Corporate Bonds

Highlights Global Duration: The current mix of rising government bond yields, bear-steepening yield curves and rising inflation expectations is not surprising, given reduced political uncertainty and greater perceived tolerance of higher inflation by central banks. Maintain a below-benchmark portfolio duration stance, favoring low-inflation countries (core Europe, Japan) over higher-inflation countries (U.S., U.K.). U.K. Gilts: The selloff in Gilts looks similar to the path followed by U.S. Treasuries after the Fed's quantitative easing programs, only with a much larger currency decline. Yields have more upside in the near-term, especially against bond markets with lower inflation pressures. Downgrade U.K. allocations to below-benchmark (2 of 5) and upgrade core European exposure by upgrading France to neutral (3 of 5). U.K. Corporates: The Bank of England's corporate bond purchase program has made valuations quite expensive in the sectors where the central bank has been most active. We continue to recommend an above-benchmark stance on U.K. Investment Grade corporates versus nominal Gilts, but focusing on sectors that still over some relative value (mostly Communications). Feature Chart of the WeekA Rough Couple Of Months For Bonds A Rough Couple Of Months For Bonds A Rough Couple Of Months For Bonds There is not a lot of love for government bonds right now. Yields continue to grind higher, led by rising inflation expectations and bear-steepening moves in the core Developed market yield curves at a time when bond durations are extremely elevated (Chart of the Week). Bond investors may be starting to worry about monetary authorities falling behind the inflation-fighting curve, particularly with the heads of some major central banks openly expressing tolerance of inflation overshooting policy targets. It remains to be seen if the markets will start discounting significantly higher inflation. Within the major Developed economies, only in the U.K. are market-based inflation expectations currently above the central bank target level ... and only then after a historic currency collapse that has already caused a surge in U.K. import prices. The more important point is that the monetary authorities seem almost happy (relieved?) to see inflation expectations finally moving up and are unlikely to be very aggressive in trying to stop that trend. Only in the U.S. is there talk of a monetary tightening in the near term and, even there, little has been promised after a likely December rate hike with some Fed officials talking about letting the U.S. economy "run hot" for a while. The time for bond investors to start worrying more about inflation is when central banks begin to worry less about inflation. Favoring the bond markets with the lower rates of inflation seems like a reasonable investment strategy to pursue in the current environment. Global Duration - Stay Below-Benchmark In our previous Weekly Report,1 we revisited the reasons behind our current below-benchmark duration recommendation that has stood since July. We concluded that the case for higher yields was still intact. An additional factor that we did not discuss, but which has also had a significant influence on bond yields this year, has been the rise of political uncertainty on both sides of the Atlantic. Between the U.K. Brexit drama, and the rise of the protectionist Donald Trump in the U.S. Presidential election, investors have had to worry more about political risk than in previous years. This uncertainty created massive safe haven flows into core Developed market bonds, helping drive yields down to secular lows (Chart 2). Chart 2Uncertainty Fading, Yields Rising Uncertainty Fading, Yields Rising Uncertainty Fading, Yields Rising Yet the shock of the Brexit vote has not resulted in any noticeable slump in global growth, with even the U.K. economic data starting to show some improvement of late (more on that in the next section). As investors have come to realize that the Brexit vote was having no material effect on global growth, the political uncertainty premium on global bond yields has unwound, with yields in the major Developed bond markets now back to, or even surpassing, the pre-Brexit levels. In the case of the U.S. election, the recent decline in Trump's polling numbers has coincided with the rise in U.S. Treasury yields (Chart 3). Given the significant changes to all aspects of the U.S. government that Trump has proposed (foreign policy, immigration policy, tax policy, etc), his campaign represents the "greater uncertainty" choice in the U.S. election. So as his polling numbers decline, so should any impact on U.S. Treasury yields from political uncertainty. While this is hardly the only factor influencing Treasury yields, it is one piece of the puzzle that has turned a bit more bond bearish of late. So with less political uncertainty weighing on bonds, investors can turn their focus back to the usual drivers of yields - growth, inflation and monetary policy expectations. The