CMBS

Highlights Chart 1More Stimulus Required More Stimulus Required More Stimulus Required The unemployment rate fell for the second consecutive month in June, down to 11.1% from a peak of 14.7%. Bond markets shrugged off the news, and rightly so, as this recent pace of improvement is unlikely to continue through July and August. The main reason for pessimism is that the number of new COVID cases started rising again in late June, consistent with a pause in high-frequency economic indicators (Chart 1). This second wave of infections will slow the pace at which furloughed employees are returning to work, a development that has been responsible for all of the unemployment rate’s recent improvement. Beneath the surface, the number of permanently unemployed continues to rise (Chart 1, bottom panel). The implication for policymakers is that it is too early to back away from fiscal stimulus. In particular, expanded unemployment benefits must be extended, in some form, beyond the July 31 expiry date. We are confident that Congress will eventually pass another round of stimulus, though it may not make the July 31 deadline. For investors, bond yields are still biased higher on a 6-12 month horizon, but their near-term outlook is now in the hands of Congress. We continue to recommend benchmark portfolio duration, along with several tactical overlay trades designed to profit from higher yields. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 189 basis points in June, bringing year-to-date excess returns up to -529 bps. The average index spread tightened 24 bps on the month. We still view investment grade corporates as attractively valued, with the index’s 12-month breakeven spread only just below its historical median (Chart 2). With the Fed providing strong backing for the market, we are confident that investment grade corporate bond spreads will continue to tighten. As such, we want to focus on cyclical segments of the market that tend to outperform during periods of spread tightening (panel 2). One caveat is that the Fed’s lending facilities can’t prevent ratings downgrades (bottom panel). Therefore, we also want to avoid sectors and issuers that are mostly likely to be downgraded. High-quality Baa-rated issues are the sweet spot that we want to target. Those securities will tend to outperform the overall index as spreads tighten, but are not likely to be downgraded. Subordinate bank bonds are a prime example of securities that exist within that sweet spot.1 In recent weeks we published deep dives into several different industry groups within the corporate bond market. In addition to our overweight recommendation for subordinate bank bonds, we also recommend an overweight allocation to investment grade Healthcare bonds.2 We advise underweight allocations to investment grade Technology and Pharmaceutical bonds.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Table 3BCorporate Sector Risk Vs. Reward* Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff High-Yield: Neutral High-Yield outperformed the duration-equivalent Treasury index by 90 basis points in June, bringing year-to-date excess returns up to -855 bps (Chart 3A). The average index spread tightened 11 bps on the month and has tightened 500 bps since the Fed unveiled its corporate bond purchase programs on March 23. We reiterated our call to overweight Ba-rated junk bonds and underweight bonds rated B and below in a recent report.4 In that report, we noted that high-yield spreads appear tight relative to fundamentals across the board, but that the Ba-rated credit tier will continue to perform well because most issuers are eligible for support through the Fed’s emergency lending facilities. Specifically, we showed that “moderate” and “severe” default scenarios for the next 12 months – defined as a 9% and 12% default rate, respectively, with a 25% recovery rate – would lead to a negative excess spread for B-rated bonds (Chart 3B). The same holds true for lower-rated credits. Chart 3AHigh-Yield Market Overview High-Yield Market Overview High-Yield Market Overview Chart 3BB-Rated Excess Return Scenarios Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff We appear to be on track for that sort of outcome. Moody’s recorded 20 defaults in May, matching the worst month of the 2015/16 commodity bust and bringing the trailing 12-month default rate up to 6.4%. Meanwhile, the trailing 12-month recovery rate is a meagre 22%. At the industry level, in recent reports we recommended an overweight allocation to high-yield Technology bonds5 and underweight allocations to high-yield Healthcare and Pharmaceuticals.6 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 13 basis points in June, dragging year-to-date excess returns down to -44 bps. The conventional 30-year MBS index option-adjusted spread (OAS) has tightened 5 bps since the end of May, but it still offers a pick-up relative to other comparable sectors. The MBS index OAS stands at 95 bps, greater than the 81 bps offered by Aa-rated corporate bonds (Chart 4), the 54 bps offered by Aaa-rated consumer ABS and the 76 bps offered by Agency CMBS. At some point this spread advantage will present a buying opportunity, but we think it is still too soon. As we wrote in a recent report, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare in the second half of this year (bottom panel).7 The primary mortgage rate did not match the decline in Treasury yields seen earlier this year. Essentially, this means that even if Treasury yields are unchanged in 2020 H2, a further 50 bps drop in the mortgage rate cannot be ruled out. Such a move would lead to a significant increase in prepayment losses, one that is not priced into current index spreads. While the index OAS has widened lately, expected prepayment losses (aka option cost) have dropped (panels 2 & 3). We are concerned this decline in expected prepayment losses has gone too far and that, as a result, the current index OAS is overstated. Government-Related:  Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 78 basis points in June, bringing year-to-date excess returns up to -399 bps. Sovereign debt outperformed duration-equivalent Treasuries by 112 bps on the month, bringing year-to-date excess returns up to -828 bps. Foreign Agencies outperformed the Treasury benchmark by 37 bps in June, bringing year-to-date excess returns up to -764 bps. Local Authority debt outperformed Treasuries by 268 bps in June, bringing year-to-date excess returns up to -439 bps. Domestic Agency bonds outperformed by 14 bps, bringing year-to-date excess returns up to -58 bps. Supranationals outperformed by 12 bps, bringing year-to-date excess returns up to -19 bps. We updated our outlook for USD-denominated Emerging Market (EM) Sovereign bonds in a recent report.8 In that report we posited that valuation and currency trends are the primary drivers of EM sovereign debt performance (Chart 5). On valuation, we noted that the USD sovereign bonds of: Mexico, Colombia, UAE, Saudi Arabia, Qatar, Indonesia, Malaysia and South Africa all offer a spread pick-up relative to US corporate bonds of the same credit rating and duration. However, of those countries that offer attractive spreads, most have currencies that look vulnerable based on the ratio of exports to foreign debt obligations. In general, we don’t see a compelling case for USD-denominated sovereigns based on value and currency outlook, although Mexican debt stands out as looking attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 68 basis points in June, bringing year-to-date excess returns up to -582 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries widened in June and continue to look attractive compared to typical historical levels. In fact, both the 2-year and 10-year Aaa Muni yields are higher than the same maturity Treasury yield, despite municipal debt’s tax exempt status (Chart 6). Municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.9 In that report we also mentioned our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push muni yields lower from current levels. Despite the MLF’s shortcomings, we aren’t yet ready to downgrade our muni allocation. For one thing, federal assistance to state & local governments will probably be the centerpiece of the forthcoming stimulus bill. The Fed could also feel pressure to reduce MLF pricing if the stimulus is delayed. Further, while the budget pressure facing municipal governments is immense, states are also holding very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve was mostly unchanged in June. Both the 2-year/10-year and 5-year/30-year slopes steepened 1 bp on the month, reaching 50 bps and 112 bps, respectively. With no expectation – from either the Fed or market participants – that the fed funds rate will be lifted before the end of 2022, short-maturity yield volatility will stay low and the Treasury slope will trade directionally with the level of yields for the foreseeable future. The yield curve will steepen when yields rise and flatten when they fall. With that in mind, we continue to recommend duration-neutral yield curve steepeners that will profit from moderately higher yields, but that won’t decrease the average duration of your portfolio. Specifically, we recommend going long the 5-year bullet and short a duration-matched 2/10 barbell.10 In a recent report we noted that valuation is a concern with this recommended position.11 The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet also looks expensive on our yield curve models (Appendix B). However, we also noted that the 5-year bullet traded at much more expensive levels during the last zero-lower-bound period between 2010 and 2013 (bottom panel). With short rates once again pinned at zero, we expect the 5-year bullet will once again hit levels of extreme over-valuation. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 99 basis points in June, bringing year-to-date excess returns up to -400 bps. The 10-year TIPS breakeven inflation rate rose 19 bps on the month and currently sits at 1.39%. The 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps on the month and currently sits at 1.62%. TIPS breakevens have moved up rapidly during the past couple of months, but they remain low compared to average historical levels. Our own Adaptive Expectations Model suggests that the 10-year TIPS breakeven inflation rate should rise to 1.53% during the next 12 months (Chart 8).12 On inflation, it also looks like we are past the cyclical trough. The WTI oil price is back up to $41 per barrel after having briefly turned negative (panel 4), and trimmed mean inflation measures suggest that the massive drop in core is overdone (panel 3). If inflation has indeed troughed, then the real yield curve will continue to steepen as near-term inflation expectations move higher. We have been advocating real yield curve steepeners since the oil price turned negative in April.13 The curve has steepened considerably since then, but still has upside relative to levels seen during the past few years (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 103 basis points in June, bringing year-to-date excess returns up to -2 bps. Aaa-rated ABS outperformed duration-equivalent Treasuries by 8 bps in June, bringing year-to-date excess returns up to +7 bps. Meanwhile, non-Aaa ABS outperformed by 233 bps in June, bringing year-to-date excess returns up to -88 bps (Chart 9). Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Securities Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS and we recommend owning those securities as well. This is despite the fact that non-Aaa bonds are not eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a recent report.14  We noted that the stimulus received from the CARES act caused real personal income to increase significantly during the past few months and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further fiscal stimulus will be needed to sustain those recent income gains. But we are sufficiently confident that a follow-up stimulus bill will be passed that we advocate moving down in quality within consumer ABS. Non-Agency CMBS:  Overweight  Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 211 basis points in June, bringing year-to-date excess returns up to -501 bps. Aaa CMBS outperformed Treasuries by 164 bps in June, bringing year-to-date excess returns up to -233 bps. Non-Aaa CMBS outperformed by 407 bps in June, bringing year-to-date excess returns up to -1451 bps (Chart 10). Our view of non-agency CMBS has not changed during the past month, but we realize that it is more accurately described as a “Neutral” allocation as opposed to “Overweight”. Our view is that we want an overweight allocation to Aaa-rated CMBS because that sector offers an attractive spread relative to history and benefits from Fed support through TALF. However, we advocate an underweight allocation to non-Aaa non-agency CMBS. Those securities are not eligible for TALF and, unlike consumer ABS, their fundamental credit outlook has deteriorated significantly as a result of the COVID recession.15  Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 104 basis points in June, bringing year-to-date excess returns up to -58 bps. The average index spread tightened 19 bps on the month to 77 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Performance Since March 23 Announcement Of Emergency Fed Facilities Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of July 3, 2020) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of July 3, 2020) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 57 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 57 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of July 3, 2020) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 10 The rationale for why this position will profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 11 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 12 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 We discussed our outlook for CMBS in more detail in US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights High-Yield: Our analysis of current junk spread levels relative to likely economic outcomes leaves us inclined to maintain our current recommended positioning: Overweight Ba-rated bonds, underweight bonds rated B & below. Fed/Treasuries: There is no urgency for the Fed to provide more explicit forward rate guidance. The market has already taken on board the expectation that the funds rate will stay pinned at zero at least through the end of 2022. Investors should keep portfolio duration near benchmark but add tactical overlay positions: long TIPS versus nominal Treasuries, and steepeners along both the nominal and real yield curves. Securitizations: We recommend that investors continue to overweight Aaa-rated consumer ABS and CMBS, as both sectors offer attractive spreads and benefit from TALF. Despite the lack of Fed support, adding some non-Aaa consumer ABS exposure also makes sense. Investors should continue to avoid Agency MBS, where value has improved but prepayment risk remains high. Feature In case it wasn’t already obvious that the Fed will continue to act as a tailwind behind risky asset prices, Chair Powell made it abundantly clear at last week’s FOMC press conference. When asked about the risk of bubbles in financial markets, Powell’s response was to focus on the millions of unemployed workers and imply that it would be a dereliction of the Fed’s duties if it were to hold back on monetary stimulus because it thought asset prices were too high. Ironically, this strong statement of market support came the day before the S&P 500 fell 6% in a single session. Nonetheless, with the Fed providing such aggressive forward guidance on top of direct intervention in certain segments of the fixed income market, it behooves us to consider whether our recommended portfolio allocation is insufficiently aggressive. The Strong Performance Of Low-Rated Junk Chart 1Lower-Rated Junk Bonds Playing Catch-Up Lower-Rated Junk Bonds Playing Catch-Up Lower-Rated Junk Bonds Playing Catch-Up Within the high-yield corporate bond market we have been advising an overweight allocation to Ba-rated bonds but an underweight allocation to bonds rated B and below. The reasoning is that Ba-rated bonds are largely eligible for the Fed’s emergency lending facilities while lower-rated junk bonds are mostly left out in the cold.1 This positioning worked well throughout April and the first half of May, but lower-rated junk bonds have started to play catch-up during the past month (Chart 1). High-Yield Index Fundamentals To get a sense of whether we should extend our overweight recommendation to the B and below credit tiers, let’s first perform a valuation exercise on the entire high-yield index. In this exercise we consider current spread levels relative to likely economic outcomes. We set aside any impact from direct Fed intervention for the time being. Our analysis revolves around the High-Yield Default-Adjusted Spread (Chart 2). This valuation measure takes the junk index spread and subtracts default losses realized during the subsequent 12 month period. The spread’s historical average is around 250 bps, but it has occasionally dipped below zero during periods when default losses swamp the compensation offered by the index. Chart 2High-Yield Index Assessment: Default-Adjusted Spread High-Yield Index Assessment: Default-Adjusted Spread High-Yield Index Assessment: Default-Adjusted Spread The Default-Adjusted Spread also lines up very closely with 12-month excess returns (Chart 2, panel 2). A simple linear regression model of 12-month excess returns versus the Default-Adjusted Spread gives an R2 of 53% and tells us that the threshold between positive and negative excess returns is a Default-Adjusted Spread of 187 bps. That is, if the Default-Adjusted Spread is above 187 bps we should expect high-yield to outperform Treasuries, if it is below 187 bps we should expect high-yield to underperform. With that in mind, we can apply some quick figures to the current context. The High-Yield index option-adjusted spread is 611 bps. If we assume a default rate of 10% and recovery rate of 25% for the next 12 months, we get expected default losses of 750 bps and a Default-Adjusted Spread of -139 bps. We should expect Treasuries to outperform junk bonds in that scenario. Ba-rated bonds are largely eligible for the Fed’s emergency lending facilities while lower-rated junk bonds are mostly left out in the cold. We can also perform the same sort of analysis in reverse. If we target a Default-Adjusted Spread of 187 bps – the spread that is consistent with high-yield performing in line with Treasuries – and we also assume a recovery rate of 25%, then the current index spread gives us an implied 12-month default rate of 5.7% (Chart 2, bottom panel). That is, we should expect high-yield to outperform Treasuries during the next 12 months if the default rate comes in below 5.7%, and underperform if it is above 5.7%. There are a couple assumptions used in the above analysis that require clarification. First, we relied on a simple linear regression model to get the result that a Default-Adjusted Spread of 187 bps is consistent with junk bonds breaking even with Treasuries. This is not an entirely accurate depiction of the historical record. Table 1 shows a more complete picture of the historical linkage between the Default-Adjusted Spread and 12-month high-yield excess returns. Here, we see that junk bonds have actually outperformed duration-matched Treasuries 81% of the time when the Default-Adjusted Spread is between 150 bps and 200 bps, and 72% of the time when it is between 100 bps and 150 bps. Relative junk bond losses only become more likely than gains when the Default-Adjusted Spread is below 100 bps. Table 1The Default-Adjusted Spread & High-Yield Excess Returns No Holding Back No Holding Back Second, we assumed a 25% recovery rate when we calculated our implied default rate of 5.7%. This is low compared to the historical average, but we would argue that a low recovery rate assumption is appropriate in the current environment. We analyzed the main economic drivers of default and recovery rates in a recent Special Report and found that the recovery rate observed during an economic downturn is primarily driven by corporate balance sheet leverage heading into that downturn.2 Corporate balance sheets were carrying a lot of debt heading into the current recession, meaning that we should expect a lower-than-normal recovery rate. In fact, the current trailing 12-month recovery rate is 22%, below our assumed level. Table 2 shows what the Default-Adjusted Spread will be for the next 12 months under different default and recovery rate assumptions. We think that 25% is a reasonable recovery rate assumption and expect that the default rate will be somewhere between 9% and 12% during the next 12 months. At present, Moody’s baseline 12-month default rate forecast is 11.6%. Table 2Default-Adjusted Spread (BPs) Given Different Assumptions For Default And Recovery Rates No Holding Back No Holding Back Clearly, junk spreads do not offer adequate compensation for default losses in the economic environment we anticipate. This logic also extends to the individual B and Caa/C credit tiers when we look at them in isolation. A Focus On B-Rated & Below Junk Bonds Charts 3A and 3B show the historical linkage between Default-Adjusted Spreads and excess returns for those specific credit tiers, with forecasts