and FHLMC and the assets of FNMA and FHLMC. In connection with the conservatorship, the U.S. Department of the Treasury (the “U.S. Treasury”) entered into a Senior Preferred Stock Purchase Agreement to provide additional financing to each of FNMA and FHLMC.
FNMA and FHLMC continue to operate as going concerns while in conservatorship and each remains liable for all of its obligations, including its guaranty obligations, associated with its mortgage-backed securities. The Senior Preferred Stock Purchase Agreement is intended to enhance each of FNMA’s and FHLMC’s ability to meet its obligations. The FHFA has indicated that the conservatorship of each enterprise will end when the director of FHFA determines that FHFA’s plan to restore the enterprise to a safe and solvent condition has been completed.
Under the Federal Housing Finance Regulatory Reform Act of 2008 (the “Reform Act”), which was included as part of the Housing and Economic Recovery Act of 2008, FHFA, as conservator or receiver, has the power to repudiate any contract entered into by FNMA or FHLMC prior to FHFA’s appointment as conservator or receiver, as applicable, if FHFA determines, in its sole discretion, that performance of the contract is burdensome and that repudiation of the contract promotes the orderly administration of FNMA’s or FHLMC’s affairs. The Reform Act requires FHFA to exercise its right to repudiate any contract within a reasonable period of time after its appointment as conservator or receiver.
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FHFA, in its capacity as conservator, has indicated that it has no intention to repudiate the guaranty obligations of FNMA or FHLMC because FHFA views repudiation as incompatible with the goals of the conservatorship. However, in the event that FHFA, as conservator or if it is later appointed as receiver for FNMA or FHLMC, were to repudiate any such guaranty obligation, the conservatorship or receivership estate, as applicable, would be liable for actual direct compensatory damages in accordance with the provisions of the Reform Act. Any such liability could be satisfied only to the extent of FNMA’s or FHLMC’s assets available therefor.
In the event of repudiation, the payments of interest to holders of FNMA or FHLMC mortgage-backed securities would be reduced if payments on the mortgage loans represented in the mortgage loan groups related to such mortgage-backed securities are not made by the borrowers or advanced by the servicer. Any actual direct compensatory damages for repudiating these guaranty obligations may not be sufficient to offset any shortfalls experienced by such mortgage-backed security holders.
Further, in its capacity as conservator or receiver, FHFA has the right to transfer or sell any asset or liability of FNMA or FHLMC without any approval, assignment or consent. Although FHFA has stated that it has no present intention to do so, if FHFA, as conservator or receiver, were to transfer any such guaranty obligation to another party, holders of FNMA or FHLMC mortgage-backed securities would have to rely on that party for satisfaction of the guaranty obligation and would be exposed to the credit risk of that party.
In addition, certain rights provided to holders of mortgage-backed securities issued by FNMA and FHLMC under the operative documents related to such securities may not be enforced against FHFA, or enforcement of such rights may be delayed, during the conservatorship or any future receivership. The operative documents for FNMA and FHLMC mortgage-backed securities may provide (or with respect to securities issued prior to the date of the appointment of the conservator may have provided) that upon the occurrence of an event of default on the part of FNMA or FHLMC, in its capacity as guarantor, which includes the appointment of a conservator or receiver, holders of such mortgage-backed securities have the right to replace FNMA or FHLMC as trustee if the requisite percentage of mortgage-backed securities holders consent. The Reform Act prevents mortgage-backed security holders from enforcing such rights if the event of default arises solely because a conservator or receiver has been appointed. The Reform Act also provides that no person may exercise any right or power to terminate, accelerate or declare an event of default under certain contracts to which FNMA or FHLMC is a party, or obtain possession of or exercise control over any property of FNMA or FHLMC, or affect any contractual rights of FNMA or FHLMC, without the approval of FHFA, as conservator or receiver, for a period of 45 or 90 days following the appointment of FHFA as conservator or receiver, respectively.
FHFA and the White House have made public statements regarding plans to consider ending the conservatorships of FNMA and FHLMC. In the event that FNMA and FHLMC are taken out of conservatorship, it is unclear how the capital structure of FNMA and FHLMC would be constructed and what effects, if any, there may be on FNMA’s and FHLMC’s creditworthiness and guarantees of certain mortgage-backed securities. It is also unclear whether the U.S. Treasury would continue to enforce its rights or perform its obligations under the Senior Preferred Stock Programs. Should FNMA’s and FHLMC’s conservatorship end, there could be an adverse impact on the value of their securities, which could cause losses to the Fund.
FNMA and FHLMC have entered into a joint initiative to develop and operate a common securitization platform for the issuance of a uniform mortgage-backed security (“UMBS”) (the “Single Security Initiative”) that aligns the characteristics of FNMA and FHLMC certificates. In June 2019, under the Single Security Initiative, FNMA and FHLMC started issuing a UMBS in place of their current offerings of to-be-announced-eligible securities. The Single Security Initiative seeks to support the overall liquidity of the to-be-announced (“TBA”) market and aligns the characteristics of FNMA and FHLMC certificates. The long-term effects that the Single Security Initiative may have on the market for TBA and other mortgage backed securities are uncertain.
Government-Sponsored Enterprise (“GSE”) Credit Risk Transfer Securities and GSE Credit-Linked Notes. GSE credit risk transfer securities are notes issued directly by a GSE, such as FNMA or FHLMC, and GSE credit-linked notes are notes issued by a special purpose vehicle (“SPV”) sponsored by a GSE. Investors in these notes provide credit protection for the applicable GSE’s mortgage-related securities guarantee obligations. In this regard, a noteholder receives compensation for providing credit protection to the GSE and, when a specified level of losses on the relevant mortgage loans occurs, the principal balance and certain payments owed to the noteholder may be reduced. In addition, noteholders may receive a return of principal prior to the stated maturity date reflecting
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prepayment on the underlying mortgage loans and in any other circumstances that may be set forth in the applicable loan agreement. The notes may be issued in different tranches representing the issuance of different levels of credit risk protection to the GSE on the underlying mortgage loans and the notes are not secured by the reference mortgage loans.
GSE Credit Risk Transfer Securities Structure. In this structure, the GSE receives the note sale proceeds. The GSE pays noteholders monthly interest payments and a return of principal on the stated maturity date based on the initial investment amount, as reduced by any covered losses on the reference mortgage loans.
GSE Credit-Linked Notes Structure. In this structure, the SPV receives the note sale proceeds and the SPV’s obligations to the noteholder are collateralized by the note sale proceeds. The SPV invests the proceeds in cash or other short-term assets. The SPV also enters into a credit protection agreement with the GSE pursuant to which the GSE pays the SPV monthly premium payments and the SPV compensates the GSE for covered losses on the reference mortgage loans. The SPV pays noteholders monthly interest payments based on the premium payments paid by the GSE and the performance on the invested note sale proceeds. The noteholders also receive a return of principal on a stated maturity date based on the initial investment amount, as reduced by any covered losses on the reference mortgage loans paid by the SPV or the GSE.
Risks Related to GSE Credit Risk Transfer Securities and GSE Credit-Linked Notes.
GSE credit risk transfer securities are general obligations issued by a GSE and are unguaranteed and unsecured. GSE credit-linked notes are similar, except that the notes are issued by an SPV, rather than by a GSE, and the obligations of the SPV are collateralized by the note proceeds as invested by the SPV, which are invested in cash or short-term securities. Although both GSE credit risk transfer securities and GSE credit-linked notes are unguaranteed, obligations of an SPV are also not backstopped by the Department of Treasury or an obligation of a GSE.
The risks associated with these investments are different than the risks associated with an investment in mortgage-backed securities issued by GSEs or a private issuer. If a GSE fails to pay principal or interest on its credit risk transfers or goes through a bankruptcy, insolvency or similar proceeding, holders of such credit risk transfers will have no direct recourse to the underlying mortgage loans. In addition, some or all of the mortgage default risk associated with the underlying mortgage loans is transferred to noteholders. As a result, there can be no assurance that losses will not occur on an investment in GSE credit risk transfer securities or GSE credit-linked notes and funds investing in these instruments may be exposed to the risk of loss on their investment. In addition, these investments are subject to prepayment risk.
In the case of GSE credit-linked notes, if a GSE fails to make a premium or other required payment to the SPV, the SPV may be unable to pay a noteholder the entire amount of interest or principal payable to the noteholder. In the event of a default on the obligations to noteholders, the SPV’s principal and interest payment obligations to noteholders will be subordinated to the SPV’s credit protection payment obligations to the GSE. Payment of such amounts to noteholders depends on the cash available in the trust from the loan proceeds and the GSE’s premium payments.
Any income earned by the SPV on investments of loan proceeds is expected to be less than the interest payments amounts to be paid to noteholders of the GSE credit-linked notes and interest payments to noteholders will be reduced if the GSE fails to make premium payments to the SPV. An SPV’s investment of loan proceeds may also be concentrated in the securities of a few number of issuers. A noteholder bears any investment losses on the allocable portion of the loan proceeds.
An SPV that issues GSE credit-linked notes may fall within the definition of a “commodity pool” under the Commodity Exchange Act and the GSEs operating the SPV may be required to register as “commodity pool operators” (“CPOs”). Certain GSEs are not required to register as CPOs in reliance on CFTC no-action relief, subject to certain conditions similar to those under CFTC Rule 4.13(a)(3), with respect to the operation of the SPV. If the GSE or SPV is ineligible for no-action relief or fails to comply with such conditions, noteholders that are investment vehicles, such as the Fund, may become ineligible to claim an exclusion from CPO regulation, to the extent they are currently eligible to claim the exclusion. The Fund may consider steps in order to continue to qualify from CPO registration, or may determine to register as a CPO, which could cause the Fund to incur increased costs.
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Privately Issued Mortgage-Related (Non-Agency) Assets. Commercial banks, savings and loan institutions, private mortgage insurance companies, mortgage bankers and other secondary market issuers also create pass-through pools of conventional residential mortgage loans. Such issuers may be the originators and/or servicers of the underlying mortgage loans as well as the guarantors of the mortgage-related assets. Pools created by such non-governmental issuers generally offer a higher rate of interest than government and government-related pools because there are no direct or indirect government or agency guarantees of payments in the former pools. However, timely payment of interest and principal of these pools may be supported by various forms of insurance or guarantees, including individual loan, title, pool and hazard insurance and letters of credit, which may be issued by governmental entities, private insurers or the mortgage poolers. The insurance and guarantees are issued by governmental entities, private insurers or the mortgage poolers. Such insurance and guarantees, and the creditworthiness of the issuers thereof, will be considered in determining whether a mortgage-related security meets the Fund’s investment quality standards. There can be no assurance that insurers or guarantors can meet their obligations under the insurance policies or guarantee arrangements.
Privately issued mortgage-related assets are not subject to the same underwriting requirements for the underlying mortgages that are applicable to those mortgage-related assets that have a government or government-sponsored entity guarantee. As a result, the mortgage loans underlying privately issued mortgage-related assets may, and frequently do, have less favorable collateral, credit risk or other underwriting characteristics than government or government-sponsored mortgage-related assets and have wider variances in a number of terms including interest rate, term, size, purpose and borrower characteristics.
Mortgage pools underlying privately issued mortgage-related assets more frequently include second mortgages, high loan-to-value ratio mortgages and manufactured housing loans, in addition to commercial mortgages and other types of mortgages where a government or government sponsored entity guarantee is not available. The coupon rates and maturities of the underlying mortgage loans in a privately issued mortgage-related assets pool may vary to a greater extent than those included in a government guaranteed pool, and the pool may include subprime mortgage loans. Subprime loans are loans made to borrowers with weakened credit histories or with a lower capacity to make timely payments on their loans. For these reasons, the loans underlying these securities have had in many cases higher default rates than those loans that meet government underwriting requirements.
The risk of non-payment is greater for mortgage-related assets that are backed by loans that were originated under weak underwriting standards, including loans made to borrowers with limited means to make repayment. A level of risk exists for all loans, although, historically, the poorest performing loans have been those classified as subprime. Other types of privately issued mortgage-related assets, such as those classified as pay-option adjustable rate or Alt-A have also performed poorly. Even loans classified as prime have experienced higher levels of delinquencies and defaults. The substantial decline in real property values across the U.S. has exacerbated the level of losses that investors in privately issued mortgage-related assets have experienced. It is not certain when these trends may reverse. Market factors that may adversely affect mortgage loan repayment include adverse economic conditions, unemployment, a decline in the value of real property, or an increase in interest rates.
The Fund may purchase privately issued mortgage-related assets that are originated, packaged and serviced by third party entities. It is possible these third parties could have interests that are in conflict with the holders of mortgage-related assets, and such holders (such as the Fund) could have rights against the third parties or their affiliates. For example, if a loan originator, servicer or its affiliates engaged in negligence or willful misconduct in carrying out its duties, then a holder of the mortgage-related asset could seek recourse against the originator/servicer or its affiliates, as applicable. Also, as a loan originator/servicer, the originator/servicer or its affiliates may make certain representations and warranties regarding the quality of the mortgages and properties underlying a mortgage-related asset. If one or more of those representations or warranties is false, then the holders of the mortgage-related assets (such as the Fund) could trigger an obligation of the originator/servicer or its affiliates, as applicable, to repurchase the mortgages from the issuing trust. Notwithstanding the foregoing, many of the third parties that are legally bound by trust and other documents have failed to perform their respective duties, as stipulated in such trust and other documents, and investors have had limited success in enforcing terms. To the extent third party entities involved with privately issued mortgage-related assets are involved in litigation relating to the securities, actions may be taken that are adverse to the interests of holders of the mortgage-related assets, including the Fund. For example, third parties may seek to withhold proceeds due to holders of the mortgage-related assets, including the Fund, to cover legal or related costs. Any such action could result in losses to the Fund.
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Privately issued mortgage-related assets are not traded on an exchange and there may be a limited market for the securities, especially when there is a perceived weakness in the mortgage and real estate market sectors. Without an active trading market, mortgage-related assets held in the Fund’s portfolio may be particularly difficult to value because of the complexities involved in assessing the value of the underlying mortgage loans.
The assets underlying mortgage-related assets may be represented by a portfolio of residential or commercial mortgages (including both whole mortgage loans and mortgage participation interests that may be senior or junior in terms of priority of repayment) or portfolios of mortgage pass-through securities issued or guaranteed by GNMA, FNMA or FHLMC. Mortgage loans underlying a mortgage-related asset may in turn be insured or guaranteed by the FHA or the VA. In the case of privately issued mortgage-related assets whose underlying assets are neither U.S. government securities nor U.S. government-insured mortgages, to the extent that real properties securing such assets may be located in the same geographical region, the security may be subject to a greater risk of default than other comparable securities in the event of adverse economic, political or business developments that may affect such region and, ultimately, the ability of residential homeowners to make payments of principal and interest on the underlying mortgages.
Collateralized Mortgage Obligations (“CMOs”). A CMO is a debt obligation of a legal entity that is collateralized by mortgages and divided into classes. A CMO is a hybrid between a mortgage-backed bond and a mortgage pass-through security. Similar to a bond, interest and prepaid principal is paid, in most cases, semi-annually or on a monthly basis. CMOs may be collateralized by whole mortgage loans or private mortgage bonds, but are more typically collateralized by portfolios of mortgage pass-through securities guaranteed by GNMA, FHLMC, or FNMA and their income streams.
CMOs are structured into multiple classes, often referred to as “tranches,” with each class bearing a different stated maturity and entitled to a different schedule for payments of principal and interest, including pre-payments. Actual maturity and average life will depend upon the pre-payment experience of the collateral. In the case of certain CMOs (known as “sequential pay” CMOs), payments of principal received from the pool of underlying mortgages, including prepayments, are applied to the classes of CMOs in the order of their respective final distribution dates. Thus, no payment of principal will be made to any class of sequential pay CMOs until all other classes having an earlier final distribution date have been paid in full.
In a typical CMO transaction, a corporation (“issuer”) issues multiple series (e.g., A, B, C, Z) of CMO bonds (“Bonds”). Proceeds of the Bond offering are used to purchase mortgages or mortgage pass-through certificates (“Collateral”). The Collateral is pledged to a third party trustee as security for the Bonds. Principal and interest payments from the Collateral are used to pay principal on the Bonds in the order A, B, C, Z. The Series A, B, and C Bonds all bear current interest. Interest on the Series Z Bond is accrued and added to principal and a like amount is paid as principal on the Series A, B, or C Bond currently being paid off. When the Series A, B, and C Bonds are paid in full, interest and principal on the Series Z Bond begins to be paid currently. With some CMOs, the issuer serves as a conduit to allow loan originations (primarily builders or savings and loan associations) to borrow against their loan portfolios. CMOs may be less liquid and may exhibit greater price volatility than other types of mortgage- or asset-backed securities.
As CMOs have evolved, some classes of CMO bonds have become more common. For example, the Fund may invest in parallel-pay and planned amortization class (“PAC”) CMOs and multi-class pass-through certificates. Parallel-pay CMOs and multi-class pass-through certificates are structured to provide payments of principal on each payment date to more than one class. These simultaneous payments are taken into account in calculating the stated maturity date or final distribution date of each class, which, as with other CMO and multi-class pass-through structures, must be retired by its stated maturity date or final distribution date but may be retired earlier. PACs generally require payments of a specified amount of principal on each payment date. PACs are parallel-pay CMOs with the required principal amount on such securities having the highest priority after interest has been paid to all classes. Any CMO or multi-class pass-through structure that includes PAC securities must also have support tranches—known as support bonds, companion bonds or non-PAC bonds—which lend or absorb principal cash flows to allow the PAC securities to maintain their stated maturities and final distribution dates within a range of actual prepayment experience. These support tranches are subject to a higher level of maturity risk compared to other mortgage-related assets, and usually provide a higher yield to compensate investors. If principal cash flows are received in amounts outside a pre-determined range such that the support bonds cannot lend or absorb sufficient cash
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flows to the PAC securities as intended, the PAC securities are subject to heightened maturity risk. Consistent with the Fund’s investment objectives and policies, PIMCO may invest in various tranches of CMO bonds, including support bonds.
CMOs that are issued or guaranteed by the U.S. government or by any of its agencies or instrumentalities will be considered U.S. government securities by the Fund.
FHLMC Collateralized Mortgage Obligations. FHLMC CMOs are debt obligations of FHLMC issued in multiple classes having different maturity dates which are secured by the pledge of a pool of conventional mortgage loans purchased by FHLMC. Payments of principal and interest on the CMOs are made semi-annually, as opposed to monthly. The amount of principal payable on each semi-annual payment date is determined in accordance with FHLMC’s mandatory sinking fund schedule, which in turn, is equal to approximately 100% of FHA prepayment experience applied to the mortgage collateral pool. All sinking fund payments in the CMOs are allocated to the retirement of the individual classes of bonds in the order of their stated maturities. Payment of principal on the mortgage loans in the collateral pool in excess of the amount of FHLMC’s minimum sinking fund obligation for any payment date are paid to the holders of the CMOs as additional sinking fund payments. Because of the “pass-through” nature of all principal payments received on the collateral pool in excess of FHLMC’s minimum sinking fund requirement, the rate at which principal of the CMOs is actually repaid is likely to be such that each class of bonds will be retired in advance of its scheduled maturity date.
If collection of principal (including prepayments) on the mortgage loans during any semi-annual payment period is not sufficient to meet FHLMC’s minimum sinking fund obligation on the next sinking fund payment date, FHLMC agrees to make up the deficiency from its general funds.
Criteria for the mortgage loans in the pool backing the FHLMC CMOs are identical to those of FHLMC PCs. FHLMC has the right to substitute collateral in the event of delinquencies and/or defaults.
Commercial or Residential Mortgage-Backed Securities. Commercial mortgage-backed securities (“CMBS”) and residential mortgage-backed securities (“RMBS”) include securities that reflect an interest in, and are secured by, mortgage loans on commercial or residential real property. Many of the risks of investing in CMBS or RMBS reflect the risks of investing in the real estate securing the underlying mortgage loans. These risks reflect the effects of local and other economic conditions on real estate markets, the ability of tenants to make loan payments, and the ability of a property to attract and retain tenants. CMBS or RMBS may be less liquid and exhibit greater price volatility than other types of mortgage- or ABS.
CMO Residuals. CMO residuals are mortgage securities issued by agencies or instrumentalities of the U.S. government or by private originators of, or investors in, mortgage loans, including savings and loan associations, homebuilders, mortgage banks, commercial banks, investment banks and special purpose entities of the foregoing.
The cash flow generated by the mortgage assets underlying a series of CMOs is applied first to make required payments of principal and interest on the CMOs and second to pay the related administrative expenses and any management fee of the issuer. The residual in a CMO structure generally represents the interest in any excess cash flow remaining after making the foregoing payments. Each payment of such excess cash flow to a holder of the related CMO residual represents income and/or a return of capital. The amount of residual cash flow resulting from a CMO will depend on, among other things, the characteristics of the mortgage assets, the coupon rate of each class of CMO, prevailing interest rates, the amount of administrative expenses and the pre-payment experience on the mortgage assets. In particular, the yield to maturity on CMO residuals is extremely sensitive to pre-payments on the related underlying mortgage assets, in the same manner as an interest-only (“IO”) class of SMBSs. See “Stripped Mortgage-Backed Securities” below. In addition, if a series of a CMO includes a class that bears interest at an adjustable rate, the yield to maturity on the related CMO residual will also be extremely sensitive to changes in the level of the index upon which interest rate adjustments are based. As described below with respect to SMBSs, in certain circumstances the Fund may fail to recoup fully its initial investment in a CMO residual.
CMO residuals are generally purchased and sold by institutional investors through several investment banking firms acting as brokers or dealers. In addition, CMO residuals may, or pursuant to an exemption therefrom, may not,
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have been registered under the Securities Act of 1933, as amended (the “Securities Act”). CMO residuals, whether or not registered under the Securities Act, may be subject to certain restrictions on transferability and may be deemed illiquid.
Adjustable Rate Mortgage-Backed Securities. ARMBSs have interest rates that reset at periodic intervals. Acquiring ARMBSs permits the Fund to participate in increases in prevailing current interest rates through periodic adjustments in the coupons of mortgages underlying the pool on which ARMBSs are based. Such ARMBSs generally have higher current yield and lower price fluctuations than is the case with more traditional fixed-income debt securities of comparable rating and maturity. In addition, when prepayments of principal are made on the underlying mortgages during periods of rising interest rates, the Fund can reinvest the proceeds of such prepayments at rates higher than those at which they were previously invested. Mortgages underlying most ARMBSs, however, have limits on the allowable annual or lifetime increases that can be made in the interest rate that the mortgagor pays. Therefore, if current interest rates rise above such limits over the period of the limitation, the Fund, when holding an ARMBS, does not benefit from further increases in interest rates. Moreover, when interest rates are in excess of coupon rates (i.e., the rates being paid by mortgagors) of the mortgages, ARMBSs behave more like fixed-income securities and less like adjustable rate securities and are subject to the risks associated with fixed-income securities. In addition, during periods of rising interest rates, increases in the coupon rate of adjustable rate mortgages generally lag current market interest rates slightly, thereby creating the potential for capital depreciation on such securities.
Stripped Mortgage-Backed Securities. SMBS are derivative multi-class mortgage securities. SMBS may be issued by agencies or instrumentalities of the U.S. government, or by private originators of, or investors in, mortgage loans, including savings and loan associations, mortgage banks, commercial banks, investment banks and special purpose entities of the foregoing.
SMBS are usually structured with two classes that receive different proportions of the interest and principal distributions on a pool of mortgage assets. A common type of SMBS will have one class receiving some of the interest and most of the principal from the mortgage assets, while the other class will receive most of the interest and the remainder of the principal. In the most extreme case, one class will receive all of the interest (the “IO” class), while the other class will receive all of the principal (the “PO” class). The yield to maturity on an IO class is extremely sensitive to the rate of principal payments (including prepayments) on the related underlying mortgage assets, and a rapid rate of principal payments may have a material adverse effect on the Fund’s yield to maturity from these securities. If the underlying mortgage assets experience greater than anticipated prepayments of principal, the Fund may fail to recoup some or all of its initial investment in these securities even if the security is in one of the highest rating categories. SMBSs may be deemed “illiquid.”
Other Mortgage-Related Assets. Other mortgage-related assets include securities other than those described above that directly or indirectly represent a participation in, or are secured by and payable from, mortgage loans on real property, including mortgage dollar rolls/buybacks, CMO residuals or SMBSs. Other mortgage-related assets may be equity or debt securities issued by agencies or instrumentalities of the U.S. government or by private originators of, or investors in, mortgage loans, including savings and loan associations, homebuilders, mortgage banks, commercial banks, investment banks, partnerships, trusts and special purpose entities of the foregoing.
Mortgage-related assets include, among other things, securities that reflect an interest in reverse mortgages. In a reverse mortgage, a lender makes a loan to a homeowner based on the homeowner’s equity in his or her home. While a homeowner must be age 62 or older to qualify for a reverse mortgage, reverse mortgages may have no income restrictions. Repayment of the interest or principal for the loan is generally not required until the homeowner dies, sells the home, or ceases to use the home as his or her primary residence.
There are three general types of reverse mortgages: (1) single-purpose reverse mortgages, which are offered by certain state and local government agencies and nonprofit organizations; (2) federally-insured reverse mortgages, which are backed by the U. S. Department of Housing and Urban Development; and (3) proprietary reverse mortgages, which are privately offered loans. A mortgage-related asset may be backed by a single type of reverse mortgage. Reverse mortgage-related assets include agency and privately issued mortgage-related assets. The principal government guarantor of reverse mortgage-related securities is GNMA.
Reverse mortgage-related assets may be subject to risks different than other types of mortgage-related assets due to the unique nature of the underlying loans. The date of repayment for such loans is uncertain and may occur sooner
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or later than anticipated. The timing of payments for the corresponding mortgage-related security may be uncertain. Because reverse mortgages are offered only to persons 62 and older and there may be no income restrictions, the loans may react differently than traditional home loans to market events. Additionally, there can be no assurance that service providers to reverse mortgage trusts (“RMTs”) will diligently and appropriately execute their duties with respect to servicing such trusts. As a result, investors (which may include the Fund) in notes issued by RMTs may be deprived of payments to which they are entitled. This could result in losses to the Fund. Investors, including the Fund, may determine to pursue negotiations or legal claims or otherwise seek compensation from RMT service providers in certain instances. This may involve the Fund incurring costs and expenses associated with such actions.
Mortgage-Related Derivative Instruments. The Fund may engage in derivatives transactions related to mortgage-backed securities, including purchasing and selling exchange-listed and over-the-counter (“OTC”) put and call options, futures and forwards on mortgages and mortgage-backed securities. The Fund may also invest in mortgage-backed securities credit default swaps, which include swaps the reference obligation for which is a mortgage-backed security or related index, such as the CMBX Index (a tradeable index referencing a basket of commercial mortgage-backed securities) or the ABX (a tradeable index referencing a basket of sub-prime mortgage-backed securities). The Fund may also invest in swaps the reference obligation for which is a mortgage-related index, such as the TRX Index (a tradeable index referencing total return swaps based on commercial mortgage-backed securities). The Fund may invest in newly developed mortgage related derivatives that may hereafter become available.
Asset-Backed Securities. The Fund may invest in, or have exposure to, ABS, which are securities that represent a participation in, or are secured by and payable from, a stream of payments generated by particular assets, most often a pool or pools of similar assets (e.g., trade receivables). ABS are created from many types of assets, including, but not limited to, auto loans, accounts receivable such as credit card receivables and hospital account receivables, home equity loans, student loans, boat loans, mobile home loans, recreational vehicle loans, manufactured housing loans, aircraft leases, computer leases and syndicated bank loans. The credit quality of these securities depends primarily upon the quality of the underlying assets and the level of credit support and/or enhancement provided. To protect ABS investors from the possibility that some borrowers could miss payments or even default on their loans, ABS include various forms of credit enhancement.
The underlying assets (e.g., loans) are subject to prepayments that shorten the securities’ weighted average maturity and may lower their return. If the credit support or enhancement is exhausted, losses or delays in payment may result if the required payments of principal and interest are not made. The value of these securities also may change because of changes in the market’s perception of the creditworthiness of the servicing agent for the pool, the originator of the pool, or the financial institution or trust providing the credit support or enhancement. Typically, there is no perfected security interest in the collateral that relates to the financial assets that support ABS. ABS have many of the same characteristics and risks as the mortgage backed securities described above.
The Fund may purchase or have exposure to commercial paper, including asset-backed commercial paper (“ABCP”), that is issued by structured investment vehicles or other conduits. These conduits may be sponsored by mortgage companies, investment banking firms, finance companies, hedge funds, private equity firms and special purpose finance entities. ABCP typically refers to a short-term debt security, the payment of which is supported by cash flows from underlying assets, or one or more liquidity or credit support providers, or both. Assets backing ABCP include credit card, car loan and other consumer receivables and home or commercial mortgages, including subprime mortgages. The repayment of ABCP issued by a conduit depends primarily on the cash collections received from the conduit’s underlying asset portfolio and the conduit’s ability to issue new ABCP. Therefore, there could be losses to the Fund if investing in ABCP in the event of credit or market value deterioration in the conduit’s underlying portfolio, mismatches in the timing of the cash flows of the underlying asset interests and the repayment obligations of maturing ABCP, or the conduit’s inability to issue new ABCP. To protect investors from these risks, ABCP programs may be structured with various protections, such as credit enhancement, liquidity support, and commercial paper stop-issuance and wind-down triggers. However, there can be no guarantee that these protections will be sufficient to prevent losses to investors in ABCP. Some ABCP programs provide for an extension of the maturity date of the ABCP if, on the related maturity date, the conduit is unable to access sufficient liquidity through the issue of additional ABCP. This may delay the sale of the underlying collateral and the Fund may incur a loss if the value of the collateral deteriorates during the extension period. Alternatively, if collateral for ABCP deteriorates in value, the collateral may be required to be sold at inopportune times or at prices insufficient to repay the principal and interest on the ABCP. ABCP programs may provide for the issuance of subordinated notes as an additional form of credit enhancement. The subordinated
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notes are typically of a lower credit quality and have a higher risk of default. To the extent the Fund purchases these subordinated notes, it will have a higher likelihood of loss than investors in the senior notes.
Some ABS, particularly home equity loan transactions, are subject to interest-rate risk and prepayment risk. A change in interest rates can affect the pace of payments on the underlying loans, which in turn, affects total return on the securities. ABS also carry credit or default risk. If many borrowers on the underlying loans default, losses could exceed the credit enhancement level and result in losses to investors in an ABS transaction. Additionally, the value of ABS is subject to risks associated with the servicers’ performance. In some circumstances, a servicer’s or originator’s mishandling of documentation related to the underlying collateral (e.g., failure to properly document a security interest in the underlying collateral) may affect the rights of the security holders in and to the underlying collateral. Finally, ABS have structure risk due to a unique characteristic known as early amortization, or early payout, risk. Built into the structure of most ABS are triggers for early payout, designed to protect investors from losses. These triggers are unique to each transaction and can include: a big rise in defaults on the underlying loans, a sharp drop in the credit enhancement level, or even the bankruptcy of the originator. Once early amortization begins, all incoming loan payments (after expenses are paid) are used to pay investors as quickly as possible based upon a predetermined priority of payment.
Collateralized Bond Obligations, Collateralized Loan Obligations and Other Collateralized Debt Obligations. The Fund may invest in each of CBOs, CLOs, other CDOs and other similarly structured securities. CBOs, CLOs and other CDOs are types of ABS. A CBO is a trust that is often backed by a diversified pool of high risk, below investment grade fixed income securities. The collateral can be from many different types of fixed income securities such as high-yield debt, residential privately issued mortgage-related assets, commercial or residential privately issued mortgage-related assets, trust preferred securities and emerging market debt. A CLO is a trust typically collateralized by a pool of loans, which may include, among others, domestic and foreign senior secured loans, senior unsecured loans and subordinate corporate loans, including loans that may be rated below investment grade or equivalent unrated loans. Other CDOs are trusts backed by other types of assets representing obligations of various parties. CBOs, CLOs and other CDOs may charge management fees and administrative expenses.
For CBOs, CLOs and other CDOs, the cash flows from the trust are split into two or more portions, called tranches, varying in risk and yield. The riskiest portion is the “equity” tranche which bears the bulk of defaults from the bonds or loans in the trust and serves to protect the other, more senior tranches from default in all but the most severe circumstances. Since it is partially protected from defaults, a senior tranche from a CBO trust, CLO trust or trust of another CDO typically have higher ratings and lower yields than their underlying securities, and can be rated investment grade. Despite the protection from the equity tranche, CBO, CLO or other CDO tranches can experience substantial losses due to actual defaults, downgrades of the underlying collateral by rating agencies, forced liquidation of the collateral pool due to a failure of coverage tests, increased sensitivity to defaults due to collateral default and disappearance of protecting tranches, market anticipation of defaults, as well as aversion to CBO, CLO or other CDO securities as a class. Interest on certain tranches of a CDO may be paid in kind or deferred and capitalized (paid in the form of obligations of the same type rather than cash), which involves continued exposure to default risk with respect to such payments.
The risks of an investment in a CBO, CLO or other CDO depend largely on the type of the collateral securities and the class of the instrument in which the Fund invests. Normally, CBOs, CLOs and other CDOs are privately offered and sold, and thus, are not registered under the securities laws. As a result, investments in CBOs, CLOs and other CDOs may be characterized by the Fund as illiquid investments. However, an active dealer market may exist for CBOs, CLOs and other CDOs allowing them to qualify for transactions under Rule 144A of the Securities Act. In addition to the normal risks associated with fixed-income securities discussed elsewhere in this Statement of Additional Information and the Prospectus (e.g., prepayment risk, credit risk, liquidity risk, market risk, structural risk, legal risk and interest rate risk (which may be exacerbated if the interest rate payable on a structured financing changes based on multiples of changes in interest rates or inversely to changes in interest rates) and default risk), CBOs, CLOs and other CDOs carry additional risks that include, but are not limited to: (i) the possibility that distributions from collateral securities will not be adequate to make interest or other payments; (ii) the risk that the quality of the collateral may decline in value or default; (iii) the risk that the Fund may invest in CBOs, CLOs or other CDOs that are subordinate to other classes; (iv) the complex structure of the security may not be fully understood at the time of investment and may produce disputes with the issuer or unexpected investment results; (v) the investment return achieved by the Fund could be significantly different than those predicted by financial models; (vi) the lack of a
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readily available secondary market for CDOs; (vii) risk of forced “fire sale” liquidation due to technical defaults such as coverage test failures; and (viii) the CDO’s manager may perform poorly.
Other Asset-Backed Securities. Similarly, PIMCO expects that other ABS (unrelated to mortgage loans) will be offered to investors in the future and may be purchased by the Fund. Several types of ABS have already been offered to investors, including Enhanced Equipment Trust Certificates (“EETCs”) and Certificates for Automobile Receivablessm (“CARSsm”).
EETCs are typically issued by specially-created trusts established by airlines, railroads, or other transportation corporations. The proceeds of EETCs are used to purchase equipment, such as airplanes, railroad cars, or other equipment, which in turn serve as collateral for the related issue of the EETCs. The equipment generally is leased by the airline, railroad or other corporation, which makes rental payments to provide the projected cash flow for payments to EETC holders. Holders of EETCs must look to the collateral securing the certificates, typically together with a guarantee provided by the lessee corporation or its parent company for the payment of lease obligations, in the case of default in the payment of principal and interest on the EETCs. However, because principal and interest payments on EETCs are funded in the ordinary course by the lessee corporation, the Fund treats EETCs as corporate bonds/obligations for purposes of compliance testing and related classifications.
CARSsm represent undivided fractional interests in a trust whose assets consist of a pool of motor vehicle retail installment sales contracts and security interests in the vehicles securing the contracts. Payments of principal and interest on CARSsm are passed through monthly to certificate holders, and are guaranteed up to certain amounts and for a certain time period by a letter of credit issued by a financial institution unaffiliated with the trustee or originator of the trust. An investor’s return on CARSsm may be affected by early prepayment of principal on the underlying vehicle sales contracts. If the letter of credit is exhausted, the trust may be prevented from realizing the full amount due on a sales contract because of state law requirements and restrictions relating to foreclosure sales of vehicles and the obtaining of deficiency judgments following such sales or because of depreciation, damage or loss of a vehicle, the application of federal and state bankruptcy and insolvency laws, or other factors. As a result, certificate holders may experience delays in payments or losses if the letter of credit is exhausted.
Consistent with the Fund’s investment objective and policies, PIMCO also may invest in other types of asset-backed and related securities (such as credit card receivables or student loans). Other ABS may be collateralized by the fees earned by service providers. The value of ABS may be substantially dependent on the servicing of the underlying asset pools and is therefore subject to risks associated with the negligence by, or defalcation of, their servicers. In certain circumstances, the mishandling of related documentation may also affect the rights of the security holders in and to the underlying collateral. The insolvency of entities that generate receivables or that utilize the assets may result in added costs and delays in addition to losses associated with a decline in the value of the underlying assets.
Investors should note that Congress from time to time may consider actions that would limit or remove the explicit or implicit guarantee of the payment of principal and/or interest on many types of ABS. Any such action would likely adversely impact the value of such securities.
Alt Lending ABS. The “Alt Lending” ABS in which the Fund may invest are typically not listed on any securities exchange and not registered under the Securities Act. In addition, the Fund anticipates that these instruments may only be sold to a limited number of investors and may have a limited or nonexistent secondary market. Accordingly, the Fund currently expects that certain investments in Alt Lending ABS will face heightened levels of liquidity risk. Although currently there is generally no active reliable, secondary market for certain Alt Lending ABS, a secondary market for these alternative lending-related instruments may develop.
Real Estate Assets and Related Derivatives
The Fund may generally gain exposure to the real estate sector by investing in real-estate linked derivatives, real estate investment trusts (“REITs”) and common, preferred and convertible securities of issuers in real estate-related industries. The Fund may also invest in loans or other investments secured by real estate (other than mortgage-backed securities) and may, as a result of default, foreclosure or otherwise, take possession of and hold real estate as a direct owner (see “Loans and Other Indebtedness; Loan Participations and Assignments” below). Each of these types of investments are subject, directly or indirectly, to risks associated with ownership of real estate, including changes in
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the general economic climate or local conditions (such as an oversupply of space or a reduction in demand for space), loss to casualty or condemnation, increases in property taxes and operating expenses, zoning law amendments, changes in interest rates, overbuilding and increased competition, including competition based on rental rates, variations in market value, changes in the financial condition of tenants, changes in operating costs, attractiveness and location of the properties, adverse changes in the real estate markets generally or in specific sectors of the real estate industry and possible environmental liabilities. Real estate-related investments may entail leverage and may be highly volatile.
REITs are pooled investment vehicles that own, and typically operate, income-producing real estate. Some REITs also finance real estate. If a REIT meets certain requirements, including distributing to shareholders substantially all of its taxable income (other than net capital gains), then it is not generally taxed on the income distributed to shareholders. REITs are subject to management fees and other expenses, and so the Fund would bear its proportionate share of the costs of the REITs’ operations if it invests in REITs. Dividends received by the Fund from a REIT generally will not constitute qualified dividend income. REITs may not provide complete tax information to the Fund until after the calendar year-end. Consequently, because of the delay, it may be necessary for the Fund to request permission from the Internal Revenue Service (“IRS”) to extend the deadline for issuance of Form 1099-DIV.
There are three general categories of REITs: equity REITs, mortgage REITs and hybrid REITs. Equity REITs invest primarily in direct fee ownership or leasehold ownership of real property; they derive most of their income from rents. Mortgage REITs invest mostly in mortgages on real estate, which may secure construction, development or long-term loans, and the main source of their income is mortgage interest payments. Hybrid REITs hold both ownership and mortgage interests in real estate.
Along with the risks common to different types of real estate-related securities, REITs, no matter the type, involve additional risk factors. These include poor performance by the REIT’s manager, changes to the tax laws, and failure by the REIT to qualify for favorable tax treatment afforded to REITs under the Internal Revenue Code of 1986, as amended (the “Code”) or exemption under the 1940 Act. Furthermore, REITs are not typically diversified and are heavily dependent on cash flow. Investments in REIT equity securities could require the Fund to accrue and distribute income not yet received by the Fund. On the other hand, investments in REIT equity securities can also result in the Fund’s receipt of cash in excess of the REIT’s earnings; if the Fund distributes such amounts, such distribution could constitute a return of capital to Fund shareholders for federal income tax purposes under the Code. In addition, some REITs have limited diversification because they invest in a limited number of properties, a narrow geographic area, or a single type of property. Also, the organizational documents of a REIT may contain provisions that make changes in control of the REIT difficult and time-consuming. Finally, private REITs are not traded on a national securities exchange. As such, these products are generally illiquid. This reduces the ability of the Fund to redeem its investment early. Private REITs are also generally harder to value and may bear higher fees than public REITs.
Some of the REITs in which the Fund may invest may be permitted to hold senior or residual interests in real estate mortgage investment conduits (“REMICs”) or debt or equity interests in taxable mortgage pools (“TMPs”). The Fund may also hold interests in “Re-REMICs”, which are interests in securitizations formed by the contribution of asset backed or other similar securities into a trust which then issues securities in various tranches. The Fund may participate in the creation of a Re-REMIC by contributing assets to the trust and receiving junior and/or senior securities in return. An interest in a Re-REMIC security may be riskier than the securities originally held by and contributed to the trust, and the holders of the Re-REMIC securities will bear the costs associated with the securitization.
Foreign (Non-U.S.) Securities
The Fund invests predominantly in U.S. dollar-denominated debt securities, which may include those issued by foreign corporations or supra-national government agencies. The Fund may invest without limit in non-U.S. dollar denominated securities (of both developed and “emerging market” countries), including obligations of non-U.S. governments and their respective sub-divisions, agencies and government-sponsored enterprises. The Fund may invest up to 40% of its total assets in securities and instruments that are economically tied to “emerging market” countries, except the Fund may invest without limit in investment grade sovereign debt denominated in the relevant country's local currency with less than 1 year remaining to maturity (“short-term investment grade sovereign debt”) issued by emerging market issuers. The Fund may also invest directly in foreign currencies, including local emerging market countries.
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The foreign securities in which the Fund may invest include without limit Eurodollar obligations and “Yankee Dollar” obligations. Eurodollar obligations are U.S. dollar-denominated certificates of deposit and time deposits issued outside the U.S. capital markets by foreign branches of U.S. banks and by foreign banks. Yankee Dollar obligations are U.S. dollar-denominated obligations issued in the U.S. capital markets by foreign banks. Eurodollar and Yankee Dollar obligations are generally subject to the same risks that apply to domestic debt issues, notably credit risk, interest rate risk, market risk and liquidity risk. Additionally, Eurodollar (and to a limited extent, Yankee Dollar) obligations are subject to certain sovereign risks. One such risk is the possibility that a sovereign country might prevent capital, in the form of U.S. dollars, from flowing across its borders. Other risks include adverse political and economic developments; the extent and quality of government regulation of financial markets and institutions; the imposition of foreign withholding or other taxes; and the expropriation or nationalization of foreign issuers.
The Fund may also invest in American Depositary Receipts (“ADRs”), European Depositary Receipts (“EDRs”) or Global Depositary Receipts (“GDRs”). ADRs are U.S. dollar-denominated receipts issued generally by domestic banks and represent the deposit with the bank of a security of a non-U.S. issuer. EDRs are foreign currency-denominated receipts similar to ADRs and are issued and traded in Europe, and are publicly traded on exchanges or over-the-counter (“OTC”) in the United States. GDRs may be offered privately in the United States and also trade in public or private markets in other countries. ADRs, EDRs and GDRs may be issued as sponsored or unsponsored programs. In sponsored programs, an issuer has made arrangements to have its securities trade in the form of ADRs, EDRs or GDRs. In unsponsored programs, the issuer may not be directly involved in the creation of the program. Although regulatory requirements with respect to sponsored and unsponsored programs are generally similar, in some cases it may be easier to obtain financial information from an issuer that has participated in the creation of a sponsored program.
Investing in non-U.S. securities involves special risks and considerations not typically associated with investing in U.S. securities. These include: differences in accounting, auditing and financial reporting standards, generally higher commission rates on non-U.S. portfolio transactions, the possibility of expropriation or confiscatory taxation, adverse changes in investment or exchange control regulations, including the imposition of sanctions and other similar measures adverse changes in investment or exchange control regulations (which may include suspension of the ability to transfer currency from a country), market disruption, the possibility of security suspensions, political instability which can affect U.S. investments in non-U.S. countries and potential restrictions on the flow of international capital. In addition, foreign securities and the Fund’s income in respect of those securities may be subject to foreign taxes, including taxes withheld from payments on those securities, which would reduce the Fund’s return on such securities. Non-U.S. securities often trade with less frequency and volume than domestic securities and therefore may exhibit greater price volatility. Changes in foreign exchange rates will affect the value of those securities that are denominated or quoted in currencies other than the U.S. dollar. The currencies of non-U.S. countries may experience significant declines against the U.S. dollar, and devaluation may occur subsequent to investments in these currencies by the Fund.
Investment in sovereign debt can involve a high degree of risk. The governmental entity that controls the repayment of sovereign debt may not be able or willing to repay the principal and/or interest when due in accordance with the terms of the debt. A governmental entity’s willingness or ability to repay principal and interest due in a timely manner may be affected by, among other factors, its cash flow situation, the extent of its foreign reserves, the availability of sufficient foreign exchange on the date a payment is due, the relative size of the debt service burden to the economy as a whole, the governmental entity’s policy toward the International Monetary Fund, and the political constraints to which a governmental entity may be subject. Governmental entities may also depend on expected disbursements from foreign governments, multilateral agencies and others to reduce principal and interest arrearages on their debt. The commitment on the part of these governments, agencies and others to make such disbursements may be conditioned on a governmental entity’s implementation of economic reforms and/or economic performance and the timely service of such debtor’s obligations. Failure to implement such reforms, achieve such levels of economic performance or repay principal or interest when due may result in the cancellation of such third parties’ commitments to lend funds to the governmental entity, which may further impair such debtor’s ability or willingness to service its debts in a timely manner. Consequently, governmental entities may default on their sovereign debt. Holders of sovereign debt (including the Fund) may be requested to participate in the rescheduling of such debt and to extend further loans to governmental entities. There is no bankruptcy proceeding by which sovereign debt on which governmental entities have defaulted may be collected in whole or in part. Quasi-sovereign obligations are typically less liquid and less standardized than direct sovereign obligations.
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The investments in foreign currency denominated debt obligations and hedging activities by the Fund will likely produce a difference between the Fund’s book income and its taxable income. This difference may cause a portion of the Fund’s income distributions to constitute returns of capital for tax purposes or require the Fund to make distributions exceeding book income to qualify as a regulated investment company (“RIC”) for U.S. federal tax purposes. The Fund’s investments in non-U.S. securities may increase or accelerate the amount of ordinary income recognized by shareholders. See “Taxation.”
Euro- and European Union-related risks. The global economic crisis brought several small economies in Europe to the brink of bankruptcy and many other economies into recession and weakened the banking and financial sectors of many European countries. For example, the governments of Greece, Spain, Portugal, and the Republic of Ireland experienced severe economic and financial difficulties between 2009 and 2012, an event that is commonly referred to as the “European sovereign debt crisis.” As was the case during the European sovereign debt crisis, large public deficits could cause some European countries to become dependent on assistance from other European governments and institutions or other central banks or supranational agencies such as the International Monetary Fund. Assistance may be dependent on a country’s implementation of reforms or reaching a certain level of performance. Failure to reach those objectives or an insufficient level of assistance could result in a deep economic downturn. Responses to economic or financial difficulties by European governments, central banks and others, including austerity measures and reforms, may be ineffective, may limit future economic growth or recovery, and/or may result in social unrest or other unintended consequences. Any of the forgoing events could significantly affect the value of the Fund’s European investments.
The national politics of European countries can be unpredictable and subject to influence by disruptive political groups or ideologies. The occurrence of conflicts, war or terrorist activities in Europe could have an adverse impact on financial markets. For example, Russia launched a large-scale invasion of Ukraine in February 2022. The extent, duration and impact of Russia’s military action in Ukraine, related sanctions and retaliatory actions are difficult to ascertain, but could be significant and have severe adverse effects on the region, including significant adverse effects on the regional, European, and global economies and the markets for certain securities and commodities, such as oil and natural gas, as well as other sectors, and on the Fund's investments in securities and instruments that are economically tied to the region, including declines in value and reductions in liquidity.
The Economic and Monetary Union of the European Union (“EMU”) is comprised of the European Union (“EU”) members that have adopted the euro currency. By adopting the euro as its currency, a member state relinquishes control of its own monetary policies. As a result, European countries are significantly affected by fiscal and monetary policies implemented by the EMU and European Central Bank. The euro currency may not fully reflect the strengths and weaknesses of the various economies that comprise the EMU and Europe generally.
It is possible that one or more EMU member countries could abandon the euro and return to a national currency and/or that the euro will cease to exist as a single currency in its current form. The effects of such an abandonment or a country’s forced expulsion from the euro on that country, the rest of the EMU, and global markets are impossible to predict, but are likely to be negative. The exit of any country out of the euro may have an extremely destabilizing effect on other Eurozone countries and their economies and a negative effect on the global economy as a whole. Such an exit by one country may also increase the possibility that additional countries may exit the euro should they face similar financial difficulties. In addition, in the event of one or more countries’ exit from the euro, it may be difficult to value investments denominated in euros or in a replacement currency.
On January 31, 2020, the United Kingdom officially withdrew from the EU (commonly known as “Brexit”). Upon the United Kingdom’s withdrawal, the EU and the United Kingdom entered into a transition phase, which concluded on December 31, 2020. Negotiators representing the United Kingdom and EU came to a preliminary trade agreement that took effect on January 1, 2021, but many aspects of the United Kingdom-EU trade relationship remain subject to further negotiations. Uncertainties remain relating to certain aspects of the United Kingdom’s future economic, trading, and legal relationships with the European Union and with other countries. Due to political uncertainty, it is not possible to anticipate the form or nature of the future trading relationship between the United Kingdom and the EU. The UK, EU and broader global economy may experience substantial volatility in foreign exchange markets and a sustained weakness in the British pound’s exchange rate against the United States dollar, the euro and other currencies, which may impact Fund returns. Brexit may also destabilize some or all of the other EU member countries and/or the Eurozone. These developments could result in losses to the Fund, as there may be negative effects on the value of the Fund’s investments and/or on the Fund’s ability to enter into certain transactions or
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value certain investments, and these developments may make it more difficult for the Fund to exit certain investments at an advantageous time or price. Such events could result from, among other things, increased uncertainty and volatility in the United Kingdom, the EU and other financial markets; fluctuations in asset values; fluctuations in exchange rates; decreased liquidity of investments located, traded or listed within the United Kingdom, the EU or elsewhere; changes in the willingness or ability of financial and other counterparties to enter into transactions or the price and terms on which other counterparties are willing to transact; and/or changes in legal and regulatory regimes to which Fund investments are or become subject. Any of these events, as well as an exit or expulsion of an EU member state other than the United Kingdom from the EU, could negatively impact Fund returns.
Redenomination Risk. Continuing uncertainty as to the status of the euro and the EMU has created significant volatility in currency and financial markets generally. Any partial or complete dissolution of the EMU could have significant adverse effects on currency and financial markets, and on the values of the Fund’s portfolio investments. If one or more EMU countries were to stop using the euro as its primary currency, the Fund’s investments in such countries may be redenominated into a different or newly adopted currency. As a result, the value of those investments could decline significantly and unpredictably. In addition, securities or other investments that are redenominated may be subject to foreign currency risk, liquidity risk and valuation risk to a greater extent than similar investments currently denominated in euros. To the extent a currency used for redenomination purposes is not specified in respect of certain EMU-related investments, or should the euro cease to be used entirely, the currency in which such investments are denominated may be unclear, making such investments particularly difficult to value or dispose of. The Fund may incur additional expenses to the extent it is required to seek judicial or other clarification of the denomination or value of such securities. There can be no assurance that if the Fund earns income or capital gains in a non-U.S. country or PIMCO otherwise seeks to withdraw the Fund’s investments from a given country, capital controls imposed by such country will not prevent, or cause significant expense in doing so.
CSDR Related Risk. The European Union has adopted a settlement discipline regime under Regulation (EU) No 909/2014 and the Settlement Discipline RTS as they may be modified from time to time (“CSDR”), which will have phased compliance dates. It aims to reduce the number of settlement fails that occur in EEA central securities depositories (“CSDs”) and address settlement fails where they occur. The key elements of the regime are: (i) mandatory buy-ins – if a settlement fail continues for a specified period of time after the intended settlement date, a buy-in process must be initiated to effect the settlement; (ii) cash penalties—EEA CSDs are required to impose cash penalties on participants that cause settlement fails and distribute these to receiving participants; and (iii) allocations and confirmations – EEA investment firms are required to take measures to prevent settlement fails, including putting in place arrangements with their professional clients to communicate securities allocations and transaction confirmations.
These requirements apply to transactions in transferable securities (e.g., shares and bonds), money market instruments, units in funds and emission allowances that are to be settled via an EEA CSD and, in the case of cash penalties and buy-in requirements only, are admitted to trading or traded on an EEA trading venue or cleared by an EEA central counterparty.
The implementation of the CSDR settlement discipline regime for funds that enter into in-scope transactions may result in increased operational and compliance costs being borne directly or indirectly by the Fund. CSDR may also affect liquidity and increase trading costs associated with relevant securities. If in-scope transactions are subject to additional expenses and penalties as a consequence of the CSDR settlement discipline regime, such expenses and penalties may be charged to the Fund.
Investments in Russia. In addition to the risks listed above under “Foreign (Non-U.S.) Securities,” investing in Russia presents additional risks. In particular, investments in Russia are subject to the risk that the United States and/or other countries may impose economic sanctions, export or import controls, or other similar measures. Other similar measures may include, but are not limited to, banning or expanding bans on Russia or certain persons or entities associated with Russia from global payment systems that facilitate cross-border payments, restricting the settlement of securities transactions by certain investors, and freezing Russian assets or those of particular countries, entities or persons with ties to Russia (e.g., Belarus). Such sanctions or other similar measures - which may impact companies in many sectors, including energy, financial services, technology, accounting, quantum computing, shipping, aviation, metals and mining, defense, architecture, engineering, construction, manufacturing, and transportation, among others - and Russia's countermeasures may negatively impact the Fund’s performance and/or ability to achieve its investment objectives. For example, certain investments in Russian companies or instruments tied to Russian companies may be prohibited and/or existing investments may become illiquid (e.g., in the event that transacting in certain existing
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investments is prohibited, securities markets close, or market participants cease transacting in certain investments in light of geopolitical events, sanctions or related considerations), which could render any such securities held by the Fund unmarketable for an indefinite period of time and/or cause the Fund to sell portfolio holdings at a disadvantageous time or price or to continue to hold investments that a Fund no longer seeks to hold. It is also possible that such sanctions, export and import controls, or similar measures may prevent U.S.-based entities that provide services to the Fund from transacting with Russian or Belarusian entities. Under such circumstances, the Fund may not receive payments due with respect to certain investments, such as the payments due in connection with the Fund’s holding of a fixed income security. In addition, such sanctions and other similar measures, and the Russian government's response, could result in a downgrade of Russia's credit rating or of securities of issuers located in or economically tied to Russia, devaluation of Russia's currency and/or increased volatility with respect to Russian securities and the ruble. More generally, investments in Russian securities are highly speculative and involve significant risks and special considerations not typically associated with investments in the securities markets of the United States and most other developed countries. Over the past century, Russia has experienced political, social and economic turbulence and has endured decades of communist rule under which tens of millions of its citizens were collectivized into state agricultural and industrial enterprises. Since the collapse of the Soviet Union, Russia’s government has been faced with the daunting task of stabilizing its domestic economy, while transforming it into a modern and efficient structure able to compete in international markets and respond to the needs of its citizens. However, to date, many of the country’s economic reform initiatives have floundered. In this environment, there is always the risk that the nation’s government will abandon the current program of economic reform and replace it with radically different political and economic policies that would be detrimental to the interests of foreign investors, a risk that has been at least partially realized in connection with Russia's countersanctions. Further changes could entail a return to a centrally planned economy and nationalization of private enterprises similar to what existed under the old Soviet Union.
Russia has attempted, and may attempt in the future, to assert its influence in the region surrounding it through economic or military measures. In February 2022, Russia launched a large-scale invasion of Ukraine. As a result, Russia, and other countries, persons and entities that have provided material aid to Russia's aggression against Ukraine, have been the subject of economic sanctions and import and export controls imposed by countries throughout the world, including the United States. Such measures have had and may continue to have an adverse effect on the Russian, Belarusian and other securities and economies, which may, in turn, negatively impact the Fund. Moreover, disruptions caused by Russian military action or other actions (including cyberattacks, espionage or other asymmetric measures) or resulting actual or threatened responses to such activity may impact Russia’s economy and Russian and other issuers of securities in which the Fund is invested. Such resulting actual or threatened responses may include, but are not limited to, purchasing and financing restrictions, withdrawal of financial intermediaries, boycotts or changes in consumer or purchaser preferences, sanctions, export or import controls, tariffs or cyberattacks on the Russian government, Russian companies or Russian individuals, including politicians. Any actions by Russia made in response to such sanctions or retaliatory measures could further impair the value and liquidity of Fund investments. Sanctions and other similar measures have resulted in defaults on debt obligations by certain corporate issuers and the Russian Federation that could lead to cross-defaults or cross-accelerations on other obligations of these issuers.
Poor accounting standards, inept management, pervasive corruption, insider trading and crime, and inadequate regulatory protection for the rights of investors all pose a significant risk, particularly to foreign investors. In addition, there is the risk that the Russian tax system will not be reformed to prevent inconsistent, retroactive, and/or exorbitant taxation, or, in the alternative, the risk that a reformed tax system may result in the inconsistent and unpredictable enforcement of the new tax laws. Investments in Russia may be subject to the risk of nationalization or expropriation of assets. Regional armed conflict and its collateral economic and market effects may also pose risks for investments in Russia.
Compared to most national securities markets, the Russian securities market suffers from a variety of problems not encountered in more developed markets. There is little long-term historical data on the Russian securities market because it is relatively new and a substantial proportion of securities transactions in Russia are privately negotiated outside of stock exchanges. The inexperience of the Russian securities market and the limited volume of trading in securities in the market may make obtaining accurate prices on portfolio securities from independent sources more difficult than in more developed markets. Additionally, because of less stringent auditing and financial reporting standards than apply to U.S. companies, there may be little reliable corporate information available to investors. As a result, it may be difficult to assess the value or prospects of an investment in Russian companies. Securities of Russian
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companies also may experience greater price volatility than securities of U.S. companies. These issues can be magnified as a result of sanctions and other similar measures that may be imposed and the Russian government’s response.
