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

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

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

Highlights Chart 1Softer PMIs In December Softer PMIs In December Softer PMIs In December A bond bear market looked to be underway in December, with the 10-year Treasury yield reaching as high as 1.93% just before Christmas. But two developments during the past week drove it back down to 1.80%, and could prevent yields from rising during the next month or two. Five macro factors are important for US bond yields (global growth, the output gap, the US dollar, policy uncertainty and sentiment). Two of those factors flipped from sending bond-bearish to bond-bullish signals during the past week. First, policy uncertainty had been ebbing due to the US/China phase 1 trade deal, but it ramped up again due to US military conflict with Iran. Second, our preferred global growth indicators had been showing tentative signs of bottoming, but reversed course in December. The Global Manufacturing PMI fell from 50.3 to 50.1 in December, and the US ISM Manufacturing PMI fell from 48.1 to 47.2 (Chart 1). We continue to forecast higher bond yields in 2020, but recent events have likely postponed any significant sell-off. Stay tuned. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 119 basis points in December and by 619 bps in 2019. In our 2020 Key Views report, we argued that the credit cycle will remain supportive for corporate bonds this year, but that we prefer to take credit risk in the high-yield space where valuation is more attractive.1 With inflation expectations still depressed, the Fed can maintain its “easy money” policy for some time yet. This accommodative stance will encourage banks to keep the credit taps running, leading to tight spreads. The third quarter’s tightening of C&I lending standards is a risk to our view (Chart 2), especially if this month’s survey reveals that the tightening continued into Q4. We don’t think that will be the case, given that the yield curve – another indicator of monetary conditions – steepened sharply in the fourth quarter. As stated above, valuation is the main hurdle for investment grade corporates. Spreads for all credit tiers are below our targets (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher.  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Setbacks Setbacks Table 3BCorporate Sector Risk Vs. Reward* Setbacks Setbacks High-Yield Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 202 basis points in December, and by 886 bps in 2019. The index option-adjusted spread tightened 34 bps on the month and currently sits at 335 bps, 102 bps above our target (Chart 3). With attractive valuation, accommodative monetary conditions and a looming recovery in global economic growth, we expect junk spreads to tighten during the next 6-12 months. One notable development from last year is that the Ba and B credit tiers outperformed the Caa credit tier. This is unusual in an environment of positive excess junk returns. We analyzed the divergence between Caa and the rest of the junk index in a recent report and came to two conclusions.3 First, the historical data show that 12-month periods of overall junk bond outperformance are more likely to be followed by underperformance if Caa is the worst performing credit tier. Second, we can identify several reasons for 2019’s Caa spread widening that make us inclined to downplay any negative signal. Specifically, we note that the Caa credit tier’s exposure to the shale oil sector is responsible for the bulk of 2019’s underperformance (bottom panel). The conflict between the US and Iran should boost oil prices during the next few months, benefiting the US shale sector and causing some of this divergence to unwind. MBS: Overweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 34 basis points in December, and by 56 basis points in 2019. The conventional 30-year zero-volatility spread tightened 10 bps on the month, driven by an 8 bps tightening of the option-adjusted spread (OAS) and a 2 bps decline in expected prepayment losses (aka option cost). We recommend an overweight allocation to Agency MBS, particularly relative to corporate bonds rated A or higher, for three reasons.4 First, expected compensation is competitive. The conventional 30-year MBS OAS is 45 bps (Chart 4). This is only 7 bps below the spread offered by Aa-rated corporate bonds (panel 4). Also, spreads for all investment grade corporate bond credit tiers are below our targets. Second, risk-adjusted compensation heavily favors MBS. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most homeowners have already had at least one opportunity to refinance. This burnout will keep refi activity low, and MBS spreads tight. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 54 basis points in December, and by 252 bps in 2019. Sovereign debt outperformed duration-equivalent Treasuries by 175 bps on the month, and by 697 bps in 2019. Local Authority and Foreign Agency bonds outperformed the Treasury benchmark by 41 bps and 73 bps, respectively, in December, and by 287 bps and 341 bps, respectively, in 2019. Domestic Agency bonds and Supranationals both performed in line with Treasuries in December, but outperformed by 51 bps and 36 bps, respectively, in 2019. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to US corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.5 This is also true for Local Authorities and Foreign Agencies, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).6 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 51 basis points in December, and by 57 bps in 2019 (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell 6% in December, and currently sits at 78% (Chart 6). We upgraded municipal bonds in early October, as yield ratios had become significantly more attractive, especially at the long-end of the Aaa curve (panel 2).7 Yield ratios have tightened a lot since then, but value remains at long maturities. Specifically, 2-year, 5-year and 10-year M/T yield ratios are all below average pre-crisis levels at 66%, 68% and 78%, respectively. But 20-year and 30-year yield ratios stand at 87% and 91%, respectively, above average pre-crisis levels. Fundamentally, state and local government balance sheets remain solid. Our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outpace downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview Long-dated Treasury yields rose in December, while the Fed’s forward guidance kept short-maturity yields low. The result is that the 2/10 slope steepened 17 bps in December and the 5/30 slope steepened 11 bps (Chart 7). Looking back on 2019 we find that, despite August’s curve inversion scare, the 2/10 slope steepened 13 bps on the year and the 5/30 slope steepened 19 bps. In our 2020 Key Views report, we argued that the 2/10 Treasury slope will stay positive in 2020, in a range between 0 bps and 50 bps.8 We also expect further modest steepening during the next few months as the Fed continues to hold down the front-end of the curve in an effort to re-anchor inflation expectations, even as improving global growth pushes long-dated yields higher. Despite our outlook for modest curve steepening, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. This position offers positive carry (bottom panel), due to the extreme overvaluation of the 5-year note. It also looks attractive on our yield curve models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 112 basis points in December, and by 42 bps in 2019. The 10-year TIPS breakeven inflation rate rose 16 bps on the month and currently sits at 1.78%. The 5-year/5-year forward TIPS breakeven inflation rate rose 14 bps on the month and currently sits at 1.86%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations remains stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target since mid-2018 (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. It takes time for expectations to adapt to a changing macro environment, but even accounting for those long lags, our Adaptive Expectations Model pegs the 10-year TIPS breakeven inflation rate as 16 bps too low (panel 4).9 It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor long-term inflation expectations. As a result, the actual inflation data will lead expectations higher, causing the TIPS breakeven inflation curve to flatten.10 Any politically-driven increase in oil prices will only exacerbate TIPS breakeven curve flattening. ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in December, but outperformed the benchmark by 69 bps in 2019. The index option-adjusted spread for Aaa-rated ABS widened 6 bps on the month. It currently sits at 37 bps, 3 bps above its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS ranks among the most defensive US spread products, and also offers more expected return than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends continue to shift in the wrong direction. The consumer credit delinquency rate remains low, but has put in a clear bottom. This is also true for the household interest expense ratio (panel 3). Senior Loan Officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, our favorable outlook for global growth causes us to shy away from defensive spread products, and deteriorating credit metrics make consumer ABS even less appealing. Stay underweight. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in December, and by 233 bps in 2019. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month. It currently sits at 71 bps, below its average pre-crisis level but somewhat above levels seen during the past two years (Chart 10). The macro outlook for commercial real estate (CRE) is somewhat unfavorable, with lenders tightening loan standards (panel 4) in an environment of tepid demand. The Fed’s Senior Loan Officer Survey shows that banks saw slightly stronger demand for nonfarm nonresidential CRE loans in Q3, after four consecutive quarters of falling demand (bottom panel). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 16 basis points in December, but outperformed the benchmark by 91 bps in 2019. The index option-adjusted spread widened 4 bps on the month, and currently sits at 57 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this high-rated sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 22 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Setbacks Setbacks Setbacks Setbacks Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of January 3, 2020) Setbacks Setbacks Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of January 3, 2020) Setbacks Setbacks Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 33 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 33 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Setbacks Setbacks Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of January 3, 2020) Setbacks Setbacks Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 2 For details on how we arrive at our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 6 Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 9 For further details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Chart 1Manufacturing PMIs Track Bond Yields Manufacturing PMIs Track Bond Yields Manufacturing PMIs Track Bond Yields November’s manufacturing PMI data were released yesterday, giving us an update for two of our preferred global growth indicators: the Global Manufacturing PMI and the US ISM Manufacturing PMI (Chart 1). Unfortunately, the two indicators sent conflicting signals, providing us with very little clarity on the global growth outlook. On the positive side, the Global Manufacturing PMI jumped back above 50 for the first time since April. China is the largest weighting in the global index, and its PMI rose for the fifth consecutive month. Conversely, the US ISM Manufacturing PMI dipped further into contractionary territory in November – from 48.3 to 48.1. Optimistically, the index’s inventory component contracted by more than the new orders component, meaning that the difference between new orders and inventories rose to its highest level since May. The difference between new orders and inventories often leads the overall ISM index by several months. All in all, we continue to see tentative signs of stabilization in our preferred global growth indicators. But a more significant rebound will be necessary to push bond yields higher in the first half of next year, as we expect. Stay tuned. Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 63 basis points in November, bringing year-to-date excess returns up to +494 bps. We consider three main factors in our credit cycle analysis: (i) corporate balance sheet health, (ii) monetary conditions and (iii) valuation.1 On balance sheets, our top-down measure of gross leverage is high and rising (Chart 2). In contrast, interest coverage ratios remain solid, propped up by the Fed’s accommodative stance. With inflation expectations still depressed, the Fed can maintain its “easy money” policy for some time yet. The third quarter’s tightening of C&I lending standards is a concern, because it suggests that monetary conditions may not be sufficiently stimulative for banks to keep the credit taps running (bottom panel). But the yield curve, another indicator of monetary conditions, has steepened significantly since Q3, suggesting that lending standards will soon move back into “net easing” territory. For now, we see valuation as the main headwind for investment grade credit spreads. Spreads for all credit tiers are below our targets, with the Baa tier looking less expensive than the others (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds, with a preference for the Baa credit tier. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher (see page 7). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Mixed Messages Mixed Messages Table 3BCorporate Sector Risk Vs. Reward* Mixed Messages Mixed Messages High-Yield Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 47 basis points in November, bringing year-to-date excess returns up to +671 bps. The index option-adjusted spread tightened 22 bps on the month and currently sits at 370 bps, 131 bps above our target (Chart 3). Ba and B rated junk bonds outperformed the Treasury benchmark by 79 bps and 76 bps, respectively, in November. But Caa-rated credit underperformed Treasuries by 89 bps. This continues the trend of Caa underperformance that has been in place since late last year (panel 3). We analyzed the divergence between Caa and the rest of the junk bond universe in last week’s report and came to two conclusions.3 First, the historical data show that 12-month periods of overall junk bond outperformance are more likely to be followed by underperformance if Caa is the worst performing credit tier. Second, we can identify several reasons for this year’s Caa underperformance that make us inclined to downplay any potential negative signal. Specifically, we note that the Caa credit tier’s exposure to the shale oil sector is responsible for the bulk of this year’s underperformance (bottom panel). With elevated spreads, accommodative monetary conditions and a looming recovery in global economic growth, we expect junk spreads to tighten during the next 6-12 months.    MBS: Overweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in November, bringing year-to-date excess returns up to +22 bps. The conventional 30-year zero-volatility spread tightened 3 bps on the month, as a 5 bps tightening of the option-adjusted spread (OAS) was offset by a 2 bps increase in expected prepayment losses (aka option cost). We recommend an overweight allocation to Agency MBS, particularly relative to corporate bonds rated A or higher, for three reasons.4 First, expected compensation is competitive. The conventional 30-year MBS OAS is now 50 bps (Chart 4). This is very close to its pre-crisis average and only 3 bps below the spread offered by Aa-rated corporate bonds (panel 4). Also, spreads for all investment grade corporate bond credit tiers trade below our targets. Second, risk-adjusted compensation heavily favors MBS. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most homeowners have already had at least one opportunity to refinance their mortgages. This burnout will keep refi activity low, and MBS spreads tight (panel 2). Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 14 basis points in November, bringing year-to-date excess returns up to +197 bps. Sovereign debt outperformed duration-equivalent Treasuries by 36 bps on the month, bringing year-to-date excess returns up to +513 bps. Local Authorities outperformed the Treasury benchmark by 24 bps, bringing year-to-date excess returns up to +245 bps. Meanwhile, Foreign Agencies outperformed by 4 bps, bringing year-to-date excess returns up to +266 bps. Domestic Agencies outperformed by 11 bps in November, bringing year-to-date excess returns up to +51 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +36 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to US corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.5 This is also true for Foreign Agencies and Local Authorities, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).6 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 70 basis points in November, bringing year-to-date excess returns up to +6bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell 4% in November, and currently sits at 83% (Chart 6). We upgraded municipal bonds in early October, as yield ratios had become significantly more attractive, especially at the long-end of the Aaa curve (panel 2).7 Specifically, 2-year and 5-year M/T yield ratios are somewhat below average pre-crisis levels at 68% and 72%, respectively. However, M/T yield ratios for longer maturities (10 years and higher) are all above average pre-crisis levels. M/T yield ratios for 10-year, 20-year and 30-year maturities are 84%, 93% and 97%, respectively. Fundamentally, state & local government balance sheets remain solid. Our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outnumber downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve shifted higher in November, steepening out to the 7-year maturity and flattening beyond that. The 2/10 Treasury slope was unchanged on the month. It currently sits at 17 bps. The 5/30 slope flattened 7 bps to end the month at 59 bps (Chart 7). In a recent report we discussed the 6-12 month outlook for the 2/10 Treasury slope.8 We considered the main macro factors that influence the slope of the yield curve: Fed policy, wage growth, inflation expectations and the neutral fed funds rate. We concluded that the 2/10 slope has room to steepen during the next few months, as the Fed holds down the front-end of the curve in an effort to re-anchor inflation expectations. However, we see the 2/10 slope remaining in a range between 0 bps and 50 bps, owing to strong wage growth and downbeat neutral rate expectations. Despite the outlook for modest curve steepening, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. This position offers strong positive carry (bottom panel), due to the extreme overvaluation of the 5-year note, and looks attractive on our yield curve models (see Appendix B). TIPS: Overweight   Chart 8TIPS Market Overview Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 47 basis points in November, bringing year-to-date excess returns up to -70 bps.The 10-year TIPS breakeven inflation rate rose 8 bps on the month and currently sits at 1.62%. The 5-year/5-year forward TIPS breakeven inflation rate rose 9 bps on the month and currently sits at 1.73%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations remains stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target for most of the year (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. As we have pointed out in prior research, it can take time for expectations to adapt to a changing macro environment.9 That being said, the 10-year TIPS breakeven inflation rate is currently 29 bps too low according to our Adaptive Expectations Model, a model whose primary input is 10-year trailing core inflation (panel 4). It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor inflation expectations near desired levels. We anticipate that the committee will do so, and maintain our view that long-dated TIPS breakevens will move above 2.3% before the end of the cycle. ABS: Underweight Asset-Backed Securities outperformed the duration-equivalent Treasury index by 7 basis points in November, bringing year-to-date excess returns up to +74 bps. Chart 9ABS Market Overview ABS Market Overview ABS Market Overview The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month. It currently sits at 34 bps; its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS rank among the most defensive US spread products and also offer more expected return than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends continue to shift in the wrong direction. The consumer credit delinquency rate is still low, but has put in a clear bottom. The is true for the household interest expense ratio (panel 3). Senior Loan Officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, our favorable outlook for global growth causes us to shy away from defensive spread products, and deteriorating ABS credit metrics are also a cause for concern. Stay underweight. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in November, dragging year-to-date excess returns down to +221 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month. It currently sits at 72 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate (CRE) is somewhat unfavorable, with lenders tightening loan standards (panel 4) in an environment of tepid demand. The Fed’s Senior Loan Officer Survey shows that banks saw slightly stronger demand for nonfarm nonresidential CRE loans in Q3, after four consecutive quarters of falling demand (bottom panel). CRE prices are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 7 basis points in November, bringing year-to-date excess returns up to +107 bps. The index option-adjusted spread tightened 2 bps on the month, and currently sits at 54 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this high-rated sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 26 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index.   To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Mixed Messages Mixed Messages Mixed Messages Mixed Messages 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 November 29 2019) Mixed Messages Mixed Messages 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 November 29, 2019) Mixed Messages Mixed Messages 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 45 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 45 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) Mixed Messages Mixed Messages Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of November 29, 2019) Mixed Messages Mixed Messages Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2   For details on how we arrive at our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3  Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 4  Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 5  Please see US Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 6  Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 7  Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8  Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 9  Please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com   Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Global: Global growth momentum is bottoming out, leading indicators are improving, inflation is subdued, and central bankers are biased to maintain accommodative monetary policies. This is a bullish “sweet spot” for financial markets, suggesting further upside for global risk assets like equities and corporate credit, especially relative to government bonds. US: The overall US economy is weathering the storm from the global manufacturing slump, which is showing signs of bottoming out.  Stay below-benchmark on US Treasury duration, with an initial yield target of 2.25% for the benchmark 10-year. Canada: The Bank of Canada is hinting that “insurance” rate cuts may be needed, but with the Canadian economy and inflation both remaining resilient, the central bank is more likely to keep rates steady until global growth improves.  Stay neutral on Canadian government bonds, for now, but prepare to move to underweight in early 2020. Feature After knocking on the door several times in recent weeks, global equity markets are finally enjoying a true breakout.  In the U.S., the S&P 500 is setting new all-time highs on a daily basis, while equities in Europe and emerging markets (EM) are also registering solid gains. There is no conflicting signal from global corporate credit markets where spreads remain stable, or from the volatility space with measures like the US VIX index hovering near the 2019 lows. Chart Of The WeekThings Are Looking Up Things Are Looking Up Things Are Looking Up Despite this positive price action, many remain skeptical that this “risk rally” is sustainable.  Just last week, a headline in the Financial Times declared that the “U.S. stock market’s new highs baffles investors”. We find that reluctance to accept the equity market strength to be even more baffling, as the current macro backdrop is a perfect “sweet spot” for risk assets to do well.  Global economic momentum is bottoming out, with improving leading indicators suggesting better days lie ahead for growth.  A majority of central banks worldwide have eased monetary policy over the past several months, providing a more supportive liquidity backdrop for financial markets.  