plugged in for “mild”, “moderate” and “severe” default scenarios. All three scenarios use a recovery rate of 25%. The assumed default rate is 6% in the “mild” scenario, 9% in the “moderate” scenario and 12% in the “severe” scenario. Default-adjusted compensation is unattractive in all three cases. Chart 3AB-Rated Default-Adjusted Spread No Holding Back No Holding Back Chart 3BCaa/C-Rated Default-Adjusted Spread No Holding Back No Holding Back Bottom Line: Our analysis of current junk spread levels relative to likely economic outcomes leaves us inclined to maintain our current recommended positioning: Overweight Ba-rated bonds, underweight bonds rated B & below. The Fed’s support for the Ba credit tier will significantly limit default losses for those bonds, making current spread levels attractive. However, absent Fed intervention, junk spreads are already far too tight. Investors should avoid bonds rated B & below where issuers generally don’t benefit from the Fed’s emergency programs. No Rush For More Explicit Forward Guidance In addition to Chair Powell’s strong statement of support for risky assets, last week’s FOMC meeting brought us the committee’s updated interest rate projections. With only two exceptions, those projections revealed that all Fed policymakers expect to keep the fed funds rate at its current level at least until the end of 2022. There had been some expectation that the Fed might provide more explicit forward guidance for the funds rate. Something along the lines of the “Evans Rule” that was used during the last zero-lower-bound episode. For example, the Fed could pledge to not increase rates until the unemployment rate is below some specified threshold or inflation is above some specified threshold. Fed policymakers expect to keep the fed funds rate at its current level at least until the end of 2022. This sort of forward guidance would be useful if the Fed needed to convince markets about its commitment to keeping rates pinned near zero, but the market has already internalized that message. Notice in Chart 4 that expectations priced into the overnight index swap curve show no rate hikes through the end of 2022. The same goes for the median estimate from the New York Fed’s April 2020 Survey of Market Participants. Chart 4Fed Policymakers And Market Participants Agree: No Hikes Until 2023 Fed Policymakers And Market Participants Agree: No Hikes Until 2023 Fed Policymakers And Market Participants Agree: No Hikes Until 2023 More explicit forward rate guidance will likely be required in the future, when the market starts to price-in the eventual return of rate hikes. But for the time being, the Fed will probably be content to stay the course. Treasury Positioning The combination of the Fed’s strong commitment to zero interest rates and the risks to the 6-12 month economic outlook that we detailed in last week’s report make us inclined to maintain our recommended “At Benchmark” portfolio duration stance.3 However, we also recognize that yields are more likely to rise than fall in the coming months as the US economy re-opens and the economic data trend higher. For this reason, we advise holding several tactical overlay trades that will profit from rising bond yields: overweight TIPS versus nominal Treasuries, duration-neutral nominal curve steepeners, real yield curve steepeners. On TIPS, May’s CPI report showed a third consecutive month-over-month decline but the drop was far less severe than what was seen in March and April (Chart 5). This is a preliminary indication that we could already be passed the trough in inflation. The fact that trimmed mean CPI has not followed the core measure lower during the past few months is further evidence that inflation may not fall much more from its current level (Chart 5, bottom panel). If inflation has indeed bottomed, then our recommendation to favor TIPS over nominal Treasuries looks very good. We calculate that the current 1-year TIPS breakeven inflation rate is 0.1%, slightly below trailing 12-month headline CPI inflation (Chart 5, panel 2). Along the nominal Treasury curve, we continue to recommend favoring the 5-year bullet over a duration-matched 2/10 barbell. This position will profit from continued 2/10 yield curve steepening (Chart 6). We also recommend steepeners along the real yield curve. The real 2/10 slope has already steepened a lot (Chart 6, bottom panel), but has more room to run given that the 2-year cost of inflation compensation remains well below the 10-year cost (Chart 6, panel 3). Chart 5Is The Trough In Inflation Already##br## Behind Us? Is The Trough In Inflation Already Behind Us? Is The Trough In Inflation Already Behind Us? Chart 6Keep Steepeners Along Both The Nominal And Real Yield Curves Keep Steepeners Along Both The Nominal And Real Yield Curves Keep Steepeners Along Both The Nominal And Real Yield Curves Bottom Line: There is no urgency for the Fed to provide more explicit forward rate guidance. The market has already taken on board the expectation that the funds rate will stay pinned at zero at least through the end of 2022. Investors should keep portfolio duration near benchmark but add tactical overlay positions: long TIPS versus nominal Treasuries, and steepeners along both the nominal and real yield curves. Securitized Products Update Take Some Non-Aaa Risk In Consumer ABS, But Not In CMBS Since the Fed rolled out its emergency lending facilities in late-March, our spread product strategy has been to favor sectors that offer attractive spreads and that benefit from Fed support. This has meant owning Aaa-rated consumer ABS and CMBS, which are eligible for the Fed’s Term Asset-Backed Securities Loan Facility (TALF), and avoiding non-Aaa securitizations, which don’t qualify for Fed support. How has this worked out? Aaa-rated ABS and CMBS have both performed well since spreads peaked on March 23 (Chart 7). Within ABS, Aaa issues have beaten Treasuries by 390 bps since March 23 compared to 290 bps for non-Aaa securities. In CMBS, non-Aaa securities have lagged, losing 470 bps versus Treasuries since March 23 compared to gains of 810 bps for Aaa CMBS. As Chart 7 makes plain, no segments of either market have regained all of the ground that was lost during March’s blow-up. Chart 7Opportunities In Non-Aaa Consumer ABS, But Not In CMBS Opportunities In Non-Aaa Consumer ABS, But Not In CMBS Opportunities In Non-Aaa Consumer ABS, But Not In CMBS Going forward, we think it is wise to re-consider our strategy when it comes to consumer ABS. Specifically, we think investors should dip into non-Aaa ABS where we see potential for strong returns, even in the absence of Fed support. The reason for our optimism is that consumer credit losses will probably turn out to be significantly lower than many had feared in March. During the past two months, we learned that federal government stimulus actually caused real personal income to rise by 9% since February. Also, consumers have generally been able to keep up with their debt payments.4  According to data from TransUnion, the percentage of credit card and mortgage loans that are more than 30 days past due actually declined in April compared to March. For auto loans it only increased by 7 bps (Table 3). Further, the data show that households paid off significantly more of their credit card balances than usual in April, presumably because they received an influx of cash from the government but had fewer spending opportunities due to the quarantine. Table 3No Spike In Consumer Credit Delinquencies No Holding Back No Holding Back There remains a risk that Congress will delay passing further stimulus measures to keep consumers flush during the next few months. But we think enough stimulus will be delivered to prevent a significant default spike in credit cards and auto loans. Investors should add some exposure to non-Aaa consumer ABS. CMBS is a different story. The commercial real estate market is particularly challenged by the current environment. The office and retail sectors in particular were already facing structural headwinds from remote working and online shopping, respectively. The pandemic has accelerated the adoption of those trends. Not surprisingly, May’s CMBS delinquency rate saw its largest jump since 2017 and more delinquencies are certainly on the way (Chart 8). Chart 8Challenging Environment For CMBS Challenging Environment For CMBS Challenging Environment For CMBS Investors should continue to avoid non-Aaa CMBS. Continue To Avoid Agency MBS We have been advising an underweight allocation to Agency MBS because, even though the securities benefit from support through the Fed’s direct MBS purchases, value has been insufficiently attractive. That is starting to change. Agency MBS spreads widened considerably during the past month and are now very close to Aa-rated corporate bond spreads. They are also greater than Agency CMBS and Aaa ABS spreads (Chart 9). However, despite improving valuations, we remain concerned about risks in the MBS sector. Notice in the top 2 panels of Chart 9 that the MBS option-adjusted spread (OAS) has returned to 2012 levels, but the nominal spread (which is not adjusted for expected prepayment losses) remains quite low. This means that the prepayment loss assumption embedded in the current index OAS is much lower than it was in 2012. Is this reasonable? We estimate that 63% of the conventional 30-year MBS index is eligible for refinancing. In part, yes it is. Even with mortgage rates at all-time lows, we estimate that 63% of the conventional 30-year MBS index is eligible for refinancing. This is lower than what was seen in 2012 (Chart 10). However, we would also argue that mortgage rates have room to fall further Chart 9Agency MBS Spreads Have Widened Agency MBS Spreads Have Widened Agency MBS Spreads Have Widened Chart 10Prepayment Risk Is Elevated Prepayment Risk Is Elevated Prepayment Risk Is Elevated Despite having fallen to all-time lows, this year’s decline in the 30-year mortgage rate has been much smaller than what was seen in Treasury or MBS yields (Chart 10, bottom 3 panels). The 30-year mortgage rate could drop by another 50 bps and it would only restore typical primary and secondary mortgage spread levels. We estimate that a further 50 bps drop in the mortgage rate would increase the refinanceable share of the MBS index from 63% to 74% (horizontal dashed line in the second panel of Chart 10). This is below 2012 levels, but still leads us to the conclusion that the current index OAS understates the risk of prepayment losses. In summary, the Agency MBS OAS is starting to look more attractive but we are concerned that it embeds an overly optimistic prepayment loss assumption. Investors should maintain underweight allocations to Agency MBS. Bottom Line: We recommend that investors continue to overweight Aaa-rated consumer ABS and CMBS, as both sectors offer attractive spreads and benefit from TALF. Despite the lack of Fed support, adding some non-Aaa consumer ABS exposure also makes sense. Investors should continue to avoid Agency MBS, where value has improved but prepayment risk remains high. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 4Performance Since March 23 Announcement Of Emergency Fed Facilities No Holding Back No Holding Back Footnotes 1 For more details on the Fed’s emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 4 For more details on the outlook for the US consumer please see US Investment Strategy Weekly Report, “So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)”, dated June 8, 2020, available at usis.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1More Stimulus Forthcoming? More Stimulus Forthcoming? More Stimulus Forthcoming? Last week we posited that bond yields could move modestly higher during the next couple of months as the US economy re-opens and economic growth recovers. However, any economic recovery is contingent on the US consumer maintaining an adequate amount of income, whether that income comes from employment or government assistance. So far, real personal income is holding up nicely. It is actually up 9% since February as the CARES act’s one-time stimulus checks and enlarged unemployment insurance benefits have more than offset the 9% drop in income from non-government sources (Chart 1). Contrast this with 2008, when government assistance only tempered the peak-to-trough decline in income from 8% to 4%. However, the stimulus checks are not recurring and the extra unemployment benefits lapse at the end of July. Before then, either employment income will have to rise or the government will have to pass additional stimulus measures. Otherwise, real personal income will fall and any nascent economic recovery will be stopped in its tracks. Stay tuned. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 181 basis points in May, bringing year-to-date excess returns up to -705 bps. The average index spread tightened 28 bps on the month and has tightened 199 bps since the Fed unveiled its corporate bond purchase programs on March 23. However, the index’s 12-month breakeven spread remains above its historical median (Chart 2). Spreads are high relative to history and the investment grade corporate bond market benefits strongly from Fed support.1 The sector therefore meets both our criteria for an overweight allocation. One caveat to our overweight stance is that while Fed lending can forestall bankruptcy, it can’t clean up highly-levered corporate balance sheets. With firms taking on more debt, either from the Fed or the public market, ratings downgrades remain a risk. Indeed, Moody’s already downgraded 18 investment grade issuers in March and another 7 in April, while recording no upgrades in either month (panel 4). With downgrade risk still in play, sector and firm selection is particularly important. Investors should seek out pockets of the market that are unlikely to be downgraded, subordinate bank bonds being one example (bottom panel).2  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Filling The Income Gap Filling The Income Gap Table 3BCorporate Sector Risk Vs. Reward* Filling The Income Gap Filling The Income Gap High-Yield: Neutral Chart 3AHigh-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 427 basis points in May, bringing year-to-date excess returns up to -937 bps. The average index spread tightened 107 bps on the month and has tightened 463 bps since the Fed unveiled its corporate bond purchase programs on March 23. Encouragingly, lower-rated (B & below) credits performed well in May, but they still lag the Ba credit tier since the March 23 peak in spreads (Chart 3A). Appendix A on page 14 shows returns for all fixed income sectors since March 23. Chart 3BB-Rated Excess Return Scenarios Filling The Income Gap Filling The Income Gap Better performance from the lower credit tiers that don’t benefit from the Fed’s emergency facilities signals that investors are becoming more optimistic about an economic turnaround. But for our part, we remain skeptical about valuations in the B-rated and lower space. Chart 3B shows that “moderate” and “severe” default scenarios for the next 12 months – defined as a 9% and 12% default rate, respectively, with a 25% recovery rate – would lead to a negative excess spread for B-rated bonds.3 The same holds true for lower-rated credits. We appear to be on track for that sort of outcome. Moody’s recorded 15 defaults in April, the highest monthly figure since the 2015/16 commodity bust, bringing the trailing 12-month default rate up to 5.4%. Meanwhile, the trailing 12-month recovery rate is a meagre 21%. MBS: Underweight Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in May, bringing year-to-date excess returns up to -31 bps. Chart 4MBS Market Overview MBS Market Overview MBS Market Overview The average yield of the conventional 30-year MBS index rose from 1.18% to 1.74% on the month, and the index duration extended from 1.5 to 2.9. The result is that value – as measured by the index option-adjusted spread (OAS) – has improved considerably, especially relative to other spread products. The 30-year conventional MBS index OAS is now 100 bps. This is greater than the 91 bps and 93 bps offered by Aaa-rated consumer ABS and Agency CMBS, respectively. It’s also greater than the 91 bps offered by Aa-rated corporate bonds (Chart 4). There’s no doubt that MBS are starting to look more attractive, and if current trends continue, we will likely upgrade our recommendation in the coming months. However, we are reluctant to do so just yet because we worry that the prepayment assumptions embedded in the current index OAS will turn out to be too low. Our concern stems from the extremely high primary/secondary mortgage spread (bottom 2 panels). That wide spread shows that capacity constraints have so far prevented mortgage originators from competing on price and dropping rates, even as Treasury and MBS yields plummeted. The risk remains that bond yields will stay low and that primary mortgage rates will eventually play catch-up. That could lead to a surge of refinancing activity and wider MBS spreads. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 162 basis points in May, bringing year-to-date excess returns up to -474 bps. Sovereign debt outperformed duration-equivalent Treasuries by 589 bps on the month, bringing year-to-date excess returns up to -930 bps. Foreign Agencies outperformed the Treasury benchmark by 99 bps in May, bringing year-to-date excess returns up to -798 bps. Local Authority debt outperformed Treasuries by 187 bps in May, bringing year-to-date excess returns up to -688 bps. Domestic Agency bonds outperformed by 15 bps, bringing year-to-date excess returns up to -72 bps. Supranationals outperformed by 8 bps, bringing year-to-date excess returns up to -31 bps. We updated our outlook for USD-denominated Emerging Market (EM) Sovereign bonds in a recent report.4 In that report we posited that valuation and the performance of EM currencies are the primary drivers of sovereign debt performance (Chart 5). On valuation, we noted that the USD sovereign bonds of: Mexico, Saudi Arabia, UAE, Colombia, Qatar, South Africa and Malaysia all offer a spread pick-up relative to US corporate bonds of the same credit rating and duration. However, of those countries that offer attractive spreads, most have currencies that look vulnerable based on the ratio of exports to foreign debt obligations. In general, we don’t see a compelling case for USD-denominated sovereigns based on value and currency outlook, although Mexican debt stands out as looking attractive on a risk/reward basis.    Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 290 basis points in May, bringing year-to-date excess returns up to -646 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries tightened considerably in May, but valuations remain very attractive. The 2-year Aaa Muni / Treasury spread stands at -2 bps, implying a breakeven effective tax rate of 12%.5 Meanwhile, the 10-year Aaa Muni / Treasury spread is above zero (Chart 6). As we showed in last week’s report, municipal bonds are also attractively priced relative to corporates across the entire investment grade credit spectrum.6 In last week’s report we also flagged our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push muni yields lower from current levels. Despite the MLF’s shortcomings, we aren’t yet ready to downgrade our muni allocation. For one thing, federal assistance to state & local governments is likely on its way, and the Fed could feel pressure to lower MLF pricing if that stimulus is delayed. Further, while the budget pressure facing municipal governments is immense, states are also holding very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve steepened in May, as long-maturity yields rose and short-dated yields declined slightly. The 2-year/10-year Treasury slope steepened 5 bps to end the month at 49 bps. The 5-year/30-year Treasury slope steepened 19 bps to end the month at 111 bps. One good thing about the fed funds rate being pinned at zero is that it greatly simplifies yield curve strategy. As we showed in a recent report, when the funds rate is at its lower bound the Treasury slope will trade directionally with yields.7 That is, the yield curve will steepen when yields rise and flatten when they fall. Therefore, if you want to put on a position that will profit from lower yields but that doesn’t increase the average duration of your portfolio, you can enter a duration-neutral flattener: long a 2/10 or 2/30 barbell and short the 5-year or 7-year bullet, in duration-matched terms. Or if, like us, you do not want to make a large duration bet but suspect that Treasury yields will move modestly higher as the US economy re-opens during the next couple of months, you can enter a duration-neutral steepener: long the 5-year bullet and short a duration-matched 2/10 barbell.8 In terms of value, the 5-year yield no longer trades deeply negative relative to the 2/10 and 2/30 barbells (Chart 7), though it remains somewhat expensive according to our models (see Appendix B). TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 62 basis points in May, bringing year-to-date excess returns up to -494 bps. The 10-year TIPS breakeven inflation rate rose 8 bps to 1.16%. The 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps to 1.48%. March’s market crash created an extraordinary amount of long-run value in TIPS. For example, headline CPI has to average below 1.16% for the next decade for a buy & hold investor to lose money long the 10-year TIPS and short the equivalent-maturity nominal Treasury. In last week’s report we argued that such a position should also work on a 12-month horizon.9 We calculate that headline CPI will have to be below -0.6% for the next 12 months for a long TIPS/short nominals position to lose money. With the recent drop in core inflation not mimicked by the trimmed mean and oil prices already on the mend (Chart 8), we’d bet against headline CPI getting that low. We also advise investors to enter real yield curve steepeners.10 In a repeat of the 2008/09 zero-lower-bound episode, front-end real yields jumped this year when oil prices collapsed (bottom 2 panels). In 2008/09, the real yield curve steepened sharply once oil prices troughed. We think now is a good time to position for a similar outcome. