Corporate Bonds

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 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 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 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 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 Chart 3BCaa/C-Rated Default-Adjusted Spread 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 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? Chart 6Keep 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 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 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 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 Chart 10Prepayment 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 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 Duration: Investors should keep portfolio duration close to benchmark, but continue to hold yield curve steepeners (on both the nominal and real yield curves) as well as overweight TIPS positions versus nominal Treasuries. These tactical trades will profit from higher Treasury yields in the near-term. Healthcare: We recommend an overweight allocation to investment grade Healthcare bonds relative to the overall investment grade corporate index. But we also recommend an underweight allocation to high-yield Healthcare relative to the high-yield corporate index.  Pharmaceuticals: Investors should underweight Pharmaceutical bonds in both the investment grade and high-yield credit universes. How Much Higher For Bond Yields? Two weeks ago, we warned that bonds would struggle in the near-term as the re-opening of the US economy led to an improvement in economic data.1 However, we definitely didn’t anticipate the magnitude of the positive data surprise that has occurred since then. The US Economic Surprise Index was -55 one week ago and today it sits at +66 (Chart 1)! The bulk of that jump occurred after Friday’s employment report revealed that 2.5 million jobs were added in May when Bloomberg’s consensus estimate had called for a contraction of 7.5 million. Against this back-drop, it shouldn’t be too surprising that bond yields jumped sharply. The 30-year Treasury yield rose 27 bps last week to 1.68% and the 10-year yield rose 26 bps to 0.91% (Chart 2). The 2-year yield rose a more modest 6 bps to 0.22%, as the Fed maintains its tight grip on the front-end of the curve. Chart 1Back In Business Chart 2Yields Have Room To Move Higher For investors, the first relevant question is: How high can yields go? Our view is that if last week does indeed represent the cyclical economic trough, then forward rates at the long-end of the curve will revert to levels consistent with market expectations for the long-run neutral fed funds rate. The median estimate of that rate from the New York Fed’s most recent Survey of Market Participants is 2%, but with an unusually wide interquartile range of 1.3% to 2.5% (Chart 2, bottom panel). At the very least, we’d expect the 10-year and 30-year Treasury yields to re-test their respective 200-day moving averages of 1.38% and 1.91%, respectively. However, we are not ready to declare last week the economic trough for three reasons: First, we cannot rule out a re-acceleration in the number of confirmed COVID cases as the economy re-opens. This could lead to the re-imposition of lockdown measures come fall. Second, last week’s positive economic data might cause some members of Congress to question the need for further fiscal stimulus. This would be a mistake. In last week’s report we showed that fiscal measures have done a good job propping up household income so far, but these measures are temporary and will need to be renewed.2  Even after last week’s large drop, the unemployment rate is still 3.3% above its Great Recession peak (Chart 1, bottom panel). This is by no means a fully healed economy that can withstand policymakers taking their feet off the gas. Even after last week’s large drop, the unemployment rate is still 3.3% above its Great Recession peak. Finally, US political risks are heightened with anti-police protests occurring daily in most major cities. Added to that, President Trump is now the underdog heading into November’s election and he will need to develop a reelection bid that doesn’t hinge on the economy. Our geopolitical strategists think a doubling down on “America First” foreign and trade policies makes the most sense.3 A significant move in that direction would certainly send a flight to quality into US bonds. Investment Strategy As we advised two weeks ago, nimble investors should tactically reduce duration as yields still have more upside in the next month or two. However, we are not yet sufficiently confident in the sustainability of the economic rebound to recommend reducing portfolio duration on a 6-12 month horizon. Rather, we continue to recommend keeping portfolio duration close to benchmark while holding several less risky positions that will profit from higher yields. Specifically, investors should hold duration-neutral curve steepeners along the nominal Treasury curve. We advise going long the 5-year note and short a 2/10 barbell.4 We also like holding TIPS over nominal Treasuries and positioning for a steeper real Treasury curve.5 In terms of spread product, we also recommend staying the course. This entails overweighting corporate bonds rated Ba and higher, Aaa consumer ABS, Aaa CMBS (both agency and non-agency) and municipal bonds, while avoiding corporate bonds rated B and below and residential mortgage-backed securities. Appendix A at the end of this report shows how these positions have performed since the March 23 peak in spreads. The remainder of this report focuses on the Healthcare and Pharmaceutical sectors of both the investment grade and high-yield corporate bond markets. Investment Grade Healthcare & Pharma Risk Profile When assessing the risk profiles for investment grade-rated Healthcare and Pharmaceutical bonds, we first consider the credit rating distributions of both sectors relative to the overall Bloomberg Barclays corporate index (Chart 3). Chart 3Investment Grade Credit Rating Distribution* Immediately, we see that the Healthcare sector has a lower credit rating than the benchmark: 71% of the Healthcare index is rated Baa, compared to 48% for the corporate index. Meanwhile, the Pharmaceuticals sector has slightly higher credit quality than the corporate benchmark: 12% of the Pharmaceuticals index is rated Aa or Aaa, compared to 8% for the corporate index. Credit rating alone suggests that Healthcare should trade cyclically relative to the corporate index. That is, it should outperform during periods of spread tightening and underperform during periods of spread widening. However, this turns out to not be the case. Chart 4 shows that healthcare has outperformed the corporate benchmark during each of the last five major bouts of spread widening and underperformed during periods of spread tightening. Clearly, despite its low credit rating, Healthcare trades like a defensive corporate bond sector. Healthcare’s historically defensive nature is confirmed by its duration-times-spread (DTS) ratio, which has tended to be below 1.0 (Chart 4, top panel).6 Though recently, the DTS ratio climbed above 1.0 due to a lengthening of the sector’s duration (Chart 4, bottom panel). This suggests that Healthcare, while historically defensive, might trade more cyclically during the next 12 months. Neither the Healthcare nor Pharmaceuticals sectors offer a spread advantage over the corporate index. Pharmaceuticals, on the other hand, are a much more cut and dry defensive sector (Chart 5). The DTS ratio is almost always below 1.0 and the sector has a strong track record of outperforming the corporate index during periods of spread widening (Chart 5, panels 2 & 3) Chart 4IG Healthcare Risk Profile Chart 5IG Pharma Risk Profile   Valuation Turning to valuation, we find that neither sector offers a spread advantage compared to the corporate index or its comparable credit tier (Table 1). This is true whether we look at the raw option-adjusted spread or if we control for duration differences by looking at the 12-month breakeven spread.7  It is interesting to note that the Healthcare index offers a spread advantage compared to the A-rated corporate index. On the one hand, this is not surprising because the Healthcare index carries an average Baa rating. On the other hand, we have seen that Healthcare tends to trade more defensively than its average credit rating implies. This arguably makes its spread advantage over A-rated debt somewhat compelling. Table 1IG Healthcare & Pharma Valuation Balance Sheet Health Both the Healthcare and Pharmaceuticals sectors loaded up on debt during the last recovery. The amount of Healthcare debt in the corporate index grew 8.8 times since 2010. Meanwhile, total debt in the corporate index grew 2.4 times. The result is that Healthcare’s weight in the corporate index increased from 1.1% in 2010 to 4.3% today (Chart 6). The Pharma sector also increased its debt load at a faster pace than the overall corporate universe since 2010 (3.2 times versus 2.4 times), but the boom in Pharma debt has been much milder than in Healthcare. The weight of Pharmaceuticals in the corporate index increased from 4.1% in 2010 to 5.5% today (Chart 7). Chart 6IG Healthcare Debt Growth Chart 7IG Pharma Debt Growth Despite rapid debt growth during the past few years, credit quality in both the Healthcare and Pharma sectors appears quite solid. Appendix B lists the issuers in the Healthcare index, grouping them by credit tier and indicating whether they carry a positive, stable or negative ratings outlook from Moody’s. Of the 56 issuers in the Healthcare index, only six currently have a negative ratings outlook. The two largest issuers in the Healthcare index are Cigna and CVS Health. Both carry Baa ratings, but Moody’s just confirmed Cigna’s ratings outlook at stable in mid-May. CVS Health, on the other hand, has carried a negative ratings outlook since 2018. Appendix C lists issuers in the Pharmaceuticals index. Of the 17 issuers, only four carry a negative ratings outlook. None of the Baa-rated Pharmaceutical issuers currently has a negative ratings outlook. The two biggest issuers in the index are Bristol-Myers Squibb and Abbvie. Bristol-Myers Squibb is A-rated with a negative outlook, while Abbvie is Baa-rated with a stable outlook. Macro Considerations In a typical demand-driven recession, consumers tend to prioritize healthcare spending while they cut back on more discretionary outlays. This dynamic is probably what causes healthcare bonds to trade defensively relative to the overall corporate index. However, the unique nature of the COVID recession has thrown this traditional pattern into reverse. Consumer spending on health care services is down 40% since February while overall consumer spending is 19% lower (Chart 8). Oddly, healthcare bonds shrugged off this year’s massive drop in spending and continued to behave defensively – outperforming the corporate index when spreads widened and underperforming since the March 23 peak in spreads. Despite the plunge in spending, pricing power in the health care industry remains strong. Health care services prices continue to accelerate even as overall inflation has dropped sharply (Chart 8, bottom panel). Unlike healthcare, pharmaceutical spending has held firm during the past couple of months (Chart 9). Consumer spending on pharmaceuticals is only down 4% since February, while overall consumer spending is down 19%. But despite firm spending, medicinal drug prices have decelerated in concert with the overall headline CPI (Chart 9, bottom panel). Chart 8Healthcare Demand & Pricing Power Chart 9Pharmaceutical Demand & Pricing Power Investment Conclusions Putting everything together, we are inclined to recommend an underweight allocation to Pharmaceuticals and an overweight allocation to investment grade Healthcare. Pharmaceuticals are simply too expensive and too defensive for the current environment. Given our positive outlook on investment grade corporate bonds, we should target cyclical sectors with elevated spreads that have more room to compress. Healthcare is slightly more interesting. It has behaved like a typical defensive sector so far this year, but there are some indications that it is becoming more cyclical. The DTS ratio recently shot above 1.0 and consumer spending on healthcare services is poised for a rapid snapback. In terms of valuation, healthcare is expensive relative to other Baa-rated bonds but cheap versus the A-rated universe. This would seem to make healthcare a good risk-adjusted bet. Even if the sector continues to behave defensively, its spread advantage over A-rated bonds makes it an attractively priced defensive sector. High-Yield Healthcare & Pharma Risk Profile Considering the risk profile of high-yield Healthcare and Pharmaceuticals, we first notice that both sectors have significantly lower credit ratings than the overall junk index (Chart 10). Ba-rated credits account for 29% and 24% of the Healthcare and Pharma indexes, respectively, compared to 54% for the High-Yield index as a whole. Chart 10High-Yield Credit Rating Distribution* The fact that significant portions of the Healthcare and Pharmaceutical indexes are rated B and lower immediately raises alarm bells. This is because we do not expect that many B-rated or lower issuers will be able to take advantage of the Fed’s Main Street Lending Program. This lack of Fed support for the lower-rated junk tiers has led us to recommend underweighting junk bonds rated B & below.8 High-yield Healthcare and Pharmaceuticals sectors have significantly lower credit ratings than the overall junk index. Interestingly, despite low credit ratings, a look at both sectors’ DTS ratios and historical excess returns reveals that they tend to trade defensively relative to the high-yield benchmark index. Healthcare outperformed the high-yield index by 473 bps from the beginning of the year until the March 23 peak in spreads and has underperformed the index by 123 bps since (Chart 11). Similarly, Pharmaceuticals outperformed the junk index by 670 bps from the