Because of the recent formation of the Russian securities market as well as the underdeveloped state of the banking and telecommunications systems, settlement, clearing and registration of securities transactions are subject to significant risks. Prior to the implementation of the National Settlement Depository (“NSD”), a recognized central securities depository, there was no central registration system for equity share registration in Russia and registration was carried out by either the issuers themselves or by registrars located throughout Russia. Title to Russian equities held through the NSD is now based on the records of the NSD and not the registrars. Although the implementation of the NSD has enhanced the efficiency and transparency of the Russian securities market, issues resulting in loss still can occur. In addition, sanctions by the European Union against the NSD, as well as the potential for sanctions by other governments, could make it more difficult to conduct or confirm transactions involving Russian securities. Ownership of securities issued by Russian companies that are not held through depositories such as the NSD may be defined according to entries in the company’s share register and normally evidenced by extracts from the register or by formal share certificates. These services may be carried out by the companies themselves or by registrars located throughout Russia. In such cases, the risk is increased that the Fund could lose ownership rights through fraud, negligence, or even mere oversight. While the Fund will endeavor to ensure that its interest continues to be appropriately recorded either itself or through a custodian or other agent by inspecting the share register and by obtaining extracts of share registers through regular confirmations, these extracts have no legal enforceability and it is possible that subsequent illegal amendment or other fraudulent act may deprive the Fund of its ownership rights or improperly dilute its interests. In addition, while applicable Russian regulations impose liability on registrars for losses resulting from their errors, it may be difficult for the Fund to enforce any rights it may have against the registrar or issuer of the securities in the event of loss of share registration. Furthermore, significant delays or problems may occur in registering the transfer of securities, which could cause the Fund to incur losses due to a counterparty’s failure to pay for securities the Fund has delivered or the Fund’s inability to complete its contractual obligations because of theft or other reasons.
In addition, issuers and registrars are still prominent in the validation and approval of documentation requirements for corporate action processing in Russia. Because the documentation requirements and approval criteria vary between registrars and issuers, there remain unclear and inconsistent market standards in the Russian market with respect to the completion and submission of corporate action elections. In addition, sanctions or Russian countermeasures may prohibit or limit the Fund's ability to participate in corporate actions, and therefore require the Fund to forego voting on or receiving funds that would otherwise be beneficial to the Fund. To the extent that the Fund suffers a loss relating to title or corporate actions relating to its portfolio securities, it may be difficult for the Fund to enforce its rights or otherwise remedy the loss. Russian securities laws may not recognize foreign nominee accounts held with a custodian bank, and therefore the custodian may be considered the ultimate owner of securities they hold for their clients. The Fund also may experience difficulty in obtaining and/or enforcing judgments in Russia.
The Russian economy is heavily dependent upon the export of a range of commodities including most industrial metals, forestry products, oil, and gas. Accordingly, it is strongly affected by international commodity prices and is particularly vulnerable to any weakening in global demand for these products, and to sanctions or other actions that may be directed at the Russian economy as a whole or at Russian oil, natural gas, metals or timber industries.
Foreign investors also face a high degree of currency risk when investing in Russian securities and a lack of available currency hedging instruments. In addition, Russia has implemented certain capital controls on foreign portfolio investments and there is the risk that the Russian government will impose additional capital controls on foreign portfolio investments. Such capital controls may prevent the sale of a portfolio of foreign assets and the repatriation of investment income and capital.
Political Risks/Risks of Conflicts. Recently, various countries have seen significant internal conflicts and in some cases, civil wars may have had an adverse impact on the securities markets of the countries concerned. In addition, the occurrence of new disturbances due to acts of war or other political developments cannot be excluded. Apparently stable systems may experience periods of disruption or improbable reversals of policy. Nationalization, expropriation or confiscatory taxation, currency blockage, political changes, government regulation, political, regulatory or social instability or uncertainty or diplomatic developments, including the imposition of sanctions or other similar measures, could adversely affect the Fund’s investments. The transformation from a centrally planned, socialist economy to a
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more market oriented economy has also resulted in many economic and social disruptions and distortions. Moreover, there can be no assurance that the economic, regulatory and political initiatives necessary to achieve and sustain such a transformation will continue or, if such initiatives continue and are sustained, that they will be successful or that such initiatives will continue to benefit foreign (or non-national) investors. Certain instruments, such as inflation index instruments, may depend upon measures compiled by governments (or entities under their influence) which are also the obligors.
Emerging Market Securities
The Fund may invest up to 40% of its total assets in securities and instruments that are economically tied to “emerging market” countries, except the Fund may invest without limit in short-term investment grade sovereign debt issued by emerging market issuers. To the extent that the Fund invests in instruments economically tied to non-U.S. countries, it may invest in a range of countries and, as such, the value of the Fund’s assets may be affected by uncertainties such as international political developments, including the imposition of sanctions and other similar measures, changes in government policies, changes in taxation, restrictions on foreign investment and currency repatriation, currency fluctuations, changes or uncertainty in exchange rates (and related risks, such as uncertainty regarding the reliability of issuers’ financial reporting), nationalization of industries or assets, and other developments in the laws and regulations of countries in which investment may be made. PIMCO generally considers an instrument to be economically tied to an emerging market country if: the issuer is organized under the laws of an emerging market country; the currency of settlement of the security is a currency of an emerging market country; the security is guaranteed by the government of an emerging market country (or any political subdivision, agency, authority or instrumentality of such government); for an asset-backed or other collateralized security, the country in which the collateral backing the security is located is an emerging market country; or the security’s “country of exposure” is an emerging market country, as determined by the criteria set forth below.
With respect to derivative instruments, PIMCO generally considers such instruments to be economically tied to emerging market countries if the underlying assets are currencies of emerging market countries (or baskets or indexes of such currencies), or instruments or securities that are issued or guaranteed by governments of emerging market countries or by entities organized under the laws of emerging market countries or if an instrument’s “country of exposure” is an emerging market country. A security’s “country of exposure” is determined by PIMCO using certain factors provided by a third-party analytical service provider. The factors are applied in order such that the first factor to result in the assignment of a country determines the “country of exposure.” Both the factors and the order in which they are applied may change in the discretion of PIMCO. The current factors, listed in the order in which they are applied, are: (i) if an asset-backed or other collateralized security, the country in which the collateral backing the security is located; (ii) the “country of risk” of the issuer; (iii) if the security is guaranteed by the government of a country (or any political subdivision, agency, authority or instrumentality of such government), the country of the government or instrumentality providing the guarantee; (iv) the “country of risk” of the issuer’s ultimate parent; or (v) the country where the issuer is organized or incorporated under the laws thereof. “Country of risk” is a separate four-part test determined by the following factors, listed in order of importance: (i) management location; (ii) country of primary listing; (iii) sales or revenue attributable to the country; and (iv) reporting currency of the issuer. PIMCO has broad discretion to identify countries that it considers to qualify as emerging markets. In exercising such discretion, PIMCO identifies countries as emerging markets consistent with the strategic objectives of the Fund. For example, the Fund may consider a country to be an emerging market country based on a number of factors including, but not limited to, if the country is classified as an emerging or developing economy by any supranational organization such as the World Bank or the United Nations, or related entities, or if the country is considered an emerging market country for purposes of constructing emerging markets indices. In some cases, this approach may result in PIMCO identifying a particular country as an emerging market with respect to the Fund, that may not be identified as an emerging market with respect to other funds managed by PIMCO.
The risks of investing in non-U.S. securities are particularly high when the issuers are tied economically to countries with developing or “emerging market” economies. Countries with “emerging market” economies are those with securities markets that are, in the opinion of PIMCO, less sophisticated than more developed markets in terms of participation by investors, analyst coverage, liquidity and regulation. Investing in emerging market countries involves certain risks not typically associated with investing in U.S. securities, and imposes risks greater than, or in addition to, risks of investing in non-U.S., developed countries. These risks include: greater risks of nationalization or expropriation of assets or confiscatory taxation; currency devaluations and other currency exchange rate fluctuations; greater social, economic and political uncertainty and instability (including the risk of war); more substantial
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government involvement in the economy; less government supervision and regulation of the securities markets and participants in those markets; controls on foreign investment and limitations on repatriation of invested capital and on the Fund’s ability to exchange local currencies for U.S. dollars; unavailability of currency hedging techniques in certain emerging market countries; the fact that companies in emerging market countries may be smaller, less seasoned and newly organized companies; the difference in, or lack of, auditing and financial reporting standards, which may result in unavailability of material information about issuers; the risk that it may be more difficult to obtain and/or enforce a judgment in a court outside the United States; the imposition of sanctions or other similar measures; and greater price volatility, substantially less liquidity and significantly smaller market capitalization of securities markets. In addition, a number of emerging market countries restrict, to various degrees, foreign investment in securities, and high rates of inflation and rapid fluctuations in inflation rates have had, and may continue to have, negative effects on the economies and securities markets of certain emerging market countries. Also, any change in the leadership or politics of emerging market countries, or the countries that exercise a significant influence over those countries, may halt the expansion of or reverse the liberalization of foreign investment policies now occurring and adversely affect existing investment opportunities.
Emerging market countries typically have less established legal, accounting and financial reporting systems than those in more developed markets, which may reduce the scope or quality of financial information available to investors. Moreover, the PCAOB, which regulates auditors of U.S. public companies, is unable to inspect audit work papers in certain non-U.S. countries. Therefore, financial reports may present an incomplete, untimely or misleading picture of a non-U.S. issuer, as compared to the financial reports of U.S. companies. Governments in emerging market countries are often less stable and more likely to take extra-legal action with respect to companies, industries, assets, or foreign ownership than those in more developed markets. Moreover, it can be more difficult for investors to bring litigation or enforce judgments against issuers in emerging markets or for U.S. regulators to bring enforcement actions against such issuers.
Nationalization, expropriation or confiscatory taxation, currency blockage, political changes or diplomatic developments, including the imposition of sanctions or other similar measures, could adversely affect the Fund’s investments in a foreign country. In the event of nationalization, expropriation or other confiscation, the Fund could lose its entire investment in that country. Adverse conditions in a certain region can adversely affect securities of other countries whose economies appear to be unrelated. To the extent the Fund invests in emerging market securities that are economically tied to a particular region, country or group of countries, the Fund may be more sensitive to adverse political or social events affecting that region, country or group of countries. Economic, business, political, or social instability may affect emerging market securities differently, and often more severely, than developed market securities.
The Fund may also invest in Brady Bonds. Brady Bonds are securities created through the exchange of existing commercial bank loans to sovereign entities for new obligations in connection with debt restructurings under a debt restructuring plan introduced by former U.S. Secretary of the Treasury, Nicholas F. Brady (the “Brady Plan”). Brady Plan debt restructurings have been implemented in a number of countries, including: Argentina, Bolivia, Brazil, Bulgaria, Costa Rica, the Dominican Republic, Ecuador, Jordan, Mexico, Niger, Nigeria, Panama, Peru, the Philippines, Poland, Uruguay, and Venezuela. Beginning in the early 2000s, certain countries began retiring their Brady Bonds, including Brazil, Colombia, Mexico, the Philippines and Venezuela.
Brady Bonds may be collateralized or uncollateralized, are issued in various currencies (primarily the U.S. dollar) and are actively traded in the OTC secondary market. Brady Bonds are not considered to be U.S. government securities. U.S. dollar-denominated, collateralized Brady Bonds, which may be fixed rate par bonds or floating rate discount bonds, are generally collateralized in full as to principal by U.S. Treasury zero coupon bonds having the same maturity as the Brady Bonds. Interest payments on these Brady Bonds generally are collateralized on a one-year or longer rolling-forward basis by cash or securities in an amount that, in the case of fixed rate bonds, is equal to at least one year of interest payments or, in the case of floating rate bonds, initially is equal to at least one year’s interest payments based on the applicable interest rate at that time and is adjusted at regular intervals thereafter. Certain Brady Bonds are entitled to “value recovery payments” in certain circumstances, which in effect constitute supplemental interest payments but generally are not collateralized. Brady Bonds are often viewed as having three or four valuation components: (i) the collateralized repayment of principal at final maturity; (ii) the collateralized interest payments; (iii) the uncollateralized interest payments; and (iv) any uncollateralized repayment of principal at maturity (these uncollateralized amounts constitute the “residual risk”).
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Most Mexican Brady Bonds issued to date have principal repayments at final maturity fully collateralized by U.S. Treasury zero coupon bonds (or comparable collateral denominated in other currencies) and interest coupon payments collateralized on an 18-month rolling-forward basis by funds held in escrow by an agent for the bondholders. A significant portion of the Venezuelan Brady Bonds and the Argentine Brady Bonds issued to date have principal repayments at final maturity collateralized by U.S. Treasury zero coupon bonds (or comparable collateral denominated in other currencies) and/or interest coupon payments collateralized on a 14-month (for Venezuela) or 12-month (for Argentina) rolling-forward basis by securities held by the Federal Reserve Bank of New York as collateral agent.
Brady Bonds involve various risk factors including residual risk and the history of defaults with respect to commercial bank loans by public and private entities of countries issuing Brady Bonds. There can be no assurance that Brady Bonds in which the Fund may invest will not be subject to restructuring arrangements or to requests for new credit, which may cause the Fund to suffer a loss of interest or principal on any of its holdings.
Foreign Currency Transactions
The Fund may purchase and sell foreign currency options and foreign currency futures contracts and related options (see “Derivative Instruments” below), and may engage in foreign currency transactions either on a spot (cash) basis at the rate prevailing in the currency exchange market at the time or through forward currency contracts (“forwards”). The Fund may engage in these transactions in order to attempt to protect against uncertainty in the level of future foreign exchange rates in the purchase and sale of securities. The Fund may also use foreign currency options, foreign currency forward contracts, foreign currency futures and foreign currency spot transactions to increase exposure to a foreign currency or to shift exposure to foreign currency fluctuations from one currency to another. Since some foreign exchange transactions for the Fund are directed to the Fund’s custodian for execution, execution of such transactions may be better or worse than comparable transactions effected by other intermediaries.
A forward involves an obligation to purchase or sell a certain amount of a specific currency at a future date, which may be any fixed number of days from the date of the contract agreed upon by the parties, at a price set at the time of the contract. These contracts may be bought or sold to protect the Fund against a possible loss resulting from an adverse change in the relationship between foreign currencies and the U.S. dollar or to increase exposure to a particular foreign currency. Although, when used for hedging, forwards are intended to minimize the risk of loss due to a decline in the value of the hedged currencies, at the same time, they tend to limit any potential gain which might result should the value of such currencies increase. Forwards are subject to the risks discussed under “Derivatives Instruments” below. Forwards are used primarily to adjust the foreign exchange exposure of the Fund with a view to protecting the outlook, and the Fund might be expected to enter into such contracts under the following circumstances:
Lock In. When PIMCO desires to lock in the U.S. dollar price on the purchase or sale of a security denominated in a foreign currency.
Cross Hedge. If a particular currency is expected to decrease against another currency, the Fund may sell the currency expected to decrease and purchase a currency which is expected to increase against the currency sold in an amount approximately equal to some or all of the Fund’s portfolio holdings denominated in the currency sold.
Direct Hedge. If PIMCO wants to limit the risk of owning a particular currency, and/or if PIMCO thinks that the Fund can benefit from price appreciation in a given country’s bonds but does not want to hold the currency, it may employ a direct hedge back into the U.S. dollar. In either case, the Fund would enter into a forward contract to sell the currency in which a portfolio security is denominated and purchase U.S. dollars at an exchange rate established at the time it initiated the contract. The cost of the direct hedge transaction may offset most, if not all, of the yield advantage offered by the foreign security, but the Fund would hope to benefit from an increase (if any) in the value of the bond.
Proxy Hedge. The Fund might choose to use a proxy hedge, which may be less costly than a direct hedge. In this case, the Fund, having purchased a security, will sell a currency whose value is believed to be closely linked to the currency in which the security is denominated. Interest rates prevailing in the country whose currency was sold would be expected to be closer to those in the United States and lower than those of securities denominated in the currency of the original holding. This type of hedging entails greater risk than a direct hedge because it is dependent on a stable relationship between the two currencies paired as proxies and the relationships can be very unstable at times.
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Costs of Hedging. When the Fund purchases a foreign (non-U.S.) bond with a higher interest rate than is available on U.S. bonds of a similar maturity, the additional yield on the foreign (non-U.S.) bond could be substantially reduced or lost if the Fund were to enter into a direct hedge by selling the foreign currency and purchasing the U.S. dollar. This is what is known as the “cost” of hedging. Proxy hedging attempts to reduce this cost through an indirect hedge back to the U.S. dollar.
It is important to note that hedging costs are treated as capital transactions and are not, therefore, deducted from the Fund’s dividend distribution and are not reflected in its yield. Instead such costs will, over time, be reflected in the Fund’s net asset value per share.
The Fund may enter into foreign currency transactions as a substitute for cash investments and for other investment purposes not involving hedging, including, without limitation, to exchange payments received in a foreign currency into U.S. dollars or in anticipation of settling a transaction that requires the Fund to deliver a foreign currency.
The forecasting of currency market movement is extremely difficult, and whether any hedging strategy will be successful is highly uncertain. Moreover, it is impossible to forecast with precision the market value of portfolio securities at the expiration of a foreign currency forward contract. Accordingly, the Fund may be required to buy or sell additional currency on the spot market (and bear the expense of such transaction) if PIMCO’s predictions regarding the movement of foreign currency or securities markets prove inaccurate. Also, foreign currency transactions, like currency exchange rates, can be affected unpredictably by intervention (or the failure to intervene) by U.S. or foreign governments or central banks, or by currency controls or political developments. Such events may prevent or restrict the Fund’s ability to enter into foreign currency transactions, force the Fund to exit a foreign currency transaction at a disadvantageous time or price or result in penalties for the Fund, any of which may result in a loss to the Fund. In addition, the use of cross-hedging transactions may involve special risks, and may leave the Fund in a less advantageous position than if such a hedge had not been established. Because foreign currency forward contracts are privately negotiated transactions, there can be no assurance that the Fund will have the flexibility to roll-over a foreign currency forward contract upon its expiration if it desires to do so. Additionally, there can be no assurance that the other party to the contract will perform its services thereunder. Under definitions adopted by the U.S. Commodity Futures Trading Commission (the “CFTC”) and the SEC, many non-deliverable foreign currency forwards are considered swaps for certain purposes, including determination of whether such instruments need to be exchange-traded and centrally cleared as discussed further in “Risks of Potential Government Regulation of Derivatives” and “Additional Risk Factors in Cleared Derivatives Transactions.” These changes are expected to reduce counterparty risk as compared to bi-laterally negotiated contracts.
The Fund may hold a portion of its assets in bank deposits denominated in foreign currencies, so as to facilitate investment in foreign securities as well as to protect against currency fluctuations and the need to convert such assets into U.S. dollars (thereby also reducing transaction costs). To the extent these monies are converted back into U.S. dollars, the value of the assets so maintained will be affected favorably or unfavorably by changes in foreign currency exchange rates and exchange control regulations.
Tax Consequences of Hedging and other Foreign Currency Transactions. Foreign currency gains are generally treated as qualifying income for purposes of the 90% gross income test described under “Taxation” below. However, it is possible the Internal Revenue Service (“IRS”) could issue contrary regulations with respect to foreign currency gains that are not directly related to a RIC’s principal business of investing in stocks or securities (or options or futures with respect to stocks or securities), and such regulations could apply retroactively. Such regulations, if issued, could limit the ability of the Fund to enter into the foreign currency transactions described above or could bear adversely on the Fund’s ability to qualify as a RIC. In addition, hedging transactions may result in the application of the mark-to-market and straddle provisions of the Code. Those provisions could affect the amount, timing or character of dividends paid by the Fund, including whether dividends paid by the Fund are classified as capital gains or ordinary income.
Foreign Currency Exchange-Related Securities
Foreign Currency Warrants. Foreign currency warrants such as Currency Exchange Warrantssm are warrants which entitle the holder to receive from their issuer an amount of cash (generally, for warrants issued in the United States, in U.S. dollars) which is calculated pursuant to a predetermined formula and based on the exchange rate
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between a specified foreign currency and the U.S. dollar as of the exercise date of the warrant. Foreign currency warrants generally are exercisable upon their issuance and expire as of a specified date and time. Foreign currency warrants have been issued in connection with U.S. dollar-denominated debt offerings by major corporate issuers in an attempt to reduce the foreign currency exchange risk which, from the point of view of prospective purchasers of the securities, is inherent in the international fixed income marketplace. Foreign currency warrants may attempt to reduce the foreign exchange risk assumed by purchasers of a security by, for example, providing for a supplemental payment in the event that the U.S. dollar depreciates against the value of a major foreign currency such as the Japanese yen or the Euro. The formula used to determine the amount payable upon exercise of a foreign currency warrant may make the warrant worthless unless the applicable foreign currency exchange rate moves in a particular direction (e.g., unless the U.S. dollar appreciates or depreciates against the particular foreign currency to which the warrant is linked or indexed) or degree. Foreign currency warrants are severable from the debt obligations with which they may be offered, and may be listed on exchanges. Foreign currency warrants may be exercisable only in certain minimum amounts, and an investor wishing to exercise warrants who possesses less than the minimum number required for exercise may be required either to sell the warrants or to purchase additional warrants, thereby incurring additional transaction costs. In the case of any exercise of warrants, there may be a time delay between the time a holder of warrants gives instructions to exercise and the time the exchange rate relating to exercise is determined, during which time the exchange rate could change significantly, thereby affecting both the market and cash settlement values of the warrants being exercised. The expiration date of the warrants may be accelerated if the warrants should be delisted from an exchange or if their trading should be suspended permanently, which would result in the loss of any remaining “time value” of the warrants (i.e., the difference between the current market value and the exercise value of the warrants), and, in the case the warrants were “out-of-the-money,” in a total loss of the purchase price of the warrants. Warrants are generally unsecured obligations of their issuers and are not standardized foreign currency options issued by the Options Clearing Corporation (the “OCC”). Unlike foreign currency options issued by the OCC, the terms of foreign exchange warrants generally will not be amended in the event of governmental or regulatory actions affecting exchange rates or in the event of the imposition of other regulatory controls affecting the international currency markets. The initial public offering price of foreign currency warrants is generally considerably in excess of the price that a commercial user of foreign currencies might pay in the interbank market for a comparable option involving significantly larger amounts of foreign currencies. Foreign currency warrants are subject to significant foreign exchange risk, including risks arising from complex political or economic factors.
Principal Exchange Rate Linked Securities. Principal exchange rate linked securities (“PERLs”) are debt obligations the principal on which is payable at maturity in an amount that may vary based on the exchange rate between the U.S. dollar and a particular foreign currency at or about that time. The return on “standard” principal exchange rate linked securities is enhanced if the foreign currency to which the security is linked appreciates against the U.S. dollar, and is adversely affected by increases in the foreign exchange value of the U.S. dollar; “reverse” principal exchange rate linked securities are like “standard” securities, except that their return is enhanced by increases in the value of the U.S. dollar and adversely impacted by increases in the value of foreign currency. Interest payments on the securities are generally made in U.S. dollars at rates that reflect the degree of foreign currency risk assumed or given up by the purchaser of the notes (i.e., at relatively higher interest rates if the purchaser has assumed some of the foreign exchange risk, or relatively lower interest rates if the issuer has assumed some of the foreign exchange risk, based on the expectations of the current market). PERLs may in limited cases be subject to acceleration of maturity (generally, not without the consent of the holders of the securities), which may have an adverse impact on the value of the principal payment to be made at maturity.
Performance Indexed Paper. Performance indexed paper is U.S. dollar-denominated commercial paper the yield of which is linked to certain foreign exchange rate movements. The yield to the investor on performance indexed paper is established at maturity as a function of spot exchange rates between the U.S. dollar and a designated currency as of or about that time (generally, the index maturity two days prior to maturity). The yield to the investor will be within a range stipulated at the time of purchase of the obligation, generally with a guaranteed minimum rate of return that is below, and a potential maximum rate of return that is above, market yields on U.S. dollar-denominated commercial paper, with both the minimum and maximum rates of return on the investment corresponding to the minimum and maximum values of the spot exchange rate two business days prior to maturity.
U.S. Government Securities
U.S. government securities are obligations of, and, in certain cases, guaranteed by, the U.S. government, its agencies or instrumentalities. The U.S. government does not guarantee the net asset value of the Fund’s shares. U.S. government securities are subject to market and interest rate risk, and may be subject to varying degrees of credit
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risk. Some U.S. government securities, such as Treasury bills, notes and bonds, and securities guaranteed by GNMA, are supported by the full faith and credit of the United States; others, such as those of the Federal Home Loan Banks, are supported by the right of the issuer to borrow from the U.S. Treasury; others, such as those of the FNMA, are supported by the discretionary authority of the U.S. government to purchase the agency’s obligations; and still others, such as securities issued by members of the Farm Credit System, are supported only by the credit of the agency, instrumentality or corporation. U.S. government securities may include zero coupon securities, which do not distribute interest on a current basis and tend to be subject to greater risk than interest-paying securities of similar maturities.
Securities issued by U.S. government agencies or government-sponsored enterprises may not be guaranteed by the U.S. Treasury. GNMA, a wholly owned U.S. government corporation, is authorized to guarantee, with the full faith and credit of the U.S. government, the timely payment of principal and interest on securities issued by institutions approved by GNMA and backed by pools of mortgages insured by the Federal Housing Administration or guaranteed by the VA. Government-related guarantors (i.e., not backed by the full faith and credit of the U.S. government) include the FNMA and FHLMC. Pass-through securities issued by FNMA are guaranteed as to timely payment of principal and interest by FNMA but are not backed by the full faith and credit of the U.S. government. FHLMC guarantees the timely payment of interest and ultimate collection of principal, but its PCs are not backed by the full faith and credit of the U.S. government. Instead, they are supported only by the discretionary authority of the U.S. government to purchase the agency’s obligations. Under the direction of the FHFA, FNMA and FHLMC have entered into a joint initiative to develop a common securitization platform for the issuance of UMBS (the “Single Security Initiative”) that aligns the characteristics of FNMA and FHLMC certificates. The Single Security Initiative was implemented in June 2019, and the effects it may have on the market for mortgage-backed securities are uncertain.
U.S. government securities include securities that have no coupons, or have been stripped of their unmatured interest coupons, individual interest coupons from such securities that trade separately, and evidences of receipt of such securities. Such securities may pay no cash income, and are purchased at a deep discount from their value at maturity. Because interest on zero coupon securities is not distributed on a current basis but is, in effect, compounded, zero coupon securities tend to be subject to greater risk than interest-paying securities of similar maturities. Custodial receipts issued in connection with so-called trademark zero coupon securities, such as CATs and TIGRs, are not issued by the U.S. Treasury, and are therefore not U.S. government securities, although the underlying bond represented by such receipt is a debt obligation of the U.S. Treasury. Other zero coupon Treasury securities (e.g., STRIPs and CUBEs) are direct obligations of the U.S. government.
Municipal Securities
The Fund may invest in securities issued by states, territories, possessions, municipalities and other political subdivisions, agencies, authorities and instrumentalities of states, territories, possessions and multi-state agencies or authorities.
Municipal Securities. Municipal securities include debt obligations issued by governmental entities to obtain funds for various public purposes, including the construction of a wide range of public facilities, the refunding of outstanding obligations, the payment of general operating expenses, and the extension of loans to public institutions and facilities. Municipal securities can be classified into two principal categories, including “general obligation” bonds and other securities and “revenue” bonds and other securities. General obligation bonds are secured by the issuer’s full faith, credit and taxing power for the payment of principal and interest. Revenue securities are payable only from the revenues derived from a particular facility or class of facilities or, in some cases, from the proceeds of a special excise tax or other specific revenue source, such as the user of the facility being financed. Municipal securities also may include “moral obligation” securities, which normally are issued by special purpose public authorities. If the issuer of moral obligation securities is unable to meet its debt service obligations from current revenues, it may draw on a reserve fund, the restoration of which is a moral commitment but not a legal obligation of the governmental entity that created the special purpose public authority. Municipal securities may be structured as fixed-, variable- or floating-rate obligations or as zero-coupon, PIKs and step-coupon securities and may be privately placed or publicly offered.
The Fund may invest in instruments, or participations in instruments, issued in connection with lease obligations or installment purchase contract obligations of municipalities (“municipal lease obligations”). Although municipal lease obligations do not constitute general obligations of the issuing municipality, a lease obligation may be backed by the municipality’s covenant to budget for, appropriate funds for and make the payments due under the lease obligation. However, certain municipal lease obligations contain “non-appropriation” clauses, which provide that the municipality
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has no obligation to make lease or installment purchase payments in future years unless money is appropriated for such purpose in the relevant years. Municipal lease obligations may be less readily marketable than other municipal securities.
Projects financed with certificates of participation generally are not subject to state constitutional debt limitations or other statutory requirements that may apply to other municipal securities. Payments by the public entity on the obligation underlying the certificates are derived from available revenue sources. That revenue might be diverted to the funding of other municipal service projects. Payments of interest and/or principal with respect to the certificates are not guaranteed and do not constitute an obligation of a state or any of its political subdivisions.
Municipal leases may also be subject to “abatement risk.” The leases underlying certain municipal lease obligations may state that lease payments are subject to partial or full abatement. That abatement might occur, for example, if material damage to or destruction of the leased property interferes with the lessee’s use of the property. However, in some cases that risk might be reduced by insurance covering the leased property, or by the use of credit enhancements such as letters of credit to back lease payments, or perhaps by the lessee’s maintenance of reserve monies for lease payments. While the obligation might be secured by the lease, it might be difficult to dispose of that property in case of a default.
Municipal notes may be issued by governmental entities and other tax-exempt issuers in order to finance short-term cash needs or, occasionally, to finance construction. Most municipal notes are general obligations of the issuing entity payable from taxes or designated revenues expected to be received within the relevant fiscal period. Municipal notes generally have maturities of one year or less. Municipal notes can be subdivided into two sub-categories: (i) municipal commercial paper and (ii) municipal demand obligations. Municipal commercial paper typically consists of very short-term unsecured negotiable promissory notes that are sold, for example, to meet seasonal working capital or interim construction financing needs of a governmental entity or agency. While these obligations are intended to be paid from general revenues or refinanced with long-term debt, they frequently are backed by letters of credit, lending agreements, note repurchase agreements or other credit facility agreements offered by banks or institutions.
Municipal demand obligations can be subdivided into two general types: variable rate demand notes and master demand obligations. Variable rate demand notes are tax-exempt municipal obligations or participation interests that provide for a periodic adjustment in the interest rate paid on the notes. They permit the holder to demand payment of the notes, or to demand purchase of the notes at a purchase price equal to the unpaid principal balance, plus accrued interest either directly by the issuer or by drawing on a bank letter of credit or guaranty issued with respect to such note. The issuer of the municipal obligation may have a corresponding right to prepay at its discretion the outstanding principal of the note plus accrued interest upon notice comparable to that required for the holder to demand payment. The variable rate demand notes in which the Fund may invest are payable, or are subject to purchase, on demand usually on notice of seven calendar days or less. The terms of the notes generally provide that interest rates are adjustable at intervals ranging from daily to six months.
Master demand obligations are tax-exempt municipal obligations that provide for a periodic adjustment in the interest rate paid and permit daily changes in the amount borrowed. The interest on such obligations is, in the opinion of counsel for the borrower, excluded from gross income for federal income tax purposes (but not necessarily for alternative minimum tax purposes). Although there is no secondary market for master demand obligations, such obligations are considered by the Fund to be liquid because they are payable upon demand.
Investing in municipal securities is subject to certain risks. There are variations in the quality of municipal securities, both within a particular classification and between classifications, and the rates of return on municipal securities can depend on a variety of factors, including general money market conditions, the financial condition of the issuer, general conditions of the municipal bond market, the size of a particular offering, the maturity of the obligation, and the rating of the issue. The ratings of NRSROs represent their opinions as to the quality of municipal securities. It should be emphasized, however, that these ratings are general and are not absolute standards of quality, and municipal securities with the same maturity, interest rate, and rating may have different rates of return while municipal securities of the same maturity and interest rate with different ratings may have the same rate of return.
The payment of principal and interest on most municipal securities purchased by the Fund will depend upon the ability of the issuers to meet their obligations. An issuer’s obligations under its municipal securities are subject to the
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provisions of bankruptcy, insolvency, and other laws affecting the rights and remedies of creditors, such as the United States Bankruptcy Code. The power or ability of an issuer to meet its obligations for the payment of interest on and principal of its municipal securities may be materially adversely affected by litigation or other conditions.
There are particular considerations and risks relevant to investing in a portfolio of a single state’s municipal securities, such as the greater risk of concentration of portfolio holdings. Each state’s municipal securities may include, in addition to securities issued by the relevant state and its political subdivisions, agencies, authorities and instrumentalities, securities issued by the governments of Guam, Puerto Rico or the U.S. Virgin Islands. These securities may be subject to different risks than municipal securities issued by the relevant state and its political subdivisions, agencies, authorities and instrumentalities.
Municipal Bonds. Municipal bonds share the attributes of debt/fixed income securities in general, but are generally issued by states, municipalities and other political subdivisions, agencies, authorities and instrumentalities of states and multi-state agencies or authorities. The municipal bonds that the Fund may purchase include general obligation bonds and limited obligation bonds (or revenue bonds), including industrial development bonds issued pursuant to former federal tax law. General obligation bonds are obligations involving the credit of an issuer possessing taxing power and are payable from such issuer’s general revenues and not from any particular source. Limited obligation bonds are payable only from the revenues derived from a particular facility or class of facilities or, in some cases, from the proceeds of a special excise or other specific revenue source or annual revenues. Tax-exempt private activity bonds and industrial development bonds generally are also revenue bonds and thus are not payable from the issuer’s general revenues. The credit and quality of private activity bonds and industrial development bonds are usually related to the credit of the corporate user of the facilities. Payment of interest on and repayment of principal of such bonds is the responsibility of the user and any guarantor. The Fund does not expect to be eligible to pass through to shareholders the tax-exempt character of interest earned on municipal bonds. The Fund may be more sensitive to adverse economic, business or political developments if it invests a substantial portion of its assets in industrial development bonds.
A fund that may invest in municipal bonds may invest in pre-refunded municipal bonds. Pre-refunded municipal bonds are tax-exempt bonds that have been refunded to a call date prior to the final maturity of principal, or, in the case of pre-refunded municipal bonds commonly referred to as “escrowed-to-maturity bonds,” to the final maturity of principal, and remain outstanding in the municipal market. The payment of principal and interest of the pre-refunded municipal bonds held by the Fund is funded from securities in a designated escrow account that holds U.S. Treasury securities or other obligations of the U.S. government (including its agencies and instrumentalities (“Agency Securities”)). Interest payments on pre-refunded municipal bonds issued on or prior to December 31, 2017 are exempt from federal income tax; interest payments on pre-refunded municipal bonds issued after December 31, 2017 are not exempt from federal income tax.
As the payment of principal and interest is generated from securities held in an escrow account established by the municipality and an independent escrow agent, the pledge of the municipality has been fulfilled and the original pledge of revenue by the municipality is no longer in place. Pre-refunded municipal bonds may bear an AAA/Aaa rating (for example, if re-rated by a rating service or, if not re-rated, determined by PIMCO to be of comparable quality) because they are backed by U.S. Treasury securities or Agency Securities. For the avoidance of any doubt, PIMCO’s determination of issuer credit rating will be used for compliance with the Fund’s investment parameters when an issue either loses its rating or is not re-rated upon pre-refunding. The escrow account securities pledged to pay the principal and interest of the pre-refunded municipal bond do not guarantee the price movement of the bond before maturity. Issuers of municipal bonds refund in advance of maturity the outstanding higher cost debt and issue new, lower cost debt, placing the proceeds of the lower cost issuance into an escrow account to pre-refund the older, higher cost debt. Investments in pre-refunded municipal bonds held by the Fund may subject the Fund to interest rate risk, market risk and credit risk. In addition, while a secondary market exists for pre-refunded municipal bonds, if the Fund sells pre-refunded municipal bonds prior to maturity, the price received may be more or less than the original cost, depending on market conditions at the time of sale. To the extent permitted by the SEC and the IRS, the Fund’s investment in pre-refunded municipal bonds backed by U.S. Treasury and Agency securities in the manner described above, will, for purposes of diversification tests applicable to the Fund, be considered an investment in the respective U.S. Treasury and Agency securities.
Under the Code, certain limited obligation bonds are considered “private activity bonds” and interest paid on such bonds is treated as an item of tax preference for purposes of calculating federal alternative minimum tax liability.
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Certain Risks of Investing in Municipal Bonds. Economic downturns and budgetary constraints have made municipal bonds more susceptible to downgrade, default and bankruptcy. In addition, difficulties in the municipal bond markets could result in increased illiquidity, volatility and credit risk, and a decrease in the number of municipal bond investment opportunities. The value of municipal bonds may also be affected by uncertainties involving the taxation of municipal bonds or the rights of municipal bond holders in the event of a bankruptcy. Proposals to restrict or eliminate the federal income tax exemption for interest on municipal bonds are introduced before Congress from time to time. These legal uncertainties could affect the municipal bond market generally, certain specific segments of the market, or the relative credit quality of particular securities.
The Fund may purchase and sell portfolio investments to take advantage of changes or anticipated changes in yield relationships, markets or economic conditions. The Fund may also sell municipal bonds due to changes in PIMCO’s evaluation of the issuer. The secondary market for municipal bonds typically has been less liquid than that for taxable debt/fixed income securities, and this may affect the Fund’s ability to sell particular municipal bonds at then-current market prices, especially in periods when other investors are attempting to sell the same securities.
Additionally, municipal bonds rated below investment grade (i.e., high yield municipal bonds) may not be as liquid as higher-rated municipal bonds. Reduced liquidity in the secondary market may have an adverse impact on the market price of a municipal bond and on the Fund’s ability to sell a municipal bond in response to changes or anticipated changes in economic conditions or to meet the Fund’s cash needs. Reduced liquidity may also make it more difficult to obtain market quotations based on actual trades for purposes of valuing the Fund’s portfolio. For more information on high yield securities please see “High Yield Securities (“Junk Bonds”) and Securities of Distressed Companies” above.
Prices and yields on municipal bonds are dependent on a variety of factors, including general money-market conditions, the financial condition of the issuer, general conditions of the municipal bond market, the size of a particular offering, the maturity of the obligation and the rating of the issue. A number of these factors, including the ratings of particular issues, are subject to change from time to time. Information about the financial condition of an issuer of municipal bonds may not be as extensive as that which is made available by corporations whose securities are publicly traded.
The perceived increased likelihood of default among issuers of municipal bonds has resulted in constrained illiquidity, increased price volatility and credit downgrades of issuers of municipal bonds. Local and national market forces—such as declines in real estate prices and general business activity—may result in decreasing tax bases, fluctuations in interest rates, and increasing construction costs, all of which could reduce the ability of certain issuers of municipal bonds to repay their obligations. Certain issuers of municipal bonds have also been unable to obtain additional financing through, or must pay higher interest rates on, new issues, which may reduce revenues available for issuers of municipal bonds to pay existing obligations. In addition, events have demonstrated that the lack of disclosure rules in this area can make it difficult for investors to obtain reliable information on the obligations underlying municipal bonds. Adverse developments in the municipal bond market may negatively affect the value of all or a substantial portion of the Fund’s holdings in municipal bonds.
Obligations of issuers of municipal bonds are subject to the provisions of bankruptcy, insolvency and other laws affecting the rights and remedies of creditors. Congress or state legislatures may seek to extend the time for payment of principal or interest, or both, or to impose other constraints upon enforcement of such obligations. There is also the possibility that as a result of litigation or other conditions, the power or ability of issuers to meet their obligations for the payment of interest and principal on their municipal bonds may be materially affected or their obligations may be found to be invalid or unenforceable. Such litigation or conditions may from time to time have the effect of introducing uncertainties in the market for municipal bonds or certain segments thereof, or of materially affecting the credit risk with respect to particular bonds. Adverse economic, business, legal or political developments might affect all or a substantial portion of the Fund’s municipal bonds in the same manner.
From time to time, proposals have been introduced before Congress for the purpose of restricting or eliminating the federal income tax exemption for interest on certain types of municipal bonds. Additionally, certain other proposals have been introduced that would have the effect of taxing a portion of exempt interest and/or reducing the tax benefits of receiving exempt interest. It can be expected that similar proposals may be introduced in the future. As a result of any such future legislation, the availability of such municipal bonds for investment by the Fund and the value of such municipal bonds held by the Fund may be affected. In addition, it is possible that events occurring after the date of a
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municipal bond’s issuance, or after the Fund’s acquisition of such obligation, may result in a determination that the interest paid on that obligation is taxable, in certain cases retroactively.
Some longer-term municipal bonds give the investor the right to “put” or sell the security at par (face value) within a specified number of days following the investor’s request—usually one to seven days. This demand feature enhances a security’s liquidity by shortening its effective maturity and enables it to trade at a price equal to or very close to par. If a demand feature terminates prior to being exercised, the Fund would hold the longer-term security, which could experience substantially more volatility.
The Fund may invest in taxable municipal bonds, such as Build America Bonds. Build America Bonds are tax credit bonds created by the American Recovery and Reinvestment Act of 2009, which authorized state and local governments to issue Build America Bonds as taxable bonds in 2009 and 2010, without volume limitations, to finance any capital expenditures for which such issuers could otherwise issue traditional tax-exempt bonds. State and local governments may receive a direct federal subsidy payment for a portion of their borrowing costs on Build America Bonds equal to 35% of the total coupon interest paid to investors (or 45% in the case of Recovery Zone Economic Development Bonds). The state or local government issuer can elect to either take the federal subsidy or pass the 35% tax credit along to bondholders. The Fund’s investments in Build America Bonds or similar taxable municipal bonds will result in taxable income and the Fund may elect to pass through to holders of the Fund’s Common Shares (“Common Shareholders”) the corresponding tax credits. The tax credits can generally be used to offset federal income taxes and the alternative minimum tax, but such credits are generally not refundable. Build America Bonds or similar taxable municipal bonds involve similar risks as tax-exempt municipal bonds, including credit and market risk. They are intended to assist state and local governments in financing capital projects at lower borrowing costs and are likely to attract a broader group of investors than tax-exempt municipal bonds. Although Build America Bonds were only authorized for issuance during 2009 and 2010, the program may have resulted in reduced issuance of tax- exempt municipal bonds during the same period.
The Build America Bond program expired on December 31, 2010, at which point no further issuance of new Build America Bonds was permitted. As of the date of this Statement of Additional Information, there is no indication that Congress will renew the program to permit issuance of new Build America Bonds.
Puerto Rico Municipal Securities. Municipal obligations issued by the Commonwealth of Puerto Rico (“Puerto Rico” or the “Commonwealth”) or its political subdivisions, agencies, instrumentalities, or public corporations may be affected by economic, market, political, and social conditions in Puerto Rico. Puerto Rico currently is experiencing significant fiscal and economic challenges, including substantial debt service obligations, high levels of unemployment, underfunded public retirement systems, and persistent government budget deficits. These challenges may negatively affect the value of the Fund’s investments in Puerto Rico municipal securities. Major ratings agencies have downgraded the general obligation debt of Puerto Rico to below investment grade and continue to maintain a negative outlook for this debt, which increases the likelihood that the rating will be lowered further. Further downgrades or defaults may place additional strain on the Puerto Rico economy and may negatively affect the value, liquidity, and volatility of the Fund’s investments in Puerto Rico municipal securities. Legislation, including legislation that would allow Puerto Rico to restructure its municipal debt obligations, thus increasing the risk that Puerto Rico may never pay off municipal indebtedness, or may pay only a small fraction of the amount owed, could also impact the value of the Fund’s investments in Puerto Rico municipal securities.
In September 2017, two successive hurricanes - Irma and Maria - caused severe damage to Puerto Rico. The Commonwealth's infrastructure was severely damaged by high winds and substantial flooding, including damage to the Commonwealth's water, power, and telecommunications infrastructure, and resulted in more than 1 million people losing power. In late December 2019 and January 2020, a series of earthquakes, including a magnitude 6.4 earthquake-the strongest to hit the island in more than a century-caused an estimated $200 million in damage. The aftershocks from these earthquakes may continue for years, and it is not currently possible to predict the extent of the damage that could arise from any aftershocks. The full extent of the natural disasters’ impact on Puerto Rico’s economy and foreign investment in Puerto Rico is difficult to estimate, but is expected to have substantially adverse effects on Puerto Rico’s economy. In addition to diverting funds to relief and recovery efforts, Puerto Rico is expected to lose substantial revenue as a result of decreased tourism and general business operations. There can be no assurances that Puerto Rico will receive the necessary aid to rebuild from the damage caused by the hurricanes or earthquakes or that future catastrophic weather events or natural disasters will not cause similar damage.
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In addition, the Commonwealth was significantly impacted by a pandemic, which had a substantially adverse effect on the health of the population and economic activity. In March 2020, the Oversight Board authorized the Commonwealth to implement a $787 million relief package to fight the pandemic and its economic impacts, of which $500 million was incremental new spending made available through a special appropriation. Any reduction in the Commonwealth’s revenues as a result of the pandemic could have a negative ability on the Commonwealth to meet its debt service obligations, including with respect to debt held by the Fund. Further, Congress passed the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) in March 2020, which provided for approximately $2.2 trillion in disaster relief. Among other things, the CARES Act established the Coronavirus Relief Fund, from which Puerto Rico received $2.2 billion. In March 2021, the American Rescue Plan was signed into law, which provided an additional $350 billion in emergency funding for state, local, territorial, and Tribal governments, including $4.5 billion specifically for relief to U.S. territories. The rate and level at which the federal government and the Commonwealth took on new debt could have a negative impact on their fiscal health, which could lead to prolonged challenges. A failure by Puerto Rico to meet its debt obligations could lead to a significant decline in the value, liquidity, and marketability of Fund investments.
As of the date of this SAI, S&P, Moody’s and Fitch each have withdrawn their unenhanced ratings of Puerto Rico’s general obligation debt. The withdrawals reflect only the views of the respective rating agency, an explanation of which may be obtained from each such rating agency. There is no assurance that the withdrawals will continue for any given period of time or that they will not be reversed by the rating agency if, in the judgment of such rating agency, circumstances so warrant. A downward revision or withdrawal of a general obligation bond rating may have an adverse effect on the market prices of the securities issued by the Commonwealth and its political subdivisions, instrumentalities, and authorities.
Corporate Debt Securities
The Fund may invest in corporate debt securities of U.S. issuers and foreign issuers, and/or it may hold its assets in these securities for cash management purposes. The investment return of corporate debt securities reflects interest earnings and changes in the market value of the security. The market value of a corporate debt obligation may generally be expected to rise and fall inversely with interest rates generally. There also exists the risk that the issuers of the securities may not be able to meet their obligations on interest or principal payments at the time called for by an instrument. Corporate income-producing securities may include forms of preferred or preference stock.
The rate of interest on a corporate debt security may be fixed, floating or variable, and may vary inversely with respect to a reference rate. The rate of return or return of principal on some debt obligations may be linked or indexed to the level of exchange rates between the U.S. dollar and a foreign currency or currencies. Corporate debt securities may be acquired with warrants attached.
Securities rated Baa and BBB are the lowest which are considered “investment grade” obligations. Moody’s describes securities rated Baa as judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative characteristics. S&P describes securities rated BBB as exhibiting adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to weaken the obligor’s capacity to meet its financial commitments on the obligation. Fitch describes securities rated BBB as having good credit quality with current low expectations of default. The capacity for payment of financial commitments is considered adequate, but adverse business or economic conditions are more likely to impair this capacity. For a discussion of securities rated below investment grade, see “High Yield Securities (“Junk Bonds”) and Securities of Distressed Companies” below.
Commercial Paper
Commercial paper represents short-term unsecured promissory notes issued in bearer form by corporations such as banks or bank holding companies and finance companies. The Fund may invest in commercial paper of any credit quality consistent with the Fund’s investment objective and policies, including unrated commercial paper. See Appendix A to the Prospectus for a description of the ratings assigned by Moody’s, S&P and Fitch to commercial paper. The rate of return on commercial paper may be linked or indexed to the level of exchange rates between the U.S. dollar and a foreign currency or currencies.
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Convertible Securities
The Fund may invest in convertible securities, which may offer higher income than the common stocks into which they are convertible. A convertible security is a bond, debenture, note, preferred security or other security that entitles the holder to acquire common stock or other equity securities of the same or a different issuer. A convertible security generally entitles the holder to receive interest paid or accrued until the convertible security matures or is redeemed, converted or exchanged. Before conversion, convertible securities have characteristics similar to non-convertible debt securities or preferred securities, as applicable. Convertible securities rank senior to common stock in a corporation’s capital structure and, therefore, generally entail less risk than the corporation’s common stock, although the extent to which such risk is reduced depends in large measure upon the degree to which the convertible security sells above its value as a fixed income security. Convertible securities are subordinate in rank to any senior debt obligations of the issuer, and, therefore, an issuer’s convertible securities entail more risk than its debt obligations. Convertible securities generally offer lower interest or dividend yields than non-convertible debt securities of similar credit quality because of the potential for capital appreciation. In addition, convertible securities are often lower-rated securities.
Because of the conversion feature, the price of the convertible security will normally fluctuate in some proportion to changes in the price of the underlying asset, and as such is subject to risks relating to the activities of the issuer and/or general market and economic conditions. The income component of a convertible security may tend to cushion the security against declines in the price of the underlying asset. However, the income component of convertible securities causes fluctuations based upon changes in interest rates and the credit quality of the issuer.
If the convertible security’s “conversion value,” which is the market value of the underlying common stock that would be obtained upon the conversion of the convertible security, is substantially below the “investment value,” which is the value of a convertible security viewed without regard to its conversion feature (i.e., strictly on the basis of its yield), the price of the convertible security is typically governed principally by its investment value. If the conversion value of a convertible security increases to a point that approximates or exceeds its investment value, the value of the security will typically be principally influenced by its conversion value. A convertible security generally will sell at a premium over its conversion value to the extent investors place value on the right to acquire the underlying common stock while holding an income-producing security.
A convertible security may be subject to redemption at the option of the issuer at a predetermined price. If a convertible security held by the Fund is called for redemption, the Fund would be required to permit the issuer to redeem the security and convert it to underlying common stock, or would sell the convertible security to a third party, which may have an adverse effect on the Fund’s ability to achieve its investment objective. The Fund generally would invest in convertible securities for their favorable price characteristics and total return potential.
The Fund may invest in so-called “synthetic convertible securities,” which are composed of two or more different securities whose investment characteristics, taken together, resemble those of convertible securities. A third party or PIMCO may create a “synthetic” convertible security by combining separate securities that possess the two principal characteristics of a traditional convertible security, i.e., an income-producing security (“income-producing component”) and the right to acquire an equity security (“convertible component”). The income-producing component is achieved by investing in non-convertible, income-producing securities such as bonds, preferred securities and money market instruments, which may be represented by derivative instruments. The convertible component is achieved by investing in securities or instruments such as warrants or options to buy common stock at a certain exercise price, or options on a stock index. Unlike a traditional convertible security, which is a single security having a unitary market value, a synthetic convertible comprises two or more separate securities, each with its own market value. Therefore, the “market value” of a synthetic convertible security is the sum of the values of its income-producing component and its convertible component. For this reason, the values of a synthetic convertible security and a traditional convertible security may respond differently to market fluctuations.
More flexibility is possible in the assembly of a synthetic convertible security than in the purchase of a convertible security. Although synthetic convertible securities may be selected where the two components are issued by a single issuer, thus making the synthetic convertible security similar to the traditional convertible security, the character of a synthetic convertible security allows the combination of components representing distinct issuers, when PIMCO believes that such a combination may better achieve the Fund’s investment objective. A synthetic convertible security also is a more flexible investment in that its two components may be purchased separately. For example, the
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Fund may purchase a warrant for inclusion in a synthetic convertible security but temporarily hold short-term investments while postponing the purchase of a corresponding bond pending development of more favorable market conditions.
A holder of a synthetic convertible security faces the risk of a decline in the price of the security or the level of the index or security involved in the convertible component, causing a decline in the value of the security or instrument, such as a call option or warrant purchased to create the synthetic convertible security. Should the price of the stock fall below the exercise price and remain there throughout the exercise period, the entire amount paid for the call option or warrant would be lost. Because a synthetic convertible security includes the income-producing component as well, the holder of a synthetic convertible security also faces the risk that interest rates will rise, causing a decline in the value of the income-producing component.
The Fund also may purchase synthetic convertible securities created by other parties, including convertible structured notes. Convertible structured notes are income-producing debentures linked to equity, and are typically issued by investment banks. Convertible structured notes have the attributes of a convertible security; however, the investment bank that issues the convertible note, rather than the issuer of the underlying common stock into which the note is convertible, assumes credit risk associated with the underlying investment, and the Fund in turn assumes credit risk associated with the convertible note.
Contingent Convertible Instruments. Contingent convertible securities (“CoCos”) are a form of hybrid debt security issued primarily by non-U.S. issuers, which have loss absorption mechanisms built into their terms. CoCos have no stated maturity, have fully discretionary coupons and are typically issued in the form of subordinated debt instruments. CoCos generally either convert into common stock of the issuer or have their principal written down upon the occurrence of certain triggering events (“triggers”) linked to regulatory capital thresholds or regulatory actions calling into question the issuing banking institution’s continued viability as a going-concern. In certain scenarios, investors in CoCos may suffer a loss of capital ahead of equity holders or when equity holders do not. There is no guarantee that the Fund will receive a return of principal on CoCos. Any indication that an automatic write-down or conversion event may occur can be expected to have an adverse effect on the market price of CoCos. CoCos are often rated below investment grade and are subject to the risks of high yield securities. Because CoCos are issued primarily by financial institutions, CoCos may present substantially increased risks at times of financial turmoil, which could affect financial institutions more than companies in other sectors and industries. Further, the value of an investment in CoCos is unpredictable and will be influenced by many factors and risks, including interest rate risk, credit risk, market risk and liquidity risk. An investment by the Fund in CoCos may result in losses to the Fund.
CoCos’ unique equity conversion or principal write-down features are tailored to the issuing banking institution and its regulatory requirements. Some additional risks associated with CoCos include, but are not limited to:
Loss absorption risk. CoCos may be subject to an automatic write-down (i.e., the automatic write-down of the principal amount or value of the securities, potentially to zero, and the cancellation of the securities) under certain circumstances, which could result in the Fund losing a portion or all of its investment in such securities. In addition, the Fund may not have any rights with respect to repayment of the principal amount of the securities that has not become due or the payment of interest or dividends on such securities for any period from (and including) the interest or dividend payment date falling immediately prior to the occurrence of such automatic write-down. An automatic write-down could also result in a reduced income rate if the dividend or interest payment is based on the security’s par value. In addition, CoCos have fully discretionary coupons. This means coupons can potentially be cancelled at the issuer’s discretion or at the request of the relevant regulatory authority in order to help the issuer absorb losses and may be suspended in the event there are insufficient distributable reserves.
Subordinated instruments. CoCos will, in the majority of circumstances, be issued in the form of subordinated debt instruments in order to provide the appropriate regulatory capital treatment prior to a conversion. Accordingly, in the event of liquidation, dissolution or winding-up of an issuer prior to a conversion having occurred, the rights and claims of the holders of the CoCos, such as the Fund, against the issuer in respect of or arising under the terms of the CoCos shall generally rank junior to the claims of all holders of unsubordinated obligations of the issuer and may also become junior to other obligations of the issuer. In addition, if the CoCos are converted into the issuer’s underlying equity securities following a conversion event (i.e., a “trigger”), each holder will be subordinated due to their conversion from being the holder of a debt instrument to being the holder of an equity instrument.
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Market value will fluctuate based on unpredictable factors. The trading behavior of a given issuer’s CoCos may be strongly impacted by the trading behavior of other issuers’ CoCos, such that negative information from an unrelated CoCo may cause a decline in value of one or more CoCos held by the Fund. Accordingly, the trading behavior of CoCos may not follow the trading behavior of other similarly structured securities. The value of CoCos is unpredictable and will be influenced by many factors including, without limitation: (i) the creditworthiness of the issuer and/or fluctuations in such issuer’s applicable capital ratios; (ii) supply and demand for the CoCos; (iii) general market conditions and available liquidity; and (iv) economic, financial and political events that affect the issuer, its particular market or the financial markets in general.
Equity Securities
Subject to the Fund’s investment policies, the Fund may invest up to 20% of its total assets in common stocks and other equity securities from time to time, including those it has received through the conversion of a convertible security held by the Fund or in connection with the restructuring of a debt security. Common stocks include common shares and other common equity interests issued by private or public issuers. The Fund may invest in securities that have not been registered for public sale in the U.S. or relevant non-U.S. jurisdictions, including without limit securities eligible for purchase and sale pursuant to Rule 144A under the Securities Act, or relevant provisions of applicable non-U.S. law, and other securities issued in private placements. The Fund may also invest in preferred securities.
The market price of common stocks and other equity securities may go up or down, sometimes rapidly or unpredictably. Equity securities may decline in value due to factors affecting equity securities markets generally, particular industries represented in those markets, or the issuer itself. The values of equity securities may decline due to general market conditions that are not specifically related to a particular company, such as real or perceived adverse economic conditions, changes in the general outlook for corporate earnings, changes in interest or currency rates or adverse investor sentiment generally. They may also decline due to factors that affect a particular industry or industries, such as labor shortages or increased production costs and competitive conditions within an industry. Equity securities generally have greater price volatility than fixed income securities. These risks are generally magnified in the case of equity investments in distressed companies.
Different types of equity securities provide different voting and dividend rights and priority in the event of the bankruptcy and/or insolvency of the issuer. In addition to common stock, equity securities may include preferred securities, convertible securities and warrants, which are discussed elsewhere in the Prospectus and this Statement of Additional Information. Equity securities other than common stock are subject to many of the same risks as common stock, although possibly to different degrees. The risks of equity securities are generally magnified in the case of equity investments in distressed companies.
Preferred Securities
Preferred securities represent an equity interest in a company that generally entitles the holder to receive, in preference to the holders of other stocks such as common stocks, dividends and a fixed share of the proceeds resulting from a liquidation of the company. Some preferred securities also entitle their holders to receive additional liquidation proceeds on the same basis as holders of a company’s common stock, and thus also represent an ownership interest in that company. Preferred securities are subject to issuer-specific and market risks applicable generally to equity securities. In addition, a company’s preferred securities generally pay dividends only after the company makes required payments to holders of its bonds and other debt. For this reason, the value of preferred securities will usually react more strongly than bonds and other debt to actual or perceived changes in the company’s financial condition or prospects. Preferred securities of smaller companies may be more vulnerable to adverse developments than preferred securities of larger companies.
The value of a company’s preferred securities may fall as a result of factors relating directly to that company’s products or services. A preferred security’s value may also fall because of factors affecting not just the company, but companies in the same industry or in a number of different industries, such as increases in production costs. The value of preferred securities may also be affected by changes in financial markets that are relatively unrelated to the company or its industry, such as changes in interest rates or currency exchange rates. In addition, a company’s preferred securities generally pay dividends only after the company makes required payments to holders of its bonds and other debt. For this reason, the value of preferred securities will usually react more strongly than bonds and other
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debt to actual or perceived changes in the company’s financial condition or prospects. Preferred securities of smaller companies may be more vulnerable to adverse developments than those of larger companies.
Smaller Company Risk. The general risks associated with debt instruments or equity securities are particularly pronounced for securities issued by companies with small market capitalizations. Small capitalization companies involve certain special risks. They are more likely than larger companies to have limited product lines, markets or financial resources, or to depend on a small, inexperienced management group. Securities of smaller companies may trade less frequently and in lesser volume than more widely held securities and their values may fluctuate more sharply than other securities. They may also have limited liquidity. These securities may therefore be more vulnerable to adverse developments than securities of larger companies, and the Fund may have difficulty purchasing or selling securities positions in smaller companies at prevailing market prices. Also, there may be less publicly available information about smaller companies or less market interest in their securities as compared to larger companies. Companies with medium-sized market capitalizations may have risks similar to those of smaller companies.