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 101 basis points in May, bringing year-to-date excess returns up to -104 bps. The index option-adjusted spread for Aaa-rated ABS tightened 49 bps on the month to 91 bps. It remains 51 bps above where it was at the beginning of the year. Aaa-rated ABS meet both our criteria to own. Index spreads are elevated and the securities benefit from Fed support through the TALF program. Specifically, TALF allows eligible counterparties to borrow against Aaa ABS collateral at a rate of OIS + 125 bps (Chart 9). TALF benefits don’t extend to non-Aaa ABS and we recommend avoiding those securities even though valuation is more attractive. Since the March 23 peak in spreads, non-Aaa ABS have outperformed Aaa-rated ABS by 197 bps, but have only re-traced a fraction of their prior losses (panel 2). As with municipal bonds, Aaa ABS yields are now below the cost of TALF loans. This certainly makes the bullish case for ABS spreads less robust. However, unlike munis, yields are only slightly below the cost of Fed support (bottom panel). Also, as shown on page 1, government spending has so far prevented a collapse in personal income. As long as this continues, it should prevent a wave of consumer bankruptcies and ABS defaults. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 99 basis points in May, bringing year-to-date excess returns up to -697 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 22 bps on the month to 169 bps. As was the case in April, non-Aaa CMBS underperformed Aaa securities (Chart 10). This is not surprising given that only Aaa-rated CMBS benefit from the Fed’s TALF program and the underlying credit outlook for commercial real estate is very poor with most people now working from home. We continue to recommend avoiding non-Aaa CMBS, but think that Aaa spreads can tighten further. The cost of borrowing against Aaa CMBS through TALF remains well below the current Aaa non-agency CMBS yield (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 62 basis points in May, bringing year-to-date excess returns up to -161 bps. The average index spread tightened 9 bps on the month to 93 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Performance Since March 23 Announcement Of Emergency Fed Facilities Filling The Income Gap Filling The Income Gap Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of May 29, 2020) Filling The Income Gap Filling The Income Gap Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of May 29, 2020) Filling The Income Gap Filling The Income Gap Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 51 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 51 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Filling The Income Gap Filling The Income Gap Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of May 29, 2020) Filling The Income Gap Filling The Income Gap Footnotes 1 For a detailed description of the Fed’s different emergency facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 2 For more details on our recommendation to favor subordinate bank bonds please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 3 For an explanation of how we calculate default-adjusted spreads by credit tier please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 5 Investors will see a greater after-tax yield in the municipal bond compared to the Treasury bond if their effective tax rate is above the breakeven effective tax rate. 6 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 8 The rationale for why barbell positions profit from curve flattening and bullet positions profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Bonds Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 10 For more details on this recommendation please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Chart 1Low-Rated Junk Returns Are Lagging Low-Rated Junk Returns Are Lagging Low-Rated Junk Returns Are Lagging The story of bond markets in April is a story about the Federal Reserve. Traditional relationships have broken down and clear divisions have formed between sectors that are receiving Fed support and those that are not. For example, we would usually expect the riskiest (i.e. lowest-rated) pockets of the corporate bond market to perform worst in down markets and best in up markets. However, Fed intervention has disrupted this dynamic since the central bank announced a slew of emergency lending facilities on March 23. Since then, Baa and Ba rated corporates – sectors that benefit from Fed support – have behaved as usual, but lower-rated junk bonds – sectors that remain cut off from Fed support – have lagged (Chart 1). To take advantage of this disruption, we continue to advocate a strategy of favoring sectors that have attractive spreads and that benefit from Fed support. Appendix A of this report presents returns across a range of fixed income sectors since the Fed’s intervention began on March 23. We will update this table regularly going forward to keep tabs on the policy-driven disruptions to typical bond market behavior. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 455 basis points in April, bringing year-to-date excess returns up to -871 bps. The average index spread tightened 70 bps on the month, and 171 bps since the Fed unveiled its corporate bond purchase programs on March 23. However, even after all that tightening, the index spread remains 113 bps wider than it was at the end of last year (Chart 2). Spreads are high relative to history and the investment grade corporate bond market benefits strongly from Fed support through the SMCCF and PMCCF.1 The sector therefore meets both of our criteria for purchase and we recommend an overweight allocation. One note of caution is that, as Chair Powell emphasized at last week’s FOMC press conference, the Fed has lending powers but not spending powers. That is, it can forestall bankruptcy for eligible firms by offering loans, but many firms will still see their credit ratings downgraded if they become saddled with debt. Already, Moody’s downgraded 219 issuers in March and upgraded only 19 (panel 4). Downgrades surely continued through April and will persist in the months ahead. With that in mind, there is value in favoring sectors and firms that are unlikely to face downgrade during the recession. As we explained in last week’s report, subordinate bank bonds are attractive in this regard.2 Banks remain very well capitalized and subordinate bonds offer greater expected returns than higher-rated senior bank debt.  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Policy-Driven Bond Market The Policy-Driven Bond Market Table 3B The Policy-Driven Bond Market The Policy-Driven Bond Market High-Yield: Neutral High-Yield outperformed the duration-equivalent Treasury index by 420 basis points in April, bringing year-to-date excess returns up to -1308 bps. The average index spread tightened 136 bps on the month, and 356 bps since the Fed unveiled its corporate bond purchase programs on March 23 (Chart 3A). As noted on page 1, the junk bond market is experiencing unusually large return differentiation between credit tiers. This is because the Fed is offering support to the higher-rated segments of the market (Ba and some B), while the lower-rated tiers have been left out in the cold.3 We recommend that investors overweight Ba-rated junk bonds because that sector meets our criteria of offering elevated spreads compared to history and benefitting from Fed support. However, we will only recommend owning bonds rated B and lower if those sectors offer adequate compensation for expected default losses. On that note, Chart 3B shows the relationship between 12-month B-rated excess returns and the Default-Adjusted Spread. We define three scenarios for default losses: The mild scenario is a 6% default rate and 25% recovery rate, the moderate scenario is a 9% default rate and 25% recovery rate, the severe scenario is a 12% default rate and 25% recovery rate. Our base case expectation lies somewhere between the moderate and severe scenarios. Chart 3AHigh-Yield Market Overview High-Yield Market Overview High-Yield Market Overview Chart 3BB-Rated Excess Return Scenarios The Policy-Driven Bond Market The Policy-Driven Bond Market As Chart 3B makes plain, B-rated spreads don’t offer adequate compensation for our base case default loss scenario. The same hold true for credits rated Caa & lower.4 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 48 basis points in April, bringing year-to-date excess returns up to -34 bps. The conventional 30-year zero-volatility spread tightened 24 bps on the month, split between 18 bps of option-adjusted spread (OAS) tightening and a 6 bps reduction in expected prepayment losses (aka option cost). Agency MBS benefit a great deal from Fed intervention. In fact, the Fed is aggressively purchasing the securities in the secondary market. However, we see better opportunities elsewhere in US fixed income. MBS spreads have already completely recovered from March’s sell off and spreads are low compared to other sectors. The conventional 30-year MBS OAS is 70 bps below the Aa-rated corporate OAS (Chart 4), 82 bps below the Aaa-rated consumer ABS OAS, 135 bps below the Aaa-rated non-agency CMBS OAS and 48 bps below the Agency CMBS OAS. Moreover, the primary mortgage rate has still not declined very much despite this year’s huge fall in Treasury yields. This leaves open the possibility that the mortgage rate could come down in the coming months, leading to a renewed spike in refinancing activity. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 44 basis points in April, bringing year-to-date excess returns up to -626 bps. Sovereign debt underperformed duration-equivalent Treasuries by 69 bps on the month, dragging year-to-date excess returns down to -1434 bps. Foreign Agencies outperformed the Treasury benchmark by 151 bps in April, bringing year-to-date excess returns up to -888 bps. Local Authority debt outperformed Treasuries by 98 bps in April, bringing year-to-date excess returns up to -859 bps. Domestic Agency bonds outperformed by 16 bps, bringing year-to-date excess returns up to -87 bps. Supranationals outperformed by 24 bps, bringing year-to-date excess returns up to -39 bps. USD-denominated Sovereign bonds didn’t rally alongside US corporate credit in April. Rather, spreads widened on the month since the sector only benefits modestly from Fed intervention via currency swap lines for a select few countries.5 The result of April’s underperformance is that Sovereign spreads are no longer very expensive compared to US corporate credit (Chart 5). A buying opportunity could emerge in USD-denominated Sovereign debt during the next few months, but we would want to see signs of emerging market currencies forming a bottom versus the dollar before making that call. As of now, EM currencies continue to weaken (bottom panel). Municipal Bonds: Overweight Chart 6State & Local Governments Need Support State & Local Governments Need Support State & Local Governments Need Support Municipal bonds underperformed the duration-equivalent Treasury index by 167 basis points in April, dragging year-to-date excess returns down to -909 bps (before adjusting for the tax advantage). The spreads between Aaa-rated municipal yields and Treasury yields tightened at the short end of the curve but widened significantly at the long end (Chart 6). Specifically, the 2-year spread tightened 18 bps on the month and the 5-year spread tightened 7 bps on the month. However, the 10-year, 20-year and 30-year spreads widened 6 bps, 32 bps and 34 bps, respectively. The divergence between spread changes at the short and long ends of the curve is once again the result of Fed intervention. The Fed’s Municipal Liquidity Facility initially promised to extend credit to state & local governments for a maximum maturity of 2 years. This was later extended to three years and several other changes were made to allow more municipalities to access the facility.6 We see a buying opportunity in municipal bonds at both long and short maturities. First and foremost, the Fed has already shown that it is willing to modify the scope of its lending facilities if some segments of the market are in distress, and the moral hazard argument against lending to state and local governments is weak when the Fed is already active in the corporate sector. Second, despite Senate Majority Leader Mitch McConnell’s posturing, Congress will likely authorize more direct aid to distressed state & local governments in the coming weeks.7 All in all, elevated spreads offer a compelling buying opportunity in municipal debt.   Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened in April. The 2-year/10-year Treasury slope flattened 3 bps on the month to 44 bps. The 5-year/30-year slope flattened 6 bps on the month to 92 bps. One good thing about the fed funds rate being pinned at zero is that it greatly simplifies yield curve strategy. As we showed in a recent report, when the funds rate is at its lower bound the Treasury slope will trade directionally with yields.8 That is, the yield curve will steepen when yields rise and flatten when they fall. Therefore, if you want to put on a position that will profit from lower yields but that doesn’t increase the average duration of your portfolio, you can enter a duration-neutral flattener: long a 2/10 or 2/30 barbell and short the 5-year or 7-year bullet, in duration-matched terms. Or if, like us, you do not want to make a large duration bet but suspect that Treasury yields will be higher in 12 months, you can enter a duration-neutral steepener: long the 5-year bullet and short a duration-matched 2/10 barbell.9 In terms of value, the 5-year yield no longer trades deeply negative relative to the 2/10 and 2/30 barbells (Chart 7), though it remains somewhat expensive according to our models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 198 basis points in April, bringing year-to-date excess returns up to -552 bps. The 10-year TIPS breakeven inflation rate rose 21 bps to 1.08%. The 5-year/5-year forward TIPS breakeven inflation rate rose 17 bps to 1.43%. As we noted in a recent report, March’s market crash created an extraordinary amount of long-run value in TIPS.10 For example, the 10-year and 5-year TIPS breakeven inflation rates are down to 1.08% and 0.68%, respectively. This means that a buy & hold position long TIPS and short the equivalent-maturity nominal Treasury will make money if average annual inflation is greater than 0.68% for the next five years, or greater than 1.08% for the next ten (Chart 8). This seems like a slam dunk. On a shorter time horizon, investors should also consider entering real yield curve steepeners.11 The recent collapse in oil prices drove down short-dated inflation expectations. This, in turn, caused short-maturity real yields to rise because the Fed’s zero-lower-bound policy has killed nominal yield volatility at the short-end of the curve (panels 4 & 5). During the last recession, the real yield curve steepened sharply once oil prices troughed in 2008. We think now is a good time to position for a similar outcome.  ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed securities outperformed the duration-equivalent Treasury index by 117 basis points in April, bringing year-to-date excess returns up to -203 bps. The index option-adjusted spread for Aaa-rated ABS tightened 51 bps on the month to 140 bps. It remains 100 bps above where it was at the beginning of the year. Aaa-rated consumer ABS meet both our criteria to own. Index spreads are elevated compared to typical historical levels and the sector benefits from Fed support through the TALF program.12 Specifically, TALF allows investors to borrow against Aaa ABS collateral at a rate of OIS + 125 bps. The current index yield remains above that level (Chart 9).13 The combination of attractive valuations and strong Fed support makes this sector a buy. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in April, dragging year-to-date excess returns down to -789 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 19 bps on the month to 190 bps. Aaa-rated CMBS actually outperformed duration-matched Treasuries by 100 bps in April, in contrast to the lower credit tiers, which lagged. Once again, the divergence between Aaa and lower credit tier performance is driven by the Fed. Aaa-rated CMBS benefit from TALF, while lower-rated securities do not.14 In fact, TALF borrowers can access the facility at a rate of OIS + 125 bps. The index yield remains well above this level (Chart 10).   The combination of attractive valuation and strong Fed support makes Aaa-rated non-agency CMBS a buy. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 144 basis points in April, bringing year-to-date excess returns up to -221 bps. The average index spread tightened 27 bps on the month to 103 bps, still well above typical historical levels (panel 4). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Performance Since March 23 Announcement Of Emergency Fed Facilities The Policy-Driven Bond Market The Policy-Driven Bond Market Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of May 1, 2020) The Policy-Driven Bond Market The Policy-Driven Bond Market Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of May 1, 2020) The Policy-Driven Bond Market The Policy-Driven Bond Market Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 30 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 30 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Policy-Driven Bond Market The Policy-Driven Bond Market Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of May 1, 2020) The Policy-Driven Bond Market The Policy-Driven Bond Market ​​​​​​​   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a detailed description of the Fed’s different emergency facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 3 For a more detailed description of the Fed’s emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 4 For a more detailed analysis of Default-Adjusted Spreads by credit tier please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 5 The complete list of countries, and more detailed analysis of the swap lines, is found in US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 6 For more details on the MLF please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 7 Please see Geopolitical Strategy Weekly Report, “Drowning In Oil (GeoRisk Update)”, dated April 24, 2020, available at gps.