beginning of the year until March 23 and have since underperformed by 136 bps (Chart 12). Chart 11HY Healthcare Risk Profile Chart 12HY Pharma Risk Profile Valuation Turning to spreads, we would characterize both high-yield Healthcare and Pharmaceuticals as expensive (Table 2). Despite both sectors carrying average credit ratings of B, they offer spreads that are below both the overall junk index average and the average for other B-rated credits. Tight option-adjusted spreads are at least partially attributable to low average duration for both sectors. If we adjust for duration differences by looking at 12-month breakeven spreads, we see that Pharmaceuticals look somewhat cheap versus other B-rated credits while Healthcare remains expensive. Table 2HY Healthcare & Pharma Valuation Balance Sheet Health Healthcare debt has grown less quickly than overall high-yield index debt since 2010 (Chart 13). Healthcare debt has grown 1.7 times since 2010 while the overall index has grown 1.8 times. This has caused Healthcare’s weight in the index to fall from 6.2% to 5.7%. In contrast, the high-yield Pharmaceuticals sector has grown rapidly during the past decade (Chart 14). Pharma debt has increased 10.3 times since 2010 compared to 1.8 times for the overall index. This has brought the sector’s weight in the index up to 2.3% from 0.4% Chart 13HY Healthcare Debt Growth Chart 14HY Pharma Debt Growth Looking beyond debt growth, in the current environment we are mostly concerned with the number of issuers in each index that will be able to access Fed support through the Main Street Lending facilities. In this regard, neither sector fares particularly well. Appendix D lists all high-yield Healthcare issuers along with their ratings outlooks, number of employees, 2019 revenues and total debt-to-EBITDA ratios. To qualify for the Fed’s Main Street Lending facilities, issuers must have either less than 15000 employees or less than $5 billion in 2019 revenues. Additionally, they must be able to keep their Debt-to-EBITDA ratios below 6.0. We estimate that all but three of the Ba-rated Healthcare issuers are eligible for the Main Street program, but only one of the B-rated issuers is eligible. High-yield Pharmaceuticals issuers are listed in Appendix E. Here, we once again find that only one of the B-rated issuers is likely to qualify for the Main Street lending facilities. Of the two Ba-rated issuers, one is likely to qualify. The other is Bausch Health, a Canadian firm that is by far the largest issuer in the Pharma index. It would need to turn to the Canadian authorities for help in an emergency lending situation. Investment Conclusions We recommend underweight allocations to both the high-yield Healthcare and Pharmaceuticals sectors. In the current environment we prefer to focus our high-yield credit exposure on the Ba-rated credit tier where issuers are more likely to have access to Fed support. The large concentration of B-rated and lower issuers in both the Healthcare and Pharma sectors, along with their generally expensive valuations, makes us wary about both sectors. 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 3Performance Since March 23 Announcement Of Emergency Fed Facilities Appendix B Table 4Investment Grade Healthcare Issuers Appendix C Table 5Investment Grade Pharmaceuticals Issuers Appendix D Table 6High-Yield Healthcare Issuers Appendix E Table 7High-Yield Pharmaceuticals Issuers   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Bonds Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Portfolio Allocation Summary, “Filling The Income Gap”, dated June 2, 2020, available at usbs.bcaresearch.com 3 Please see Geopolitical Strategy Weekly Report, “Spheres Of Influence (GeoRisk Update)”, dated May 29, 2020, available at gps.bcaresearch.com 4 For more details on this recommended yield curve position please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 For more details on these recommendations 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 6 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007. 7 The 12-month breakeven spread represents the spread widening that must occur for a sector to underperform a duration-matched position in Treasury securities during the next 12 months. It can be proxied by option-adjusted spread divided by duration. 8 For more details 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 Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The Chinese economy continues to recover, albeit less quickly than the first two months following a re-opening of the economy. The demand side of the Chinese economic recovery in May marginally outpaced the supply side, with a notable improvement concentrated in the construction sector. We are initiating two new trades: long material sector stocks versus the broad indices, in both onshore and offshore equity markets. Feature The recovery in China’s economy and asset prices has entered a “tapering phase”, in which the speed of the recovery is normalizing from a rapid rebound two months after the economy re-opened. The direction of the ultra-accommodative monetary and fiscal stance has not changed, but the aggressiveness in the stimulus impulse is abating as the recovery continues. As we highlighted in last week’s report, the announced stimulus at this year's NPC was less than meets the eye of investors.1 Chart 1A Quick Reversal In The Outperformance Of Chinese Stocks Near-term downside risks in Chinese stocks were highlighted by last week’s quick reversal in the outperformance of Chinese equities relative to global benchmarks (Chart 1). As the US and European economies re-open and the stimulus impulse in major developed markets (DMs) is at peak intensity, Chinese stocks will underperform those in DMs, particularly US stocks. The re-escalation in Sino-US tensions will also add to the near-term volatility in Chinese equities. Therefore, we maintain our tactical (0-3 months) neutral view on aggregate Chinese equity indexes, in both domestic and offshore markets. Beyond Q2, however, our baseline view still supports an outperformance in Chinese stocks. The stepped-up stimulus measures since March should start to trickle down into the broader economy. Global business activities and demand will slowly normalize in the summer, helping to revive China’s exports. Moreover, an intensified pressure on employment, indicated in this month’s employment subcomponents in manufacturing and non-manufacturing PMIs, should prompt policymakers to roll out more growth-supporting measures in Q3. Tables 1 and 2 below highlight key developments in China’s economic and financial market performance in the past month. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Chart 2ASpeed Of Manufacturing Activity Recovery Has Moderated China’s official manufacturing PMI slipped to 50.6 in May from 50.8 a month earlier (Chart 2A). While the reading suggests that manufacturing activities are still in an expansionary mode, the speed of the expansion has moderated compared with April and March. The supply side of manufacturing activities and employment were the biggest drags on May’s official PMI. The production subcomponent in the PMI decelerated whereas new orders increased from April (Chart 2A, bottom panel). The net result is an improved supply-demand balance in the manufacturing sector, however, the improvement is marginal. It also differs from the V-shaped recovery in 2008/09, when both new orders and production subcomponents grew simultaneously (Chart 2B). The demand side of the economy is still concentrated in the policy-driven construction sector. The rebound in construction PMI continues to significantly outpace that in manufacturing and non-manufacturing PMIs (Chart 2C, top panel). The construction employment sub-index ticked up by 1.7 percentage points in May, compared with a slowdown of 0.8 percentage points in manufacturing and 0.1 percentage points in non-manufacturing employment PMIs (Chart 2C, bottom panel). Chart 2BDemand Struggles To Outpace Supply Chart 2CDemand Recovery Is Concentrated In Construction While a buoyant construction sector should provide a strong tailwind to raw material prices and related machinery sales, a laggard recovery from other sectors means the upside potential in aggregate producer prices (PPI) will be limited in the current quarter. In May, there was a rebound in the PMI sub-indices measuring raw material purchase prices and ex-factory prices, which heralds easing in the contraction of PPI in Q2 (Chart 3). However, neither of the PMI price sub-indices has returned to levels reached in January, when PPI growth was last positive. Moreover, weaker readings in the purchases and raw material inventory subcomponents suggest that manufacturers may be reluctant to restock due to sluggish global trade and a lagging rebound in domestic demand (Chart 3, bottom panel).  This month’s PMI shows that the employment subcomponents in both the manufacturing and non-manufacturing PMIs are contracting (Chart 4). Because demand for Chinese export goods remains sluggish, we expect unemployment in China’s labor-intensive export manufacturing sector to rise in Q2 and even into Q3. The intensified pressure on employment will likely prompt Chinese policymakers to roll out more demand-supporting measures. Chart 3PPI Contraction Will Ease But Upside Limited In Q2/Q3 Chart 4Employment In Trouble, A Catalyst For More Easing The BCA Li Keqiang Leading Indicator rose moderately in April. A plunge in the Monetary Conditions Index (MCI) limited the magnitude of the indicator's increase, offsetting an uptick in money supply and credit growth (Chart 5). A rapid disinflation in headline consumer prices (CPI) since the beginning of this year has pushed up the real savings deposit rate, which contributed to the MCI’s nose-dive. In our view, the MCI’s sharp drop is idiosyncratic and does not signify a tightening in the PBoC’s monetary stance or overall monetary conditions. Huge fluctuations in food prices have been driving the headline CPI since March 2019, while the core CPI remains stable. While food prices historically have very little correlation with the PBoC's monetary policy actions, a disinflationary environment will provide the central bank more room for easing. Odds are high that the PBoC will cut the savings deposit rate for the first time since 2015.  Chart 5Monetary Conditions Are Not As Tight As The Indicator Suggests The yield curve in Chinese government bonds quickly flattened around the time of the National People’s Congress (NPC), with the short end of the curve rising faster than the long end (Chart 6). This is in keeping with our assessment that while the market is expecting the recovery to continue in China, it is unimpressed with the intensity of upcoming stimulus and monetary easing. Monetary easing seems to be taking a pause, but we do not think this indicates a change in the PBoC’s policy stance (Chart 7). Instead, weak global demand, slow recovery in the domestic economy and intensified pressure on domestic employment, all will incentivize policymakers to up their game by mid-year. As such, we expect the yield curve to steepen again in H2, with the short-end of the curve fluctuating at a low level and the 10-year government bond yield picking up when the economy gains traction. Chart 6The Bond Market May Be Incorrectly Pricing In A Monetary Tightening Chart 7A Pause Before More Easing In June The spread in Chinese corporate bond yields has dropped by more than 30bps from its peak in April. This is in line with that of major DM countries and a reflection of the easier liquidity conditions globally (Chart 8). We anticipate that the yield spreads in Chinese corporate bonds will continue to normalize. However, a flare in US-China tensions will put upward pressure on the financing costs of lower-rated corporations (Chart 8, bottom panel). The default rate among Chinese corporate bonds is unlikely to rise meaningfully this year, in light of ultra-accommodative monetary conditions and the Chinese government’s bailout programs to backstop corporate defaults. Chinese corporate bond defaults and non-performing loans historically have correlated with periods of financial sector de-leveraging and de-risking, other than during economic downturns. We continue to recommend investors hold China’s corporate bonds in the coming 6-12 months in a USD-CNH hedged term. Chart 8Financing Costs May Rise For Lower-Rated Corporations Chart 9Cyclicals Are Struggling To Break Out Among Chinese equities, cyclical sectors have struggled to outperform defensives in both onshore and offshore markets (Chart 9). This reflects investors’ concerns over the slow recovery in domestic demand and heightened geopolitical risk between the US and China. As such, we continue to favor domestic, demand-driven sectors among the cyclical stocks, such as consumer discretionary and construction-related materials. We upgraded consumer discretionary stocks from neutral to overweight on May 20, and we are now initiating two trades to long material sector stocks versus the broad markets in both the domestic and investable markets. The constituents of both China’s investable and domestic material sectors are highly concentrated in the metal and mining subsectors, which roughly account for half of the material sectors’ weight in the MSCI and MSCI A Onshore Indexes, respectively. Chart 10 highlights that the material sectors’ relative performance is highly correlated with CRB raw materials in both domestic and investable markets. Given that China’s credit cycles historically lead the CRB material index by about six months, China’s massive credit stimulus will boost CRB raw materials by end-Q2 and thus, the outperformance of the material sectors.  The RMB has depreciated by almost 3% in the wake of a re-escalation in US-China frictions. The CNY/USD spot rate is approaching its weakest point reached in September 2019 (Chart 11). Furthermore, on May 29, the PBoC set the CNY/USD reference rate at its lowest level since 2008, a move that suggests defending the RMB is no longer in China’s interest. Downward pressure on the RMB will persist in the months leading up to the November US presidential election. The US economy is in a much more fragile state than in 2018/19, which may hinder President Trump’s willingness to resort to tariffs between now and November. However, we cannot completely roll out the probability that Trump will impose further tariffs on Chinese exports, if he is losing the election through weak public support and is removed from his financial and economic constraints.  