Adjustable Rate and Auction Preferred Securities. Typically, the dividend rate on an adjustable rate preferred security is determined prospectively each quarter by applying an adjustment formula established at the time of issuance of the security. Although adjustment formulas vary among issues, they typically involve a fixed premium or discount relative to rates on specified debt securities issued by the U.S. Treasury. Typically, an adjustment formula will provide for a fixed premium or discount adjustment relative to the highest base yield of three specified U.S. Treasury securities: the 90-day Treasury bill, the 10-year Treasury note and the 20-year Treasury bond. The premium or discount adjustment to be added to or subtracted from this highest U.S. Treasury base rate yield is fixed at the time of issue and cannot be changed without the approval of the holders of the security. The dividend rate on another type of preferred security in which the Fund may invest, commonly known as auction preferred securities, is adjusted at intervals that may be more frequent than quarterly, such as every 7 or 49 days, based on bids submitted by holders and prospective purchasers of such securities and may be subject to stated maximum and minimum dividend rates. The issues of most adjustable rate and auction preferred securities currently outstanding are perpetual, but are redeemable after a specified date, or upon notice, at the option of the issuer. Certain issues supported by the credit of a high-rated financial institution provide for mandatory redemption prior to expiration of the credit arrangement. No redemption can occur if full cumulative dividends are not paid. Although the dividend rates on adjustable and auction preferred securities are generally adjusted or reset frequently, the market values of these preferred securities may still fluctuate in response to changes in interest rates. Market values of adjustable preferred securities also may substantially fluctuate if interest rates increase or decrease once the maximum or minimum dividend rate for a particular security is approached. Auctions for U.S. auction preferred securities have failed since early 2008, and the dividend rates payable on such preferred securities since that time typically have been paid at their maximum applicable rate (typically a function of a reference rate of interest). PIMCO expects that auction preferred securities will continue to pay dividends at their maximum applicable rate for the foreseeable future and cannot predict whether or when the auction markets for auction preferred securities may resume normal functioning.
Fixed Rate Preferred Securities. Some fixed rate preferred securities in which the Fund may invest, known as perpetual preferred securities, offer a fixed return with no maturity date. Because they never mature, perpetual preferred securities act like long-term bonds and can be more volatile than and more sensitive to changes in interest rates than other types of preferred securities that have a maturity date. The Fund may also invest in sinking fund preferred securities. These preferred securities also offer a fixed return, but have a maturity date and are retired or redeemed on a predetermined schedule. The shorter duration of sinking fund preferred securities makes them perform somewhat like intermediate-term bonds and they typically have lower yields than perpetual preferred securities.
Bank Obligations
The Fund may invest in bank capital securities of both non-U.S. (foreign) and U.S. issuers. Bank capital securities are issued by banks to help fulfill their regulatory capital requirements. There are three common types of bank capital: Lower Tier II, Upper Tier II and Tier I. Bank capital is generally, but not always, of investment grade quality. Upper Tier II securities are commonly thought of as hybrids of debt and preferred securities. Upper Tier II securities are often perpetual (with no maturity date), callable and have a cumulative interest deferral feature. This means that under certain conditions, the issuer bank can withhold payment of interest until a later date. However, such deferred interest payments generally earn interest. Tier I securities often take the form of trust preferred securities. Foreign banks may be categorized in multiple industries for purposes of the Fund’s industry concentration policy.
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Bank obligations in which the Fund may invest include, without limitation, certificates of deposit, bankers’ acceptances and fixed time deposits. Certificates of deposit are negotiable certificates that are issued against funds deposited in a commercial bank for a definite period of time and that earn a specified return. Bankers’ acceptances are negotiable drafts or bills of exchange, normally drawn by an importer or exporter to pay for specific merchandise, which are “accepted” by a bank, meaning, in effect, that the bank unconditionally agrees to pay the face value of the instrument on maturity. Fixed time deposits are bank obligations payable at a stated maturity date and bearing interest at a fixed rate. Fixed time deposits may be withdrawn on demand by the investor, but may be subject to early withdrawal penalties which vary depending upon market conditions and the remaining maturity of the obligation. There are generally no contractual restrictions on the right to transfer a beneficial interest in a fixed time deposit to a third party, although there is generally no market for such deposits.
The activities of U.S. banks and most foreign banks are subject to comprehensive regulations which, in the case of U.S. regulations, have undergone substantial changes in the past decade and are currently subject to legislative and regulatory scrutiny. The enactment of new legislation or regulations, as well as changes in interpretation and enforcement of current laws, may affect the manner of operations and profitability of U.S. and foreign banks. Significant developments in the U.S. banking industry have included increased competition from other types of financial institutions, increased acquisition activity and geographic expansion. Banks may be particularly susceptible to certain economic factors, such as interest rate changes and adverse developments in the market for real estate. Fiscal and monetary policy and general economic cycles can affect the availability and cost of funds, loan demand and asset quality and thereby impact the earnings and financial conditions of banks.
U.S. and global markets recently have experienced increased volatility, including as a result of the recent failures of certain U.S. and non-U.S. banks, which could be harmful to the Fund and issuers in which they invest. For example, if a bank at which a Fund or issuer has an account fails, any cash or other assets in bank or custody accounts, which may be substantial in size, could be temporarily inaccessible or permanently lost by the Fund or issuer. If a bank that provides a subscription line credit facility, asset-based facility, other credit facility and/or other services to an issuer or to a fund fails, the issuer or fund could be unable to draw funds under its credit facilities or obtain replacement credit facilities or other services from other lending institutions with similar terms.
Issuers in which the Fund may invest can be affected by volatility in the banking sector. Even if banks used by issuers in which the Fund invests remain solvent, continued volatility in the banking sector could contribute to, cause or intensify an economic recession, increase the costs of capital and banking services or result in the issuers being unable to obtain or refinance indebtedness at all or on as favorable terms as could otherwise have been obtained. Conditions in the banking sector are evolving, and the scope of any potential impacts to the Fund and issuers, both from market conditions and also potential legislative or regulatory responses, are uncertain. Such conditions and responses, as well as a changing interest rate environment, can contribute to decreased market liquidity and erode the value of certain holdings, including those of U.S. and non-U.S. banks. Continued market volatility and uncertainty and/or a downturn in market and economic and financial conditions, as a result of developments in the banking industry or otherwise (including as a result of delayed access to cash or credit facilities), could have an adverse impact on the Fund and issuers in which they invest.
Obligations of foreign banks involve somewhat different investment risks than those affecting obligations of U.S. banks, including the possibilities that their liquidity could be impaired because of future political and economic developments, that their obligations may be less marketable than comparable obligations of U.S. banks, that a foreign jurisdiction might impose withholding or other taxes on interest income payable on those obligations, that foreign deposits may be seized or nationalized, that foreign governmental restrictions such as exchange controls may be adopted which might adversely affect the payment of principal and interest on those obligations and that the selection of those obligations may be more difficult because there may be less publicly available information concerning foreign banks and the accounting, auditing and financial reporting standards, practices and requirements applicable to foreign banks may differ from those applicable to U.S. banks. Foreign banks are not generally subject to examination by any U.S. government agency or instrumentality.
Loans and Other Indebtedness; Loan Acquisitions, Participations and Assignments
The Fund may purchase indebtedness and participations in loans held and/or originated by private financial institutions, including commercial and residential mortgage loans, corporate loans and consumer loans, as well as interests and/or servicing or similar rights in such loans. Such instruments may be secured or unsecured and may be
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newly-originated (and may be specifically designed for the Fund). Indebtedness is different from traditional debt securities in that debt securities are part of a large issue of securities to the public whereas indebtedness may not be a security, and may represent a specific commercial loan to a borrower. Loan participations typically represent direct participation, together with other parties, in a loan to a borrower, and generally are offered by banks or other financial institutions or lending syndicates. The Fund may participate in such syndications, or can buy part of a loan, becoming a part lender. When purchasing indebtedness and loan participations, the Fund assumes the credit risk associated with the borrower and may assume the credit risk associated with an interposed bank or other financial intermediary. The indebtedness and loan participations that the Fund may acquire may not be rated by any nationally recognized rating service.
A loan is often administered by an agent bank acting as agent for all holders. The agent bank administers the terms of the loan, as specified in the loan agreement. In addition, the agent bank is normally responsible for the collection of principal and interest payments from the borrower and the apportionment of these payments to the credit of all institutions which are parties to the loan agreement. Unless, under the terms of the loan or other indebtedness, the Fund has direct recourse against the borrower, the Fund may have to rely on the agent bank or other financial intermediary to apply appropriate credit remedies against a borrower.
A financial institution’s employment as agent bank might be terminated in the event that it fails to observe a requisite standard of care or becomes insolvent. A successor agent bank would generally be appointed to replace the terminated agent bank, and assets held by the agent bank under the loan agreement would likely remain available to holders of such indebtedness. However, if assets held by the agent bank for the benefit of the Fund were determined to be subject to the claims of the agent bank’s general creditors, the Fund might incur certain costs and delays in realizing payment on a loan or loan participation and could suffer a loss of principal and/or interest. In situations involving other interposed financial institutions (e.g., an insurance company or governmental agency) similar risks may arise.
Purchasers of loans and other forms of direct indebtedness depend primarily upon the creditworthiness of the borrower for payment of principal and interest. If the Fund does not receive scheduled interest or principal payments on such indebtedness, the NAV, market share price and/or yield of the Common Shares could be adversely affected. Loans that are fully secured offer the Fund more protection than an unsecured loan in the event of non-payment of scheduled interest or principal. However, there is no assurance that the liquidation of collateral from a secured loan would satisfy the borrower’s obligation, or that the collateral could be liquidated. In the event of the bankruptcy of a borrower, the Fund could experience delays or limitations in its ability to realize the benefits of any collateral securing a loan.
The Fund may acquire loans and loan participations with credit quality comparable to that of issuers of its securities investments. Indebtedness of companies whose creditworthiness is poor and/or subprime in quality involves substantially greater risks, and may be highly speculative. Some companies may never pay off their indebtedness, or may pay only a small fraction of the amount owed. Consequently, when acquiring indebtedness of companies with poor credit, the Fund bears a substantial risk of losing the entire amount invested of the instrument acquired. The Fund may make purchases of indebtedness and loan participations to achieve income and/or capital appreciation, rather than to seek income.
The Fund will limit the amount of its total assets that it will invest in any one issuer and the Fund will limit the amount of its total assets that it will invest in issuers within the same industry. For purposes of this limit, the Fund generally will treat the borrower as the “issuer” of indebtedness held by the Fund. In the case of loan participations where a bank or other lending institution serves as a financial intermediary between the Fund and the borrower, if the participation does not shift to the Fund the direct debtor-creditor relationship with the borrower, the Fund will treat both the lending bank or other lending institution and the borrower as “issuers.” Treating a financial intermediary as an issuer of indebtedness may restrict the Fund’s ability to invest in indebtedness related to a single financial intermediary, or a group of intermediaries engaged in the same industry, even if the underlying borrowers represent many different companies and industries.
Loans and other types of direct indebtedness (which the Fund may purchase or otherwise gain exposure to) may not be readily marketable and may be subject to restrictions on resale. In connection with certain loan transactions, transaction costs that are borne by the Fund may include the expenses of third parties that are retained to assist with reviewing and conducting diligence, negotiating, structuring and servicing a loan transaction, and/or providing other services in connection therewith. Furthermore, the Fund may incur such costs in connection with loan transactions that
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are pursued by the Fund but not ultimately consummated (so-called “broken deal costs”). In some cases, negotiations involved in disposing of indebtedness may require weeks to complete. Consequently, some indebtedness may be difficult or impossible to dispose of readily at what PIMCO believes to be a fair price. In addition, valuation of illiquid indebtedness involves a greater degree of judgment in determining the Fund’s net asset value than if that value were based on available market quotations, and could result in significant variations in the Fund’s daily share price. At the same time, some loan interests are traded among certain financial institutions and accordingly may be deemed liquid. As the market for different types of indebtedness develops, the liquidity of these instruments may improve. Acquisitions of loan participations are considered to be debt obligations for purposes of the Fund’s investment restriction relating to the lending of funds or assets by the Fund.
Acquisition of loans through a purchase of a loan or direct assignment of a financial institution’s interests with respect to a loan may involve additional risks to the Fund. The purchaser of an assignment typically succeeds to all the rights and obligations under the loan agreement with the same rights and obligations as the assigning lender. Assignments may, however, be arranged through private negotiations between potential assignees and potential assignors, and the rights and obligations acquired by the purchaser of an assignment may differ from, and be more limited than, those held by the assigning lender. If a loan is foreclosed, the Fund could become part owner of any collateral, and would bear the costs and liabilities associated with owning and disposing of the collateral. In addition, it is conceivable that under emerging legal theories of lender liability, the Fund could be held liable as co-lender. It is unclear whether loans and other forms of direct indebtedness offer securities law protections against fraud and misrepresentation.
The purchaser of an assignment typically succeeds to all the rights and obligations under the loan agreement with the same rights and obligations as the assigning lender. Assignments may, however, be arranged through private negotiations between potential assignees and potential assignors, and the rights and obligations acquired by the purchaser of an assignment may differ from, and be more limited than, those held by the assigning lender.
The Fund may make, participate in or acquire debtor-in-possession financings (commonly known as “DIP financings”). DIP financings are arranged when an entity seeks the protections of the bankruptcy court under Chapter 11 of the U.S. Bankruptcy Code. These financings allow the entity to continue its business operations while reorganizing under Chapter 11. Such financings constitute senior liens on unencumbered security (i.e., security not subject to other creditors’ claims). There is a risk that the entity will not emerge from Chapter 11 and be forced to liquidate its assets under Chapter 7 of the U.S. Bankruptcy Code. In the event of liquidation, the Fund’s only recourse will be against the property securing the DIP financing. Various state licensing requirements could apply to the Fund with respect to the origination, acquisition, holding, servicing, foreclosure and/or disposition of loans and similar assets. The licensing requirements could apply depending on the location of the borrower, the location of the collateral securing the loan, or the location where the Fund or PIMCO operates or has offices. In states in which it is licensed, the Fund or PIMCO will be required to comply with applicable laws and regulations, including consumer protection and anti-fraud laws, which could impose restrictions on the Fund’s or PIMCO’s ability to take certain actions to protect the value of its holdings in such assets and impose compliance costs. Failure to comply with such laws and regulations could lead to, among other penalties, a loss of the Fund’s or PIMCO’s license, which in turn could require the Fund to divest assets located in or secured by real property located in that state. These risks will also apply to issuers and entities in which the Fund invests that hold similar assets, as well as any origination company or servicer in which the Fund owns an interest.
Loan origination and servicing companies are routinely involved in legal proceedings concerning matters that arise in the ordinary course of their business. These legal proceedings range from actions involving a single plaintiff to class action lawsuits with potentially tens of thousands of class members. In addition, a number of participants in the loan origination and servicing industry (including control persons of industry participants) have been the subject of regulatory actions by state regulators, including state Attorneys General, and by the federal government. Governmental investigations, examinations or regulatory actions, or private lawsuits, including purported class action lawsuits, may adversely affect such companies’ financial results. To the extent the Fund seeks to engage in servicing directly, or has a financial interest in, or is otherwise affiliated with, an origination or servicing company, the Fund will be subject to enhanced risks of litigation, regulatory actions and other proceedings. As a result, the Fund may be required to pay legal fees, settlement costs, damages, penalties or other charges, any or all of which could materially adversely affect the Fund and its holdings.
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Alternative Lending ABS
The Fund may invest in shares, certificates, notes or other securities issued by a special purpose entity (“SPE”) sponsored by an alternative lending platform or its affiliates (the “Sponsor”) that represent the right to receive principal and interest payments due on pools of whole loans or fractions of whole loans, which may (but may not) be issued by the Sponsor, held by the SPE (“Alt Lending ABS”). Alternative lending, which may include or sometimes be referred to as peer-to-peer lending, online lending or marketplace lending, is a method of financing in which an alternative lending platform (i.e., an online lending marketplace or lender that is not a traditional lender, such as a bank) facilitates the borrowing and lending of money while generally not relying on deposits for capital to fund loans. It is considered an alternative to more traditional debt financing done through a bank. There are several different models of alternative lending but, very generally, a platform typically matches consumers, small or medium-sized businesses or other types of borrowers with investors that are interested in gaining investment exposure to the loans made to such borrowers. Prospective borrowers are usually required to provide or give access to certain financial information to the platform, such as the intended purpose of the loan, income, employment information, credit score, debt-to-income ratio, credit history (including defaults and delinquencies) and home ownership status, and, in the case of small business loans, business financial statements and personal credit information regarding any guarantor, some of which information is made available to prospective lenders. Often, platforms charge fees to borrowers to cover these screening and administrative costs. Based on this and other relevant supplemental information, the platform usually assigns its own credit rating to the borrower and sets the interest rate for the requested borrowing. Platforms then post the borrowing requests online and investors may choose among the loans, based on the interest rates the loans are expected to yield less any servicing or origination fees charged by the platform or others involved in the lending arrangement, the background data provided on the borrowers and the credit rating assigned by the platform. In some cases, a platform partners with a bank to originate a loan to a borrower, after which the bank sells the loan to the platform or directly to the investor; alternatively, some platforms may originate loans themselves. Some investors, including the Fund, may not review the particular characteristics of the loans in which they invest at the time of investment, but rather negotiate in advance with platforms the general criteria of the investments, as described above. As a result, the Fund is dependent on the platforms’ ability to collect, verify and provide information to the Fund about each loan and borrower. Platforms may set minimum eligibility standards for borrowers to participate in alternative lending arrangements and may limit the maximum permitted borrowings. Depending on the purpose and the nature of the loan, its term may, for example, be as short as six months or shorter, or as long as thirty years or longer.
Privacy and Data Security Laws
The Gramm-Leach-Bliley Act (“GLBA”) and other laws limit the disclosure of certain non-public personal information about a consumer to non-affiliated third parties and require financial institutions to disclose certain privacy policies and practices with respect to information sharing with both affiliates and non-affiliated third parties. Many states and a number of non-U.S. jurisdictions have enacted privacy and data security laws requiring safeguards on the privacy and security of consumers’ personally identifiable information. Other laws deal with obligations to safeguard and dispose of private information in a manner designed to avoid its dissemination.
Privacy rules adopted by the U.S. Federal Trade Commission and SEC implement GLBA and other requirements and govern the disclosure of consumer financial information by certain financial institutions, ranging from banks to private investment funds. U.S. platforms following certain models generally are required to have privacy policies that conform to these GLBA and other requirements. In addition, such platforms typically have policies and procedures intended to maintain platform participants’ personal information securely and dispose of it properly.
The Fund generally does not intend to obtain or hold borrowers’ non-public personal information, and the Fund has implemented procedures designed to prevent the disclosure of borrowers’ non-public personal information to the Fund. However, service providers to the Fund or its direct or indirect fully-owned subsidiaries, including their custodians and the platforms acting as loan servicers for the Fund or its direct or indirect fully-owned subsidiaries, may obtain, hold or process such information. The Fund cannot guarantee the security of non-public personal information in the possession of such a service provider and cannot guarantee that service providers have been and will continue to comply with GLBA, other data security and privacy laws and any other related regulatory requirements. Violations of GLBA and other laws could subject the Fund to litigation and/or fines, penalties or other regulatory action, which, individually or in the aggregate, could have an adverse effect on the Fund. The Fund may also face regulations related to privacy and data security in the other jurisdictions in which the Fund invests.
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Loans
To the extent the Fund invests in loans, the Fund may be subject to greater levels of credit risk, call (or “prepayment”) risk, settlement risk and liquidity risk, than funds that do not invest in such securities. These instruments are considered predominantly speculative with respect to an issuer’s continuing ability to make principal and interest payments, and may be more volatile than other types of securities. An economic downturn or individual corporate developments could adversely affect the market for these instruments and reduce the Fund’s ability to sell these instruments at an advantageous time or price. An economic downturn would generally lead to a higher non-payment rate, and a loan may lose significant market value before a default occurs. The Fund may also be subject to greater levels of liquidity risk than funds that do not invest in loans. In addition, the loans in which the Fund invests may not be listed on any exchange and a secondary market for such loans may be comparatively less liquid relative to markets for other more liquid fixed-income securities. Consequently, transactions in loans may involve greater costs than transactions in more actively traded securities. In connection with certain loan transactions, transaction costs that are borne by the Fund may include the expenses of third parties that are retained to assist with reviewing and conducting diligence, negotiating, structuring and servicing a loan transaction, and/or providing other services in connection therewith. Furthermore, the Fund may incur such costs in connection with loan transactions that are pursued by the Fund but not ultimately consummated (so-called “broken deal costs”).
Restrictions on transfers in loan agreements, a lack of publicly-available information, irregular trading activity and wide bid/ask spreads among other factors, may, in certain circumstances, make loans difficult to value accurately or sell at an advantageous time or price than other types of securities or instruments. These factors may result in the Fund being unable to realize full value for the loans and/or may result in the Fund not receiving the proceeds from a sale of a loan for an extended period after such sale, each of which could result in losses to the Fund. Loans may have extended trade settlement periods, which may result in cash not being immediately available to the Fund. As a result, transactions in loans that settle on a delayed basis may limit the Fund’s ability to make additional investments or satisfy the Fund’s repurchase obligations. The Fund may seek to satisfy any short-term liquidity needs resulting from an extended trade settlement process by, among other things, selling portfolio assets, holding additional cash or entering into temporary borrowing arrangements with banks and other potential funding sources. If an issuer of a loan prepays or redeems the loan prior to maturity, the Fund may have to reinvest the proceeds in other loans or similar instruments that may pay lower interest rates. Loans in which the Fund invests may or may not be collateralized, although the loans may not be fully collateralized and the collateral may be unavailable or insufficient to meet the obligations of the borrower. The Fund may have limited rights to exercise remedies against such collateral or a borrower, and loan agreements may impose certain procedures that delay receipt of the proceeds of collateral or require the Fund to act collectively with other creditors to exercise its rights with respect to a loan. Loans may not be considered securities under the federal securities laws. In such circumstances, fewer legal protections may be available with respect to the Fund’s investment in loans. In particular, if a loan is not considered a security under the federal securities laws, certain legal protections normally available to securities investors under the federal securities laws, such as those against fraud and misrepresentation, may not be available. Because of the risks involved in investing in loans, an investment in the Fund that invests in such instruments should be considered speculative.
Loans that are covenant-lite obligations contain fewer maintenance covenants than other types of loans, or no maintenance covenants, and may not include terms that allow the lender to monitor the performance of the borrower and declare a default if certain criteria are breached. Covenant-lite loans carry a risk that the borrower could transfer or encumber its assets, which could reduce the amount of assets that can be used to satisfy debts and result in losses for debtholders. Covenant-lite obligations may carry more risk than traditional loans as they allow borrowers to engage in activities that would otherwise be difficult or impossible under a covenant-heavy loan agreement. In the event of default, covenant-lite obligations may exhibit diminished recovery values as the lender may not have the opportunity to negotiate with the borrower prior to default. The Fund may have a greater risk of loss on investments in covenant-lite obligations as compared to investments in traditional loans.
Secondary trades of loans may have extended settlement periods. Any settlement of a secondary market purchase of loans in the ordinary course, on a settlement date beyond the period expected by loan market participants (i.e., T+7 for par/near par loans and T+20 for distressed loans, in other words more than seven or twenty business days beyond the trade date, respectively) is subject to the “delayed compensation” rules prescribed by the Loan Syndications and Trading Association (“LSTA”) and addressed in the LSTA’s standard loan documentation for par/near par trades and for distressed trades. “Delayed compensation” is a pricing adjustment comprised of certain interest and fees, which is payable between the parties to a secondary loan trade. The LSTA introduced a requirements-based rules program in
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order to incentivize shorter settlement times for secondary transactions and discourage certain delay tactics that create friction in the loan syndications market by, among other things, mandating that the buyer of a loan satisfy certain “basic requirements” as prescribed by the LSTA no later than T+5 in order for the buyer to receive the benefit of interest and other fees accruing on the purchased loan from and after T+7 for par/near par loans (for distressed trades, T+20) until the settlement date, subject to certain specific exceptions. These “basic requirements” generally require a buyer to execute the required trade documentation and to be, and remain, financially able to settle the trade no later than T+7 for par/near par loans (and T+20 for distressed trades). In addition, buyers are required to fund the purchase price for a secondary trade upon receiving notice from the agent of the effectiveness of the trade in the agent’s loan register. The Fund, as a buyer of a loan in the secondary market, would need to meet these “basic requirements” or risk forfeiting all or some portion of the interest and other fees accruing on the loan from and after T+7 for par/near par loans (for distressed trades, T+20) until the settlement date. The “delayed compensation” mechanism does not mitigate the other risks of delayed settlement or other risks associated with investments in loans.
Investors should be aware that the Fund’s investment in a loan may result in the Fund or PIMCO receiving information about the issuer that may be deemed material, non-public information. Under such circumstances, the Fund’s investment opportunities may be limited, as trading in securities of such issuer may be restricted. Additionally, PIMCO may seek to avoid receiving material, non-public information about issuers of loans. As a result, PIMCO may forgo certain investment opportunities or be disadvantaged as compared to other investors that do not restrict information that they receive from loan issuers.
Second Lien or Other Subordinated (Mezzanine) or Unsecured Loans or Debt. The Fund may invest in unsecured loans and subordinated or mezzanine obligations including second and lower lien loans and the mezzanine and equity (or “first loss”) tranches of CLO issues. In addition to the risks described above, second lien or other subordinated (mezzanine) or unsecured loans or debt generally are subject to similar risks as those associated with investments in senior loans. In addition, because second lien or other subordinated (mezzanine) or unsecured loans or debt are subordinated in payment and/or lower in lien priority to senior loans, they are subject to additional risk that the cash flow of the borrower and property securing the loan or debt, if any, may be insufficient to meet scheduled payments after giving effect to the senior secured obligations of the borrower. This risk is generally higher for subordinated unsecured loans or debt, which are not backed by a security interest in any specific collateral. Second lien or subordinated loans or debt, both secured and unsecured, may have greater price volatility than senior loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in second lien loans and subordinated loans or debt, both secured and unsecured, which would create greater credit risk exposure. Second lien or other subordinated or unsecured loans or debt of below investment grade quality share risks similar to those associated with investments in other below investment grade securities and obligations.
Delayed Funding Loans and Revolving Credit Facilities
The Fund may also enter into, or acquire participations in, delayed draw and delayed funding loans and revolving credit facilities. Delayed draw and delayed funding loans and revolving credit facilities are borrowing arrangements in which the lender agrees to make loans up to a maximum amount upon demand by the borrower during a specified term. A revolving credit facility differs from a delayed draw and delayed funding loan in that as the borrower repays the loan, an amount equal to the repayment may be borrowed again during the term of the revolving credit facility. Delayed draw and delayed funding loans and revolving credit facilities usually provide for floating or variable rates of interest. These commitments may have the effect of requiring the Fund to increase its investment in an issuer at a time when it might not otherwise decide to do so (including a time when the issuer’s financial condition makes it unlikely that such amounts will be repaid).
The Fund may invest in delayed draw and delayed funding loans and revolving credit facilities with credit quality comparable to that of issuers of its securities investments. Delayed draw and delayed funding loans and revolving credit facilities may be subject to restrictions on transfer, and only limited opportunities may exist to resell such instruments. As a result, the Fund may be unable to sell such investments at an opportune time or may have to resell them at less than fair market value. For a further discussion of the risks involved in investing in loan participations and other forms of direct indebtedness see “Loans and Other Indebtedness, Loan Participations and Assignments.” Participation interests in revolving credit facilities will be subject to the limitations discussed in “Loans and Other Indebtedness, Loan Participations and Assignments.” Delayed draw and delayed funding loans and revolving credit facilities are considered to be debt obligations for purposes of the Fund’s investment restriction relating to the lending of funds or assets by the Fund.
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Zero-Coupon Bonds, Step-Ups and Payment-In-Kind Securities
The Fund may invest directly or indirectly in zero-coupon securities, “step-ups” and PIKs (including PIK loans and bonds). Zero-coupon securities are debt obligations that do not entitle the holder to any periodic payments of interest either for the entire life of the obligation or for an initial period after the issuance of the obligations. Like zero-coupon bonds, “step-up” bonds pay no interest initially but eventually begin to pay a coupon rate prior to maturity, which rate may increase at stated intervals during the life of the security. PIKs are debt obligations that pay “interest” in the form of other debt obligations instead of cash. Partial pay-in-kind loans and bonds are debt obligations that pay such “interest” partly in cash. Each of these instruments is normally issued and traded at a deep discount from face value. The amount of the discount varies depending on such factors as the time remaining until maturity of the securities, prevailing interest rates, the liquidity of the security and the perceived credit quality of the issuer. The market prices of zero-coupon bonds, step-ups and PIKs generally are more volatile than the market prices of debt instruments that pay interest currently and in cash and are likely to respond to changes in interest rates to a greater degree than do other types of securities having similar maturities and credit quality.
In order to satisfy a requirement for qualification as a RIC under the Code, an investment company, such as the Fund, must distribute each year at least 90% of its net investment income, including the original issue discount accrued on zero-coupon bonds, step-ups and PIKs. Because the Fund will not, on a current basis, receive cash payments from the issuer of these securities in respect of any accrued original issue discount, in some years, the Fund may have to sell other portfolio holdings in order to obtain cash to satisfy the distribution requirements under the Code even though investment considerations might otherwise make it undesirable for the Fund to sell securities at such time. Under many market conditions, investments in zero-coupon bonds, step-ups and PIKs may be illiquid, making it difficult for the Fund to dispose of them or determine their current value.
Variable and Floating Rate Debt Securities
Variable and floating rate securities provide for a periodic adjustment in the interest rate paid on the obligations. The terms of such obligations must provide that interest rates are adjusted periodically based upon an interest rate adjustment index as provided in the respective obligations. The adjustment intervals may be regular, and range from daily up to annually, or may be event based, such as based on a change in the prime rate.
The Fund may invest in floating rate debt instruments, including variable and floating rate loans (described in more detail above). Variable and floating rate securities are securities that pay interest at rates that adjust whenever a specified interest rate changes, float at a fixed margin above a generally recognized base lending rate and/or reset or are redetermined (e.g., pursuant to an auction) on specified dates (such as the last day of a month or calendar quarter). These instruments may include, without limitation, variable-rate preferred securities, bank loans, money market instruments and certain types of mortgage-backed and other ABS. Due to their variable- or floating-rate features, these instruments will generally pay higher levels of income in a rising interest rate environment and lower levels of income as interest rates decline. For the same reason, the market value of a variable- or floating-rate instrument is generally expected to have less sensitivity to fluctuations in market interest rates than a fixed-rate instrument, although the value of a floating-rate instrument may nonetheless decline as interest rates rise and due to other factors, such as changes in credit quality.
The Fund may invest in floating rate debt instruments (“floaters”) and engage in credit spread trades. The interest rate on a floater is a variable rate which is tied to another interest rate, such as a money-market index or U.S. Treasury bill rate. The interest rate on a floater resets periodically, typically every six months. While, because of the interest rate reset feature, floaters provide the Fund with a certain degree of protection against rises in interest rates, the Fund will participate in any declines in interest rates as well. A credit spread trade is an investment position relating to a difference in the prices or interest rates of two securities or currencies where the value of the investment position is determined by movements in the difference between the prices or interest rates, as the case may be, of the respective securities or currencies.
The Fund may also invest without limit in inverse floating rate debt instruments (“inverse floaters”). The interest rate on an inverse floater resets in the opposite direction from the market rate of interest to which the inverse floater is indexed. An inverse floater may exhibit greater price volatility than a fixed rate obligation of similar credit quality. See “Mortgage-Related and Other Asset-Backed Securities” above. The Fund’s investments in variable- and floating-rate securities may require the Fund to accrue and distribute income not yet received. As a result, in order to generate cash
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to make the requisite distributions, the Fund may be required to sell securities in its portfolio that it would otherwise have continued to hold. See “Taxation.”
Inflation-Indexed Bonds
The Fund may invest in inflation-indexed bonds. Inflation-indexed bonds are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation. Two structures are common. The U.S. Treasury and some other issuers utilize a structure that accrues inflation into the principal value of the bond. Many other issuers pay out the Consumer Price Index accruals as part of a semiannual coupon.
Inflation-indexed bonds issued by the U.S. Treasury have maturities of approximately five, ten or thirty years, although it is possible that securities with other maturities will be issued in the future. The U.S. Treasury securities pay interest on a semi-annual basis equal to a fixed percentage of the inflation-adjusted principal amount. For example, if the Fund purchased an inflation-indexed bond with a par value of $1,000 and a 3% real rate of return coupon (payable 1.5% semi-annually), and the rate of inflation over the first six months was 1%, the mid-year par value of the bond would be $1,010 and the first semi-annual interest payment would be $15.15 ($1,010 times 1.5%). If inflation during the second half of the year resulted in the whole year’s inflation equaling 3%, the end-of-year par value of the bond would be $1,030 and the second semi-annual interest payment would be $15.45 ($1,030 times 1.5%).
If the periodic adjustment rate measuring inflation falls, the principal value of inflation-indexed bonds will be adjusted downward, and consequently the interest payable on these securities (calculated with respect to a smaller principal amount) will be reduced. Repayment of the original bond principal upon maturity (as adjusted for inflation) is guaranteed in the case of a U.S. Treasury inflation-indexed bond, even during a period of deflation, although the inflation-adjusted principal received could be less than the inflation-adjusted principal that had accrued to the bond at the time of purchase. However, the current market value of the bonds is not guaranteed and will fluctuate. The Fund may also invest in other inflation-related bonds that may or may not provide a similar guarantee. If a guarantee of principal is not provided, the adjusted principal value of the bond repaid at maturity may be less than the original principal amount.
The value of inflation-indexed bonds is expected to change in response to changes in real interest rates. Real interest rates in turn are tied to the relationship between nominal interest rates and the rate of inflation. Therefore, if the rate of inflation rises at a faster rate than nominal interest rates, real interest rates might decline, leading to an increase in value of inflation-indexed bonds. In contrast, if nominal interest rates increase at a faster rate than inflation, real interest rates might rise, leading to a decrease in value of inflation-indexed bonds.
While these securities are expected to provide protection from long-term inflationary trends, short-term increases in inflation may lead to a decline in value. If interest rates rise due to reasons other than inflation (for example, due to changes in currency exchange rates), investors in these securities may not be protected to the extent that the increase is not reflected in the bond’s inflation measure.
The periodic adjustment of U.S. inflation-indexed bonds is tied to the Consumer Price Index for All Urban Consumers (“CPI-U”), which is not seasonally adjusted and which is calculated monthly by the U.S. Bureau of Labor Statistics. The CPI-U is a measurement of changes in the cost of living, made up of components such as housing, food, transportation and energy. Inflation-indexed bonds issued by a foreign (non-U.S.) government are generally adjusted to reflect a comparable inflation index calculated by that government. There can be no assurance that the CPI-U or any foreign (non-U.S.) inflation index will accurately measure the real rate of inflation in the prices of goods and services. Moreover, there can be no assurance that the rate of inflation in a foreign (non-U.S.) country will be correlated to the rate of inflation in the United States.
Any increase in the principal amount of an inflation-indexed bond will be considered taxable ordinary income, even though investors do not receive their principal until maturity. As a result, in order to generate cash to make the requisite distributions, the Fund may be required to sell securities in its portfolio that it would otherwise have continued to hold. See “Taxation.”
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Event-Linked Bonds
The Fund may obtain event-linked exposure by investing in “event-linked bonds,” or “event-linked swaps,” or by implementing “event-linked strategies.” Event-linked exposure results in gains that typically are contingent on the non-occurrence of a specific “trigger” event, such as a hurricane, earthquake or other physical or weather-related phenomena. Some event-linked bonds are commonly referred to as “catastrophe bonds.” They may be issued by government agencies, insurance companies, reinsurers, special purpose corporations or other on-shore or off-shore entities (such special purpose entities are created to accomplish a narrow and well-defined objective, such as the issuance of a note in connection with a reinsurance transaction). If a trigger event causes losses exceeding a specific amount in the geographic region and time period specified in a bond, the Fund may lose a portion or all of its principal invested in the bond. If no trigger event occurs, the Fund will recover its principal plus interest. For some event-linked bonds, the trigger event or losses may be based on company-wide losses, index-portfolio losses, industry indices or readings of scientific instruments rather than specified actual losses. Often the event-linked bonds provide for extensions of maturity that are mandatory, or optional at the discretion of the issuer, in order to process and audit loss claims in those cases where a trigger event has, or possibly has, occurred. An extension of maturity may increase volatility. In addition to the specified trigger events, event-linked bonds also may expose the Fund to certain unanticipated risks including but not limited to issuer risk, credit risk, counterparty risk, adverse regulatory or jurisdictional interpretations and adverse tax consequences.
Event-linked bonds are a relatively new type of financial instrument. As such, there is no significant trading history for many of these securities, and there can be no assurance that a liquid market in these instruments will develop. Lack of a liquid market may impose the risk of higher transaction costs and the possibility that the Fund may be forced to liquidate positions when it would not be advantageous to do so. Event-linked bonds are typically rated, and the Fund will only invest in event-linked bonds that meet the credit quality requirements for the Fund.
Commodities
The Fund may purchase or sell derivatives, securities or other instruments that provide exposure to commodities. The Fund’s investments in commodities-related instruments may subject the Fund to greater volatility than investments in traditional securities. The value of commodity-related instruments may be affected by changes in overall market movements, foreign currency exchange rates, commodity index volatility, changes in interest rates, or supply and demand factors affecting a particular industry or commodity market, such as drought, floods, weather, livestock disease, pandemics and public health emergencies, embargoes, taxation, war, terrorism, cyber hacking, economic and political developments, environmental proceedings, tariffs, changes in storage costs, availability of transportation systems and international economic, political and regulatory developments. An unexpected surplus of a commodity caused by one of the aforementioned factors, for example, may cause a significant decrease in the value of the commodity (and a decrease in the value of any investments directly correlated to the commodity). Conversely, an unexpected shortage of a commodity caused by one of the aforementioned factors may cause a significant increase in the value of the commodity (and a decrease in the value of any investments inversely correlated to that commodity). The commodity markets are subject to temporary distortions and other disruptions due to, among other factors, lack of liquidity, the participation of speculators, and government regulation and other actions.
The Fund may focus its commodity-related investments in a particular sector of the commodities market (such as gold, oil, metal, carbon or agricultural products). As a result, to the extent the Fund focuses its investments in a particular sector of the commodities market, the Fund may be more susceptible to risks associated with those sectors, including the risk of loss due to adverse economic, business or political developments affecting a particular sector. See “Derivative Instruments” below for a more detailed discussion of risks related to commodities, including additional discussion of commodity-related derivative instruments.
Derivative Instruments
The Fund may, but is not required to, utilize various derivative strategies (both long and short positions) involving the purchase or sale of futures and forward contracts (including foreign currency exchange contracts), call and put options, credit default swaps, total return swaps, basis swaps and other swap agreements and other derivative instruments for investment purposes, leveraging purposes or in an attempt to hedge against market, credit, interest rate, currency and other risks in the portfolio.
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Generally, derivatives are financial contracts whose value depends on, or is derived from, the value of an underlying asset, reference rate or index and may relate to, among other things, stocks, bonds, interest rates, currencies or currency exchange rates, commodities, related indexes and other assets. The following describes certain derivative instruments and products in which the Fund may invest and risks associated therewith. The derivatives market is always changing and the Fund may invest in derivatives other than those shown below.
In pursuing its investment objective, the Fund may, to the extent permitted by its investment objective and policies, purchase and sell (write) both put options and call options on securities, swap agreements, recovery locks, securities indexes, commodity indexes and foreign currencies, and enter into interest rate, foreign currency, index and commodity futures contracts and purchase and sell options on such futures contracts (“futures options”) for hedging purposes, to seek to replicate the composition and performance of a particular index, or as part of its overall investment strategies. The Fund also may purchase and sell foreign currency options for purposes of increasing exposure to a foreign currency or to shift exposure to foreign currency fluctuations from one country to another. The Fund also may enter into swap agreements with respect to interest rates, commodities, indexes of securities or commodities, and to the extent it may invest in foreign currency denominated securities, may enter into swap agreements with respect to foreign currencies. The Fund may invest in structured notes and enter into transactions involving other similar instruments as discussed herein. All of these transactions are referred to collectively herein as “derivatives.” If other types of financial instruments, including other types of options, futures contracts, or futures options are traded in the future, the Fund also may use those instruments, provided that their use is consistent with the Fund’s investment objectives.
The value of some derivative instruments in which the Fund invests may be particularly sensitive to changes in prevailing interest rates, and, like the other investments of the Fund, the ability of the Fund to successfully utilize these instruments may depend in part upon the ability of PIMCO to forecast interest rates and other economic factors correctly. If PIMCO incorrectly forecasts such factors and has taken positions in derivative instruments contrary to prevailing market trends, the Fund could be exposed to additional, unforeseen risks, including the risk of loss.
The Fund might not employ any of the strategies described below, and no assurance can be given that any strategy used will succeed. Like most other investments, derivatives are subject to the risk that the market value of the instrument will change in a way detrimental to the Fund's interest. If PIMCO incorrectly forecasts interest rates, market values or other economic factors in using a derivatives strategy for the Fund, the Fund might have been in a better position if it had not entered into the transaction at all. Also, suitable derivatives transactions may not be available in all circumstances. Because many derivatives have a leverage component, adverse changes in the value or level of the underlying asset, reference rate or index could result in a loss substantially greater than the amount invested in the derivative itself. The use of certain derivatives involves the risk that a loss may be sustained as a result of the failure of another party (usually referred to as a “counterparty”) to make required payments or otherwise comply with the contract's terms. Counterparty risk also includes the risks of having concentrated exposure to a counterparty. Using derivatives is also subject to operational and legal risks. Operational risk generally refers to risk related to potential operational issues, including documentation issues, settlement issues, systems failures, inadequate controls, and human error. Legal risk generally refers to insufficient documentation, insufficient capacity or authority of counterparty, or legality or enforceability of a contract. The use of these strategies involves certain special risks, including a possible imperfect correlation, or even no correlation, between price movements of derivative instruments and price movements of related investments. While some strategies involving derivative instruments can reduce the risk of loss, they can also reduce the opportunity for gain or even result in losses by offsetting favorable price movements in related investments or otherwise. This is due, in part, to liquidity risk which refers to the possible inability of the Fund to purchase or sell a portfolio security at a time that otherwise would be favorable or the possible need to sell a portfolio security at a disadvantageous time and the possible inability of the Fund to close out or liquidate its derivatives positions. Liquidity risk also refers to the risk that the Fund may be required to hold additional cash or sell other investments in order to obtain cash to close out derivatives or meet the liquidity demands that derivatives can create to make payments of margin, collateral, or settlement payments to counterparties. The Fund may have to sell a security at a disadvantageous time or price to meet such obligations. In addition, the Fund’s use of such instruments may cause the Fund to realize higher amounts of short-term capital gains (generally subject to tax when distributed to shareholders at ordinary income tax rates) than if it had not used such instruments. If the Fund gains exposure to an asset class using derivative instruments backed by a collateral portfolio of fixed-income instruments, changes in the value of the fixed-income instruments may result in greater or lesser exposure to that asset class than would have resulted from a direct investment in securities comprising that asset class.
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Participation in the markets for derivative instruments involves investment risks and transaction costs to which the Fund may not be subject absent the use of these strategies. The skills needed to successfully execute derivative strategies may be different from those needed for other types of transactions. If the Fund incorrectly forecasts the value and/or creditworthiness of securities, currencies, interest rates, counterparties or other economic factors involved in a derivatives transaction, the Fund might have been in a better position if the Fund had not entered into such derivatives transaction. In evaluating the risks and contractual obligations associated with particular derivative instruments, it is important to consider that certain derivatives transactions may be modified or terminated only by mutual consent of the Fund and its counterparty and certain derivatives transactions may be terminated by the counterparty or the Fund, as the case may be, upon the occurrence of certain Fund-related or counterparty-related events, which may result in losses or gains to the Fund based on the market value of the derivatives transactions entered into between the Fund and the counterparty. In addition, such early terminations may result in taxable events and accelerate gain or loss recognition for tax purposes. It may not be possible for the Fund to modify, terminate, or offset the Fund’s obligations or the Fund’s exposure to the risks associated with a derivatives transaction prior to its termination or maturity date, which may create a possibility of increased volatility and/or decreased liquidity to the Fund. Upon the expiration or termination of a particular contract, the Fund may wish to retain its position in the derivative instrument by entering into a similar contract, but may be unable to do so if the counterparty to the original contract is unwilling, or unable, to enter into the new contract and no other appropriate counterparty can be found, which could cause the Fund not to be able to maintain certain desired investment exposures or not to be able to hedge other investment positions or risks, which could cause losses to the Fund. Furthermore, after such an expiration or termination of a particular contract, the Fund may have fewer counterparties with which to engage in additional derivatives transactions, which could lead to potentially greater counterparty risk exposure to one or more counterparties and which could increase the cost of entering into certain derivatives. In such cases, the Fund may lose money.
The Fund may engage in investment strategies, including the use of derivatives, to, among other things, seek to generate current, distributable income without regard to possible declines in the Fund’s net asset value. The Fund’s income and gain-generating strategies, including certain derivatives strategies, may generate current, distributable income, even if such strategies could potentially result in declines in the Fund’s net asset value. The Fund’s income and gain-generating strategies, including certain derivatives strategies, may generate current income and gains taxable as ordinary income sufficient to support monthly distributions, even in situations when the Fund has experienced a decline in net assets due to, for example, adverse changes in the broad U.S. or non-U.S. securities markets or the Fund’s portfolio investments, or arising from its use of derivatives. Consequently, shareholders may receive distributions subject to tax at ordinary income rates at a time when their investment in the Fund has declined in value, which may be economically similar to a taxable return of capital.
The tax treatment of certain derivatives may be open to different interpretations. Any recharacterization of payments made or received by the Fund pursuant to derivatives potentially could affect the amount, timing or characterization of Fund distributions. In addition, the tax treatment of such investment strategies may be changed by regulation or otherwise.
Also, suitable derivative and/or hedging transactions may not be available in all circumstances, and there can be no assurance that the Fund will be able to identify or employ a desirable derivative and/or hedging transaction at any time or from time to time or, if a strategy is used, that it will be successful.
As further described below under “Additional Risk Factors in Cleared Derivatives Transactions,” recent legislative and regulatory reforms have resulted in new clearing, margin, reporting and registration requirements for participants in the derivatives market. While the ultimate impact is not yet clear, these changes could restrict and/or impose significant costs or other burdens upon the Fund’s ability to participate in derivatives transactions. Similarly, these changes could impose limits or restrictions on the counterparties with which the Fund engages in derivatives transactions. As a result, the Fund may be unable to use certain derivative instruments or otherwise execute its investment strategy. These risks may be particularly acute to the extent the Fund uses commodity-related derivative instruments.
Options on Securities and Indexes. The Fund may, to the extent specified herein or in the Prospectus, purchase and sell both put and call options on equity, fixed-income or other securities (including securities to be purchased when-issued, delayed delivery and forward commitment transactions) or indexes in standardized contracts traded on foreign or domestic securities exchanges, boards of trade, or similar entities, or quoted on the National Association of Securities Dealers Automated Quotations System (“NASDAQ”) or on an OTC market, and agreements, sometimes
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called cash puts, which may accompany the purchase of a new issue of bonds from a dealer. Among other reasons, the Fund may purchase put options to protect holdings in an underlying or related security against a decline in market value, and may purchase call options to protect against increases in the prices of securities it intends to purchase pending its ability to invest in such securities in an orderly manner.
An option on a security (or index) is a contract that gives the holder of the option, in return for a premium, the right to buy from (in the case of a call) or sell to (in the case of a put) the writer of the option the security underlying the option (or the cash value of an option that is on an index or cash settled) at a specified exercise price, often at any time during the term of the option for American options or only at expiration for European options. The writer of an option on a security that requires physical delivery has the obligation upon exercise of the option to deliver the underlying security upon payment of the exercise price (in the case of a call) or to pay the exercise price upon delivery of the underlying security (in the case of a put). Certain put options written by the Fund, which counterparties may use as a source of liquidity, may be structured to have an exercise price that is less than the market value of the underlying securities that would be received by the Fund. Upon exercise, the writer of an option on an index or a cash-settled option on a security is obligated to pay the difference between the cash value of the index and the exercise price multiplied by the specified multiplier for the option. An index is designed to reflect features of a particular financial or securities market, a specific group of financial instruments or securities, or certain economic indicators.
If an option written by the Fund expires unexercised, the Fund realizes a capital gain equal to the premium received at the time the option was written. If an option purchased by the Fund expires unexercised, the Fund realizes a capital loss equal to the premium paid. Prior to the earlier of exercise or expiration, an exchange-traded option may be closed out by an offsetting purchase or sale of an option of the same series (type, exchange, underlying security or index, exercise price, and expiration). There can be no assurance, however, that a closing purchase or sale transaction can be effected when the Fund desires. In addition, the Fund may sell put or call options it has previously purchased, which could result in a net gain or loss depending on whether the amount realized on the sale is more or less than the premium and other transaction costs paid on the put or call option which is sold. Prior to the exercise or expiration, an option may be closed out by an offsetting purchase or sale of an option of the same series.
The Fund will realize a capital gain from a closing purchase transaction if the cost of the closing option is less than the premium received from writing the option, or, if it is more, the Fund will realize a capital loss. If the premium received from a closing sale transaction is more than the premium paid to purchase the option, the Fund will realize a capital gain or, if it is less, the Fund will realize a capital loss. The principal factors affecting the market value of a put or a call option include supply and demand, interest rates, the current market price of the underlying security or index in relation to the exercise price of the option, the volatility of the underlying security or index, and the time remaining until the expiration date.
The premium paid for a put or call option purchased by the Fund is an asset of the Fund. The premium received for an option written by the Fund is recorded as a deferred credit. The value of an option purchased or written is marked-to-market daily and is valued in accordance with the Fund’s valuation policies and procedures. See “Net Asset Value” below.
The Fund may write straddles consisting of a combination of a call and a put written on the same underlying security.
OTC Options. Pursuant to policies adopted by the Fund’s Board, purchased OTC options and the assets used as cover for OTC options written by the Fund may be treated as liquid.
Risks Associated with Options on Securities and Indexes. There are several risks associated with transactions in options on securities and on indexes. For example, there are significant differences between the securities and options markets that could result in an imperfect correlation between these markets, causing a given transaction not to achieve its objectives. A decision as to whether, when and how to use options involves the exercise of skill and judgment, and even a well-conceived transaction may be unsuccessful to some degree because of market behavior or unexpected events.
The writer of an American option often has no control over the time when it may be required to fulfill its obligation as a writer of the option. Once an option writer has received an exercise notice, it cannot effect a closing purchase transaction in order to terminate its obligation under the option and must deliver the underlying security at
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the exercise price. To the extent the Fund writes a put option, the Fund has assumed the obligation during the option period to purchase the underlying investment from the put buyer at the option’s exercise price if the put buyer exercises its option, regardless of whether the value of the underlying investment falls below the exercise price. This means that the Fund that writes a put option may be required to take delivery of the underlying investment and make payment for such investment at the exercise price. This may result in losses to the Fund and may result in the Fund holding the underlying investment for some period of time when it is disadvantageous to do so. If a put or call option purchased by the Fund is not sold when it has remaining value, and if the market price of the underlying security remains equal to or greater than the exercise price (in the case of a put), or remains less than or equal to the exercise price (in the case of a call), the Fund will lose its entire investment in the option. Also, where a put or call option on a particular security is purchased to hedge against price movements in a related security, the price of the put or call option may move more or less than the price of the related security.
There can be no assurance that a liquid market will exist when the Fund seeks to close out an option position. If the Fund were unable to close out an option that it had purchased on a security, it would have to exercise the option in order to realize any profit or the option may expire worthless. If the Fund were unable to close out a covered call option that it had written on a security, it would not be able to sell the underlying security unless the option expired without exercise. As the writer of a covered call option, the Fund forgoes, during the option’s life, the opportunity to profit from increases in the market value of the security covering the call option above the sum of the premium and the exercise price of the call.
If trading were suspended in an option purchased by the Fund, the Fund would not be able to close out the option. If restrictions on exercise were imposed, the Fund might be unable to exercise an option it has purchased. Movements in the index may result in a loss to the Fund; however, such losses may be mitigated by changes in the value of the Fund’s securities during the period the option was outstanding.
To the extent that the Fund writes a call option on a security it holds in its portfolio, the Fund has, in return for the premium on the option, given up the opportunity to profit from a price increase in the underlying security above the exercise price during the option period, but, as long as its obligation under such call option continues, has retained the risk of loss should the price of the underlying security decline.
Foreign Currency Options. To the extent the Fund invests in foreign currency-denominated securities, it may buy or sell put and call options on foreign currencies. In addition, the Fund may buy or sell put and call options on foreign currencies either on exchanges or in the OTC market. A put option on a foreign currency gives the purchaser of the option the right to sell a foreign currency at the exercise price until the option expires. A call option on a foreign currency gives the purchaser of the option the right to purchase the currency at the exercise price until the option expires. Currency options traded on U.S. or other exchanges may be subject to position limits which may limit the ability of the Fund to reduce foreign currency risk using such options. OTC options differ from traded options in that they are bilateral contracts with price and other terms negotiated between buyer and seller, and generally do not have as much market liquidity as exchange-traded options. Under definitions adopted by the CFTC and SEC, many foreign currency options are considered swaps for certain purposes, including determination of whether such instruments need to be exchange-traded and centrally cleared as discussed further in “Risks of Potential Government Regulation of Derivatives.”
Futures Contracts and Futures Options. A futures contract is an agreement to buy or sell a security or other asset for a set price on a future date. These contracts are traded on exchanges, so that, in most cases, a party can close out its position on the exchange for cash, without delivering the underlying security or other underlying asset. An option on a futures contract gives the holder of the option the right to buy or sell a position in a futures contract from or to the writer of the option, at a specified price and on or before a specified expiration date. The Fund may invest in futures or options on futures with respect to interest rates, foreign currencies, securities or commodity indexes. The Fund may invest in foreign exchange futures contracts and options thereon (“futures options”) that are traded on a U.S. or foreign exchange or board of trade, or similar entity, or quoted on an automated quotation system as an adjunct to their securities activities. In addition, the Fund may purchase and sell futures contracts on various securities indexes (“Index Futures”) and related options for hedging purposes and for investment purposes. The Fund purchase and sale of Index Futures is limited to contracts and exchanges which have been approved by the CFTC. Through the use of Index Futures and related options, the Fund may diversify risk in its portfolio without incurring the substantial brokerage costs which may be associated with investment in the securities of multiple issuers. The Fund may also avoid potential market and liquidity problems which may result from increases in positions already held by the Fund.
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An interest rate, commodity, foreign currency or index futures contract provides for the future sale or purchase of a specified quantity of a financial instrument, commodity, foreign currency or the cash value of an index at a specified price and time. A Futures contract on an index is an agreement pursuant to which a party agrees to pay or receive an amount of cash equal to the difference between the value of the index at the close of the last trading day of the contract and the price at which the index contract was originally written. Although the value of an Index might be a function of the value of certain specified securities, no physical delivery of these securities is made. A unit is the value of the relevant Index from time to time. Entering into a contract to buy units is commonly referred to as buying or purchasing a contract or holding a long position in an Index. Index Futures contracts can be traded through all major commodity brokers. The Fund will ordinarily be able to close open positions on the futures exchange on which Index Futures are then traded at any time up to and including the expiration day.
The Fund may close open positions on the futures exchanges on which Index Futures are traded at any time up to and including the expiration day. All positions which remain open at the close of the last business day of the contract’s life are required to settle on the next business day (based upon the value of the relevant index on the expiration day), with settlement made with the appropriate clearing house. Positions in Index Futures may be closed out by the Fund only on the futures exchanges upon which the Index Futures are then traded.
A public market exists in futures contracts covering a number of indexes as well as financial instruments and foreign currencies, including, but not limited to: the S&P 500; the S&P Midcap 400; the Nikkei 225; the Markit CDX credit index; the iTraxx credit index; U.S. Treasury bonds; U.S. Treasury notes; U.S. Treasury bills; 90-day commercial paper; bank certificates of deposit; Eurodollar certificates of deposit; the Australian dollar; the Canadian dollar; the British pound; the Japanese yen; the Swiss franc; the Mexican peso; and certain multinational currencies, such as the euro. It is expected that other futures contracts will be developed and traded in the future. Certain futures contracts on indexes, financial instruments or foreign currencies may represent new investment products that lack performance track records.
The Fund might use financial futures contracts to hedge against anticipated changes in interest rates that might adversely affect either the value of the Fund’s securities or the price of the securities which the Fund intends to purchase. The Fund’s hedging activities may include sales of futures contracts as an offset against the effect of expected increases in interest rates, and purchases of futures contracts as an offset against the effect of expected declines in interest rates. Although other techniques could be used to reduce the Fund’s exposure to interest rate fluctuations, the Fund may be able to hedge its exposure more effectively and perhaps at a lower cost by using futures contracts and futures options.
The Fund may also invest in commodity futures contracts and options thereon. A commodity futures contract is an agreement to buy or sell a commodity, such as an energy, agricultural or metal commodity at a later date at a price and quantity agreed-upon when the contract is bought or sold.
The Fund may purchase and write call and put futures options. Futures options possess many of the same characteristics as options on securities and indexes (discussed above). A futures option gives the holder the right, in return for the premium paid, to assume a long position (call) or short position (put) in a futures contract at a specified exercise price at any time during the period of the option. Upon exercise of a call option, the holder acquires a long position in the futures contract and the writer is assigned the opposite short position. In the case of a put option, the opposite is true. A call option is “in the money” if the value of the futures contract that is the subject of the option exceeds the exercise price. A put option is “in the money” if the exercise price exceeds the value of the futures contract that is the subject of the option.
When a purchase or sale of a futures contract is made by the Fund, the Fund is required to deposit with its custodian a specified amount of assets determined to be liquid (“initial margin”). The margin required for a futures contract is set by the exchange on which the contract is traded and may be modified during the term of the contract. Margin requirements on foreign exchanges may be different than U.S. exchanges. The initial margin is in the nature of a performance bond or good faith deposit on the futures contract which is returned to the Fund upon termination of the contract, assuming all contractual obligations have been satisfied. The Fund expects to earn interest income on its initial margin deposits. A futures contract held by the Fund is valued daily at the official settlement price of the exchange on which it is traded. Each day the Fund pays or receives cash, called “variation margin,” equal to the daily change in value of the futures contract. This process is known as “marking-to-market.” Variation margin does not represent a borrowing or loan by the Fund but is instead a settlement between the Fund and the broker of the amount
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one would owe the other if the futures contract expired. In computing daily net asset value, the Fund will mark-to-market its open futures positions.
The Fund is also required to deposit and maintain margin with respect to put and call options on futures contracts written by it. Such margin deposits will vary depending on the nature of the underlying futures contract (and the related initial margin requirements), the current market value of the option, and other futures positions held by the Fund.
Customer Account Agreements and related addenda govern cleared derivatives transactions such as futures, options on futures, and cleared OTC derivatives. Such transactions require posting of initial margin as determined by each relevant clearing agency which is segregated in an account at a futures commission merchant (“FCM”) registered with the CFTC. In the United States, counterparty risk may be reduced as creditors of an FCM cannot have a claim to Fund assets in the segregated account. Portability of exposure reduces risk to the Fund. Variation margin, or changes in market value, are generally exchanged daily, but may not be netted between futures and cleared OTC derivatives unless the parties have agreed to a separate arrangement in respect of portfolio margining. Although some futures contracts call for making or taking delivery of the underlying securities or commodities, generally these obligations are closed out prior to delivery by offsetting purchases or sales of matching futures contracts (i.e., with the same exchange, underlying security or index, and delivery month). Closing out a futures contract sale is effected by purchasing an offsetting futures contract for the same aggregate amount of the specific type of financial instrument or commodity with the same delivery date. If an offsetting purchase price is less than the original sale price, the Fund realizes a capital gain, or if it is more, the Fund realizes a capital loss.