news is not very bond bullish on those fronts either. Global economic indicators are not pointing to any material slowing of growth, with the OECD leading economic indicators (LEI) currently in the process of bottoming out or increasing (Chart 4). While absolute growth rates are hardly booming in the Developed world, the cyclical upturn in many Emerging economies this year has been a positive surprise. If the Emerging LEIs are to be believed, this pickup in growth can continue into next year. Chart 3Trump Really Is The 'King Of Debt' bca.gfis_wr_2016_10_18_c3 bca.gfis_wr_2016_10_18_c3 Chart 4Signs Of A Global Growth Upturn bca.gfis_wr_2016_10_18_c4 bca.gfis_wr_2016_10_18_c4 Meanwhile, inflationary pressures are potentially appearing in some of the Developed economies, most notably the U.S. and the U.K. The end of the disinflationary shock from the oil price collapse in 2014/15 has played a large role here. However, measures of spare economic capacity like the output gap or the unemployment gap2 have narrowed considerably in the major Developed economies (Chart 5), so it is perhaps no surprise that inflation expectations are starting to move higher in some of the those countries. Against this backdrop where the world might be a bit more inflationary than has been the case over the past several years, these comments last week from two prominent central bankers may have set off some alarm bells for bond investors: Bank of England Governor Mark Carney: "We're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order [...] to cushion the blow [from Brexit]." U.S. Federal Reserve Chair Janet Yellen: "[...] it might be possible to reverse these adverse supply-side effects [from a deep recession] by temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labor market." This comes on top of the Bank of Japan's decision last month to move to deliberately target an overshoot of the 2% inflation target in order to raise depressed longer-term inflation expectations. The central banks may have a tough time convincing the markets that they would tolerate much of a rise in inflation above the policy targets. Already, interest rate expectations embedded in money market yield curves have either priced out additional rate cuts or, in the case of the U.S., priced in some modest rate hikes (Chart 6). This pricing appears correct, in our view. Chart 5The Gaps Are Closing Fast The Gaps Are Closing Fast The Gaps Are Closing Fast Chart 6Rate Expectations Have Turned Less Dovish bca.gfis_wr_2016_10_18_c6 bca.gfis_wr_2016_10_18_c6 We still see the Fed delivering on another rate hike in December but, even then, the median FOMC projection is only calling for two more rate hikes in 2017 following one increase this year. In the case of the Euro Area, our base case remains that the European Central Bank (ECB) will not end its asset purchase program in early 2017, as currently scheduled, but will also not push short-term interest rates deeper into negative territory. In the U.K., our expectation is that the BoE will not provide any new stimulus (i.e. cutting the policy rate to 0% or extending the current asset purchase program beyond March of next year), but will not move to quickly tighten policy either, even with U.K. inflation surging and the Pound collapsing. Chart 7Inflation Expectations Are Moving First Inflation Expectations Are Moving First Inflation Expectations Are Moving First The Bank of Japan (BoJ) may try another interest rate cut in the coming months to try and help weaken the yen, but given its new policy of yield curve "targeting", we do not expect longer-term Japanese government bond (JGB) yields to move in response to a rate cut, if it does occur. Meanwhile, we expect no policy moves from the Bank of Canada or the Reserve Bank of Australia over the next six months, even though the domestic economy looks in good shape in the latter. We continue to advise keeping a below-benchmark stance on overall portfolio duration, as the global growth and inflation backdrop has become a bit less bond-friendly at a time when longer-term bond yields remain generally overvalued. In terms of our country allocation, we recommend below-benchmark exposure where inflation expectations are rising the fastest and are most likely to continue doing so - the U.S. and, as of this week, the U.K. (see the next section). We also continue to recommend favoring inflation-linked bonds/swaps in the U.S. and U.K. over nominal government debt. Finally, we advise neutral allocations to the markets where inflation expectations are farthest from the central bank targets: Japan and core Europe (Chart 7). Bottom Line: The current mix of rising government bond yields, bear-steepening yield curves and rising inflation expectations is not surprising, given reduced political uncertainty and greater perceived tolerance of higher inflation by central banks. Maintain a below-benchmark portfolio duration stance, favoring low-inflation countries (core Europe, Japan) over higher-inflation countries (U.S., U.K.). U.K.: Monetary Overkill From The BoE? U.K. Gilts have suffered major losses over the past couple of months, with the benchmark 10-year yield up +30bps since the BoE cut rates and introduced a new round of quantitative easing (QE) back on August 4th. Reducing the policy rate and ramping up QE should, in theory, be supportive for the Gilt market. However, the BoE's actions may be causing the growth and inflation backdrop in the U.K. to become very unfriendly for Gilts: Domestic economic data have improved sharply higher in the months after the June Brexit vote, with retail sales and manufacturing in particular showing large improvements, even as business optimism took a hit following the vote to leave the European Union (Chart 8); U.K. realized inflation has started to move higher in response to the collapse of the Pound and higher import prices, which now are rising at a positive annual rate for the first time since 2011 (Chart 9 & Chart 10). Chart 8What Post-Brexit Slump? What Post-Brexit Slump? What Post-Brexit Slump? Chart 9Blame The Pound For Rising U.K. Inflation Blame The Pound For Rising U.K. Inflation Blame The Pound For Rising U.K. Inflation This type of response from Gilt yields to a QE announcement is not unprecedented; a similar pattern unfolded after the Fed's QE announcements earlier in the decade. In Chart 11, we show a "cycle-on-cycle" analysis of the U.K. and the U.S. financial markets around past QE announcements. The dotted lines in all panels of the chart represent the equally-weighted average of the three Fed QE announcements (in 2008, 2010 and 2012), while the solid line is the current U.K. cycle. The vertical line in the chart represents the day of the QE announcement, so in this chart we are "lining up" the U.K. now with the U.S. back then. Chart 10BoE QE: Good For Corporates, Bad For Inflation BoE QE: Good For Corporates, Bad For Inflation BoE QE: Good For Corporates, Bad For Inflation Chart 11Gilts Following The Post-Fed-QE Playbook Gilts Following The Post-Fed-QE Playbook Gilts Following The Post-Fed-QE Playbook The conclusion from Chart 11 is that Gilts are behaving in a similar fashion to Treasuries after the Fed announced its QE programs. Yields rose almost immediately, led by a wider term premium and higher inflation expectations. The initial response was modestly bullish for the currency, but then that was quickly reversed as inflation expectations continued to rise. Risk assets like equities and credit performed very well in response to the QE. The biggest difference between the U.K. now and the U.S. then is the magnitude of the currency decline. The Pound has fallen -17% since the Brexit vote, and the decline has accelerated in recent weeks on the back of increased worries about a possible "hard Brexit" - a more protectionist outcome than was originally feared after the June vote. With the U.K. having a massive current account deficit (-5.7% of GDP), any news that could stall capital inflows into the U.K. (like worries about greater protectionism) can trigger an outsized currency decline. With the Pound unlikely to rebound in the near-term, the inflationary effects of the weaker currency can continue to feed through into both realized and expected inflation. Already, the 10yr U.K. CPI swap rate has risen to 3.6% - the high end of the range of the post-2008 crisis era. We have recommended favoring inflation-linked Gilts over nominal Gilts since the BoE's QE announcement in August, and we continue to recommend owning U.K. inflation protection. If Gilts continue to follow the post-Fed-QE playbook shown in Chart 11, then Gilt yields will likely to rise until the end of the year. Chart 12Gilt Underperformance Will Continue Gilt Underperformance Will Continue Gilt Underperformance Will Continue We have maintained an overweight stance on Gilts since the BoE announcement, as we had expected the QE effect on the supply/demand balance in the Gilt market to dominate via an even more depressed Gilt term premium. A strong possibility of a final BoE rate cut to 0% was also a reason to favor Gilts over other Developed economy government bonds. But with the Pound continuing to plunge and inflation expectations soaring, and with little sign of a big downturn in the U.K. economy, it is difficult to argue that the BoE needs to easy policy again. Even if they did, the markets would likely interpret the next cut as being "monetary overkill" that was unnecessary and creates future inflation risks. This would likely exacerbate the current selloff in Gilts. The recent comments from BoE Governor Carney highlighted earlier in this report suggest that he is quite comfortable with the current monetary policy stance, and that he is not overly concerned about the inflationary effects of a weaker Pound. This suggests that the BoE will not be quickly reversing any of the August monetary easing measures, even as U.K. inflation continues to rise. Given this new policy of "benign neglect" towards rising inflation by the BoE, this week we are downgrading our recommended