In any case, in the coming months CNY/USD exchange rate will likely continue to decouple from the economic fundamentals such as interest rate differentials (Chart 11, bottom panel). Instead, the exchange rate will be largely driven by market sentiment surrounding the US-China frictions.  Volatility in CNY/USD will increase, but the overall trend in the CNY/USD will continue downwards as long as the escalation in US-China tensions persists. On a 6- to 12-month horizon, however, we expect that the depreciation trend in the RMB to moderately reverse as the Chinese economy continues to strengthen. Chart 10Material Sectors Should Benefit From The Stimulus And Construction Boom Chart 11The CNY/USD Will Continue To Decouple From Interest Rate Differentials Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Weekly Report "Taking The Pulse Of The People’s Congress," dated May 28, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart 1More 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 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* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3AHigh-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 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 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 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 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 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 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 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 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 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) 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) 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) 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) 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 Investment Grade Sector Valuation: Our investment grade corporate bond sector valuation models for the US, euro area, UK, Canada and Australia show some common messages, as markets have adjusted to a virus-stricken world. The most attractive valuations can be found within Energy and Financials, with defensive sectors like Utilities and Consumer Non-Cyclicals looking expensive everywhere. Global Corporate Bond Strategy: Investors should focus global investment grade corporate bond allocations along country lines, while keeping overall spread risk close to benchmark levels, over the next 6-12 months. Specifically, we favor overweighting the US (especially at maturities of five years or less where the Fed is buying) and the UK, while keeping a neutral allocation to euro area corporates. We also like Australian and Canadian corporate debt versus sovereigns in both countries. Feature Chart 1A Swift Policy Response Has Brought Spreads Under Control Global policymakers have responded swiftly and aggressively to the COVID-19 outbreak and associated deep worldwide recession. This includes not only fiscal stimulus and monetary easing, but central banks buying corporate debt outright and providing other liquidity backstops. Coming at a time of collapsing economic growth and deteriorating corporate credit quality, these combined policy initiatives have reduced the negative tail risk for growth-sensitive assets like corporate debt. The result: a sharp tightening of corporate bond spreads across the developed markets (Chart 1). After such a large and broad-based rally, the easiest gains from the “beta” of owning corporate credit have been exhausted. Additional spread tightening is still expected in the coming months as governments begin to restart their economies after the COVID-19 quarantines start to loosen and global growth slowly begins to improve. Spreads are unlikely to return all the way to the pre-virus tights, however, as the recovery will be uneven and there is still the threat of a second wave of coronavirus infections later this year. To that end, it makes sense for investors to begin seeking out the “alpha” in corporate debt markets by looking at relative valuations across sectors to find opportunities. It makes sense for investors to begin seeking out the “alpha” in corporate debt markets by looking at relative valuations across sectors to find opportunities.  In this report, we will conduct a review of our entire suite of global investment grade corporate sector relative value models. We will cover the US, provide fresh updates of our recently published look at the euro area1 and the UK,2 while also revisiting our relative value framework for Canada first introduced last year.3 We will also apply the same corporate bond sector value methodology to a new country: Australia. In addition, we will examine value across credit tiers using breakeven spread analysis for each of these regions. A Brief Note On Our Corporate Bond Relative Value Tools Before delving into the results from our models, we take this opportunity to refresh readers on the methodology underpinning these analyses. Our sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall investment grade universe of individual developed market economies (using Bloomberg Barclays bond indices). The methodology takes each sector’s individual option-adjusted spread (OAS) and regresses it with all other sectors in a cross-sectional model. The models vary slightly across countries/regions, as the independent variables in the regression are selected based on parameter significance and predictive power for local sector spreads. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS – a.k.a. the residual from the regression - is our valuation metric used to inform our sector allocation ranking. We then look at the relationship between these residuals and duration-times-spread (DTS), our primary measure of sector riskiness, to give a reading on the risk/reward trade-off for each sector. We then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. To examine value across credit tiers, we use a different metric - 12-month breakeven spread percentile rankings. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. With the key details of our models squared away, we will now present the results of our models for each country/region, along with our recommended allocation across sectors. We also discuss our recommended level of overall spread risk for each country/region, which helps inform our specific sector weightings. A Country-By-Country Assessment Of Investment Grade Corporates US In Table 1, we present the latest output from our US investment grade sector valuation model. In keeping with the framework used by BCA Research US Bond Strategy, we use the average credit rating, duration, and duration-squared (convexity) of each sector as the model inputs. To determine our US sector recommendations, we not only need to look at the spread valuations from the relative value model, but we must also consider what level of overall US spread risk (DTS) to target. Table 1US Investment Grade Corporate Sector Valuation & Recommended Allocation With the Fed now purchasing investment grade corporates with maturities of up to five years in the primary and secondary markets, it makes sense to take advantage of that explicit support by focusing exposures on shorter-maturity bonds. Thus, we recommend targeting a relatively moderate level of spread risk (within an overweight allocation to US investment grade corporates) by favoring sectors with a DTS less than or equal to that of the overall US investment grade index. The sweet spot, therefore, is the upper-left quadrant in Chart 2 - sectors with positive risk-adjusted spread residuals from the relative value model and a relatively lower DTS. Chart 2US Investment Grade Corporate Sectors: Risk Vs. Reward Chart 3US IG: More Value In The Lower Tiers On that basis, some of the most attractive overweight candidates are Cable Satellite, Media Entertainment, Integrated Energy, Diversified Manufacturing, Brokerage/Asset Managers, and Other Financials. Meanwhile, the least attractive sectors within this framework are Railroads, Communications, Wirelines, Wireless, Other Industrials and Utilities (including Electric, Natural Gas, and Other Utilities). While we have chosen to underweight much of the Energy space (with the exception of Integrated Energy) because of generally high DTS numbers, investors who are comfortable with taking on a higher level of spread risk can find some of the most attractive risk-adjusted valuations within oil related sectors. Our colleagues at BCA Research Commodity & Energy Strategy expect oil prices to continue to steadily rise in the months ahead, with Brent oil trading, on average, at $40/bbl this year and $68/bbl in 2021.4 We recommend targeting a relatively moderate level of spread risk (within an overweight allocation to US investment grade corporates). Across credit tiers, the higher-quality portion of the US investment grade corporate bond market appears unattractive, with spreads ranking below the historical median for Aaa- and Aa-rated debt (Chart 3). Conversely, Baa-rated debt appears most attractive, with spreads almost in the historical upper quartile. Euro Area In Table 2, we present the results of our euro area investment grade sector valuation model. The independent variables in this model are each sector’s duration, trailing 12-month spread volatility, and credit rating. Note that we will be using the same independent variables in our UK model. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation Spreads have already tightened significantly since our last discussion of euro area corporates in mid-April, with credit markets more fully pricing in greater monetary stimulus from the European Central Bank (ECB) – including increased government and corporate bond purchases. Thus, we believe it is reasonable to target a neutral level of overall portfolio DTS close to that of the benchmark index (within a neutral allocation to euro area investment grade). This means that, visually, we can think about our overweight candidates as sectors that are in the top half of Chart 4 - with positive residuals from our relative value model - but close to the dashed vertical line denoting the euro area benchmark index DTS. Target a neutral level of overall portfolio DTS close to that of the benchmark index (within a neutral allocation to euro area investment grade). Chart 4Euro Area Investment Grade Corporate Sectors: Risk Vs. Reward Chart 5Euro Area IG: All Credit Buckets Are Attractive Within this framework, the most attractive sectors are Diversified Manufacturing, Packaging, Media Entertainment, Wireless, Wirelines, Automotive, Retailers, Services, Integrated Energy, Refining, Other Industrials, Bank Subordinated Debt and Brokerage/Asset Managers. The most unattractive sectors are Chemicals, Metals & Mining, Lodging, Restaurants, Consumer Products, Pharmaceuticals, Independent Energy, Midstream Energy, Airlines, Electric Utilities, and Senior Bank Debt. On a breakeven spread basis, all euro area investment grade credit tiers look attractive and rank well above their historical medians (Chart 5). The greatest value is in the upper rungs, with Aa-rated spreads ranking in the historical upper quartile; Aaa-rated and A-rated spreads almost meet that qualification as well, with Baa-rated spreads lagging a bit further behind (but still well above median). UK In Table 3, we present the latest output from our UK relative value spread model. With the Bank of England’s record expansion of corporate bond holdings still underway, we see good reason to maintain our overweight allocation to UK investment grade corporates on a tactical (0-6 months) and strategic basis (6-12 months). We are also targeting an overall portfolio DTS higher than that of the benchmark index—which we accomplish by overweighting sectors in the upper right quadrant of Chart 6. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation Chart 6UK Investment Grade Corporate Sectors: Risk Vs. Reward Chart 7UK IG: Value In All Tiers Except Aaa Based on this framework, some of the most attractive overweight candidates are Diversified Manufacturing, Cable Satellite, Media Entertainment, Railroads, Financial Institutions, Life Insurance, Healthcare and Other Financials. Meanwhile, the most unattractive sectors are Basic Industry, Chemicals, Metals and Mining, Building Materials, Lodging, Consumer Products, Food & Beverage, Pharmaceuticals, Energy, and Technology. On a breakeven spread basis, Aa-rated spreads appear most attractive while A-rated and Baa-rated spreads also rank above their historical medians (Chart 7). Canada Table 4 shows the output from our Canadian relative value spread model. The independent variables in this model are: sector duration, one-year ahead default probability (as calculated by Bloomberg) and credit rating. Table 4Canada Investment Grade Corporate Sector Valuation & Recommended Allocation This week, the Bank of Canada (BoC) will join peer central banks in purchasing investment grade debt via its Corporate Bond Purchase Program (CBPP). First announced in April, the program has a maximum size of C$10 billion, equal to only 2% of the Bloomberg Barclays Canadian investment grade index. Nonetheless, the BoC’s actions have already helped rein in corporate spreads. Yet given this unprecedented support from the central bank, with room to add more if necessary to stabilize Canadian financial conditions, we feel comfortable recommending an overweight allocation to Canadian investment grade corporates vs. Canadian sovereign debt, but with spread risk close to the overall index. Consequently, we are targeting sectors in the upper half of Chart 8 with a DTS close to the corporate average denoted by the dashed line. Chart 8Canada Investment Grade Corporate Sectors: Risk Vs. Reward Chart 9Canada IG: Great Value Across Tiers Our top overweight candidates are concentrated within the Financials category: Life Insurance, Healthcare REITs and Other Financials. Meanwhile, we recommend underweighting Construction Machinery, Environmental, Retailers, Supermarkets, Wirelines, Transportation Services, Cable Satellite, and Media Entertainment. On a breakeven spread basis, there is value in all credit tiers in the Canadian investment grade space, with Aaa-rated, Aa-rated, and Baa-rated spreads all in the uppermost historical quartile (Chart 9). Australia Table 5 shows the output from our new Australia relative value spread model. The independent variables in this model are sector credit rating, one-year ahead default probability (as calculated by Bloomberg), and yield-to-maturity. Due to the relatively small size of the Australian corporate bond market, we are focusing our analysis on Level 3 sectors within the Bloomberg Barclays Classification System (BCLASS) rather than the more granular Level 4 analysis we have employed for other markets. Table 5Australia Investment Grade Corporate Sector Valuation & Recommended Allocation We recently recommended going overweight Australian investment grade corporate debt vs. government bonds.5 We feel comfortable reiterating that overweight stance while maintaining a neutral level of overall spread risk. As with Canada, we are looking for sectors in Chart 10 that show positive risk-adjusted valuations and have a DTS close to the Australian corporate benchmark. Chart 10Australia Investment Grade Corporate Sectors: Risk Vs. Reward Chart 11Australia IG: Favor A-Rated and Baa-Rated Credit Based on that, our top overweight candidates are Capital Goods, Consumer Cyclicals, Energy, Other Utility, Insurance, Finance Companies, and Other Financials. Meanwhile, we are avoiding sectors such as Technology, Transportation, Electric and Natural Gas. On a breakeven spread basis, Baa-rated spreads look incredibly attractive, ranking at the 99.9th percentile; A-rated spreads are also above their historical median (Chart 11). Meanwhile, the higher quality Aaa and Aa tiers are relatively unattractive. As the relevant data by credit tier are not available in the Bloomberg Barclays Indices, we have instead used the Bloomberg AusBond Indices for this particular case, which unfortunately limits the history of our analysis to mid-2014. Bottom Line: Investors should focus global investment grade corporate bond allocations along country lines, while keeping overall spread risk close to benchmark levels, over the next 6-12 months. Specifically, we favor overweighting the US (especially at maturities of five years or less where the Fed is buying) and the UK, while keeping a neutral allocation to euro area corporates. We also like Australian and Canadian corporate debt versus sovereigns in both countries. Comparing Sector Valuations Across Markets The above analyses have allowed us to paint a picture of sector valuation within regions. However, there is added benefit in looking at risk-adjusted valuations across the three major corporate bond markets—the US, euro area and UK—with the intent of spotting broader sector level trends in the global investment grade universe that are not limited to just one market. Looking at Table 6, we can see some clear patterns: Table 6Valuations Across Major Corporate Bond Markets Chart 12Canada, Euro Area, and UK Win Out On A Breakeven Spread Basis The most attractive sectors across the board are concentrated in the Financials space. Brokerage/Asset Managers, Insurance—especially Life Insurance - REITs and Other Financials all look well positioned. Valuations for Oil Field Services and Refining within the Energy space are also creating an attractive entry point ahead of the steady rebound in oil prices. Conversely, the most expensive sectors are the traditionally “defensive” ones, such as Utilities, Consumer Non-Cyclicals, and even Technology, which is now debatably a defensive sector. Most interesting are the idiosyncratic stories. These are sectors which have benefited or lost in outsized ways due to the unique impacts of COVID-19 on the economy, but which also have relatively wide or tight risk-adjusted spreads across all three countries. For example, Packaging and Paper, which should benefit from the increased demand for online shopping, and Media Entertainment, which benefits from a captive audience boosting streams and ratings, both have attractive spreads. On the other hand, we have Restaurants, with unattractive spread valuations at a time where more people will choose to stay home rather than take the health and safety risks associated with eating out. The most expensive sectors are the traditionally “defensive” ones, such as Utilities, Consumer Non-Cyclicals, and even Technology, which is now debatably a defensive sector. Finally, we can also employ our breakeven spread analysis to assess value across investment grade corporate bond markets and the country level (Chart 12). Within this framework, all the regions we have covered in this report appear attractive – especially Canada, the euro area and the UK – with Australia only appearing fairly valued. Bottom Line: Our investment grade corporate bond sector valuation models for the US, euro area, UK, Canada and Australia show some common messages, as markets have adjusted to a virus-stricken world. The most attractive valuations can be found within Energy and Financials, with defensive sectors like Utilities and Consumer Non-Cyclicals looking expensive everywhere.   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Buy What The Central Banks Are Buying", dated April 14, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Weekly Report, "The Great White North: A Framework For Analyzing Canadian Corporate Bonds", dated August 28, 2019, available at gfis.bcaresearch.com. 4 Please see BCA Research Commodity & Energy Strategy Weekly Report, "US Politics Will Drive 2H20 Oil Prices", dated May 21, 2020, available at ces.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: All Good Streaks Must Come To An End", dated May 13, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Low-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 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* Table 3B 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 Chart 3BB-Rated Excess Return Scenarios 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 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 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 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 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 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 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 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 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) 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) 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) 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)​​​​​​​   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 ECB: The ECB disappointed markets last week who expected an increase in the size of its asset purchase schemes given the recent increase of Italian bond yields. For now, the central bank remains focused on preventing a European credit crunch through increased use of bank funding measures like TLTROs – although a renewed selloff in BTPs would likely change the minds of the “Italy hawks” on the ECB Governing Council. Euro Area High-Yield: Valuations for euro area junk bonds improved somewhat during the COVID-19 selloff, but spreads do not offer much protection from the coming surge in default losses. Remain underweight euro area high-yield corporates in global fixed income portfolios. Feature Chart 1Will Growth Trump Liquidity For Euro Area Junk Bonds? Over the past week, investors heard from the three major developed market central banks – the Federal Reserve, the European Central Bank (ECB) and the Bank of Japan (BoJ). The Fed and BoJ did little to seriously impact financial markets, offering only strengthened forward guidance on already hyper-easy policy settings along with some expansion of existing asset purchase programs (involving municipal bonds for the Fed, JGBs and Japanese corporate bonds for the BoJ). The ECB was the most interesting of the three, because of what was NOT done – namely, an increase in the amount of asset purchases – and what it implies about the policy debate within the central bank on how to deal with Italy. The hit to the euro area economy from the COVID-19 lockdowns has been sharp and brutal, pushing the entire region quickly into deep recession (Chart 1). Given such a severe hit to growth, and with policy interest rates already at zero (or even negative), the only avenue for the ECB to deliver more stimulus is through expanding its balance sheet through asset purchases and liquidity provision to banks. This makes the ECB’s next moves on its balance sheet critical for determining the future path of European risk assets like equities and high-yield corporate bonds – the latter of which we discuss later in this report. A Cautious Next Step From The ECB Chart 2An Unprecedented Economic Collapse The need for the ECB to do something at last week’s monetary policy meeting was obvious. Real GDP for the entire region is estimated to have contracted -3.8% on a year-over-year basis in the first quarter of the year. At the country level, large declines occurred in France (-5.8%), Italy (-4.7%) and Spain (-5.2%) that were far greater than seen during the 2009 recession. The decline was broad-based across industries as well, with the European Commission’s (EC) business confidence indices collapsing in April for manufacturing, services, retail and construction (Chart 2). The bottom has also fallen out on the EC price expectations indices, suggesting that outright deflation across the euro area is just around the corner. The ECB last week provided what were called “alternative scenarios” for the impact of COVID-19 on euro area growth. We presume these are meant to be an alternative to the most recent set of ECB economic projections that were published in March that now look wildly optimistic given the COVID-19 lockdowns. The revised scenarios now call for a real GDP contraction in 2020 of anywhere from -5% to -12%, with only a partial recovery of those losses in 2021.1 The central bank also provided an estimate of the output loss by industry from COVID-19 related lockdowns (Table 1) – a staggering -60% for retail, transportation, accommodation and food services and -40% for manufacturing and construction. Table 1The Lockdown Has Been Painful For Europe Against this horrendous growth and inflation backdrop, with forecasts being slashed, the expectation was that the ECB would ramp up the size of its bond buying programs to try and ease financial conditions further. That would help cushion the growth downturn and attempt to put a floor under collapsing inflation expectations (Chart 3). Yet at last week’s monetary policy meeting, the ECB announced the following: No changes in policy interest rates No increase in the size of the Asset Purchase Program (APP) from the existing €120bn or Pandemic Emergency Purchase Program (PEPP) from the existing €750bn For existing targeted long-term refinancing operations (TLTROs) between June 2020 and June 2021, interest rates were lowered by -25bps A new long-term refinancing operation for euro area banks was introduced called the Pandemic Emergency Long Term Refinancing Operation (PELTRO), which would offer liquidity to euro area banks on a monthly basis until December, at an interest rate of -0.25%. The increased use of LTROs was an easier way for the ECB Governing Council to avoid a potential credit crunch if euro area banks become more risk averse. The ECB clearly wants to take no chances on banks reining in loan activity. The latest ECB Bank Lending Survey, released just two days before last week’s policy meeting, showed a modest tightening of standards for bank loans to businesses in the first quarter of 2020. This was most visible in Germany and Italy, with France actually showing a slight decline in the net percentage of banks tightening lending standards (Chart 4). The survey also showed that euro area banks expected a significant net easing of lending standards in response to the loan guarantees and liquidity support measures announced by European governments to mitigate the impact of COVID-19 lockdowns. Chart 3Expanding The Balance Sheet Is The Only Tool The ECB Has Left Chart 4The ECB Wants To Avoid A Credit Crunch With bank lending growth across the entire euro area having already increased to 4.9% on a year-over-year basis in March, the fastest pace in two years, the ECB clearly wants to take no chances on banks reining in loan activity - even if those loans are merely for stressed companies tapping existing credit lines, or taking advantage of government loan guarantees to minimize layoffs in a deep recession. Another surge in Italian bond yields in the next few months would likely trigger an increase in the size of the PEPP. However, there was likely an additional reason why the ECB chose the LTRO route over ramping up asset purchases – internal political divisions over Italy. Chart 5Italian Financial Stability Remains Critical For The ECB There remain some on the ECB Governing Council that do not wish to keep buying more BTPs, thus giving Italy a blank check to run even larger budget deficits. The unique nature of the COVID-19 outbreak has somewhat loosened those biases against the highly indebted countries of southern Europe, as evidenced by the inclusion of Greek bonds in the PEPP shopping list. Yet there are still many within the ECB, and within the governments of the “hard money” countries of the euro area, who would prefer to see Italy get monetary support for greater deficit spending through ECB vehicles with conditionality like Outright Monetary Transactions (OMT). Given these internal divisions over Italy, an increase in the size of the existing asset purchase schemes will only take place if there is a major increase in Italian risk premiums that