Conversely, if an offsetting sale price is more than the original purchase price, the Fund realizes a capital gain, or if it is less, the Fund realizes a capital loss. Any transaction costs must also be included in these calculations.
The Fund will only enter into futures contracts and futures options which are standardized and traded on a U.S. or foreign exchange, board of trade, or similar entity, or quoted on an automated quotation system, or in the case of futures options, for which an established OTC market exists.
The requirements for qualification as a RIC also may limit the extent to which the Fund may enter into futures, futures options and forward contracts. See “Taxation.”
Commodity Pool Operators and Commodity Trading Advisors. The CFTC has adopted regulations that subject registered investment companies and their investment advisers to regulation by the CFTC if the registered investment company invests more than a prescribed level of its liquidation value in futures, options on futures or commodities, swaps, or other financial instruments regulated under the Commodity Exchange Act (“CEA”) and the rules thereunder (“commodity interests”), or if the Fund markets itself as providing investment exposure to such instruments. The Investment Manager is registered with the CFTC as a CPO. However, with respect to the Fund, the Investment Manager has claimed an exclusion from registration as a CPO pursuant to CFTC Rule 4.5. For the Investment Manager to remain eligible for this exclusion, the Fund must comply with certain limitations, including limits on its ability to use any commodity interests and limits on the manner in which the Fund holds out its use of such commodity interests. These limitations may restrict the Fund’s ability to pursue its investment objectives and strategies, increase the costs of implementing its strategies, result in higher expenses for the Fund, and/or adversely affect the Fund’s total return. To the extent the Fund becomes ineligible for this exclusion from CFTC regulation, the Fund may consider steps in order to continue to qualify for exemption from CFTC regulation, or may determine to operate subject to CFTC regulation.
Risks Associated with Futures and Futures Options. There are several risks associated with the use of futures contracts and futures options as hedging techniques. A purchase or sale of a futures contract may result in losses in excess of the amount invested in the futures contract. There can be no guarantee that there will be a correlation between price movements in the hedging vehicle and in the Fund securities being hedged. In addition, there are significant differences between the securities and futures markets that could result in an imperfect correlation between the markets, causing a given hedge not to achieve its objective. The degree of imperfection of correlation depends on circumstances such as variations in speculative market demand for futures and futures options on securities, including technical influences in futures trading and futures options, and differences between the financial instruments being hedged and the instruments underlying the standard contracts available for trading in such respects as interest rate levels, maturities, and creditworthiness of issuers. A decision as to whether, when and how to hedge involves the
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exercise of skill and judgment, and even a well-conceived hedge may be unsuccessful to some degree because of market behavior or unexpected interest rate trends.
Futures contracts on U.S. government securities historically have reacted to an increase or decrease in interest rates in a manner similar to that in which the underlying U.S. government securities reacted. To the extent, however, that the Fund enters into such futures contracts, the value of such futures will not vary in direct proportion to the value of the Fund’s holdings of U.S. government securities. Thus, the anticipated spread between the price of the futures contract and the hedged security may be distorted due to differences in the nature of the markets. The spread also may be distorted by differences in initial and variation margin requirements, the liquidity of such markets and the participation of speculators in such markets.
Additionally, the price of Index Futures may not correlate perfectly with movement in the relevant index due to certain market distortions. First, all participants in the futures market are subject to margin deposit and maintenance requirements. Rather than meeting additional margin deposit requirements, investors may close futures contracts through offsetting transactions which could distort the normal relationship between the index and futures markets. Second, the deposit requirements in the futures market are less onerous than margin requirements in the securities market, and as a result, the futures market may attract more speculators than does the securities market. Increased participation by speculators in the futures market may also cause temporary price distortions. In addition, trading hours for foreign stock Index Futures may not correspond perfectly to hours of trading on the foreign exchange to which a particular foreign stock Index Future relates. This may result in a disparity between the price of Index Futures and the value of the relevant index due to the lack of continuous arbitrage between the Index Futures price and the value of the underlying index.
Futures exchanges may limit the amount of fluctuation permitted in certain futures contract prices during a single trading day. The daily limit establishes the maximum amount that the price of a futures contract may vary either up or down from the previous day’s settlement price at the end of the current trading session. Once the daily limit has been reached in a futures contract subject to the limit, no more trades may be made on that day at a price beyond that limit. The daily limit governs only price movements during a particular trading day and therefore does not limit potential losses because the limit may work to prevent the liquidation of unfavorable positions. For example, futures prices have occasionally moved to the daily limit for several consecutive trading days with little or no trading, thereby preventing prompt liquidation of positions and subjecting some holders of futures contracts to substantial losses.
There can be no assurance that a liquid market will exist at a time when the Fund seeks to close out a futures or a futures option position, and that the Fund would remain obligated to meet margin requirements until the position is closed. In addition, many of the contracts discussed above are relatively new instruments without a significant trading history. As a result, there can be no assurance that an active secondary market will develop or continue to exist.
Risks Associated with Commodity Futures Contracts. There are several additional risks associated with transactions in commodity futures contracts, including but not limited to:
Storage. Unlike the financial futures markets, in the commodity futures markets there are costs of physical storage associated with purchasing the underlying commodity. The price of the commodity futures contract will reflect the storage costs of purchasing the physical commodity, including the time value of money invested in the physical commodity. To the extent that the storage costs for an underlying commodity change while the Fund is invested in futures contracts on that commodity, the value of the futures contract may change proportionately.
Reinvestment. In the commodity futures markets, producers of the underlying commodity may decide to hedge the price risk of selling the commodity by selling futures contracts today to lock in the price of the commodity at delivery tomorrow. In order to induce speculators to purchase the other side of the same futures contract, the commodity producer generally must sell the futures contract at a lower price than the expected future spot price. Conversely, if most hedgers in the futures market are purchasing futures contracts to hedge against a rise in prices, then speculators will only sell the other side of the futures contract at a higher futures price than the expected future spot price of the commodity. The changing nature of the hedgers and speculators in the commodity markets will influence whether futures prices are above or below the expected future spot price, which can have significant implications for the Fund. If the nature of hedgers and speculators in futures markets has shifted when it is time for the Fund to reinvest the proceeds of a maturing contract in a new futures contract, the Fund might reinvest at higher or lower futures prices, or choose to pursue other investments.
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Other Economic Factors. The commodities which underlie commodity futures contracts may be subject to additional economic and non-economic variables, such as drought, floods, weather, livestock disease, embargoes, tariffs, and international economic, political and regulatory developments. These factors may have a larger impact on commodity prices and commodity-linked instruments, including futures contracts, than on traditional securities. Certain commodities are also subject to limited pricing flexibility because of supply and demand factors. Others are subject to broad price fluctuations as a result of the volatility of the prices for certain raw materials and the instability of supplies of other materials. These additional variables may create additional investment risks which subject the Fund’s investments to greater volatility than investments in traditional securities.
Additional Risks of Options on Securities, Futures Contracts, Futures Options and Forward Currency Exchange Contracts and Options Thereon. Options on securities, futures contracts, futures options, forward currency exchange contracts and options on forward currency exchange contracts may be traded on non-U.S. exchanges. Such transactions may not be regulated as effectively as similar transactions in the United States, may not involve a clearing mechanism and related guarantees, and are subject to the risk of governmental actions affecting trading in, or the prices of, non-U.S. securities. The value of such positions also could be adversely affected by: (i) other complex non-U.S. political, legal and economic factors; (ii) lesser availability than in the United States of data on which to make trading decisions; (iii) delays in the Fund’s ability to act upon economic events occurring in non-U.S. markets during non-business hours in the United States; (iv) the imposition of different exercise and settlement terms and procedures and margin requirements than in the United States; and (v) lesser trading volume.
Swap Agreements and Options on Swap Agreements. The Fund may engage in swap transactions, including, but not limited to, swap agreements on interest rates, security or commodity indexes, specific securities and commodities, and credit and event-linked swaps. To the extent the Fund may invest in non-U.S. currency-denominated securities, it also may invest in currency exchange rate swap agreements. The Fund also may enter into options on swap agreements (“swaptions”).
The Fund may enter into swap transactions for any legal purpose consistent with its investment objective and policies, such as attempting to obtain or preserve a particular return or spread at a lower cost than obtaining a return or spread through purchases and/or sales of instruments in other markets, to protect against currency fluctuations, as a duration management technique, to protect against any increase in the price of securities the Fund anticipates purchasing at a later date, or to gain exposure to certain markets in a more cost-efficient manner.
OTC swap agreements are bilateral contracts entered into primarily by institutional investors for periods ranging from a few weeks to more than one year. In a standard OTC swap transaction, two parties agree to exchange the returns (or differentials in rates of return) earned or realized on particular predetermined investments or instruments. The gross returns to be exchanged or “swapped” between the parties are generally calculated with respect to a “notional amount,” i.e., the return on or change in value of a particular dollar amount invested at a particular interest rate or in a “basket” of securities or commodities representing a particular index. A “quanto” or “differential” swap combines both an interest rate and a currency transaction. Certain swap agreements, such as interest rate swaps, are traded on exchanges and cleared through central clearing counterparties. Other forms of swap agreements include interest rate caps, under which, in return for a premium, one party agrees to make payments to the other to the extent that interest rates exceed a specified rate, or “cap”; interest rate floors, under which, in return for a premium, one party agrees to make payments to the other to the extent that interest rates fall below a specified rate, or “floor”; and interest rate collars, under which a party sells a cap and purchases a floor or vice versa in an attempt to protect itself against interest rate movements exceeding given minimum or maximum levels. A total return swap agreement is a contract in which one party agrees to make periodic payments to another party based on the change in market value of underlying assets, which may include a single stock, a basket of stocks, or a stock index during the specified period, in return for periodic payments based on a fixed or variable interest rate or the total return from other underlying assets. Consistent with the Fund’s investment objective and general investment policies, the Fund may invest in commodity swap agreements. For example, an investment in a commodity swap agreement may involve the exchange of floating-rate interest payments for the total return on a commodity index. In a total return commodity swap, the Fund will receive the price appreciation of a commodity index, a portion of the index, or a single commodity in exchange for paying an agreed-upon fee. If the commodity swap is for one period, the Fund may pay a fixed fee, established at the outset of the swap. However, if the term of the commodity swap is more than one period, with interim swap payments, the Fund may pay an adjustable or floating fee. With a “floating” rate, the fee may be pegged to a base rate, such as the London Interbank Offered Rate, and is adjusted each period. Therefore, if interest rates increase over the term of the swap contract, the Fund may be required to pay a higher fee at each swap reset date.
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The Fund also may enter into combinations of swap agreements in order to achieve certain economic results. For example, the Fund may enter into two swap transactions, one of which offsets the other for a period of time. After the offsetting swap transaction expires, the Fund would be left with the economic exposure provided by the remaining swap transaction. The intent of such an arrangement would be to lock in certain terms of the remaining swap transaction that the Fund may wish to gain exposure to in the future without having that exposure during the period the offsetting swap is in place.
The Fund also may enter into swaptions. A swaption is a contract that gives a counterparty the right (but not the obligation) in return for payment of a premium, to enter into a new swap agreement or to shorten, extend, cancel or otherwise modify an existing swap agreement, at some designated future time on specified terms. The Fund may write (sell) and purchase put and call swaptions.
Depending on the terms of the particular option agreement, the Fund will generally incur a greater degree of risk when it writes a swaption than it will incur when it purchases a swaption. When the Fund purchases a swaption, it risks losing only the amount of the premium it has paid should it decide to let the option expire unexercised. However, when the Fund writes a swaption, upon exercise of the option the Fund will become obligated according to the terms of the underlying agreement.
The Fund also may enter into forward volatility agreements, also known as volatility swaps. In a volatility swap, the counterparties agree to make payments in connection with changes in the volatility (i.e., the magnitude of change over a specified period of time) of an underlying reference instrument, such as a currency, rate, index, security or other financial instrument. Volatility swaps permit the parties to attempt to hedge volatility risk and/or take positions on the projected future volatility of an underlying reference instrument. For example, the Fund may enter into a volatility swap in order to take the position that the reference instrument’s volatility will increase over a particular period of time. If the reference instrument’s volatility does increase over the specified time, the Fund will receive a payment from its counterparty based upon the amount by which the reference instrument’s realized volatility level exceeds a volatility level agreed upon by the parties. If the reference instrument’s volatility does not increase over the specified time, the Fund will make a payment to the counterparty based upon the amount by which the reference instrument’s realized volatility level falls below the volatility level agreed upon by the parties. Payments on a volatility swap will be greater if they are based upon the mathematical square of volatility (i.e., the measured volatility multiplied by itself, which is referred to as “variance”). This type of volatility swap is frequently referred to as a variance swap. The Fund may potentially engage in variance swaps.
Most types of swap agreements entered into by the Fund will calculate the obligations of the parties to the agreement on a “net basis.” Consequently, the Fund’s current obligations (or rights) under a swap agreement will generally be equal only to the net amount to be paid or received under the agreement based on the relative values of the positions held by each party to the agreement.
The Fund also may enter into OTC and cleared credit default swap agreements. The credit default swap agreement may reference one or more debt securities or obligations that are not currently held by the Fund. The protection “buyer” in an OTC credit default swap contract is generally obligated to pay the protection “seller” an upfront or a periodic stream of payments over the term of the contract until a credit event, such as a default, on a reference obligation has occurred. If a credit event occurs, the seller generally must pay the buyer the “par value” (full notional value) of the swap in exchange for an equal face amount of deliverable obligations of the reference entity described in the swap, or the seller may be required to deliver the related net cash amount if the swap is cash settled. The Fund may be either the buyer or seller in the transaction. If the Fund is a buyer and no credit event occurs, the Fund may recover nothing if the swap is held through its termination date. However, if a credit event occurs, the buyer may receive the full notional value of the swap in exchange for an equal face amount of deliverable obligations of the reference entity whose value may have significantly decreased.
As a seller, the Fund generally receives an upfront payment or a fixed rate of income throughout the term of the swap provided that there is no credit event. As the seller, the Fund would effectively add leverage to its portfolio because, in addition to its total net assets, the Fund would be subject to investment exposure on the notional amount of the swap. The spread of a credit default swap is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount. When spreads rise, market perceived credit risk rises and when spreads fall, market perceived credit risk falls. Wider credit spreads and decreasing market values, when compared to the notional amount of the swap, represent a deterioration of the credit soundness of the
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issuer of the reference obligation and a greater likelihood or risk of default or other credit event occurring as defined under the terms of the agreement. For credit default swap agreements on ABS and credit indices, the quoted market prices and resulting values, as well as the annual payment rate, serve as an indication of the current status of the payment/performance risk.
Credit default swap agreements sold by the Fund may involve greater risks than if the Fund had invested in the reference obligation directly since, in addition to general market risks, credit default swaps are subject to illiquidity risk, counterparty risk (with respect to OTC credit default swaps) and credit risk. A buyer generally also will lose its investment and recover nothing should no credit event occur and the swap is held to its termination date. If a credit event were to occur, the value of any deliverable obligation received by the seller, coupled with the upfront or periodic payments previously received, may be less than the full notional value it pays to the buyer, resulting in a loss of value to the seller. In addition, there may be disputes between the buyer and seller of a credit default swap agreement or within the swaps market as a whole as to whether a credit event has occurred or what the payment should be. Such disputes could result in litigation or other delays, and the outcome could be adverse for the buyer or seller. The Fund’s obligations under a credit default swap agreement will be accrued daily (offset against any amounts owing to the Fund).
The Dodd-Frank Act and related regulatory developments require the clearing and exchange-trading of certain standardized OTC derivative instruments that the CFTC and SEC have defined as “swaps.” The CFTC has implemented mandatory exchange-trading and clearing requirements under the Dodd-Frank Act and the CFTC continues to approve contracts for central clearing. Uncleared swaps are subject to certain margin requirements that mandate the posting and collection of minimum margin amounts on certain uncleared swaps transactions, which may result in the Fund and its counterparties posting higher margin amounts for uncleared swaps than would otherwise be the case. These amounts beyond coverage of daily exposure, if any, may (or if required by law, will) be segregated with a third-party custodian. To the extent the Fund is required by regulation to post additional collateral beyond coverage of daily exposure, it could potentially incur costs, including in procuring eligible assets to meet collateral requirements, associated with such posting. There can be no assurance that such regulatory changes will not result in losses to the Fund.
Whether the Fund’s use of swap agreements or swaptions will be successful in furthering its investment objective will depend on PIMCO’s ability to predict correctly whether certain types of investments are likely to produce greater returns than other investments. Moreover, the Fund bears the risk of loss of the amount expected to be received under a swap agreement in the event of the default or bankruptcy of a swap agreement counterparty. Certain restrictions imposed on the Fund by the Code may limit the Fund’s ability to use swap agreements. The swaps market is subject to increasing regulations, in both U.S. and non-U.S. markets. It is possible that developments in the swaps market, including additional government regulation, could adversely affect the Fund’s ability to terminate existing swap agreements or to realize amounts to be received under such agreements.
Swaps are highly specialized instruments that require investment techniques, risk analyses, and tax planning different from those associated with traditional investments. The use of a swap requires an understanding not only of the reference asset, reference rate, or index but also of the swap itself, without the benefit of observing the performance of the swap under all possible market conditions.
Because OTC swap agreements are bilateral contracts that may be subject to contractual restrictions on transferability and termination and because they may have remaining terms of greater than seven days, swap agreements may be considered to be illiquid and subject to regulatory limitations on investments in illiquid investments. Please refer to “Illiquid Investments” below for further discussion of regulatory considerations and constraints relating to investment liquidity. To the extent that a swap is not liquid, it may not be possible to initiate a transaction or liquidate a position at an advantageous time or price, which may result in significant losses.
Like most other investments, swap agreements are subject to the risk that the market value of the instrument will change in a way detrimental to the Fund’s interest. The Fund bears the risk that PIMCO will not accurately forecast future market trends or the values of assets, reference rates, indexes, or other economic factors in establishing swap positions for the Fund. If PIMCO attempts to use a swap as a hedge against, or as a substitute for, a portfolio investment, the Fund will be exposed to the risk that the swap will have or will develop imperfect or no correlation with the portfolio investment. This could cause substantial losses for the Fund. While hedging strategies involving
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swap instruments can reduce the risk of loss, they can also reduce the opportunity for gain or even result in losses by offsetting favorable price movements in other Fund investments. Many swaps are complex and often valued subjectively.
Structured Notes. The Fund may invest without limit in “structured” notes, which are privately negotiated debt obligations where the principal and/or interest is determined by reference to the performance of a benchmark asset, market or interest rate, such as selected securities, an index of securities or specified interest rates, or the differential performance of two assets or markets, such as indexes reflecting bonds. Depending on the terms of the note, the Fund may forgo all or part of the interest and principal that would be payable on a comparable conventional note. The rate of return on structured notes may be determined by applying a multiplier to the performance or differential performance of the referenced index(es) or other asset(s). Application of a multiplier involves leverage which will serve to magnify the potential for gain and the risk of loss. The Fund may use structured notes to add leverage to the portfolio and for investment as well as risk management purposes. Like other sophisticated strategies, the Fund’s use of structured notes may not work as intended. Certain issuers of structured products may be deemed to be investment companies as defined in the 1940 Act. As a result, the Fund’s investments in these structured products may be subject to limits applicable to investments in investment companies and may be subject to restrictions contained in the 1940 Act.
Risks of Potential Government Regulation of Derivatives. It is possible that additional government regulation of various types of derivative instruments, including futures, options and swap agreements, and regulation of certain market participants’ use of the same, may limit or prevent the Fund from using such instruments as a part of its investment strategy, and could ultimately prevent the Fund from being able to achieve its investment objective. It is impossible to fully predict the effects of past, present or future legislation and regulation by multiple regulators in this area, but the effects could be substantial and adverse. It is possible that legislative and regulatory activity could limit or restrict the ability of the Fund to use certain instruments as a part of its investment strategy. Limits or restrictions applicable to the counterparties or issuers, as applicable, with which the Fund engages in derivative transactions could also limit or prevent the Fund from using certain instruments.
There is a possibility of future regulatory changes altering, perhaps to a material extent, the nature of an investment in the Fund or the ability of the Fund to continue to implement its investment strategies. The futures, options and swaps markets are subject to comprehensive statutes, regulations, and margin requirements. In addition, the SEC, CFTC and the exchanges are authorized to take extraordinary actions in the event of a market emergency, including, for example, the implementation or reduction of speculative position limits, the implementation of higher margin requirements, the establishment of daily price limits and the suspension of trading.
The regulation of futures, options and swaps transactions in the United States is a changing area of law and is subject to modification by government and judicial action.
In particular, the Dodd-Frank Act sets forth a legislative framework for OTC derivatives, including financial instruments, such as swaps, in which the Fund may invest. Title VII of the Dodd-Frank Act makes broad changes to the OTC derivatives market, grants significant authority to the SEC and the CFTC to regulate OTC derivatives and market participants, and, among other things, requires clearing and exchange trading of many OTC derivatives transactions and imposes minimum margin and capital requirements on uncleared OTC derivatives transactions.
The CFTC and various exchanges have rules limiting the maximum net long or short positions which any person or group may own, hold or control in any given futures contract or option on such futures contract. PIMCO will need to consider whether the exposure created under these contracts might exceed the applicable limits in managing the Fund, and the limits may constrain the ability to use such contracts. In addition, the CFTC in October 2020 adopted amendments to its position limits rules that establish certain new and amended position limits for 25 specified physical commodity futures and related options contracts traded on exchanges, other futures contracts and related options directly or indirectly linked to such 25 specified contracts, and any OTC transactions that are economically equivalent to the 25 specified contracts. PIMCO will need to consider whether the exposure created under these contracts might exceed the new and amended limits in anticipation of the applicable compliance dates, and the limits may constrain the ability of the Fund to use such contracts. The amendments also modify the bona fide hedging exemption for which certain swap dealers are currently eligible, which could limit the amount of speculative OTC transaction capacity each such swap dealer would have available for the Fund prior to the applicable compliance date.
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Provisions in the Dodd-Frank Act include capital and margin requirements and the mandatory use of clearinghouse mechanisms for many OTC derivatives transactions. The CFTC, SEC and other federal regulators have adopted rules and regulations enacting the provisions of the Dodd-Frank Act. However, swap dealers, major market participants and swap counterparties are experiencing, and will continue to experience, new and additional regulations, requirements, compliance burdens and associated costs. The Dodd-Frank Act and the rules promulgated thereunder may negatively impact the Fund’s ability to meet its investment objective either through limits or requirements imposed on it or upon its counterparties. In particular, new position limits imposed on the Fund or its counterparties may impact its ability to invest in futures, options and swaps in a manner that efficiently meets its investment objective. New requirements, even if not directly applicable to the Fund, including margin requirements, changes to the CFTC speculative position limits regime and mandatory clearing, discussed further below in “Additional Risk Factors in Cleared Derivatives Transactions,” may increase the cost of the Fund’s investments and cost of doing business, which could adversely affect investors.
Additionally, the U.S. government and the EU have adopted mandatory minimum margin requirements for bilateral derivatives. Such requirements could increase the amount of margin required to be provided by the Fund in connection with its derivatives transactions and, therefore, make derivatives transactions more expensive.
Also, in the event of a counterparty’s (or its affiliate’s) insolvency, the possibility exists that the Fund’s ability to exercise remedies, such as the termination of transactions, netting of obligations and realization on collateral, could be stayed or eliminated under new special resolution regimes adopted in the United States, the EU and various other jurisdictions. Such regimes provide government authorities broad authority to intervene when a financial institution is experiencing financial difficulty. In particular, in the EU, governmental authorities could reduce, eliminate, or convert to equity the liabilities to the Fund of a counterparty experiencing financial difficulties (sometimes referred to as a “bail in”).
Additional Risk Factors in Cleared Derivatives Transactions. Some types of swaps (including interest rate swaps and credit default index swaps on North American and European indices) are required to be centrally cleared, and additional types of swaps may be required to be centrally cleared in the future. In a cleared derivatives transaction, the Fund’s counterparty is a clearing house, rather than a bank or broker. Since the Fund is not a member of clearing houses and only members of a clearing house can participate directly in the clearing house, the Fund will hold cleared derivatives through accounts at clearing members. In cleared derivatives transactions, the Fund will make payments (including margin payments) to and receive payments from a clearing house through its accounts at clearing members. Clearing members guarantee performance of their clients’ obligations to the clearing house.
In many ways, centrally cleared derivative arrangements are less favorable to registered funds than bilateral arrangements. For example, the Fund may be required to provide greater amounts of margin for cleared derivatives transactions than for bilateral derivatives transactions. Also, in contrast to bilateral derivatives transactions, following a period of notice to the Fund, a clearing member generally can require termination of existing cleared derivatives transactions at any time or increases in margin requirements above the margin that the clearing member required at the beginning of a transaction. Clearing houses also have broad rights to increase margin requirements for existing transactions or to terminate transactions at any time. Any increase in margin requirements or termination by the clearing member or the clearing house could interfere with the ability of the Fund to pursue its investment strategy. Further, any increase in margin requirements by a clearing member could also expose the Fund to greater credit risk to its clearing member, because margin for cleared derivatives transactions in excess of clearing house margin requirements typically is held by the clearing member. Also, the Fund is subject to risk if it enters into a derivatives transaction that is required to be cleared (or that PIMCO expects to be cleared), and no clearing member is willing or able to clear the transaction on the Fund’s behalf. While the documentation in place between the Fund and its clearing members generally provides that the clearing members will accept for clearing all transactions submitted for clearing that are within credit limits (specified in advance) for the Fund, the Fund is still subject to the risk that no clearing member will be willing or able to clear a transaction. In those cases, the transaction might have to be terminated, and the Fund could lose some or all of the benefit of the transaction, including loss of an increase in the value of the transaction and/or loss of hedging protection offered by the transaction. In addition, the documentation governing the relationship between the Fund and the clearing members is developed by the clearing members and generally is less favorable to the Fund than typical bilateral derivatives documentation. For example, this documentation generally includes a one-way indemnity by the Fund in favor of the clearing member, indemnifying the clearing member against losses it incurs in connection with acting as the Fund’s clearing member, and the documentation typically does not give the Fund any rights to exercise remedies if the clearing member defaults or becomes insolvent.
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Some types of cleared derivatives are required to be executed on an exchange or on a swap execution facility (a “SEF”). A SEF is a trading platform where multiple market participants can execute derivatives by accepting bids and offers made by multiple other participants in the platform. This execution requirement may make it more difficult and costly for funds, such as the Fund, to enter into highly tailored or customized transactions. Trading swaps on a SEF may offer certain advantages over traditional bilateral OTC trading, such as ease of execution, price transparency, increased liquidity and/or favorable pricing. Execution through a SEF is not, however, without additional costs and risks, as parties are required to comply with SEF and CFTC rules and regulations, including disclosure and recordkeeping obligations, and SEF rights of inspection, among others. SEFs typically charge fees, and if the Fund executes derivatives on a swap execution facility through a broker intermediary, the intermediary may impose fees as well. The Fund also may be required to indemnify a SEF, or a broker intermediary who executes swaps on a SEF on the Fund’s behalf, against any losses or costs that may be incurred as a result of the Fund’s transactions on the SEF. In addition, the Fund may be subject to execution risk if it enters into a derivatives transaction that is required to be cleared, and no clearing member is willing to clear the transaction on the Fund’s behalf. In that case, the transaction might have to be terminated, and the Fund could lose some or all of the benefit of any increase in the value of the transaction after the time of the trade.
These and other new rules and regulations could, among other things, further restrict the Fund’s ability to engage in, or increase the cost to the Fund of, derivatives transactions, for example, by making some types of derivatives no longer available to the Fund, increasing margin or capital requirements, or otherwise limiting liquidity or increasing transaction costs. These regulations are relatively new and evolving, so their potential impact on the Fund and the financial system are not yet known. While the new regulations and the central clearing of some derivatives transactions are designed to reduce systemic risk (i.e., the risk that the interdependence of large derivatives dealers could cause a number of those dealers to suffer liquidity, solvency or other challenges simultaneously), there is no assurance that the new clearing mechanisms will achieve that result, and in the meantime, as noted above, central clearing will expose the Fund to new kinds of risks and costs.
A Note on Commodity-Linked Derivatives. The Fund may seek to gain exposure to the commodity markets by investing in commodity-linked derivative instruments, swap transactions, or index-linked or commodity linked structured notes.
The value of a commodity-linked derivative investment generally is based upon the price movements of a physical commodity (such as energy, mineral, or agricultural products), a commodity futures contract or commodity index, or other economic variable based upon changes in the value of commodities or the commodities markets. Swap transactions are privately negotiated agreements between the Fund and a counterparty to exchange or swap investment cash flows or assets at specified intervals in the future. The obligations may extend beyond one year. There is no central exchange or market for swap transactions and therefore they are less liquid investments than exchange-traded instruments. The Fund bears the risk that the counterparty could default under a swap agreement. See “Swap Agreements and Options on Swap Agreements” above for further detail about swap transactions. Further, the Fund may invest in derivative debt instruments with principal and/or coupon payments linked to the value of commodities, commodity futures contracts or the performance of commodity indices. These are “commodity-linked” or “index-linked” notes, and are sometimes referred to as “structured notes” because the terms of the debt instrument may be structured by the issuer of the note and the purchaser of the note. See “Structured Notes” above for further discussion of these notes.
The value of these notes will rise or fall in response to changes in the underlying commodity or related index of investment. These notes expose the Fund economically to movements in commodity prices. These notes also are subject to risks, such as credit, market and interest rate risks, that in general affect the values of debt securities. Therefore, at the maturity of the note, the Fund may receive more or less principal that it originally invested. The Fund might receive interest payments on the note that are more or less than the stated coupon interest payments.
The Fund’s investments in commodity-linked instruments may bear on or be limited by the Fund’s intention to qualify as a RIC under the Code. See “Taxation.”
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Hybrid Instruments
The Fund may invest in “hybrid” or indexed securities, which is a type of potentially high-risk derivative that combines a traditional stock, bond, or commodity with an option or forward contract. Generally, the principal amount, amount payable upon maturity or redemption, or interest rate of a hybrid is tied (positively or negatively) to the price of some commodity, currency or securities index or another interest rate or some other economic factor (each a “benchmark”).
The interest rate or (unlike most fixed-income securities) the principal amount payable at maturity of a hybrid security may be increased or decreased, depending on changes in the value of the benchmark. An example of a hybrid could be a bond issued by an oil company that pays a small base level of interest with additional interest that accrues in correlation to the extent to which oil prices exceed a certain predetermined level. Such a hybrid instrument would be a combination of a bond and a call option on oil.
Hybrids can be used as an efficient means of pursuing a variety of investment goals, including currency hedging, duration management and increased total return. Hybrids may not bear interest or pay dividends. The value of a hybrid or its interest rate may be a multiple of a benchmark and, as a result, may be leveraged and move (up or down) more steeply and rapidly than the benchmark.
These benchmarks may be sensitive to economic and political events, such as commodity shortages and currency devaluations, which cannot be readily foreseen by the purchaser of a hybrid. Under certain conditions, the redemption value of a hybrid could be zero. Thus, an investment in a hybrid may entail significant market risks that are not associated with a similar investment in a traditional, U.S. dollar-denominated bond that has a fixed principal amount and pays a fixed rate or floating rate of interest. The purchase of hybrids also exposes the Fund to the credit risk of the issuer of the hybrids. These risks may cause significant fluctuations in the net asset value of the Fund.
Certain hybrid instruments may provide exposure to the commodities markets. These are derivative securities with one or more commodity-linked components that have payment features similar to commodity futures contracts, commodity options, or similar instruments. Commodity-linked hybrid instruments may be either equity or fixed-income securities and are considered hybrid instruments because they have both security and commodity-like characteristics. A portion of the value of these instruments may be derived from the value of a commodity, futures contract, index or other economic variable. The Fund will only invest in commodity-linked hybrid instruments that qualify under applicable rules of the CFTC for an exemption from the provisions of the CEA.
Certain issuers of structured products such as hybrid instruments may be deemed to be investment companies, as defined in the 1940 Act. As a result, the Fund’s investments in these products may be subject to limits applicable to investments in investment companies and may be subject to other restrictions imposed by the 1940 Act. In addition, the Fund’s investments in these products may be limited by the Fund’s intention to qualify as a RIC, and may limit the Fund’s ability to so qualify.
Leverage and Borrowing
The Fund utilizes leverage through its outstanding auction rate preferred shares of the Fund (“ARPS” and, together with any other preferred shares the Fund may have outstanding, “Preferred Shares”) and may obtain additional leverage through reverse repurchase agreements, dollar rolls or borrowings, such as through bank loans or commercial paper and/or other credit facilities. The amount of leverage the Fund utilizes may vary. Information regarding the terms and features of the Preferred Shares is provided under “Description of Capital Structure” in the prospectus.
The Fund may also enter into transactions other than those noted above that may give rise to a form of leverage including, among others, selling credit default swaps, futures and forward contracts (including foreign currency exchange contracts), total return swaps and other derivative transactions, loans of portfolio securities, short sales, when-issued, delayed delivery and forward commitment transactions. The Fund may also determine to issue other types of Preferred Shares.
Depending upon market conditions and other factors, the Fund may or may not determine to add leverage following an offering to maintain or increase the total amount of leverage (as a percentage of the Fund’s total assets)
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that the Fund currently maintains, taking into account the additional assets raised through the issuance of Common Shares in such offering. The Fund utilizes certain kinds of leverage, such as reverse repurchase agreements and selling credit default swaps, opportunistically and may choose to increase or decrease, or eliminate entirely, its use of such leverage over time and from time to time based on PIMCO’s assessment of the yield curve environment, interest rate trends, market conditions and other factors. The Fund may also determine to decrease the leverage it currently maintains through its outstanding Preferred Shares through Preferred Shares redemptions or tender offers and may or may not determine to replace such leverage through other sources. If the Fund determines to add leverage following an offering, it is not possible to predict with accuracy the precise amount of leverage that would be added, in part because it is not possible to predict the number of Common Shares that ultimately will be sold in an offering or series of offerings. To the extent that the Fund does not add additional leverage following an offering, the Fund’s total amount of leverage as a percentage of its total assets will decrease, which could result in a reduction of investment income available for distribution to Common Shareholders.
The Fund’s net assets attributable to its Preferred Shares and the net proceeds the Fund obtains from reverse repurchase agreements, dollar rolls or other forms of leverage utilized, if any, will be invested in accordance with the Fund’s investment objective and policies as described in the Prospectus and any prospectus supplement. So long as the rate of return, net of applicable Fund expenses, on the debt obligations and other investments purchased by the Fund exceeds the dividend rates payable on the Preferred Shares together with the costs to the Fund of other leverage it utilizes, the investment of the Fund’s assets attributable to leverage will generate more income than will be needed to pay the costs of the leverage. If so, and all other things being equal, the excess may be used to pay higher dividends to Common Shareholders than if the Fund were not so leveraged. Leveraging transactions pursued by the Fund may increase its duration and sensitivity to interest rate movements.
Regarding the costs associated with the Fund’s Preferred Shares, the terms of the ARPS provide that they would ordinarily pay dividends at a rate set at auctions held every seven days, normally payable on the first business day following the end of the rate period, subject to a maximum applicable rate calculated as a function of the ARPS’ then-current rating and a reference interest rate, as described below. However, the weekly auctions for the ARPS, as well as auctions for similar preferred shares of other closed-end funds in the U.S., have failed since February 2008, and the dividend rates on the ARPS since that time have been paid at the maximum applicable rate (i.e. the greater of a multiple of or a spread plus a reference rate, which is either (i) for a rate period of fewer than 365 days, the Secured Overnight Funding Rate plus spread adjustments intended to serve as a reasonable substitute of the previously-applicable LIBOR Rate (as defined and detailed in the Fund’s Bylaws), or (ii) for a rate period of 365 days or more, the applicable Treasury Index Rate). In September 2011, Moody’s, a ratings agency that provides ratings for the Fund’s ARPS, downgraded its rating of the ARPS from “Aaa” to “Aa2,” citing what it believed to be persistently thin asset coverage levels, increased NAV volatility and concerns about secondary market liquidity for some assets supporting rated obligations. In July 2012, Moody’s downgraded its rating of the ARPS from “Aa2” to “Aa3” pursuant to a revised ratings methodology adopted by Moody’s. See “Description of Capital Structure.” Under the Fund’s amended and restated bylaws (the “Bylaws”), the 2011 downgrade resulted in an increase in the dividend rate multiplier from 1.25 to 1.50, thereby increasing the dividend rate payable to ARPS holders and increasing the expenses to Common Shareholders associated with the Fund’s leverage. In May 2020, Fitch downgraded its rating of the ARPS from “AAA” to “AA,” indicating the downgrades reflected recent extreme market volatility and reduced asset liquidity, which it believed had quickly eroded asset coverage cushions for closed-end funds and challenged fund managers’ ability to deleverage. Under the Bylaws, the 2020 Fitch downgrade resulted in an increase in the applicable spread over the reference rate from 125 bps to 150 bps, thereby increasing the dividend rate payable to ARPS holders and increasing the costs to Common Shareholders associated with the Fund’s leverage. On December 4, 2020, Fitch published ratings criteria relating to closed-end fund obligations, including preferred shares, which effectively result in a rating cap of “AA” for debt and preferred stock issued by closed-end funds and a rating cap of “A” for (i) debt and preferred shares issued by closed-end funds exposed to corporate debt, emerging market debt, below-investment-grade and unrated debt, structured securities and equity, (ii) and closed-end funds with material exposure to “BBB” category rated assets. Following the close of business on April 30, 2021, Fitch downgraded its rating of the ARPS from “AA” to “A” pursuant to the revised ratings methodology and related new rating caps. Under the Bylaws, the April 2021 Fitch downgrade resulted in an increase in the dividend rate multiplier from 1.50 to 2.00, which could increase the dividend rate payable to ARPS holders should the maximum dividend rate be determined via the multiplier in lieu of the spread noted above (the maximum dividend rate is based on the greater of a multiple of or a spread plus a reference rate) and, thereby, increase the expenses to Common Shareholders associated with the Fund’s leverage. In December 2022, Moody’s downgraded its rating of the ARPS from “Aa3” to “A1,” stating that the downgrades occurred because of, among other matters, trends in the Fund’s risk-adjusted asset coverage metrics and the evolution of its sector
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exposures. Under the Bylaws, the 2022 Moody’s downgrade resulted in an increase in the applicable spread over the reference rate from 150 bps to 200 bps. As noted herein, the maximum applicable rate actually payable to ARPS holders is based on the greater of a multiple of or a spread plus a reference rate, which is either the applicable Secured Overnight Funding Rate or the applicable Treasury Index Rate depending on the rate period. The applicable spread change resulting from the 2022 Moody’s downgrade will therefore only impact the maximum applicable rate if the applicable spread formula is greater than the multiplier formula. See “Description of Capital Structure – Preferred Share Dividends.” See “Use of Leverage” and “Description of Capital Structure.” The Fund expects that the ARPS will continue to pay dividends at the maximum applicable rate for the foreseeable future and cannot predict whether or when the auction markets for the ARPS may resume normal functioning. See “Principal Risks of the Fund—Leverage Risk,” “Principal Risks of the Fund—Additional Risks Associated with the Fund’s Preferred Shares” and “Description of Capital Structure” in the Prospectus for more information.
Under the 1940 Act, the Fund is not permitted to issue new preferred shares unless immediately after such issuance the value of the Fund’s total net assets (as defined below) is at least 200% of the liquidation value of the outstanding Preferred Shares and the newly issued preferred shares plus the aggregate amount of any senior securities of the Fund representing indebtedness (i.e., such liquidation value plus the aggregate amount of senior securities representing indebtedness may not exceed 50% of the Fund’s total net assets). In addition, the Fund is not permitted to declare any cash dividend or other distribution on its Common Shares unless, at the time of such declaration, the value of the Fund’s total net assets satisfies the above-referenced 200% coverage requirement.
The Fund is subject to the 1940 Act requirement that an investment company satisfy an asset coverage requirement of 300% of its senior securities represented by indebtedness measured at the time the investment company incurs the indebtedness. This means that at any given time the value of the Fund's total senior securities represented indebtedness may not exceed one-third the value of its total assets (including assets attributable to such leverage). The Fund's issuance of Preferred Shares and use of derivatives results in leverage, but any such leverage is not subject to the 300% asset coverage requirement. This is because (1) derivatives will, to the extent permitted by the Derivatives Rule, not be “senior securities” under the 1940 Act and (2) under the 1940 Act, Preferred Shares are subject to the 200% asset coverage requirement described above (not the 300% asset coverage requirement applicable to indebtedness). The interests of persons with whom the Fund enters into leverage arrangements will not necessarily be aligned with the interests of the Fund's shareholders and such persons will have claims on the Fund's assets that are senior to those of the Fund's shareholders.
The Fund may enter into derivatives or other transactions that may provide leverage (other than through the issuance of Preferred Shares or bank borrowing). The Derivatives Rule regulates a registered investment company’s use of derivatives and certain other transactions that create future payment and/or delivery obligations by the Fund. This new rule became operative in August 2022. The Derivatives Rule prescribes specific VaR leverage limits that apply to the Fund (although the Fund in the future could qualify for the Limited Derivatives User Exception (as defined in the Derivatives Rule) and would therefore not be subject to all the requirements of the Derivatives Rule). VaR is an estimate of potential losses on an instrument or portfolio over a specified time horizon and at a given confidence level. The Fund may apply a relative VaR test or an absolute VaR test (if the Fund’s derivatives risk manager determines that a designated reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test). The limit under the relative VaR test when the Fund has outstanding Preferred Shares is 250% (or 200% when no Preferred Shares are outstanding) of the VaR of a designated reference portfolio, which, very generally, may be a designated unleveraged index or the Fund’s securities portfolio excluding derivatives. If applicable, the limit under the absolute VaR test when the Fund has outstanding Preferred Shares is 25% (or 20% when no Preferred Shares are outstanding) of the value of the Fund’s net assets. The Derivatives Rule also requires the Fund to appoint a derivatives risk manager, maintain a derivatives risk management program designed to identify, assess, and reasonably manage the risks associated with transactions covered by the rule, and abide by certain Board and other reporting obligations and recordkeeping requirements. With respect to reverse repurchase agreements or other similar financing transactions in particular, the Derivatives Rule permits a fund to enter into such transactions if the fund either (i) complies with the asset coverage requirements of Section 18 of the 1940 Act, and combines the aggregate amount of indebtedness associated with all reverse repurchase agreements and similar financing with the aggregate amount of any other senior securities representing indebtedness when calculating the relevant asset coverage ratio, or (ii) treats all reverse repurchase agreements and similar financing transactions as derivatives transactions for all purposes under the Derivatives Rule. The Fund has adopted procedures for investing in derivatives and other transactions in compliance with the Derivatives Rule. Compliance with the Derivatives Rule could adversely affect the
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value or performance of the Fund. Limits or restrictions applicable to the counterparties or issuers, as applicable, with which the Fund may engage in derivative transactions could also limit or prevent the Fund from using certain instruments.
The Fund’s use of derivatives and other similar instruments is generally subject to a VaR leverage limit, derivatives risk management program, and reporting requirements under Rule 18f-4 unless the Fund qualifies as “limited derivatives user” as defined in the rule or the Fund’s use of such an instrument satisfies the conditions of certain exemptions under the rule.
Leveraging is a speculative technique and there are special risks and costs involved. The Fund cannot assure you that its Preferred Shares and use of any other forms of leverage (such as the use of reverse repurchase agreements or derivatives strategies) if any, will result in a higher yield on your Common Shares. When leverage is used, the NAV and market price of the Common Shares and the yield to Common Shareholders will be more volatile. See “Principal Risks of the Fund—Leverage Risk” in the Prospectus. In addition, dividend, interest and other costs and expenses borne by the Fund with respect to its Preferred Shares and its use of any other forms of leverage are borne by the Common Shareholders (and not by the holders of Preferred Shares) and result in a reduction of the NAV of the Common Shares. In addition, because the fees received by the Investment Manager are based on the average weekly total managed assets of the Fund (“total managed assets” includes the total assets of the Fund (including any assets attributable to any preferred shares or other forms of leverage that may be outstanding), the Investment Manager has a financial incentive for the Fund to have preferred shares outstanding and to utilize other forms of leverage, which may create a conflict of interest between the Investment Manager, on the one hand, and the Common Shareholders, on the other hand. The fees received by the Investment Manager are not, however, charged on asset attributable to leverage obtained by the Fund other than through preferred shares. The Fund’s ability to utilize leverage is also limited by asset coverage requirements and other guidelines imposed by rating agencies (currently Moody’s and Fitch) that provide ratings for the ARPS, which may be more restrictive than the limitations imposed by the 1940 Act noted above. See “Description of Capital Structure” in the Prospectus for more information.
In addition, dividend, interest and other costs and expenses borne by the Fund with respect to its use of reverse repurchase agreements, borrowings or any other forms of leverage are borne by the Common Shareholders and result in a reduction of the net asset value of the Common Shares.
The Fund’s ability to utilize leverage is also limited by asset coverage requirements and other guidelines imposed by rating agencies that provide ratings for the Preferred Shares, which may be more restrictive than the limitations imposed by the 1940 Act noted above. See “Description of Capital Structure” in the Prospectus for more information.
The Fund also may borrow money in order to repurchase its shares or as a temporary measure for extraordinary or emergency purposes, including for the payment of dividends or the settlement of securities transactions which otherwise might require untimely dispositions of portfolio securities held by the Fund.
Reverse Repurchase Agreements
The Fund may enter into reverse repurchase agreements and economically similar transactions for hedging or cash management purposes or to add leverage to its portfolio. See the sections “Use of Leverage” in the Prospectus and “Leverage and Borrowing” above. A reverse repurchase agreement involves the sale of a portfolio-eligible security by the Fund to another party coupled with its agreement to repurchase the instrument at a specified time and price. Under a reverse repurchase agreement, the Fund continues to be entitled to receive any principal and interest payments on the underlying security during the term of the agreement. Reverse repurchase agreements involve leverage risk and the risk that the market value of securities retained by the Fund may decline below the repurchase price of the securities sold by the Fund which it is obligated to repurchase. Such transactions also can be subject to the risks discussed under “Derivative Instruments,” in addition to the risks discussed in this section.
The Fund also may effect simultaneous purchase and sale transactions that are known as “sale-buybacks.” A sale-buyback is similar to a reverse repurchase agreement, except that in a sale-buyback, the counterparty that purchases the security is entitled to receive any principal or interest payments made on the underlying security pending settlement of the Fund’s repurchase of the underlying security.
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Mortgage Dollar Rolls/Buy Backs
A mortgage dollar roll/buyback is similar to a reverse repurchase agreement in certain respects. In a “dollar roll” or “buyback” transaction, the Fund sells a mortgage-related security, such as a security issued by GNMA, to a dealer and simultaneously agrees to repurchase a similar security (but not the same security) in the future at a pre-determined price. A “dollar roll/buyback” can be viewed, like a reverse repurchase agreement, as a collateralized borrowing in which the Fund pledges a mortgage-related security to a dealer to obtain cash. However, unlike reverse repurchase agreements, the dealer with which the Fund enters into a dollar roll/buyback transaction is not obligated to return the same securities as those originally sold by the Fund, but only securities which are “substantially identical.” To be considered “substantially identical,” the securities returned to the Fund generally must: (1) be collateralized by the same types of underlying mortgages; (2) be issued by the same agency and be part of the same program; (3) have a similar original stated maturity; (4) have identical net coupon rates; (5) have similar market yields (and therefore price); and (6) satisfy “good delivery” requirements, meaning that the aggregate principal amounts of the securities delivered and received back must be within a specified percentage of the initial amount delivered. Because dollar roll/buyback transactions may be for terms ranging between one and six months, dollar roll transactions may be deemed “illiquid.”
It is possible that changing government regulation may affect the Fund’s use of these strategies. Changes in regulatory requirements concerning margin for certain types of financing transactions, such as repurchase agreements, reverse repurchase agreements, and securities lending and borrowing, could impact the Fund’s ability to utilize these investment strategies and techniques.
Repurchase Agreements
For the purposes of maintaining liquidity and achieving income, the Fund may enter into repurchase agreements with domestic commercial banks or registered broker-dealers. A repurchase agreement is a contract under which the Fund would acquire a security for a relatively short period (usually not more than one week) subject to the obligation of the seller to repurchase and the Fund to resell such security at a fixed time and price (representing the Fund’s cost plus interest). The Fund bears a risk of loss in the event that the other party to a repurchase agreement defaults on its obligations and the Fund is delayed or prevented from exercising its rights to dispose of the collateral securities. This risk includes the risk of procedural costs or delays in addition to a loss on the securities if their value should fall below their repurchase price.
Credit-Linked Trust Certificates
The Fund may invest in credit-linked trust certificates, which are investments in a limited purpose trust or other vehicle which, in turn, invests in a basket of derivative instruments, such as credit default swaps, total return swaps, basis swaps, interest rate swaps and other derivative transactions or securities, in order to provide exposure to the high yield or another debt securities market. For instance, the Fund may invest in credit-linked trust certificates as a cash management tool in order to gain exposure to the high yield markets and/or to remain fully invested when more traditional income-producing securities are not available, including during the period when the net proceeds of this offering and any future offering are being invested.
Like an investment in a bond, investments in these credit-linked trust certificates represent the right to receive periodic income payments (in the form of distributions) and payment of principal at the end of the term of the certificate. However, these payments are conditioned on the Fund’s receipt of payments from, and the Fund’s potential obligations to, the counterparties to the derivative instruments and other securities in which the trust invests. For instance, the issuer may sell one or more credit default swaps, under which the issuer would receive a stream of payments over the term of the swap agreements provided that no event of default has occurred with respect to the referenced debt obligation upon which the swap is based. If a default occurs, the stream of payments may stop and the trust would be obligated to pay to the counterparty the par (or other agreed upon value) of the referenced debt obligation. This, in turn, would reduce the amount of income and principal that the Fund would receive as an investor in the trust. Please see “Derivatives Instruments–Swap Agreements and Options on Swap Agreements” in this Statement of Additional Information for additional information about credit default swaps. The Fund’s investments in these instruments are indirectly subject to the risks associated with derivative instruments, including, among others, credit risk, default or similar event risk, counterparty risk, interest rate risk, leverage risk and management risk. It is expected that the issuers which issue credit-linked trust certificates will constitute “private” investment companies,
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exempt from registration under the 1940 Act. Therefore, the certificates will be subject to the risks described under “Other Investment Companies,” and will not be subject to applicable investment limitations and other regulation imposed by the 1940 Act (although the Fund will remain subject to such limitations and regulation, including with respect to its investments in the certificates). Although the issuers are typically private investment companies, they generally are not actively managed such as a “hedge fund” might be. It is also expected that the certificates will be exempt from registration under the Securities Act. Accordingly, there may be no established trading market for the certificates and they may constitute illiquid investments. See “Principal Risks of the Fund–Liquidity Risk” in the Prospectus. If market quotations are not readily available for the certificates, they will be valued by the Valuation Designee (as defined herein). See “Net Asset Value” in the Prospectus.
When-Issued, Delayed Delivery and Forward Commitment Transactions
The Fund may purchase or sell securities on a when-issued, delayed delivery or forward commitment basis. These transactions may be known as TBA transactions. Typically, no income accrues on securities the Fund has committed to purchase prior to the time delivery of the securities is made.
When purchasing a security on a when-issued, delayed delivery or forward commitment basis, the Fund assumes the rights and risks of ownership of the security, including the risk of price and yield fluctuations, and takes such fluctuations into account when determining its net asset value. Because the Fund is not required to pay for the security until the delivery date, these risks are in addition to the risks associated with the Fund’s other investments. If the Fund remains substantially fully invested at a time when when-issued, delayed delivery or forward commitment purchases are outstanding, the purchases may result in a form of leverage.
When the Fund has sold a security on a when-issued, delayed delivery or forward commitment basis, the Fund does not participate in future gains or losses with respect to the security. If the other party to a transaction fails to deliver or pay for the securities, the Fund could miss a favorable price or yield opportunity or could suffer a loss. Additionally, when selling a security on a when-issued, delayed delivery, or forward commitment basis without owning the security, the Fund will incur a loss if the security’s price appreciates in value such that the security’s price is above the agreed upon price on the settlement date.
The Fund may dispose of or renegotiate a transaction after it is entered into, and may purchase or sell when-issued, delayed delivery or forward commitment securities before the settlement date, which may result in a gain or loss. There is no percentage limitation on the extent to which the Fund may purchase or sell securities on a when-issued, delayed delivery or forward commitment basis.
The Fund may purchase or sell securities, including mortgage-backed securities, in the to-be-announced (“TBA”) market. A TBA purchase commitment is a security that is purchased or sold for a fixed price and the underlying securities are announced at a future date. Recently finalized FINRA rules include mandatory margin requirements for the TBA market with limited exceptions. TBAs have historically not been required to be collateralized. The collateralization of TBA trades is intended to mitigate counterparty credit risk between trade and settlement, but could increase the cost of TBA transactions and impose added operational complexity. Such transactions also can be subject to the risks discussed under “Derivative Instruments,” in addition to the risks discussed in this section.
Common Stocks
Common stock includes common shares and other common equity interests issued by public or private issuers. The value of a company’s stock may fall as a result of factors directly relating to that company, such as decisions made by its management or lower demand for the company’s products or services. A stock’s value also may fall because of factors affecting not just the company, but also companies in the same industry or in a number of different industries, such as increases in production costs. The value of a company’s stock also may be affected by changes in financial markets that are relatively unrelated to the company or its industry, such as changes in interest rates or currency exchange rates. In addition, a company’s stock generally pays dividends only after the company invests in its own business and makes required payments to holders of its bonds, other debt and preferred securities. For this reason, the value of a company’s stock will usually react more strongly than its bonds, other debt and preferred securities to actual or perceived changes in the company’s financial condition or prospects. Stocks of smaller companies may be more vulnerable to adverse developments than those of larger companies. Stocks of companies that the portfolio managers
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believe are fast-growing may trade at a higher multiple of current earnings than other stocks. The value of such stocks may be more sensitive to changes in current or expected earnings than the values of other stocks.
Short Sales
The Fund may make short sales of securities (i) to offset potential declines in long positions in similar securities, (ii) to increase the flexibility of the Fund, (iii) for investment return, (iv) as part of a risk arbitrage strategy, and (v) as part of its overall portfolio management strategies involving the use of derivative instruments. A short sale is a transaction in which the Fund sells a security it does not own in anticipation that the market price of that security will decline or will underperform relative to other securities held in the Fund’s portfolio.
When the Fund makes a short sale, it will often borrow the security sold short and deliver it to the broker-dealer through which it made the short sale as collateral for its obligation to deliver the security upon conclusion of the sale. In connection with short sales of securities, the Fund may pay a fee to borrow securities or maintain an arrangement with a broker to borrow securities and is often obligated to pay over any accrued interest and dividends on such borrowed securities.
If the price of the security sold short increases between the time of the short sale and the time that the Fund replaces the borrowed security, the Fund will incur a loss; conversely, if the price declines, the Fund will realize a capital gain. Any gain will be decreased, and any loss increased, by the transaction costs described above. The successful use of short selling may be adversely affected by imperfect correlation between movements in the price of the security sold short and the securities being hedged.
The Fund may invest pursuant to a risk arbitrage strategy to take advantage of a perceived relationship between the value of two securities. Frequently, a risk arbitrage strategy involves the short sale of a security.
The Fund may engage in short sales “against the box.” A short sale is “against the box” to the extent that the Fund contemporaneously owns, or has the right to obtain at no added cost, securities identical to those sold short. The Fund will engage in short selling to the extent permitted by the federal securities laws and rules and interpretations thereunder. To the extent the Fund engages in short selling in foreign (non-U.S.) jurisdictions, the Fund will do so to the extent permitted by the laws and regulations of such jurisdiction.
The Fund may also engage in so-called “naked” short sales (i.e., short sales that are not “against the box”), in which case the Fund’s losses could theoretically be unlimited, in cases where the Fund is unable for whatever reason to close out its short position. The Fund has the flexibility to engage in short selling to the extent permitted by the 1940 Act and rules and interpretations thereunder. Such transactions also can be subject to the risks discussed under “Derivative Instruments,” in addition to the risks discussed in this section.
Illiquid Investments
The Fund may invest without limit in illiquid investments (i.e., investments that the Fund reasonably expects cannot be sold or disposed of in current market conditions in seven calendar days or less without the sale or disposition significantly changing the market value of the securities). PIMCO may be subject to significant delays in disposing of illiquid investments, and transactions in illiquid investments may entail registration expenses and other transaction costs that are higher than those for transactions in liquid investments. The term “illiquid investments” for this purpose means any investment that the Fund reasonably expects cannot be sold or disposed of in current market conditions in seven calendar days or less without the sale or disposition significantly changing the market value of the investment. Depending on the circumstances, illiquid securities may be considered to include, among other things, certain purchased OTC options and the assets used to cover certain written OTC options, securities or other liquid assets being used as cover for such options, repurchase agreements with maturities in excess of seven days, certain loan participation interests, fixed time deposits which are not subject to prepayment or provide for withdrawal penalties upon prepayment (other than overnight deposits), securities that are subject to legal or contractual restrictions on resale (such as privately placed debt securities), and other securities which legally or in PIMCO’s opinion may be deemed illiquid (not including securities issued pursuant to Rule 144A under the Securities Act), and certain commercial paper determined to be liquid.
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Rule 144A Securities
The Fund may invest in securities that have not been registered for public sale, but that are eligible for purchase and sale pursuant to Rule 144A under the Securities Act. Rule 144A permits certain qualified institutional buyers, such as the Fund, to trade in privately placed securities that have not been registered for sale under the Securities Act. Rule 144A Securities may be deemed illiquid, although the Fund may determine that certain Rule 144A Securities are liquid.
Other Investment Companies
To the extent consistent with its objectives and strategy and permissible under the 1940 Act, the Fund may invest other investment companies (including exchange-traded funds (“ETFs”), business development companies and money market trusts, including other investment companies managed by PIMCO or its affiliates), and may otherwise invest indirectly in securities consistent with the Fund’s investment objectives and strategies, including through a joint venture vehicle. The Fund may invest in certain money market funds and/or short-term bond funds (“Central Funds”), to the extent permitted by the 1940 Act, the rules thereunder or exemptive relief therefrom. The Central Funds are registered investment companies created for use by certain registered investment companies advised by PIMCO in connection with their cash management activities. The Fund treats its investments in other investment companies that invest primarily in types of securities in which the Fund may invest directly as investments in such types of securities for purposes of the Fund’s investment policies (e.g., the Fund’s investment in an investment company that invests primarily in debt securities will be treated by the Fund as an investment in a debt security).
In general, under the 1940 Act, an investment company such as the Fund may not (i) own more than 3% of the outstanding voting securities of any one registered investment company, (ii) invest more than 5% of its total assets in the securities of any single registered investment company or (iii) invest more than 10% of its total assets in securities of other registered investment companies (the “3-5-10% Limitations”). The SEC adopted new Rule 12d1-4 under the 1940 Act, which provides an exemption to permit acquiring funds to invest in the securities of other registered investment companies in excess of the 3-5-10% Limitations, subject to certain conditions. In connection with the adoption of Rule 12d1-4, the SEC adopted certain other regulatory changes and took other actions related to the ability of the Fund to invest in another investment company in excess of the 3-5-10% Limitations.