stance on U.K. fixed income from above-benchmark (4 of 5) to below-benchmark (2 of 5). As an offset, we are upgrading our allocation to core European bonds to neutral (3 of 5) - specifically in France, where we are currently below-benchmark (2 of 5). The spreads between U.K. Gilts and French debt have been widening as Gilt yields have increased (Chart 12), and we see the spreads returning to their pre-Brexit ranges in the months ahead. Bottom Line: The selloff in Gilts looks similar to the path followed by U.S. Treasuries after the Fed's quantitative easing programs, only with a much larger currency decline. Yields have more upside in the near-term, especially against bond markets with lower inflation pressures. Downgrade U.K. allocations to below-benchmark (2 of 5) and upgrade core European exposure by upgrading France to neutral (3 of 5). A Quick Update On U.K. Corporate Bonds The BoE's expanded QE program also included an increase in Investment Grade non-financial corporate bond purchases. The plan called for the BoE to purchase 10bn pounds worth of corporate debt over an 18-month period. The BoE has pursued a weighting scheme across sectors that differs from the market-capitalization based weightings of a traditional U.K. corporate bond benchmark index. For example, the BoE is buying far more debt from sectors like Electricity, Consumer Non-Cyclicals, Industrials and Transportation relative to the weights in the Barclays U.K. corporate bond index (Chart 13). Chart 13BoE Corporate Bond Purchases Are Not Following The Benchmark Return Of The Bond Vigilantes Return Of The Bond Vigilantes The impact of the BoE bond buying can be seen in current corporate bond spread valuations. The BoE's heavy focus on Utilities & Industrials issuers drove the spreads on the Barclays benchmark indices for those sectors down to the lows of the past few years (Chart 14). We can also see this in our own U.K. sector spread relative value framework, where the sectors that have the heaviest BoE involvement also have the most expensive spreads (Table 1). Chart 14U.K. Corporate Spreads Are Tight (Ex Financials) U.K. Corporate Spreads Are Tight (Ex Financials) U.K. Corporate Spreads Are Tight (Ex Financials) Table 1U.K. Investment Grade Corporate Sector Spread Valuations Return Of The Bond Vigilantes Return Of The Bond Vigilantes With the BoE becoming such a large marginal player in the U.K. corporate bond market, an overweight position versus nominal Gilts is still warranted. The weakness of the Pound is also supportive of the performance of U.K. non-financial corporates, as evidenced by the strong correlation of corporate bond excess returns, equity returns and the swings of the trade-weighted Pound over the past five years (Chart 15 & Chart 16). Chart 15U.K. Equities & Corps Are Both Performing Well... U.K. Equities & Corps Are Both Performing Well... U.K. Equities & Corps Are Both Performing Well... Chart 16...Thanks To The Plunging Currency ...Thanks To The Plunging Currency ...Thanks To The Plunging Currency In terms of individual sector recommendations, favor names in the Communications sectors (specifically, Cable & Satellite and Wireless), where spreads are cheap in our valuation framework and the BoE can potentially buy bonds as part of its QE program. One final note: U.K. Financials score the cheapest in our sector valuation model, and there is a case for shifting to an overweight in those sectors (most Banks and Insurers), even if the BoE is not buying those bonds. Financials will likely benefit from higher Gilt yields and a steeper Gilt curve, but could also require higher risk premiums as the Brexit process plays out and the business models of banks may need to be altered in a post-EU U.K. This likely makes U.K. Financials more of a riskier carry trade than an undervalued spread-compression trade. Bottom Line: The Bank of England's corporate bond purchase program has made valuations quite expensive in the sectors where the central bank has been most active. We continue to recommend an above-benchmark stance on U.K. Investment Grade corporates versus nominal Gilts, but focusing on sectors that still over some relative value where the central bank is buying (mostly in Communications). Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Bond Bear Phase Continues", dated October 11, 2016, available at gfis.bcaresearch.com 2 The unemployment rate minus the NAIRU or "full employment" level of unemployment The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Return Of The Bond Vigilantes Return Of The Bond Vigilantes Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Muni Credit Cycle: The reading from our Municipal Health Monitor supports low Muni/Treasury yield ratios for now, but will become less supportive near the end of 2017. This is consistent with historical lags between the muni and corporate credit cycles. Issuance: State & local government investment spending will increase in 2017, as will muni issuance for new capital. Pensions: The pension funding problem