The world’s most important central bank, the Federal Reserve, has delivered a cumulative -75bps of rate cuts since July, helping to cool off the US dollar, which is now flat on a year-over-year basis in trade-weighted terms (Chart Of The Week).  A softening dollar is also often a signal that global growth is improving, as it indicates a shift in capital flows into more economically-sensitive non-U.S. markets like Europe and EM.  Thus, a weaker greenback combined with better global growth prospects should help lift global bond yields by raising depressed inflation expectations (middle panel).  The “sweet spot” of accelerating growth and easy money will support the continued outperformance of global equities and credit over government bonds, in an environment of gently rising bond yields. Yet with policymakers worldwide still playing the stimulus game, fearful of persistent negative impacts on growth from the U.S.-China trade dispute and other political uncertainties, it will take a large and sustained increase in inflation expectations before there is any shift to a more hawkish global policy bias.  This is critical for bond markets, as a much bigger move higher in global bond yields would require not just a pricing out of rate cut expectations, but the pricing in of future rate hikes. Such a repricing will not occur before there is clear evidence that global growth, broadly speaking, is accelerating for a sustained period and not just stabilizing in a few countries. The earliest we can envision such a hawkish shift for global monetary policy would be late in 2020, led by the Fed signaling a removal of some of the “insurance” rate cuts of 2019.  Until that happens, the “sweet spot” of accelerating growth and easy money will support the continued outperformance of global equities and credit over government bonds, in an environment of gently rising bond yields. The Art Of Analyzing Economic Data At Turning Points Typically, at turning points in the global growth cycle, there are always data available to support the arguments of both optimists and pessimists. That is certainly the case today, where so-called “hard” economic data that is reported with a lag (i.e. exports, durable goods orders) remains weak, but leading indicators are starting to improve. For example, the global manufacturing PMI data for October released last week shows the following (Chart 2): strong pickup in China, with the Caixin manufacturing PMI now up to 51.7; slight improvement in the US ISM manufacturing index, which rose from 47.8 to 48.3 in the month but remains below the 50 boom/bust line; bounce in the U.K. Markit manufacturing PMI index, rising from 48.3 to 49.6; the slightest of increases in the overall euro area Markit manufacturing PMI, from 45.7 to 45.9, still below the 50 line but showing marginal improvement in the critical German PMI; Continued weakness in the Japanese Markit manufacturing PMI, which fell to 48.4. The relative message from the PMIs fits with the signals sent from the OECD leading economic indicators (LEI) for those same countries, with the China LEI strengthening the most and the LEIs in Europe and Japan still struggling. The US is a mixed bag, with the ISM ticking up but the LEI languishing. There is, however, a sign of optimism in the export sub-index of the ISM manufacturing data. That measure surged nine points in October from 41.0 to 50.4, signaling a potential bottoming of the overall ISM index within the next three months (Chart 3).  While the ISM exports index is volatile, the modest improvement seen in the export order series from the China manufacturing PMI over the past few months (bottom panel) suggests that there may be a more significant improvement in global trade activity brewing – as signaled by the improvement in our global LEI index. Another possible explanation for the reduction in U.S. capital spending is slowing growth in corporate profits, which is related to a number of factors beyond the impact of tariffs and the trade war. Chart 2Global PMIs Are A Mixed Bag Global PMIs Are A Mixed Bag Global PMIs Are A Mixed Bag Chart 3Momentum Turning For The Trade Warriors? Momentum Turning For The Trade Warriors? Momentum Turning For The Trade Warriors? Bottom Line: Global growth momentum is bottoming out, leading indicators are improving, inflation is subdued, and central bankers are biased to maintain accommodative monetary policies. This is a bullish “sweet spot” for financial markets, suggesting further upside for global risk assets like equities and corporate credit, especially relative to government bonds. US Capital Spending Slowdown:  Only A Cautious Pause Chart 4Rising Uncertainty? Or Just Slowing Profit Growth? Rising Uncertainty? Or Just Slowing Profit Growth? Rising Uncertainty? Or Just Slowing Profit Growth? For growth pessimists in the US, a modest boost to “soft” data like the ISM does not allay their concerns about a broadening US economic slowdown. The trade war with China and the global manufacturing recession have had a clear negative impact on business confidence when looking at measures like the Conference Board CEO survey.  At the same time, US capital spending has contracted in real terms during the 2nd and 3rd quarter of 2019.  A logical inference would be to say that uncertainty over the trade war has led to a reduction in capex. Another possible explanation for the reduction in U.S. capital spending is slowing growth in corporate profits, which is related to a number of factors beyond the impact of tariffs and the trade war. Like the fading impact of the 2018 U.S. corporate tax cuts (that helped trigger a surge in after-tax earnings growth) and the squeeze on profit margins from higher labor costs. On a year-over-year basis, US profit growth has slowed from nearly 25% in 2018 to 1.8% in the 3rd quarter (a projection based on the 76% of S&P 500 companies that have already reported).  The real non-residential investment spending category from the US GDP accounts has slowed alongside profits, from 6.8% to 1.3% on a year-over-year basis (Chart 4). At the same time, annual growth in US non-farm payrolls has slowed only modestly from 1.91% to 1.4%, with average hourly earnings growth falling from a 2019 peak of 3.4% to 3.0% in October. Given the tightness of the US labor market, with firms continuing to report difficulties in finding quality labor, it should come as no surprise that employment and wages have not slowed as much as capital spending, despite the sharp downturn in profit growth.  Businesses that see their earnings getting squeezed will seek to protect profits by cutting back on investment and hiring activity. With a tight labor market, however, cutting capital spending is an easier and less costly decision than laying off workers, as it may be even harder to re-hire those employees if the economy starts to improve once again. With the US Treasury curve no longer inverted, after -75bps of Fed rate cuts and with longer-dated Treasury yields starting to increase, the US economy is stepping back from the recessionary abyss that worried investors during the summer. That can also be seen when breaking down the US non-residential investment data into its broad sub-components (Chart 5).  On a contribution-to-growth basis, the only part of US investment spending that is outright contracting year-over-year is Structures. There is still modest positive annual growth in Equipment investment, although that did contract on a quarter-on-quarter basis in Q3/2019. The Intellectual Property Products category (which includes Software, in addition to Research & Development) continues to expand at a steady pace. Chart 5Slowing US Capex Focused On Structures How Sweet It Is How Sweet It Is Chart 6The Fed Has Dis-Inverted The UST Curve The Fed Has Dis-Inverted The UST Curve The Fed Has Dis-Inverted The UST Curve So similar to signals from global PMIs and LEIs, the U.S. capital spending and employment data are sending a mixed message about U.S. growth. Yes, capital spending has slowed but the bulk of the deceleration has come in the component where canceling or delaying investment plans is easiest – buildings and construction. It is not necessarily an indication that a deeper economic downturn is unfolding. Similar cutbacks in Structures investment, without a broader decline in overall capital spending, occurred in 2013 and 2015/16.  