The Fund may invest in other investment companies (including those advised by PIMCO) to gain broad market or sector exposure or for cash management purposes, including during periods when it has large amounts of uninvested cash (such as the period shortly after the Fund receives the proceeds of the offering of its Common Shares) or when PIMCO believes share prices of other investment companies offer attractive values. The Fund may invest in certain money market funds and/or short-term bond funds (“Central Funds”), to the extent permitted by the 1940 Act, the rules thereunder or exemptive relief therefrom. The Central Funds are registered investment companies created for use by certain registered investment companies advised by PIMCO in connection with their cash management activities.
As a shareholder in an investment company, the Fund will bear its ratable share of that investment company’s expenses and would remain subject to payment of the Fund’s management fees and other expenses with respect to assets so invested. Common Shareholders would therefore be subject to duplicative expenses to the extent the Fund invests in other investment companies. In addition, the securities of other investment companies may also be leveraged and will therefore be subject to the same leverage risks described in the Prospectus and herein.
Private Placements
A private placement involves the sale of securities that have not been registered under the Securities Act, or relevant provisions of applicable non-U.S. law, to certain institutional and qualified individual purchasers, such as the Fund. In addition to the general risks to which all securities are subject, securities received in a private placement generally are subject to strict restrictions on resale, and there may be no liquid secondary market or ready purchaser for such securities. Therefore, the Fund may be unable to dispose of such securities when it desires to do so, or at the most favorable time or price. Private placements may also raise valuation risks.
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Fund Operations
Operational Risk. An investment in the Fund, like any fund, can involve operational risks arising from factors such as processing errors, human errors, inadequate or failed internal or external processes, failures in systems and technology, changes in personnel and errors caused by third-party service providers. The occurrence of any of these failures, errors or breaches could result in a loss of information, regulatory scrutiny, reputational damage or other events, any of which could have a material adverse effect on the Fund. While the Fund seeks to minimize such events through controls and oversight, there may still be failures that could cause losses to the Fund.
Market Disruptions Risk. The Fund is subject to investment and operational risks associated with financial, economic and other global market developments and disruptions, including those arising from war, terrorism, market manipulation, government interventions, defaults and shutdowns, political changes or diplomatic developments, public health emergencies (such as the spread of infectious diseases, pandemics and epidemics) and natural/environmental disasters, which can all negatively impact the securities markets, interest rates, secondary trading, ratings, credit risk, inflation, deflation, other factors relating to the Fund's investments or the Investment Manager's operations and the value of an investment in the Fund, its distributions and its returns. These events can also impair the technology and other operational systems upon which the Fund’s service providers, including PIMCO as the Fund’s investment adviser, rely, and could otherwise disrupt the Fund’s service providers’ ability to fulfill their obligations to the Fund. Furthermore, events involving limited liquidity, defaults, non-performance or other adverse developments that affect financial institutions or the financial services industry generally, or concerns or rumors about any events of these kinds or other similar risks, have in the past and may in the future lead to market-wide liquidity problems.
A widespread health crisis, such as a global pandemic, could cause substantial market volatility, exchange trading suspensions or restrictions and closures of securities exchanges and businesses. Such a health care crisis could also impact the ability to complete redemptions, and adversely impact investments held by the Fund. For example, the outbreak of COVID 19, a respiratory disease caused by a novel coronavirus, caused volatility, severe market dislocations and liquidity constraints in many markets, including markets for the securities the Fund holds. The transmission of COVID-19 and efforts to contain its spread resulted in travel restrictions and disruptions, closed international borders, enhanced health screenings at ports of entry and elsewhere, disruption of and delays in healthcare service preparation and delivery, quarantines, event and service cancellations or interruptions, disruptions to business operations (including staff furloughs and reductions) and supply chains, and a reduction in consumer and business spending, as well as general economic concern and uncertainty . These disruptions led to instability in the market place, including equity and debt market losses and overall volatility, and the jobs market. The impact of COVID-19, and other infectious illness outbreaks, epidemics or pandemics that may arise in the future, could adversely affect the economies of many nations or the entire global economy, the financial well-being and performance of individual issuers, borrowers and sectors and the health of the markets generally in potentially significant and unforeseen ways. In addition, the impact of infectious illnesses, such as COVID-19, in emerging market countries may be greater due to generally less established healthcare systems. Public health crises may exacerbate other pre-existing political, social and economic risks in certain countries or globally.
The foregoing could lead to a significant economic downturn or recession, increased market volatility, a greater number of market closures, higher default rates and adverse effects on the values and liquidity of securities or other assets. Such impacts, which may vary across asset classes, may adversely affect the performance of the Fund. In certain cases, an exchange or market may close or issue trading halts on specific securities or even the entire market, which may result in the Fund being, among other things, unable to buy or sell certain securities or financial instruments or to accurately price their investments.
Cyber Security Risk. As the use of technology, including cloud-based technology, has become more prevalent in the course of business, the Fund has become potentially more susceptible to operational and information security risks resulting from breaches in cyber security. A breach in cyber security refers to both intentional and unintentional cyber events from outside threat actors or internal resources that may, among other things, cause the Fund to lose proprietary information, suffer data corruption and/or destruction or lose operational capacity, result in the unauthorized release or other misuse of confidential information, or otherwise disrupt normal business operations. Cyber security breaches may involve unauthorized access to the Fund’s digital information systems (e.g., through “hacking” or malicious software coding) and may come from multiple sources, including outside attacks such as denial-of-service attacks (i.e., efforts to make network services unavailable to intended users) or cyber extortion, including exfiltration of data held for ransom and/or “ransomware” attacks that renders systems inoperable until ransom is paid, or insider actions (e.g.,
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intentionally or unintentionally harmful acts of PIMCO personnel). In addition, cyber security breaches involving the Fund’s third party service providers (including but not limited to advisers, administrators, transfer agents, custodians, vendors, suppliers, distributors and other third parties), trading counterparties or issuers in which the Fund invests can also subject the Fund to many of the same risks associated with direct cyber security breaches or extortion of company data. PIMCO’s use of cloud-based service providers could heighten or change these risks.
Cyber security failures or breaches may result in financial losses to the Fund and its shareholders. For example, cyber security failures or breaches involving trading counterparties or issuers in which the Fund invests could adversely impact such counterparties or issuers and cause the Fund’s investment to lose value. These failures or breaches may also result in disruptions to business operations, potentially resulting in financial losses; interference with the Fund’s ability to calculate its NAV, process shareholder transactions or otherwise transact business with shareholders; impediments to trading; violations of applicable privacy and other laws; regulatory fines; penalties; third party claims in litigation; reputational damage; reimbursement or other compensation costs; additional compliance costs and cyber security risk management costs and other adverse consequences. In addition, substantial costs may be incurred in order to prevent any cyber incidents in the future.
Like with operational risk in general, the Fund has established risk management systems and business continuity plans designed to reduce the risks associated with cyber security. However, there are inherent limitations in these plans and systems, including that certain risks may not have been identified, in large part because different or unknown threats may emerge in the future. As such, there is no guarantee that such efforts will succeed, especially because the Fund does not directly control the cyber security systems of issuers in which the Fund may invest, trading counterparties or third-party service providers to the Fund. Such entities have experienced cyber attacks and other attempts to gain unauthorized access to systems from time to time, and there is no guarantee that efforts to prevent or mitigate the effects of such attacks or other attempts to gain unauthorized access will be successful. There is also a risk that cyber security breaches may not be detected. The Fund and its shareholders may suffer losses as a result of a cyber security breach related to the Fund, its service providers, trading counterparties or the issuers in which the Fund invests.
Portfolio Turnover
A change in the securities held by the Fund and reinvestment of the proceeds is known as “portfolio turnover.” PIMCO manages the Fund without regard generally to restrictions on portfolio turnover. Trading in fixed income securities does not generally involve the payment of brokerage commissions, but does involve indirect transaction costs. Trading in equity securities involves the payment of brokerage commissions, which are transaction costs paid by the Fund. The use of futures contracts may involve the payment of commissions to futures commission merchants. High portfolio turnover (e.g., greater than 100%) involves correspondingly greater expenses to the Fund, including brokerage commissions or dealer mark-ups and other transaction costs on the sale of securities and reinvestments in other securities. The higher the rate of portfolio turnover of the Fund, the higher these transaction costs borne by the Fund generally will be. Such sales may result in realization of taxable capital gains (including short-term capital gains which are taxed when distributed to shareholders who are individuals at ordinary income tax rates). See “Taxation.”
The portfolio turnover rate of the Fund is calculated by dividing (a) the lesser of purchases or sales of portfolio securities for the particular fiscal year by (b) the monthly average of the value of the portfolio securities owned by the Fund during the particular fiscal year. In calculating the rate of portfolio turnover, there is excluded from both (a) and (b) all derivatives and all securities, including options, whose maturities or expiration dates at the time of acquisition were one year or less. Proceeds from short sales and assets used to cover short positions undertaken are also excluded from both (a) and (b). For the fiscal year ended June 30, 2023, the Fund’s portfolio turnover rate was 33%. For the fiscal year ended June 30, 2022, the Fund’s portfolio turnover rate was 45%. For the fiscal year ended July 31, 2021, the Fund’s portfolio turnover rate was 38%.
Warrants to Purchase Securities
The Fund may invest in or acquire warrants to purchase equity or fixed income securities. Warrants are instruments that give the holder the right, but not the obligation, to buy a security directly from an issuer at a specific price for a specific period of time. Changes in the value of a warrant do not necessarily correspond to changes in the value of its underlying security. The price of a warrant may be more volatile than the price of its underlying security, and a warrant may offer greater potential for capital appreciation as well as capital loss. Warrants do not entitle a
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holder to dividends or voting rights with respect to the underlying security, do not represent any rights in the assets of the issuing company and are subject to the risk that the issuer-counterparty may fail to honor its obligations. A warrant ceases to have value if it is not exercised prior to its expiration date. These factors can make warrants more speculative than other types of investments. Bonds with warrants attached to purchase equity securities have many characteristics of convertible bonds and their prices may, to some degree, reflect the performance of the underlying stock. Bonds also may be issued with warrants attached to purchase additional fixed income securities at the same coupon rate. A decline in interest rates would permit the Fund to buy additional bonds at the favorable rate or to sell the warrants at a profit. If interest rates rise, the warrants would generally expire with no value.
The Fund may from time to time use non-standard warrants, including low exercise price warrants or low exercise price options (“LEPOs”), to gain exposure to issuers in certain countries. LEPOs are different from standard warrants in that they do not give their holders the right to receive a security of the issuer upon exercise. Rather, LEPOs pay the holder the difference in price of the underlying security between the date the LEPO was purchased and the date it is sold. Additionally, LEPOs entail the same risks as other OTC derivatives, including the risks that the counterparty or issuer of the LEPO may not be able to fulfill its obligations, that the holder and counterparty or issuer may disagree as to the meaning or application of contractual terms, or that the instrument may not perform as expected. Furthermore, while LEPOs may be listed on an exchange, there is no guarantee that a liquid market will exist or that the counterparty or issuer of a LEPO will be willing to repurchase such instrument when the Fund wishes to sell it.
Loans of Portfolio Securities
Subject to certain conditions described in the Prospectus and below, the Fund may make secured loans of its portfolio securities to brokers, dealers and other financial institutions amounting to no more than one-third of its total assets. The risks in lending portfolio securities, as with other extensions of credit, include possible delay in recovery of the securities or possible loss of rights in the collateral should the borrowers (which typically include broker-dealers and other financial services companies) fail financially. Securities loans are made to broker-dealers pursuant to agreements requiring that loans be continuously secured by collateral consisting of U.S. government securities, cash or cash equivalents (negotiable certificates of deposit, bankers’ acceptances or letters of credit) maintained on a daily mark-to-market basis in an amount at least equal at all times to the market value of the securities lent. The borrower pays to the Fund, as the lender, an amount equal to any dividends or interest received on the securities lent.
The Fund may invest only the cash collateral received in interest-bearing, short-term securities or receive a fee from the borrower. In the case of cash collateral, the Fund typically pays a rebate to the lender. Although voting rights or rights to consent with respect to the loaned securities pass to the borrower, the Fund, as the lender, retains the right to call the loans and obtain the return of the securities loaned at any time on reasonable notice, and it will do so in order that the securities may be voted by the Fund if the holders of such securities are asked to vote upon or consent to matters materially affecting the investment. The Fund may also call such loans in order to sell the securities involved. The Fund’s performance will continue to reflect changes in the value of the securities loaned and will also reflect the receipt of either interest, through investment of cash collateral by the Fund in permissible investments, or a fee, if the collateral is U.S. government securities.
Government Intervention Risk
Governmental and quasi-governmental authorities and regulators throughout the world have in the past responded to major economic disruptions with a variety of significant fiscal and monetary policy changes, including but not limited to, direct capital infusions into companies, and financial markets, economic relief packages and changes to interest rates. The introduction and adoption of these packages could cause market disruption and volatility. In addition, the end of any such program could cause market downturns, disruptions and volatility, particularly if markets view the ending as premature. There can be no guarantee that any such measures taken in the past or in connection with future events (within the United States or other affected countries throughout the world) will be sufficient or have their intended effect. In addition, an unexpected or quick reversal of such measures could cause market downturns, disruptions, volatility and inflation, which could adversely affect the Fund’s investments.
In addition, federal, state and other governments, their regulatory agencies or self-regulatory organizations may take actions that affect the regulation of the instruments in which the Fund invests, or the issuers of such instruments, in ways that are unforeseeable. Legislation or regulation may also change the way in which the Fund itself is regulated. Such legislation or regulation could limit or preclude the Fund’s ability to achieve its investment objective. Also, while
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such legislation or regulations are intended to strengthen markets, systems and public finances, they could affect fund expenses and the value of fund investments in unpredictable ways.
The current direction of governments and regulators may have the effect of reducing market liquidity, market resiliency and money supply, whether through higher rates, tighter financial regulations or the Liquidity Rule proposals that may prevent mutual funds from participating in certain markets. During periods when interest rates are low (or negative), the Fund’s yield (or total return) may also be low and fall below zero. Very low or negative interest rates may heighten interest rate risk. The Fund may be subject to heightened levels of interest rate risk because the U.S. Federal Reserve (the “Federal Reserve”) has raised interest rates. To the extent the Federal Reserve continues to raise interest rates, there is a risk that rates across the financial system may rise. Changing interest rates may have unpredictable effects on markets, may result in heightened market volatility and may detract from Fund performance to the extent the Fund is exposed to such interest rates and/or volatility.
Governments or their agencies may also acquire distressed assets from financial or other institutions and acquire ownership interests in those institutions. Such a program may have positive or negative effects on the liquidity, valuation and performance of the Fund’s portfolio holdings. Furthermore, volatile financial markets can expose the Fund to greater market and liquidity risk and potential difficulty in valuing portfolio instruments held by the Fund. The Fund has established procedures to assess the liquidity of portfolio holdings and to value instruments for which market prices may not be readily available. PIMCO will monitor developments and seeks to manage the Fund in a manner consistent with achieving each Fund’s investment objective, but there can be no assurance that it will be successful in doing so.
The value of the Fund’s holdings is also generally subject to the risk of future local, national or global economic disturbances based on unknown weaknesses in the markets in which the Fund invests. In the event of such a disturbance, issuers of securities held by the Fund may experience significant declines in the value of their assets and even cease operations, or may receive government assistance accompanied by increased restrictions on their business operations or other government intervention. In addition, it is not certain that the U.S. government will intervene in response to a future market disturbance and the effect of any such future intervention cannot be predicted. It is difficult for issuers to prepare for the impact of future financial downturns, although companies can seek to identify and manage future uncertainties through risk management programs.
Quantitative Investing Risk
PIMCO employs and/or relies on algorithms, models or other systems in connection with many of its investment activities, including research, forecasting, selection, optimization, order routing, execution, and allocation processes (together, “Systems”). These Systems, which may be employed together and operate without human intervention, rely heavily on the use of proprietary and nonproprietary data, software, hardware, and intellectual property, including data, software and hardware that may be licensed or otherwise obtained from third parties. The use of such Systems has inherent limitations and risks. Although PIMCO seeks to develop and use Systems appropriately and effectively, there can be no assurance that it will successfully do so. The Systems are extremely complex and may involve the use of financial, economic, econometric and statistical theories, research and modeling and related translation into computer code. Errors may occur in the design, writing, testing, validation, monitoring, and/or implementation of Systems, including in the manner in which Systems function together. The effectiveness of Systems may diminish over time, including as a result of market changes and changes in the behavior of market participants. The quality of the resulting analysis, investment selections, portfolio construction, asset allocations, proposed and executed trades, risk management, allocations of investment opportunities and trading strategies depends on a number of factors including the accuracy and quality of data inputs into the Systems, including through automated and manual integration of completed transactions, the mathematical and analytical assumptions and underpinnings of the Systems' coding, the accuracy in translating those analytics into program code or interpreting the output of a System by another System in order to facilitate a transaction, change in market conditions, the successful integration of the various Systems into the portfolio selection and trading process and whether actual market events correspond to one or more assumptions underlying the Systems. Accordingly, Systems are subject to errors and/or mistakes (“System Incidents”) that may adversely impact the Fund. For example, System Incidents may result in Systems performing in a manner other than as intended, including, but not limited to, failure to achieve desired performance or investment objectives, execution of unanticipated trades or failure or delays in executing intended trades, failure to properly allocate trades, failure to properly gather and organize available data, or failure to identify hedging or other risk management opportunities or targets, all of which may adversely impact the Fund.
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PIMCO relies on quantitative models, data, execution and trading algorithms (including, without limitation, algorithms utilized in third-party automated trading platforms that match buyers and sellers based on price and other characteristics of the underlying investment) supplied by third parties for certain funds. Such models, data and algorithms are used to construct sets of transactions and investments, to implement, route, and execute investment decisions, and to provide risk management insights. When the third-party models, data or algorithms prove to be incorrect or incomplete, any decisions or investments made in reliance thereon expose applicable funds to additional risks. For example, PIMCO does not have the same insight or access into the construction, coding or testing of the algorithms, and PIMCO and applicable funds will be exposed to systems, cyber security and other risks associated with the third party models, data or algorithms. For these reasons, and subject to PIMCO satisfying its standard of care, PIMCO generally will not compensate applicable funds for any losses associated with third-party models, data, or algorithms, and applicable funds will bear all such losses. PIMCO, subject to satisfying its standard of care, generally does not expect to disclose certain such events to applicable funds.
The Systems rely heavily on appropriate data inputs and it is impossible and impracticable to factor all relevant, available data into the Systems. PIMCO will use its discretion to determine what data to gather and what subset of data the Systems utilize. In addition, due to the automated nature of gathering data, the volume and depth of data available, the complexity and often manual nature of data cleaning, and the fact that the data may come from third-party sources, it is inevitable that not all desired and/or relevant data will be available to, or processed by, PIMCO at all times. Where incorrect or incomplete data is available, PIMCO may, and often will, continue to generate forecasts and make investment decisions based on the data available. Additionally, PIMCO may determine that certain available data, while potentially useful in generating forecasts and/or making investment decisions, is not cost effective to gather due to, among other factors, the technology costs or third-party vendor costs and, in such cases, PIMCO will not utilize such data. PIMCO has full discretion to select the data it utilizes, and may elect to use or may refrain from using any specific data or type of data in the Systems. The data used in the development and use of Systems may not be the most accurate data available or free of errors. Further, if incorrect market or other data are entered into an otherwise properly functioning System, the System's resulting output, including proposed trades or investment recommendations, may be inconsistent with the underlying investment strategy. Even if data is input correctly, prices anticipated by the data through the Systems may differ substantially from market prices, especially for financial instruments with complex characteristics, such as derivatives, in which the Fund may invest. Most Systems require continual monitoring and enhancements, and there is no guarantee that such monitoring and enhancements will be successful or that Systems will operate as intended. The successful deployment of the investment strategy, the portfolio construction process and/or the trading process could be severely compromised by software or hardware malfunctions, viruses, glitches, connectivity loss, system crashes or various other System Incidents, including, in particular, where multiple Systems contribute to the process, in particular where there is no human intervention (e.g., where one System develops a signal or possible trade and another System interprets or optimizes that recommended signal or possible trade to facilitate a trade order, another System routes and executes that trade order, and another System allocates the completed trade, and where this process runs again in reliance on the preceding automated transaction). System Incidents may be difficult to detect and PIMCO may not immediately or ever detect certain System Incidents, which may have an increasing impact on the Fund over time.
PIMCO has adopted policies and procedures that it believes are reasonably designed to prevent, detect, escalate and remediate System Incidents. PIMCO will address System Incidents in accordance with this policy but there is no guarantee that measures taken to address a System Incident will be successful. PIMCO has policies and procedures that address identification and correction of errors that may occur in connection with PIMCO's management of the Fund and other client accounts (“Trade Errors”). PIMCO generally does not classify System Incidents to be Trade Errors and applicable funds generally will bear all losses associated with System Incidents, subject to PIMCO satisfying its standard of care. Further, PIMCO generally does not expect to disclose System Incidents to the Fund.
Regulatory Risk
Financial entities, such as investment companies and investment advisers, are generally subject to extensive government regulation and intervention. Government regulation and/or intervention may change the way the Fund is regulated, affect the expenses incurred directly by the Fund and the value of its investments, and limit and/or preclude the Fund’s ability to achieve its investment objective. Government regulation may change frequently and may have significant adverse consequences. Moreover, government regulation may have unpredictable and unintended effects. Actions by governmental entities may also impact certain instruments in which a Fund invests. For example, certain instruments in which a Fund may invest have relied on or will continue to rely in some fashion upon the London
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Interbank Offered Rate (“LIBOR”). LIBOR was traditionally an average interest rate, determined by the ICE Benchmark Administration, that banks charge one another for the use of short-term money. On March 5, 2021, the Financial Conduct Authority (“FCA”), the United Kingdom’s financial regulatory body and regulator of LIBOR, publicly announced that all U.S. Dollar LIBOR settings will either cease to be provided by any administrator or will no longer be representative (i) immediately after December 31, 2021 for one-week and two-month U.S. Dollar LIBOR settings and (ii) immediately after June 30, 2023 for the remaining U.S. Dollar LIBOR settings. As of January 1, 2022, as a result of supervisory guidance from U.S. regulators, U.S. regulated entities have generally ceased entering into new LIBOR contracts with limited exceptions. Publication of all Japanese yen and the one- and six-month sterling LIBOR settings have ceased, and while publication of the three-month Sterling LIBOR setting will continue through at least the end of March 2024 on the basis of a changed methodology (known as “synthetic LIBOR”), this rate has been designated by the FCA as unrepresentative of the underlying market that it seeks to measure and is solely available for use in legacy transactions. Certain bank-sponsored committees in other jurisdictions, including Europe, the United Kingdom, Japan and Switzerland, have selected alternative reference rates denominated in other currencies. Although the transition process away from LIBOR for many instruments has been completed, some LIBOR use is continuing and there are potential effects related to the transition away from LIBOR or continued use of LIBOR on the Fund, or on certain instruments in which the Fund invests, which can be difficult to ascertain, and may vary depending on factors that include, but are not limited to: (i) existing fallback or termination provisions in individual contracts and (ii) whether, how, and when industry participants adopt new reference rates for affected instruments. So-called “tough legacy” contracts have LIBOR interest rate provisions with no fallback provisions contemplating a permanent discontinuation of LIBOR, inadequate fallback provisions or fallback provisions which may not effectively result in a transition away from LIBOR prior to LIBOR’s planned replacement date. On March 15, 2022, the Adjustable Interest Rate (LIBOR) Act was signed into law. This law provides a statutory fallback mechanism on a nationwide basis to replace LIBOR with a benchmark rate that is selected by the Board of Governors of the Federal Reserve System based on the Secured Overnight Financing Rate (“SOFR”) for tough legacy contracts. On February 27, 2023, the Federal Reserve System’s rule in connection with this law became effective, establishing benchmark replacements based on SOFR and Term SOFR (a forward-looking measurement of market expectations of SOFR implied from certain derivatives markets) for applicable tough legacy contracts governed by U.S. law. In addition, the FCA has announced that it will require the publication of synthetic LIBOR for the one-month, three-month and six-month U.S. Dollar LIBOR settings after June 30, 2023 through at least September 30, 2024. Certain of the Fund’s investments may involve individual tough legacy contracts which may be subject to the Adjustable Interest Rate (LIBOR) Act or synthetic LIBOR and no assurances can be given that these measures will have had the intended effects. Moreover, certain aspects of the transition from LIBOR have relied on or will continue to rely on the actions of third-party market participants, such as clearing houses, trustees, administrative agents, asset servicers and certain service providers; PIMCO cannot guarantee the performance of such market participants and any failure on the part of such market participants to manage their part of the LIBOR transition could impact the Fund. The transition of investments from LIBOR to a replacement rate as a result of amendment, application of existing fallbacks, statutory requirements or otherwise may also result in a reduction in the value of certain instruments held by the Fund or a reduction in the effectiveness of related Fund transactions such as hedges. In addition, an instrument’s transition to a replacement rate could result in variations in the reported yields of the Fund that holds such instrument. Any such effects of the transition away from LIBOR, as well as other unforeseen effects, could result in losses to the Fund.
Additionally, alteration of the terms of a debt instrument or a modification of the terms of other types of contracts to replace LIBOR or another interbank offered rate (“IBOR”) with a new reference rate could result in a taxable exchange and the realization of income and gain/loss for U.S. federal income tax purposes. The IRS has issued final regulations regarding the tax consequences of the transition from IBOR to a new reference rate in debt instruments and non-debt contracts. Under the final regulations, alteration or modification of the terms of a debt instrument to replace an operative rate that uses a discontinued IBOR with a qualified rate (as defined in the final regulations) including true up payments equalizing the fair market value of contracts before and after such IBOR transition, to add a qualified rate as a fallback rate to a contract whose operative rate uses a discontinued IBOR or to replace a fallback rate that uses a discontinued IBOR with a qualified rate would not be taxable. The IRS may provide additional guidance, with potential retroactive effect.
In October 2020, the SEC adopted a final rule related to the use of TOBs, derivatives, reverse repurchase agreements and certain other transactions by registered investment companies. The Fund’s trading of derivatives and other transactions that create future payment or delivery obligations (except reverse repurchase agreements and similar financing transactions) is subject to value-at-risk (“VaR”) leverage limits and derivatives risk management program
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and reporting requirements. Generally, these requirements apply unless the Fund satisfies a “limited derivatives users” exception that is included in the final rule.
Under the rule, when a fund trades reverse repurchase agreements or similar financing transactions, including certain tender option bonds, it needs to aggregate the amount of indebtedness associated with the reverse repurchase agreements or similar financing transactions with the aggregate amount of any other senior securities representing indebtedness when calculating the fund’s asset coverage ratio or treat all such transactions as derivatives transactions. Reverse repurchase agreements or similar financing transactions aggregated with other indebtedness do not need to be included in the calculation of whether the Fund satisfies the limited derivatives users exception, but for funds subject to the VaR testing requirement, reverse repurchase agreements and similar financing transactions must be included for purposes of such testing whether treated as derivatives transactions or not. The SEC also provided guidance in connection with the rule regarding the use of securities lending collateral that may limit the Fund’s securities lending activities. In addition, under the final rule, a fund is permitted to invest in a security on a when-issued or forward-settling basis, or with a non-standard settlement cycle, and the transaction will be deemed not to involve a senior security (as defined under Section 18(g) of the Act), provided that, (i) the Fund intends to physically settle the transaction and (ii) the transaction will settle within 35 days of its trade date (the “Delayed-Settlement Securities Provision”). A fund may otherwise engage in when-issued, forward-settling and non-standard settlement cycle securities transactions that do not meet the conditions of the Delayed-Settlement Securities Provision so long as the Fund treats any such transaction as a “derivatives transaction” for purposes of compliance with the final rule. Furthermore, under the rule, the Fund is permitted to enter into an unfunded commitment agreement, and such unfunded commitment agreement will not be subject to the asset coverage requirements under the Act, if the Fund reasonably believes, at the time it enters into such agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to all such agreements as they come due. These requirements may limit the ability of the Fund to use derivatives, reverse repurchase agreements and similar financing transactions, when-issued, delayed delivery and forward commitment transactions, and unfunded commitment agreements as part of its investment strategies. These requirements may increase the cost of the Fund’s investments and cost of doing business, which could adversely affect investors. PIMCO cannot predict the effects of these requirements on the Fund.
In October 2020, the SEC adopted certain regulatory changes and took other actions related to the ability of registered investment companies to invest in other registered investment companies. These changes, which are now in effect, include, among other things, the adoption of Rule 12d1-4 under the Act (the “Fund of Funds Rule”), the rescission of Rule 12d1-2 under the Act, and the withdrawal of certain related exemptive relief and no-action assurances. Such changes could adversely impact the investment strategies and operations of the Fund and Underlying PIMCO Funds, as well as funds serving as underlying funds of Affiliated Funds of Funds or third-party funds of funds.
In December 2020, the SEC adopted a rule addressing fair valuation of fund investments. The new rule sets forth requirements for good faith determinations of fair value, as well as for the performance of fair value determinations, including related oversight and reporting obligations. The new rule also defines “readily available market quotations” for purposes of the definition of “value” under the 1940 Act, and the SEC noted that this definition will apply in all contexts under the 1940 Act.
In May 2022, the SEC proposed a framework that would require certain registered funds (such as the Fund) to disclose their environmental, social, and governance (“ESG”) investing practices. Among other things, the proposed requirements would mandate that funds meeting three pre-defined classifications (i.e., integrated, ESG focused and/or impact funds) provide prospectus and shareholder report disclosure related to the ESG factors, criteria and processes used in managing the fund. The proposal’s impact on the Fund will not be known unless and until any final rulemaking is adopted.
In November 2022, the SEC adopted amendments to Form N-PX under the Act to improve the utility to investors of proxy voting information reported by mutual funds, ETFs and certain other funds. The rule amendments will expand the scope of funds’ Form N-PX reporting obligations, subject managers to Form N-PX reporting obligations for “Say on Pay” votes, enhance Form N-PX disclosures, permit joint reporting by funds, managers and affiliated managers on Form N-PX; and require website availability of fund proxy voting records. The amendments will become effective on July 1, 2024. Funds and managers will be required to file their first reports covering the period from July 1, 2023 to June 30, 2024 on amended Form N-PX by August 31, 2024.
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In September 2023, the SEC has adopted amendments to Rule 35d-1, the rule under the 1940 Act that regulates the names used for registered investment companies (the “names rule”). The amendments expand the types of names that could be considered materially deceptive or misleading if a fund does not adopt a policy to invest, under normal circumstances, at least 80% of the value of its assets in the investment focus that the name suggests. The amended rule now regards the use of terms that suggest the fund makes investments that have, or whose issuers have, particular characteristics as materially deceptive or misleading unless the fund satisfies the requirements of the rule. The rule text specifically refers to terms such as “growth” or “value” in the fund’s name, or terms indicating that the fund’s investment decisions incorporate one or more environmental, social or governance factors as covered by the amendments. The amendments to the names rule will become effective sixty days following publication in the Federal Register. Fund groups with $1 billion or more in net assets will have twenty-four months to comply with the amendments, and fund groups with less than $1 billion will have thirty months to comply. The amendments are expected to have a significant impact, with SEC officials estimating that approximately 75% of all funds will be affected in some manner.
During periods when interest rates are low (or negative), the Fund’s yield (or total return) may also be low and fall below zero. Very low or negative interest rates may heighten interest rate risk. The Fund may be subject to heightened levels of interest rate risk because the U.S. Federal Reserve (the “Federal Reserve”) has raised interest rates from historically low levels and has signaled an intention to continue to do so. To the extent the Federal Reserve continues to raise interest rates, there is a risk that rates across the financial system may rise. Changing interest rates may have unpredictable effects on markets, may result in heightened market volatility and may detract from Fund performance to the extent the Fund is exposed to such interest rates and/or volatility.
The current direction of governments and regulators may have the effect of reducing market liquidity, market resiliency and money supply, whether through higher rates, tighter financial regulations or the proposals relating to Rule 22e-4 under the 1940 Act that may prevent mutual funds from participating in certain markets.
In addition, regulatory actions or actions taken by law enforcement entities in the United States or outside of the United States may also adversely affect the Fund’s investments. For example, assets that become subject to sanctions or that are involved in illegal activities such as money laundering or kleptocracy, may be seized, subject to forfeiture, frozen or otherwise become unmarketable, will lose value or become worthless and consequently adversely affect the Fund’s value. Actions such as geographical targeting orders for, or new rulemaking related to, real estate investments issued by FinCEN may also lengthen the settlement process, make a real estate asset less liquid and harder to sell, and/or increase costs associated with these portfolio investments issued by FinCEN may also lengthen the settlement process, make a real estate asset less liquid and harder to sell, and/or increase costs associated with these portfolio investments.
Participation on Creditors Committees
Generally, when the Fund holds bonds or other similar fixed-income securities of an issuer, the Fund becomes a creditor of the issuer. As a creditor of an issuer, the Fund may be subject to challenges related to the securities that it holds, either in connection with the bankruptcy of the issuer or in connection with another action brought by other creditors of the issuer, shareholders of the issuer or the issuer itself (collectively, “restructuring transactions”). Although under no obligation to do so, PIMCO, as adviser to the Fund, may from time to time have an opportunity to consider, on behalf of the Fund and other similarly situated clients, negotiating or otherwise participating in the restructuring of the Fund’s portfolio investment or the issuer of such investment. PIMCO, in its judgment and discretion and based on the considerations deemed by PIMCO to be relevant, may believe that it is in the best interests of the Fund to negotiate or otherwise participate in a restructuring transaction. Accordingly, and subject to applicable procedures approved by the Board, the Fund may from time to time participate on committees formed by creditors to negotiate with the management of financially troubled issuers of securities held by the Fund. Such participation may subject the Fund to expenses such as legal fees and may make the Fund an “insider” of the issuer for purposes of the federal securities laws, and therefore may restrict the Fund’s ability to trade in or acquire additional positions in a particular security when it might otherwise desire to do so. Participation by the Fund on such committees also may expose the Fund to potential liabilities under the federal bankruptcy laws or other laws governing the rights of creditors and debtors. Similarly, subject to the above-mentioned procedures, PIMCO may actively participate in bankruptcy court and related proceedings on behalf of the Fund in order to protect the Fund’s interests in connection with a restructuring transaction, and PIMCO may cause the Fund to enter into an agreement reasonably indemnifying third parties or advancing from the Fund’s assets any legal fees or other costs to third parties, including parties
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involved in or assisting the Fund with a restructuring transaction, such as trustees, servicers and other third parties. Further, PIMCO has the general authority, subject to the above-mentioned procedures, to represent the Fund on creditors’ committees (or similar committees) or otherwise in connection with the restructuring of an issuer’s debt and generally with respect to challenges related to the securities held by the Fund relating to the bankruptcy of an issuer or in connection with another action brought by other creditors of the issuer, shareholders of the issuer or the issuer itself.
Short-Term Investments / Temporary Defensive Strategies
In attempting to respond to adverse market, economic, political, or other conditions, as determined by PIMCO, when PIMCO deems it appropriate to do so, the Fund may, for temporary defensive purposes, deviate from its investment strategy by investing some or all of its total assets in investments such as high grade debt securities, including high quality, short-term debt securities, and cash and cash equivalents. Such investments may prevent the Fund from achieving its investment objective.
Subsidiaries and Affiliates
The Fund may execute its strategy by investing through one or more subsidiaries. The Fund reserves the right to establish additional subsidiaries through which the Fund may execute its strategy. The Fund will treat a subsidiary’s assets as assets of the Fund for purposes of determining compliance with various provisions of the 1940 Act applicable to the Fund, including those relating to investment policies (Section 8), capital structure and leverage (Section 18) and affiliated transactions and custody (Section 17).
The Fund has received exemptive relief from the SEC that, to the extent the Fund relies on such relief, permits it to (among other things) co-invest with certain other persons, including certain affiliates of the Investment Manager and certain public or private funds managed by the Investment Manager and its affiliates, subject to certain terms and conditions. The exemptive relief from the SEC with respect to co-investments imposes extensive conditions on any co-investments made in reliance on such relief.
Tax Consequences
The requirements for qualification as a RIC under Subchapter M of the Code may limit the extent to which the Fund may invest in certain positions and transactions described above and the Fund’s investment in certain positions and transactions described above may limit the Fund’s ability to qualify as such.
In addition, the Fund’s utilization of certain investment instruments may alter the amount, timing and character of the Fund’s income, and, in turn, of the Fund’s distributions to its shareholders, relative to other means of achieving similar investment exposure. In certain circumstances, the Fund may be required to sell assets in order to meet RIC distribution requirements even when investment considerations make such sales otherwise undesirable. For more information concerning these requirements and the taxation of the Fund’s investments, see “Taxation” below.
INVESTMENT RESTRICTIONS
Fundamental Investment Restrictions
The investment restrictions set forth below, are each a fundamental policy of the Fund that may not be changed without the approval of the holders of a majority of the outstanding Common Shares and any outstanding preferred shares of beneficial interest (including Preferred Shares) voting together as a single class, and of the holders of a majority of any outstanding preferred shares of beneficial interest (including Preferred Shares) voting as a separate class. The Fund may not:
(1)
Concentrate its investments in a particular “industry,” as that term is used in the 1940 Act and as interpreted, modified, or otherwise permitted by regulatory authority having jurisdiction, from time to time.
(2)
With respect to 75% of the Fund’s total assets, purchase the securities of any issuer, except securities issued or guaranteed by the U.S. Government or any of its agencies or instrumentalities or securities issued by other investment companies, if, as a result, (i) more than 5% of the Fund’s total assets would be invested in the securities of that issuer, or (ii) the Fund would hold more than 10% of the outstanding voting securities of that issuer.
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(3)
Purchase or sell real estate, although it may purchase securities secured by real estate or interests therein, or securities issued by companies which invest in real estate, or interests therein.
(4)
Purchase or sell commodities or commodities contracts or oil, gas or mineral programs. This restriction shall not prohibit the Fund, subject to restrictions described in the Prospectus and elsewhere in this Statement of Additional Information, from purchasing, selling or entering into futures contracts, options on futures contracts, forward contracts, or any interest rate, securities-related or other hedging instrument, including swap agreements and other derivative instruments, subject to compliance with any applicable provisions of the federal securities or commodities laws.
(5)
Borrow money or issue any senior security, except to the extent permitted under the 1940 Act and as interpreted, modified, or otherwise permitted by regulatory authority having jurisdiction, from time to time.
(6)
Make loans, except to the extent permitted under the 1940 Act, and as interpreted, modified, or otherwise permitted by regulatory authority having jurisdiction, from time to time.
(7)
Act as an underwriter of securities of other issuers, except to the extent that in connection with the disposition of portfolio securities, it may be deemed to be an underwriter under the federal securities laws.
Other Information Regarding Investment Restrictions
Subject to the Fund’s self-imposed limitations, if any, as they may be amended from time to time, the Fund interprets its policies with respect to leverage and borrowing, issuing senior securities and lending to permit such activities as may be lawful for the Fund, to the full extent permitted by the 1940 Act or by exemption from the provisions therefrom pursuant to exemptive order of the SEC.
Currently, under the 1940 Act, the Fund may generally not lend money or property to any person, directly or indirectly, if such person controls or is under common control with the Fund, except for a loan from the Fund to a company that owns all of the outstanding securities of the Fund, except directors’ and qualifying shares.
For purposes of the foregoing, “majority of the outstanding,” when used with respect to particular shares of the Fund (whether voting together as a single class or voting as separate classes), means (i) 67% or more of such shares present at a meeting, if the holders of more than 50% of such shares are present or represented by proxy, or (ii) more than 50% of such shares, whichever is less.
Unless otherwise indicated, all limitations applicable to the Fund’s investments (as stated above and elsewhere in this Statement of Additional Information or in the Prospectus) apply only at the time a transaction is entered into. For example, any subsequent change in a rating assigned by any rating service to a security (or, if unrated, deemed by PIMCO to be of comparable quality), or change in the percentage of the Fund’s assets invested in certain securities or other instruments, or change in the average maturity or duration of the Fund’s investment portfolio, resulting from market fluctuations or other changes in the Fund’s total assets, will not require the Fund to dispose of an investment. In the event that rating agencies assign different ratings to the same security, PIMCO will determine which rating it believes best reflects the security’s quality and risk at that time, which may be the higher of the several assigned ratings.
Under the Fund’s policy in paragraph (3) above in “Fundamental Investment Restrictions,” where the Fund purchases a loan or other security secured by real estate or interests therein, in the event of a subsequent default, foreclosure, or similar event, the Fund may take possession of and hold the underlying real estate in accordance with its rights under the initial security and subsequently sell or otherwise dispose of such real estate.
Under the 1940 Act, a “senior security” does not include any promissory note or evidence of indebtedness where such loan is for temporary purposes only and in an amount not exceeding 5% of the value of the total assets of the issuer at the time the loan is made. A loan is presumed to be for temporary purposes if it is repaid within sixty days and is not extended or renewed.
For purposes of applying the terms of the Fund’s policy in paragraph (1) above (the “industry concentration policy”), the Fund would be deemed to “concentrate” its investments in a particular industry if it invested more than 25% of its total assets in that industry. For purposes of the industry concentration policy, PIMCO will, on behalf of the Fund, make reasonable determinations as to the appropriate industry classification to assign to each security or instrument in which the Fund invests. The definition of what constitutes a particular “industry” is an evolving one, particularly for industries or sectors within industries that are new or are undergoing rapid development. Some
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securities could reasonably fall within more than one industry category. The Fund’s industry concentration policy does not preclude it from focusing investments in issuers in a group of related industrial sectors (such as different types of utilities). For purposes of the industry concentration policy, a foreign government is considered to be an industry, although currency positions are not considered to be an investment in a foreign government for these purposes. Mortgage-related or ABS that are issued or guaranteed as to principal or interest by the U.S. Government or its agencies or instrumentalities are not subject to the Fund’s industry concentration policy, by virtue of the exclusion from that test available to all U.S. Government securities. Tax-exempt municipal bonds issued by states, municipalities and other political subdivisions, agencies, authorities and instrumentalities of states and multi-state agencies and authorities are not subject to the Fund’s industry concentration policy.
To the extent that an underlying investment company in which the Fund invests has adopted a policy to concentrate its investments in a particular industry, the Fund will, to the extent applicable, take such underlying investment company’s concentration policy into consideration for purposes of the Fund’s own industry concentration policy.
The Fund interprets its policies with respect to borrowing and lending to permit such activities as may be lawful for the Fund, to the full extent permitted by the 1940 Act or by exemption from the provisions therefrom pursuant to exemptive order of the SEC.
It is a condition of the issuance of the Preferred Shares that they be issued with a credit quality rating of “Aaa” from Moody’s and a rating of “AAA” from Fitch. In order to obtain and maintain the required rating, the Fund will be required to comply with investment quality, diversification and other guidelines established by Moody’s and Fitch. Such guidelines will likely be more restrictive than the restrictions set forth above. The Fund does not anticipate that such guidelines would have a material adverse effect on the holders of the Common Shares (“Common Shareholders”) or its ability to achieve its investment objective. Each of Fitch and Moody’s receives fees in connection with their ratings issuances.
For purposes of its investment policies and restrictions, the Fund may value derivative instruments at market value, notional value or full exposure value (i.e., the sum of the notional amount for the contract plus the market value), or any combination of the foregoing (e.g., notional value for purposes of calculating the numerator and market value for purposes of calculating the denominator for compliance with a particular policy or restriction). For example, the Fund may value credit default swaps at full exposure value for purposes of the Fund’s credit quality guidelines because such value in general better reflects the Fund’s actual economic exposure during the term of the credit default swap agreement. As a result, the Fund may, at times, have notional exposure to an asset class (before netting) that is greater or lesser than the stated limit or restriction noted in the Fund’s prospectus. In this context, both the notional amount and the market value may be positive or negative depending on whether the Fund is selling or buying protection through the credit default swap. The manner in which certain securities or other instruments are valued by the Fund for purposes of applying investment policies and restrictions may differ from the manner in which those investments are valued by other types of investors.
From time to time, the Fund may voluntarily participate in actions (for example, rights offerings, conversion privileges, exchange offers, credit event settlements, etc.) where the issuer or counterparty offers securities or instruments to holders or counterparties, such as the Fund, and the acquisition is determined to be beneficial to Fund shareholders (“Voluntary Action”). Notwithstanding any percentage investment limitation listed under this “Investment Restrictions” section or any percentage investment limitation of the 1940 Act or rules thereunder, if the Fund has the opportunity to acquire a permitted security or instrument through a Voluntary Action, and the Fund will exceed a percentage investment limitation following the acquisition, it will not constitute a violation if, prior to the receipt of the securities or instruments and after announcement of the offering, the Fund sells an offsetting amount of assets that are subject to the investment limitation in question at least equal to the value of the securities or instruments to be acquired.
Unless otherwise indicated, all percentage limitations on Fund investments (as stated throughout this Statement of Additional Information or in the Prospectus) that are not: (i) specifically included in this “Investment Restrictions” section; or (ii) imposed by the 1940 Act, rules thereunder, the Code or related regulations (the “Elective Investment Restrictions”), will apply only at the time of investment unless the acquisition is a Voluntary Action. For the avoidance of doubt, unless otherwise stated, all percentage limitations on Fund investments that are (i) specifically included in this “Fundamental Investment Restrictions” section; or (ii) Elective Investment Restrictions, will apply at the time of
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investment. In addition, and notwithstanding the foregoing, for purposes of this policy, certain Non-Fundamental Investment Restrictions, as noted above, are also considered Elective Investment Restrictions. The percentage limitations and absolute prohibitions with respect to Elective Investment Restrictions are not applicable to the Fund’s acquisition of securities or instruments through a Voluntary Action. Certain percentage limitations or absolute prohibitions stated in certain Elective Investment Restrictions by their terms apply only with respect to specific securities or instruments as opposed to asset classes or economic exposures represented by such securities or instruments; for purposes of applying such limitations or prohibitions, a Fund may not count investments in derivatives or other instruments that are not the specific securities or instruments limited or prohibited by the express terms of the Elective Investment Restriction. In such cases, the Fund may obtain greater economic exposure to asset classes represented by such specific securities or instruments because such exposure is not restricted by the express terms of the Elective Investment Restriction.
The Fund may engage in roll-timing strategies where the Fund seeks to extend the expiration or maturity of a position, such as a forward contract, futures contract or to-be-announced (“TBA”) transaction, on an underlying asset by closing out the position before expiration and contemporaneously opening a new position with respect to the same underlying asset that has substantially similar terms except for a later expiration date. Such “rolls” enable the Fund to maintain continuous investment exposure to an underlying asset beyond the expiration of the initial position without delivery of the underlying asset. Similarly, as certain standardized swap agreements transition from OTC trading to mandatory exchange-trading and clearing due to the implementation of Dodd-Frank Act regulatory requirements, the Fund may “roll” an existing OTC swap agreement by closing out the position before expiration and contemporaneously entering into a new exchange-traded and cleared swap agreement on the same underlying asset with substantially similar terms except for a later expiration date. These types of new positions opened contemporaneous with the closing of an existing position on the same underlying asset with substantially similar terms are collectively referred to as “Roll Transactions.” Elective Investment Restrictions (defined in the preceding paragraph), which normally apply at the time of investment, do not apply to Roll Transactions (although Elective Investment Restrictions will apply to the Fund’s entry into the initial position). In addition and notwithstanding the foregoing, for purposes of this policy, those Non- Fundamental Investment Restrictions that are considered Elective Investment Restrictions for purposes of the policy on Voluntary Actions (described in the preceding paragraph) are also Elective Investment Restrictions for purposes of this policy on Roll Transactions. The Fund will test for compliance with Elective Investment Restrictions at the time of the Fund’s initial entry into a position, but the percentage limitations and absolute prohibitions set forth in the Elective Investment Restrictions are not applicable to the Fund’s subsequent acquisition of securities or instruments through a Roll Transaction.
Management of the Fund
Trustees and Officers
The business of the Fund is managed under the direction of the Board. Subject to the provisions of the Fund’s Amended and Restated Agreement and Declaration of Trust, as may be amended from time to time (the “Declaration”), its Amended and Restated Bylaws, as may be amended from time to time (the “Bylaws”), and Massachusetts law, the Trustees have all powers necessary and convenient to carry out this responsibility, including the election and removal of the Fund’s officers.
Board Leadership Structure. The Board consists of eight Trustees, six of whom are not “interested persons” (within the meaning of Section 2(a)(19) of the 1940 Act) of the Fund or of the Investment Manager (the “Independent Trustees”), which represents 75% of the Trustees that are Independent Trustees.
An Independent Trustee serves as Chair of the Board and is selected by a vote of the majority of the Independent Trustees. The Chair of the Board presides at meetings of the Board, acts as a liaison with service providers, officers, attorneys and other Trustees generally between meetings, and performs such other functions as may be requested by the Board from time to time.
The Board meets regularly four times each year to discuss and consider matters concerning the Fund, and also holds special meetings to address matters arising between regular meetings. The Independent Trustees regularly meet outside the presence of management and are advised by independent legal counsel.
77
The Board has established five standing Committees to facilitate the Trustees’ oversight of the management of the Fund: the Audit Oversight Committee, the Governance and Nominating Committee, the Valuation Oversight Committee, the Contracts Committee and the Performance Committee. The functions and role of each Committee are described below under “Committees of the Board of Trustees.” The membership of each Committee (other than the Performance Committee) consists of only the Independent Trustees. The Performance Committee consists of all the Trustees. The Independent Trustees believe that participation on each Committee allows them to participate in the full range of the Board’s oversight duties.
The Board reviews its leadership structure periodically and has determined that this leadership structure, including an Independent Chair, a supermajority of Independent Trustees and Committee membership limited to Independent Trustees (with the exception of the Performance Committee), is appropriate in light of the characteristics and circumstances of the Fund. In reaching this conclusion, the Board considered, among other things, the predominant role of the Investment Manager in the day-to-day management of Fund affairs, the extent to which the work of the Board is conducted through the Committees, the number of funds in the Fund Complex (as defined below) overseen by Board members, the variety of asset classes those funds include, the assets of the Fund and the other funds in the fund complex and the management, distribution and other service arrangements of the Fund and such other funds. The Board also believes that its structure, including the presence of two Trustees who are or have been executives with the Investment Manager or Investment Manager-affiliated entities, facilitates an efficient flow of information concerning the management of the Fund to the Independent Trustees.
Risk Oversight. The Fund has retained the Investment Manager to provide investment advisory services and administrative services. Accordingly, the Investment Manager is immediately responsible for the management of risks that may arise from Fund investments and operations. Some employees of the Investment Manager serve as the Fund’s officers, including the Fund’s principal executive officer and principal financial and accounting officer, chief compliance officer and chief legal officer. The Investment Manager and the Fund’s other service providers have adopted policies, processes, and procedures to identify, assess and manage different types of risks associated with the Fund’s activities. The Board oversees the performance of these functions by the Investment Manager and the Fund’s other service providers, both directly and through the Committee structure it has established. The Board receives from the Investment Manager a wide range of reports, both on a regular and as-needed basis, relating to the Fund’s activities and to the actual and potential risks of the Fund. These include reports on investment and market risks, custody and valuation of Fund assets, compliance with applicable laws, and the Fund’s financial accounting and reporting.
In addition, the Board meets periodically with the portfolio managers of the Fund or their delegates to receive reports regarding the portfolio management of the Fund and its performance, including its investment risks. In the course of these meetings and discussions with the Investment Manager, the Board has emphasized to the Investment Manager the importance of maintaining vigorous risk management programs and procedures with respect to the Fund.
In addition, the Board has appointed a Chief Compliance Officer (“CCO”). The CCO oversees the development of compliance policies and procedures that are reasonably designed to minimize the risk of violations of the federal securities laws (“Compliance Policies”). The CCO reports directly to the Independent Trustees, interacts with individuals within the Investment Manager’s organization and provides presentations to the Board at its quarterly meetings and an annual report on the application of the Compliance Policies. The Board periodically discusses relevant risks affecting the Fund with the CCO at these meetings. The Board has approved the Compliance Policies and reviews the CCO’s reports. Further, the Board annually reviews the sufficiency of the Compliance Policies, as well as the appointment and compensation of the CCO.
The Board recognizes that the reports it receives concerning risk management matters are, by their nature, typically summaries of the relevant information. Moreover, the Board recognizes that not all risks that may affect the Fund can be identified in advance; that it may not be practical or cost-effective to eliminate or mitigate certain risks; that it may be necessary to bear certain risks (such as investment-related risks) in seeking to achieve the Fund’s investment objective; and that the processes, procedures and controls employed to address certain risks may be limited in their effectiveness.
The Trustees and officers of the Fund, their year of birth, the position they hold with the Fund, their term of office and length of time served, a description of their principal occupations during the past five years, the number of portfolios in the Fund Complex (as defined below) that the Trustee oversees and any other public company directorships held by the Trustee are listed in the two tables immediately following. Except as shown, each Trustee’s
78
and officer’s principal occupation and business experience for the last five years have been with the employer(s) indicated, although in some cases the Trustee may have held different positions with such employer(s).
The charts below identify the Trustees and executive officers of the Fund. Unless otherwise indicated, the address of all persons below is c/o Pacific Investment Management Company LLC, 1633 Broadway, New York, New York 10019.
Independent Trustees*
| Name, Year of Birth and Class |
Position(s) Held with the Fund |
Term of Office and Length of Time Served** |
Principal Occupation(s) During the Past 5 Years |
Number of Portfolios in Fund Complex Overseen by Trustee |
Other Directorships Held by Trustee During the Past 5 Years |
| Deborah A. DeCotis 1952 Class II |
Chair of the Board, Trustee |
Chair, Since 2019 Trustee, Since 2011 |
Advisory Director, Morgan Stanley & Co., Inc. (since 1996); Member, Circle Financial Group (since 2009); Member, Council on Foreign Relations (since 2013); Trustee, Smith College (since 2017); Director, Watford Re (since 2017); and Director, Cadre Inc., a manufacturer of safety equipment (since 2022). Formerly, Co-Chair Special Projects Committee, Memorial Sloan Kettering (2005-2015); Trustee, Stanford University (2010- 2015); Principal, LaLoop LLC, a retail accessories company (1999-2014); Director, Helena Rubenstein Foundation (1997-2010); and Director, Armor Holdings (2002-2010). |
30 |
Trustee, Allianz Funds (2011-2021); Trustee, Virtus Funds (2021-Present) |
| Sarah E. Cogan 1956 Class II |
Trustee |
Since 2019 |
Retired Partner, Simpson Thacher & Bartlett LLP (law firm)(1989-2018); Director, Girl Scouts of Greater New York, Inc. (since 2016); and Trustee, Natural Resources Defense Council, Inc. (since 2013). |
30 |
Trustee, Allianz Funds (2019-2021); Trustee, Virtus Funds (2021-Present) |
| Joseph B. Kittredge, Jr.(1) 1954 Class II |
Trustee |
Since 2020 |
Trustee (since 2019) and Governance Committee (since 2020), Vermont Law School (since 2019); Formerly, Director and Treasurer, Center for Reproductive Rights (2015-2021); Director (2013-2020) and Chair (2018-2020), ACLU of Massachusetts; General Counsel, Grantham, Mayo, Van Otterloo & Co. LLC (2005-2018) and Partner (2007-2018); President, GMO Trust (institutional mutual funds) (2009-2018); Chief Executive Officer, GMO Trust (2009-2015); and President and Chief Executive Officer, GMO Series Trust (platform based mutual funds) (2011-2013). |
30 |
Trustee, GMO Trust (2010- 2018); Chairman of the Board of Trustees, GMO Series Trust (2011- 2018) |
79
| Name, Year of Birth and Class |
Position(s) Held with the Fund |
Term of Office and Length of Time Served** |
Principal Occupation(s) During the Past 5 Years |
Number of Portfolios in Fund Complex Overseen by Trustee |
Other Directorships Held by Trustee During the Past 5 Years |
| Kathleen A. McCartney 1955 Class III |
Trustee |
Since 2022 |
Director (since 2013) and President (since 2020), Five Colleges, Inc., consortium of liberal arts colleges and universities; President Emerita, Smith College (since 2023). Formerly, President, Smith College (2013-2023); Director, American Council on Education Board of Directors, (2015-2019); Director, Consortium on Financing Higher Education Board of Directors (2015-2019); Director, edX Board of Directors, online course provider (2012-2013); Director, Bellwether Education Partners Board, national nonprofit organization (2010-2013); Dean, Harvard Graduate School of Education (2006-2013); Trustee, Tufts University (2007-2013). |
30 |
None |
| Alan Rappaport 1953 Class I |
Trustee |
Since 2010 |
Director, Victory Capital Holdings, Inc., an asset management firm (since 2013). Formerly, Adjunct Professor, New York University Stern School of Business (2011-2020); Lecturer, Stanford University Graduate School of Business (2013-2020); Advisory Director (formerly Vice Chairman), Roundtable Investment Partners (2009-2018); Member of Board of Overseers, NYU Langone Medical Center (2015-2016); Trustee, American Museum of Natural History (2005-2015); Trustee, NYU Langone Medical Center (2007-2015); and Vice Chairman (formerly, Chairman and President), U.S. Trust (formerly, Private Bank of Bank of America, the predecessor entity of U.S. Trust) (2001-2008). |
30 |
Trustee, Allianz Funds (2010-2021); Trustee, Virtus Closed-End Funds (2021-2023) |
80
| Name, Year of Birth and Class |
Position(s) Held with the Fund |
Term of Office and Length of Time Served** |
Principal Occupation(s) During the Past 5 Years |
Number of Portfolios in Fund Complex Overseen by Trustee |
Other Directorships Held by Trustee During the Past 5 Years |
| E. Grace Vandecruze 1963 Class III |
Trustee |
Since 2021 |
Founder and Managing Director, Grace Global Capital LLC, a strategic advisory firm to the insurance industry (since 2006); Director, The Doctors Company, a medical malpractice insurance company (since 2020); Director, Link Logistics REIT, a real estate company (since 2021); Director and Member of the Investment & Risk Committee, Resolution Life Group Holdings, a global life insurance group (since 2021); Director, Wharton Graduate Executive Board; and Director, Blackstone Private Equity Strategies Fund L.P. (since 2022). Formerly, Chief Financial Officer, ShoulderUp Technology Acquisition Corp, a special purpose acquisition company (2021-2023); Director, Resolution Holdings (2015-2019); Director and Member of the Audit Committee and the Wealth Solutions Advisory Committee, M Financial Group, a life insurance company (2015-2021); Chief Financial Officer, Athena Technology Acquisition Corp, a special purpose acquisition company (2021-2022); and Director, SBLI USA, a life insurance company (2015-2018). |
30 |
None |
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Interested Trustees***
| Name, Address and Year of Birth |
Position(s) Held with the Fund |
Term of Office and Length of Time Served |
Principal Occupation(s) During the Past 5 Years |
Number of Portfolios in Fund Complex Overseen by Trustee |
Other Directorships Held by Trustee During the Past 5 Years |
| Libby D. Cantrill****(2) 1977 Class III |
Trustee |
Since April 2023 |
Managing Director, Head of Public Policy, PIMCO (since 2007); Institutional Account Manager, PIMCO (2007-2010); Legislative Aide, House of Representatives (2003-2005); Investment Banking Analyst, Morgan Stanley (2000-2003). |
30 |
Member of the Board of Directors, Covenant House New York (2021-Present); Member of the Board, Securities Industry and Financial Markets Association (2022-Present) |
| David N. Fisher**** 1968 Class I |
Trustee |
Since 2019 |
Managing Director and Co-Head of U.S. Global Wealth Management Strategic Accounts, PIMCO (since 2021); and Director, Court Appointed Special Advocates (CASA) of Orange County, a non-profit organization (since 2015). Formerly, Managing Director and Head of Traditional Product Strategies, PIMCO (2015-2021); Global Bond Strategist, PIMCO (2008-2015); and Managing Director and Head of Global Fixed Income, HSBC Global Asset Management (2005-2008). |
30 |
None |
*
“Independent Trustees” are those Trustees who are not “interested persons” of the Fund (as defined in Section 2(a)(19) of the 1940 Act).