will only get worse in the coming years. Credit ratings do not adequately reflect the risk from under-funded pensions. Election: Muni/Treasury yield ratios have not yet discounted Donald Trump's recent plunge in the polls. Maintain an overweight allocation to municipal bonds for the time being, but stand prepared to gradually reduce exposure as the muni credit cycle starts to turn in late 2017. Feature The financial crisis marked a major inflection point in the municipal bond market. Not only did the economic fall-out from the housing crash lead to historically large state & local government budget gaps, but the end of bond insurance and a growing realization that municipal default is possible have focused investor attention on credit quality more than ever before. In this Special Report we zero-in on the Municipal/Treasury (M/T) yield ratio.1 We identify its major short-run and long-run drivers, and assess where it is headed in the context of the municipal bond credit cycle. The Longer-Run Outlook For Yield Ratios An important input to our understanding of the municipal credit cycle is our Muni Health Monitor (MHM). The MHM is a composite of eight indicators of state & local government budget health. Full details of the indicator and its components can be found in the Appendix to this report. The MHM has an excellent track record of signaling the major inflection points in muni ratings migration (Chart 1). We observe that the MHM bottomed in 2006, one year before the previous trough in ratings migration. The MHM also crossed into "deteriorating health" territory six months before municipal downgrades started to outpace upgrades in 2008. More recently, the MHM crossed back into "improving health" territory in Q4 2012. Muni ratings migration also peaked in Q4 2012 and upgrades began outpacing downgrades in Q4 2014. Chart 1The Municipal Health Monitor Leads Ratings bca.usbs_sr_2016_10_18_c1 bca.usbs_sr_2016_10_18_c1 We pay attention to the trends in muni ratings because ratings and state & local government net borrowing explain more than 50% of the variation in the average M/T yield ratio since 1997 (Chart 2). Further, increased investor focus on the creditworthiness of municipal issues has made the yield ratio even more responsive to ratings and net borrowing since the Great Recession. So where are we currently situated in the muni credit cycle? The MHM remains in "improving health" territory, but appears to have entered an extended bottoming-out phase. Given the re-leveraging that has already occurred in the corporate sector, it would be extremely unusual for the MHM to improve further during this cycle. In fact, our Corporate Health Monitor tends to lead the MHM by about two years (Chart 3). This squares with what we know about the behavior of state & local governments throughout the economic cycle. Chart 2The Muni Credit Cycle Illustrated I bca.usbs_sr_2016_10_18_c2 bca.usbs_sr_2016_10_18_c2 Chart 3The Muni Credit Cycle Illustrated II The Muni Credit Cycle Illustrated II The Muni Credit Cycle Illustrated II Typically, the corporate sector will increase debt loads when times are good and will then be forced to de-lever when the economy enters recession, profits contract and those debt loads become unsustainable. State & local government budget gaps, on the other hand, will tend to narrow during an economic recovery as rapid income growth translates into increased tax revenue. It is only during a recession that state & local government budget gaps widen, since tax revenue plummets while expenditure growth - particularly for social benefits - remains firm. The end result is that the municipal credit cycle tends to lag the corporate credit cycle. This is also apparent in the ratings data (Chart 3, bottom panel), which suggest that we should expect to see muni downgrades (and hence yield ratios) head higher near the end of next year. The typical lag between the corporate credit cycle and the municipal credit cycle suggests that M/T yield ratios should remain well behaved until late-2017, and then begin to move higher. However, the extraordinary length of the current economic recovery gives us some cause to believe that the lags in this cycle may be somewhat longer. We turn to a macro analysis of net state & local government borrowing to shed some further light on this issue. Net borrowing is simply the difference between revenues and expenditures. On the revenue side of the ledger, state & local governments have already seen a significant deceleration in tax receipts during the past year (Chart 4). Every source of tax revenue - except for property taxes - has slowed alongside what has been disappointing overall economic growth so far in 2016. While a return to the 10% revenue growth that was seen in the mid-2000s is unlikely, we expect most of the recent deceleration will soon be reversed. Aggregate weekly hours bounced sharply in September (Chart 5), and federal income tax withholdings also continue to grow rapidly. Both indicators suggest that income