During the past two U.S. recessions in 2001 and 2008, however, all categories of capital spending contracted. If we look at the breakdown of the contribution to US investment spending today, the backdrop looks more like those non-recessionary years. With the US Treasury curve no longer inverted, after -75bps of Fed rate cuts and with longer-dated Treasury yields starting to increase, the US economy is stepping back from the recessionary abyss that worried investors during the summer (Chart 6).  The trade détente between the US and China will help boost depressed business confidence, especially with global growth already showing signs of bottoming out. This, along with a softer US dollar and some easing of wage pressures, will help put a floor underneath US corporate profit growth. Treasury yields have more upside from here, as markets are still priced for -25bps of Fed rate cuts over the next year that is unlikely to happen if the US economy rebounds, as we expect.  Bottom Line:  The overall US economy is weathering the storm from the global manufacturing slump, which is showing signs of bottoming out.  Stay below-benchmark on US Treasury duration, with an initial yield target of 2.25% for the benchmark 10-year. The Bank Of Canada’s Newfound Caution Is Unwarranted Chart 7Canada Is A High-Beta Bond Market Canada Is A High-Beta Bond Market Canada Is A High-Beta Bond Market The Bank of Canada (BoC) has been one of the few central banks to resist the shift towards easier global monetary policy in 2019.  This has resulted in Canadian government bonds trading at relatively wide yield spreads to other countries in the developed world, even as global growth has slowed in 2019 (Chart 7).  With global growth now set to improve over the next 6-12 months, Canada’s historic status as a “high yield beta” bond market during periods of rising global yields suggests that Canadian government bonds should underperform in 2020. However, in the press conference following last week’s policy meeting, BoC Governor Stephen Poloz noted that the BoC was “mindful that the resilience of Canada’s economy will be increasingly tested as trade conflicts and uncertainty persist.” Poloz even revealed that an “insurance” rate cut was discussed at the policy meeting, although the BoC Governing Council decided against it.  This is similar language to that parroted by the more dovish global central bankers over the past several months, raising the risk that Canada could be a lower-beta bond market if the Canadian economy falters. That outcome seems unlikely, given the indications of improving growth momentum, occurring alongside tight labor markets and stable inflation: The RBC/Markit Canadian manufacturing PMI has climbed from a trough of 49 in May to 51 in October, indicating that real GDP growth accelerated in Q3 (Chart 8, top panel); The BoC’s Autumn 2019 Business Outlook Survey (BoS) showed that an increasing share of firms are reporting labor shortages, coinciding with a sharp pickup in the annual growth rate of average weekly earnings to just over 4% (middle panel); Core inflation measures remain right at the midpoint of the BoC’s 1-3% target range, although breakeven inflation rates from Canadian Real Return Bonds remain closer to the bottom end of that range (bottom panel); After a long period of adjustment, house prices and housing activity are showing some signs of recovery in response to easier financial conditions, rising household incomes and improved affordability (Chart 9); Chart 8Resilience In Canadian Growth & Inflation Resilience In Canadian Growth & Inflation Resilience In Canadian Growth & Inflation Chart 9Canadian Housing Showing Improvement Canadian Housing Showing Improvement Canadian Housing Showing Improvement Canadian investment spending is set to pick up, as the Autumn 2019 BoS reported a modest improvement in overall business sentiment and an increase in capital spending plans with a growing number of firms facing capacity pressures (Chart 10). Our bias is to downgrade Canadian government bonds to underweight heading into 2020, as we expect a return to their typical high-beta status during a period of accelerating global growth and rising bond yields. Chart 10Signs Of Life For Canadian Capex? Signs Of Life For Canadian Capex? Signs Of Life For Canadian Capex? Looking forward, reduced U.S.-China trade tensions should provide a boost to Canadian capex. Firms that had previously held off in the past few months due to the slowdown in the economy, caused partially by worries over global trade, will start to invest again. The BoC’s updated forecasts in the latest Monetary Policy Report released last week showed that the central bank expects Canadian exports to resume their expansion in 2020 – despite Governor Poloz’s stated concerns over global growth. Oil and gas exports are expected to improve as pipeline and rail capacity gradually expand, while consumer goods excluding automobiles should remain strong. Improvement in Chinese economic activity would provide a meaningful lift to Canadian exports, as Chinese imports from Canada are still contracting at a double-digit rate (Chart 11).  More importantly, Canadian exports to the country’s largest trade partner, the US, have already stabilized and should accelerate as the US economy gains momentum in the next 6-12 months. As Governor Poloz mentioned during the press conference, the BoC's decisions are not going to be directly influenced by political events such as Prime Minister Justin Trudeau’s recent re-election. Yet the odds of Canadian fiscal stimulus have shot up after Trudeau could only secure a minority government in the Canadian Parliament. Any fiscal stimulus is starting from a healthier place with the budget deficit currently at only -1% of GDP and the net government debt-to-GDP ratio falling towards a low 40% level (Chart 12).  Expected fiscal stimulus will provide an incremental boost to Canadian growth in 2020. Chart 11The Global Trade Slump Has Hurt Canada The Global Trade Slump Has Hurt Canada The Global Trade Slump Has Hurt Canada Chart 12Canada Can Afford A Fiscal Stimulus Canada Can Afford A Fiscal Stimulus Canada Can Afford A Fiscal Stimulus Net-net, the Canadian economy appears to be in good shape, with momentum starting to improve.  Inflation remains close to the BoC target, with rising pressures stemming from a tight labor market. This is not a backdrop that would be conducive to an “insurance” rate cut in December or even in early 2020.  Only -18bps of rate cuts over the next twelve months are discounted in the Canadian Overnight Index Swap (OIS) curve. Yet there is only a 16% chance of a -25bp cut expected at the December 2019 meeting, according to Bloomberg.  In other words, the markets are not taking the threat of a BoC rate cut seriously – a view that we agree with. Chart 13Stay Neutral On Canadian Government Bonds Stay Neutral On Canadian Government Bonds Stay Neutral On Canadian Government Bonds We suspect that Governor Poloz’s comments about a potential BoC policy ease were more designed to take some steam out of the strengthening Canadian dollar (Chart 13), which was threatening a major breakout going into last week’s BoC meeting.  We would be surprised if a rate cut was delivered at the December 2019 BoC meeting, but the dovish message sent last week does raise the possibility that the BoC could shock us. For now, we are choosing to stick with our neutral recommendation on Canadian government bonds, but we will re-evaluate after the December 4 BoC meeting. Our bias is to downgrade Canadian government bonds to underweight heading into 2020, as we expect a return to their typical high-beta status during a period of accelerating global growth and rising bond yields. Bottom Line: The Bank of Canada is hinting that “insurance” rate cuts may be needed, but with the Canadian economy and inflation both remaining resilient, the central bank is more likely to keep rates steady until global growth improves.  Stay neutral on Canadian government bonds, for now, but prepare to move to underweight in early 2020. A Brief Follow Up To Our US MBS Versus IG Corporates Recommendation Chart 14Spread Targets Reached - Downgrade US IG To Neutral Spread Targets Reached - Downgrade US IG To Neutral Spread Targets Reached - Downgrade US IG To Neutral In last week’s report, we made the case for raising allocations to US Agency MBS while reducing exposure to higher-quality US investment grade (IG) corporate credit.1 We implemented the trade in our model bond portfolio, lowering our recommended allocation to US IG and increasing the weighting to US Agency MBS.  We now see a case for shifting to a formal strategic recommendation, upgrading US Agency MBS to overweight (a ranking of 4 out of 5 in the tables on page 14) and downgrading US IG to neutral (3 out of 5).  