**
Under the Fund’s Amended and Restated Agreement and Declaration of Trust, a Trustee serves until his or her retirement, removal, disqualification, resignation or replacement.
***
The Trustee is an “interested person” of the Fund, as defined in Section 2(a)(19) of the 1940 Act, due to their affiliations with PIMCO and its affiliates.
****
Mr. Fisher’s and Ms. Cantrill’s address is 650 Newport Center Drive, Newport Beach, California 92660.
(1)
Mr. Kittredge has informed the Board of his expected retirement from all of the PIMCO Sponsored Closed-End Funds, effective as of June 30, 2024.
(2)
Ms. Cantrill was appointed as a Trustee of the Fund effective April 30, 2023.
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Officers
| Name, Address and Year of Birth |
Position(s) Held with Fund |
Term of Office and Length of Time Served |
Principal Occupation(s) During the Past 5 Years |
| Joshua D. Ratner 1976 |
President |
Since January 2024 |
Executive Vice President and Head of Americas Operations: Deputy General Counsel, PIMCO. President, PIMCO-Managed Funds, PIMCO Flexible Real Estate Income Fund, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series and PIMCO Equity Series VIT. |
| Keisha Audain-Pressley 1975 |
Chief Compliance Officer |
Since 2018 |
Executive Vice President and Deputy Chief Compliance Officer, PIMCO. Chief Compliance Officer, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT, PIMCO Flexible Real Estate Income Fund and PIMCO Capital Solutions BDC Corp. |
| Ryan G. Leshaw1 1980 |
Chief Legal Officer |
Since 2019 |
Executive Vice President and Deputy Counsel, PIMCO. Chief Legal Officer, PIMCO-Managed Funds, PIMCO Flexible Real Estate Income Fund and PIMCO Capital Solutions BDC Corp. Chief Legal Officer and Secretary, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series and PIMCO Equity Series VIT. Formerly, Associate, Willkie Farr & Gallagher LLP. |
| Peter G. Strelow1 1970 |
Senior Vice President |
Since 2019 |
Managing Director and Co-Chief Operating Officer, PIMCO. Senior Vice President, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series and PIMCO Equity Series VIT. Formerly, Chief Administrative Officer, PIMCO. |
83
| Name, Address and Year of Birth |
Position(s) Held with Fund |
Term of Office and Length of Time Served |
Principal Occupation(s) During the Past 5 Years |
| Wu-Kwan Kit1 1981 |
Vice President Senior Counsel and Secretary |
Since 2018 |
Senior Vice President and Senior Counsel, PIMCO. Vice President, Senior Counsel and Secretary, PIMCO-Managed Funds, PIMCO Flexible Real Estate Income Fund and PIMCO Capital Solutions BDC Corp. Assistant Secretary, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series and PIMCO Equity Series VIT. Formerly, Assistant General Counsel, VanEck Associates Corp. |
| Douglas B. Burrill 1980 |
Vice President |
Since 2022 |
Senior Vice President, PIMCO. Vice President, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT, PIMCO Flexible Real Estate Income Fund and PIMCO Capital Solutions BDC Corp. |
| Carol K. Chan1 1982 |
Vice President |
Since January 2024 |
Senior Vice President, PIMCO. Vice President, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT and PIMCO Flexible Real Estate Income Fund. |
| Alyssa M. Creighton1 1974 |
Vice President |
Since January 2024 |
Senior Vice President, PIMCO. Vice President, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT, PIMCO Flexible Real Estate Income Fund and PIMCO Capital Solutions BDC Corp. |
| Jason R. Duran1 1977 |
Vice President |
Since 2023 |
Senior Vice President, PIMCO. Vice President, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series and PIMCO Equity Series VIT. |
84
| Name, Address and Year of Birth |
Position(s) Held with Fund |
Term of Office and Length of Time Served |
Principal Occupation(s) During the Past 5 Years |
| Kenneth W. Lee1 1972 |
Vice President |
Since 2022 |
Senior Vice President, PIMCO. Vice President, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT, PIMCO Flexible Real Estate Income Fund and PIMCO Capital Solutions BDC Corp. |
| Greg J. Mason2 1980 |
Vice President |
Since 2023 |
Senior Vice President, PIMCO. Vice President, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT and PIMCO Flexible Real Estate Income Fund. |
| Colleen P. McLaughlin2 1983 |
Vice President |
Since January 2024 |
Senior Vice President, PIMCO. Vice President, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT and PIMCO Flexible Real Estate Income Fund. |
| Shiv Narain1 1981 |
Vice President |
Since January 2024 |
Executive Vice President, PIMCO. Vice President, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT and PIMCO Flexible Real Estate Income Fund. |
| Keith A. Werber1 1973 |
Vice President |
Since 2022 |
Executive Vice President, PIMCO. Vice President, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT, PIMCO Flexible Real Estate Income Fund and PIMCO Capital Solutions BDC Corp. |
| Paul T. Wildermuth1 1979 |
Vice President |
Since January 2024 |
Vice President, PIMCO. Vice President, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT and PIMCO Flexible Real Estate Income Fund. |
85
| Name, Address and Year of Birth |
Position(s) Held with Fund |
Term of Office and Length of Time Served |
Principal Occupation(s) During the Past 5 Years |
| Bijal Parikh1 1978 |
Treasurer |
Since 2021 |
Executive Vice President, PIMCO. Treasurer, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT and PIMCO Flexible Real Estate Income Fund. |
| Brandon T. Evans1 1982 |
Deputy Treasurer |
Since 2022 |
Senior Vice President, PIMCO. Deputy Treasurer, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT and PIMCO Flexible Real Estate Income Fund. |
| Erik C. Brown2 1967 |
Assistant Treasurer |
Since 2015 |
Executive Vice President, PIMCO. Assistant Treasurer, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT, PIMCO Flexible Real Estate Income Fund and PIMCO Capital Solutions BDC Corp. |
| Matthew L. Goodman 1977 |
Assistant Treasurer |
Since January 2024 |
Vice President, PIMCO. Assistant Treasurer, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT and PIMCO Flexible Real Estate Income Fund. |
| Laine E. Pacetti1 1989 |
Assistant Treasurer |
Since January 2024 |
Vice President, PIMCO. Assistant Treasurer, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT and PIMCO Flexible Real Estate Income Fund. |
| Jason R. Stern 1979 |
Assistant Treasurer |
Since January 2024 |
Vice President, PIMCO. Assistant Treasurer, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT and PIMCO Flexible Real Estate Income Fund. |
86
| Name, Address and Year of Birth |
Position(s) Held with Fund |
Term of Office and Length of Time Served |
Principal Occupation(s) During the Past 5 Years |
| Chi H. Vu1 1983 |
Assistant Treasurer |
Since January 2024 |
Vice President, PIMCO. Assistant Treasurer, PIMCO-Managed Funds, PIMCO Funds, PIMCO Variable Insurance Trust, PIMCO ETF Trust, PIMCO Equity Series, PIMCO Equity Series VIT and PIMCO Flexible Real Estate Income Fund. |
(1)
The address of these officers is Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, California 92660.
(2)
The address of these officers is Pacific Investment Management Company LLC, 401 Congress Ave., Austin, Texas 78701.
Each of the Fund’s executive officers is an “interested person” of the Fund (as defined in Section 2(a)(19) of the 1940 Act) as a result of his or her position(s) set forth in the table above.
Trustee Qualifications. The Board has determined that each Trustee is qualified to serve as such based on several factors (none of which alone is decisive). Each Trustee is knowledgeable about the Fund’s business and service provider arrangements in part because he or she serves as trustee or director to a number of other investment companies advised by the Investment Manager and/or its affiliates with similar arrangements to that of the Fund, or has had significant experience in the investment management and/or financial services industries. Among the factors the Board considers when concluding that an individual is qualified to serve on the Board were the following: (i) the individual’s business and professional experience and accomplishments; (ii) the individual’s ability to work effectively with other members of the Board; (iii) the individual’s prior experience, if any, serving on the boards of public companies (including, where relevant, other investment companies) and other complex enterprises and organizations; and (iv) how the individual’s skills, experiences and attributes would contribute to an appropriate mix of relevant skills and experience on the Board.
In respect of each current Trustee, the individual’s substantial professional accomplishments and prior experience, including, in some cases, in fields related to the operations of the Fund, were a significant factor in the determination by the Board that the individual is qualified to serve as a Trustee of the Fund. The following is a summary of various qualifications, experiences and skills of each Trustee (in addition to business experience during the past five years set forth in the table above) that contributed to the Board’s conclusion that an individual is qualified to serve on the Board. References to qualifications, experiences and skills are not intended to hold out the Board or individual Trustees as having any special expertise or experience, and shall not impose any greater responsibility or liability on any such person or on the Board by reason thereof.
Libby D. Cantrill — Ms. Cantrill has substantial experience in the investment management industry. Ms. Cantrill has 18 years of investment experience and is the Head of Public Policy and is a managing director in PIMCO’s portfolio management group. In her role, she analyzes policy and political risk for the firm’s Investment Committee and leads U.S. policymaker engagement and policy strategy for the firm. She also works closely with PIMCO’s Global Advisory Board and has served as a rotating member of the firm’s Executive Committee. Ms. Cantrill is a Chartered Financial Analyst charterholder.
Sarah E. Cogan — Ms. Cogan has substantial legal experience in the investment management industry, having served as a partner at a large international law firm in the corporate department for over 25 years and as former head of the registered funds practice. She has extensive experience in oversight of investment company boards through her experience as counsel to the Independent Trustees of certain PIMCO-Managed Funds and as counsel to other independent trustees, investment companies and asset management firms.
Deborah A. DeCotis — Ms. DeCotis has substantial senior executive experience in the investment banking industry, having served as a Managing Director for Morgan Stanley. She has extensive board experience and experience in oversight of investment management functions through her experience as a former Director of the Helena Rubenstein Foundation, Stanford Graduate School of Business and Armor Holdings.
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David N. Fisher — Mr. Fisher has substantial executive experience in the investment management industry. Mr. Fisher is a Managing Director and Co-Head of U.S. Global Wealth Management Strategic Accounts at PIMCO. In this role, he helps oversee relationships with key distribution partners and develop the firm's growth strategy across wealth management channels. Prior to taking on this position, Mr. Fisher was Head of Traditional Product Strategies at PIMCO, where he oversaw teams of product strategists covering core and non-core fixed income strategies as well as the firm's suite of equity strategies, was a Global Bond Strategist at PIMCO and has managed PIMCO’s Total Return Strategy. Because of his familiarity with PIMCO and its affiliates, Mr. Fisher serves as an important information resource for the Independent Trustees and as a facilitator of communication with PIMCO.
Joseph B. Kittredge, Jr. — Mr. Kittredge has substantial experience in the investment management industry, having served for thirteen years as General Counsel to Grantham, Mayo, Van Otterloo & Co. LLC, the adviser to the GMO mutual fund complex, and as a Trustee and senior officer for funds in the GMO complex. Previously, he was a partner at a large international law firm. Mr. Kittredge has extensive experience in asset management regulation and has provided legal advice to investment company boards, registered funds and their sponsors with respect to a broad range of financial, legal, tax, regulatory and other issues. He also serves as the Audit Oversight Committee’s Chair and has been determined by the Board to be an “audit committee financial expert.”
Kathleen A. McCartney — Ms. McCartney has substantial board experience, having served on a number of nonprofit boards, as trustee of Tufts University, director of the American Council on Education, director of the Consortium on Financing Higher Education, founding board member of edX, and director of the Bellwether Education Partners board. She also has substantial senior executive experience as the President Emerita and former President of Smith College and director of Five Colleges, Inc.
Alan Rappaport — Mr. Rappaport has substantial senior executive experience in the financial services industry. He formerly served as Chairman and President of the Private Bank of Bank of America and as Vice Chairman of U.S. Trust and as an Advisory Director of an investment firm.
E. Grace Vandecruze — Ms. Vandecruze has substantial senior executive experience in the financial services industry. She is Founder and Managing Director of Grace Global Capital LLC, a strategic advisory firm to the insurance industry (since 2006). She has extensive board experience and experience in oversight of investment management and insurance company functions through her experience as a Director and Member of the Audit Committee and the Wealth Solutions Advisory Committee, M Financial Group, a life insurance company (2015-2021), a Director of The Doctors Company, a medical malpractice insurance company (since 2020) and a Director and Member of the Investment & Risk Committee, Resolution Life Group Holdings, a global life insurance group (since 2021).
Committees of the Board of Trustees
Audit Oversight Committee. The Board has established an Audit Oversight Committee, in accordance with Section 3(a)(58)(A) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), currently consisting of Messrs. Kittredge and Rappaport and Mses. Cogan, DeCotis, McCartney and Vandecruze, each of whom is an Independent Trustee. Mr. Kittredge is the current Chair of the Fund’s Audit Oversight Committee.
The Audit Oversight Committee provides oversight with respect to the internal and external accounting and auditing procedures of the Fund and, among other things, determines the selection of an independent registered public accounting firm for the Fund and considers the scope of the audit, approves all audit and permitted non-audit services proposed to be performed by those auditors on behalf of the Fund and approves non-audit services to be performed by the auditors for certain affiliates, including PIMCO and entities in a control relationship with PIMCO that provide services to the Fund where the engagement relates directly to the operations and financial reporting of the Fund. The Audit Oversight Committee considers the possible effect of those services on the independence of the Fund’s independent registered public accounting firm.
During the fiscal year ended June 30, 2023, the Audit Oversight Committee met four times. Each member of the Fund’s Audit Oversight Committee is “independent,” as independence for audit committee members is defined in the currently applicable listing standards of the NYSE, on which the Common Shares of the Fund are listed.
Governance and Nominating Committee. The Board has established a Governance and Nominating Committee composed solely of Independent Trustees, currently consisting of Messrs. Kittredge and Rappaport and Mses. Cogan,
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DeCotis, McCartney and Vandecruze. Ms. DeCotis is the current Chair of the Governance and Nominating Committee. The primary purposes and responsibilities of the Governance and Nominating Committee are: (i) advising and making recommendations to the Board on matters concerning Board governance and related Trustee practices, and (ii) the screening and nomination of candidates for election to the Board as Independent Trustees.
The responsibilities of the Governance and Nominating Committee include considering and making recommendations to the Fund’s Board regarding: (1) governance, retirement and other policies, procedures and practices relating to the Board and the Trustees; (2) in consultation with the Chair of the Trustees, matters concerning the functions and duties of the Board and committees of the Board; (3) the size of the Board and, in consultation with the Chair of the Board, the Board’s committees and their composition; and (4) Board and committee meeting procedures. The Committee will also periodically review and recommend for approval by the Board the structure and levels of compensation and any related benefits to be paid or provided by the Fund to the Independent Trustees for their services on the Board and any committees on the Board.
The Governance and Nominating Committee is responsible for reviewing and recommending qualified candidates to the Board in the event that a position is vacated or created or when Trustees are to be re-elected. During the fiscal year ended June 30, 2023, the Governance and Nominating Committee met five times. Each member of the Fund’s Governance and Nominating Committee is “independent,” as independence for audit committee members is defined in the currently applicable listing standards of the NYSE, on which the Common Shares of the Fund are listed.
Qualifications, Evaluation and Identification of Trustee Nominees. The Governance and Nominating Committee of the Fund requires that Trustee candidates have a college degree or equivalent business experience. When evaluating candidates, the Governance and Nominating Committee may take into account a wide variety of factors including, but not limited to: (i) availability and commitment of a candidate to attend meetings and perform his or her responsibilities on the Board, (ii) relevant industry and related experience, (iii) educational background, (iv) ability, judgment and expertise and (v) overall diversity of the Board’s composition. The process of identifying nominees involves the consideration of candidates recommended by one or more of the following sources: (i) the Fund’s current Trustees, (ii) the Fund’s officers, (iii) the Fund’s investment adviser, (iv) the Fund’s shareholders and (v) any other source the Committee deems to be appropriate. The Governance and Nominating Committee may, but is not required to, retain a third-party search firm at the Fund’s expense to identify potential candidates.
Consideration of Candidates Recommended by Shareholders. The Governance and Nominating Committee will review and consider nominees recommended by shareholders to serve as Trustees, provided that the recommending shareholder follows the “Procedures for Shareholders to Submit Nominee Candidates”, which are set forth as Appendix A to the Fund’s Governance and Nominating Committee Charter and attached as Appendix A to this Statement of Additional Information. Among other requirements, these procedures provide that the recommending shareholder must submit any recommendation in writing to the Fund, to the attention of the Fund’s Secretary, at the address of the principal executive offices of the Fund and that such submission must be received at such offices not less than 45 days nor more than 75 days prior to the date of the Board or shareholder meeting at which the nominee would be elected. Any recommendation must include certain biographical and other information regarding the candidate and the recommending shareholder, and must include a written and signed consent of the candidate to be named as a nominee and to serve as a Trustee if elected. The foregoing description of the requirements is only a summary. Please refer to Appendix B to the Governance and Nominating Committee Charter, which is attached to this Statement of Additional Information as Appendix A for details.
The Governance and Nominating Committee has full discretion to reject nominees recommended by shareholders, and there is no assurance that any such person properly recommended and considered by the Committee will be nominated for election to the Board of Trustees.
Diversity. The Governance and Nominating Committee takes diversity of a particular nominee and overall diversity of the Board into account when considering and evaluating nominees for Trustee. The Board has adopted a diversity policy and, when considering a nominee’s and the Board’s diversity, the Committee generally considers the manner in which each nominee’s professional experience, education, expertise in matters that are relevant to the oversight of the Fund (e.g., investment management, distribution, accounting, trading, compliance, legal), general leadership experience, and life experience are complementary and, as a whole, contribute to the ability of the Board to oversee the Fund.
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Valuation Oversight Committee. The Board has established a Valuation Oversight Committee currently consisting of Messrs. Kittredge and Rappaport and Mses. Cogan, DeCotis, McCartney and Vandecruze. Ms. Vandecruze is the current Chair of the Valuation Oversight Committee. The Valuation Oversight Committee has been delegated responsibility by the Board for overseeing determination of the fair value of the Fund’s portfolio securities and other assets. The Valuation Oversight Committee reviews and approves procedures for the fair valuation of the Fund’s portfolio securities and periodically reviews, reports and assessments provided by the Investment Manager pursuant to the Fund’s valuation procedures and the Investment Manager’s pricing policy. With respect to the fair valuation of portfolio securities for which market quotations are not readily available, the Investment Manager has been designated as “Valuation Designee” for the Fund in accordance with Rule 2a-5 under the 1940 Act. Each Fund’s Valuation Oversight Committee reports to the Board periodically as to the Committee’s activities and oversight of the Investment Manager’s administration of the Fund’s valuation procedures and the Valuation Designee’s carrying out of its responsibilities under Rule 2a-5.
During the fiscal year ended June 30, 2023, the Valuation Oversight Committee met five times.
Contracts Committee. The Board has established a Contracts Committee currently consisting of Messrs. Kittredge and Rappaport and Mses. Cogan, DeCotis, McCartney and Vandecruze. Ms. Cogan serves as the current Chair of the Fund’s Contracts Committee. The Contracts Committee meets as the Board deems necessary to review the performance of, and the reasonableness of the fees paid to, as applicable, the Fund’s investment adviser(s) and any sub-adviser(s), administrators(s) and principal underwriters(s) and to make recommendations to the Board regarding the approval and continuance of the Fund’s contractual arrangements for investment advisory, sub-advisory, administrative and distribution services, as applicable. The Contracts Committee also may review and evaluate the terms of other contracts or amendments thereto with the Fund’s other major service providers at the Board’s request.
During the fiscal year ended June 30, 2023, the Contracts Committee met three times. The Contracts Committee also may review and evaluate the terms of other contracts or amendments thereto with the Fund’s other major service providers at the Board’s request.
Performance Committee. The Board has established a Performance Committee, currently consisting of Messrs. Fisher, Kittredge and Rappaport and Mses. Cantrill, Cogan, DeCotis, McCartney and Vandecruze. Mr. Rappaport serves as the current Chair of the Performance Committee. The Performance Committee’s responsibilities include reviewing the performance of the Fund and any changes in investment philosophy, approach and personnel of the Investment Manager.
During the fiscal year ended June 30, 2023, the Performance Committee met four times.
Securities Ownership
For each Trustee, the following table discloses the dollar range of equity securities in the Fund beneficially owned by the Trustee and, on an aggregate basis, in any registered investment companies overseen by the Trustee within the Fund’s family of investment companies as of December 31, 2023:
| Name of Trustee |
Dollar Range of Equity Securities in the Fund |
Aggregate Dollar Range of Equity Securities in All Registered Investment Companies Overseen by Trustee in Family of Investment Companies(1) |
| Independent Trustees |
|
|
| Sarah E. Cogan |
$1 - $10,000 |
Over $100,000 |
| Deborah A. DeCotis |
None |
Over $100,000 |
| Joseph B. Kittredge, Jr. |
None |
$50,001 - $100,000 |
| Kathleen A. McCartney |
None |
None |
| Alan Rappaport |
None |
Over $100,000 |
| E. Grace Vandecruze |
None |
Over $100,000 |
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| Name of Trustee |
Dollar Range of Equity Securities in the Fund |
Aggregate Dollar Range of Equity Securities in All Registered Investment Companies Overseen by Trustee in Family of Investment Companies(1) |
| Interested Trustees |
|
|
| Libby D. Cantrill(2) |
None |
None |
| John C. Maney(3) |
None |
Over $100,000 |
| David N. Fisher |
None |
Over $100,000 |
(1)
The term “Family of Investment Companies” as used herein includes the Fund and the following registered investment companies: PIMCO Municipal Income Fund, PIMCO California Municipal Income Fund, PIMCO New York Municipal Income Fund, PIMCO Municipal Income Fund II, PIMCO California Municipal Income Fund II, PIMCO New York Municipal Income Fund II, PIMCO Municipal Income Fund III, PIMCO California Municipal Income Fund III, PIMCO New York Municipal Income Fund III, PIMCO Access Income Fund, PIMCO Corporate & Income Opportunity Fund, PIMCO Corporate & Income Strategy Fund, PIMCO Dynamic Income Fund, PIMCO Dynamic Income Opportunities Fund, PIMCO Dynamic Income Strategy Fund, PIMCO Global StocksPLUS® & Income Fund, PIMCO High Income Fund, PIMCO Income Strategy Fund, PCM Fund, Inc., PIMCO Strategic Income Fund, Inc., PIMCO Flexible Credit Income Fund, PIMCO Flexible Emerging Markets Income Fund, PIMCO California Flexible Municipal Income Fund and PIMCO Flexible Municipal Income Fund, and each series of PIMCO Managed Accounts Trust..
(2)
Ms. Cantrill was appointed as a Trustee of the Fund effective April 30, 2023.
(3)
Mr. Maney retired from the Board effective April 30, 2023.
To the Fund’s knowledge, the following table provides information regarding each class of securities owned beneficially in an investment adviser or principal underwriter of the Fund, or a person (other than a registered investment company) directly or indirectly controlling, controlled by, or under common control with an investment adviser or principal underwriter of the Fund as of December 31, 2023 by Independent Trustees and their immediate family members:
| Name of Trustee |
Name of Owners and Relationships to Trustee |
Company |
Title of Class |
Value of Securities |
Percent of Class |
| Sarah E. Cogan |
None |
N/A |
N/A |
N/A |
N/A |
| Deborah A. DeCotis |
None |
N/A |
N/A |
N/A |
N/A |
| Joseph B. Kittredge, Jr. |
None |
N/A |
N/A |
N/A |
N/A |
| Kathleen A. McCarthy |
None |
N/A |
N/A |
N/A |
N/A |
| Alan Rappaport |
None |
N/A |
N/A |
N/A |
N/A |
| E. Gace Vandecruze |
None |
N/A |
N/A |
N/A |
N/A |
To the best of the Fund’s knowledge, as of March 31, 2023, the Trustees and officers of the Fund, as a group, owned less than 1% of the outstanding Common Shares.
Except as noted below in the table, to the Fund’s knowledge, no persons own of record 5% or more of the Fund’s outstanding Common Shares, and no person is reflected on the books and records of the Fund as owning beneficially 5% or more of the outstanding Common Shares of the Fund as of April 9, 2024:
| Record/Beneficial Owner |
% of Common Shares |
| CHARLES SCHWAB & CO INC101 MONTGOMERY STSAN FRANCISCO, CA 94104-4151 |
22.67% |
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| Record/Beneficial Owner |
% of Common Shares |
| NATIONAL FINANCIAL SERVICES LLC200 LIBERTY ST, ONE WORLD FINANCIAL CENTERNEW YORK NY 10281-1003 |
20.13% |
| MORGAN STANLEY SMITH BARNEYHARBORSIDE FINANCIAL CENTER, PLAZA 2JERSEY CITY, NJ 07311 |
7.14% |
| Record/Beneficial Owner |
% of Perferred Shares |
| STATE STREET BANK & TRUST1776 HERITAGE DRIVENORTH QUINCY, MA 02171 |
67.94%* |
| BANK OF NEW YORK MELLONONE WALL STREETNEW YORK, NEW YORK 10286 |
23.66% |
| CHARLES SCHWAB & CO INC101 MONTGOMERY STSAN FRANCISCO, CA 94104-4151 |
5.34% |
* Entity owned 25% or more of the outstanding shares of beneficial interest of the Fund, and therefore may be presumed to “control” the Fund, as that term is defined in the 1940 Act.
Trustees’ Compensation
Each of the Independent Trustees serves as a trustee of PIMCO Municipal Income Fund, PIMCO California Municipal Income Fund, PIMCO New York Municipal Income Fund, PIMCO Municipal Income Fund II, PIMCO California Municipal Income Fund II, PIMCO New York Municipal Income Fund II, PIMCO Municipal Income Fund III, PIMCO California Municipal Income Fund III, PIMCO New York Municipal Income Fund III, PIMCO Access Income Fund, PIMCO Corporate & Income Opportunity Fund, PIMCO Corporate & Income Strategy Fund, PIMCO Dynamic Income Fund, PIMCO Dynamic Income Opportunities Fund, PIMCO Dynamic Income Strategy Fund, PIMCO Global StocksPLUS® & Income Fund, PIMCO High Income Fund, PIMCO Income Strategy Fund, PCM Fund, Inc. and PIMCO Strategic Income Fund, Inc., each a closed-end fund for which the Investment Manager serves as investment manager (together, the “PIMCO Closed-End Funds”), as well as PIMCO Flexible Emerging Markets Income Fund, PIMCO California Flexible Municipal Income Fund, PIMCO Flexible Credit Income Fund and PIMCO Flexible Municipal Income Fund, each a closed-end management investment company that is operated as an “interval fund” for which PIMCO serves as investment manager (the “PIMCO Interval Funds”), and PIMCO Managed Accounts Trust (“PMAT”), an open-end investment management company with multiple series for which PIMCO serves as investment adviser and administrator (together with the PIMCO Closed- End Funds, and the PIMCO Interval Funds, the “PIMCO-Managed Funds”).
Effective January 1, 2024, each Independent Trustee receives annual compensation of $275,000 for his or her service on the Boards of the PIMCO-Managed Funds, payable quarterly; the Independent Chair of the Boards receives an additional $100,000 per year, payable quarterly; the Audit Oversight Committee Chair receives an additional $35,000 annually, payable quarterly; the Performance Committee Chair receives an additional $15,000 annually, payable quarterly; the Valuation Oversight Committee Chair receives an additional $10,000 annually, payable quarterly; and the Contracts Committee Chair receives an additional $30,000 annually, payable quarterly. Trustees are also reimbursed for meeting related expenses.
Each Trustee’s compensation for his or her service as a Trustee on the Boards of the PIMCO-Managed Funds and other costs in connection with meetings of such Funds are allocated among the PIMCO-Managed Funds, as applicable, on the basis of fixed percentages as among PMAT, the PIMCO Interval Funds and the PIMCO Closed-End Funds. Trustee compensation and other costs are then further allocated pro rata among the individual funds within each grouping based on each such fund’s relative net assets.
The Fund has no employees. The Fund’s officers and Interested Trustees (Mr. Fisher and Ms. Cantrill) are compensated by PIMCO or its affiliates, as applicable.
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The Trustees do not currently receive any pension or retirement benefits from the Fund or the Fund Complex (see below).
The following table sets forth information regarding the compensation received by the Independent Trustees for the fiscal year ended June 30, 2023. For serving as trustees of the Fund and other funds in the same Fund Complex as the Fund. Each officer and each Trustee who is a director, officer, partner, member or employee of the Investment Manager, or of any entity controlling, controlled by or under common control with the Investment Manager, including any Interested Trustee, serves without any compensation from the Fund.
| Name of Trustee(1) |
Aggregate Compensation from the Fund for the Fiscal Year Ended June 30, 2023 |
Pension or Retirement Benefits Accrued as Part of Fund Expenses |
Estimated Annual Benefits Upon Retirement |
Total Compensation from the Fund Complex Paid to the Trustees for the Calendar Year Ending December 31, 2023 |
| Sarah E. Cogan |
$8,406 |
N/A |
N/A |
$275,000 |
| Deborah A. DeCotis |
$9,935 |
N/A |
N/A |
$325,000 |
| Joseph B. Kittredge, Jr. |
$8,712 |
N/A |
N/A |
$285,000 |
| Kathleen A. McCartney |
$7,642 |
N/A |
N/A |
$250,000 |
| Alan Rappaport |
$7,948 |
N/A |
N/A |
$260,000 |
| E. Grace Vandecruze |
$7,795 |
N/A |
N/A |
$260,000 |
(1)
Ms. Cantrill and Mr. Fisher are interested Persons of the Fund and do not receive compensation from the Fund for their services as Trustees. Mr. Maney retired from the Board as of April 30, 2023. Mr. Maney was an interested person of the Fund and did not receive compensation from the Fund for his services as a Trustee.
Codes of Ethics
The Fund and PIMCO have each adopted a code of ethics under Rule 17j-1 of the 1940 Act. These codes permit personnel subject to the codes to invest in securities, including securities that may be purchased or held by the Fund. The codes of ethics are available on the EDGAR Database on the SEC’s Internet site at http://www.sec.gov, and copies may be obtained, after paying a duplicating fee, by electronic request at the following email address: publicinfo@sec.gov.
Investment Manager
Investment Manager
PIMCO, a Delaware limited liability company, serves as investment manager to the Fund pursuant to an investment management agreement (the “Investment Management Agreement”) between PIMCO and the Fund. PIMCO is located at 650 Newport Center Drive, Newport Beach, California 92660. As of December 31, 2023, PIMCO had approximately $1.86 trillion in assets under management and $1.46 trillion in third party assets under management.
PIMCO is a majority owned subsidiary of Allianz Asset Management of America LLC (“Allianz Asset Management”) with a minority interest held by Allianz Asset Management U.S. Holding II LLC, a Delaware limited liability company, and by certain current and former officers of PIMCO. Allianz Asset Management was organized as a limited partnership under Delaware law in 2000. Allianz Asset Management of America LP merged with Allianz Asset Management, with the latter being the surviving entity, effective January 1, 2023. Following the merger, Allianz Asset Management is PIMCO LLC's managing member and direct parent entity. Through various holding company structures, Allianz Asset Management is majority owned by Allianz SE. Allianz SE is a European based, multinational insurance and financial services holding company and a publicly traded German company.
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The general partner of Allianz Asset Management has substantially delegated its management and control of Allianz Asset Management to a Management Board. The Management Board of Allianz Asset Management is comprised of Tucker J. Fitzpatrick.
As of the date of this Statement of Additional Information, there are no significant institutional shareholders of Allianz SE. Absent an SEC exemption or other regulatory relief, the Fund generally is precluded from effecting principal transactions with brokers that are deemed to be affiliated persons of the Fund or PIMCO, and the Fund’s ability to purchase securities being underwritten by an affiliated broker or a syndicate including an affiliated broker is subject to restrictions. Similarly, the Fund’s ability to utilize the affiliated brokers for agency transactions is subject to the restrictions of Rule 17e-1 under the 1940 Act. PIMCO does not believe that the restrictions on transactions with the affiliated brokers described above will materially adversely affect its ability to provide services to the Fund, the Fund’s ability to take advantage of market opportunities, or the Fund’s overall performance.
Investment Management Agreement
Pursuant to an investment management agreement between PIMCO and the Fund (the “Investment Management Agreement”), the Fund has agreed to pay PIMCO an annual fee, payable monthly, in an amount equal to 0.830% of the average weekly total managed assets of the Fund (“Total managed assets” includes the total assets of the Fund (including any assets attributable to any preferred shares or other forms of leverage that may be outstanding)). For purposes of calculating average weekly total managed assets, the Fund’s derivative instruments will be valued based on their market value.
Pursuant to the Investment Management Agreement, PIMCO shall provide to the Fund investment guidance and policy direction in connection with the management of the Fund, including oral and written research, analysis, advice and statistical and economic data and information. In addition, under the terms of the Investment Management Agreement, subject to the general supervision of the Board of Trustees, PIMCO shall provide or cause to be furnished all supervisory and administrative and other services reasonably necessary for the operation of the Fund under what is essentially an all-in fee structure, including but not limited to the supervision and coordination of matters relating to the operation of the Fund, including any necessary coordination among the custodian, transfer agent, dividend disbursing agent, and recordkeeping agent (including pricing and valuation of the Fund), accountants, attorneys, auction agents and other parties performing services or operational functions for the Fund; the provision of adequate personnel, office space, communications facilities, and other facilities necessary for the effective supervision and administration of the Fund, as well as the services of a sufficient number of persons competent to perform such supervisory and administrative and clerical functions as are necessary for compliance with federal securities laws and other applicable laws; the maintenance of the books and records of the Fund; the preparation of all federal, state, local and foreign tax returns and reports for the Fund; the provision of administrative services to shareholders for the Fund including the maintenance of a shareholder information telephone number, the provision of certain statistical information and performance of the Fund, an internet website (if requested), and maintenance of privacy protection systems and procedures; the preparation and filing of such registration statements and other documents with such authorities as may be required to register and maintain the listing of the shares of the Fund; the taking of other such actions as may be required by applicable law (including establishment and maintenance of a compliance program for the Fund); and the preparation, filing and distribution of proxy materials, periodic reports to shareholders and other regulatory filings.
PIMCO may in-source or outsource certain processes or functions in connection with the supervisory and administrative services it provides without notice to investors. Depending upon the nature of the services and subject to applicable law, agreements and the Fund’s governing documents, fees associated with in-sourced or outsourced services will be borne by the Fund or PIMCO. In addition, PIMCO, and not the Fund, could benefit from certain fee reduction arrangements under certain such agreements.
In addition, under the Investment Management Agreement, PIMCO will procure, at its own expense, the following services, and will bear expenses associated with the following for the Fund: a custodian or custodians for the Fund to provide for the safekeeping of the Fund’s assets; a recordkeeping agent to maintain the portfolio accounting records for the Fund; a transfer agent for the Fund; a dividend disbursing agent and/or registrar for the Fund; all audits by the Fund’s independent public accountant (except fees to auditors associated with satisfying rating agency requirements for preferred shares or other securities issued by the Fund and other related requirements in the Fund’s organizational documents); valuation services; maintaining the Fund’s tax records; all costs and/or fees incident to
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meetings of the Fund’s shareholders, the preparation, printing and mailing of the Fund’s prospectuses (although the Fund will bear such expenses in connection with the offerings made pursuant to the Prospectus as noted below), notices and proxy statements, press releases and reports to its Shareholders, the filing of reports with regulatory bodies, the maintenance of the Fund’s existence and qualification to do business, the expense of issuing, redeeming, registering and qualifying for sale, common shares with the federal and state securities authorities, and the expense of qualifying and listing Shares with any securities exchange or other trading system; legal services (except for extraordinary legal expenses); costs of printing certificates representing Shares of the Fund; the Fund’s pro rata portion of its fidelity bond and other insurance premiums; and association membership dues.
The Fund (and not PIMCO) will be responsible for certain fees and expenses that are not covered by the unified fee under the Investment Management Agreement. These include fees and expenses, including travel expenses, and fees and expenses of legal counsel retained for their benefit, of Trustees who are not officers, employees, partners, shareholders or members of PIMCO or its subsidiaries or affiliates; the salaries and other compensation or expenses, including travel expenses, of the Fund’s executive officers and employees, if any, who are not officers, directors, shareholders, members, partners or employees of PIMCO or its subsidiaries or affiliates; taxes and governmental fees, if any, levied against the Fund; brokerage fees and commissions, and other portfolio transaction expenses incurred by or for the Fund (including, without limitation, fees and expenses of outside legal counsel or third-party consultants retained in connection with reviewing, negotiating and structuring specialized loan and other investments made by the Fund, subject to specific or general authorization by the Board (for example, so-called “broken-deal costs” (e.g., fees, costs, expenses and liabilities, including, for example, due diligence-related fees, costs, expenses and liabilities, with respect to unconsummated investments))); expenses of the Fund’s securities lending (if any), including any securities lending agent fees, as governed by a separate securities lending agreement; costs, including interest expenses, of borrowing money or engaging in other types of leverage financing, including, without limitation, through the use by the Fund of reverse repurchase agreements, tender option bonds, bank borrowings and credit facilities; costs, including dividend cost and/or interest expenses and other costs (including, without limitation, offering and related legal costs, fees to brokers, fees to auction agents, fees to transfer agents, fees to ratings agencies and fees to auditors associated with satisfying ratings agency requirements for preferred shares or other securities issued by the Fund and other related requirements in the Fund’s organizational documents) associated with the Fund’s issuance, offering, redemption and maintenance of preferred shares, commercial paper or other senior securities for the purpose of incurring leverage; fees and expenses of any underlying funds or other pooled vehicles in which the Fund invests; dividend and interest expenses on short positions taken by the Fund; organizational and offering expenses of the Fund, including with respect to share offerings following the Fund’s initial offering, such as rights and shelf offerings (including expenses associated with offerings made pursuant to the Prospectus), and expenses associated with tender offers and other share repurchases and redemptions; extraordinary expenses including extraordinary legal expenses as may arise, including expenses incurred in connection with litigation, proceedings, other claims, and the legal obligations of the Fund to indemnify its Trustees, officers, employees, shareholders, distributors, and agents with respect thereto; and expenses of the Fund which are capitalized in accordance with generally accepted accounting principles.
Because the fees received by the Investment Manager are based on the average weekly total managed assets of the Fund (“total managed assets” includes the total assets of the Fund (including any assets attributable to any preferred shares or other forms of leverage that may be outstanding)), the Investment Manager has a financial incentive for the Fund to maintain and utilize preferred shares and other forms of leverage which may create a conflict of interest between the Investment Manager, on the one hand, and the holders of the Fund’s Common Shares, on the other hand.
A discussion regarding the basis for the Board’s most recent continuation of the Investment Management Agreement is available in the Fund’s annual report to shareholders for the fiscal year ended June 30, 2023. Pursuant to the Investment Management Agreement, the Fund paid the Investment Manager the following amounts for the fiscal year ended June 30, 2023, period ended June 30, 2022 and fiscal year ended July 31, 2021:
| Fiscal Year |
Management Fee Paid by Fund (in thousands) |
| June 30, 2023 |
$6,715 |
| August 1, 2021 – June 30, 2022 |
$7,823 |
| July 31, 2021 |
$8,503 |
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PIMCO expects to earn a profit on the management fee paid by the Fund. Also, under the terms of the Investment Management Agreement, PIMCO, and not Common Shareholders, would benefit from any price decreases in third-party services, including decreases resulting from an increase in net assets.
In rendering investment advisory services to the Fund, PIMCO may use the resources of one or more foreign (non-U.S.) affiliates that are not registered under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) (the “PIMCO Overseas Affiliates”), to provide portfolio management, research and trading services to the Fund under the Memorandums of Understanding (“MOUs”). Each of the PIMCO Overseas Affiliates are Participating Affiliates of PIMCO as that term is used in relief granted by the staff of the SEC allowing U.S. registered advisers to use investment advisory and trading resources of unregistered advisory affiliates subject to the regulatory supervision of the registered adviser. Each PIMCO Overseas Affiliate and any of their respective employees who provide services to the Funds are considered under the MOUs to be “associated persons” of PIMCO as that term is defined in the Advisers Act for purposes of PIMCO’s required supervision.
Certain Terms of the Investment Management Agreement
The Investment Management Agreement was approved by the Trustees of the Fund (including all of the Trustees who are not “interested persons” of the Investment Manager). By its terms the Investment Management Agreement continues in force with respect to the Fund for an initial one year period, and continues in force from year to year thereafter, but only so long as its continuance is approved at least annually by (i) vote, cast in person at a meeting called for that purpose, of a majority of those Trustees who are not “interested persons” of the Investment Manager or the Fund, and (ii) by the full Board of Trustees or the vote of a majority of the outstanding shares of all classes of the Fund. The Investment Management Agreement automatically terminates on assignment. The Investment Management Agreement may be terminated on not less than 60 days’ notice by the Investment Manager to the Fund or by the Fund to the Investment Manager.
The Investment Management Agreement provides that the Investment Manager shall not be subject to any liability in connection with the performance of its services thereunder in the absence of willful misfeasance, bad faith, gross negligence or reckless disregard of its obligations and duties.
Portfolio Managers
Other Accounts Managed. Alfred T. Murata, Mohit Mittal and Giang Bui, the portfolio managers who are jointly and primarily responsible for the day-to-day management of the Fund, also manage other registered investment companies, other pooled investment vehicles and other accounts, as indicated in the table below. The following table identifies, as of December 31, 2023 for Messrs. Murata and Mittal and Ms. Bui: (i) the number of other registered investment companies, pooled investment vehicles and other accounts managed by the portfolio manager (exclusive of the Fund); and (ii) the total assets of such other companies, vehicles and accounts, and the number and total assets of such other companies, vehicles and accounts with respect to which the advisory fee is based on performance. The information includes amounts managed by a team, committee or other group that includes the portfolio managers.
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| Portfolio Manager |
Total Number of Other Accounts |
Total Assets of All Other Accounts (in $ Millions) |
Number of Other Accounts Paying a Performance Fee |
Total Assets of Other Accounts Paying a Performance Fee (in $ Millions) |
| Registered Investment Companies |
30 |
30 |
$98,297.68 |
0 |
| Other Pooled Investment |
26 |
25 |
$37,472.56 |
4 |
| Vehicles Other Accounts |
157 |
153 |
$89,251.11 |
10 |
| Giang Bui |
|
|
|
|
| Registered Investment Companies |
7 |
$4,693.73 |
0 |
$0.00 |
| Other Pooled Investment |
3 |
$7,190.21 |
2 |
$6,783.38 |
| Vehicles Other Accounts |
1 |
$466.66 |
0 |
$0.00 |
Conflicts of Interest
From time to time, potential and actual conflicts of interest may arise between a portfolio manager’s management of the investments of the Fund, on the one hand, and the management of other accounts, on the other. Potential and actual conflicts of interest may also arise as a result of PIMCO’s other business activities and PIMCO’s possession of material non-public information (“MNPI”) about an issuer. Other accounts managed by a portfolio manager might have similar investment objectives or strategies as the Fund, track the same index the Fund tracks or otherwise hold, purchase, or sell securities that are eligible to be held, purchased or sold by the Fund. The other accounts might also have different investment objectives or strategies than the Fund. Investors should be aware that investments made by the Fund and the results achieved by the Fund at any given time, including for the same or similar instruments, are not expected to be the same as those made by other funds for which PIMCO acts as investment adviser, including funds with names, investment objectives and policies, and/or portfolio management teams, similar to the Fund. This may be attributable to a wide variety of factors, including, but not limited to, the use of a different strategy or portfolio management team, the execution venue(s) used for a given strategy or fund, when a particular fund commenced operations or the size of a particular fund, in each case as compared to other similar funds. Potential and actual conflicts of interest may also arise as a result of PIMCO serving as investment adviser to accounts that invest in the Fund or to accounts in which the Fund invests. In this case, such conflicts of interest could in theory give rise to incentives for PIMCO to, among other things, vote proxies, purchase or redeem shares of the underlying account, or take other actions with respect to the underlying account, in a manner beneficial to the investing account and/or PIMCO but detrimental to the underlying account. Such conflicts of interest could similarly in theory give rise to incentives for PIMCO to, among other things, vote proxies or purchase or redeem shares of the underlying account, or take other actions with respect to the underlying account, in a manner beneficial to the underlying account and/or PIMCO and that may or may not be detrimental to the investing account. For example, even if there is a fee waiver or reimbursement in place relating to the Fund's investment in an underlying account, or relating to an investing account's investment in the Fund, this will not necessarily eliminate all conflicts of interest, as PIMCO could nevertheless have a financial incentive to favor investments in PIMCO-affiliated funds and managers (for example, to increase the assets under management of PIMCO or a fund, product or line of business, or otherwise provide support to, certain funds, products or lines of business), which could also impact the manner in which certain transaction fees are set. Conversely, PIMCO’s duties to the Fund, as well as regulatory or other limitations applicable to the Fund, may affect the courses of action available to PIMCO-advised accounts (including the Fund) that invest in the Fund in a manner that is detrimental to such investing accounts. In addition, regulatory restrictions, actual or potential conflicts of interest or other considerations may cause PIMCO to restrict or prohibit participation in certain investments.
Because PIMCO is affiliated with Allianz SE, a large multi-national financial institution (together with its affiliates, “Allianz”), conflicts similar to those described below may occur between the Fund or other accounts managed by PIMCO and PIMCO’s affiliates or accounts managed by those affiliates. Those affiliates (or their clients),
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which generally operate autonomously from PIMCO, may take actions that are adverse to the Fund or other accounts managed by PIMCO. In many cases, PIMCO will not be in a position to mitigate those actions or address those conflicts, which could adversely affect the performance of the Fund or other accounts managed by PIMCO (each, a “Client,” and collectively, the “Clients”). In addition, because certain Clients are affiliates of PIMCO or have investors who are affiliates or employees of PIMCO, PIMCO may have incentives to resolve conflicts of interest in favor of these Clients over other Clients.
Knowledge and Timing of Fund Trades. A potential conflict of interest may arise as a result of a portfolio manager’s day-to-day management of the Fund. Because of their positions with the Fund, the portfolio managers know the size, timing and possible market impact of the Fund’s trades. It is theoretically possible that the portfolio managers could use this information to the advantage of other accounts they manage and to the possible detriment of the Fund.
Cross Trades. A potential conflict of interest may arise in instances where the Fund buys an instrument from a Client or sells an instrument to a Client (each, a “cross trade”). Such conflicts of interest may arise, among other reasons, as a result of PIMCO representing the interests of both the buying party and the selling party in the cross trade or because the price at which the instrument is bought or sold through a cross trade may not be as favorable as the price that might have been obtained had the trade been executed in the open market. PIMCO effects cross trades when appropriate pursuant to procedures adopted under applicable rules and SEC guidance. Among other things, such procedures require that the cross trade is consistent with the respective investment policies and investment restrictions of both parties and is in the best interests of both the buying and selling accounts.
Selection of Service Providers. PIMCO, its affiliates and its employees may have relationships with service providers that recommend, or engage in transactions with or for, the Fund, and these relationships may influence PIMCO’s selection of these service providers for the Fund. Additionally, as a result of these relationships, service providers may have conflicts that create incentives for them to promote the Fund over other funds or financial products. In such circumstances, there is a conflict of interest between PIMCO and the Fund if the Fund determines not to engage or continue to engage these service providers.
Investment Opportunities. A potential conflict of interest may arise as a result of a portfolio manager’s management of a number of accounts with varying investment guidelines. Often, an investment opportunity may be suitable for one or more Clients, but may not be available in sufficient quantities for all accounts to participate fully. In addition, regulatory issues applicable to PIMCO or the Funds or other accounts may result in the Funds not receiving securities that may otherwise be appropriate for them. Similarly, there may be limited opportunity to sell an investment held by the Fund and another Client. In addition, regulatory issues applicable to PIMCO or the Fund or other accounts may result in the Fund not receiving securities that may otherwise be appropriate for it. Similarly, there may be limited opportunity to sell an investment held by the Fund and another Client. PIMCO has adopted policies and procedures reasonably designed to allocate investment opportunities on a fair and equitable basis over time. In addition, regulatory issues applicable to PIMCO or one or more Clients may result in certain Clients not receiving securities that may otherwise be appropriate for them.
PIMCO seeks to allocate orders across eligible Client accounts with similar investment guidelines and investment styles fairly and equitably, taking into consideration relevant factors including, among others, applicable investment restrictions and guidelines, including regulatory restrictions; Client account-specific investment objectives, restrictions and other Client instructions, as applicable; risk tolerances; amounts of available cash; the need to rebalance a Client account’s portfolio (e.g., due to investor contributions and redemptions); whether the allocation would result in a Client account receiving a trivial amount or an amount below the established minimum quantity; regulatory requirements; the origin of the investment; the bases for an issuer’s allocation to PIMCO; and other Client account-specific factors. As part of PIMCO’s trade allocation process, portions of new fixed income investment opportunities are distributed among Client account categories where the relevant portfolio managers seek to participate in the investment. Those portions are then further allocated among the Client accounts within such categories pursuant to PIMCO’s trade allocation policy. Portfolio managers managing quantitative strategies and specialized accounts, such as those focused on international securities, mortgage-backed securities, bank loans, or other specialized asset classes, will likely receive an increased distribution of new fixed income investment opportunities where the investment involves a quantitative strategy or specialized asset class that matches the investment objective or focus of the Client account category. PIMCO seeks to allocate fixed income investments to Client accounts with the general purpose of maintaining consistent concentrations across similar accounts and achieving, as nearly as possible, portfolio characteristic parity among such accounts. Client accounts furthest from achieving portfolio characteristic parity
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typically receive priority in allocations. With respect to an order to buy or sell an equity security in the secondary market, PIMCO seeks to allocate the order across Client accounts with similar investment guidelines and investment styles fairly and equitably over time, taking into consideration the relevant factors discussed above.
Any particular allocation decision among Client accounts may be more or less advantageous to any one Client or group of Clients, and certain allocations will, to the extent consistent with PIMCO’s fiduciary obligations, deviate from a pro rata basis among Clients in order to address for example, differences in legal, tax, regulatory, risk management, concentration, exposure, Client guideline limitations and/or mandate or strategy considerations for the relevant Clients. PIMCO may determine that an investment opportunity or particular purchases or sales are appropriate for one or more Clients, but not appropriate for other Clients, or are appropriate or suitable for, or available to, Clients but in different sizes, terms, or timing than is appropriate or suitable for other Clients. For example, some Clients have higher risk tolerances than other Clients, such as private funds, which, in turn, allows PIMCO to allocate a wider variety and/or greater percentage of certain types of investments (which may or may not outperform other types of investments) to such Clients. Further, the respective risk tolerances of different types of Clients may change over time as market conditions change. Those Clients receiving an increased allocation as a result of the effect of their respective risk tolerance may be Clients that pay higher investment management fees or that pay incentive fees. In addition, certain Client account categories focusing on certain types of investments or asset classes will be given priority in new issue distribution and allocation with respect to the investments or asset classes that are the focus of their investment mandate. PIMCO may also take into account the bases for an issuer’s allocation to PIMCO, for example, by giving priority allocations to Client accounts holding existing positions in the issuer’s debt if the issuer’s allocation to PIMCO is based on such holdings. PIMCO also may determine not to allocate to or purchase or sell for certain Clients all investments for which all Clients may be eligible. Legal, contractual, or regulatory issues and/or related expenses applicable to PIMCO or one or more Clients may result in certain Clients not receiving securities that may otherwise be appropriate for them or may result in PIMCO selling securities out of Client accounts even if it might otherwise be beneficial to continue to hold them. Additional factors that are taken into account in the distribution and allocation of investment opportunities to Client accounts include, without limitation: ability to utilize leverage and risk tolerance of the Client account; the amount of discretion and trade authority given to PIMCO by the Client; availability of other similar investment opportunities; the Client account’s investment horizon and objectives; hedging, cash and liquidity needs of the portfolio; minimum increments and lot sizes; and underlying benchmark factors. Given all of the foregoing factors, the amount, timing, structuring, or terms of an investment by a Client, including the Fund, may differ from, and performance may be lower than, investments and performance of other Clients, including those that may provide greater fees or other compensation (including performance-based fees or allocations) to PIMCO. PIMCO has also adopted additional procedures to complement the general trade allocation policy that are designed to address potential conflicts of interest due to the side-by-side management of the Fund and certain pooled investment vehicles, including investment opportunity allocation issues.
From time to time, PIMCO may take an investment position or action for one or more Clients that may be different from, or inconsistent with, an action or position taken for one or more other Clients having similar or differing investment objectives. These positions and actions may adversely impact, or in some instances may benefit, one or more affected Clients (including Clients that are PIMCO affiliates) in which PIMCO has an interest, or which pays PIMCO higher fees or a performance fee. For example, a Client may buy a security and another Client may establish a short position in that same security. The subsequent short sale may result in a decrease in the price of the security that the other Client holds. Similarly, transactions or investments by one or more Clients may have the effect of diluting or otherwise disadvantaging the values, prices or investment strategies of another Client.
When PIMCO implements for one Client a portfolio decision or strategy ahead of, or contemporaneously with, similar portfolio decisions or strategies of another Client, market impact, liquidity constraints or other factors could result in one or more Clients receiving less favorable trading results, the costs of implementing such portfolio decisions or strategies could be increased or such Clients could otherwise be disadvantaged. On the other hand, potential conflicts may also arise because portfolio decisions regarding a Client may benefit other Clients. For example, the sale of a long position or establishment of a short position for a Client may decrease the price of the same security sold short by (and therefore benefit) other Clients, and the purchase of a security or covering of a short position in a security for a Client may increase the price of the same security held by (and therefore benefit) other Clients.
Under certain circumstances, a Client may invest in a transaction in which one or more other Clients are expected to participate, or already have made or will seek to make, an investment. In addition, to the extent permitted by
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applicable law, a Client may also engage in investment transactions that may result in other Clients being relieved of obligations, or that may cause other Clients to divest certain investments (e.g., a Client may make a loan to, or directly or indirectly acquire securities or indebtedness of, a company that uses the proceeds to refinance or reorganize its capital structure, which could result in repayment of debt held by another Client). Such Clients (or groups of Clients) may have conflicting interests and objectives in connection with such investments, including with respect to views on the operations or activities of the issuer involved, the targeted returns from the investment and the timeframe for, and method of, exiting the investment. When making such investments, PIMCO may do so in a way that favors one Client over another Client, even if both Clients are investing in the same security at the same time. Certain Clients may invest on a “parallel” basis (i.e., proportionately in all transactions at substantially the same time and on substantially the same terms and conditions). In addition, other accounts may expect to invest in many of the same types of investments as another account. However, there may be investments in which one or more of such accounts does not invest (or invests on different terms or on a non-pro rata basis) due to factors such as legal, tax, regulatory, business, contractual or other similar considerations or due to the provisions of a Client’s governing documents. Decisions as to the allocation of investment opportunities among such Clients present numerous conflicts of interest, which may not be resolved in a manner that is favorable to a Client’s interests. To the extent an investment is not allocated pro rata among such entities, a Client could incur a disproportionate amount of income or loss related to such investment relative to such other Client.
In addition, Clients may invest alongside one another in the same underlying investments or otherwise pursuant to a substantially similar investment strategy as one or more other Clients. In such cases, certain Clients may have preferential liquidity and information rights relative to other Clients holding the same investments, with the result that such Clients will be able to withdraw/redeem their interests in underlying investments in priority to Clients who may have more limited access to information or more restrictive withdrawal/redemption rights. Clients with more limited information rights or more restrictive liquidity may therefore be adversely affected in the event of a downturn in the markets.
Further, potential conflicts may be inherent in PIMCO’s use of multiple strategies. For example, conflicts will arise in cases where different Clients invest in different parts of an issuer’s capital structure, including circumstances in which one or more Clients may own private securities or obligations of an issuer and other Clients may own or seek to acquire private securities of the same issuer. For example, a Client may acquire a loan, loan participation or a loan assignment of a particular borrower in which one or more other Clients have an equity investment, or may invest in senior debt obligations of an issuer for one Client and junior debt obligations or equity of the same issuer for another Client.
PIMCO may also, for example, direct a Client to invest in a tranche of a structured finance vehicle, such as a CLO or CDO, where PIMCO is also, at the same or different time, directing another Client to make investments in a different tranche of the same vehicle, which tranche’s interests may be adverse to other tranches. PIMCO may also cause a Client to purchase from, or sell assets to, an entity, such as a structured finance vehicle, in which other Clients may have an interest, potentially in a manner that will have an adverse effect on the other Clients. There may also be conflicts where, for example, a Client holds certain debt or equity securities of an issuer, and that same issuer has issued other debt, equity or other instruments that are owned by other Clients or by an entity, such as a structured finance vehicle, in which other Clients have an interest.
In each of the situations described above, PIMCO may take actions with respect to the assets held by one Client that are adverse to the other Clients, for example, by foreclosing on loans, by putting an issuer into default, or by exercising rights to purchase or sell to an issuer, causing an issuer to take actions adverse to certain classes of securities, or otherwise. In negotiating the terms and conditions of any such investments, or any subsequent amendments or waivers or taking any other actions, PIMCO may find that the interests of a Client and the interests of one or more other Clients could conflict. In these situations, decisions over items such as whether to make the investment or take an action, proxy voting, corporate reorganization, how to exit an investment, or bankruptcy or similar matters (including, for example, whether to trigger an event of default or the terms of any workout) may result in conflicts of interest. Similarly, if an issuer in which a Client and one or more other Clients directly or indirectly hold different classes of securities (or other assets, instruments or obligations issued by such issuer or underlying investments of such issuer) encounters financial problems, decisions over the terms of any workout will raise conflicts of interests (including, for example, conflicts over proposed waivers and amendments to debt covenants). For example, a debt holder may be better served by a liquidation of the issuer in which it may be paid in full, whereas an equity or junior bond holder might prefer a reorganization that holds the potential to create value for the equity holders. In some
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cases PIMCO may refrain from taking certain actions or making certain investments on behalf of Clients in order to avoid or mitigate certain conflicts of interest or to prevent adverse regulatory or other effects on PIMCO, or may sell investments for certain Clients (in each case potentially disadvantaging the Clients on whose behalf the actions are not taken, investments not made, or investments sold). In other cases, PIMCO may not refrain from taking actions or making investments on behalf of certain Clients that have the potential to disadvantage other Clients. In addition, PIMCO may take actions or refrain from taking actions in order to mitigate legal risks to PIMCO or its affiliates or its Clients even if disadvantageous to a Client’s account. Moreover, a Client may invest in a transaction in which one or more other Clients are expected to participate, or already have made or will seek to make, an investment.
Additionally, certain conflicts may exist with respect to portfolio managers who make investment decisions on behalf of several different types of Clients. Such portfolio managers may have an incentive to allocate trades, time or resources to certain Clients, including those Clients who pay higher investment management fees or that pay incentive fees or allocations, over other Clients. These conflicts may be heightened with respect to portfolio managers who are eligible to receive a performance allocation under certain circumstances as part of their compensation.