threatens the financial stability of the entire euro area. On that front, risk indicators like the BTP-Bund spread and credit default spreads on Italian banks have risen over the past month, but remain well below the stressed levels witnessed during the Global Financial Crisis and the European Debt Crisis (Chart 5). Additionally, Italian bank stocks have actually been outperforming their euro area peers since early 2019, while the Italy-Germany spread curve is not inverted (2-year spreads higher than 10yr spreads) as occurred in 2011 when investors feared Italy would crash out of the euro. With Italian government yields still at relatively low and manageable levels, even as the highly-indebted Italian government has stated that its budget deficit will surge to -10% of GDP to provide stimulus to a virus-ravaged economy, there is no pressure on the ECB to increase the size of the PEPP that was just announced less than two months ago. Yet even with all the internal divisions, another surge in Italian bond yields in the next few months would likely trigger an increase in the size of the PEPP to prevent a broader tightening of euro area financial conditions. For this reason, we continue to recommend a strategic (6-12 months) overweight stance on Italian government bonds within global fixed income portfolios. Bottom Line: The ECB disappointed markets last week who expected an increase in the size of its asset purchase schemes given the recent increase of Italian bond yields. For now, the central bank remains focused on preventing a European credit crunch through increased use of bank funding measures like TLTROs – although a renewed selloff in BTPs would likely change the minds of the “Italy hawks” on the ECB Governing Council. A Quick Look At Euro Area High-Yield Valuation We recently upgraded our recommended investment stance on euro area investment grade corporate bonds to neutral.2 This shift was based on the ECB increasing the amount of its corporate bond purchases as part of its COVID-19 monetary easing measures, coming after the Fed announced its own new programs to buy US investment grade corporates. With the major central banks providing direct support to higher quality corporates, the left side of the return distribution for those bonds eligible for these purchase programs has effectively been reduced. This warrants a higher weighting for those bonds in investor portfolios. For high-yield corporates, the story is more nuanced. Both the Fed and ECB have announced that investment grade bonds purchased in their bond buying programs, which are then subsequently downgraded to below investment grade, can stay on the balance sheet of those programs. This makes Ba-rated junk bonds – the highest credit tier below investment grade – a relatively more attractive bet within the overall high-yield universe, both in the US and Europe. Although the lack of a direct central bank bid still makes high-yield corporates a riskier bet in a recessionary environment where default losses will surely increase. This means rather than just “buying what the central banks are buying”, we must rely on more traditional metrics to determine if high-yield bonds offer value. To evaluate the attractiveness of euro area high-yield corporates, we use three different approaches that use relative value to other credit markets, or more intrinsic value based on potential credit losses. Relative spreads vs. euro area investment grade One way to assess the value of euro area high-yield is to compare its credit spread to that of higher-rated euro area investment grade corporate bonds. Since movements in both spreads are highly correlated, as they both benefit from accelerating euro area economic growth (and vice versa), any change in spreads between the two could represent a relative value opportunity. Currently, the option-adjusted spread (OAS) of the euro area high-yield benchmark index (635bps) is 449bps over that of the investment grade index (186bps), using Bloomberg Barclays index data (Chart 6). While this is a relatively wide spread differential for the years since the 2008 financial crisis, it is not a particularly large gap during a recession that is likely to be deeper than the 2009 downturn. The same argument holds when looking at the ratio of the euro area high-yield OAS to the investment grade OAS, which is only at average levels for the post crisis period (3rd panel). 12-month breakeven spreads One of our favorite credit valuation tools is the 12-month breakeven spread, which measures the amount of spread widening over a one-year horizon that would make the total return of a corporate bond equal to that of a duration-matched government bond. We apply that calculation to data for an entire spread product sector, like investment grade or high-yield, to determine a breakeven spread for that sector. We then look at the percentile ranks of the breakeven spread versus its own history to determine if that particular fixed income sector looks relatively attractive. Rather than just “buying what the central banks are buying”, we must rely on more traditional metrics to determine if high-yield bonds offer value. On that basis, euro area high-yield corporates, across all credit tiers, offer somewhat attractive spreads, with 12-month breakevens in the upper half of the historical distribution (Chart 7). US high-yield, by comparison, offers far more attractive spreads with 12-month breakevens in the upper quartile of their historical distribution across all credit tiers. Only the riskiest Caa-rated bonds are in the top 25% of the distribution in the euro area (Chart 8). Chart 6In The Euro Area, HY Is Not That Cheap Versus IG Chart 712-Month Breakeven Spreads For Euro Area HY Are Now More Attractive ... Chart 8… But Not Versus US High-Yield The overall attractiveness of US high-yield versus euro area equivalents can also be seen when comparing the benchmark index yields in common currency terms. For the overall indices, euro area junk bond yields, hedged into USD dollars, offer a yield of 7.8%, virtually equal to the 8.0% yield in the US (Chart 9), although more material differences do exist within credit tiers. Chart 9A Comparison Of Junk Bond Yields In The Euro Area & The US Default-adjusted spreads The other metric that we use to assess the value of high-yield corporate bonds is default-adjusted spreads. This measure takes the high-yield index OAS and subtracts credit losses to determine an “excess” spread. We look at the current default-adjusted spread versus its long-run average to determine if high-yield spreads offer an attractive valuation cushion relative to expected credit losses. To determine the credit losses, we need the default rate, and the recovery rate given default, for the overall high-yield market. For defaults, we will use the output of our euro area default rate model (Chart 10). The model uses four variables: lending standards for businesses from the ECB bank lending survey, high-yield ratings downgrades as a share of all rating actions, euro area real GDP growth, and the median debt-to-equity ratio for a sample of issuers in the euro area high-yield space. All the variables are advanced such that the model produces a one-year-ahead forecast of expected high-yield defaults.3 Our high-yield model is projecting that the euro area default rate will climb to 11% by the end of 2020, before declining to 8% mid-2021 as the euro area economy recovers from the 2020 recession. For the euro recovery rate, we are using a range based on the historical experience during recessions (30%) and recoveries (45%). Using our default rate model projection, and that range of recovery rates, we can produce a range of euro area default-adjusted spreads. Euro area high-yield spreads do not offer much of a spread cushion to absorb expected default losses over the next year. Thus, euro area junk bonds are expensive. In Chart 11, we show the history of the euro area default adjusted spread. We have added the long run average (358bps) and the +/1 standard deviation of the spread. Spreads at or lower than -1 standard deviation are considered expensive (i.e. the high-yield index spread is too low relative to credit losses), and vice versa. The shaded box in the bottom right corner of the chart represents our forecasted default-adjusted spread for the next year. Chart 10Our Model Says The Euro Area Default Rate Will Surpass 10% Chart 11Euro Area HY Default-Adjusted Spreads Do Not Offer Compelling Value Chart 12An Aggressive Overweight Stance On Risk Assets Is Still Not Warranted Our projected spread range over the next twelve months is 218bps to -112bps, well below the long-run average and at the low end of the historical distribution. We conclude from this analysis that current euro area high-yield spreads do not offer much of a spread cushion to absorb expected default losses over the next year. Thus, euro area junk bonds are expensive. Given the lack of a compelling valuation argument under all our metrics, we are leaving our recommended investment stance on euro area high-yield bonds at underweight. We continue to focus our recommended global spread product allocations on overweights in markets where there is direct and explicit support from policymaker purchase programs: US investment grade bonds with maturity of less than five years, US Ba-rated high-yield bonds, and UK investment grade corporates. This selectively overweight investment stance on global credit is warranted from a risk management perspective, as well. Our “Pro-Risk Checklist” of indicators that would lead us to recommend a more aggressive stance on risk assets in general, and spread product in particular, is still flashing a cautious message (Chart 12). The US dollar continues to strengthen (exacerbating global deflation and dollar funding pressures); the VIX index of US equity volatility has fallen below our threshold of 40, but not by much; and the number of new global (ex-China) COVID-19 cases is showing mixed results, falling in the US and Italy but increasing elsewhere. Bottom Line: Valuations for euro area junk bonds improved somewhat during the COVID-19 selloff, but spreads do not offer much protection from the coming surge in default losses. Remain underweight euro area high-yield corporates in global fixed income portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The alternative ECB growth forecasts can be found here: https://www.ecb.europa.eu/pub/economic-bulletin/focus/2020/html/ecb.ebbox202003_01~767f86ae95.en.html 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Buy What The Central Banks Are Buying", dated April 14, 2020, available at gfis.bcaresearch.com. 3 For real GDP growth, we use Bloomberg consensus forecasts for the next four quarters in the model. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Real Yield Curve: Last week’s negative oil print could signal the peak in deflationary sentiment for this cycle. It’s a good time for bond investors to enter real yield curve steepeners. Buy a short-maturity real yield (1-year or 2-year) and sell a long-maturity real yield (10-year or 30-year). High-Yield: High-yield bond spreads are much too tight relative to the VIX and ratings migration. This is justified for Ba-rated issuers that can tap the Fed’s emergency programs. However, B-rated and below spreads look vulnerable. Investors should overweight Ba-rated junk bonds and underweight the B-rated and below credit tiers. Bank Bonds: US bond investors should overweight subordinate bank bonds within an allocation to investment grade corporate credit. Subordinate bank bonds are Baa-rated and thus offer reasonably high spreads. But unlike other Baa-rated bonds, banks should avoid ratings downgrades during this cycle. Feature Oil was the big mover in financial markets last week, with the WTI price dropping briefly into negative territory on the day before expiry of the May futures contract.1  Bond markets didn’t react much to the negative oil price (Chart 1), but this doesn’t mean that the energy market is unimportant for yields. On the contrary, the oil price often sends important signals about the near-term outlook for inflation, a key input for bond investors. Chart 1Negative Oil Didn't Shock The Bond Market A Bond Market Trade Inspired By Negative Oil The Fisher Equation is the formula that relates nominal yields, real yields and inflation expectations. In its simplest form the Fisher equation is: Nominal Yield = Real Yield + Inflation Expectations When applying this equation to the act of bond yield forecasting we find it helpful to note that both the nominal yield and inflation expectations have specific valuation anchors. The Federal Reserve sets the valuation anchor for nominal yields because it controls the overnight nominal interest rate. If you enter a long position in a nominal Treasury security and hold to maturity you will make money versus a position in cash if the average overnight nominal interest rate turns out to be lower than the nominal bond yield at the time of purchase. The oil price often sends important signals about the near-term outlook for inflation, a key input for bond investors. Similarly, inflation expectations are anchored by the actual inflation rate. If you enter a long position in inflation protection and hold to maturity you will make money if actual inflation turns out to be higher than the rate that was embedded in bond prices at the time of purchase.2 Turning to real yields, we see why the Fisher Equation is important. Real yields have no obvious valuation anchor. This means that the best forecasting technique is often to: (1)   Use our known valuation anchors (the fed funds rate and inflation) to forecast the nominal yield and inflation expectations. (2)  Use the Fisher Equation to back-out a fair value for real yields. With all that said, let’s apply this framework to today’s bond market in light of last week’s dramatic oil price moves. Inflation Compensation The cost of inflation protection tracks the oil price, more so at the front end of the curve than at the long end. This makes sense given that recent oil price trends tell us a fair amount about the outlook for inflation over the next year but very little about