The rationale for the shift is based on valuation. Our colleagues at BCA Research US Bond Strategy calculate spread targets for each credit tier within US IG (Aaa, Aa, A and Baa). The targets are determined using a methodology that ranks the option-adjusted spread (OAS) of the Bloomberg Barclays index for each credit tier relative to its history, while controlling for the “phase” of the economic cycle as determined by the slope of the US Treasury yield curve.2 The latest rally in IG has driven the OAS for all tiers below those targets, with the Baa tier looking less expensive than the others (Chart 14).  As a result, we now advise only a neutral allocation to US IG corporates, with a preference for the Baa credit tier. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1Please see BCA Research Global Fixed Income Strategy Weekly Report, “Big Mo(mentum) Is Turning Positive”, dated Oct 29, 2019, available at gfis.bcaresearch.com 2For details on how those spread targets are determined, please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index How Sweet It Is How Sweet It Is Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1The Fed Must Remain Dovish The Fed Must Remain Dovish The Fed Must Remain Dovish Many were quick to label last week’s FOMC decision a “hawkish cut”. This is somewhat true in the near-term. The Fed lowered rates by 25 basis points while signaling that it doesn’t expect to have to cut more. But this focus on the near-term rate path misses the big picture. In the post-meeting press conference, Chairman Powell mentioned inflation expectations several different times. At one point, he called them “central” to the Fed’s framework and said “we need them to be anchored at a level that’s consistent with our symmetric 2 percent inflation goal.” As of today, the 5-year/5-year forward TIPS breakeven inflation rate is 1.69%, well short of the 2.3%-2.5% range that is consistent with the Fed’s goal (Chart 1). The Fed will take care to maintain an accommodative policy stance until inflation expectations are re-anchored. This will provide strong support for risk assets, and we recommend overweight positions in spread product versus Treasuries. We also expect that global growth will improve enough in the coming months for the Fed to keep its promise to stand pat. With the market still priced for 29 bps of cuts during the next 12 months, investors should keep portfolio duration low. Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in October, bringing year-to-date excess returns up to +429 bps. We consider three main factors in our credit cycle analysis: (i) corporate balance sheet health, (ii) monetary conditions and (iii) valuation.1 On balance sheets, our top-down measure of gross leverage is elevated and rising (Chart 2). In contrast, interest coverage ratios remain solid, propped up by the Fed’s accommodative stance. With inflation expectations still depressed, the Fed can maintain its “easy money” policy for some time yet. The Fed’s Senior Loan Officer survey shows that C&I lending standards tightened in Q3 (bottom panel). We expect the Fed’s accommodative stance to push standards back into “net easing” territory in Q4. But if standards continue to tighten, it could indicate that monetary conditions are not as accommodative as we think. For now, we see valuation as the main headwind for investment grade credit spreads. Spreads for all credit tiers are now below our targets, with the Baa tier looking less expensive than the others (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds, with a preference for the Baa credit tier. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Fed Will Stay Supportive The Fed Will Stay Supportive Table 3BCorporate Sector Risk Vs. Reward* The Fed Will Stay Supportive The Fed Will Stay Supportive High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield performed in line with the duration-equivalent Treasury index in October, keeping year-to-date excess returns steady at +621 bps. The junk index’s option-adjusted spread (OAS) has been fairly stable for most of the year, but the sector has become increasingly attractive from a risk/reward perspective.3 This is because the index’s negatively convex nature has caused its average duration to fall alongside declining Treasury yields. Chart 3 shows that while the index OAS has been rangebound, the 12-month breakeven spread has widened considerably.4 In other words, while junk expected returns have been stable, those expected returns now come with considerably less risk. As a result, the junk index OAS looks increasingly attractive relative to our spread target.5 Specifically, we now view the junk index OAS as 141 bps cheap (panel 3). Falling index duration also explains the divergence between quality spreads and the index OAS. Many have observed that the spread differential between Caa and Ba-rated junk bonds has widened in recent months, while the overall index OAS has been stable (panel 4). However, the divergence evaporates when we look at 12-month breakeven spreads instead of OAS (bottom panel). MBS: Overweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in October, bringing year-to-date excess returns up to +3 bps. The conventional 30-year zero-volatility spread widened 4 bps on the month, as a 5 bps widening of the option-adjusted spread (OAS) was partially offset by a 1 bp decline in option cost (i.e. the expected losses from prepayments). This week we recommend upgrading Agency MBS from neutral to overweight, and in particular, we recommend favoring Agency MBS over corporate bonds rated A or higher. We have three main reasons for this recommendation.6 First, expected compensation is competitive. The conventional 30-year MBS OAS is now 53 bps. This is above its pre-crisis average (Chart 4), and only 4 bps below the spread offered by a Aa-rated corporate bond. All investment grade corporate bond credit tiers also look expensive relative to our spread targets. Second, risk-adjusted compensation heavily favors MBS. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most people have already had at least one opportunity to refinance their mortgages. This burnout will keep refi activity low, and MBS spreads tight (panel 2). Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 20 basis points in October, bringing year-to-date excess returns up to +183 bps. Sovereign debt outperformed duration-equivalent Treasuries by 38 bps on the month, bringing year-to-date excess returns up to +475 bps. Local Authorities outperformed the Treasury benchmark by 9 bps, bringing year-to-date excess returns up to +220 bps. Meanwhile, Foreign Agencies outperformed by 63 bps, bringing year-to-date excess returns up to +261 bps. Domestic Agencies underperformed by 2 bps in October, dragging year-to-date excess returns down to +40 bps. Supranationals underperformed by 8 bps on the month, dragging year-to-date excess returns down to +31 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to U.S. corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.7 This is also true for Foreign Agencies and Local Authorities, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).8  Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 7 basis points in October, dragging year-to-date excess returns down to -64 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell almost 2% in October, and currently sits at 85% (Chart 6). We recently upgraded municipal bonds from neutral to overweight.9 The decision was based on the fact that yield ratios had jumped significantly. Yield ratios continue to look attractive relative to average pre-crisis levels, especially at the long-end of the Aaa curve (panel 2). Specifically, 2-year and 5-year M/T yield ratios are close to average pre-crisis levels at 73% and 77%, respectively. Meanwhile, M/T yield ratios for longer maturities are all above average pre-crisis levels. M/T yield ratios for 10-year, 20-year and 30-year maturities are 86%, 94% and 97%, respectively.   