From time to time, PIMCO personnel may come into possession of MNPI which, if disclosed, might affect an investor’s decision to buy, sell or hold a security. Should a PIMCO employee come into possession of MNPI with respect to an issuer, he or she generally will be prohibited from communicating such information to, or using such information for the benefit of, Clients, which could limit the ability of Clients to buy, sell or hold certain investments, thereby limiting the investment opportunities or exit strategies available to Clients. In addition, holdings in the securities or other instruments of an issuer by PIMCO or its affiliates may affect the ability of a Client to make certain acquisitions of or enter into certain transactions with such issuer. PIMCO has no obligation or responsibility to disclose such information to, or use such information for the benefit of, any person (including Clients). Moreover, restrictions imposed by or through third-party automated trading platforms could affect a Client's ability to transact through, or the quality of execution achieved through, such platforms.
PIMCO maintains one or more restricted lists of companies whose securities are subject to certain trading prohibitions due to PIMCO’s business activities. PIMCO may restrict trading in an issuer’s securities if the issuer is on a restricted list or if PIMCO has MNPI about that issuer. In some situations, PIMCO may restrict Clients from trading in a particular issuer’s securities in order to allow PIMCO to receive MNPI on behalf of other Clients. A Client may be unable to buy or sell certain securities until the restriction is lifted, which could disadvantage the Client. PIMCO may also be restricted from making (or divesting of) investments in respect of some Clients but not others. In some cases PIMCO may not initiate or recommend certain types of transactions, or may otherwise restrict or limit its advice relating to certain securities if a security is restricted due to MNPI or if PIMCO is seeking to limit receipt of MNPI.
PIMCO may conduct litigation or engage in other legal actions on behalf of one or more Clients. In such cases, Clients may be required to bear certain fees, costs, expenses and liabilities associated with the litigation. Other Clients that are or were investors in, or otherwise involved with, the subject investments may or may not (depending on the circumstances) be parties to such litigation actions, with the result that certain Clients may participate in litigation actions in which not all Clients with similar investments may participate, and such non-participating Clients may benefit from the results of such litigation actions without bearing or otherwise being subject to the associated fees, costs, expenses and liabilities. PIMCO, for example, typically does not pursue legal claims on behalf of its separate accounts. Furthermore, in certain situations, litigation or other legal actions pursued by PIMCO on behalf of a Client may be brought against or be otherwise adverse to a portfolio company or other investment held by a Client.
Co-Investments. The 1940 Act imposes significant limits on co-investment with affiliates of the Fund. The Fund has received exemptive relief from the SEC that, to the extent the Fund relies on such relief, permits it to (among other things) co-invest with certain other persons, including certain affiliates of the Investment Manager and certain public or private funds managed by the Investment Manager and its affiliates, subject to certain terms and conditions. Co-investment transactions may give rise to conflicts of interest or perceived conflicts of interest among the Fund and its affiliates. The exemptive relief from the SEC with respect to co-investments imposes extensive conditions on any co-investments made in reliance on such relief that may limit or restrict the Fund’s ability to participate in an investment or participate in an investment to a lesser extent. An inability to receive the desired allocation to potential investments may affect the Fund’s ability to achieve the desired investment returns. In the event investment opportunities are allocated among the Fund and its affiliates pursuant to co-investment exemptive relief, the Fund may not be able to structure its investment portfolio in the manner desired. Although PIMCO will endeavor to allocate investment opportunities in a fair and equitable manner, the Fund will generally not be permitted to co-invest in any
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issuer in which a fund managed by PIMCO or any of its downstream affiliates (other than the Fund and its downstream affiliates) currently has an investment. However, the Fund would be able to co-invest with funds managed by PIMCO or any of its downstream affiliates, subject to compliance with existing regulatory guidance, applicable regulations and its allocation procedures. Pursuant to co-investment exemptive relief, the Fund will be able to invest in opportunities in which PIMCO and/or its affiliates has an investment, and PIMCO and/or its affiliates will be able to invest in opportunities in which the Fund has made an investment. From time to time, the Fund and its affiliates may make investments at different levels of an issuer’s capital structure or otherwise in different classes of an issuer’s securities. Such investments inherently give rise to conflicts of interest or perceived conflicts of interest between or among the various classes of securities that may be held by such entities. PIMCO has adopted procedures governing the co-investment in securities acquired in private placements with certain clients of PIMCO.
The foregoing is not a complete list of conflicts to which PIMCO or Clients may be subject. PIMCO seeks to review conflicts on a case-by-case basis as they arise. Any review will take into consideration the interests of the relevant Clients, the circumstances giving rise to the conflict, applicable PIMCO policies and procedures, and applicable laws. Clients (and investors in the Fund) should be aware that conflicts will not necessarily be resolved in favor of their interests and may in fact be resolved in a manner adverse to their interests. PIMCO will attempt to resolve such matters fairly, but even so, matters may be resolved in favor of other Clients which pay PIMCO higher fees or performance fees or in which PIMCO or its affiliates have a significant proprietary interest. Clients (and investors in the Fund) should also be aware that the Fund may experience losses associated with decisions or actions directly or indirectly attributable to PIMCO, and PIMCO may determine whether compensation to the Fund for such losses is appropriate in view of its standard of care. PIMCO will attempt to resolve such matters fairly subject to applicable PIMCO policies and procedures, and applicable laws, but even so, such matters may not be resolved in favor of Clients' (and Fund investors') interests and may in fact be resolved in a manner adverse to their interests. There can be no assurance that any actual or potential conflicts of interest will not result in a particular Client or group of Clients receiving less favorable investment terms in or returns from certain investments than if such conflicts of interest did not exist.
Conflicts like those described above may also occur between Clients, on the one hand, and PIMCO or its affiliates, on the other. These conflicts will not always be resolved in favor of the Client. In addition, because PIMCO is affiliated with Allianz, a large multi-national financial institution, conflicts similar to those described above may occur between clients of PIMCO and PIMCO’s affiliates or accounts managed by those affiliates. Those affiliates (or their clients), which generally operate autonomously from PIMCO, may take actions that are adverse to PIMCO’s Clients. In many cases, PIMCO will have limited or no ability to mitigate those actions or address those conflicts, which could adversely affect Client performance. In addition, certain regulatory or internal restrictions may prohibit PIMCO from using certain brokers or investing in certain companies (even if such companies are not affiliated with Allianz) because of the applicability of certain laws and regulations or internal Allianz policies applicable to PIMCO, Allianz SE or their affiliates. An account’s willingness to negotiate terms or take actions with respect to an investment may also be, directly or indirectly, constrained or otherwise impacted to the extent Allianz SE, PIMCO, and/or their affiliates, directors, partners, managers, members, officers or personnel are also invested therein or otherwise have a connection to the subject investment (e.g., serving as a trustee or board member thereof).
Performance Fees. A portfolio manager may advise certain accounts with respect to which the advisory fee is based entirely or partially on performance. Performance fee arrangements may create a conflict of interest for the portfolio manager in that the portfolio manager may have an incentive to allocate the investment opportunities that he or she believes might be the most profitable to such other accounts instead of allocating them to the Fund. PIMCO has adopted policies and procedures reasonably designed to allocate investment opportunities between the Fund and such other accounts on a fair and equitable basis over time.
Certain service providers to the Fund are expected to be owned by or otherwise related to or affiliated with a Client, and in certain cases, such service providers are expected to be, or are owned by, employed by, or otherwise related to, PIMCO, Allianz SE, their affiliates and/or their respective employees, consultants and other personnel. PIMCO may, in its sole discretion, determine to provide, or engage or recommend an affiliate of PIMCO to provide, certain services to the Fund, instead of engaging or recommending one or more third parties to provide such services. Subject to the governance requirements of a particular fund and applicable law, PIMCO or its affiliates, as applicable, will receive compensation in connection with the provision of such services. As a result, PIMCO faces a conflict of interest when selecting or recommending service providers for the Fund. Fees paid to an affiliated service provider will be determined in PIMCO’s commercially reasonable discretion, taking into account the relevant facts and
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circumstances, and consistent with PIMCO’s responsibilities. Although PIMCO has adopted various policies and procedures intended to mitigate or otherwise manage conflicts of interest with respect to affiliated service providers, there can be no guarantee that such policies and procedures (which may be modified or terminated at any time in PIMCO’s sole discretion) will be successful.
Portfolio Manager Compensation
PIMCO’s and its affiliates’ approach to compensation seeks to provide professionals with a compensation process that is driven by values of collaboration, openness, responsibility and excellence.
Generally, compensation packages consist of three components. The compensation program for portfolio managers is designed to align with clients’ interests, emphasizing each portfolio manager’s ability to generate long-term investment success for clients, among other factors. A portfolio manager’s compensation is not based solely on the performance of the Fund or any other account managed by that portfolio manager:
Base Salary – Base salary is determined based on core job responsibilities, positions/levels and market factors. Base salary levels are reviewed annually, when there is a significant change in job responsibilities or position, or a significant change in market levels.
Variable Compensation – In addition to a base salary, portfolio managers have a variable component of their compensation, which is based on a combination of individual and company performance and includes both qualitative and quantitative factors. The following non-exhaustive list of qualitative and quantitative factors is considered when determining total compensation for portfolio managers:
•
Performance measured over a variety of longer- and shorter-term periods, including 5-year, 4-year, 3-year, 2-year and 1-year dollar-weighted and account-weighted, pre-tax total and risk-adjusted investment performance as judged against the applicable benchmarks (which may include internal investment performance-related benchmarks) for each account managed by a portfolio manager (including the Fund) and relative to applicable industry peer groups and;
•
Amount and nature of assets managed by the portfolio manager.
The variable compensation component of an employee’s compensation may include a deferred component. The deferred portion will generally be subject to vesting and may appreciate or depreciate based on the performance of PIMCO and/or its affiliates. PIMCO’s Long-Term Incentive Plan provides participants with deferred cash awards that appreciate or depreciate based on PIMCO’s operating earnings over a rolling three-year period.
Portfolio managers who are Managing Directors of PIMCO receive compensation from a non-qualified profit sharing plan consisting of a portion of PIMCO’s net profits. Portfolio managers who are Managing Directors receive an amount determined by the Compensation Committee, based upon an individual’s overall contribution to the firm.
Securities Ownership
To the best of the Fund’s knowledge, the table below shows the dollar range of shares of the Fund beneficially owned by Alfred T. Murata, Mohit Mittal and Giang Bui as of December 31, 2023.
| Name of Portfolio Manager |
Dollar Range of Equity Securities in the Fund |
| Alfred T. Murata |
None |
| Mohit Mittal |
None |
| Giang Bui |
None |
Proxy Voting Policies and Procedures
PIMCO has adopted written proxy voting policies and procedures (“Proxy Policy”) as required by Rule 206(4)-6 under the Investment Advisers Act of 1940, as amended. The Fund has adopted the Proxy Policy of PIMCO when voting proxies on its behalf.
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Policy Statement: The Proxy Policy is intended to foster PIMCO’s compliance with its fiduciary obligations and applicable law; the policy applies to any voting or consent rights with respect to securities held in accounts over which PIMCO has discretionary voting authority. The Proxy Policy is designed in a manner reasonably expected to ensure that voting and consent rights are exercised in the best interests of PIMCO’s clients.
Overview: PIMCO has adopted a written Proxy Policy as required by Rule 206(4)-6 under the Advisers Act. Proxies generally describe corporate action-consent rights (relative to fixed-income securities) and proxy voting ballots (relative to fixed-income or equity securities) as determined by the issuer or custodian. As a general matter, when PIMCO has proxy voting authority, PIMCO has a fiduciary obligation to monitor corporate events and to take appropriate action on client proxies that come to its attention. Each proxy is voted on a case-by-case basis, taking into account relevant facts and circumstances. When considering client proxies, PIMCO may determine not to vote a proxy in limited circumstances.
Equity Securities. The term “equity securities” means common and preferred stock, including common and preferred shares issued by investment companies; it does not include debt securities convertible into equity securities. PIMCO has retained an Industry Service Provider (“ISP”) to provide research and voting recommendations for proxies relating to equity securities in accordance with the ISP’s guidelines. By following the guidelines of an independent third party, PIMCO seeks to mitigate potential conflicts of interest PIMCO may have with respect to proxies covered by the ISP. PIMCO will follow the recommendations of the ISP unless: (i) the ISP does not provide a voting recommendation; or (ii) a portfolio manager or analyst decides to override the ISP’s voting recommendation. In either such case as described above, the Legal and Compliance department will review the proxy to determine whether an actual or potential conflict of interest exists. When the ISP does not provide a voting recommendation, the relevant portfolio manager or analyst will make a determination regarding how, or if, the proxy will be voted by completing required documentation.
Fixed Income Securities. Fixed-income securities can be processed as proxy ballots or corporate action-consents at the discretion of the issuer/custodian. Voting or consent rights shall not include matters which are primarily decisions to buy or sell investments, such as tender offers, exchange offers, conversions, put options, redemptions, and Dutch auctions. When processed as proxy ballots, the ISP generally does not provide a voting recommendation and their role is limited to election processing and recordkeeping. In such instances, any elections would follow the standard process discussed above for equity securities. When processed as corporate action-consents, the Legal and Compliance department will review all election forms to determine whether an actual or potential conflict of interest exists with respect to the portfolio manager’s or analyst’s consent election. PIMCO’s Credit Research and Portfolio Management Groups are responsible for issuing recommendations on how to vote proxy ballots and corporation action-consents with respect to fixed income securities.
Resolution of Potential and Identified Conflicts of Interest. The Proxy Policy permits PIMCO to seek to resolve material conflicts of interest by pursuing any one of several courses of action. With respect to material conflicts of interest between PIMCO and a client account, the Proxy Policy permits PIMCO to either: (i) convene a working group to assess and resolve the conflict (the “Proxy Working Group”); or (ii) vote in accordance with protocols previously established by the Proxy Policy, the Proxy Working Group and/or other relevant procedures approved by PIMCO’s Legal and Compliance department or PIMCO’s Conflict Committee with respect to specific types of conflicts.
PIMCO will supervise and periodically review its proxy voting activities and the implementation of the Proxy Policy. PIMCO’s Proxy Policy, and information about how PIMCO voted a client’s proxies, is available upon request.
Sub-Adviser Engagement. As an investment manager, PIMCO may exercise its discretion to engage a Sub-Adviser to provide portfolio management services to certain Funds. Consistent with its management responsibilities, the Sub-Adviser will assume the authority for voting proxies on behalf of PIMCO for these Funds. Sub-Advisers may utilize third parties to perform certain services related to their portfolio management responsibilities. As a fiduciary, PIMCO will maintain oversight of the investment management responsibilities performed by the Sub-Adviser and contracted third parties.
Information about how PIMCO voted the Fund’s proxies for the most recent twelve month period ended June 30th (Form N-PX) will be available no later than the following August 31st, without charge, upon request, by calling the Fund at (844) 312-2113), on the Fund's website at www.pimco.com and on the SEC’s website at http://www.sec.gov.
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PORTFOLIO TRANSACTIONS AND BROKERAGE
Investment Decisions and Portfolio Transactions
Investment decisions for the Fund and for the other investment advisory clients of PIMCO are made with a view to achieving their respective investment objectives. Investment decisions are the product of many factors in addition to basic suitability for the particular client involved (including the Fund). Some securities considered for investments by the Fund also may be appropriate for other clients served by PIMCO. Thus, a particular security may be bought or sold for certain clients even though it could have been bought or sold for other clients at the same time, including accounts in which PIMCO, its affiliates and its employees may have a financial interest. If a purchase or sale of securities consistent with the investment policies of the Fund and one or more of these clients served by PIMCO is considered at or about the same time, transactions in such securities will be allocated among the Fund and other clients pursuant to PIMCO’s trade allocation policy, as applicable, that is designed to ensure that all accounts, including the Fund, are treated fairly, equitably, and in a non-preferential manner, such that allocations are not based upon fee structure or portfolio manager preference. PIMCO may acquire on behalf of its clients (including the Fund) securities or other financial instruments providing exposure to different aspects of the capital and debt structure of an issuer, including without limitation those that relate to senior and junior/subordinate obligations of such issuer. In certain circumstances, the interests of those clients exposed to one portion of the issuer’s capital and debt structure may diverge from those clients exposed to a different portion of the issuer’s capital and debt structure. PIMCO may advise some clients or take actions for them in their best interests with respect to their exposures to an issuer’s capital and debt structure that may diverge from the interests of other clients with different exposures to the same issuer’s capital and debt structure.
PIMCO may aggregate orders for the Fund with simultaneous transactions entered into on behalf of its other clients when, in its reasonable judgment, aggregation may result in an overall economic benefit to the Fund and the other clients in terms of pricing, brokerage commissions or other expenses. When feasible, PIMCO allocates trades prior to execution. When pre-execution allocation is not feasible, PIMCO promptly allocates trades following established and objective procedures. Allocations generally are made at or about the time of execution and before the end of the trading day. As a result, one account may receive a price for a particular transaction that is different from the price received by another account for a similar transaction on the same day. In general, trades are allocated among portfolio managers on a pro rata basis (to the extent a portfolio manager decides to participate fully in the trade), for further allocation by each portfolio manager among that manager’s eligible accounts. In allocating trades among accounts, portfolio managers generally consider a number of factors, including, but not limited to, each account’s deviation (in terms of risk exposure and/or performance characteristics) from a relevant model portfolio, each account’s investment objectives, restrictions and guidelines, its risk exposure, its available cash, and its existing holdings of similar securities. Once trades are allocated, they may be reallocated only in unusual circumstances due to recognition of specific account restrictions. In some cases, PIMCO may sell a security on behalf of a client, including the Fund, to a broker-dealer that thereafter may be purchased for the accounts of one or more other clients, including the Fund, from that or another broker-dealer. PIMCO has adopted procedures it believes are reasonably designed to obtain the best execution for the transactions by each account.
Where applicable, PIMCO considers relevant ESG factors in its investment research process with the goal of enhancing risk-adjusted returns. Integrating relevant factors into the evaluation process does not mean that ESG related information is the sole or primary consideration for an investment decision. PIMCO's portfolio managers and analyst teams consider a variety of factors including the materiality of those factors to make investment decisions. Where material, ESG factors can be important considerations when evaluating long-term investment opportunities and risks for asset classes, where applicable. The materiality of ESG considerations to investment decisions typically varies across asset classes, strategies, products and valuations.
Brokerage and Research Services
There is generally no stated commission in the case of fixed income securities, which are often traded in the OTC markets, but the price paid by the Fund usually includes an undisclosed dealer commission or mark-up. In underwritten offerings, the price paid by the Fund includes a disclosed, fixed commission or discount retained by the underwriter or dealer. Transactions on U.S. stock exchanges and other agency transactions involve the payment by the Fund of negotiated brokerage commissions. Such commissions vary among different brokers. Also, a particular broker may charge different commissions according to such factors as the difficulty and size of the transaction. Transactions in foreign securities generally involve the payment of fixed brokerage commissions, which are generally higher than
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those in the United States. Transactions in fixed income securities on certain foreign exchanges may involve commission payments.
PIMCO places all orders for the purchase and sale of portfolio securities, options, futures contracts, swap agreements and other instruments for the Fund and buys and sells such securities, options, futures, swap agreements and other instruments for the Fund through a substantial number of brokers and dealers, as well as automated trading platforms (“ATPs”). In so doing, PIMCO uses its best efforts to obtain for the Fund the best execution available, except to the extent it may be permitted to pay higher brokerage commissions as described below. In seeking best execution, PIMCO, having in mind the Fund’s best interests, considers all factors it deems relevant, including, by way of illustration, price, the size of the transaction, the nature of the market for the security, the amount of the commission, the timing of the transaction taking into account market prices and trends, the reputation, experience and financial stability of the broker-dealer (or ATP) involved and the quality of service rendered by the broker-dealer (or ATP) in other transactions. ATPs may charge fees, such as access or transaction fees, similar to commissions or mark-ups. Changes in the aggregate amount of brokerage commissions paid by the Fund from year-to-year may be attributable to changes in the asset size of the Fund, the volume of the portfolio transactions effected by the Fund, the types of instruments in which the Fund invests, or the rates negotiated by PIMCO on behalf of the Fund. Although the Fund may use financial firms that sell Fund shares to effect transactions for the Fund's portfolio, neither the Fund nor PIMCO will consider the sale of Fund shares as a factor when choosing financial firms to effect those transactions.
The Fund paid $2,256, $420 and $4,335 in brokerage commissions during the fiscal year ended June 30, 2023, period from August 1, 2021 to June 30, 2022 and fiscal year ended July 31, 2021, respectively.
PIMCO places orders for the purchase and sale of portfolio investments for the Fund’s account with brokers or dealers or ATPs selected by it in its discretion. In effecting purchases and sales of portfolio securities for the account of the Fund, PIMCO will seek the best price and execution of the Fund’s orders. In doing so, the Fund may pay higher commission rates than the lowest available when PIMCO believes it is reasonable to do so in light of the value of the brokerage and research services provided by the broker effecting the transaction, as discussed below.
It has for many years been a common practice in the investment advisory business for advisers of investment companies and other institutional investors to receive research and brokerage products and services (together, “services”) from broker-dealers that execute portfolio transactions for the clients of such advisers. Consistent with this practice, PIMCO may receive research services from many broker-dealers with which PIMCO places the Fund’s portfolio transactions. PIMCO also may receive research or research related credits from brokers that are generated from underwriting commissions when purchasing new issues of fixed income securities or other assets for the Fund. These services, which in some cases may also be purchased for cash, include such matters as general economic and security market reviews, industry and company reviews, evaluations of securities and recommendations as to the purchase and sale of securities and services related to the execution of securities transactions. Some of these services are of value to PIMCO in advising various of its clients (including the Fund), although not all of these services are necessarily useful and of value in managing the Fund. Conversely, research and brokerage services provided to the Fund by broker-dealers in connection with trades executed on behalf of other clients of PIMCO may be useful to PIMCO in managing the Fund, although not all of these services may be necessarily useful and of value to PIMCO in managing such other clients.
In reliance on the “safe harbor” provided by Section 28(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), PIMCO may cause the Fund to pay broker-dealers which provide them with “brokerage and research services” (as defined in the Exchange Act) an amount of commission for effecting a securities transaction for the Fund in excess of the commission which another broker-dealer would have charged for effecting that transaction if PIMCO determines in good faith that the commission is reasonable in relation to the value of the brokerage and research services provided by the broker-dealer viewed in terms of either a particular transaction or PIMCO’s overall responsibilities to the advisory accounts for which PIMCO exercises investment discretion.
PIMCO may place orders for the purchase and sale of exchanged-listed portfolio securities with a broker-dealer that is an affiliate of PIMCO where, in the judgment of PIMCO, such firm will be able to obtain a price and execution at least as favorable as other qualified broker-dealers.
Pursuant to rules of the SEC, a broker-dealer that is an affiliate of PIMCO may receive and retain compensation for effecting portfolio transactions for the Fund on a national securities exchange of which the broker-dealer is a
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member if the transaction is “executed” on the floor of the exchange by another broker which is not an “associated person” of the affiliated broker-dealer, and if there is in effect a written contract between PIMCO and the Fund expressly permitting the affiliated broker-dealer to receive and retain such compensation.
SEC rules further require that commissions paid to such an affiliated broker dealer, or PIMCO by the Fund on exchange transactions not exceed “usual and customary brokerage commissions.” The rules define “usual and customary” commissions to include amounts which are “reasonable and fair compared to the commission, fee or other remuneration received or to be received by other brokers in connection with comparable transactions involving similar securities being purchased or sold on a securities exchange during a comparable period of time.”
The Fund did not pay any commissions to affiliated brokers during the fiscal year ended June 30, 2023, period from August 1, 2021 to June 30, 2022 and fiscal year ended July 31, 2021.
Holdings of Securities of the Fund’s Regular Brokers and Dealers
The following table lists the regular brokers or dealers of the Fund whose securities the Fund acquired during the fiscal year ended June 30, 2023, as well as the Fund’s holdings in such brokers or dealers as of June 30, 2023.
| Broker or Dealer |
Value of Securities Held by the Fund as of June 30, 2023 ($000) |
| Nomura Securities International Inc. |
$30,503 |
| JPMorgan Chase & Co. |
16,261 |
| Credit Suisse (USA), Inc. |
12,895 |
| Banc of America Securities LLC |
8,939 |
| Citigroup Global Markets, Inc. |
5,762 |
| Goldman Sachs & Co. |
3,510 |
| Barclays, Inc. |
2,470 |
| Morgan Stanley & Co., Inc. |
2,469 |
| Deutsche Bank Securities, Inc. |
633 |
| SG AMERICAS SECURITIES |
509 |
| HSBC Securities (USA), Inc. |
410 |
| State Street Bank & Trust Co. |
366 |
| BNP Paribas Securities Corp. |
100 |
DISTRIBUTIONS
See “Distributions” in the Prospectus for information relating to distributions to Fund shareholders.
For U.S. federal income tax purposes, the Fund is currently required to allocate each type of its income (such as ordinary income and net capital gain), if any, between and among Common Shares and each series of Preferred Shares in proportion to total distributions paid to each class for the tax year. While any Preferred Shares are outstanding, the Fund may not declare any cash dividend or other distribution on its Common Shares unless: (i) immediately after such transaction, the Fund would satisfy Moody’s Ratings Agency Preferred Shares Asset Coverage, Fitch Preferred Shares Asset Coverage and 1940 Act Preferred Shares Asset Coverage would be satisfied (each as defined and described under “Description of Capital Structure – Rating Agency Guidelines and Asset Coverage” in the Prospectus); (ii) full cumulative dividends on the Preferred Shares due on or prior to the date of the transaction have been declared and paid or shall have been declared and sufficient funds for the payment thereof deposited with the auction agent for the Preferred Shares; and (iii) the Fund has redeemed the full number of Preferred Shares required to be redeemed by any provision for mandatory redemption contained in the Bylaws. See “Preferred Shares Redemption.” This latter limitation on the Fund’s ability to make distributions on its Common Shares could cause the Fund to incur income and excise tax and, under certain circumstances, impair the ability of the Fund to maintain its qualification for taxation as a regulated investment company. See “Taxation.”
The Board of Trustees has declared a dividend of $0.071800 per Common Share payable on April 1, 2024.
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DESCRIPTION OF SHARES
Common Shares
The Fund's Declaration authorizes the issuance of an unlimited number of Common Shares. The Common Shares currently outstanding have been issued with a par value of $0.00001 per share.
All Common Shares of the Fund have equal rights as to the payment of dividends and the distribution of assets upon liquidation of the Fund. The Common Shares currently outstanding have been fully paid and, subject to matters discussed in “Anti-Takeover and Other Provisions in the Declaration of Trust-Shareholder Liability” below, are non-assessable, and have no pre-emptive or conversion rights or rights to cumulative voting. At any time when the Fund’s ARPS are outstanding, Common Shareholders will not be entitled to receive any distributions from the Fund unless all accrued dividends on ARPS have been paid, and unless asset coverage (as defined in the 1940 Act) with respect to ARPS would be at least 200% after giving effect to such distributions. See “Description of Capital Structure” in the Prospectus.
The Common Shares are listed on the NYSE under the trading or “ticker” symbol “PFN”. The Fund intends to hold annual meetings of shareholders so long as the Common Shares are listed on a national securities exchange and such meetings are required as a condition to such listing.
Shares of closed-end investment companies may frequently trade at prices lower than net asset value, although they have during some periods traded at prices equal to or higher than net asset value and during other periods traded at prices lower than net asset value. There can be no assurance that Common Shares or shares of other similar funds will trade at a price higher than net asset value in the future. Net asset value will be reduced immediately following any offering of ARPS by the costs of that offering paid by the Fund. Net asset value generally increases when interest rates decline, and decreases when interest rates rise, and these changes are likely to be greater in the case of a fund, such as the Fund, having a leveraged capital structure. Whether investors realize gains or losses upon the sale of Common Shares will not depend upon the Fund’s net asset value but will depend entirely upon whether the market price of the Common Shares at the time of sale is above or below the original purchase price for the shares. Since the market price of the Fund’s Common Shares will be determined by factors beyond the control of the Fund, the Fund cannot predict whether the Common Shares will trade at, below, or above net asset value or at, below or above the initial public offering price. Accordingly, the Common Shares are designed primarily for long-term investors, and investors in the Common Shares should not view the Fund as a vehicle for trading purposes. See “Repurchase of Common Shares; Conversion to Open-End Fund.”
ARPS
See “Description of Capital Structure” in the Prospectus for information relating to the ARPS.
As used in this Statement of Additional Information and in the Prospectus, unless otherwise noted, the Fund’s “net assets” include assets of the Fund attributable to any outstanding ARPS, with no deduction for the liquidation preference of the ARPS. Solely for financial reporting purposes, however, the Fund is required to exclude the liquidation preference of ARPS from “net assets,” so long as the ARPS have redemption features that are not solely within the control of the Fund. For all regulatory and tax purposes, the Fund’s ARPS will be treated as stock (rather than indebtedness).
ANTI-TAKEOVER AND OTHER PROVISIONS IN THE DECLARATION OF TRUST
Shareholder Liability
Under Massachusetts law, shareholders could, under certain circumstances, be held personally liable for the obligations of the Fund. However, the Declaration contains an express disclaimer of shareholder liability for acts or obligations of the Fund and requires that notice of such limited liability be given in each agreement, obligation or instrument entered into or executed by the Fund or the Trustees. The Declaration also provides for indemnification out of the Fund’s assets and property for all loss and expense of any shareholder held personally liable on account of being or having been a shareholder. Thus, the risk of a shareholder incurring financial loss on account of shareholder liability
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should be limited to circumstances in which such disclaimer is inoperative or the Fund is unable to meet its obligations, and thus should be considered remote.
Anti-Takeover Provisions
As described below, the Declaration includes provisions that could limit the ability of other entities or persons to acquire control of the Fund, convert the Fund to open-end status or to change the composition of its Board of Trustees, and could have the effect of depriving shareholders of opportunities to sell their shares at a premium over prevailing market prices by discouraging a third party from seeking to obtain control of the Fund.
The Fund’s Trustees are divided into three classes (Class I, Class II and Class III), having initial terms of one, two and three years, respectively. At each annual meeting of shareholders, the term of one class will expire and each Trustee elected to that class will hold office until the third annual meeting thereafter. The classification of the Board of Trustees in this manner could delay for an additional year the replacement of a majority of the Board of Trustees. In addition, the Declaration provides that a Trustee may be removed only for cause and only (i) by action of at least seventy-five percent (75%) of the outstanding shares of the classes or series of shares entitled to vote for the election of such Trustee, or (ii) by written instrument, signed by at least seventy-five percent (75%) of the remaining Trustees, specifying the date when such removal shall become effective. Cause for these purposes shall require willful misconduct, dishonesty or fraud on the part of the Trustee in the conduct of his office or such Trustee being convicted of a felony. Except as provided in the next paragraph, the affirmative vote or consent of at least seventy-five percent (75%) of the Board of Trustees and at least seventy-five percent (75%) of the holders of shares of the Fund outstanding and entitled to vote thereon are required to authorize any of the following transactions (each a “Material Transaction”): (1) a merger, consolidation or share exchange of the Fund or any series or class of shares of the Fund with or into any other person or company, or of any such person or company with or into the Fund or any such series or class of shares; (2) the issuance or transfer by the Fund or any series or class of shares (in one or a series of transactions in any twelve-month period) of any securities of the Fund or such series or class to any other person or entity for cash, securities or other property (or combination thereof) having an aggregate fair market value of $1,000,000 or more, excluding sales of securities of the Fund or such series or class in connection with a public offering, issuances of securities of the Fund or such series or class pursuant to a dividend reinvestment plan adopted by the Fund and issuances of securities of the Fund or such series or class upon the exercise of any stock subscription rights distributed by the Fund; or (3) a sale, lease, exchange, mortgage, pledge, transfer or other disposition by the Fund or any series or class of shares (in one or a series of transactions in any twelve-month period) to or with any person of any assets of the Fund or such series or class having an aggregate fair market value of $1,000,000 or more, except for transactions in securities effected by the Fund or such series or class in the ordinary course of its business. The same affirmative votes are required with respect to any shareholder proposal as to specific investment decisions made or to be made with respect to the Fund’s assets or the assets of any series or class of shares of the Fund. Notwithstanding the approval requirements specified in the preceding paragraph, the Declaration requires no vote or consent of the Fund’s shareholders to authorize a Material Transaction if the transaction is approved by a vote of both a majority of the Board of Trustees and seventy-five percent (75%) of the Continuing Trustees (as defined below), so long as all other conditions and requirements, if any, provided for in the Fund’s Bylaws and applicable law (including any shareholder voting rights under the 1940 Act) have been satisfied.
In addition, the Declaration provides that the Fund may be terminated at any time by vote or consent of at least seventy-five percent (75%) of the Fund’s shares entitled to vote or, alternatively, by vote or consent of both a majority of the Board of Trustees and seventy-five percent (75%) of the Continuing Trustees (as defined below) upon written notice to shareholders of the Fund.
In certain circumstances, the Declaration also imposes shareholder voting requirements that are more demanding than those required under the 1940 Act in order to authorize a conversion of the Fund from a closed-end to an open-end investment company. See “Repurchase of Common Shares; Conversion to Open-End Fund” below.
As noted, the voting provisions described above could have the effect of depriving Common Shareholders of an opportunity to sell their Common Shares at a premium over prevailing market prices by discouraging a third party from seeking to obtain control of the Fund in a tender offer or similar transaction. In the view of the Fund’s Board of Trustees, however, these provisions offer several possible advantages, including: (1) requiring persons seeking control of the Fund to negotiate with its management regarding the price to be paid for the amount of Common Shares required to obtain control; (2) promoting continuity and stability; and (3) enhancing the Fund’s ability to pursue
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long-term strategies that are consistent with its investment objectives and management policies. The Board of Trustees has determined that the voting requirements described above, which are generally greater than the minimum requirements under the 1940 Act, are in the best interests of the Fund’s Common Shareholders generally.
A “Continuing Trustee,” as used in the discussion above, is any member of the Fund’s Board of Trustees who either (i) has been a member of the Board for a period of at least thirty-six months (or since the commencement of the Fund’s operations, if less than thirty-six months) or (ii) was nominated to serve as a member of the Board of Trustees by a majority of the Continuing Trustees then members of the Board.
The foregoing is intended only as a summary and is qualified in its entirety by reference to the full text of the Declaration and the Fund’s Bylaws, both of which have been filed as exhibits to the Fund’s registration statement on file with the SEC.
Liability of Trustees
The Declaration provides that the obligations of the Fund are not binding upon the Trustees of the Fund individually, but only upon the assets and property of the Fund, and that the Trustees shall not be liable for errors of judgment or mistakes of fact or law. Nothing in the Declaration, however, protects a Trustee against any liability to which he or she would otherwise be subject by reason of willful misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of his or her office.
Derivative and Direct Claims of Shareholders
A shareholder may not bring or maintain any court action, proceeding or claim on behalf of the Fund or any series or class of shares without first making demand on the Trustees requesting the Trustees to bring or maintain such action, proceeding or claim. Such demand shall not be excused under any circumstances, including claims of alleged interest on the part of the Trustees, unless the plaintiff makes a specific showing that irreparable nonmonetary injury to the Trust or series or class of shares would otherwise result. The Trustees shall consider such demand within 45 days of its receipt by the Fund. In their sole discretion, the Trustees may submit the matter to a vote of shareholders of the Fund or a series or class of shares, as appropriate. Any decision by the Trustees to bring, maintain or settle (or not to bring, maintain or settle) such court action, proceeding or claim, or to submit the matter to a vote of shareholders shall be made by the Trustees in their business judgment and shall be binding upon the shareholders.
A shareholder or group of shareholders may not bring or maintain a direct action or claim for monetary damages against the Fund or the Trustees predicated upon an express or implied right of action under the Declaration or the 1940 Act (excepting rights of action permitted under Section 36(b) of the 1940 Act) , nor shall any single shareholder, who is similarly situated to one or more other shareholders with respect to the alleged injury, have the right to bring such an action, unless such group of shareholders or shareholder has obtained authorization from the Trustees to bring the action. The requirement of authorization shall not be excused under any circumstances, including claims of alleged interest on the part of the Trustees. The Trustees shall consider such request within 45 days of its receipt by the Fund. In their sole discretion, the Trustees may submit the matter to a vote of shareholders of the Fund or series or class of shares, as appropriate. Any decision by the Trustees to settle or to authorize (or not to settle or to authorize) such court action, proceeding or claim, or to submit the matter to a vote of shareholders, shall be made in their business judgment and shall be binding on all shareholders. Any person purchasing or otherwise acquiring or holding any interest in shares of beneficial interest of the Fund will be deemed to have notice of and consented to the foregoing provisions. These provisions may limit a shareholder's ability to bring a claim against the Trustees, officers or other agents of the Fund and its service providers, which may discourage such lawsuits with respect to such claims.
These provisions in the Declaration regarding derivative and direct claims of shareholders shall not apply to claims made under federal securities laws.
repurchase of common shares; CONVERSION TO OPEN-END FUND
The Fund is a closed-end investment company and as such its shareholders will not have the right to cause the Fund to redeem their shares. Instead, the Fund’s Common Shares will trade in the open market at a price that will be a function of several factors, including dividend levels and stability (which will in turn be affected by dividend and interest payments by the Fund’s portfolio holdings, regulations affecting the timing and character of Fund’s
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distributions, Fund expenses and other factors), portfolio credit quality, liquidity, call protection, market supply and demand, and similar factors relating to the Fund’s portfolio holdings. Shares of a closed-end investment company may frequently trade at prices lower than net asset value. The Fund’s Board will regularly monitor the relationship between the market price and net asset value of the Common Shares. If the Common Shares were to trade at a substantial discount to net asset value for an extended period of time, the Board may consider the repurchase of its Common Shares on the open market or in private transactions, the making of a tender offer for such shares or the conversion of the Fund to an openend investment company. The Fund cannot assure you that the Board will decide to take or propose any of these actions, or that share repurchases or tender offers will actually reduce any market discount. The Fund has no present intention to repurchase its Common Shares and would do so only in the circumstances described in this section.
Notwithstanding the foregoing, at any time when the Fund’s ARPS are outstanding, the Fund may not purchase, redeem or otherwise acquire for consideration any of its Common Shares unless and only if: (i) immediately after such transaction, the Fund would satisfy Moody’s Preferred Shares Asset Coverage, Fitch Ratings Agency Preferred Shares Asset Coverage and 1940 Act Preferred Shares Asset Coverage would be satisfied (each as defined and described under “Description of Capital Structure— Rating Agency Guidelines and Asset Coverage” in the Prospectus); (ii) full cumulative dividends on the Preferred Shares due on or prior to the date of the transaction have been declared and paid or shall have been declared and sufficient funds for the payment thereof deposited with the auction agent for the Preferred Shares; and (iii) the Fund has redeemed the full number of Preferred Shares required to be redeemed by any provision for mandatory redemption contained in the Bylaws.
Subject to its investment limitations, the Fund may borrow to finance the repurchase of shares or to make a tender offer. Interest on any borrowings to finance share repurchase transactions or the accumulation of cash by the Fund in anticipation of share repurchases or tenders will reduce the Fund’s net income. Any share repurchase, tender offer or borrowing that might be approved by the Board would have to comply with the Exchange Act and the 1940 Act and the rules and regulations thereunder.
The Fund’s Board may also from time to time consider submitting to the holders of the shares of beneficial interest of the Fund a proposal to convert the Fund to an open-end investment company. In determining whether to exercise its sole discretion to submit this issue to shareholders, the Board would consider all factors then relevant, including the relationship of the market price of the Common Shares to net asset value, if any, and the extent to which the Fund’s capital structure is leveraged and the possibility of re-leveraging, the spread, if any, between the yields on securities in the Fund’s portfolio and interest and dividend charges on ARPS issued by the Fund and general market and economic conditions.
The Declaration requires the affirmative vote or consent of holders of at least seventy-five percent (75%) of each class of the Fund’s shares entitled to vote on the matter to authorize a conversion of the Fund from a closed-end to an open-end investment company, unless the conversion is authorized by both a majority of the Board and seventy-five percent (75%) of the Continuing Trustees (as defined above under “Anti-Takeover and Other Provisions in the Declaration of Trust— Anti-Takeover Provisions”). This seventy-five percent (75%) shareholder approval requirement is higher than is required under the 1940 Act. In the event that a conversion is approved by the Trustees and the Continuing Trustees as described above, the minimum shareholder vote required under the 1940 Act would be necessary to authorize the conversion. Currently, the 1940 Act would require approval of the holders of a “majority of the outstanding” Common Shares and ARPS voting together as a single class, and the holders of a “majority of the outstanding” ARPS voting as a separate class, in order to authorize a conversion.
If the Fund were to convert to an open-end company, it would be required to redeem all ARPS then outstanding (required in turn that it liquidate a portion of its investment portfolio) and the Fund’s Common Shares likely would no longer be listed on the NYSE. In contrast to a closed-end investment company, shareholders of an open-end investment company may require the company to redeem their shares at any time (except in certain circumstances as authorized by or under the 1940 Act) at their net asset value, less any redemption charge that is in effect at the time of redemption. In addition, if the Fund were to convert to an open-end company, it would likely have to significantly reduce any leverage it is then employing and would not be able to invest more than 15% of its net assets in illiquid investments, either or both of which may necessitate a substantial repositioning of the Fund’s investment portfolio, which may in turn generate substantial transaction costs, which would be borne by Common Shareholders, and may adversely affect Fund performance and Fund dividends. Shareholders of an open-end investment company may require the company to redeem their shares on any business day (except in certain circumstances as authorized by or under the
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1940 Act) at their net asset value, less such redemption charge, if any, as might be in effect at the time of redemption. In order to avoid maintaining large cash positions or liquidating favorable investments to meet redemptions, open-end companies typically engage in a continuous offering of their shares. Open-end companies are thus subject to periodic asset in-flows and out-flows that can complicate portfolio management.
The repurchase by the Fund of its shares at prices below net asset value will result in an increase in the net asset value of those shares that remain outstanding. However, there can be no assurance that share repurchases or tenders at or below net asset value will result in the Fund’s shares trading at a price equal to their net asset value. Nevertheless, the fact that the Fund’s shares may be the subject of repurchase or tender offers at net asset value from time to time, or that the Fund may be converted to an open-end company, may reduce any spread between market price and net asset value that might otherwise exist.
In addition, a purchase by the Fund of its Common Shares will decrease the Fund’s total assets. This would likely have the effect of increasing the Fund’s expense ratio. Any purchase by the Fund of its Common Shares at a time when Preferred Shares, reverse repurchase agreements, credit default swaps or other forms of leverage are outstanding will increase the leverage applicable to the outstanding Common Shares then remaining. See the Prospectus under “Principal Risks of the Fund—Leverage Risk.”
Before deciding whether to take any action if the Fund’s Common Shares trade below net asset value, the Board would consider all relevant factors, including the extent and duration of the discount, the liquidity of the Fund’s portfolio, the impact of any action that might be taken on the Fund or its shareholders and market considerations. Based on these considerations, even if the Fund’s shares should trade at a discount, the Board may determine that, in the interest of the Fund and its shareholders, no action should be taken.
TAXATION
The following discussion of U.S. federal income tax consequences of investment in Common Shares of the Fund is based on the Code, U.S. Treasury regulations, and other applicable authority, as of the date of this Statement of Additional Information. These authorities are subject to change by legislative or administrative action, possibly with retroactive effect. The following discussion is only a summary of some of the important U.S. federal income tax considerations generally applicable to investments in Common Shares of the Fund. This summary does not purport to be a complete description of the U.S. federal income tax considerations applicable to an investment in Common Shares of the Fund. There may be other tax considerations applicable to particular shareholders. For example, except as otherwise specifically noted herein, we have not described certain tax considerations that may be relevant to certain types of holders subject to special treatment under the U.S. federal income tax laws, including shareholders subject to the U.S. federal alternative minimum tax, insurance companies, tax-exempt organizations, pension plans and trusts, RICs, dealers in securities, shareholders holding Common Shares through tax-advantaged accounts (such as 401(k) plans or individual retirement accounts), financial institutions, shareholders holding Common Shares as part of a hedge, straddle, or conversion transaction, entities that are not organized under the laws of the United States or a political subdivision thereof, and persons who are neither citizens nor residents of the United States. This summary assumes that investors hold Common Shares as capital assets (within the meaning of the Code). Shareholders should consult their own tax advisors regarding their particular situation and the possible application of U.S. federal, state, local, non-U.S. or other tax laws, and any proposed tax law changes.
Taxation of the Fund
The Fund has elected and intends each year to qualify and be eligible to be treated as a RIC under Subchapter M of the Code. In order to qualify for the special tax treatment accorded RICs and their shareholders, the Fund must, among other things: (a) derive at least 90% of its gross income for each taxable year from (i) dividends, interest, payments with respect to certain securities loans, and gains from the sale or other disposition of stock, securities or foreign currencies, or other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to its business of investing in such stock, securities, or currencies and (ii) net income derived from interests in “qualified publicly traded partnerships” (as defined below); (b) diversify its holdings so that, at the end of each quarter of the Fund’s taxable year, (i) at least 50% of the value of the Fund’s total assets consists of cash and cash items, U.S. government securities, securities of other RICs, and other securities limited in respect of any one issuer to a value not greater than 5% of the value of the Fund’s total assets and not more than 10% of the outstanding voting securities of such issuer, and (ii) not more than 25% of the value of the Fund’s total assets is invested, including
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through corporations in which the Fund owns a 20% or more voting stock interest, (x) in the securities (other than those of the U.S. government or other RICs) of any one issuer or of two or more issuers that the Fund controls and that are engaged in the same, similar, or related trades or businesses, or (y) in the securities of one or more qualified publicly traded partnerships (as defined below); and (c) distribute with respect to each taxable year at least 90% of the sum of its investment company taxable income (as that term is defined in the Code without regard to the deduction for dividends paid—generally, taxable ordinary income and the excess, if any, of net short-term capital gains over net long-term capital losses) and any net tax-exempt interest income for such year.
In general, for purposes of the 90% gross income requirement described in paragraph (a) above, income derived from a partnership will be treated as qualifying income only to the extent such income is attributable to items of income of the partnership that would be qualifying income if realized directly by the RIC. However, 100% of the net income derived from an interest in a “qualified publicly traded partnership” (a partnership (x) the interests in which are traded on an established securities market or are readily tradable on a secondary market or the substantial equivalent thereof and (y) that derives less than 90% of its income from the qualifying income described in paragraph (a)(i) above) will be treated as qualifying income. In general, such entities will be treated as partnerships for U.S. federal income tax purposes because they meet the passive income requirement under Code section 7704(c)(2). In addition, although in general the passive loss rules of the Code do not apply to RICs, such rules do apply to a RIC with respect to items attributable to an interest in a qualified publicly traded partnership.
For purposes of the diversification test in (b) above, the term “outstanding voting securities of such issuer” will include the equity securities of a qualified publicly traded partnership. Also, for purposes of the diversification test in (b) above, the identification of the issuer (or, in some cases, issuers) of a particular Fund investment can depend on the terms and conditions of that investment. In some cases, identification of the issuer (or issuers) is uncertain under current law, and an adverse determination or future guidance by the IRS with respect to issuer identification for a particular type of investment may adversely affect the Fund’s ability to meet the diversification test in (b) above.
If the Fund qualifies as a RIC that is accorded special tax treatment, the Fund will not be subject to U.S. federal income tax on income or gains distributed in a timely manner to Common Shareholders in the form of dividends (including Capital Gain Dividends, as defined below). If the Fund were to fail to meet the income, diversification, or distribution tests described above, the Fund could in some cases cure such failure, including by paying a fund-level tax, paying interest, making additional distributions, or disposing of certain assets. If the Fund were ineligible to or otherwise did not cure such failure for any year, or were otherwise to fail to qualify as a RIC accorded special tax treatment for such year, the Fund would be subject to tax on its taxable income at corporate rates, and all distributions from earnings and profits, including any distributions of net tax-exempt income and net long-term capital gains, would be taxable to Common Shareholders as ordinary income. Some portions of such distributions may be eligible for the dividends-received deduction in the case of corporate shareholders and may be eligible to be treated as “qualified dividend income” in the case of shareholders taxed as individuals, provided, in both cases, that the shareholder meets certain holding period and other requirements in respect of the Fund’s Common Shares (as described below). In addition, the Fund could be required to recognize unrealized gains, pay substantial taxes and interest and make substantial distributions before re-qualifying as a RIC that is accorded special tax treatment.
The Fund intends to distribute to its shareholders, at least annually, all or substantially all of its investment company taxable income (computed without regard to the dividends-paid deduction), its net tax-exempt income (if any) and its net capital gain (that is, the excess of net long-term capital gain over net short-term capital loss, in each case determined with reference to any loss carryforwards). Any taxable income including any net capital gain retained by the Fund will be subject to tax at the Fund level at regular corporate rates. In the case of net capital gain, the Fund is permitted to designate the retained amount as undistributed capital gain in a timely notice to its shareholders who would then, in turn, (i) be required to include in income for U.S. federal income tax purposes, as long-term capital gain, their share of such undistributed amount, and (ii) be entitled to credit their proportionate shares of the tax paid by the Fund on such undistributed amount against their U.S. federal income tax liabilities, if any, and to claim refunds on a properly filed U.S. tax return to the extent the credit exceeds such liabilities. If the Fund makes this designation, for U.S. federal income tax purposes, the tax basis of Common Shares owned by a shareholder of the Fund will be increased by an amount equal to the difference between the amount of undistributed capital gains included in the shareholder’s gross income under clause (i) of the preceding sentence and the tax deemed paid by the shareholder under clause (ii) of the preceding sentence. The Fund is not required to, and there can be no assurance that the Fund will, make this designation if it retains all or a portion of its net capital gain in a taxable year.
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As described under “Use of Leverage” in the Prospectus, if at any time when Preferred Shares are outstanding the Fund does not meet applicable asset coverage requirements, it will be required to suspend distributions to Common Shareholders until the requisite asset coverage is restored. Any such suspension may cause the Fund to pay a U.S. federal income and excise tax on undistributed income or gains and may, in certain circumstances, prevent the Fund from qualifying for treatment as a RIC. The Fund may repurchase or otherwise retire Preferred Shares in an effort to comply with the distribution requirement applicable to RIC.
Capital losses in excess of capital gains (“net capital losses”) are not permitted to be deducted against the Fund’s net investment income. Instead, potentially subject to certain limitations, the Fund may carry net capital losses from any taxable year forward to subsequent taxable years to offset capital gains, if any, realized during such subsequent taxable years. Capital loss carryforwards are reduced to the extent they offset current-year net realized capital gains, whether the Fund retains or distributes such gains. If the Fund incurs or has incurred net capital losses, those losses will be carried forward to one or more subsequent taxable years without expiration. Any such carryforward losses will retain their character as short-term or long-term. The Fund’s available capital loss carryforwards, if any, will be set forth in its annual shareholder report for each fiscal year.
In determining its net capital gain, including in connection with determining the amount available to support a Capital Gain Dividend (as defined below), its taxable income and its earnings and profits, a RIC generally may elect to treat part or all of any post-October capital loss (defined as any net capital loss attributable to the portion, if any, of the taxable year after October 31 or, if there is no such loss, the net long-term capital loss or net short-term capital loss attributable to such portion of the taxable year) or late-year ordinary loss (generally, the sum of its (i) net ordinary loss from the sale, exchange or other taxable disposition of property, attributable to the portion, if any, of the taxable year after October 31, and its (ii) other net ordinary loss attributable to the portion, if any, of the taxable year after December 31) as if incurred in the succeeding taxable year.
If the Fund were to fail to distribute in a calendar year at least an amount equal to the sum of 98% of its ordinary income for such year and 98.2% of its capital gain net income recognized for the one-year period ending on October 31 of such year (or November 30 or December 31 of that year if the Fund is permitted to elect and so elects), plus any such amounts retained from the prior year, the Fund would be subject to a nondeductible 4% excise tax on the undistributed amounts. For purposes of the required excise tax distribution, a RIC’s ordinary gains and losses from the sale, exchange, or other taxable disposition of property that would otherwise be taken into account after October 31 (or November 30 of that year if the RIC makes the election described above) generally are treated as arising on January 1 of the following calendar year; in the case of a RIC with a December 31 year end that makes the election described above, no such gains or losses will be so treated. Also, for these purposes, the Fund will be treated as having distributed any amount on which it is subject to corporate income tax for the taxable year ending within the calendar year. The Fund intends generally to make distributions sufficient to avoid imposition of the 4% excise tax, although there can be no assurance that it will be able to or will do so.
Fund Distributions
The Fund intends to make monthly distributions. Unless a shareholder elects otherwise, all distributions will be automatically reinvested in additional Common Shares of the Fund pursuant to the Fund’s Dividend Reinvestment Plan. A shareholder whose distributions are reinvested in Common Shares under the Dividend Reinvestment Plan will be treated for U.S. federal income tax purposes as having received an amount in distribution equal to either (i) if newly issued Common Shares are issued under the Dividend Reinvestment Plan, generally the fair market value of the newly issued Common Shares issued to the shareholder or (ii) if reinvestment is made through open-market purchases under the Dividend Reinvestment Plan, the amount of cash allocated to the shareholder for the purchase of Common Shares on its behalf in the open market. For U.S. federal income tax purposes, all distributions are generally taxable in the manner described below, whether a shareholder takes them in cash or they are reinvested pursuant to the Dividend Reinvestment Plan in additional shares of the Fund.
Fund distributions generally will be taxable to shareholders in the calendar year in which the distributions are declared, rather than the calendar year in which the distributions are received. See the discussion below regarding distributions declared in October, November or December for further information. Distributions received by tax-exempt shareholders generally will not be subject to U.S. federal income tax to the extent permitted under applicable tax law.
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For U.S. federal income tax purposes, distributions of investment income, other than exempt interest dividends (described below), are generally taxable as ordinary income. Taxes on distributions of capital gains are determined by how long the Fund owned (or is deemed to have owned) the investments that generated the gains, rather than how long a shareholder has owned his or her Common Shares. In general, the Fund will recognize long-term capital gain or loss on investments it has owned (or is deemed to have owned) for more than one year, and short-term capital gain or loss on investments it has owned (or is deemed to have owned) for one year or less. Tax rules can alter the Fund’s holding period in investments and thereby affect the tax treatment of gain or loss in respect of such investments. Distributions of net capital gain that are properly reported by the Fund as capital gain dividends (“Capital Gain Dividends”) will be taxable to shareholders as long-term capital gains includible in net capital gain and taxed to individuals at reduced rates relative to ordinary income. Distributions of net short-term capital gain (as reduced by any net long-term capital loss for the taxable year) will be taxable to shareholders as ordinary income. The IRS and the Department of the Treasury have issued proposed regulations that would impose special rules in respect of Capital Gain Dividends received through partnership interests constituting “applicable partnership interests” under Section 1061 of the Code.
Distributions of investment income reported by the Fund as derived from “qualified dividend income” will be taxed in the hands of individuals at the rates applicable to net capital gain, provided holding period and other requirements are met at both the shareholder and Fund levels. The Fund does not expect a significant portion of distributions to be derived from qualified dividend income.
In general, dividends of net investment income received by corporate shareholders of the Fund will qualify for the dividends-received deduction generally available to corporations only to the extent of the amount of eligible dividends received by the Fund from domestic corporations for the taxable year if certain holding period and other requirements are met at both the shareholder and Fund levels. The Fund does not expect a significant portion of distributions to be eligible for the dividends-received deduction.
Distributions by the Fund to its shareholders that the Fund properly reports as “section 199A dividends,” as defined and subject to certain conditions described below, are treated as qualified REIT dividends in the hands of non-corporate shareholders. Non-corporate shareholders are permitted a federal income tax deduction equal to 20% of qualified REIT dividends received by them, subject to certain limitations. Very generally, a “section 199A dividend” is any dividend or portion thereof that is attributable to certain dividends received by a RIC from REITs, to the extent such dividends are properly reported as such by the RIC in a written notice to its shareholders. A section 199A dividend is treated as a qualified REIT dividend only if the shareholder receiving such dividend holds the dividend-paying RIC shares for at least 46 days of the 91-day period beginning 45 days before the shares become ex-dividend, and is not under an obligation to make related payments with respect to a position in substantially similar or related property. The Fund is permitted to report such part of its dividends as section 199A dividends as are eligible, but is not required to do so.
Any distribution of income that is attributable to (i) income received by the Fund in lieu of dividends with respect to securities on loan pursuant to a securities lending transaction or (ii) dividend income received by the Fund on securities it temporarily purchased from a counterparty pursuant to a repurchase agreement that is treated for U.S. federal income tax purposes as a loan by the Fund, will not constitute qualified dividend income to non-corporate shareholders and will not be eligible for the dividends-received deduction for corporate shareholders.
The IRS currently requires a RIC that the IRS recognizes as having two or more “classes” of stock for U.S. federal income tax purposes to allocate to each such class proportionate amounts of each type of its income (such as ordinary income and capital gains) based upon the percentage of total dividends distributed to each class for the tax year. Accordingly, as applicable, the Fund intends each tax year to allocate Capital Gain Dividends between and among its Common Shares and each series of its preferred shares in proportion to the total dividends paid to each class with respect to such tax year. Dividends qualifying for the dividends received deduction or as qualified dividend income will be allocated between and among Common Shares and each series of preferred shares separately from dividends that do not so qualify, in each case in proportion to the total dividends paid to each share class for the Fund’s tax year.
The Code generally imposes a 3.8% Medicare contribution tax on the net investment income of certain individuals, trusts and estates to the extent their modified adjusted gross income exceeds certain threshold amounts. For these purposes, “net investment income” generally includes, among other things, (i) distributions paid by the Fund of net investment income and capital gains as described above, and (ii) any net gain from the sale, exchange or other
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taxable disposition of Fund shares. Common Shareholders are advised to consult their tax advisors regarding the possible implications of this additional tax on their investment in the Fund.
If, in and with respect to any taxable year, the Fund makes a distribution in excess of its current and accumulated “earnings and profits,” the excess distribution will be treated as a return of capital to the extent of a shareholder’s tax basis in his or her Common Shares, and thereafter as capital gain. A return of capital is not taxable, but it reduces a shareholder’s basis in his or her shares, thus reducing any loss or increasing any gain on a subsequent taxable disposition by the shareholder of such shares. Where one or more such distributions occur in and with respect to any taxable year of the Fund, the available earnings and profits will be allocated first to the distributions made to the holders of preferred shares, and only thereafter to distributions made to holders of Common Shares. As a result, the holders of preferred shares will receive a disproportionate share of the distributions, if any, treated as dividends, and the holders of the Common Shares will receive a disproportionate share of the distributions, if any, treated as a return of capital.
A distribution by the Fund will be treated as paid on December 31 of any calendar year if it is declared by the Fund in October, November or December with a record date in such a month and paid by the Fund during January of the following calendar year. Such distributions will be taxable to shareholders in the calendar year in which the distributions are declared, rather than the calendar year in which the distributions are received.
As required by federal law, detailed federal tax information with respect to each calendar year will be furnished to shareholders early in the succeeding year.
Dividends and distributions on Common Shares are generally subject to U.S. federal income tax as described herein to the extent they do not exceed the Fund’s realized income and gains, even though such dividends and distributions may economically represent a return of a particular shareholder’s investment. Such distributions are likely to occur in respect of Common Shares purchased at a time when the Fund’s net asset value reflects unrealized gains or income or gains that are realized but not yet distributed. Such realized income and gains may be required to be distributed even when the Fund’s net asset value also reflects unrealized losses.