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 9 The rationale for why barbell positions profit from curve flattening and bullet positions profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Buying Opportunities & Worst-Case Scenarios”, dated March 17, 2020, available at usbs.bcaresearch.com 11 For more details on this recommendation please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 12 For details of TALF please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Duration: While it’s possible that we are close to the US economic trough, we don’t see any immediate upside in Treasury yields. Investors should keep portfolio duration at benchmark and await signs of recovery in our preferred global growth indicators. Spread Product: Investors should buy spread products that offer attractive spreads relative to history and that benefit from Fed support. We favor: Aaa non-agency CMBS, Agency CMBS, Aaa ABS, municipal bonds and investment grade corporate bonds. High-Yield: We recommend an overweight allocation to Ba-rated high-yield corporates and an underweight allocation to high-yield bonds rated B and lower. Ba-rated bonds will benefit from Fed support and value in the B-rated and below credit tiers does not adequately compensate for likely default losses. Feature Chart 1Fed Actions Spur Rally Fed Actions Spur Rally Fed Actions Spur Rally Even though the economy remains closed and most of us are still confined to our homes, the mood in financial markets has shifted during the past few weeks. Risk assets are rallying as investors react to a cresting in the number of new COVID-19 cases and an unprecedented fiscal and monetary response. Since the Fed announced that it would step into the corporate bond market on March 23, equities have outpaced Treasuries by 28% and high-yield bonds have beaten the Treasury benchmark by 15% (Chart 1). Treasury securities initially rallied after the landmark Fed announcement but have only kept pace with cash during the past two weeks (Chart 1, bottom panel). This reversal in markets begs the question: Is the bottom already in? In this week’s report we ask that question about several different US bond sectors. Too Early To Call The Bottom In Treasury Yields At least in the Treasury market, we think it is premature to call the bottom in yields. Chart 2The Depths Of The Downturn The Depths Of The Downturn The Depths Of The Downturn In prior reports we outlined a checklist to call the trough in Treasury yields.1 Two of the items on that checklist were: a severe deterioration in the US economic data and signs of economic recovery in the rest of the world, particularly in those places where the pandemic struck first – like China. We are certainly now seeing the bad US economic data. The Economic Surprise Index is just off its all-time low and a composite of 10 high-frequency economic indicators compiled by the New York Federal Reserve is at its lowest point since the series began in 2008 (Chart 2). Similarly, weekly initial jobless claims set a record three weeks ago. Though they remain extremely elevated, new claims have declined in each of the past two weeks (Chart 2, bottom panel). All this at least raises the possibility that we are close to the trough in US economic growth. However, our second criterion of improving demand outside the US, particularly in China, has not been met. This is crucial because bond investors will need to see that there is light at the end of the tunnel before concluding that US economic activity will trend higher. China’s Manufacturing PMI bounced to just above 50 in March, suggesting that only a small majority of firms experienced better economic conditions in March compared to February. China’s credit impulse is advancing, demonstrating that policymakers are pumping a large amount of stimulus into the economy. But high-frequency growth barometers – like the CRB Raw Industrials index, the performance of cyclical versus defensive equity sectors and the trend in Emerging Market currencies – all remain downbeat (Chart 3). Bond investors will need to see improving demand outside the US before concluding that US economic activity will trend higher. For Treasury yields, the broad CRB Raw Industrials commodity benchmark is particularly important. This is because the ratio between the CRB index and the price of gold closely tracks the 10-year Treasury yield (Chart 4). In a typical economic downturn, we first see Treasury yields and the CRB index fall together as global demand weakens. Then, monetary policy responds by turning more accommodative, leading to a rebound in the price of gold as investors start to reckon with the potential long-run inflationary impact of monetary stimulus. Eventually, bond yields will bottom. But this will only occur once the stimulus seeps through to the real economy and gains in the CRB index start to outpace gains in gold. Chart 3No Global Growth Recovery Yet No Global Growth Recovery Yet No Global Growth Recovery Yet Chart 4Track The CRB/Gold Ratio Track The CRB/Gold Ratio Track The CRB/Gold Ratio The dynamic described above means that we should expect Treasury yields to lag risk assets as the market bottoms. In other words, we will see a sustained rebound in equity prices and corporate bond excess returns before Treasury yields move meaningfully higher. This is especially true in this cycle because the Fed has indicated that it will be slow to shift away from its accommodative policy stance. Bottom Line: While it’s possible that we are close to the US economic trough, we don’t see any immediate upside in Treasury yields. Investors should keep portfolio duration at benchmark and await signs of recovery in our preferred global growth indicators. To hedge against the risk of higher Treasury yields without making a large duration bet, investors should implement duration-neutral curve steepeners. We recommend going long the 5-year bullet and short the duration-matched 2/10 barbell.2 Is The Bottom In For Investment Grade Spread Product Excess Returns? We hesitate to call the bottom in overall spread product returns versus Treasuries. However, we do see many buying opportunities in specific US fixed income sectors. In deciding which sectors to own, we advise investors to search for sectors that: (A)  Have attractive spreads and (B)  Benefit from one or more of the Fed’s recently announced programs We described each of the Fed’s different lending facilities in last week’s Special Report, and will not repeat that exercise this week.3 Instead, we run through a list of sectors where we think spreads have already peaked and that bond investors should own today. Aaa CMBS Aaa-rated CMBS, both non-agency and agency-backed, meet our two criteria of offering attractive spreads and benefiting from Fed support (Chart 5). The Aaa non-agency CMBS index spread is 119 bps wider than at the end of 2019, and the securities can be used as collateral under the Fed’s Term Asset-Backed Loan Facility (TALF). Specifically, bondholders can borrow from TALF against their Aaa non-agency CMBS collateral at a rate of OIS + 125 bps (Chart 5, panel 2). TALF will also impose a haircut of around 15% on CMBS collateral. Chart 5Buy Aaa CMBS Buy Aaa CMBS Buy Aaa CMBS Agency-backed CMBS are even more attractive on a risk-adjusted basis. The Agency CMBS index spread is 50 bps above its end-2019 level and the Fed is directly purchasing Agency CMBS as part of its ongoing mortgage-backed securities purchases. As of April 15, the Fed had purchased $5.7 billion of Agency CMBS since it announced CMBS purchases on March 23. The outstanding par value of the Bloomberg Barclays Agency CMBS index is about $204 billion. If the Fed’s current pace of purchases continues for one year, it will own just under half of the index’s par value. Aaa ABS Though the spread is not quite as attractive as for Aaa non-agency CMBS, the spread on Aaa-rated consumer ABS is 115 bps wider since the end of 2019 (Chart 6). As with CMBS, this sector also benefits from TALF with an interest rate of OIS + 125 bps, and an even smaller haircut. Chart 6Buy Aaa Consumer ABS & Munis Buy Aaa Consumer ABS & Munis Buy Aaa Consumer ABS & Munis Municipal Bonds We also like the opportunity in municipal bonds. Spreads between Aaa-rated municipal bond yields and Treasuries have come down off their recent all-time highs but remain attractive compared to historical levels (Chart 6, bottom panel). The Fed’s Municipal Liquidity Facility (MLF) offers direct 2-year loans to state & local governments. This will provide a back-stop for municipal debt with a maturity of 2 years or less but will also help municipalities meet interest payments on longer-maturity bonds when they are due. Aaa-rated CMBS, both non-agency and agency-backed, meet our two criteria of offering attractive spreads and benefit­ing from Fed support. We would therefore advise investors to buy municipal bonds at both the short and long ends of the curve. We also do not rule out further Fed measures to support the municipal bond market in the coming weeks, possibly even secondary market bond purchases. The amount of Fed support for state & local governments so far is much less than what is being done for the corporate sector. There is also no convincing moral hazard argument against scaling-up support for investment grade rated munis, especially when the Fed is already supporting some parts of the high-yield corporate market. Investment Grade Corporates As mentioned above, the Fed is providing an exceptional amount of policy support to the investment grade corporate bond market, mainly through three facilities: The Secondary Market Corporate Credit Facility (SMCCF) that will purchase corporate bonds and ETFs in the secondary market. The Primary Market Corporate Credit Facility (PMCCF) that will purchase new bond issues in the primary market. The Main Street New and Expanded Lending Facilities (MSNLF & MSELF) that will purchase corporate loans from banks, removing them from bank balance sheets. All three of these facilities support the investment grade corporate bond market, and investment grade corporate spreads remain elevated compared to history across all credit tiers (Chart 7). Chart 7Buy Investment Grade Corporates Buy Investment Grade Corporates Buy Investment Grade Corporates Bottom Line: Investors should buy spread products that offer attractive spreads relative to history and that benefit from Fed support. We favor: Aaa non-agency CMBS, Agency CMBS, Aaa ABS, municipal bonds and investment grade corporate bonds. Have High-Yield Spreads Already Peaked? In the high-yield market we follow the same rules we applied in the previous section. We want to buy sectors that have attractive spreads and that benefit from Fed support. Within high-yield, the Ba credit tier meets these criteria as it offers an elevated spread and loans to Ba-rated issuers are eligible under the MSNLF and MSELF. The SMCCF will also purchase some high-yield ETFs and both the SMCCF and PMCCF will purchase securities that were recently downgraded to Ba from Baa. However, for the most part, securities rated B and below will not benefit from the Fed’s new facilities and thus will trade purely on fundamentals.4 This demarcation between securities rated Ba and above and those rated B and below is already showing up in excess returns. Since the Fed first announced corporate bond purchases on March 23, Ba-rated junk bonds have outperformed Treasuries by 16.88%, beating B-rated bonds (13.84%), Caa-rated bonds (9.53%) and the lowest Ca/C-rated credit tier (6.85%) (Table 1). Table 1Corporate Bond Performance Since Announcement Of Fed Purchases Is The Bottom Already In? Is The Bottom Already In? Assessing High-Yield Fundamentals Even without Fed support, lower-tier junk bonds are still worth buying if spreads provide adequate compensation for expected defaults. We assessed the likely magnitude of the looming default cycle in a recent Special Report.5 One main conclusion from that report is that, due to elevated corporate sector leverage, the recovery rate on defaulted debt will likely be low during the next 12 months – on the order of 20-25%. Second, based on the expected magnitude and duration of the current economic shock, we expect a significant surge in the speculative grade corporate default rate during the next 12 months, likely hitting a range of 9%-13%. Even without Fed support, lower-tier junk bonds are still worth buying if spreads provide adequate compensation for expected defaults.  With these default loss assumptions in hand, we can see what sort of buffer is priced into different high-yield credit tiers. Charts 8-10 show calendar-year excess returns for Ba, B and Caa-C high-yield credit tiers on the vertical axes. On the horizontal axes, the charts show the index spread at the start of the 12-month investment horizon less realized default losses over the course of the year.6 Chart 8Ba Default-Adjusted Spread Is The Bottom Already In? Is The Bottom Already In? Chart 9B Default-Adjusted Spread Is The Bottom Already In? Is The Bottom Already In? Chart 10Caa-C Default-Adjusted Spread Is The Bottom Already In? Is The Bottom Already In? We first observe that a Default-Adjusted Spread below 200 bps usually coincides with negative excess returns for all three credit tiers. In fact, for the Caa-C tier, we’d like to see a Default-Adjusted Spread above 500 bps before going long. Second, the green diamonds in all three charts identify likely outcomes for the next 12 months in three different default loss scenarios. The “Mild Scenario” is defined as a 6% speculative grade default rate and 25% recovery rate. The “Moderate Scenario” is defined as a 9% speculative grade default rate and 25% recovery rate. The “Severe Scenario” is defined as a 12% default rate and 25% recovery rate.7 Based on those choices, we’d place our base case default loss assumptions for the next 12 months somewhere between the Moderate and Severe scenarios. Charts 8-10 clearly show that, while Ba-rated issuers might still perform decently, the B-rated and below credit tiers are not priced at all for our base case default outlook. Note that this analysis does not consider Fed support in any way. Factoring that in, Ba-rated bonds look even better compared to bonds rated B and below. Bottom Line: We recommend an overweight allocation to Ba-rated high-yield corporates and an underweight allocation to high-yield bonds rated B and lower. Ba-rated bonds will benefit from Fed support and value in the B-rated and below credit tiers does not adequately compensate for likely default losses.    Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “When And Where Will Bond Yields Trough?”, dated March 10, 2020, available at usbs.bcaresearch.com 2 For more details on why we recommend this yield curve positioning please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 3 Please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 4 As we noted in last week’s Special Report, some B-rated issuers will benefit from the MSELF. But this support is minor compared to what is being offered to securities rated Ba and higher. 5 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 6  We use Ba and Caa-C default losses for those credit tiers. For B-rated bonds, we found that overall speculative grade default losses work slightly better than default losses for the B credit tier specifically. 7 We use historical correlations to translate overall speculative grade default rate assumptions into default rate assumptions for the Ba and Caa-C credit tiers. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The Fed has been awfully busy since the middle of March, … : Over the last 30 days, the Fed has unleashed a barrage of measures to support market liquidity and alleviate economic hardship. … unveiling a package of facilities to keep credit flowing to consumers, businesses and municipalities, … : The Fed is building a sizable firewall against market seizure, touching on commercial paper, money market funds, asset-backed securities, small business loans, municipal notes, investment-grade corporate bonds and ETFs and high-yield corporate ETFs. … and loosening regulatory strictures to encourage banks to put their capital buffers to work: The Fed and other major bank regulators have eased some of the post-2008 rules to encourage banks to ramp up market-making activity and increase lending to cushion the shock to the economy. Investors should buy what the Fed is buying: Fixed income investors should look to capture excess spreads in markets that have not yet priced in the full effect of the Fed’s indemnity. Banks and agency mortgage REITs offer a way to implement this theme in equities. Feature What A Difference A Pandemic Makes “Whatever it takes” is clearly the order of the day for Jay Powell and company, as well as Congress and the White House, to mitigate the potentially pernicious second-round economic damage from COVID-19. In this Special Report, we detail the Fed’s key initiatives. Central banks are neither omniscient nor omnipotent, and they cannot stave off all of the pressure from mass quarantines, but we do expect the Fed’s measures will cushion the economic blow, and reflate prices in targeted asset markets. The Fed began pulling out all the stops to fight the virus on Sunday, March 15th with what have now become stock emergency responses: zero rates and purchases of Treasuries and agency mortgage-backed securities (MBS). Although the MBS purchases began the week of March 23rd, and have continued at a steady clip despite appearing to have swiftly surpassed their $200 billion target, they have not yet achieved much traction in the mortgage market. The spread between the current coupon agency MBS and the 10-year Treasury yield has come down a bit, but the average 30-year fixed-rate home mortgage rate does not reflect the 150 basis points ("bps") of rate cuts since the beginning of March (Chart 1). The Fed’s measures are intended to help direct the flow of credit to adversely affected constituencies with a pressing need for it. Other measures to relieve liquidity pressures, like the Fed’s ongoing overnight repo operations, have achieved their aim. The signal indicator of liquidity strains, the effective fed funds rate, was bumping up against the top of the Fed’s target range for several days after the return to zero interest rate policy. Over the last week, however, it has settled around 5 bps, near the bottom of its range (Chart 2), suggesting that the formerly tight overnight funding market is now amply supplied. Chart 1MBS Purchases Haven't Helped Main Street Yet MBS Purchases Haven't Helped Main Street Yet MBS Purchases Haven't Helped Main Street Yet Chart 2Overnight Funding Stresses ##br##Have Eased Overnight Funding Stresses Have Eased Overnight Funding Stresses Have Eased The rest of the Fed’s measures (Table 1) have been more finely targeted, intended to help direct the flow of credit to adversely affected constituencies with a pressing need for it. We focus on the most important measures in the following section and summarize their common elements in Table 2. The following discussions of the individual programs highlight their intent, their chances of success, and yardsticks for tracking their progress. We conclude with the fixed income and equity niches that are most likely to benefit from the Fed’s efforts. Table 1A Frenzied Month Of Activity Alphabet Soup: A Summary Of The Fed's Anti-Virus Measures Alphabet Soup: A Summary Of The Fed's Anti-Virus Measures Table 2The 2020 Federal Reserve Emergency Programs Alphabet Soup: A Summary Of The Fed's Anti-Virus Measures Alphabet Soup: A Summary Of The Fed's Anti-Virus Measures A Field Guide To The Acronym Jungle Money Market Mutual Fund Liquidity Facility (MMLF) Under the MMLF, which started on March 23rd, US banks can borrow from the Fed to purchase eligible assets mainly from prime money market funds. These assets are in turn pledged to the Fed as collateral, effectively allowing the Fed to lend to prime money market funds via banks. Assets eligible for purchase from these funds include: US Treasuries & fully guaranteed agencies Securities issued by US GSEs Asset-backed commercial paper (ABCP) rated A1 or its equivalent, issued by a US issuer US municipal short-term debt (excluding variable rate demand notes) Backed by $10 billion of credit protection from the Treasury, the Fed will lend at the primary credit rate (the discount rate, currently 0.25%) for pledged asset purchases of US Treasuries, fully guaranteed agencies or securities issued by US GSEs. For any other assets pledged, the Fed will charge an additional 100 bps – with the exception of US municipal short-term debt to which the Fed only applies a 25-bps surcharge. Chart 3The MMLF Already Providing Some Relief The MMLF Already Providing Some Relief The MMLF Already Providing Some Relief Loans made under the MMLF are fully non-recourse (the Fed can recover nothing more from the borrower than the pledged collateral). Banks borrowing from the Fed under the MMLF bear no credit risk and have therefore been exempted from risk-based capital and leverage requirements for any asset pledged to the MMLF, an important element that should promote MMLF participation. This facility is a direct descendant of the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), which operated from September 2008 to February 2010 to prevent a run on prime money market funds after a prominent fund “broke the buck.” Its objective is to help prime money market funds meet redemption requests from investors and increase liquidity in the markets for the assets held by these funds – most notably commercial paper where prime money market funds represent 21% of the market. Those funds have experienced large outflows in the midst of the coronavirus pandemic and building economic crisis – erasing $140 billion, or 18%, of the fund segment’s total net assets in a matter of days (Chart 3, top panel). Since it started, the MMLF has extended $53 billion of credit to prime money funds, about a third of AMLF’s output in its first 10 days of operation. The financial sector is suffering a big shock, but it is not the source of the problem like it was in 2008, so the situation is not as dire as it was in late 2008, and we are already seeing a tentative stabilization of asset outflows from money market funds. Commercial paper spreads have also narrowed, implying that the combination of the MMLF and the CPFF (see below) is having the intended effect (Chart 3, bottom panel). Commercial Paper Funding Facility (CPFF) Starting today, April 14th, the Fed will revive 2008’s Commercial Paper Funding Facility (CPFF) with the aim of restoring liquidity to a market where investment grade corporate borrowers raise cash to finance payroll, inventories, accounts payable and other short-term liabilities. The 2020 iteration applies to municipalities as well, extending its reach across the real economy. Via a Special Purpose Vehicle (SPV) (see Box) funded with a $10 billion equity investment from the Treasury Department, the CPFF will purchase US dollar-denominated investment-grade (A1/P1/F1) three-month asset-backed, corporate and municipal commercial paper priced at the overnight index swap rate (OIS) plus 110 bps. Lower-rated issuers are not eligible, but investment-grade borrowers who were downgraded to A2/P2/F2 after March 17th, 2020 can be grandfathered into the program at a higher spread of OIS+200 bps. The pricing is tighter than it was in 2008, when unsecured investment grade and asset-backed issues were priced at OIS+100 bps and OIS+300 bps, respectively, and the Fed did not have the loss protection provided by an equity investment in the SPV.   