Fundamentally, state & local government balance sheets remain solid. Our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outnumber downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve steepened considerably in October, as short-dated yields came under downward pressure even as long-maturity yields edged higher. The 2/10 Treasury slope steepened 12 bps on the month, and currently sits at 17 bps. The 5/30 slope steepened 9 bps on the month, and currently sits at 66 bps (Chart 7). Last week’s report discussed the outlook for the 2/10 Treasury slope on a 6-12 month horizon.10 We considered the main macro factors that influence the slope of the yield curve: Fed policy, wage growth, inflation expectations and the neutral fed funds rate. We concluded that the 2/10 slope has room to steepen during the next few months, as the Fed holds down the front-end of the curve in an effort to re-anchor inflation expectations. However, we see the 2/10 slope remaining in a range between 0 bps and 50 bps, owing to strong wage growth and downbeat neutral rate expectations. Despite the outlook for modest curve steepening, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. This position offers strong positive carry (bottom panel), due to the extreme overvaluation of the 5-year note, and looks attractive on our yield curve models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 27 basis points in October, bringing year-to-date excess returns up to -64 bps. The 10-year TIPS breakeven inflation rate rose 1 bp on the month, and currently sits at 1.60%. The 5-year/5-year forward TIPS breakeven inflation rate fell 8 bps on the month, and currently sits at 1.69%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations is becoming increasingly stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target for most of the year (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. As we have pointed out in prior research, it can take time for expectations to adapt to a changing macro environment.11 That being said, the 10-year TIPS breakeven rate is currently 32 bps too low according to our Adaptive Expectations Model, a model whose primary input is 10-year trailing core inflation (panel 4). It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor inflation expectations near desired levels. We anticipate that the committee will do so, and maintain our view that long-dated TIPS breakevens will move above 2.3% before the end of the cycle. ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in October, dragging year-to-date excess returns down to +67 bps. The index option-adjusted spread for Aaa-rated ABS widened 5 bps on the month. It currently sits at 39 bps, 5 bps above its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS rank among the most defensive U.S. spread products and also offer more expected return than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends continue to shift in the wrong direction. The consumer credit delinquency rate is still low, but has put in a clear bottom. The same is true for the household interest expense ratio (panel 3). Senior loan officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, our favorable outlook for global growth causes us to shy away from defensive spread products, and deteriorating ABS credit metrics are also a cause for concern. Stay underweight. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in October, bringing year-to-date excess returns up to +233 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS was flat on the month. It currently sits at 73 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate (CRE) is somewhat unfavorable, with lenders tightening loan standards (panel 4) in an environment of tepid demand. The Fed’s Senior Loan Officer survey shows that banks saw slightly stronger demand for nonfarm nonresidential CRE loans in Q3, after four consecutive quarters of falling demand (bottom panel). CRE prices have accelerated of late, but are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in October, bringing year-to-date excess returns up to +100 bps. The index option-adjusted spread was flat on the month, and currently sits at 57 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this high-rated sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 29 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. The Fed Will Stay Supportive The Fed Will Stay Supportive The Fed Will Stay Supportive The Fed Will Stay Supportive 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: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. 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 Valuations: Raw Residuals In Basis Points (As Of November 1, 2019) The Fed Will Stay Supportive The Fed Will Stay Supportive 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 November 1, 2019) The Fed Will Stay Supportive The Fed Will Stay Supportive 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 48 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 48 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Fed Will Stay Supportive The Fed Will Stay Supportive 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 U.S. bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of November 1, 2019) The Fed Will Stay Supportive The Fed Will Stay Supportive Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 For details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Crisis Of Confidence”, dated October 22, 2019, available at usbs.bcaresearch.com 4 The 12-month breakeven spread is the spread widening required to break even with a duration-matched position in Treasuries on a 12-month horizon. It can be approximated by OAS divided by duration. 5 For details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 8 Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “Two Themes and Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Equities & Bonds: The accelerating upward momentum of global equities – the ultimate “leading economic indicator” – suggests that the current rise in global bond yields can continue. Maintain below-benchmark overall duration exposure, while staying overweight global corporate credit versus government bonds. U.S. Agency MBS: U.S. agency MBS spreads are now attractive relative to high-quality U.S. corporate bonds, both in absolute terms and on a risk-adjusted basis. Increase allocations to agency MBS, while reducing exposure to Aaa-, Aa- and A-rated U.S. corporates. Feature The U.S. Federal Reserve and European Central Bank (ECB) are both set to ease monetary policy this week. The Fed is almost certain to deliver a third consecutive 25bp rate cut at tomorrow’s FOMC meeting, while the ECB will restart its bond buying program on Friday. Yet government bond yields around the world continue to drift higher, as markets reduce expectations of incremental rate cuts moving forward. Equity prices are an excellent leading indicator of global growth, while bond yields typically reflect current economic conditions. Thus, equity prices should be considered a leading indicator of bond yields. Chart of the WeekMore Upside For Global Bond Yields More Upside For Global Bond Yields More Upside For Global Bond Yields Yields are finally responding to the evidence that global growth is troughing - a dynamic that we have been telegraphing in recent weeks. Global equity markets are rallying, with the U.S. S&P 500 hitting a new all-time high yesterday. The year-over-year increase in global equities, using the MSCI World Index, is now at +10%, the fastest pace of upward acceleration seen since January 2017. Some of that rally in U.S. stock markets can be chalked up to 3rd quarter earnings beating depressed expectations. Yet there is also a forward-looking component of the rally that bond markets are starting to notice. Equity prices are an excellent leading indicator of global growth, while bond yields typically reflect current economic conditions. Thus, equity prices should be considered a leading indicator of bond yields. We see no reason to discount the positive message on growth from rallying equity markets, especially when confirmed by an improvement in our global leading economic indicator (LEI), led by the more cyclical emerging market (EM) countries (Chart of the Week). Falling stock prices in 2018 accurately heralded the global growth slowdown of 2019 which triggered the huge decline in bond yields. Why should rising stock prices not be interpreted in the same light, predicting better global growth – and higher bond yields – over the next 6-12 months? Multiple Signals Point To Higher Bond Yields The more optimistic message on growth is not only confined to developed market (DM) stock prices. EM equities and currencies have begun to perk up, with EM corporate credit spreads remaining stable, as well, mimicking the moves seen in U.S. credit markets. Bond volatility measures like the U.S. MOVE index of Treasury options are retreating to the lower levels implied by equity volatility indices like the U.S. VIX index, which is now just above the 2019 low (Chart 2). Markets are clearly pricing out some of the more negative tail-risk outcomes that prevailed through much of 2019. Some of that reduction in volatility can be attributed to the recent de-escalation of U.S.