If the Fund holds, directly or indirectly, one or more Build America Bonds issued before January 1, 2011 or other tax credit bonds issued on or before December 31, 2017,, or other tax credit bonds issued on or before December 31, 2017, on one or more applicable dates during a taxable year, it is possible that the Fund will elect to permit its shareholders to claim a tax credit on their income tax returns equal to each shareholder’s proportionate share of tax credits from the applicable bonds that otherwise would be allowed to the Fund. In such a case, a shareholder will be deemed to receive a distribution of money with respect to its Fund shares equal to the shareholder’s proportionate share of the amount of such credits and be allowed a credit against the shareholder’s U.S. federal income tax liability equal to the amount of such deemed distribution, subject to certain limitations imposed by the Code on the credits involved. Even if the Fund is eligible to pass through tax credits to shareholders, the Fund may choose not to do so.
Sales, Exchanges or Repurchases of Shares
The sale, exchange or repurchase of Fund shares may give rise to a gain or loss. In general, any gain or loss realized upon a taxable disposition of Fund shares treated as a sale or exchange for U.S. federal income tax purposes will be treated as long-term capital gain or loss if the shares have been held for more than 12 months. Otherwise, such gain or loss on the taxable disposition of Fund shares will be treated as short-term capital gain or loss. However, any loss realized upon a taxable disposition of Fund shares held for six months or less (i) will be treated as long-term, rather than short-term, to the extent of any long-term capital gain distributions received (or deemed received) by the shareholder with respect to the shares and (ii) generally will be disallowed to the extent of any exempt-interest dividends received by the shareholder with respect to the shares. All or a portion of any loss realized upon a taxable disposition of Fund shares will be disallowed under the Code’s “wash sale” rule if other substantially identical shares of the Fund are purchased within 30 days before or after the disposition. In such a case, the basis of the newly purchased shares will be adjusted to reflect the disallowed loss.
In the event that the Fund repurchases a shareholder’s Common Shares (as described in the Prospectus), such repurchase generally will be treated as a sale or exchange of the shares by a shareholder provided that (i) the shareholder tenders, and the Fund repurchases, all of such shareholder’s shares (and such shareholder does not hold and is not deemed to hold any preferred shares), thereby reducing the shareholder’s percentage ownership of the Fund,
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whether directly or by attribution under Section 318 of the Code, to 0%, (ii) the shareholder meets numerical safe harbors under the Code with respect to percentage voting interest and reduction in ownership of the Fund following completion of the tender offer, or (iii) the tender offer otherwise results in a “meaningful reduction” of the shareholder’s ownership percentage interest in the Fund, which determination depends on a particular shareholder’s facts and circumstances.
If a tendering shareholder’s proportionate ownership of the Fund (determined after applying the ownership attribution rules under Section 318 of the Code) is not reduced to the extent required under the tests described above, such shareholder will be deemed to receive a distribution from the Fund under Section 301 of the Code with respect to the shares held (or deemed held under Section 318 of the Code) by the shareholder after the tender offer (a “Section 301 distribution”). The amount of this distribution will equal the price paid by the Fund to such shareholder for the shares sold, and will be taxable as a dividend, i.e., as ordinary income, to the extent of the Fund’s current or accumulated earnings and profits allocable to such distribution, with the excess treated as a return of capital reducing the shareholder’s tax basis in the shares held after the tender offer, and thereafter as capital gain. In the event a repurchase is treated as a Section 301 distribution, any Fund shares held by a shareholder thereafter will be subject to basis adjustments in accordance with the provisions of the Code.
Provided that no tendering shareholder is treated as receiving a Section 301 distribution as a result of selling Common Shares pursuant to a particular tender offer, shareholders who do not sell shares pursuant to that tender offer will not realize constructive distributions on their shares as a result of other shareholders selling shares in the tender offer. In the event that any tendering shareholder is deemed to receive a Section 301 distribution, it is possible that shareholders whose proportionate ownership of the Fund increases as a result of that tender offer, including shareholders who do not tender any shares, will be deemed to receive a constructive distribution under Section 305(c) of the Code in an amount equal to the increase in their percentage ownership of the Fund as a result of the tender offer. Such constructive distribution will be treated as a dividend to the extent of current or accumulated earnings and profits allocable to it.
Use of the Fund’s cash to repurchase shares may adversely affect the Fund’s ability to satisfy the distribution requirements for treatment as a RIC described above. The Fund may also recognize income in connection with the sale of portfolio securities to fund share purchases, in which case the Fund would take any such income into account in determining whether such distribution requirements have been satisfied.
If the Fund were to repurchase Common Shares on the open market, such repurchase would similarly result in a percentage increase in the interests of remaining shareholders. In such a case, a selling shareholder would likely have no specific knowledge that he or she is selling his or her shares to the Fund. It is therefore less likely that shareholders whose percentage share interests in the Fund increase as a result of any such open-market sale will be treated as having received a taxable distribution from the Fund.
The foregoing discussion does not address the tax treatment of tendering shareholders who do not hold their shares as a capital asset. Such shareholders should consult their own tax advisors on the specific tax consequences to them of participating or not participating in the tender offer.
Original Issue Discount, Payment-in-Kind Securities, Market Discount, Preferred Securities, and Commodity-Linked Notes
Some debt obligations with a fixed maturity date of more than one year from the date of issuance (and zero-coupon debt obligations with a fixed maturity date of more than one year from the date of issuance) will be treated as debt obligations that are issued originally at a discount. Generally, the amount of the original issue discount is treated as interest income and is included in the Fund’s income and required to be distributed over the term of the debt obligation, even though payment of that amount is not received until a later time, upon partial or full repayment or disposition of the debt obligation.
Some debt obligations with a fixed maturity date of more than one year from the date of issuance that are acquired by the Fund in the secondary market may be treated as having “market discount.” Very generally, market discount is the excess of the stated redemption price of a debt obligation (or in the case of an obligation issued with OID, its “revised issue price”) over the purchase price of such obligation. Subject to the discussion below regarding Section 451 of the Code, (i) generally, any gain recognized on the disposition of, and any partial payment of principal
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on, a debt obligation having market discount is treated as ordinary income to the extent the gain, or principal payment, does not exceed the “accrued market discount” on such debt obligation, (ii) alternatively, the Fund may elect to accrue market discount currently, in which case the Fund will be required to include the accrued market discount on such debt obligations in the Fund’s income (as ordinary income) and thus distribute it over the term of the debt obligations, even though payment of that amount is not received until a later time, upon partial or full repayment or disposition of the debt obligations and (iii) the rate at which the market discount accrues, and thus is included in the Fund’s income, will depend upon which of the permitted accrual methods the Fund elects. Department of Treasury have issued proposed regulations providing that this rule does not apply to market discount. If this rule were to apply to the accrual of market discount, the Fund would be required to include in income any market discount as it takes the same into account on its financial statements. The Fund reserves the right to revoke such an election at any time pursuant to applicable IRS procedures. In the case of higher-risk securities, the amount of market discount may be unclear. See “Higher-Risk Securities.”
From time to time, a substantial portion of the Fund’s investments in loans and other debt obligations could be treated as having OID and/or market discount, which, in some cases could be significant. To generate sufficient cash to make the requisite distributions, the Fund may be required to sell securities in its portfolio (including when it is not advantageous to do so) that it otherwise would have continued to hold.
A portion of the OID accrued on certain high yield discount obligations may not be deductible to the issuer and will instead be treated as a dividend paid by the issuer for purposes of the dividends-received deduction. In such cases, if the issuer of the high yield discount obligations is a domestic corporation, dividend payments by the Fund may be eligible for the dividends-received deduction to the extent attributable to the deemed dividend portion of such OID.
Some debt obligations with a fixed maturity date of more than one year from the date of issuance (and zero-coupon debt obligations with a fixed maturity date of more than one year from the date of issuance) will be treated as debt obligations that are issued originally at a discount. Generally, the amount of the original issue discount (“OID”) is treated as interest income and is included in the Fund’s income and required to be distributed over the term of the debt obligation, even though payment of that amount is not received until a later time, upon partial or full repayment or disposition of the debt obligation.
Some debt obligations with a fixed maturity date of more than one year from the date of issuance that are acquired by the Fund in the secondary market may be treated as having “market discount.” Very generally, market discount is the excess of the stated redemption price of a debt obligation (or in the case of an obligation issued with OID, its “revised issue price”) over the purchase price of such obligation. Subject to the discussion below regarding Section 451 of the Code, (i) generally, any gain recognized on the disposition of, and any partial payment of principal on, a debt obligation having market discount is treated as ordinary income to the extent the gain, or principal payment, does not exceed the “accrued market discount” on such debt obligation, (ii) alternatively, the Fund may elect to accrue market discount currently, in which case the Fund will be required to include the accrued market discount on such debt obligations in the Fund’s income (as ordinary income) and thus distribute it over the term of the debt obligations, even though payment of that amount is not received until a later time, upon partial or full repayment or disposition of the debt obligations and (iii) the rate at which the market discount accrues, and thus is included in the Fund’s income, will depend upon which of the permitted accrual methods the Fund elects. Although the application of Section 451 to the accrual of market discount is currently unclear, the Treasury and IRS have announced that they intend to issue proposed regulations providing that Section 451 does not apply to market discount. If Section 451 were to apply to the accrual of market discount, the Fund would be required to include in income any market discount as it takes the same into account on its financial statements. The Fund reserves the right to revoke such an election at any time pursuant to applicable IRS procedures. In the case of higher-risk securities, the amount of market discount may be unclear. See “Higher-Risk Securities.”
From time to time, a substantial portion of the Fund’s investments in loans and other debt obligations could be treated as having OID and/or market discount, which, in some cases could be significant. To generate sufficient cash to make the requisite distributions, the Fund may be required to sell securities in its portfolio (including when it is not advantageous to do so) that it otherwise would have continued to hold.
A portion of the OID accrued on certain high yield discount obligations may not be deductible to the issuer and will instead be treated as a dividend paid by the issuer for purposes of the dividends-received deduction. In such cases,
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if the issuer of the high yield discount obligations is a domestic corporation, dividend payments by the Fund may be eligible for the dividends-received deduction to the extent attributable to the deemed dividend portion of such OID.
Some debt obligations with a fixed maturity date of one year or less from the date of issuance may be treated as having OID or, in certain cases, “acquisition discount” (very generally, the excess of the stated redemption price over the purchase price). The Fund will be required to include the OID or acquisition discount in income (as ordinary income) and thus distribute it over the term of the debt obligation, even though payment of that amount is not received until a later time, upon partial or full repayment or disposition of the debt obligation. The rate at which OID or acquisition discount accrues, and thus is included in the Fund’s income, will depend upon which of the permitted accrual methods the Fund elects.
Some preferred securities may include provisions that permit the issuer, at its discretion, to defer the payment of distributions for a stated period without any adverse consequences to the issuer. If the Fund owns a preferred security that is deferring the payment of its distributions, the Fund may be required to report income for U.S. federal income tax purposes to the extent of any such deferred distributions even though the Fund has not yet actually received the cash distribution.
In addition, pay-in-kind obligations will, and commodity-linked notes may, give rise to income that is required to be distributed and is taxable even though the Fund receives no interest payment in cash on the security during the year.
If the Fund holds the foregoing kinds of obligations, or other obligations subject to special rules under the Code, the Fund may be required to pay out as an income distribution each year an amount which is greater than the total amount of cash interest the Fund actually received. Such distributions may be made from the cash assets of the Fund or by disposition of portfolio securities, if necessary (including when it is not advantageous to do so). The Fund may realize gains or losses from such dispositions, including short-term capital gains taxable as ordinary income. In the event the Fund realizes net capital gains from such transactions, its shareholders may receive a larger capital gain distribution than they might otherwise receive in the absence of such transactions.
Higher-Risk Securities
The Fund may invest in debt obligations that are in the lowest rating categories or are unrated, including debt obligations of issuers not currently paying interest or who are in default. Investments in debt obligations that are at risk of or in default present special tax issues for the Fund. Tax rules are not entirely clear about issues such as whether or to what extent the Fund should recognize market discount on a debt obligation when the Fund may cease to accrue interest, OID or market discount, when and to what extent the Fund may take deductions for bad debts or worthless securities and how the Fund should allocate payments received on obligations in default between principal and income. These and other related issues will be addressed by the Fund when, as and if it invests in such securities, in order to seek to ensure that it distributes sufficient income to preserve its status as a RIC and does not become subject to federal income or excise tax.
Securities Purchased at a Premium
Very generally, where the Fund purchases a bond at a price that exceeds the redemption price at maturity (i.e., at a premium), the Fund may elect to amortize the premium over the remaining term of the bond which election would apply to all bonds (other than bonds the interest on which is excludible from gross income for U.S. federal income tax purposes) held by the Fund. In the case of a taxable bond, if the Fund makes such election, which election is irrevocable without consent of the IRS, the Fund reduces the current taxable income from the bond by the amortized premium and reduces its tax basis in the bond by the amount of such offset; upon the disposition or maturity of such bonds, the Fund is permitted to deduct any remaining premium allocable to a prior period. In the case of a tax-exempt bond, tax rules require the Fund to reduce its tax basis by the amount of amortized premium. If the Fund does not elect to take a bond premium into account currently, it will recognize a capital loss when the bond matures.
Catastrophe Bonds
The proper tax treatment of income or loss realized by the retirement or sale of certain catastrophe bonds is unclear. The Fund will report such income or loss as capital or ordinary income or loss in a manner consistent with any IRS position on the subject following the publication of such a position.
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Passive Foreign Investment Companies
Equity investments by the Fund in certain “passive foreign investment companies” (“PFICs”) could subject the Fund to a U.S. federal income tax (including interest charges) on distributions received from the PFIC or on proceeds received from the disposition of shares in the PFIC. This tax cannot be eliminated by making distributions to Fund shareholders. However, the Fund may elect to treat a PFIC as a “qualified electing fund” (i.e., make a “QEF election”), in which case the Fund will be required to include its share of the company’s income and net capital gains annually, regardless of whether it receives any distribution from the company. Under U.S. U.S. Treasury regulations, any such income or net capital gain of the PFIC that is required to be included in the Fund’s gross income is qualifying income to the extent derived with respect to the Fund’s business of investing in stock, securities or currencies. The Fund also may make an election to mark the gains (and to a limited extent losses) in such holdings “to the market” as though it had sold and repurchased its holdings in those PFICs on the last day of the Fund’s taxable year. Such gains and losses are treated as ordinary income and loss. The QEF and mark-to-market elections may accelerate the recognition of income (without the receipt of cash) and increase the amount required to be distributed by the Fund to avoid taxation. Making either of these elections therefore may require the Fund to sell other investments (including when it is not advantageous to do so) to meet its distribution requirement, which also may accelerate the recognition of gain and affect the Fund’s total return. Because it is not always possible to identify a foreign corporation as a PFIC, the Fund may incur the tax and interest charges described above in some instances. Dividends paid by PFICs will not be eligible to be treated as “qualified dividend income.”
Municipal Bonds
The interest on municipal bonds is generally exempt from U.S. federal income tax. The Fund does not expect to invest 50% or more of its assets in municipal bonds on which the interest is exempt from U.S. federal income tax, or in interests in other RICs. As a result, it does not expect to be eligible to pay “exempt-interest dividends” to its shareholders under the applicable tax rules. As a result, interest on municipal bonds is taxable to shareholders of the Fund when received as a distribution from the Fund. In addition, gains realized by the Fund on the sale or exchange of municipal bonds are taxable to shareholders of the Fund when distributed to shareholders.
Certain Investments in REITs
Any investment by the Fund in equity securities of REITs may result in the Fund’s receipt of cash in excess of the REIT’s earnings; if the Fund distributes these amounts, these distributions could constitute a return of capital to Fund shareholders for U.S. federal income tax purposes. Investments in REIT equity securities also may require the Fund to accrue and to distribute income not yet received. To generate sufficient cash to make the requisite distributions, the Fund may be required to sell securities in its portfolio (including when it is not advantageous to do so) that it otherwise would have continued to hold. Dividends received by the Fund from a REIT generally will not constitute qualified dividend income.
Pursuant to proposed regulations on which the Fund may rely, distributions by the Fund to its shareholders that the Fund properly reports as “section 199A dividends,” as defined and subject to certain conditions described below, are treated as qualified REIT dividends in the hands of non-corporate shareholders. Non-corporate shareholders are permitted a federal income tax deduction equal to 20% of qualified REIT dividends received by them, subject to certain limitations. Very generally, a “section 199A dividend” is any dividend or portion thereof that is attributable to certain dividends received by a RIC from REITs, to the extent such dividends are properly reported as such by the RIC in a written notice to its shareholders. A section 199A dividend is treated as a qualified REIT dividend only if the shareholder receiving such dividend holds the dividend-paying RIC shares for at least 46 days of the 91-day period beginning 45 days before the shares become ex-dividend, and is not under an obligation to make related payments with respect to a position in substantially similar or related property. The Fund is permitted to report such part of its dividends as section 199A dividends as are eligible, but is not required to do so.
Foreign Currency Transactions
The Fund’s transactions in foreign currencies, foreign currency-denominated debt obligations and certain foreign currency options, futures contracts and forward contracts (and similar instruments) may give rise to ordinary income or loss to the extent such income or loss results from fluctuations in the value of the foreign currency concerned. Any such net gains could require a larger dividend toward the end of the calendar year. Any such net losses will generally
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reduce and potentially require the recharacterization of prior ordinary income distributions and may accelerate Fund distributions to shareholders and increase the distributions taxed to shareholders as ordinary income. Any net ordinary losses so created cannot be carried forward by the Fund to offset income or gains earned in subsequent taxable years.
Options, Futures, and Forward Contracts, Swap Agreements, and other Derivatives
In general, option premiums received by the Fund are not immediately included in the income of the Fund. Instead, the premiums are recognized when the option contract expires, the option is exercised by the holder, or the Fund transfers or otherwise terminates the option (e.g. through a closing transaction). If a call option written by the Fund is exercised and the Fund sells or delivers the underlying stock, the Fund generally will recognize capital gain or loss equal to (a) the sum of the strike price and the option premium received by the Fund minus (b) the Fund’s basis in the stock. Such gain or loss generally will be short-term or long-term depending upon the holding period of the underlying stock. If securities are purchased by the Fund pursuant to the exercise of a put option written by it, the Fund will generally subtract the premium received for purposes of computing its cost basis in the stock purchased. Gain or loss arising in respect of a termination of the Fund’s obligation under an option other than through the exercise of the option will be short-term capital gain or loss depending on whether the premium income received by the Fund is greater or less than the amount paid by the Fund (if any) in terminating the transaction. Thus, for example, if an option written by the Fund expires unexercised, the Fund generally will recognize short-term capital gain equal to the premium received.
The Fund’s options activities may include transactions constituting straddles for U.S. federal income tax purposes, that is, that trigger the U.S. federal income tax straddle rules contained primarily in Section 1092 of the Code. Such straddles include, for example, positions in a particular security, or an index of securities, and one or more options that offset the former position, including options that are “covered” by the Fund’s long position in the subject security. Very generally, where applicable, Section 1092 requires (i) that losses be deferred on positions deemed to be offsetting positions with respect to “substantially similar or related property” to the extent of unrealized gain in the latter, and (ii) that the holding period of such a straddle position that has not already been held for the long-term holding period be terminated and begin anew once the position is no longer part of a straddle. Options on single stocks that are not “deep in the money” may constitute qualified covered calls, which generally are not subject to the straddle rules; the holding period on stock underlying qualified covered calls that are “in the money” although not “deep in the money” will be suspended during the period that such calls are outstanding. Thus, the straddle rules and the rules governing qualified covered calls could cause gains that would otherwise constitute long-term capital gains to be treated as short-term capital gains, and distributions that would otherwise constitute “qualified dividend income” or qualify for the dividends-received deduction to fail to satisfy the holding period requirements and therefore to be taxed as ordinary income or to fail to qualify for the dividends received deduction, as the case may be.
The tax treatment of certain positions entered into by the Fund, including regulated futures contracts, certain foreign currency positions and certain listed non-equity options, will be governed by section 1256 of the Code (“section 1256 contracts”). Gains or losses on section 1256 contracts generally are considered 60% long-term and 40% short-term capital gains or losses (“60/40”), although certain foreign currency gains and losses from such contracts may be treated as ordinary in character. Also, section 1256 contracts held by the Fund at the end of each taxable year (and, for purposes of the 4% excise tax, on certain other dates as prescribed under the Code) are “marked to market” with the result that unrealized gains or losses are treated as though they were realized and the resulting gain or loss is treated as ordinary or 60/40 gain or loss, as applicable.
Derivatives, Hedging, and Other Transactions
In addition to the special rules described above in respect of futures and options transactions, the Fund’s transactions in other derivatives instruments (e.g., forward contracts and swap agreements), as well as any of its hedging, short sale, securities loan or similar transactions may be subject to one or more special tax rules (e.g., notional principal contract, straddle, constructive sale, straddle, wash sale and short sale rules). These rules may affect whether gains and losses recognized by the Fund are treated as ordinary or capital, accelerate the recognition of income or gains to the Fund, defer losses to the Fund, and cause adjustments in the holding periods of the Fund’s securities, thereby affecting, among other things, whether capital gains and losses are treated as short-term or long-term. These rules could, therefore, affect the amount, timing and/or character of distributions to shareholders.
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Because these and other tax rules applicable to these types of transactions are in some cases uncertain under current law, an adverse determination or future guidance by the IRS with respect to these rules (which determination or guidance could be retroactive) may affect whether the Fund has made sufficient distributions, and otherwise satisfied the relevant requirements, to maintain its qualification as a RIC and avoid a Fund-level tax.
Commodities and Commodity-Linked Instruments
The Fund’s investments in commodities and commodity-linked instruments, if any, will potentially be limited by the Fund’s intention to qualify as a RIC, and will potentially limit the Fund’s ability to so qualify. Income and gains from commodities and certain commodity-linked instruments do not constitute qualifying income to a RIC for purposes of the 90% gross income test described above. In addition, the tax treatment of some other commodity-linked instruments in which the Fund might invest is not certain, in particular with respect to whether income or gains from such instruments constitute qualifying income to a RIC. If the Fund were to treat income or gain from a particular instrument as qualifying income and the income or gain were later determined not to constitute qualifying income, and, together with any other nonqualifying income, caused the Fund’s nonqualifying income to exceed 10% of its gross income in any taxable year, the Fund would fail to qualify as a RIC unless it is eligible to and does pay a tax at the Fund level.
Book-Tax Differences
Certain of the Fund’s investments in derivative instruments and foreign currency-denominated instruments, and any of the Fund’s transactions in foreign currencies and hedging activities, are likely to produce a difference between its book income and the sum of its taxable income and net tax-exempt income (if any). If such a difference arises, and the Fund’s book income is less than the sum of its taxable income and net tax-exempt income (if any), the Fund could be required to make distributions exceeding book income to qualify as a RIC that is accorded special tax treatment and to avoid an entity-level tax. In the alternative, if the Fund’s book income exceeds the sum of its taxable income (including realized capital gains) and net tax-exempt income (if any), the distribution (if any) of such excess generally will be treated as (i) a dividend to the extent of the Fund’s remaining earnings and profits, (ii) thereafter, as a return of capital to the extent of the recipient’s basis in its shares and (iii) thereafter, as gain from the sale or exchange of a capital asset.
Short Sales
If the Fund participates in a short sale and, on the date of such short sale, the Fund either (i) does not hold securities substantially identical to those sold short or (ii) has held such substantially identical securities for one year or less, the character of gain or loss realized on such a short sale generally will be short-term. If the Fund participates in a short sale and, on the date of such short sale, the Fund has held substantially identical securities for more than one year, the character of gain realized on such short sale will be determined by reference to the Fund’s holding period in the property actually used to close the short sale; the character of loss realized on such short sale generally will be long term, regardless of the holding period of the securities actually used to close such short sale. Because net short-term capital gain (after reduction by any long-term capital loss) is generally taxed at ordinary income rates, the Fund’s short sale transactions can increase the percentage of the Fund’s gains that are taxable to shareholders as ordinary income.
Mortgage-Related Securities
The Fund may invest directly or indirectly in REMICs (including by investing in residual interests in CMOs with respect to which an election to be treated as a REMIC is in effect) or equity interests in TMPs. Under a notice issued by the IRS in October 2006 and U.S. Treasury regulations that have yet to be issued but may apply retroactively, a portion of the Fund’s income (including income allocated to the Fund from a REIT or other pass-through entity) that is attributable to a residual interest in a REMIC or an equity interest in a TMP—referred to in the Code as an “excess inclusion”—will be subject to U.S. federal income tax in all events. This notice also provides, and the regulations are expected to provide, that “excess inclusion income” of a RIC, such as the Fund, will be allocated to shareholders of the RIC in proportion to the dividends received by such shareholders, with the same consequences as if the shareholders held the related interest directly. As a result, the Fund may not be a suitable investment for charitable remainder trusts (“CRTs”), as noted below.
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Non-U.S. Taxation
Income, proceeds and gains received by the Fund from sources within foreign countries may be subject to withholding and other taxes imposed by such countries, which will reduce the return on those investments. Tax treaties between certain countries and the United States may reduce or eliminate such taxes.
If, at the close of its taxable year, more than 50% of the value of the Fund’s total assets consists of securities of foreign corporations, including for this purpose foreign governments, the Fund will be permitted to make an election under the Code that will allow shareholders a deduction or credit for foreign taxes paid by the Fund. In such a case, shareholders will include in gross income from foreign sources their pro rata shares of such taxes. A shareholder’s ability to claim an offsetting foreign tax credit or deduction in respect of such foreign taxes is subject to certain limitations imposed by the Code, which may result in the shareholder’s not receiving a full credit or deduction (if any) for the amount of such taxes. Shareholders who do not itemize on their U.S. federal income tax returns may claim a credit (but not a deduction) for such foreign taxes. If the Fund does not qualify for or chooses not to make such an election, shareholders will not be entitled separately to claim a credit or deduction for U.S. federal income tax purposes with respect to foreign taxes paid by the Fund; in that case the foreign tax will nonetheless reduce the Fund’s taxable income. Even if the Fund elects to pass through to its shareholders foreign tax credits or deductions, tax-exempt shareholders and those who invest in the Fund through tax-advantaged accounts (including those who invest through individual retirement accounts or other tax-advantaged retirement plans) will not benefit from any such tax credit or deduction.
Tax-Exempt Shareholders
Income of a RIC that would be UBTI if earned directly by a tax-exempt entity will not generally be attributed as UBTI to a tax-exempt shareholder of the RIC. Notwithstanding this “blocking” effect, a tax-exempt shareholder could realize UBTI by virtue of its investment in the Fund if shares in the Fund constitute debt-financed property in the hands of the tax-exempt shareholder within the meaning of Code Section 514(b). A tax-exempt shareholder may also recognize UBTI if the Fund recognizes “excess inclusion income” derived from direct or indirect investments in residual interests in REMICs or equity interests in TMPs as described above, if the amount of such income recognized by the Fund exceeds the Fund’s investment company taxable income (after taking into account deductions for dividends paid by the Fund).
In addition, special tax consequences apply to charitable remainder trusts (“CRTs”) that invest in regulated investment companies that invest directly or indirectly in residual interests in REMICs or equity interests in TMPs. Under legislation enacted in December 2006, if a CRTs, as defined in Section 664 of the Code, realizes any UBTI for a taxable year, a 100% excise tax is imposed on such UBTI. Under IRS guidance issued in October 2006, a CRT will not recognize UBTI solely as a result of investing in a RIC that recognizes “excess inclusion income.” Rather, if at any time during any taxable year a CRT (or one of certain other tax-exempt shareholders, such as the United States, a state or political subdivision, or an agency or instrumentality thereof, and certain energy cooperatives) is a record holder of a share in a RIC that recognizes “excess inclusion income,” then the regulated investment company will be subject to a tax on that portion of its “excess inclusion income” for the taxable year that is allocable to such shareholders at the highest federal corporate income tax rate. The extent to which this IRS guidance remains applicable in light of the December 2006 legislation is unclear. To the extent permitted under the 1940 Act, the Fund may elect to specially allocate any such tax to the applicable CRT, or other shareholder, and thus reduce such shareholder’s distributions for the year by the amount of the tax that relates to such shareholder’s interest in the Fund. CRTs and other tax-exempt shareholders are urged to consult their tax advisors concerning the consequences of investing in the Fund.
Non-U.S. Shareholders
Distributions by the Fund to shareholders that are not “United States persons” within the meaning of the Code (“foreign shareholders”) properly reported by the Fund as (1) Capital Gain Dividends, (2) short-term capital gain dividends, or (3) interest-related dividends, each as defined and subject to certain conditions described below generally are not subject to withholding of U.S. federal income tax.
In general, the Code defines (1) “short-term capital gain dividends” as distributions of net short-term capital gains in excess of net long-term capital losses and (2) “interest-related dividends” as distributions from U.S. source interest income of types similar to those not subject to U.S. federal income tax if earned directly by an individual foreign
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shareholder, in each case to the extent such distributions are properly reported as such by the Fund in a written notice to shareholders. The exceptions to withholding for Capital Gain Dividends and short-term capital gain dividends do not apply to (A) distributions to an individual foreign shareholder who is present in the United States for a period or periods aggregating 183 days or more during the year of the distribution and (B) distributions attributable to gain that is effectively connected with the conduct by the foreign shareholder of a trade or business within the United States under special rules regarding the disposition of U.S. real property interests as described below. If the Fund invests in a RIC that pays such distributions to the Fund, such distributions retain their character as not subject to withholding if properly reported when paid by the Fund to foreign shareholders. The exception to withholding for interest-related dividends does not apply to distributions to a foreign shareholder (A) that has not provided a satisfactory statement that the beneficial owner is not a United States person, (B) to the extent that the dividend is attributable to certain interest on an obligation if the foreign shareholder is the issuer or is a 10% shareholder of the issuer, (C) that is within certain foreign countries that have inadequate information exchange with the United States, or (D) to the extent the dividend is attributable to interest paid by a person that is a related person of the foreign shareholder and the foreign shareholder is a controlled foreign corporation.
The Fund is permitted to report such part of its dividends as interest-related or short-term capital gain dividends as are eligible, but is not required to do so. In the case of shares held through an intermediary, the intermediary may withhold even if the Fund reports all or a portion of a payment as an interest-related or short-term capital gain dividend to shareholders.
Foreign shareholders should contact their intermediaries regarding the application of withholding rules to their accounts.
Distributions by the Fund to foreign shareholders other than Capital Gain Dividends, short-term capital gain dividends, and interest-related dividends (e.g., dividends attributable to dividend and foreign-source interest income or to short-term capital gains or U.S. source interest income to which the exception from withholding described above does not apply) are generally subject to withholding of U.S. federal income tax at a rate of 30% (or lower applicable treaty rate).
A foreign shareholder is not, in general, subject to U.S. federal income tax on gains (and is not allowed a deduction for losses) realized on the sale of shares of the Fund unless (i) such gain is effectively connected with the conduct by the foreign shareholder of a trade or business within the United States, (ii) in the case of a foreign shareholder that is an individual, the shareholder is present in the United States for a period or periods aggregating 183 days or more during the year of the sale and certain other conditions are met, or (iii) the special rules relating to gain attributable to the sale or exchange of “U.S. real property interests” (“USRPIs”) apply to the foreign shareholder’s sale of shares of the Fund (as described below).
Foreign shareholders with respect to whom income from the Fund is effectively connected with a trade or business conducted by the foreign shareholder within the United States will in general be subject to U.S. federal income tax on the income derived from the Fund at the graduated rates applicable to U.S. citizens, residents or domestic corporations, whether such income is received in cash or reinvested in shares of the Fund and, in the case of a foreign corporation, may also be subject to a branch profits tax. If a foreign shareholder is eligible for the benefits of a tax treaty, any effectively connected income or gain will generally be subject to U.S. federal income tax on a net basis only if it is also attributable to a permanent establishment maintained by the shareholder in the United States. More generally, foreign shareholders who are residents in a country with an income tax treaty with the United States may obtain different tax results than those described herein, and are urged to consult their tax advisors.
Special rules would apply if the Fund were a qualified investment entity (“QIE”) because it is either a “U.S. real property holding corporation” (“USRPHC”) or would be a USRPHC but for the operation of certain exceptions to the definition thereof. Very generally, a USRPHC is a domestic corporation that holds USRPIs the fair market value of which equals or exceeds 50% of the sum of the fair market values of the corporation’s USRPIs, interests in real property located outside the United States, and other trade or business assets. USRPIs are generally defined as any interest in U.S. real property and any interest (other than solely as a creditor) in a USRPHC or, very generally, an entity that has been a USRPHC in the last five years. A RIC that holds, directly or indirectly, significant interests in REITs may be a USRPHC. Interests in domestically controlled QIEs, including REITs and RICs that are QIEs, not-greater-than-10% interests in publicly traded classes of stock in REITs and not-greater-than-5% interests in
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publicly traded classes of stock in RICs generally are not USRPIs, but these exceptions do not apply for purposes of determining whether the Fund is a QIE.
If an interest in the Fund were a USRPI, the Fund would be required to withhold U.S. tax on the proceeds of a share repurchase by a greater-than-5% foreign shareholder or any foreign shareholder if shares of the Fund are not considered regularly traded on an established securities market, in which case such foreign shareholder generally would also be required to file a U.S. tax return and pay any additional taxes due in connection with the repurchase.
If the Fund were a QIE, under a special “look-through” rule, any distributions by the Fund to a foreign shareholder (including, in certain cases, distributions made by the Fund in redemption of its shares) attributable directly or indirectly to (i) distributions received by the Fund from a lower-tier RIC or REIT that the Fund is required to treat as USRPI gain in its hands, or (ii) gains realized by the Fund on the disposition of USRPIs would retain their character as gains realized from USRPIs in the hands of the Fund’s foreign shareholders, and would be subject to U.S. withholding tax. In addition, such distributions could result in the foreign shareholder being required to file a U.S. tax return and pay tax on the distributions at regular U.S. federal income tax rates. The consequences to a foreign shareholder, including the rate of such withholding and character of such distributions (e.g., as ordinary income or USRPI gain), would vary depending upon the extent of the foreign shareholder’s current and past ownership of the Fund.
The Fund generally does not expect that it will be a QIE. Foreign shareholders should consult their tax advisers and, if holding shares through intermediaries, their intermediaries, concerning the application of these rules to their investment in the Fund.
Foreign shareholders also may be subject to “wash sale” rules to prevent the avoidance of the tax-filing and -payment obligations discussed above through the sale and repurchase of Fund shares.
In order for a foreign shareholder to qualify for any exemptions from withholding described above or for lower withholding tax rates under income tax treaties, or to establish an exemption from backup withholding, a foreign shareholder must comply with special certification and filing requirements relating to its non-U.S. status (including, in general, furnishing an IRS Form W-8BEN, W-8BEN-E or substitute form). Foreign shareholders should consult their tax advisors in this regard.
Special rules (including withholding and reporting requirements) apply to foreign partnerships and those holding Fund shares through foreign partnerships. Additional considerations may apply to foreign trusts and estates. Investors holding Fund shares through foreign entities should consult their tax advisers about their particular situation.
A foreign shareholder may be subject to state and local tax and to the U.S. federal estate tax in addition to the U.S. federal income tax referred to above.
A beneficial holder of shares who is a non-U.S. person may be subject to state and local tax and to the U.S. federal estate tax in addition to the U.S. federal tax on income referred to above.
Backup Withholding
The Fund is generally required to withhold and remit to the U.S. Treasury a percentage of taxable distributions and redemption proceeds, if any, paid to any individual shareholder who fails to properly furnish the Fund with a correct taxpayer identification number, who has under-reported dividend or interest income, or who fails to certify to the Fund that he or she is not subject to such withholding. Backup withholding is not an additional tax. Any amounts withheld may be credited against the shareholder’s U.S. federal income tax liability, provided the appropriate information is furnished to the IRS.
Tax Shelter Reporting Regulations
Under U.S. Treasury regulations, if a shareholder recognizes a loss of $2 million or more for an individual shareholder or $10 million or more for a corporate shareholder, the shareholder must file with the IRS a disclosure statement on IRS Form 8886. Direct shareholders of portfolio securities are in many cases excepted from this reporting requirement, but under current guidance, shareholders of a RIC are not excepted. Future guidance may extend the
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current exception from this reporting requirement to shareholders of most or all RICs. The fact that a loss is reportable under these regulations does not affect the legal determination of whether the taxpayer’s treatment of the loss is proper. Shareholders should consult their tax advisors to determine the applicability of these regulations in light of their individual circumstances.
Other Reporting and Withholding Requirements
Sections 1471-1474 of the Code and the U.S. Treasury and IRS guidance issued thereunder (collectively, “FATCA”) generally require the Fund to obtain information sufficient to identify the status of each of its shareholders under FATCA or under an applicable intergovernmental agreement (an “IGA”) between the United States and a foreign government. If a shareholder fails to provide the requested information or otherwise fails to comply with FATCA or an IGA, the Fund may be required to withhold under FATCA at a rate of 30% with respect to that shareholder on ordinary dividends. The IRS and the Department of Treasury have issued proposed regulations providing that these withholding rules will not apply to the gross proceeds of share redemptions or Capital Gain Dividends the Fund pays. If a payment by the Fund is subject to FATCA withholding, the Fund is required to withhold even if such payment would otherwise be exempt from withholding under the rules applicable to foreign shareholders described above (e.g., Capital Gain Dividends, short-term capital gain dividends and interest-related dividends).
Shareholders that are U.S. persons and own, directly or indirectly, more than 50% of the Fund could be required to report annually their “financial interest” in the Fund’s foreign financial accounts, if any, on FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR). Shareholders should consult a tax advisor, and persons investing in the Fund through an intermediary should contact their intermediary, regarding the applicability to them of this reporting requirement.
Each prospective investor is urged to consult its tax adviser regarding the applicability of FATCA and any other reporting requirements with respect to the prospective investor’s own situation, including investments through an intermediary.
Shares Purchased Through Tax-Qualified Plans
Special tax rules apply to investments through defined contribution plans and other tax-qualified plans. Shareholders should consult their tax advisers to determine the suitability of shares of the Fund as an investment through such plans and the precise effect of an investment on their particular tax situation.
PERFORMANCE RELATED AND COMPARATIVE INFORMATION
The Fund may quote certain performance-related information and may compare certain aspects of its portfolio and structure to other substantially similar closed-end funds as categorized by Broadridge Financial Solutions, Inc. (“Broadridge”), Morningstar Inc. or other independent services. Comparison of the Fund to an alternative investment should be made with consideration of differences in features and expected performance. The Fund may obtain data from sources or reporting services, such as Bloomberg Financial and Broadridge, that the Fund believes to be generally accurate.
The Fund, in its advertisements, may refer to pending legislation from time to time and the possible effect of such legislation on investors, investment strategy and related matters. At any time in the future, yields and total return may be higher or lower than past yields and there can be no assurance that any historical results will continue.
Past performance is not indicative of future results. At the time Common Shareholders sell their shares, they may be worth more or less than their original investment.
CUSTODIAN, TRANSFER AGENT, Shareholder Servicing Agent, AUCTION AGENT AND DIVIDEND DISBURSEMENT AGENT
State Street Bank and Trust Company, 801 Pennsylvania Avenue Kansas City, MO 64105, serves as custodian for assets of the Fund. The custodian performs custodial and fund accounting services.
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Equiniti Trust Company, LLC, 48 Wall Street, Floor 23, New York, New York 10005, serves as the transfer agent, registrar and dividend disbursement agent for the Common Shares, as well as agent for the Dividend Reinvestment Plan relating to the Common Shares.
The Investment Manager, at its own expense, has retained Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner & Smith, Incorporated, and UBS Securities LLC to serve as shareholder servicing agents for the Fund.
Deutsche Bank Trust Company Americas, 60 Wall Street, New York, New York 10005, serves as auction agent, transfer agent, registrar, dividend paying agent and redemption agent for the Preferred Shares.
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
PricewaterhouseCoopers LLP (“PwC”), 1100 Walnut Street, Suite 1300, Kansas City, MO 64106, serves as the independent registered public accounting firm for the Fund. PwC provides audit services, tax and other audit related services to the Fund.
COUNSEL
Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, Massachusetts 02199, passes upon certain legal matters in connection with shares offered by the Fund, and also acts as counsel to the Fund.
REGISTRATION STATEMENT
A Registration Statement on Form N-2, including any amendments thereto (the “Registration Statement”), relating to the Common Shares of the Fund offered hereby, has been filed by the Fund with the SEC, Washington, D.C. The Prospectus and this Statement of Additional Information are parts of, but do not contain all of the information set forth in, the Registration Statement, including any exhibits and schedules thereto. For further information with respect to the Fund and the Common Shares offered or to be offered hereby, reference is made to the Fund’s Registration Statement. Statements contained in the Prospectus and this Statement of Additional Information as to the contents of any contract or other document referred to are not necessarily complete and in each instance reference is made to the copy of such contract or other document filed as an exhibit to the Registration Statement, each such statement being qualified in all respects by such reference. Copies of all or any part of the Registration Statement may be obtained from the SEC upon the payment of certain fees prescribed by the SEC.
FINANCIAL STATEMENTS
The Fund’s unaudited financial statements appearing in the Fund’s semi-annual shareholder report for the period ended December 31, 2023 are incorporated by reference in this Statement of Additional Information.
The Fund’s financial statements appearing in the Fund’s annual shareholder report for the year ended June 30, 2023 are incorporated by reference in this Statement of Additional Information and have been so incorporated in reliance upon the reports of PwC, independent registered public accounting firm for the Fund, which report is included in such annual shareholder report.
The Fund’s shareholder reports available upon request and without charge by writing to the Fund at c/o Pacific Investment Management Company LLC, 1633 Broadway, New York, New York 10019.
INCORPORATION BY REFERENCE
As noted above, this Statement of Additional Information is part of a registration statement filed with the SEC. The Fund is permitted to “incorporate by reference” the information filed with the SEC, which means that the Fund can disclose important information to you by referring you to those documents. In addition, all documents subsequently filed by the Fund pursuant to Sections 13(a), 13(c), 14 or 15(d) of the Exchange Act (excluding any information furnished rather than filed) prior to the termination of the offering shall be deemed to be incorporated by reference into the prospectus and this Statement of Additional Information. The information incorporated by reference is an important part of this this Statement of Additional Information. Any statement in a document incorporated by reference into this Statement of Additional Information will be deemed to be automatically modified or superseded to
127
the extent a statement contained in (1) this Statement of Additional Information or (2) any other subsequently filed document that is incorporated by reference into this Statement of Additional Information modifies or supersedes such statement. The documents incorporated by reference herein include:
■
the Fund’s prospectus, dated [ ], filed with this statement of additional information;
■
■
■
You may obtain copies of any information incorporated by reference into this Statement of Additional Information, at no charge, by calling toll-free (844)-337-4626 or by writing to the Fund at c/o Pacific Investment Management Company LLC, 1633 Broadway, New York, New York 10019. The Fund’s periodic reports filed pursuant to Section 30(b)(2) of the 1940 Act and Sections 13 and 15(d) of the Exchange Act, as well as the Prospectus and this Statement of Additional Information, are available on the Fund’s website http://www.pimco.com/prospectuses. In addition, the SEC maintains a website at www.sec.gov, free of charge that contains these reports, the Fund’s proxy and information statements, and other information relating to the Fund.
128
Appendix A
Procedures for Shareholders to Submit Nominee Candidates for the PIMCO Sponsored Closed-End Funds
A Fund shareholder must follow the following procedures in order to properly submit a nominee recommendation for the Committee’s consideration.
1.
The shareholder/stockholder must submit any such recommendation (a “Shareholder Recommendation”) in writing to a Fund, to the attention of the Secretary, at the address of the principal executive offices of the Fund.
2.
The Shareholder Recommendation must be delivered to or mailed and received at the principal executive offices of a Fund not less than forty-five (45) calendar days nor more than seventy-five (75) calendar days prior to the date of the Board or shareholder meeting at which the nominee would be elected.
3.
The Shareholder Recommendation must include: (i) a statement in writing setting forth (A) the name, age, date of birth, business address, residence address and nationality of the person recommended by the shareholder (the “candidate”); (B) the class and number of all shares of the Fund owned of record or beneficially by the candidate, as reported to such shareholder by the candidate; (C) any other information regarding the candidate called for with respect to director nominees by paragraphs (a), (d), (e) and (f) of Item 401 of Regulation S-K or paragraph (b) of Item 22 of Rule 14a-101 (Schedule 14A) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), adopted by the Securities and Exchange Commission (or the corresponding provisions of any regulation or rule subsequently adopted by the Securities and Exchange Commission or any successor agency applicable to the Fund); (D) any other information regarding the candidate that would be required to be disclosed if the candidate were a nominee in a proxy statement or other filing required to be made in connection with solicitation of proxies for election of Directors/Trustees or directors pursuant to Section 14 of the Exchange Act and the rules and regulations promulgated thereunder; and (E) whether the recommending shareholder believes that the candidate is or will be an “interested person” of the Fund (as defined in the Investment Company Act of 1940, as amended) and, if not an “interested person,” information regarding the candidate that will be sufficient for the Fund to make such determination; (ii) the written and signed consent of the candidate to be named as a nominee and to serve as a Director/Trustee if elected; (iii) the recommending shareholder’s name as it appears on the Fund’s books; (iv) the class and number of all shares of the Fund owned beneficially and of record by the recommending shareholder; and (v) a description of all arrangements or understandings between the recommending shareholder and the candidate and any other person or persons (including their names) pursuant to which the recommendation is being made by the recommending shareholder. In addition, the Committee may require the candidate to furnish such other information as it may reasonably require or deem necessary to determine the eligibility of such candidate to serve on the Board.
CEF005SAI_041924
A-1
PART C - OTHER INFORMATION
Item 25: Financial Statements and Exhibits
Included in Part A:
Financial highlights for the six months ended December 31, 2023, fiscal year ended June 30, 2023, the fiscal period ended June 30, 2022, the fiscal years ended July 31, 2021, July 31, 2020, July 31, 2019, July 31, 2018, July 31, 2017, July 31, 2016, July 31, 2015, July 31, 2014, and July 31, 2013.
Incorporated into Part B by reference to Registrant’s most recent Certified Shareholder Report on Form N-CSRS, filed March 5, 2024 (File No. 811-21601)
Schedule of Investments as of December 31, 2023
Statement of Assets and Liabilities as of December 31, 2023
Statement of Operations for the six-months ended December 31, 2023
Statement of Changes in Net Assets for the six-months ended December 31, 2023
Statement of Cash Flows for the six-months ended December 31, 2023
Notes to Financial Statements
Incorporated into Part B by reference to Registrant’s most recent Certified Shareholder Report on Form N-CSR, filed September 1, 2023 (File No. 811-21601)
Schedule of Investments as of June 30, 2023
Statement of Assets and Liabilities as of June 30, 2023
Statement of Operations for the fiscal period ended June 30, 2023
Statements of Changes in Net Assets for the period ended June 30, 2023
Statement of Cash Flows for the fiscal period June 30, 2023
Notes to Financial Statements
Report of Independent Registered Public Accounting Firm dated August 25, 2023
Exhibits:
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a.1 |
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a.2 |
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a.3 |
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a.4 |
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a.5 |
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a.8 |
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a.9 |
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a.10 |
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a.11 |
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a.12 |
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a.13 |
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b. |
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c. |
None. |
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d.1 |
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d.2 |
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d.3 |
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d.4 |
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e. |
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f. |
None. |
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g. |
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h. |
Sales Agreement dated [ ], 2024.* |
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i. |
None. |
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j.1 |
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j.2 |
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k.1 |
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k.2 |
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k.3 |
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k.4 |
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k.5 |
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k.6 |
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k.7 |
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l. |
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m. |
None. |
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n. |
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o. |
None. |
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p. |
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q. |
None. |
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r.1 |
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r.2 |
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r.3 |
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s. |
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t.1 |
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t.2 |
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t.3 |
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u |
(1)
Incorporated by reference to Pre-Effective Amendment No. 2 to the Registrant’s Registration Statement on Form N-2 relating to its common shares of beneficial interest, Registration Nos. 333-117187 and 811- 21601 (filed on October 22, 2004).
(2)
Incorporated by reference to Pre-Effective Amendment No.1 to the Registrant’s Registration Statement on Form N-2 relating to its preferred shares of beneficial interest, Registration Nos. 333-120227 and 811-21601 (filed on March 12, 2010).
(3)
Incorporated by reference to Pre-Effective Amendment No. 1 to the Registrant’s Registration Statement on Form N-2, Registration Nos. 333-226215 and 811-21601 (filed on August 31, 2018).
(4)
Incorporated by reference to the Registrant’s Registration Statement on Form N-2, Registration Nos. 333-249436 and 811-21601 (filed on November 23, 2020).
(5)
Incorporated by reference to the Registrant’s Annual Report on Form N-CEN (File No. 811-21601) (filed September 12, 2022).
(6)
Incorporated by reference to Pre-Effective Amendment No.1 to the Registrant’s Registration Statement on Form N-2 relating to its preferred shares of beneficial interest, Registration Nos. 333-164388 and 811-21601 (filed on December 15, 2004).
(7)
Incorporated by reference to PIMCO Dynamic Income Fund’s Registration Statement on Form N-2, File Nos. 333-265802 and 811-22673 (filed on June 23, 2022).
(8)
Incorporated by reference to the Registrant’s Registration Statement on Form N-2, Registration Nos. 333-275116 and 811-21601 (filed on October 20, 2023)
*
To be filed by amendment.
**
Filed herewith.
Item 26: Marketing Arrangements
Reference is made to the sales agreement for the Registrant’s common shares (to be filed by amendment) and the section entitled “Plan of Distribution” contained in the Registrant’s Prospectus, filed as Part A of the Registrant’s Registration Statement and incorporated herein by reference.
Item 27: Other Expenses of Issuance and Distribution
| Securities and Exchange Commission Fees |
$18,540 |
| Financial Industry Regulatory Authority, Inc. Fees |
$0 |
| Printing and Engraving Expenses |
$15,000 |
| Legal Fees |
$150,000 |
| New York Stock Exchange Fees |
$124,134 |
| Accounting Expenses |
$77,750 |
| Transfer Agent Fees |
$0 |
| Trustee Fees |
$0 |
| Marketing Expenses |
$0 |
| Miscellaneous Expenses |
$0 |
| Total |
$385,424 |
Item 28: Persons Controlled by or under Common Control with Registrant
Not applicable.
Item 29: Number of Holders of Securities
At April 9, 2024:
| Title of Class |
Number of Record Holders |
| Common Shares, par value $0.00001 |
104 |
| Preferred Shares, par value $0.00001 |
14 |
Item 30: Indemnification
Reference is made to Article VIII, Sections 1 through 4, of the Registrant’s Amended and Restated Agreement and Declaration of Trust, which is incorporated by reference herein.
Insofar as indemnification for liabilities arising under the Securities Act of 1933, as amended (the “Securities Act”), may be permitted to trustees, officers and controlling persons of the Registrant by the Registrant pursuant to the Trust’s Amended and Restated Agreement and Declaration of Trust, its Eighth Amended and Restated Bylaws or otherwise, the Registrant is aware that in the opinion of the Securities and Exchange Commission, such indemnification is against public policy as expressed in the Securities Act and, therefore, is unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by trustees, officers or controlling persons of the Registrant in the successful defense of any action, suit or proceeding) is asserted by such trustees, officers or controlling persons in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue.
Item 31: Business and Other Connections of Investment Adviser
Pacific Investment Management Company LLC (“PIMCO”) is an investment adviser registered under the Investment Advisers Act of 1940 (the “Advisers Act”), as amended. The list required by this Item 31 of officers and directors of PIMCO, together with any information as to any business, profession, vocation, or employment of a substantial nature engaged in by such officers and directors during the past two years, is incorporated herein by reference from Form ADV filed by PIMCO pursuant to the Advisers Act (SEC File No. 801-48187).
Item 32: Location of Accounts and Records
The account books and other documents required to be maintained by the Registrant pursuant to Section 31(a) of the Investment Company Act of 1940, as amended, and the rules thereunder will be maintained at the offices of PIMCO, 1633 Broadway, New York, New York 10019 or the Registrant’s custodian, State Street Bank and Trust Company, 801 Pennsylvania Avenue, Kansas City, Missouri 64105.
Item 33: Management Services
Not applicable.
Item 34: Undertakings
1. Not applicable.
2. Not applicable.
3. The Registrant undertakes:
(a)
to file, during any period in which offers or sales are being made, a post-effective amendment to this Registration Statement:
(1)
to include any prospectus required by Section 10(a)(3) of the Securities Act;
(2)
to reflect in the prospectus any facts or events after the effective date of the registration statement (or the most recent post-effective amendment thereof) which, individually or in the aggregate, represent a fundamental change in the information set forth in the registration statement. Notwithstanding the foregoing, any increase or decrease in volume of securities offered (if the total dollar value of securities offered would not exceed that which was registered) and any deviation from the low or high end of the estimated maximum offering range may be reflected in the form of prospectus filed with the Commission pursuant to Rule 424(b) if, in the aggregate, the changes in volume and price represent no more than 20% change in the maximum aggregate offering price set forth in the “Calculation of Registration Fee” table in the effective registration statement.
(3)
to include any material information with respect to the plan of distribution not previously disclosed in the Registration Statement or any material change to such information in the Registration Statement.
Provided, however, that paragraphs a(1), a(2), and a(3) of this section do not apply to the extent the information required to be included in a post-effective amendment by those paragraphs is contained in reports filed with or furnished to the Commission by the Registrant pursuant to Section 13 or Section 15(d) of the Exchange Act that are incorporated by reference into the registration statement, or is contained in a form of prospectus filed pursuant to Rule 424(b) that is part of the registration statement.
(b)
that, for the purpose of determining any liability under the Securities Act, each post-effective amendment shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof;
(c)
to remove from registration by means of a post-effective amendment any of the securities being registered which remain unsold at the termination of the offering; and
(d)
that, for purposes of determining liability under the Securities Act to any purchaser:
(1)
if the Registrant is subject to Rule 430B:
(A)
Each prospectus filed by the Registrant pursuant to Rule 424(b)(3) shall be deemed to be part of the registration statement as of the date the filed prospectus was deemed part of and included in the registration statement; and
(B)
Each prospectus required to be filed pursuant to Rule 424(b)(2), (b)(5), or (b)(7) as part of a registration statement in reliance on Rule 430B relating to an offering made pursuant to Rule 415(a)(1)(i), (x), or (xi) under the Securities Act for the purpose of providing the information required by Section 10 (a) of the Securities Act shall be deemed to be part of and included in the registration statement as of the earlier of the date such form of prospectus is first used after effectiveness or the date of the first contract of sale of securities in the offering described in the prospectus. As provided in Rule 430B, for liability purposes of the issuer and any person that is at that date an underwriter, such date shall be deemed to be a new effective date of the registration statement relating to the securities in the registration statement to which that prospectus relates, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. Provided, however, that no statement made in a registration statement or prospectus that is part of the registration statement or made in a document incorporated or deemed incorporated by reference into the registration statement or prospectus that is part of the registration statement will, as to a purchaser with a time of contract of sale prior to such effective date, supersede or modify any statement that was made in the registration statement or prospectus that was part of the registration statement or made in any such document immediately prior to such effective date; or
(2)
if the Registrant is subject to Rule 430C: each prospectus filed pursuant to Rule 424(b) under the Securities Act as part of a registration statement relating to an offering, other than registration statements relying on Rule 430B or other than prospectuses filed in reliance on Rule, shall be deemed to be part of and included in the registration statement as of the date it is first used after effectiveness. Provided, however, that no statement made in a registration statement or prospectus that is part of the registration statement or made in a document incorporated or deemed incorporated by reference into the registration statement or prospectus that is part of the registration statement will, as to a purchaser with a time of contract of sale prior to such first use, supersede or modify any statement that was made in the registration statement or prospectus that was part of the registration statement or made in any such document immediately prior to such date of first use.
(e)
that for the purpose of determining liability of the Registrant under the Securities Act to any purchaser in the initial distribution of securities:
The undersigned Registrant undertakes that in a primary offering of securities of the undersigned Registrant pursuant to this registration statement, regardless of the underwriting method used to sell the securities to the purchaser, if the securities are offered or sold to such purchaser by means of any of the following communications, the undersigned Registrant will be a seller to the purchaser and will be considered to offer or sell such securities to the purchaser:
(1)
any preliminary prospectus or prospectus of the undersigned Registrant relating to the offering required to be filed pursuant to Rule 424 under the Securities Act;
(2)
free writing prospectus relating to the offering prepared by or on behalf of the undersigned Registrant or used or referred to by the undersigned Registrant;
(3)
the portion of any other free writing prospectus or advertisement pursuant to Rule 482 under the Securities Act relating to the offering containing material information about the undersigned Registrant or its securities provided by or on behalf of the undersigned Registrant; and
(4)
any other communication that is an offer in the offering made by the undersigned Registrant to the purchaser.
4.
The Registrant undertakes that:
a.
For the purpose of determining any liability under the Securities Act, the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of prospectus filed by the Registrant under Rule 424(b)(1) under the Securities Act shall be deemed to be part of this registration statement as of the time it was declared effective; and
b.
For the purpose of determining any liability under the Securities Act, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of the securities at that time shall be deemed to be the initial bona fide offering thereof.
5.
The undersigned Registrant hereby undertakes that, for purposes of determining any liability under the Securities Act, each filing of the Registrant’s annual report pursuant to Section 13(a) or Section 15(d) of the Exchange Act that is incorporated by reference into the registration statement shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof.
6.
Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue.
7.
The Registrant undertakes to send by first class mail or other means designed to ensure equally prompt delivery, within two business days of receipt of a written or oral request, any prospectus or Statement of Additional Information.
NOTICE
A copy of the Amended and Restated Agreement and Declaration of Trust of PIMCO Income Strategy Fund II (the “Fund”), together with all amendments thereto, is on file with the Secretary of State of The Commonwealth of Massachusetts, and notice is hereby given that this instrument is executed on behalf of the Fund by any officer of the Fund as an officer and not individually and that the obligations of or arising out of this instrument are not binding upon any of the Trustees of the Fund or shareholders of the Fund individually, but are binding only upon the assets and property of the Fund.
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, as amended, and the Investment Company Act of 1940, as amended, the Registrant has duly caused this registration statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Boston in the State of Massachusetts on the 19th day of April, 2024.
| PIMCO INCOME STRATEGY FUND II | |
| By: |
Joshua D. Ratner* |
| Name: |
Joshua D. Ratner |
| Title: |
President |
Pursuant to the requirements of the Securities Act of 1933, this registration statement has been signed below by the following persons in the capacities and on the date indicated.
| Name |
Capacity |
Date |
| Joshua D. Ratner* Joshua D. Ratner |
President (Principal Executive Officer) |
April 19, 2024 |
| Bijal Parikh* Bijal Parikh |
Treasurer (Principal Financial & Accounting Officer) |
April 19, 2024 |
| Libby D. Cantrill* Libby D. Cantrill |
Trustee |
April 19, 2024 |
| Sarah E. Cogan* Sarah E. Cogan |
Trustee |
April 19, 2024 |
| Deborah A. DeCotis* Deborah A. DeCotis |
Trustee |
April 19, 2024 |
| David N. Fisher* David N. Fisher |
Trustee |
April 19, 2024 |
| Joseph B. Kittredge, Jr.* Joseph B. Kittredge, Jr. |
Trustee |
April 19, 2024 |
| Kathleen McCartney* Kathleen McCartney |
Trustee |
April 19, 2024 |
| Alan Rappaport* Alan Rappaport |
Trustee |
April 19, 2024 |
| Grace Vandecruze* Grace Vandecruze |
Trustee |
April 19, 2024 |
| *By: |
/s/ David C. Sullivan David C. Sullivan as attorney-in-fact |
*
Pursuant to power of attorney.
EXHIBIT LIST