Box 1 - SPV Mechanics The Fed has set up Special Purpose Vehicles (SPV) in connection with most of the facilities we examine here. Each SPV has been seeded by the Treasury department to carry out the facility’s work. The Fed lends several multiples of the Treasury’s initial equity investment to each SPV to provide it with a total capacity of anywhere from eight to fourteen times its equity capital, based on the riskiness of the assets the SPV is purchasing or lending against. The result is that most of the cash used to operate the facilities will come from the Fed in the form of loans with full recourse to the SPVs’ assets, but the Treasury department will own the equity tranche. The Treasury therefore bears the first credit losses, should any occur. Issuers are only eligible if they have issued three-month commercial paper in the twelve months preceding the March 17th announcement of the program. The Federal Reserve did not set an explicit limit on the size of the program, but funding for any single issuer is limited to the amount of outstanding commercial paper it had during that twelve-month period. The 2020 CPFF could therefore max out above $750 billion, the peak size of the domestic commercial paper market over the past year (Chart 4). If the first CPFF’s experience is any guide, however, it’s unlikely that its full capacity will be needed. Its assets peaked at $350 billion in January 2009, around a quarter of 2008’s $1.5 trillion average outstanding balance. A similar proportion today would cap the fund at $175-200 billion. As in 2008 (Chart 5, bottom panel), the mere announcement of the program has driven commercial paper spreads significantly below their previously stressed levels (Chart 5, top panel). Chart 4Pressure On The Domestic Commercial Paper Market... Pressure On The Domestic Commercial Paper Market... Pressure On The Domestic Commercial Paper Market... Chart 5...Is Being Relieved Ahead Of The CPFF Implementation ...Is Being Relieved Ahead Of The CPFF Implementation ...Is Being Relieved Ahead Of The CPFF Implementation Term Asset-Backed Securities Loan Facility (TALF) The asset-backed securities (ABS) market funds a significant share of the credit extended to consumers and small businesses. The Fed’s TALF program that started on March 23rd aims to provide US companies holding AAA collateral with funding of up to $100 billion, in the form of 3-year non-recourse loans secured by AAA-rated ABS. It will be conducted via an SPV backed by a $10 billion equity investment from the US Treasury Department. Chart 6Narrower Spreads Promote Easier Financial Conditions At The Margin Narrower Spreads Promote Easier Financial Conditions At The Margin Narrower Spreads Promote Easier Financial Conditions At The Margin Eligible collateral includes ABS with exposure to auto loans, student loans, credit card receivables, equipment loans, floorplan loans, insurance premium finance loans, SBA-guaranteed loans and leveraged loans issued after March 23rd, 2020. Last week, the Fed added agency CMBS issued before March 23rd, 2020 and left the door open to further expansion of the pool of eligible securities. The rate charged on the loans is based on the type of collateral and its weighted average life. Depending on the ABS, the spreads will range from 75 bps to 150 bps over one of four different benchmarks (LIBOR, SOFR, OIS or the upper 25-bps bound of the target fed funds range). The spreads are reasonable, and will not keep ABS holders away from the facility, but they’re not meant to be giveaways. The 2009 TALF program originally had a $200 billion capacity, which was later expanded to $1 trillion. Those numbers make the current iteration’s $100 billion limit look awfully modest, but only $71 billion worth of loans were eventually granted the first time around. ABS spreads have already narrowed significantly (Chart 6), suggesting the program is already making a difference. Although an incremental $100 billion of loans is not likely to move the needle much for the US economy, narrower spreads will promote easier financial conditions at the margin. Secondary Market Corporate Credit Facility (SMCCF) Though no firm start date has been given, the Fed will soon enter the secondary market and start purchasing corporate bonds. As with all of the other facilities discussed in this section except the MMLF, the SMCCF is set up as an SPV. It will have up to $250 billion of buying power, anchored by $25 billion of equity funding from the Treasury department. Once it’s up and running, the SMCCF will buy non-bank corporate bonds in the secondary market that meet the following criteria: Issuer rated at least BBB-/Baa3 (the lowest investment grade tier) as of March 22nd, 2020 A remaining maturity of 5 years or less Issuer is a US business with material operations, and a majority of its employees, in the US Issuer is not expected to receive direct financial assistance from the federal government The SMCCF can own a maximum of 10% of any single firm’s outstanding debt, and it may dip into the BB-rated market for securities that were downgraded from BBB after March 22nd. In addition to cash bonds, the SMCCF will also buy ETFs that track the broad corporate bond market. The Fed says that the “preponderance” of SMCCF ETF purchases will be of ETFs tracking investment grade corporate bond benchmarks (like LQD), but it will also buy some high-yield ETFs (like HYG). We expect that the SMCCF will be able to achieve its direct goal of driving down borrowing costs for otherwise healthy firms that may struggle to access credit markets in the current environment. One way to track the program’s success is to monitor investment grade corporate credit spreads (Chart 7). Spreads have been tightening aggressively since the Fed announced the program on March 23rd but are still elevated compared to average historical levels. The slope of the line of investment grade corporate bond spreads plotted by maturity will be another important metric (Chart 8). An inverted spread slope tends to coincide with a sharply rising default rate, since it signals that investors are worried about near-term default risk. By purchasing investment grade bonds with maturities of 5 years or less, the Fed hopes to maintain a positively sloped spread curve. Chart 7SMCCF Announcement Marked The Peak In Spreads SMCCF Announcement Marked The Peak In Spreads SMCCF Announcement Marked The Peak In Spreads Chart 8Fed Wants A Positive ##br##Spread Slope Fed Wants A Positive Spread Slope Fed Wants A Positive Spread Slope Primary Market Corporate Credit Facility (PMCCF) The PMCCF employs the same structure as the SMCCF, but it is twice as large. The Treasury’s initial equity investment will be $50 billion and Fed loans will scale its capacity up to $500 billion. As a complement to the SMCCF, the PMCCF will purchase newly issued non-bank corporate bonds. The eligibility criteria are the same as the SMCCF’s, but the PMCCF will only buy bonds with a maturity of 4 years or less. The new issuance purchased by the PMCCF can be new debt or it can be used to refinance existing debt. The only caveat is that the maximum amount of borrowing from the facility cannot exceed 130% of the issuer’s maximum debt outstanding on any day between March 22nd, 2019 and March 22nd, 2020. Essentially, eligible firms can use the facility to refinance their entire stock of debt and then top it up by another 30% if they so choose. The goals of the PMCCF are to keep the primary issuance markets open and to prevent bankruptcy for firms that were rated investment grade before the virus outbreak. Investment grade corporate bond issuance shut down completely for a stretch in early March, but then surged once the Fed announced the PMCCF and SMCCF on March 23rd. The PMCCF will have achieved lasting traction if gross corporate bond issuance holds up in the coming months (Chart 9). It should also meet its bankruptcy-prevention goal, since firms will be able to refinance their maturing obligations and tack on some new debt to get through the next few months. Given the large amount of outstanding BBB-rated debt, a lot of fallen angel supply is poised to hit the high-yield bond market. While we expect the PMCCF will succeed in achieving its primary aims, it is unlikely to prevent a large number of ratings downgrades. If a given firm only makes use of the facility to refinance its existing debt at a lower rate, then its ability to service its debt will improve at the margin and its rating should be safe. However, any firm that increases its debt load via this facility will end up with a riskier balance sheet. Ratings agencies will not look through an increased debt burden, and we expect a significant number of ratings downgrades in the coming months (Chart 10, top panel). Chart 9Primary Markets Have Re-Opened Primary Markets Have Re-Opened Primary Markets Have Re-Opened Chart 10Fed Actions Won't Prevent Downgrades Fed Actions Won't Prevent Downgrades Fed Actions Won't Prevent Downgrades Given the large amount of outstanding BBB-rated debt, a lot of fallen angel supply is poised to hit the high-yield bond market (Chart 10, middle and bottom panels). The Fed will try to contain the surge by allowing the SMCCF to purchase fallen angel debt, and by providing some support to the upper tiers of high-yield credits through its Main Street Lending Programs. Main Street New Loan Facility (MSNLF) and Main Street Expanded Loan Facility (MSELF) The goal of the MSNLF and MSELF is to provide relief to large firms that are not investment grade credits. Both facilities will draw from the same SPV, which will be funded by a $75 billion equity stake from the Treasury and will then be levered up to a total size of “up to $600 billion” by the Fed. The Main Street facilities are structured differently than the PMCCF and SMCCF in that the Fed will not transact directly with nonfinancial corporate issuers. Rather, the Fed will purchase 95% of the par value of eligible loans from banks (which will retain 5% of the credit risk of each loan), hoping to free up enough extra room on bank balance sheets to promote more lending. To be eligible for purchase by the Main Street New Loan Facility, loans must be issued after April 8th, 2020 and meet the following criteria: Borrowers have less than 10,000 employees or $2.5 billion of 2019 revenue Borrowers are US firms with significant operations, and a majority of employees, in the US Loans are unsecured and have a maturity of 4 years Loans are made at an adjustable rate of SOFR + 250-400 bps Principal and interest payments are deferred for one year Loan size of $1 million to the lesser of $25 million or the amount that keeps the borrower’s Debt-to-EBITDA ratio below 4.01 Loan proceeds cannot be used to refinance existing debt Borrowers must commit to “make reasonable efforts to maintain payroll and retain employees during the term of the loan” The Main Street Expanded Loan Facility applies similar criteria to existing loans that banks will upsize before transferring 95% of the incremental risk to the Fed. The MSELF allows for loans up to the lesser of $150 million, 30% of the borrower’s existing debt (including undrawn commitments) or the amount keeps the borrower’s Debt-to-EBITDA ratio below 6.0. Borrowers can participate in only one of the MSNLF, MSELF and PMCCF, though they can tap the PPP alongside one of the Main Street lending facilities. Chart 11Main Street Programs Will Spur Bank Lending Main Street Programs Will Spur Bank Lending Main Street Programs Will Spur Bank Lending The Main Street facilities endeavor to have banks adopt an “originate to distribute” model. With the Fed assuming 95% of each loan’s credit risk, banks will have nearly unlimited balance sheet capacity to continue originating these sorts of loans. Retaining 5% of each loan ensures that the banks will have enough skin in the game to perform proper due diligence. We expect to see a significant increase in commercial bank C&I loan growth in the coming months once these facilities are up to speed (Chart 11). Crucially for high-yield investors, the debt-to-EBITDA constraints ensure that the Main Street facilities will aid BB- and some B-rated issuers but will not bail out high-default-risk issuers rated CCC and below. BB-rated firms typically have debt-to-EBITDA ratios between 3 and 4, while B-rated issuers typically fall in a range of 4 to 6. For the most part, BB-rated firms will be able to make use of either the MSNLF or MSELF, while B-rated firms will be limited to the MSELF. By leaving out issuers rated CCC & below, the Fed is acquiescing to a significant spike in corporate defaults over the next 12 months. The bulk of corporate defaults come from firms that were rated CCC or below 12 months prior (Chart 12). Chart 12A Significant Increase In Corporate Defaults Is Coming A Significant Increase In Corporate Defaults Is Coming A Significant Increase In Corporate Defaults Is Coming As with the PMCCF, we note that the Main Street facilities offer loans, not grants. While they will address firms’ immediate liquidity issues, they will do so at the cost of more indebted balance sheets. Downgrade risk remains high for BB- and B-rated companies. Paycheck Protection Program Liquidity Facility (PPPLF) The Paycheck Protection Program (PPP) is a component of the CARES Act that was designed to forestall layoffs by small businesses.  PPP loans are fully guaranteed by the Small Business Association (SBA), which will forgive them if the borrower maintains its employee headcount for eight weeks. The size of the PPPLF has yet to be announced, along with the details of its funding, but its intent is to get PPP loans off of issuers’ balance sheets so as to free up their capital and allow them to make more loans, expanding the PPP’s reach. The Fed will lend on a non-recourse basis at a rate of 0.35% to any depository institution making PPP loans,2 taking PPP loans as collateral at their full face value. PPP loans placed with the Fed are exempt from both risk-weighted and leverage-based capital adequacy measures (please see “Easing Up On The Regulatory Reins,” below). PPP is meant to be no less than a lifeline for households and small businesses, but the devil is in the details. Banks were reportedly overwhelmed with demand for PPP loans over the first five business days that they were available, suggesting that many small businesses still qualify, despite 17 million initial unemployment claims over the last three weeks. Media reports about the program highlighted that there are quite a few kinks yet to be worked out, and it has arrived too late to stave off the first waves of layoffs. Success may be most easily measured by the size of the PPPLF, which should eventually translate into fewer layoffs and bankruptcies than would otherwise have occurred. Municipal Liquidity Facility (MLF) Chart 13State & Local Governments Need Support State & Local Governments Need Support State & Local Governments Need Support The Municipal Liquidity Facility is similar in structure to the PMCCF, only it is designed to support state and local governments. The MLF SPV will be funded by a $35 billion equity investment from the Treasury, and the Fed will lever it up to a maximum size of $500 billion to purchase newly issued securities directly from state and local governments that meet the following criteria: All states (including D.C.) are eligible, as are cities with populations above 1 million and counties with populations above 2 million. The newly issued notes will have a maximum maturity of 2 years. The MLF can buy new issuance from any one state, city or county up to an amount equal to 20% of that borrower’s fiscal year 2017 general revenue. States can request a higher limit to procure funds for political subdivisions or instrumentalities that aren’t eligible themselves for the MLF. The MLF’s goal is to keep state and local governments liquid as they deal with the COVID-19 pandemic. The large size of the facility – $500 billion is five times 2019’s aggregate muni issuance – should allow it to meet its goal. However, as with the Fed’s other facilities, the support comes in the form of loans, not grants. The lost tax revenue and increased pandemic expenditures cannot be recovered. State and local government balance sheets will emerge from the recession weaker. We can track the program’s success by looking at the spread between municipal bond yields and comparable US Treasury yields. These spreads widened to all-time highs in March, but have since come in significantly, even for longer maturities (Chart 13). If this tightening does not continue, the Fed may eventually enter the secondary market to purchase long-maturity municipal bonds. Supporting such a fragmented market will be tricky, and the Fed may be hoping that more aid will come from Capitol Hill. Central Bank Liquidity Swaps Chart 14US Dollar Debt Is A Global Problem US Dollar Debt Is A Global Problem US Dollar Debt Is A Global Problem The global economy is loaded with USD-denominated debt issued by entities outside of the US. As of 3Q19, there was roughly $12 trillion of outstanding foreign-issued US dollar debt, exceeding the domestic nonfinancial corporate sector’s total issuance (Chart 14). As the sole provider of US dollars, the Fed has a role to play in supporting foreign dollar-debt issuers during this tumultuous period. Currency swap lines linking the Fed with other central banks can help alleviate the pressure on foreign borrowers to access the US dollars they need to service their debt. For example, once the Fed exchanges dollars for euros using its swap line with the European Central Bank (ECB), the ECB can then direct those US dollars toward USD-denominated borrowers within the Euro Area. Widening cross-currency basis swap spreads are a tried-and-true signal that US dollars are becoming too scarce. The Fed responded to widening basis swap spreads by instituting swap lines during the financial crisis and again during the Eurozone debt crisis of 2011. In both instances, the swap lines eventually calmed the market and basis swap spreads moved back toward zero (Chart 15). Chart 15The Cost Of US Dollars The Cost Of US Dollars The Cost Of US Dollars Since 2013, the Fed has maintained unlimited swap lines with the central banks of the Euro Area, Canada, UK, Japan and Switzerland. On March 19th, it extended limited swap lines to the central banks of Australia, Brazil, Denmark, Korea, Mexico, Norway, New Zealand, Singapore and Sweden. These swap lines will help ease stresses for some foreign issuers of US dollar debt, but not all. One potential problem is that the foreign central banks that acquire dollars via the swap lines may be unwilling or unable to direct those dollars to debtors in their countries. Another problem is that several emerging markets (EM) countries do not have access to the Fed’s swap facility. EM issuers account for roughly one-third of foreign-issued dollar debt (Chart 14, bottom panel). For example, the governments of the Philippines, Colombia, Indonesia and Turkey all carry large US dollar debt balances, not to mention US dollar debt issued by the EM corporate sector in non-swap line countries. Currency swap lines linking the Fed with other central banks can help alleviate the pressure on foreign borrowers to access the US dollars they need to service their debt. The swap lines that are already in place have led to basis swap spread tightening in developed markets. If global growth eventually rebounds and the dollar weakens, EM dollar-debt burdens will become easier to service. However, until that happens, a default by some foreign issuer of US dollar debt remains a non-trivial tail risk. The Fed may need to extend swap lines to more countries to mitigate this risk in the months ahead. Easing Up On The Regulatory Reins As we’ve argued in US Investment Strategy Special Reports the last two weeks, the largest US banks are extremely well capitalized.3 The Fed agrees, and over the last 30 days, it has issued six separate statements encouraging the banks to lend or to work with struggling borrowers, all but one of them in concert with its fellow banking regulators. Although the largest banks have amassed sizable capital cushions that would support increased lending, post-GFC regulations often crimp incentives to deploy them. Over the last 30 days, the Fed and the other federal regulators have granted banks relief from the key binding constraints. Those constraints fall into two broad categories: risk-based requirements, which are based on risk weightings assigned to individual assets, and leverage requirements, which are based on total assets or total leverage exposure. All banks are required to maintain minimum ratios of equity capital to risk-weighted assets under the former and to total leverage, which includes some off-balance-sheet exposures, under the latter. The three federal banking regulators have amended rules to exclude MMLF and PPP exposures from the regulatory capital denominator used to calculate risk-weighted and leverage ratios. The Fed also made a similar move by excluding Treasury securities and deposits held at the Fed from the denominator of the supplementary leverage ratio large banks must maintain (3% for banks with greater than $250 billion in assets, 5% for SIFIs). Reducing the denominators increases the banks’ ratios and expands their lending capacity. Community banks’ capital adequacy is determined by their leverage ratio (equity to total assets), and regulators have temporarily cut it to 8% from 9%. We expect that easing capital constraints will spur the banks to lend more in the coming weeks and months, but it’s not a sure thing. A clear lesson from the Bernanke Fed’s three rounds of quantitative easing is that the Fed can lead banks to water, but it can’t make them drink. A considerable amount of the funds the Fed deployed to buy Treasury and agency securities was simply squirreled away by banks, and wound up being neither lent nor spent. Lending is not the Fed’s sole focus, though: it hopes that easing capital regulations will also encourage banks and broker-dealers to ramp up their market-making activity, improving capital market liquidity across a range of instruments. Investment Implications While all of the programs discussed above have expiration dates, they can be extended if necessary. Flexible end dates illustrate the open-ended nature of the Fed’s (and Congress’) support, and help underpin our contention that more aid will be forthcoming at the drop of a hat. Confronting the most severe recession in 90 years and an especially competitive election, policymakers can be counted upon to err to the side of providing too much stimulus. That is not to say, however, that the measures amount to a justification for loading up on all risk assets. Every space will not be helped equally. Spreads for all corporate credit tiers are cheap compared to history, but only BB-rated and higher benefit from the Fed’s programs. Within US fixed income, investors should look for opportunities in sectors that offer attractive spreads and directly benefit from Fed support. In the corporate bond market this means owning securities rated BB or higher and avoiding debt rated B and below. Spreads for all corporate credit tiers are cheap compared to history (Charts 16A & 16B), but only BB-rated and higher benefit from the Fed’s programs. Some B-rated issuers will be able to access the MSELF, but Fed support for the B-rated credit tier is limited. Fed support is non-existent for securities rated CCC or lower. Chart 16AInvestment Grade Valuation Investment Grade Valuation Investment Grade Valuation Chart 16BHigh-Yield Valuation High-Yield Valuation High-Yield Valuation Elsewhere, several traditionally low-risk spread sectors also meet our criteria of offering attractive spreads and benefitting from Fed support. AAA-rated Consumer ABS spreads are wide and will benefit from TALF. Agency CMBS spreads are also attractive and those securities are being directly purchased by the Fed (Chart 17). We also like the opportunity in Agency bonds (the debt of Fannie Mae and Freddie Mac) and Supranationals, where spreads are currently well above historical levels (Chart 17, third panel). Chart 17Opportunities In Low-Risk Spread Product Opportunities In Low-Risk Spread Product Opportunities In Low-Risk Spread Product Chart 18Not Enough Value In Agency MBS Not Enough Value In Agency MBS Not Enough Value In Agency MBS Agency MBS are less appealing. Spreads have already tightened back to pre-COVID levels and while continued Fed buying should keep them low, returns will be much better in the investment grade corporate space (Chart 18).  