growth will be stronger during the next few months, which will support state & local tax receipts. On the expenditures side, while spending on social benefit programs has increased, state & local governments have largely dealt with budget gaps by cutting back severely on discretionary spending (Chart 6). Investment spending has also collapsed and, as a result, gross municipal bond issuance has been dominated by refinancing (Chart 6, bottom two panels). Chart 4S&L Government Revenue S&L Government Revenue S&L Government Revenue Chart 5Income Growth Will Rebound bca.usbs_sr_2016_10_18_c5 bca.usbs_sr_2016_10_18_c5 Chart 6S&L Government Expenditures bca.usbs_sr_2016_10_18_c6 bca.usbs_sr_2016_10_18_c6 This could all be about to change. Both U.S. Presidential candidates have prioritized infrastructure spending as part of their platforms. Hillary Clinton plans to increase infrastructure spending by $500 billion. This consists of $250 billion of federal infrastructure spending over the next five years and $25 billion of seed money to create a national infrastructure bank. The bank would also accept an additional $225 billion in direct loans. Clinton's plan would also bring back the Build America Bonds (BABs) program. Donald Trump has also expressed a desire to invest heavily in infrastructure, and has floated figures in the range of $1 trillion, although he has been less specific about the details. Historically, about 70% of public investment has occurred at the state & local government level (Chart 7). This suggests that if infrastructure spending became a priority it would lead to a large increase in state & local government investment and hence municipal bond issuance. However, with Clinton's plan it is still unclear whether the bulk of infrastructure spending would be financed through the Treasury market or the muni market. Certainly, to the extent that increased spending is financed through the BABs program, then tax-exempt muni issuance would not be impacted. In our view, state & local government investment spending will head higher in 2017 even without any support from the new President. The need for state & local governments to invest in infrastructure has been evident for some time, but only recently have budgets become healthy enough for governments to consider it. There is a strong correlation between state & local government investment spending and the net percentage of states with a total balance (general fund plus rainy day fund) that exceeds 5% of expenditures (Chart 8). This figure has just recently moved into positive territory and, not coincidentally, more than $200 billion worth of infrastructure spending will be on ballots requesting voter approval in November.2 Chart 7State & Local Government ##br##Drives Investment bca.usbs_sr_2016_10_18_c7 bca.usbs_sr_2016_10_18_c7 Chart 8Healthy Enough##br## To Invest bca.usbs_sr_2016_10_18_c8 bca.usbs_sr_2016_10_18_c8 The combination of resilient, but not surging, revenue growth and increased investment spending in 2017 is consistent with the idea that the muni credit cycle will follow the lead of the corporate cycle and start to turn near the end of next year. Bottom Line: The reading from our Municipal Health Monitor supports low Muni/Treasury yield ratios for now, but will become less supportive near the end of 2017. This is consistent with historical lags between the muni and corporate credit cycles. The Pension Problem Of course, the elephant in the room with regards to the long-run outlook for municipal credit quality is pensions. So far pensions have only entered our discussion of the muni credit cycle tangentially, since the pension funded ratio is a component of the MHM (see Appendix). However, large unfunded pension liabilities - should they persist - have the potential to be severely destabilizing for the muni market at some point in the future. According to the U.S. National Accounts, aggregate defined benefit pension entitlements at the state & local government level total $5.6 trillion, only 65% of which are currently funded by assets. However, this aggregate figure masks large divergences between a few municipalities with unsustainable pension liabilities and the majority of municipalities where pension liabilities are probably manageable. Chart 9Low Returns Put Pressure On Pensions Low Returns Put Pressure On Pensions Low Returns Put Pressure On Pensions In a recent report,3 the Center for Retirement Research at Boston College found that 36 states should be able to fund their existing liabilities by making annual payments that total less than 15% of revenue. However, five states - Illinois, New Jersey, Connecticut, Hawaii and Kentucky - require annual payments in excess of 25% of revenue. The breakdown is found to be similar at the city level, where pension costs were found to be manageable for the majority of cities, although Chicago, Detroit, San Jose, Miami, Houston, Baltimore, Wichita and Portland all face annual pension costs that exceed 40% of revenue. Unfortunately, while the pension