the outlook for inflation over the next 10 or 30 years. The inflation market didn’t react much to oil’s dip into negative territory last week, but this year’s broader drop in the WTI price from above $50 to below $20 had a big impact on TIPS breakeven inflation rates and CPI swap rates, particularly at short maturities (Chart 2). In fact, consistent with expectations for a very low oil price, the bond market is now pricing-in deflation over the next two years. Chart 2Bond Market Priced For Deflation Nominal Yields The Fed’s zero interest rate policy is having a profound effect on nominal bond yield volatility. Because the consensus investor expectation is that the Fed will keep rates pinned near zero for a long time, almost irrespective of economic outcomes, even a significant market event like a plunge in the oil price will do very little to move nominal bond yields. During the last zero-lower-bound period, nominal bond yield volatility fell across the entire yield curve but fell much more at the short end of the curve than at the long end (Chart 3). The same phenomenon will re-occur during the current zero-lower-bound episode. Chart 3The Zero Lower Bound Crushes Nominal Bond Yield Volatility Real Yields Using the Fisher Equation, we can deduce how real yields must move given changes in inflation expectations and nominal bond yields. With the Fed ensuring that short-maturity nominal yields remain stable, the recent decline in oil and inflation expectations caused short-dated real yields to jump (Chart 4). Long-maturity real yields remain low because (a) the shock to inflation expectations was smaller at the long-end of the curve and (b) the Fed’s forward rate guidance doesn’t suppress nominal bond yield volatility as much for long maturities. Chart 4There's Value In Short-Maturity Real Yields Investment Implications If we assume that last week’s -$37.60 WTI print will mark the cyclical trough in oil prices, US bond investors can profit by implementing real yield curve steepeners.3  Short-dated real yields will fall as oil and short-dated inflation expectations recover and nominal yields remain stable. In this scenario, real yields are more likely to rise at the long-end of the curve, given the greater volatility in long-dated nominal yields and the fact that long-maturity inflation expectations are not as depressed. Looking at the 2008 episode as a comparable, we see that the cost of inflation protection bottomed around the same time as the trough in oil, and about 7 months before the trough in 12-month headline CPI (Chart 5). After that trough, with the Fed keeping short-dated nominal rates pinned near zero, the inflation compensation curve flattened and the real yield curve steepened. Chart 5Initiate Real Yield Curve Steepeners Bottom Line: Last week’s negative oil print could signal the peak in deflationary sentiment for this cycle. It’s a good time for bond investors to enter real yield curve steepeners. Buy a short-maturity real yield (1-year or 2-year) and sell a long-maturity real yield (10-year or 30-year). Poor Junk Bond Valuations Illustrated In recent reports we have been advising investors to own spread products that offer attractive spreads and that benefit from Fed support.4 This includes investment grade corporate bonds and Ba-rated high-yield bonds, but not junk bonds rated B or below. In past reports we also showed that B-rated and below junk spreads don’t adequately compensate investors for likely default losses. But this week, we want to quickly illustrate that junk spreads are trading too tight even compared to other common coincident indicators. Specifically, we zero in on the VIX and ratings migration. In 2008, the cost of inflation protection bottomed around the same time as the trough in oil, and about 7 months before the trough in 12-month headline CPI. Charts 6A, 7A and 8A show the historical relationship between the VIX and Ba, B and Caa junk spreads. In all three cases, spreads are well below levels that have been historically consistent with the current reading from the VIX. Charts 6B, 7B and 8B show the historical relationship between the monthly Moody’s rating downgrade/upgrade ratio and Ba, B and Caa spreads. These charts tell a similar story. In fact, March saw nearly 12 times as many ratings downgrades as upgrades, the third highest monthly ratio since 1986. With more downgrades coming in the months ahead, it is apparent that junk spreads are stretched. Chart 6ABa Spreads & VIX Chart 6BBa Spreads & Ratings Chart 7AB Spreads & VIX Chart 7BB Spreads & Ratings Chart 8ACaa Spreads & VIX Chart 8BCaa Spreads & Ratings Relatively tight spreads are probably justified in the Ba space where firms will benefit from the Federal Reserve’s Main Street Lending facilities.5 However, B-rated and below securities have mostly been left out in the cold. We see high odds of spread widening for those credit tiers.  Bottom Line: High-yield bond spreads are much too tight relative to the VIX and ratings migration. This is justified for Ba-rated issuers that can tap the Fed’s emergency programs. However, B-rated and below spreads look vulnerable. Investors should overweight Ba-rated junk bonds and underweight the B-rated and below credit tiers. Subordinate Bank Debt Is A Good Bet The Fed’s decision to exclude bank bonds from its primary and secondary market corporate bond purchases complicates our investment strategy. We want to focus on sectors that offer attractive spreads and that benefit from Fed support, but should we carve out an exception for bank bonds? Bank Bonds Are A Defensive Sector First, we note that banks are a defensive corporate bond sector. This is due to bank debt’s relatively high credit rating and low duration. Notice that banks outperformed the rest of the corporate index when spreads widened in March, but have lagged the index by 131 bps since spreads peaked on March 23 (Chart 9). Bank equities don’t exhibit the same behavior and have in fact steadily underperformed the S&P 500 since the start of the year (Chart 9, bottom 2 panels). Chart 9Bank Bonds Are Defensive... However, if we consider senior and subordinate bank debt separately, a different picture emerges (Chart 10). Senior bank bonds behave defensively, as described above, but the lower-rated/higher duration subordinate bank bond index is more cyclical. It has outperformed the corporate benchmark by 316 bps since March 23 (Chart 10, bottom panel). Chart 10...Except Subordinate Debt The Value In Bank Bonds Despite being a defensive sector, senior bank bonds offer attractive risk-adjusted value. The average spread of the senior bank index is 18 bps above the spread offered by the equivalently-rated (A) corporate bond benchmark. Further, the senior bank index has lower average duration than the A-rated benchmark, making the sector very attractive on a per-unit-of-duration basis (Chart 11A). Chart 11ASenior Bank Bond Valuation Chart 11BSubordinate Bank Bond Valuation ​​​​​​​Turning to subordinate bank bonds, risk-adjusted value looks only fair compared to other equivalently-rated (Baa) corporate bonds (Chart 11B). However, in absolute terms the subordinate bank index offers a spread of 246 bps, compared to a spread of 178 bps on the senior bank index. Downgrade Risk Is Minimal We think investors should overweight subordinate bank bonds for two reasons. First, we think the Fed’s aggressive policy response means that investment grade corporate bond spreads, in general, have already peaked. We would expect defensive senior bank bonds to underperform in this environment of spread tightening, even though they offer attractive risk-adjusted value. Subordinate bank bonds should outperform the index in this environment, even if other Baa-rated sectors offer better value. Second, other Baa-rated corporate bond sectors offer elevated spreads because downgrade risk remains high. The Fed’s facilities will prevent default for investment grade firms, but many Baa-rated issuers will end up taking on a lot of debt to avoid bankruptcy and will get downgraded. We think banks are insulated from this downgrade risk. Even in the Fed's "Severely Adverse Scenario", three of banks' four main capital ratios remain above pre-GFC levels. Chart 12 shows the four main capital ratios calculated for US banks, and the dashed line shows the minimum value the Fed estimates that those ratios will hit under the “Severely Adverse Scenario” from the 2019 Stress Test. Three of the four ratios would remain above pre-crisis levels, and the Tier 1 Leverage Ratio would be only a touch lower. Chart 12Banks Have Huge Capital Buffers Further, our US Investment Strategy service observes that the large banks had sufficient earnings in the first quarter to significantly ramp up loan loss provisions without taking any capital hit at all.6 Our US Investment Strategy team believes that, as long as the shutdown doesn’t last more than six months, the big banks will have sufficient earnings power to absorb loan losses this year, without having to mark down their capital ratios, which in any case are extremely high. Bottom Line: US bond investors should overweight subordinate bank bonds within an allocation to investment grade corporate credit. Subordinate bank bonds are Baa-rated and thus offer reasonably high spreads. But unlike other Baa-rated bonds, banks should avoid ratings downgrades during this cycle. In short, subordinate bank debt looks like a reasonably safe way to capture high-beta exposure to the investment grade corporate bond market.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a more detailed explanation of the WTI price’s shocking move please see Commodity & Energy Strategy Special Alert, “WTI In Free Fall”, dated April 20, 2020, available at ces.bcaresearch.com 2 An example of a long position in inflation protection would be buying the 5-year TIPS and shorting the equivalent-maturity nominal Treasury security. 3 Our Commodity & Energy Strategy service’s view is that the WTI oil price will average ~$60 to $65 in 2021. For further details please see Commodity & Energy Strategy Weekly Report, “US Storage Tightens, Pushing WTI Lower”, dated April 16, 2020, available at ces.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 5 For more details on 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 6 Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, April 2020”, dated April 20, 2020, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Inflation-Linked Bonds: The plunging price of oil has put renewed downward pressure on global bond yields via lower inflation expectations. With oil prices set to recover over the next 6-12 months as the global economy awakens from the COVID-19 slumber, depressed market-derived inflation expectations can move higher across the developed markets – most notably in the US, the UK, Australia and Canada. Favor inflation-linked government bonds versus nominals in those countries on a strategic (6-12 months) basis. UK Corporates: The Bank of England (BoE) is supporting the UK investment grade corporate bond market with an unprecedented level and pace of purchases, with credit spreads at attractive levels. Upgrade UK investment grade corporates to overweight on a tactical (0-6 months) and strategic (6-12 months) basis. Across sectors, favor debt from sectors such as non-bank Financials and Communications that are less exposed to pandemic-related uncertainty but still benefit from BoE buying. Feature Chart of the WeekThe Link Between Oil & Bond Yields Remains Strong The shocking, albeit brief, journey of the West Texas Intermediate (WTI) oil price benchmark below zero last week was another in a long line of stunning market moves seen during the COVID-19 pandemic. Those negative oil prices were technical in nature and lasted all of one day, but the ramifications for global bond markets of the falling cost of oil in 2020 have been more enduring. Government bond yields have largely followed the ebbs and flows in energy markets for most of the past decade, and this year has been no exception (Chart of the Week). That link from oil has been through the inflation expectations component of yields, which have been (and remain) highly correlated to oil prices in virtually every developed market country. This is likely due to the persistent low global inflation backdrop since the 2008 financial crisis, which has made cyclical swings in energy prices the marginal driver of both realized and expected inflation. Chart 2BCA's Commodity Strategists Expect Oil Prices To Recover Our colleagues at BCA Research Commodity & Energy Strategy now anticipate higher oil prices over the next 12-18 months.1 Global growth is expected to recover from the COVID-19 recession sooner (and faster) than global oil production, helping to improve the demand/supply balance in energy markets and boost oil prices (Chart 2). Our energy strategists expect the benchmark Brent oil price to rise to $42/bbl by the end of 2020 and $78/bbl by the end of 2021. Those are big moves compared to the current spot price around $20/bbl, and would impart significant upward pressure on inflation expectations if the history of the past decade is any guide. That kind of move in oil prices should also help lift overall nominal government bond yields. Although the real (inflation-adjusted) component of yields is likely to remain low as major central banks like the Fed and ECB will remain highly accommodative, even when growth and inflation begin to recover, given the severity of the COVID-19 global recession. With market-based inflation expectations now at such beaten-up levels, and with the disinflationary effect of falling energy prices set to fade, we see an opportunity to play for a cyclical rebound in inflation breakevens across the developed markets by favoring inflation-linked government bonds versus nominal yielding equivalents. A Simple Framework For Finding Value In Inflation Breakevens Given the remarkably tight correlation between oil prices and market-determined inflation expectations in so many countries, it should be fairly straightforward to model the latter using the former as the main input. We have developed a series of fair value regressions for breakevens