Meanwhile, we would also advocate long positions in municipal bonds. Spreads are wide and the Fed is now providing support out to the 2-year maturity point (see Chart 13). We also see potential for the Fed to start purchasing longer-maturity municipal debt if spreads don’t tighten quickly enough. Chart 19Look For Attractive Spreads In Countries With Swap Lines Look For Attractive Spreads In Countries With Swap Lines Look For Attractive Spreads In Countries With Swap Lines Finally, we would also consider the USD-denominated sovereign debt of countries to which the Fed has extended swap lines, with Mexico offering a prime example. Its USD-denominated debt offers an attractive spread and it has been extended a swap line (Chart 19). In equities, agency mortgage REITs – monoline lenders that manage MBS portfolios 8-10 times the size of their equity capital – are a levered play on buying what the Fed’s buying. They were beaten up quite badly throughout March, and have been de-rated enough to deliver double-digit total returns as long as the repo market doesn’t flare up again, and agency MBS spreads do not widen anew. We see large banks as a direct beneficiary of policymakers’ efforts to limit credit distress and expect that their loan losses could ultimately be less than markets fear. While lenders have an incentive to be the first to push secured borrowers into default in a normal recession to ensure they’re first in line to liquidate collateral, they now have an incentive to keep borrowers from defaulting lest they end up having to carry the millstone of seized collateral on their balance sheets for an indefinite period. Regulatory forbearance may end up being every bit as helpful for bank book values as the ability to move securities into the Fed’s non-recourse facilities. Footnotes 1 This calculation uses 2019 EBITDA and includes undrawn loan commitments in total debt. 2 The Fed plans to expand the program to include non-bank SBA-approved lenders in the near future. 3 Please see the US Investment Strategy Special Reports, “How Vulnerable Are US Banks? Part 1: A 50-Year Bottom-Up Case Study,” and “How Vulnerable Are US Banks? Part 2: It’s Complicated,” published March 30 and April 6, 2020, respectively, available at usis.bcaresearch.com. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Jennifer Lacombe Associate Editor jenniferl@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com

Highlights Chart 1Will Fed Purchases Mark The Top? Will Fed Purchases Mark The Top? Will Fed Purchases Mark The Top? Policymakers can’t do much to boost economic activity when the entire population is under quarantine, but they can take steps to contain the ongoing credit shock and mitigate the risk of widespread corporate bankruptcy. If most firms can stay afloat, then at least there will be jobs to return to when shelter in place restrictions are lifted. Are the steps taken so far by the Federal Reserve and Congress sufficient in this regard? We expect that the Fed’s announcement of investment grade corporate bond purchases will mark the peak in investment grade corporate bond spreads (Chart 1). However, the Fed is doing nothing for high-yield issuers and its purchases only lower borrowing costs for investment grade firms, they don’t clean up highly levered balance sheets. Similarly, much of Congress’ fiscal stimulus package comes in the form of loans instead of grants. As such, ratings downgrades will surge and high-yield spreads probably have more near-term upside. Investors should keep portfolio duration close to benchmark, overweight investment grade corporate bonds and remain cautious vis-à-vis high-yield. Investors should also take advantage of the attractive long-run value in TIPS. Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 1040 basis points in March, dragging year-to-date excess returns down to -1268 bps. The average index spread widened 251 bps from the beginning of the month until the Fed announced its corporate bond purchase programs. It then tightened by 90 bps. It currently sits at 283 bps. Even after the recent tightening, investment grade spreads are extremely high relative to history. Our measure of the 12-month breakeven spread adjusted for changing index credit quality ranks at its 89th percentile since 1989 (Chart 2).1 This means that the sector has only been cheaper 11% of the time since 1989. As we wrote in last week’s Special Report, the Fed’s two new corporate bond purchase programs could be thought of as adding an agency guarantee to eligible securities (those with 5-years to maturity or less).2  We would also expect ineligible (longer maturity) securities to benefit from some knock-on effects, since many firms issue at both the short and long ends of the curve. As such, we recommend an overweight allocation to investment grade corporate bonds, with a preference for the short-end of the curve (5-years or less). The Fed’s purchases should lead to spread tightening, and a steepening of the spread curve (panel 4).  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Containing The Credit Shock Containing The Credit Shock Table 3BCorporate Sector Risk Vs. Reward* Containing The Credit Shock Containing The Credit Shock High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 1330 basis points in March, dragging year-to-date excess returns down to -1659 bps. The average index spread widened 600 bps from the beginning of the month until the Fed announced its corporate bond purchase programs. It then tightened by 158 bps. It currently sits at 942 bps. As we wrote in last week’s Special Report, the Fed’s corporate bond purchases will cause investment grade corporate spreads to tighten, but so far, high-yield has been left out in the cold.3 This means that we must view high-yield spreads in the context of what sort of default cycle we expect for the next 12 months. To do that, we use our Default-Adjusted Spread – the excess spread available in the index after accounting for default losses. At current spreads, our base case expectation of an 11%-13% default rate and 20%-25% recovery rate implies a Default-Adjusted Spread between -98 bps and +117bps (Chart 3). For a true buying opportunity, we would prefer a Default-Adjusted Spread above its historical average of 250 bps. This means that we would consider upgrading high-yield to overweight if the index spread widens to a range of 1075 bps – 1290 bps, in the near-term. Until then, junk investors should stay cautious. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 22 basis points in March, dragging year-to-date excess returns down to -81 bps. The conventional 30-year zero-volatility spread widened 13 bps on the month, driven by a 16 bps widening of the option-adjusted spread that was offset by a 3 bps decline in expected prepayment losses (aka option cost). Like investment grade corporates, MBS spreads will benefit from aggressive Fed purchases for the foreseeable future. However, we prefer investment grade corporates over MBS because of much more attractive valuations. Notice that the option-adjusted spread offered by a Aa-rated corporate bond is 98 bps greater than that offered by a conventional 30-year MBS (Chart 4). Further, servicer back-log is currently keeping primary mortgage rates elevated compared to both Treasury and MBS yields (panels 4 & 5). This is preventing many homeowners from refinancing, despite the Fed’s dramatic rate cuts. However, we expect these homeowners will eventually get their chance. The Fed will be very cautious about raising rates in the future, and primary mortgage spreads will tighten as servicers add capacity. This means that there is a significant amount of refi risk that is not yet priced into MBS. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related Index underperformed the duration-equivalent Treasury index by 574 basis points in March, dragging year-to-date excess returns down to -667 bps. Sovereign debt underperformed duration-equivalent Treasuries by 1046 bps in March, dragging year-to-date excess returns down to -1375 bps. Foreign Agencies underperformed the Treasury benchmark by 850 bps on the month, dragging year-to-date excess returns down to -1023 bps. Local Authority debt underperformed Treasuries by 990 bps in March, dragging year-to-date excess returns down to -948 bps. Domestic Agency bonds underperformed by 96 bps in March, dragging year-to-date excess returns down to -103 bps. Supranationals underperformed by 70 bps on the month, dragging year-to-date excess returns down to -63 bps. USD-denominated Sovereigns handily outperformed Baa-rated corporate bonds during last month’s market riot (Chart 5). But going forward, we prefer to grab the extra spread available in Baa-rated corporates, with the added bonus that the corporate sector now benefits from direct Fed purchases. The Fed’s dollar swap lines should remove some of the liquidity premium priced into sovereign spreads, but these swap lines only extend to 14 countries (Euro Area, Canada, UK, Japan, Switzerland, Australia, Brazil, Denmark, Korea, Mexico, Norway, New Zealand, Singapore and Sweden) and further dollar appreciation is possible until global growth recovers. One silver lining of last month’s indiscriminate spread widening is that some value has been created in traditionally low-risk sectors. Specifically, the Domestic Agency and Supranational option-adjusted spreads are at 46 bps and 31 bps, respectively (bottom panel). Both look like attractive buying opportunities. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by a whopping 649 basis points in March, dragging year-to-date excess returns down to -755 bps (before adjusting for the tax advantage). In fact, Aaa-rated Municipal / Treasury yield ratios have blown out across the entire curve and have made new all-time highs, above where they were during the 2008 financial crisis (Chart 6). While the spread levels are alarming, it’s not hard to understand why muni spread widening has been so dramatic. State and local governments are not only shouldering massive expenses fighting the COVID-19 crisis, but will also see tax revenues plunge as economic activity grinds to a halt. This opens up a massive whole in state & local government budgets and municipal bond prices are reacting in kind. Support in the form of Fed municipal bond purchases and direct cash injections from the federal government is required to right the ship. So far, the Fed is only supporting municipal debt with less than six months to maturity and federal government aid has come in the form of grants directed at specific spending areas. Ideally, the Fed will start purchasing long-dated municipal bonds (as it is doing with corporates) and the federal government will provide more direct aid to fill budget gaps. We expect both of those policies to be launched in the coming weeks, and thus think it is a good time to buy municipal bonds on the expectation that the “policy put” will drive spreads lower. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve underwent a massive bull-steepening in March, as the Fed cut rates by 100 bps, all the way back to the zero bound. The 2-year/10-year Treasury slope steepened 20 bps on the month. It currently sits at 39 bps. The 5-year/30-year Treasury slope steepened 22 bps on the month. It currently sits at 85 bps. One good thing about the fed funds rate being pinned at zero is that it greatly simplifies yield curve strategy. As we showed in a recent report, when the funds rate is at its lower bound the Treasury slope will trade directionally with yields.4 That is, the yield curve will steepen when yields rise and flatten when they fall. Therefore, if you want to put on a position that will profit from lower yields but that doesn’t increase the average duration of your portfolio, you can enter a duration-neutral flattener: long a 2/10 or 2/30 barbell and short the 5-year or 7-year bullet, in duration-matched terms. Or, if like us, you do not want to make a large duration bet but suspect that Treasury yields will be higher in 12 months, you can enter a duration-neutral steepener: long the 5-year bullet and short a duration-matched 2/10 barbell.5 In terms of value, the 5-year yield no longer trades deeply negative relative to the 2/10 and 2/30 barbells (Chart 7), though it remains somewhat expensive according to our models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 515 basis points in March, dragging year-to-date excess returns down to -735 bps. The 10-year TIPS breakeven inflation rate fell 55 bps on the month. It currently sits at 1.09%. The 5-year/5-year forward TIPS breakeven inflation rate fell 24 bps on the month. It currently sits at 1.39%. As we noted in a recent report, the market crash has created an extraordinary amount of long-run value in TIPS.6 For example, the 10-year and 5-year TIPS breakeven inflation rates have fallen to 1.09% and 0.78%, respectively. This means that a buy & hold position long the TIPS and short the equivalent-maturity nominal Treasury will make money if average annual inflation is greater than 0.78% for the next five years, or greater than 1.09% for the next ten (Chart 8). This seems like a slam dunk. Even on a 1-year horizon, we would argue that TIPS trades make sense. We calculate that the TIPS note maturing in April 2021 will deliver greater returns than a 12-month T-bill as long as headline CPI inflation is above -1.25% during the next 12 months (panel 4). Granted, the oil price collapse is a significant drag on CPI (bottom panel). But, we would also note that the worst year-over-year CPI print during the 2008 financial crisis was -2.1% and this included deflation in the shelter component. Shelter accounts for 33% of the CPI, compared to only 7% for Energy. ABS: Underweight  Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 342 basis points in March, dragging year-to-date excess returns down to -317 bps. The index option-adjusted spread for Aaa-rated ABS soared 158 bps on the month. It currently sits at 163 bps, well above average historical levels (Chart 9). Aaa-rated consumer ABS were not immune to the recent sell-off, but we think today’s elevated spreads signal an opportunity to increase exposure to the sector. In addition to the value argument, the Fed’s re-launched Term Asset-Backed Securities Loan Facility (TALF) should cause Aaa-rated ABS spreads to tighten in the coming months. Through TALF, eligible private investors can take out non-recourse loans from the Fed and use the proceeds to purchase Aaa-rated ABS. In our view, the combination of elevated spreads and direct Fed support for the sector suggests a buying opportunity in Aaa-rated consumer ABS. Non-Agency CMBS: Neutral  Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 786 basis points in March, dragging year-to-date excess returns down to -785 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 133 bps on the month. It currently sits at 217 bps, well above typical historical levels (Chart 10). Despite wide spreads, we are hesitant about stepping into the sector. The Fed has so far not extended its asset purchases to non-agency CMBS. There are other sectors – such as consumer ABS, Agency CMBS, and investment grade corporate bonds – that also offer attractive spreads and are benefitting directly from Fed support. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 394 basis points in March, dragging year-to-date excess returns down to -361 bps. The average index spread for Agency CMBS widened 74 bps on the month. It currently sits at 121 bps, well above typical historical levels (panel 3). Unlike its non-agency counterpart, the Fed is buying Agency CMBS as part of its mortgage-backed securities purchase program. The combination of an elevated spread and direct Fed support makes the Agency CMBS sector a high conviction overweight. Appendix A: The Golden Rule Of Bond Investing With the federal funds rate pinned at its effective lower bound for the foreseeable future, yield volatility at the front-end of the curve will decline markedly. This means that the 12-month fed funds rate expectations embedded in the yield curve provide little useful information. As such, our Golden Rule of Bond Investing is not a useful framework for implementing duration trades when the fed funds rate is pinned at zero. We will therefore temporarily stop updating the Golden Rule tables that were previously shown in Appendix A of our monthly Portfolio Allocation Summary. The Golden Rule framework will return when the fed funds rate is close to lifting off from zero. Please feel free to contact us if you have any questions.     Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of April 3, 2020) Containing The Credit Shock Containing The Credit Shock Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of April 3, 2020) Containing The Credit Shock Containing The Credit Shock Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 46 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 46 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Containing The Credit Shock Containing The Credit Shock Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of April 3, 2020) The Golden Rule's Track Record The Golden Rule's Track Record   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The 12-month breakeven spread is the spread widening required to deliver negative excess returns versus duration-matched Treasuries on a 12-month horizon. 2 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 The rationale for why barbell positions profit from curve flattening and bullet positions profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Chart 1Making New Lows Making New Lows Making New Lows While the number of daily new COVID-19 cases is falling in China, the virus is spreading rapidly to the rest of the world. It is now clear that the outbreak will not be contained, though much uncertainty remains about the magnitude and duration of the global economic fallout. US bond yields have dropped dramatically, with the 10-year yield threatening to break below 1% for the first time ever (Chart 1). Interest rate markets are also pricing-in a rapid Fed response, with more than 100 bps of rate cuts priced for the next year and a 50 bps rate cut discounted for March. On Friday, BCA released a Special Alert making the case that stock prices have fallen enough to buy the market, even on a tactical (3-month) horizon. It is too early to make a similar call looking for higher bond yields. While risk assets will get near-term support from a dovish monetary policy shift, bond yields will stay low (and could even fall further) until global economic recovery appears likely. On a 12-month horizon, our base case scenario is that the Fed will not have to deliver the 110 bps of cuts that are currently priced. We therefore expect bond yields to be higher one year from now. But investors with shorter time horizons should wait before calling the bottom in yields.  Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 176 basis points in February, dragging year-to-date excess returns down to -255 bps. Coronavirus fears pushed spreads wider in February, and the average spread for the overall investment grade index moved back above our cyclical target (Chart 2).1 As for specific credit tiers, Baa spreads are 9 bps above target and Aa spreads are 3 bps cheap. A-rated spreads are sitting right on our target, and Aaa debt remains 5 bps expensive. Looking beyond the economic fallout from the coronavirus, accommodative monetary conditions remain the key support for corporate bonds. Notably, both the 2-year/10-year and 3-year/10-year Treasury slopes steepened in February, and both remain firmly above zero. This suggests that the market believes that the Fed will keep policy easy. As we discussed two weeks ago, restrictive Fed policy – as evidenced by an inverted 3-year/10-year Treasury curve and elevated TIPS breakeven inflation rates – is required before banks choke off the supply of credit, causing defaults and a bear market in corporate spreads.2 Bottom Line: Corporate spreads will keep widening until coronavirus fears abate, but COVID-19 will not cause the end of the credit cycle. Once the dust settles, a buying opportunity will emerge in investment grade corporates, with spreads back above our cyclical targets. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields Table 3BCorporate Sector Risk Vs. Reward* Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 271 basis points in February, dragging year-to-date excess returns down to -379 bps. The junk index spread widened 110 bps on the month and is currently 37 bps below its early-2019 peak. Ex-energy, the average index spread widened 93 bps in February. It is 71 bps below its 2019 peak. High-yield spreads were well above our cyclical targets prior to the COVID-19 outbreak and have only cheapened further during the past month. More spread widening is likely in the near-term, but an exceptional buying opportunity will emerge once virus-related fears fade. This is especially true relative to investment grade corporate bonds. To illustrate the valuation disparity between investment grade and high-yield, we calculated the average monthly spread widening for each credit tier during this cycle’s three major “risk off” phases (2011, 2015 and 2018). We then used each credit tier’s average option-adjusted spread and duration to estimate monthly excess returns for that amount of spread widening (Chart 3, bottom panel). The results show that, in past years, Baa-rated corporates behaved much more defensively than Ba or B-rated bonds. But now, because of the greater spread cushion and lower duration in the junk space, estimated downside risk is similar. In other words, the valuation disparity between investment grade and junk means that investment grade corporates offer much less downside protection than usual compared to high-yield. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 7 basis points in February, dragging year-to-date excess returns down to -60 bps. The conventional 30-year zero-volatility spread widened 1 bp on the month, driven by a 7 bps widening of the option-adjusted spread that was partially offset by a 6 bps reduction in expected prepayment losses (aka option cost). The 10-year Treasury yield has made a new all-time low, and the 30-year mortgage rate – at 3.45% – is only 14 bps above its own (Chart 4). At these levels, an increase in mortgage refinancing activity is inevitable, and indeed, the MBA Refi index has bounced sharply in recent weeks. MBS spreads, however, have not yet reacted to the higher refi index (panel 3). The nominal spread on 30-year conventional MBS is only 9 bps above where it started the year, and expected prepayment losses are 5 bps lower.3 Some widening is likely during the next few months, and we recommend that investors reduce exposure to Agency MBS. Even on a 12-month horizon, MBS spreads offer good value relative to investment grade corporate bonds for now (bottom panel), but investment grade corporates will cheapen on a relative basis if the current risk-off environment continues. This is probably a good time to start paring exposure to MBS, with the intention of re-deploying into corporate credit when spreads peak. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 86 basis points in February, dragging year-to-date excess returns down to -99 bps. Sovereign debt underperformed duration-equivalent Treasuries by 270 bps in February, dragging year-to-date excess returns down to -367 bps. Foreign Agencies underperformed the Treasury benchmark by 162 bps on the month, dragging year-to-date excess returns down to -189 bps. Local Authority debt underperformed Treasuries by 14 bps in February, dragging year-to-date excess returns down to +47 bps. Domestic Agency bonds underperformed by 5 bps in February, dragging year-to-date excess returns down to -7 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +7 bps. We continue to see little value in USD-denominated Sovereign debt, outside of Mexico and Saudi Arabia where spreads look attractive compared to similarly-rated US corporate bonds (Chart 5). The Local Authority and Foreign Agency sectors, however, offer attractive combinations of risk and reward according to our Excess Return Bond Map (see Appendix C). Our Global Asset Allocation service just released a Special Report on emerging market debt that argues for favoring USD-denominated EM sovereign debt over both USD-denominated EM corporate debt and local-currency EM sovereign bonds.4 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 80 basis points in February, dragging year-to-date excess returns down to -114 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 11% on the month to 88%, remaining below its post-crisis mean (Chart 6). For some time we have been advising clients to focus municipal bond exposure at the long-end of the Aaa curve, where yield ratios were above average pre-crisis levels. But last month’s sell-off brought some value back to the front end (panel 2). Specifically, the 2-year, 5-year and 10-year M/T yield ratios are all back above their average pre-crisis levels at 85%, 83% and 86%, respectively. 20-year and 30-year maturities are still cheapest, at yield ratios of 93% and 94%, respectively. Investors should adopt a laddered allocation across the municipal bond curve, as opposed to focusing exposure at the long-end. Fundamentally, state and local government balance sheets remain solid. Our Municipal Health Monitor is in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both trends are consistent with muni ratings upgrades continuing to outpace downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-steepened dramatically in February, with yields down at least 30 bps across the board. The 2/10 Treasury slope steepened 9 bps on the month, reaching 27 bps. The 5/30 slope also steepened 9 bps to reach 76 bps. February’s plunge in yields was massive, but the fact that it occurred without 2/10 or 5/30 flattening signals that the market expects the Fed to respond quickly and that any economic pain will be relatively short lived. In fact, the front-end of the curve is now priced for 110 bps of rate cuts during the next 12 months (Chart 7). That amount of easing would bring the fed funds rate back to 0.48%, less than two 25 basis point increments off the zero lower bound. Though the drop in 12-month rate expectations didn’t move the duration-matched 2/5/10 or 2/5/30 butterfly spreads very much, the 5-year note remains very expensive relative to both the 2/10 and 2/30 barbells (bottom 2 panels). The richness in the 5-year note will reverse if the Fed delivers less than the 110 bps of rate cuts that are currently priced for the next year. At present, we view less than 110 bps of easing as the most likely scenario, and therefore maintain our position long the 2/30 barbell and short the 5-year bullet. TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 159 basis points in February, dragging year-to-date excess returns down to -232 bps. The 10-year TIPS breakeven inflation rate fell 24 bps to 1.42%. The 5-year/5-year forward TIPS breakeven inflation rate fell 21 bps to 1.50%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s inflation target. We have been recommending that investors own TIPS breakeven curve flatteners on the view that inflationary pressures will first show up in the realized inflation data and the short-end of the breakeven curve, before infecting the long-end.5 However, recent risk-off market behavior has caused long-end inflation expectations to fall dramatically, while sticky near-term inflation prints have supported short-dated expectations. Case in point, the 2-year TIPS breakeven inflation rate declined 16 bps in February, compared to a 24 bps drop for the 10-year (Chart 8). Inflation curve flattening could continue in the near-term but will reverse when risk assets recover. As a result, we recommend taking profits on TIPS breakeven curve flatteners and waiting for a period of re-steepening before putting the trade back on. Fundamentally, we note that the 10-year TIPS breakeven inflation rate is 38 bps cheap according to our re-vamped Adaptive Expectations Model (bottom panel).6 Investors should remain overweight TIPS versus nominal Treasuries on a 12-month horizon. ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in February, dragging year-to-date excess returns down to +26 bps. The index option-adjusted spread for Aaa-rated ABS widened 7 bps on the month. It currently sits at 33 bps, right on top of its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS ranks among the most defensive US spread products. This explains why the sector has weathered the recent storm so well, and why it is actually up versus Treasuries so far this year. ABS also offer higher expected returns than other low-risk spread sectors such as Domestic Agency bonds and Supranationals. For as long as the current risk-off phase continues, consumer ABS are a more attractive place to hide than Domestic Agencies or Supranationals. However, once risk-on market behavior re-asserts itself, consumer ABS will once again lag other riskier spread products. In the long-run, we also remain concerned about deteriorating consumer credit fundamentals, as evidenced by tightening lending standards for both credit cards and auto loans, and a rising household interest expense ratio (bottom 2 panels). Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 42 basis points in February, dragging year-to-date excess returns down to +1 bp. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 9 bps on the month. It currently sits at 76 bps, below its average pre-crisis level (Chart 10). In a recent Special Report, we explored how low interest rates have boosted commercial real estate (CRE) prices this cycle and concluded that a sharp drawdown in CRE prices is likely only when inflation starts to pick up steam.7 In that report we also mentioned that non-agency Aaa-rated CMBS spreads look attractive relative to US corporate bonds in risk-adjusted terms (Appendix C), and that the macro environment is close to neutral for CMBS spreads. Both CRE lending standards and loan demand were close to unchanged during the past quarter, as per the Fed’s Senior Loan Officer Survey (bottom 2 panels).  Agency CMBS: Overweight Agency CMBS performed in line with the duration-equivalent Treasury index in February, leaving year-to-date excess returns unchanged at +35 bps. The index option-adjusted spread widened 2 bps on the month to reach 56 bps. Agency CMBS offer greater expected return than Aaa-rated consumer ABS, while also carrying agency backing (Appendix C). An overweight allocation to this sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 110 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of February 28, 2020) Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of February 28, 2020) Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 50 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 50 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of February 28, 2020) Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more information on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “The Credit Cycle Is Far From Over”, dated February 18, 2020, available at usbs.bcaresearch.com 3 Expected prepayment losses (or option cost) are calculated as the difference between the index’s zero-volatility spread and its option-adjusted spread. 4 Please see Global Asset Allocation Special Report, “Understanding Emerging Markets Debt”, dated February 27, 2020, available at gaa.bcaresearch.com 5 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com  6 Please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 7 Please see US Investment Strategy / US Bond Strategy Special Report, “Commercial Real Estate And US Financial Stability”, dated January 27, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Chart 1The 2003 SARS Roadmap The 2003 SARS Roadmap The 2003 SARS Roadmap The bond market impact from the coronavirus has already been substantial. The 10-year Treasury yield has fallen back to 1.51%, below the fed funds rate. Meanwhile, the investment grade corporate bond index spread is back above 100 bps, from a January low of 93 bps. The 2003 SARS crisis is the best roadmap we can apply to the current situation. Back then, Treasury yields also fell sharply but then rebounded just as quickly when the number of SARS cases peaked (Chart 1). The impact on corporate bond excess returns was more short-lived (Chart 1, bottom panel). Like in 2003, we expect that bond yields will rise once the number of coronavirus cases peaks, but it is difficult to put a timeframe on how long that will take. The economic impact from the virus could also weigh on global PMI surveys during the next few months, delaying the move higher in Treasury yields we anticipated earlier this year. In short, we continue to expect higher bond yields and tighter credit spreads in 2020, but those moves will be delayed until markets are confident that the virus has stopped spreading. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 80 basis points in January. The sector actually outpaced the Treasury benchmark by 7 bps until January 21 when the impact of the coronavirus started to push spreads wider. As stated on page 1, we expect the impact of the coronavirus on corporate spreads to be short lived. Beyond that, low inflation expectations will keep monetary conditions accommodative. This in turn will encourage banks to ease credit supply, keeping defaults at bay and providing a strong tailwind for corporate bond returns.1 Yesterday’s Fed Senior Loan Officer survey showed a slight easing of C&I lending standards in Q4 2019, reversing the tightening that occurred in the third quarter (Chart 2). We expect that accommodative Fed policy will lead to continued easing of C&I lending standards for the remainder of the year. Despite the positive tailwind from accommodative Fed policy and easing bank lending standards, investment grade corporate bond spreads are quite expensive. Spreads for all credit tiers are below our targets (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher (see page 7). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Contagion Contagion Table 3BCorporate Sector Risk Vs. Reward* Contagion Contagion High-Yield Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 111 basis points in January. Junk outperformed the Treasury benchmark by 30 bps until January 21 when the coronavirus outbreak sent spreads sharply wider. Once the negative impact of the coronavirus passes, junk spreads will have plenty of room to tighten in 2020. In fact, the junk index spread is now at 390 bps, 154 bps above our target (Chart 3).3 While spreads for all junk credit tiers are currently above our targets, Caa-rated bonds look particularly cheap. We analyzed the divergence between Caa and the rest of the junk index in a recent report and came to two conclusions.4 First, the historical data show that 12-month periods of overall junk bond outperformance are more likely to be followed by underperformance if Caa is the worst performing credit tier. Second, we can identify several reasons for 2019’s Caa spread widening that make us inclined to downplay any negative signal. Specifically, we note that the Caa credit tier’s exposure to the shale oil sector is responsible for the bulk of 2019’s underperformance (bottom panel). Absent significant further declines in the oil price, this sector now has room to recover.   MBS: Overweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 53 basis points in January. The sector was only lagging the Treasury benchmark by 7 bps as of January 21, when the coronavirus outbreak sent spreads wider. The conventional 30-year zero-volatility spread widened 8 bps in January, driven by a 7 bps widening of the option-adjusted spread (OAS) and a 1 bp increase in expected prepayment losses (aka option cost). The fact that expected prepayment losses only rose by a single basis point even though the 30-year mortgage rate fell by 23 bps is notable. It speaks to the high level of refi burnout in the mortgage market, which is a key reason why we prefer mortgage-backed securities over investment grade corporate bonds in our portfolio. Essentially, most homeowners have already had at least one opportunity to refinance during the past few years, so prepayment risk is low even if rates fall further. Competitive expected compensation is another reason to move into Agency MBS. The conventional 30-year MBS OAS is 49 bps, only 7 bps below the spread offered by Aa-rated corporate bonds (Chart 4). Also, spreads for all investment grade corporate bond credit tiers are below our cyclical targets. Risk-adjusted compensation favors MBS even more strongly. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 14 basis points in January. The index was up 2 bps versus the Treasury benchmark until January 21, when the coronavirus outbreak hit. Sovereign debt underperformed duration-equivalent Treasuries by 99 bps on the month, and Foreign Agencies underperformed by 28 bps. Local Authorities, however, bested the Treasury benchmark by 60 bps. Domestic Agency bonds underperformed Treasuries by 2 bps in January, while Supranationals outperformed by 2 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to US corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.5 This is also true for Local Authorities and Foreign Agencies, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).6  Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 33 basis points in January (before adjusting for the tax advantage). They were up 39 bps versus the Treasury index before the coronavirus outbreak hit on January 21. The average Aaa-rated Municipal / Treasury (M/T) yield ratio swung around during the month, but settled close to where it began at 77% (Chart 6). We upgraded municipal bonds in early October, as yield ratios had become significantly more attractive, especially at the long-end of the Aaa curve (panel 2).7 Yield ratios have tightened a lot since then, but value remains at long maturities. Specifically, the 2-year, 5-year and 10-year M/T yield ratios are all below average pre-crisis levels at 62%, 65% and 78%, respectively. But 20-year and 30-year yield ratios stand at 89% and 93%, respectively, above average pre-crisis levels. Fundamentally, state and local balance sheets remain solid. Our Municipal Health Monitor is in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outpace downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in January. Treasury yields declined across the curve, and the 2/10 slope flattened from 34 bps to 18 bps. The 5/30 slope flattened from 70 bps to 67 bps. Despite the significant flattening, the 2/10 slope remains near the middle of our target 0 – 50 bps range for 2020, and we anticipate some bear-steepening once the coronavirus is contained.8 The front-end of the curve also moved in January to price-in 57 bps of Fed rate cuts during the next 12 months (Chart 7). At the beginning of the year the curve was priced for only 14 bps of rate cuts. We expect that the Fed would respond with rate cuts if the coronavirus epidemic worsens, leading to inversion of the 2/10 yield curve. However, for the time being the safer bet is that the virus will be contained relatively quickly and the Fed will remain on hold for all of 2020. Based on this view, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. The position offers positive carry and looks attractive on our yield curve models (see Appendix B).9  TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent Treasury index by 75 basis points in January. The 10-year TIPS breakeven inflation rate fell 12 bps on the month and currently sits at 1.66%. The 5-year/5-year forward TIPS breakeven inflation rate fell 16 bps on the month and currently sits at 1.71%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations remains stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target since mid-2018 (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. It takes time for expectations to adapt to a changing macro environment, but even accounting for those long lags, our Adaptive Expectations Model pegs the 10-year TIPS breakeven inflation rate as 31 bps too low (panel 4).10 It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor long-term inflation expectations. As a result, the actual inflation data will lead expectations higher, causing the TIPS breakeven inflation curve to flatten.11 ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 32 basis points in January. The index option-adjusted spread for Aaa-rated ABS tightened 14 bps on the month. It currently sits at 26 bps, below its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS ranks among the most defensive US spread products. This explains why the sector performed so well in January when other spread sectors struggled. ABS also offer higher expected returns than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends are slowly shifting in the wrong direction. The consumer credit delinquency rate remains low, but has put in a clear bottom. This is also true for the household interest expense ratio (panel 3). Senior Loan Officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 43 basis points in January. The index option-adjusted spread for non-agency CMBS tightened 6 bps on the month. It currently sits at 67 bps, below its average pre-crisis level (Chart 10). In last week’s Special Report, we explored how low interest rates have boosted commercial real estate (CRE) prices this cycle, and concluded that a sharp drawdown in CRE prices is likely only when inflation starts to pick up steam.12 In that report we also mentioned that non-agency Aaa-rated CMBS spreads look attractive relative to US corporate bonds from a risk/reward perspective (see our Excess Return Bond Map in Appendix C), and that the macro environment is only slightly unfavorable for CMBS spreads. Specifically, CRE bank lending standards are just in “net tightening” territory. But both lending standards and loan demand are very close to neutral (bottom 2 panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 34 basis points in January. The index option-adjusted spread tightened 4 bps on the month to reach 54 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 57 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Contagion Contagion Contagion Contagion Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of January 31, 2020) Contagion Contagion Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of January 31, 2020) Contagion Contagion Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 33 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 33 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Contagion Contagion Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Excess Return Bond Map (As Of January 31, 2020) Contagion Contagion ​​​​​​​ Footnotes 1 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 2  For details on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3  For details on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4  Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 6 Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 9 For further details on our recommended yield curve trade please see US Bond Strategy Weekly Report, “The Best Spot On The Yield Curve”, dated January 21, 2020, available at usbs.bcaresearch.com 10 For further details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 11  Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 12  Please see US Investment Strategy / US Bond Strategy Special Report, “Commercial Real Estate And US Financial Stability”, dated January 27, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Commercial rents have fallen in real terms, revealing that the commercial property price rally has been fueled exclusively by low rates. Limited upside for rents and an upward direction for future rates are two significant headwinds. However, commercial real estate is especially pro-cyclical and inflationary pressures need to work their way into the economy before the risk of a downturn becomes imminent. The good news is that the economy is less vulnerable to slipping commercial property prices. Large banks have shrunk their commercial property loan books and their composition has shifted towards safer categories of commercial loans. While the macroeconomic outlook remains somewhat neutral, CMBS’ risk/reward profile appears reasonably attractive relative to other US bond sectors. Feature Real estate was a bane for markets and the banking system in the last recession, and commercial properties have lately become an increasingly popular source of concern among investors. Average prices have grown by 90% over the past decade, rising well above their pre-Great Financial Crisis peaks. We have made the case that we are heading into the expansion’s last stretch. The study of economic cycles and our relentless quest to identify inflection points ahead of time become more timely as the bull market ages. To this end, current commercial property valuations deserve close scrutiny and we explore whether any underlying excesses could potentially disrupt financial stability or precipitate a recession in the US. We conclude that although commercial property prices have little hope of appreciating significantly from current levels, a reversal is not imminent until inflationary pressure forces rates higher. When prices eventually slip, the impact on the overall economy should be more attenuated than it was in the last recession, as the banking system has become less vulnerable to a downturn in commercial real estate. While the fundamental macro outlook remains neutral, suggesting no imminent pressure on spreads, US bond investors can find relative value in non-agency Aaa-rated CMBS (vs. corporate bonds rated A or higher) and in agency CMBS (vs. agency residential mortgaged-backed securities). A Rate-Driven Rally Chart 1Commercial Rents Have Decoupled From Property Prices Commercial Rents Have Decoupled From Property Prices Commercial Rents Have Decoupled From Property Prices Like all financial assets, commercial property prices are derived from discounting future cash flows to their present value. Since the crisis, a low rate environment, supported by a sluggish inflation backdrop and continuously accommodative monetary policy, has depressed the valuation equation’s denominator. Meanwhile, strong economic fundamentals and demographic trends - such as urbanization and the millennials’ tendency to marry and purchase a home at a later age - have helped boost the numerator for commercial and multi-family residential properties in the past decade. However, with the exception of multi-family residential real estate - for which price appreciation has also been the strongest - real rents have fallen (Chart 1), revealing that low rates have propelled commercial properties’ price appreciation over the past decade. The combination of falling real rents and surging property prices has depressed commercial real estate cap rates1 to cyclical low levels, raising the question of a potential unwind. Mathematically, an increase in cap rates could result, on the one hand, from rent growth outpacing inflation growth, translating into an increase in real rents on the numerator. Alternatively, cap rates could rise from falling property prices, reducing the denominator. On a cyclical horizon, the latter outcome seems more likely than the former. Little Upside Left For Rents First, the fact that rents in real terms have decreased in spite of sluggish inflation is a bad omen for the outlook for future real rents. We have made the case that there is more inflationary pressure than meets the eye beneath the surface of the US economy. The combination of an already very tight labor market and a pickup in manufacturing activity point towards further wage growth. Inflation is a lagging indicator that has more scope to rise than roll-over at this stage of the cycle. All else equal, upward inflationary pressure will depress real rents further. Second, nominal rents themselves are also facing significant headwinds. Office buildings’ and retail shopping centers’ vacancies have barely recovered from the hit they took in the last recession, while new inventory is struggling to get absorbed by new demand (Chart 2). A strong labor market generally supports the demand for office spaces but a tight labor market limits its future upside. The latter, though, increases potential wage gains and consumers’ purchasing power, whose fundamentals are already strong. We have shown that US consumers’ increased savings rates and lower debt levels put them in a good position to spend their incremental income. Chart 2Post-Crisis Office And Shopping Center Vacancies Remain Elevated... Post-Crisis Office And Shopping Center Vacancies Remain Elevated... Post-Crisis Office And Shopping Center Vacancies Remain Elevated... Chart 3...As These Sectors Face Structural Disruptions ...As These Sectors Face Structural Disruptions ...As These Sectors Face Structural Disruptions However, both sectors are facing structural disruptions. Co-working has introduced a new player in the office segment – a sub-lessor who signs long-term leases on space it rents out in short-term chunks. If a sizable sub-lessor like WeWork were forced to shrink its footprint, a lot of office supply would come back on to the market, while demand is shrinking as businesses attempt to reduce the area each employee occupies. Brick-and-mortar retailers continue to be buffeted as e-commerce captures an increasing share of consumer spending, keeping downward pressure on retail rents (Chart 3). The picture looks slightly brighter in the industrial properties space, where vacancies have recovered to healthier levels, though low vacancies have failed to lift rents as demand for properties is being met by new inventory (Chart 4). The revival in global manufacturing activity that we are expecting to occur this year should support industrial property rents in the near term, but the advanced age of the cycle limits future upside. Chart 4A Brighter Picture For Industrial And Apartment Buildings... A Brighter Picture For Industrial And Apartment Buildings... A Brighter Picture For Industrial And Apartment Buildings... Chart 5...Thanks To Rising Renters Income ...Thanks To Rising Renters Income ...Thanks To Rising Renters Income Chart 6Over-Construction Of High-Tier Properties Over-Construction Of High-Tier Properties Over-Construction Of High-Tier Properties Multi-family residential housing is the only sector that has experienced steady real rent growth, fueled by a combination of rising rentership rates and rising household income amongst renters (Chart 5). Homebuilders’ focus on building higher-end units has led to an oversupply of more expensive properties, and their prices have already started to contract on a year-on-year basis (Chart 6). Multi-family residential properties rents should lose momentum as the alternative cost of owning homes falls, especially as homebuilders attempt to right-size their mix of properties to offer more lower-end supply. Exhausted Demand A commercial real estate rally fueled by perpetually falling rates is unsustainable. Although the market sees the potential for an additional rate cut, we think the Fed is done cutting. Labor market strength and a revival in global manufacturing activity argue that no further accommodation or insurance rate cuts are necessary. From current levels, the path of least resistance for rates is upwards (Chart 7). Strong demand from institutional investors has also contributed to fueling prices. Pension funds and insurance companies’ holdings of mortgages and agency-backed securities have nearly doubled since 2010 (Chart 8, first panel) and their allocation as a percentage of total assets is nearing pre-recession highs (Chart 8, second panel). These levels allow them little flexibility to sustain their demand impulse, as there is only so much they can allocate to real estate and other alternative investments. Chart 7Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Chart 8Saturated Demand From Institutional Investors... Saturated Demand From Institutional Investors... Saturated Demand From Institutional Investors... Demand from yield-hungry investors may also get exhausted if CMBS yields deflate to the point where they lose competitiveness relative to other income-producing investments. CMBS yields have broadly moved with other bond yields since the crisis, though US high-yield corporates have widened somewhat over the last few years, making them a slightly more appealing alternative to CMBS, all else equal (Chart 9). The steady downward pressure on multi-family cap rates since 2010 (Chart 10) reveals that the collateral underlying multi-family loans has become increasingly ambitiously priced, suggesting that losses given default on multi-family backed CMBS without agency backing may be rising, eroding prospective default-adjusted returns. Chart 9...And From Yield-Hungry Investors? ...And From Yield-Hungry Investors? ...And From Yield-Hungry Investors? Chart 10Cap Rates Have Reached Cyclical Lows Cap Rates Have Reached Cyclical Lows Cap Rates Have Reached Cyclical Lows New regulations also have the potential to retract a significant share of demand for commercial mortgages. The severe housing market deterioration during the Great Financial Crisis and the government intervention required to ensure Freddie Mac’s and Fannie Mae’s solvency led the Federal Housing Finance Agency (FHFA) to place these two government sponsored enterprises (GSEs) under conservatorship in 2014 and to cap their holdings of multi-family mortgages to US$ 100 billion for each GSE. A commercial real estate rally fueled by perpetually falling rates is unsustainable. Current holdings of multi-family residential loans far exceed the stated limits (Table 1). GSEs hold nearly half of all multi-family residential loans outstanding. The post-crisis growth in GSE-guaranteed loans is largely attributable to the exclusion from the cap of certain categories of loans such as green energy loans (Chart 11). The FHFA eliminated these exemptions last year, making the US$ 200 billion cap more binding and applicable to all multi-family loans without exception.2 The impact on mortgage originators and investors is yet to be seen but it would naturally follow that demand for multi-family mortgages to bundle into CMBS would decline if the GSEs are forced to take a step back from the space. Table 1Commercial Real Estate Loans By Holder ($US Mn) Commercial Real Estate And US Financial Stability Commercial Real Estate And US Financial Stability Chart 11Multi-Family Mortgage Debt Outstanding By Mortgage Holder Multi-Family Mortgage Debt Outstanding By Mortgage Holder Multi-Family Mortgage Debt Outstanding By Mortgage Holder Late-Cycle Dynamics Commercial mortgages are typically non-recourse (in case of default, the borrower can only recover the value of the collateralized property) making the loss given default a function of property prices. When times are good and property prices rise, borrowers can easily refinance their loans. The opposite holds in bad times. Therefore, commercial real estate prices are especially pro-cyclical. In spite of the headwinds outlined above, a commercial property downturn does not seem imminent. In spite of the headwinds outlined above, a commercial property downturn does not seem imminent. First, the US economy still has momentum, is supported by highly accommodative monetary policy and should get a boost from a global growth revival. Absent any major exogenous shock to the global economy, we expect that a recession is at least eighteen months away. For as long as the economy keeps expanding, commercial real estate prices can remain elevated. Second, sources of financing remain abundant as the emergence of alternative lenders (Chart 12) has offset the banks’ tighter lending standards for commercial properties (Chart 13). The proliferation of non-bank lenders is typically a late-cycle indicator. Chart 12The Proliferation Of Alternative Lenders… Commercial Real Estate And US Financial Stability Commercial Real Estate And US Financial Stability However, when the economy starts contracting, a commercial real estate downturn could have an outsized impact on banks with significant exposure. In the late 1980s, the commercial property downturn induced a recession and the subprime mortgage bust gave rise to the Great Financial Crisis. Healthier Balance Sheets The good news for the economy today is that banks are less vulnerable to a downturn in commercial real estate than they were back then. The good news for the economy today is that banks are less vulnerable to a downturn in commercial real estate. Banks have decreased their overall exposure to commercial property loans to levels below their 2008 and 1989 peaks (Chart 14). It is worth noting, though, that smaller banks have taken an increasingly important role in the commercial property market as they now finance 65% of all commercial property loans. However, a stronger concentration in smaller banks represents a localized rather than systemic risk, as smaller banks tend to have a more concentrated geographic exposure. Conversely, large banks have significantly shrunk their commercial real estate loan books.3 Chart 14Large Banks Have Shrunk Their CRE Books... Large Banks Have Shrunk Their CRE Books... Large Banks Have Shrunk Their CRE Books... Chart 15...And Shifted Away From Speculative-Grade Loans ...And Shifted Away From Speculative-Grade Loans ...And Shifted Away From Speculative-Grade Loans Most importantly, the composition of the commercial property loan book has changed drastically since the Great Financial Crisis. Banks have significantly reduced their exposure to more speculative construction and development loans (Chart 15). Risk appetite typically increases in the latter stages of an expansion, yet construction loans remain at relatively depressed levels. The growth in commercial property loans since 2013 has entirely been explained by the rise in relatively less risky multi-family and non-residential non-farm loans. Investment Implications A commercial real estate downturn is probably not a 2020 event. Inflationary pressures need to make their presence felt across a wide swath of the economy before Fed hikes will give rates the scope to move sustainably higher. In the meantime, bond investors with a mandate to remain exposed to CMBS can reap the benefits of attractive risk/reward profiles relative to other segments of the US bond market. US Bond Strategy’s Excess Return Bond Map measures the number of standard deviations of spread widening a sector would need to experience, before losing 100 basis points relative to a duration-matched position in Treasuries4 (Chart 16). Sectors plotting near the top-right of the Map carry both high expected return and low risk. Sectors plotting near the bottom-left carry low expected return and high risk. Chart 16BCA US Bond Strategy’s Excess Return Bond Map Commercial Real Estate And US Financial Stability Commercial Real Estate And US Financial Stability Chart 17Tighter Standards And Decelerating Prices Tighter Standards And Decelerating Prices Tighter Standards And Decelerating Prices This valuation framework currently suggests that CMBS look reasonably attractive. Non-agency Aaa-rated CMBS’ expected return is more promising than Aaa-and Aa-rated corporate bonds and somewhat similar to the expected return on an A-rated corporate bond. Meanwhile, CMBS exhibit a lower risk of losing 100 bps. Similarly, Agency CMBS offer greater expected return than Conventional 30-year Agency-backed residential MBS, along with a similar risk of losses. Although relative valuations appear attractive, the fundamental outlook remains neutral for CMBS spreads, for now. Periods of tightening commercial real estate lending standards and weakening commercial loan demand have historically coincided with decelerating commercial real estate prices and widening CMBS spreads. The Fed’s Q3 2019 Senior Loan Officer Survey revealed only a small net tightening of lending standards and unchanged demand (Chart 17). Overall, the lack of inflationary pressure suggests that neither a commercial real estate downturn nor a meaningful widening of CMBS spreads is an imminent threat.   Jennifer Lacombe Senior Analyst JenniferL@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 A capitalization rate is the ratio of net operating income (rent) to price and measures the expected rate of return on a real estate investment. As such, a property’s price can also be derived by dividing its rent by its cap rate. 2 More information about GSE’s conservatorship can be found on the FHFA’s website (https://www.fhfa.gov/Conservatorship/Pages/History-of-Fannie-Mae--Freddie-Conservatorships.aspx and https://www.fhfa.gov/Media/PublicAffairs/Pages/New-Multifamily-Caps-9132019.aspx). 3 An analysis of the largest banks’ earnings call we carried out last October also revealed that large banks were unanimously shrinking their commercial real estate books. For more details, please refer to US Investment Strategy Weekly Report from October 28, 2019, "What The Biggest Banks See", available at usis.bcaresearch.com. 4 For more details on the methodology behind our Excess Return Bond Map please see US Bond Strategy October 15, 2019 Weekly Report "A Perspective On Risk And Reward", available at usbs.bcaresearch.com.