situations of most municipalities are currently manageable, they are only likely to get worse. Changes in the aggregate pension funded ratio closely track returns from a portfolio that is 50% invested in the S&P 500 and 50% invested in the Barclays Treasury index (Chart 9). Based on current equity valuations, it is probably only reasonable to expect 6% annual nominal returns from the equity market during the next 10 years,4 and the 10-year Treasury yield suggests that 1.8% is a reasonable expectation for annual nominal Treasury returns. Taken together, annual nominal investment returns from a 50/50 portfolio during the next decade could be close to 4%, far below the historical average of 8.9% and also below the 7.6% average return assumed by state & local pension plans in 2014. The two main points are that: The pension problem is likely to get worse, not better Given that large under-funded pensions are concentrated in only a few states, inter-state muni allocations are very important On this second point, we observe that states with lower pension funded ratios have higher General Obligation (GO) bond yields (Chart 10), and also that not all of the difference is reflected in credit ratings. We ran a cross-sectional regression of GO bond yields against credit rating and found that a correlation remains between the residual from that regression and the pension funded ratio (Chart 11). In other words, credit rating does not adequately control for the risk presented by under-funded pensions. Chart 10Municipal Bond Yields Vs. Pension Funded Ratios Trading The Municipal Credit Cycle Trading The Municipal Credit Cycle Chart 11Municipal Bond Yields Vs. Pension Funded Ratios: Controlling For Credit Rating Trading The Municipal Credit Cycle Trading The Municipal Credit Cycle Bottom Line: The pension funding problem will only get worse in the coming years. Credit ratings do not adequately reflect the risk from under-funded pensions. The Short-Run Outlook For Yield Ratios So far we have discussed the muni credit cycle and noted that M/T yield ratios should begin to move higher on a sustained basis at some point near the end of 2017. However, the near-term drivers of M/T yield ratios suggest that an overweight allocation to municipal bonds remains appropriate for the time being. We have found that the bulk of near-term volatility in M/T ratios can be explained by four factors (Chart 12): The Global Policy Uncertainty Index5 Gross municipal bond issuance Net municipal mutual fund flows Ratings migration The Brexit shock to policy uncertainty has now mostly been reversed. Meanwhile, our Muni Excess Supply Indicator (Chart 12, panel 4) shows that gross issuance has been outpacing fund inflows of late. This should put upward pressure on yield ratios, although this pressure has been largely offset by still supportive ratings migration (Chart 12, bottom panel). Considering all factors, this short-term model shows that the average M/T yield ratio is close to fair value. A reading close to fair value is consistent with muni returns that should exceed those from duration-equivalent Treasuries most of the time (Table 1), even before adjusting for the muni tax advantage. In fact, Table 1 shows that the odds of muni underperformance only really increase once the M/T ratio appears more than one half standard deviation expensive on our model. Chart 12A Short-Term Muni Model A Short-Term Muni Model A Short-Term Muni Model Table 1Municipal Bond Excess Returns* Based On Fair Value Model** Residual: 2010 - 2016 Trading The Municipal Credit Cycle Trading The Municipal Credit Cycle The other near-term factor that supports a continued overweight allocation to municipal debt is the prospect of a Clinton victory in next month's election. Since the beginning of the year, the average M/T ratio has closely tracked the probability of a Trump election victory (Chart 13). The reasoning is entirely logical. Trump has promised large tax cuts for the highest earners. Such tax cuts would significantly de-value the tax advantage of municipal bonds and pressure yield ratios higher. In contrast, Clinton promises to raise taxes on high income individuals. This would make the tax advantage of municipal debt more valuable, and pressure yield ratios lower. Chart 13Trump Is Bad For Yield Ratios Trump Is Bad For Yield Ratios Trump Is Bad For Yield Ratios The average M/T yield ratio has not yet discounted Trump's recent plunge in the polls. This argues for the maintenance of an overweight allocation to municipal debt in the near term. Bottom Line: M/T yield ratios appear fairly valued in the near-term, and have not yet discounted Donald Trump's recent plunge in the polls. Maintain an overweight allocation to municipal bonds for the time being, but stand prepared to gradually reduce exposure as the muni credit cycle starts to turn in late 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Appendix: The BCA Municipal Health Monitor The BCA Municipal Health Monitor is an equal-weighted composite of eight indicators