in the major developed countries which do exactly that. In this simple approach, we attempt to model the 10-year breakeven from inflation-linked bonds for eight countries – the US, the UK, Germany, Japan, France, Italy, Canada and Australia - as a function of a short-run variable (oil prices) and a long-run variable (the trend in realized inflation). Specifically, we are using the annual percentage change in the Brent oil price benchmark in local currency terms (i.e. converted from US dollars at spot exchange rates) as the short-run variable and a five-year moving average of realized headline CPI inflation as the long-run variable. The latter is included to provide an “anchor” for breakevens based on the actual performance of inflation in each country. In other words, expectations about what inflation will look like in the future are informed by what it has done in the past – what economists refer to as “adaptive” expectations. The generic regression equation used for each country is: 10-year inflation breakeven = α + β1 * (annual % change of Brent oil price in local currency terms) + β2 * (60-month moving average of headline CPI inflation) In Table 1, we present the results of the regressions of each of the eight countries, which use weekly data dating back to the start of 2012 to capture the period when oil prices have most heavily influenced inflation expectations. The coefficients, R-squareds and standard errors of the regressions are all shown, as well as the most recent model residual (i.e. the deviation of 10-year inflation expectations from model-determined fair value). All the coefficients for each model are significant. The R-squareds of the models vary, with the models for France and Australia doing the best job of explaining changes in inflation expectations in those two countries. Table 1Details Of Our New 10-Year Inflation Breakeven Models For the UK and Japan, we added an additional “dummy” variable to control for the unique situations that we believe have influenced inflation breakevens in those countries. For the UK, the period since the June 2016 Brexit vote has seen the path of inflation expectations stay nearly 50bps higher than implied by moves in GBP-denominated oil prices and the trend in actual UK inflation. For Japan, the period since the Bank of Japan initiated its Yield Curve Control policy in September 2016 has seen breakevens stay nearly 60bps below fair value as derived from JPY-denominated oil prices and the trend in actual Japanese inflation. Bond investors with longer-term investment horizons looking to play for a global growth recovery from the COVID-19 recession over the next 12-18 months should position for some widening of breakevens by favoring inflation-linked bonds over nominal paying government debt. In Charts 3 to10 over the next four pages, we show the models for each country. 10-year inflation breakevens versus the independent variables in the models are shown in the top two panels, the model fair value is presented in the 3rd panel, and the deviation from fair value is in the bottom panel. In all cases, breakevens are below fair value, suggesting that inflation-linked bonds look relatively attractive versus nominal government bonds. Chart 3Our US 10-Year TIPS Breakevens Model Chart 4Our UK 10-Year Breakeven Inflation Model Chart 5Our France 10-Year Breakeven Inflation Model Chart 6Our Italy 10-Year Breakeven Inflation Model Chart 7Our Japan 10-Year Breakeven Inflation Model Chart 8Our Germany 10-Year Breakeven Inflation Model Chart 9Our Canada 10-Year Breakeven Inflation Model Chart 10Our Australia 10-Year Breakeven Inflation Model Chart 11Real Inflation-Linked Bond Yields Will Remain Subdued For Longer The largest deviations from fair value can be found in Canada (-70bps), Australia (-48bps), the UK (-29bps), and the US (-26bps). 10-year breakevens are also below fair value in the euro zone countries and Japan, but not by more than one standard deviation as is the case for the other four countries. Bond investors with longer-term investment horizons looking to play for a global growth recovery from the COVID-19 recession over the next 12-18 months should position for some widening of breakevens by favoring inflation-linked bonds over nominal paying government debt. Focus on the four markets with breakevens furthest from fair value, although from a market liquidity perspective it is easier to implement those positions in the US and UK, which represent a combined 69% of the Bloomberg Barclays Global Inflation-Linked bond index. A rise in inflation expectations should also, eventually, put some sustained upward pressure on nominal bond yields. We would rather play that initially by positioning for higher inflation breakevens, rather than having outright below-benchmark duration exposure, as developed market central banks will stay accommodative for longer given the severity of the COVID-19 recession - that will keep real bond yields lower for longer (Chart 11). Breakevens from inflation-linked bonds are now too low across the developed markets – most notably in the US, the UK, Australia and Canada. Bottom Line: The plunging price of oil has put renewed downward pressure on global bond yields via lower inflation expectations. With oil prices set to recover over the next 6-12 months as the global economy starts to awaken from the coronavirus induced slumber, breakevens from inflation-linked bonds are now too low across the developed markets – most notably in the US, the UK, Australia and Canada. Favor linkers over nominals in those countries. Where Is The Value In UK Corporate Bonds? Chart 12Upgrade UK IG Corporates To Overweight On BoE Buying The Bank of England (BoE) initiated its Corporate Bond Purchase Scheme (CBPS) in August 2016 as part of a package of stimulus measures to cushion the economic blow from the UK’s vote to exit the European Union. As we noted in recent joint report with our sister service, BCA Research US Bond Strategy,2 the CBPS helped tighten spreads by lowering downgrade and default risk premiums and also helped spur corporate bond issuance (Chart 12). Shortly after that report was published, the BoE announced that it would be purchasing a further £10 billion in investment grade nonfinancial corporate bonds in the coming months, doubling the scheme’s aggregate holdings to £20 billion. In addition, the bank would make these purchases at a significantly faster pace than in 2016, which implies a faster transmission towards tightening of spreads. Compared to other central bank peers, however, the BoE’s program still has room to expand, which makes UK investment grade credit attractive over tactical and strategic investment horizons. Using the market value of the Bloomberg Barclays UK corporate bond index (excluding financials) as a proxy for the total value of eligible bonds, the CBPS is on track to own roughly 9% of all eligible bonds by the time the £20 billion target is reached. The neighboring European Central Bank, on the other hand, already owns 23% of the stock of eligible euro area corporate bonds in its market, and that figure is only set to increase with policymakers set to do “whatever it takes” to backstop the investment grade market. Year-to-date, UK corporate bonds appear to have recovered somewhat from the panicked selloff earlier this quarter (Table 2), with the Bloomberg Barclays UK investment grade corporate bond index down only -0.3% in total return terms. In excess return terms relative to duration-matched UK corporate bonds, however, the index is down -5.2%, indicating that weakness has persisted in the pure credit component. Table 2UK Investment Grade Corporate Bond Returns At the broad sector level, Other Industrials appear to be the outlier, having delivered positive excess returns (+0.6%) and significant total returns (+16%). These returns are not nearly as attractive, however, on a risk-adjusted basis once you consider that this sector has an index duration more than three times that of the overall index.3 Outside of that sector, the best performers, in excess return terms, are predominantly the more “defensive” sectors—Utilities (-3.4%), Technology (-3.7%), Communications (-4.2%) and Consumer Non-Cyclical (-4.6%). Meanwhile, the sectors most exposed to vanishing consumer demand and weak global growth have performed the worst—Transportation (-9.5%), Capital Goods (-7%), Energy (-6.8%), and Basic Industry (-6.2%). Credit spreads in the UK indicate that the market has already begun to stabilize in response to the BoE’s new round of corporate bond purchases. Credit spreads in the UK indicate that the market has already begun to stabilize in response to the BoE’s new round of corporate bond purchases (Chart 13). The overall index spread, although still elevated at 228bps, has already tightened by 57bps from the peak in late March. The gap between the index spreads of Baa-rated and Aa-rated UK debt remained relatively stable through the wave of sell-offs, peaking at +53bps, below the 2019 high of +55bps, and settling now to +36bps. Outside the purview of the CBPS, however, the situation is a bit rockier, with the overall high-yield index spread +590bps above that of the investment grade index. Broadly speaking, there is a clear disparity between those credit tiers that have the support of the monetary authorities and those that do not. Investment grade spreads will continue to tighten as the BoE rapidly increases its holdings of investment grade corporate bonds. However, high-yield bonds remain exposed to downgrade/default risk and ongoing uncertainty stemming from the COVID-19 economic shock. To drill down into which credit tier spreads offer the most value within the UK investment grade space, we use the 12-month breakeven spread percentile rankings. This is one of the tools we use to assess value in global credit spreads, as measured by historical “spread cushions”. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. Chart 14 shows the 12-month breakeven spread percentile rankings for all the credit tiers in the UK investment grade space. Aaa-rated debt appears most unattractive, with the spreads currently ranking below the historical median. Between the other three tiers, Aa-rated debt offers the most value, although all three are at historically attractive levels. Chart 13UK IG Has Held Up Well During The COVID-19 Shock Chart 14UK IG Breakeven Spreads Look Most Attractive For Aa-Rated Bonds On the sector-level, the disparity in spreads is most clearly visible in the sectors most exposed to the pandemic. In Charts 15 & 16, we show the history of option-adjusted spreads (OAS) for the major industrial sub-groupings of the Bloomberg Barclays UK investment grade corporate index. Spreads look widest relative to history for sectors such as Energy and Transportation, while spread widening has been contained in more insulated sectors such as Financials. Chart 15A Mixed Performance For UK IG By Sector In 2020 … Chart 16… But Spreads, In General, Remain Below Previous Cyclical Peaks Another way to assess value across UK investment grade corporates is our sector relative value framework. Borrowing from the methodology used for US corporate credit by our colleagues at BCA Research US Bond Strategy, the sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall UK investment grade universe. The methodology takes each sector's individual OAS and regresses it in a cross-sectional regression with all other sectors. The dependent variables in the model are each sector's duration, 12-month trailing spread volatility and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. We see this as an opportune time to upgrade our recommended allocation for UK investment grade corporates to overweight. The latest output from the UK relative value spread model can be found in Table 3. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot in Chart 17 shows the tradeoff between the valuation residual from our model and each sector's DTS. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation Chart 17UK Investment Grade Corporate Sectors: Valuation Versus Risk We can then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. Amid a backdrop of global uncertainty, we reiterate one of our major themes this quarter—buy what the central banks are buying. Given that UK corporate spreads are attractive on a breakeven basis, and with the BoE purchasing corporate debt at an even faster pace than during the volatile period following the shock Brexit vote in 2016, we see this as an opportune time to upgrade our recommended allocation for UK investment grade corporates to overweight. This is both on a tactical (0-6 months) and strategic basis (6-12 months). In our model bond portfolio, we have added two percentage points to our recommended UK corporate bond allocation, funded by reducing further our existing underweight on Japanese government bonds. At the sector level, given this positive backdrop for credit performance, we do not see a need to favor lower risk sectors with a DTS score below that of the overall UK investment grade index. On that basis, we are looking to go overweight sectors with higher relatively higher DTS and positive risk-adjusted spread residuals from our relative value model (and vice versa). Those overweight candidates would ideally be located in the upper right quadrant of Chart 17. Based on the latest output from the relative value model, the strongest overweight candidates are the following UK investment grade sectors: selected Financials (Insurance, Subordinated Bank Debt, and Other Financials), Media Entertainment, Cable Satellite, Tobacco, Diversified Manufacturing, and Communications. The least attractive sectors within this framework are: Packaging, Lodging, REITs, Other Industrials, Metals, Natural Gas, Restaurants, Transportation Services, Financial Institutions, and Midstream Energy. Bottom Line: The BoE is supporting the UK investment grade corporate bond market with an unprecedented level and pace of purchases. Spreads have already begun to tighten in response but are still at attractive levels. Upgrade UK investment grade corporates to overweight on a tactical (0-6 months) and strategic (6-12 months) basis. Across credit tiers, favor Aa-rated debt. Across sectors, favor debt from sectors such as non-bank Financials and Communications that are less exposed to pandemic-related uncertainty but still benefit from the CBPS.