meant to quantify trends in state & local government budget gaps and debt service capability. The components consist entirely of data that are publicly available from the Bureau of Economic Analysis, Federal Reserve, Bureau of Labor Statistics and the National Association of State Budget Officers. The eight components are described below, and shown graphically in Charts A1 & A2. Chart A1Muni Health Monitor Components I Muni Health Monitor Components I Muni Health Monitor Components I Chart A2Muni Health Monitor Components II bca.usbs_sr_2016_10_18_c15 bca.usbs_sr_2016_10_18_c15 Leverage: The ratio of total state & local government liabilities (excluding unfunded pension liabilities) to total financial assets. Interest Coverage: State & local government current budget surplus (excluding interest expenditures) divided by interest expenditures. The current surplus is calculated as the difference between current revenues and current expenditures (i.e. investment spending is excluded). Pension Funded Ratio: Total assets of state & local government pension funds divided by total pension liabilities. Revenue: State & local government current revenue in nominal terms, as a deviation from its 18-quarter trend. Surplus Margin: State & local government current budget surplus as a % of current revenue. Liquidity: State & local government total financial assets less short-term liabilities, as a % of total financial assets. Employment Growth: Year-over-year % change in state and local government employment. Total Balance: Aggregate state government total year-end balance. The total balance is the general fund balance plus the rainy day fund, as a % of total expenditures. 1 The average M/T yield ratio shown in this report is calculated by taking an equal-weighted average of M/T yield ratios for 2-year, 5-year, 10-year and 30-year maturities. For each maturity point the yield ratio is calculated as the ratio between the Bloomberg Fair Value Aaa Municipal bond yield and the Federal Reserve's constant maturity Treasury yield. 2 http://www.bloomberg.com/news/articles/2016-09-13/mega-deals-lead-ballo… 3 http://crr.bc.edu/briefs/will-pensions-and-opebs-break-state-and-local-… 4 Please see Global Investment Strategy Special Report, "Global Equity Valuations: Risks And Opportunities", dated July 1, 2016, available at gis.bcaresearch.com 5 The index was created by Professors Scott Baker, Nick Bloom and Steven Davis and is driven by the number of times terms related to economic and policy uncertainty are found in newspaper articles. Full details of the methodology are available at www.policyuncertainty.com

We are pleased to share this <i>Special Report</i> rolling out our Global ETF Strategy (GETF) service's model ETF portfolios.
We are in the latter stages of developing the digital interface that will serve as the central nervous system for the GETF service and are excited to be rolling it out next month. In the meantime, the GETF team has embarked on its regular bi-weekly publication schedule. An ETF Primer <i>Special Report</i> will follow on October 26. It will discuss ETF architecture, operation and trading, and is meant to help investors determine how they can best deploy ETFs to accomplish their tactical and strategic goals.

Global bond yields continue to grind higher, led by signs of improving growth, moderately higher inflation and central banks having difficulty staying credibly dovish. Maintain a below-benchmark duration stance.

Our Treasury yield fair value model suggests that the 10-year Treasury yield has an additional +19bps of upside. Stay at below benchmark duration.

Our <i>Fourth Quarter Strategy Outlook</i> presents the major investment themes and views we see playing out for the rest of the year and beyond.

There are two key risks that could derail a bear-flattening of the yield curve. The first is a Trump election victory, the second is a flaring of stress in the non-U.S. banking sector.

It's hard to make a case for attractive returns from any asset class over the next year. We dial down risk a bit but ending our overweight on junk bonds. Investors should pick up yield where they can but without taking excessive risk.

Although the Fed is on track to hike rates in December, the credit cycle is far more advanced than the monetary tightening cycle. Position for a December rate hike by being short duration and in curve flatteners. Weakening corporate balance sheet fundamentals mean the long-term trend is for corporate spreads to widen.

The fiscal spending impulse in China is still positive but receding. The nation's productivity and potential GDP growth are bound to decline due to a rising role of government in capital and resource allocation. Hence, cyclical stabilization could well be overwhelmed by a structural slowdown. Another bubble is forming in China, this time in the corporate bond market. The amelioration in Korean and Taiwanese exports is due to the technology sector/semiconductors, and does not reflect broad-based improvement in global trade.