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate shaktis@bcaresearch.com Footnotes 1 Please see BCA Commodity & Energy Strategy Weekly Report, "US Storage Tightens, Pushing WTI Lower", dated April 16, 2020, available at ces.bcaresearch.com. 2 Please see BCA US Bond Strategy Special Report, "Trading The US Corporate Bond Market In A Time Of Crisis", dated March 31 2020, available at usbs.bcaresearch.com. 3 Other Industrials has an index duration of 28.6 years, compared to 8.5 years for the overall UK investment grade corporate bond index. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Why is the gap between the stock market and the economy so wide?: It is well established that stocks can diverge considerably from fundamentals in the near term, but lately it is as if the stock tables and the front-page headlines are from entirely different newspapers. It may be because the virus poses much less of a threat to the owners of equities than the general populace: More affluent households are more readily able to work from home and to practice social distancing. They also have access to better medical care. With the S&P 500 having hit technical resistance, however, the gap may be nearing its upper limit: Large-caps have run in place since retracing half of their peak-to-trough losses, and the next Fibonacci resistance level is only another 5% higher. Where are the shoddy loans?: During the expansion, corporations were able to borrow on prodigally easy terms. If banks aren't holding the loans, who is? Feature That’s New York’s future, not mine – “Hold On” (Reed) For someone who entered the business as a sell-side trader, it is a matter of course that prices can diverge from fundamentals. The trading desk had a one-day horizon, and the traders necessarily made their way on price signals while barely considering fundamentals. Though the junior traders had been exposed to dividend discount models at their fancy colleges, the ones who lasted recognized they weren’t relevant to the desk’s mission. Trading the daily flow required accepting that new news can have a dramatically larger effect on stocks in the here and now than it would on the lifetime stream of earnings available to common shareholders. Long-run fair value might solely turn on the fundamentals, but animal spirits hold sway over any given tick. The sudden stop imposed by stay-at-home orders has made backward-looking economic data nearly irrelevant, but the sizable upward surprises in unemployment claims should not be ignored. Our Global Investment Strategy colleagues showed last week just how difficult it is for even severe near-term shocks to materially alter the present value of aggregate future earnings.1 Furthermore, the market effects of negative earnings shocks are inherently self-limiting at the margin because they tend to be accompanied by lower interest rates, driving up the equity risk premium and making stocks more attractive relative to “safe” fixed income alternatives. Bear markets coincide with recessions, though, as near-term earnings expectations are revised lower and animal spirits droop (Chart 1). Given that the recession just begun is expected to be the worst since the Great Depression, one would expect that equities would be stumbling in search of a bottom as investors remained fearful of taking on risk. Chart 1Joined At The Hip They have instead been acting like the S&P 500 found that bottom on March 23rd, when the index completed a 35% peak-to-trough decline in just 23 sessions. It then proceeded to gain 28.5% over the next eighteen sessions. Some retracement is to be expected after a sudden, sharp move, and the S&P 500 has only recovered half of the ground that it lost. It certainly priced in a great deal of bad news on the way down, but the data have been worsening, and investors have been forced to give up on the notion of a swift economic recovery. Why are stocks rising when economic projections are being downwardly revised and good virus news has been few and far between? We ourselves have been barely glancing at backward-looking economic data releases that merely confirm the well-understood fact that draconian social distancing measures have wrung much of the life out of the economy. The degree to which job losses have outrun consensus forecasts stands out nonetheless. Aggregate initial unemployment claims over the last five weeks have exceeded consensus expectations by 5.5 million (Table 1). Even though the forecasts have caught up to the situation on the ground, the claims data suggest that unemployment is now pushing 20%, a worst-case-scenario level that is far above the first forecasts that incorporated the effects of stay-at-home orders. Claims may well have peaked, but they’re still an order of magnitude higher than normal, and they are not finished exerting upward pressure on the unemployment rate. Table 1Job Losses Have Been Worse Than Expected Meanwhile, COVID-19 data have yet to provoke much optimism. The rate of US infections has yet to come down to Italy’s level (Chart 2), and hopes that remdesivir might prove to be a wonder drug were dashed late last week. Clients are increasingly asking us why the stock market is traveling such a dramatically different path than the economy and the virus. How could stocks have plunged at a record rate as the coronavirus drew a bead on the United States, but surged after crippling social distancing measures were put in place? Chart 2The US Has Fallen Behind Italy's Pace A Tale Of Two Boroughs The simplest answer is that the Fed’s response was swifter and more far-reaching than expected. Ditto Congressional actions, and we expect that DC will continue to deploy its fiscal firepower to try to shield households and businesses from the worst of the effects of the anti-virus measures. We believe the monetary and fiscal efforts will make a difference, and do not think it’s a coincidence that equities turned around the week of March 23rd, which began with the Fed’s rollout of a formidable new arsenal and ended with the passage of the CARES Act. But the market action has not accounted for the shift from expectations of a V-bottom to talk of Us, Ls and Ws. Two articles published a week apart in The New Yorker vividly illustrated a demographic virus gap. The first looked at COVID-19 from the perspective of financial professionals at hedge funds and other sophisticated investment aeries.2 Although the views of the investors in the profile shifted with the tide of the incoming data, they were generally of the mind that the health threat was being dramatically overhyped. One retired hedge fund manager boasted about his and his family’s non-stop early March air travel between New York, London and a Wyoming ski resort. The second article followed an emergency room resident at Elmhurst, a publicly funded hospital in a working-class Queens neighborhood, which has been described as the epicenter of the outbreak in several local media reports.3 “‘It’s become very clear to me what a socioeconomic disease this is,’” he said. “‘Short-order cooks, doormen, cleaners, deli workers – that is the patient population here. Other people were at home, but my patients were still working. A few weeks ago, when they were told to socially isolate, they still had to go back to an apartment with ten other people. Now they are in our cardiac room dying.’” Stock ownership is largely reserved to the affluent, with the top percentile of households owning 53% of equities as of the end of 2019, and the rest of the top decile owning another 35% (Chart 3). For households in the top decile, maintaining a healthy distance from the virus isn’t that difficult. Knowledge workers equipped with a laptop and a reliable internet connection can work from anywhere, unlike the Elmhurst patients in low-skilled service positions who have to work onsite. The tonier precincts of Manhattan feel nearly deserted, with their residents having decamped for second homes in lower-density areas. Perhaps it's because the Fed's attempts to shore up the economy have far more personal relevance for investors than the spread of the virus. There are no comprehensive data series on virus infections and outcomes by zip code, which would facilitate analysis of the link between household wealth and COVID-19, but New York state reports age-adjusted fatality rates in four racial/ethnic categories. In New York state ex-New York city, which has lesser extremes of wealth than the city itself, the cross-category disparities are striking (Chart 4). Race/ethnicity is far from an ideal proxy for inequality, but it is fair to conclude that financial market participants have a sound basis for being more sanguine about the virus than the overall population. Assuming that more affluent households will be able to remain out of the virus’ reach, the dichotomy can persist for as long as the economic impacts do not become so bad that investors cannot reasonably look through them. Chart 3Demographics Drive Stock Ownership ... Chart 4... And COVID-19 Fatalities Technical Resistance Back on the trading desk, technical analysis was the go-to tool for traders pricing large blocks of stock in real time. Following sizable moves, the Fibonacci sequence provided a popular method for assessing how far a stock might retrace its steps before resuming its course. The most widely used Fibonacci retracement levels are 38% and 62%, and 50%, a round number exactly between the two, has also become an anticipated stopping point. From the February 19 closing high of 3,386.15 to the March 23 closing low of 2,237.40, the S&P 500 lost 1,148.75 points. The 38%, 50% and 62% retracement levels are 2,673.93, 2,811.78 and 2,949.63, respectively. The S&P paused at the 38% level for just two days before breaking through it decisively, but it’s had more trouble making its way through 2,812, failing to hold above it for more than a day or two at a time (Chart 5). Should it escape 2,812, the 2,950 level waits just 5% higher. Chart 5Fibonacci Retracement Levels For The S&P 500 We are fundamental investors who do not get hung up on technical levels, though they can become self-fulfilling prophecies if enough participants are following them. Given the popularity of Fibonacci retracement, it is possible that a critical mass of short-term investors may view 2,812 and 2,950 as preferred levels for exiting long positions in the S&P. Our bigger near-term concern is that it is hard to see US equities making much more headway while the virus and ongoing distancing measures have the potential to cause investors to revise their fundamental expectations lower and/or lose a little bit of their policy-fueled nerve. Who's Left Holding The Bag? Multiple commentators have expressed alarm at the post-2008 increase in corporate debt, especially given anecdotal reports that lending covenants had been loosened dramatically. If the banks don’t hold the debt, as we’ve argued, who does, and could a wave of virus-inspired defaults cause larger problems in the financial system? The Fed’s fourth quarter Flow of Funds report, published last month, provides some clues, but does not answer the question definitively. As we saw in higher frequency data on aggregate banking system exposures, bank loans to nonfinancial corporations grew modestly (3.2% annualized) since December 31, 2008. Nonfinancial corporations borrowed in the bond market at double that rate (6.2% annualized). Foreign loans, powered by near doubling in 2017 and 2018, grew at an annualized 13.4% pace, and are four times as large as they were at the end of 2008. Finance company loans have shrunk, and trade payables grew at a modest 2% rate. (Chart 6). Chart 6Debt Risks Are Pretty Well Diffused Publicly available data from Preqin on the capital raised by direct lending funds suggests that their impact has been modest, accounting for only about a quarter of outstanding bank loans if every dollar they’ve raised is currently deployed. Demand for leveraged loans, senior floating-rate debt issued to high-yield borrowers, was occasionally intense as investors sought protection from rising rates. The desire for duration protection has faded as rates have plunged to new lows, but ETFs and CLOs were eager buyers at points during the last expansion. In a Special Report published last summer, our US Bond Strategy and Global Fixed Income Strategy services concluded that the ownership of leveraged loans is diffuse enough that credit strains are unlikely to pose a systemic threat. They were also encouraged that leveraged loans and high yield corporate bonds act as substitutes, keeping one another in check as investor preferences for fixed and floating instruments wax and wane. They also noted that leveraged loan lending standards had tightened last year, with a reduced share of covenant-lite loans being issued, though standards have eased again since they published their report (Chart 7). Chart 7Covenant Protections Have Eroded Chart 8Diverse Corporate Bond Ownership Will Help Mitigate The Effect Of Defaults There is no way around the fact that high yield corporate bondholders (Chart 8), owners of CLO tranches rated below AAA and leveraged loan holders face elevated credit losses as the broad economic shutdown provokes a wave of defaults in instruments without Fed support. We expect that the default losses will be spread out across enough constituents that they will not become worryingly concentrated, but they may contribute to a further erosion of risk appetites.       Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the April 23, 2020 Global Investment Strategy Weekly Report, "Could The Pandemic Actually Raise Stock Prices?" available at gis.bcaresearch.com. 2 Paumgarten, Nick. "The Price of a Pandemic." The New Yorker, April 20, 2020, pp. 20-24. The article, relaying traders’ conversations, contains some profanity. 3 Galchen, Rivka. "The Longest Shift." The New Yorker, April 27, 2020, pp. 20-26. The article, relaying ER conversations, contains some profanity.