-China trade tensions and U.K. Brexit risks, both important developments that can help lift depressed global business confidence. A reduction in trade/political uncertainty should help fortify the transmission mechanism between easing global financial conditions and economic activity – an outcome that could extend the rise in yields given stretched bond-bullish duration positioning (Chart 3). Chart 2A More Pro-Risk Global Market Backdrop A More Pro-Risk Global Market Backdrop A More Pro-Risk Global Market Backdrop Chart 3Less Uncertainty = Higher Yields Less Uncertainty = Higher Yields Less Uncertainty = Higher Yields The improving global growth story remains the bigger factor pushing bond yields higher, though. While the manufacturing PMI data within the DM world remain weak, the downward momentum is starting to bottom out on a rate-of-change basis (Chart 4). The EM aggregate PMI index is showing even more improvement, sitting at 51 and above the year-ago level, helping confirm the pickup in EM equity market momentum (bottom panel). Importantly, if this is indeed the trough in the EM PMI, the index would have bottomed above the 2015 trough of 48.5. Given the improvement seen in “Big Mo” for global equities and global LEIs and PMIs, we remain comfortable with our current below-benchmark stance on global interest rate duration exposure.  Given the improvement seen in “Big Mo” for global equities and global LEIs and PMIs, we remain comfortable with our current below-benchmark stance on global interest rate duration exposure. How high could yields rise in the near term? Looking at yields on a country-by-country level, a reasonable initial target for yields would be a return to the medium-term trend as defined by the 200-day moving average (MA). For benchmark 10-year DM government yields, those targets are: U.S. Treasuries: the 200-day MA is 2.18%, +23bps above the current level German Bunds: the 200-day MA is -0.22%, +11bps above the current level U.K. Gilts: the 200-day MA is 0.89%, +17bps above the current level Japanese government bonds (JGBs): the 200-day MA is -0.10%, +2bps above the current level Canadian government bonds: the 200-day MA is 1.59%, -2bps below the current level Australian government bonds: the 200-day MA is 1.53%, +43bps above the current level Among those markets, the U.S. is likely to reach the level implied by the 200-day MA, led by the market pricing out the -53bps of rate cuts over the next twelve months discounted in the U.S. Overnight Index Swap curve (Chart 5) – a number that includes the likely -25bp cut tomorrow. A move beyond that 200-day MA may take longer to develop, as it would require markets to begin pricing in some reversal of the Fed’s “mid-cycle cuts” of 2019. That outcome would first require a pickup in TIPS breakevens. The Fed would not feel justified in risking a tightening of financial conditions by signaling rate hikes without the catalyst of higher inflation expectations. Chart 4EM Growth Leading The Way? EM Growth Leading The Way? EM Growth Leading The Way? Chart 5UST Yields Have More Upside UST Yields Have More Upside UST Yields Have More Upside German Bund yields are even closer to that 200-day MA than Treasuries but, as in the U.S., a sustained move beyond that level would require an increase in bombed-out inflation expectations, with the 10-year EUR CPI swap rate now sitting at only 1.05% (Chart 6). As for other markets, the likelihood of reaching, or breaching, the 200-day MA is more varied (Chart 7). Chart 6Bund Yield Upside Limited By Inflation Bund Yield Upside Limited By Inflation Bund Yield Upside Limited By Inflation The move in the Canadian 10-year yield to just above its 200-day MA fits with Canada’s status as a “high-beta” bond market, as we discussed in last week’s report.1 Chart 7Which Yields Will Test The 200-day MA? Which Yields Will Test The 200-day MA? Which Yields Will Test The 200-day MA? The Bank of Canada also meets this week and, while no change in policy is expected, the central bank will be publishing a new Monetary Policy Report that will update their current line of thinking about the Canadian economy and inflation. U.K. Gilts should easily blow through the 200-day MA if and when a final Brexit deal is signed, as the Bank of England remains highly reluctant to consider any policy easing even as political uncertainty weighs on economic growth. With the European Union now agreeing to an extension of the Brexit deadline to January 31, and with U.K. prime minister Boris Johnson now pursuing an early election in December, the political risk premium in Gilts will persist. Thus, Gilt yields will likely lag the move higher seen in higher-beta markets like the U.S. and Canada. JGBs remain the ultimate low-beta bond market with the Bank of Japan continuing to anchor the 10-yield around 0%, making Japan a good overweight candidate in an environment of rising global bond yields. Australian bond yields have the largest distance to the 200-day MA, but the Reserve Bank of Australia is giving little indication that it is ready to shift away from its dovish bias anytime soon, while inflation remains subdued. We do not expect a rapid jump in yields back towards the medium-term trend in the near term, and Australian yields will continue to lag the pace of the uptrend in the higher-beta global bond markets. Net-net, a climb in yields over the next 3-6 months to (or beyond) the 200-day MA is most likely in the U.S. and Canada, and least likely in Japan, Germany and Australia (and the U.K. until the Brexit uncertainty is finally sorted out). Bottom Line: The accelerating momentum of global equities – the ultimate “leading economic indicator” – is suggesting that the current rise in global bond yields can continue. Maintain below-benchmark overall duration exposure, while staying overweight global corporate credit versus government bonds. Raise Allocations To U.S. Agency MBS Out Of Higher Quality Corporate Credit Chart 8U.S. MBS More Attractive Than High-Rated U.S. Corporates U.S. MBS More Attractive Than High-Rated U.S. Corporates U.S. MBS More Attractive Than High-Rated U.S. Corporates Our colleagues at our sister service, BCA Research U.S. Bond Strategy, recently initiated a recommendation to favor U.S. agency MBS versus high-rated (Aaa, Aa, A) U.S. corporate bonds.2 This week, we are adding this position to the BCA Research Global Fixed Income Strategy recommended model bond portfolio. There are three factors supporting this recommendation: 1) The absolute level of MBS spreads is competitive The average option-adjusted spread (OAS) for conventional 30-year U.S. agency MBS – rated Aaa and with the backing of U.S. government housing agencies - is currently 57bps. That is only 3bps below the spread on Aa-rated corporates and 26bps below that of A-rated credit. (Chart 8). 2) Risk-adjusted MBS spreads look very attractive Agency MBS exhibit negative convexity, with an interest rate duration that declines when yields fall. The opposite is true for positively convex investment grade corporate bonds, where the duration rises as yields decrease. This makes agency MBS look attractive on a risk-adjusted basis after the kind of big decline in bond yields seen in 2019. The average duration of the Bloomberg Barclays U.S. agency MBS index is now only 3.4 compared to 7.9 for an A-rated corporate bond. Both of those durations were around similar levels at the 2018 peak in U.S. bond yields, but now the gap between them is large. With those new durations, it would take a 17bp widening of the agency MBS spread for an investor to see losses versus duration-matched U.S. Treasuries, compared to only an 11bp widening of the A-rated corporate spread (bottom panel). This is a big change in the relative risk profile of agency MBS versus high-rated U.S. corporates compared to a year ago, making the former look relatively more attractive. That was not the case the last time agency MBS duration fell so sharply in 2015/16, since corporate bond spreads were widening (getting cheaper) at that time. Today, corporate bond spreads have been stable as corporate duration has increased and agency MBS duration has plunged, making risk-adjusted MBS spreads more attractive. Given our view that U.S. Treasury yields will continue to grind higher, favoring lower duration assets like agency MBS over higher duration investment grade corporates makes sense. Given our view that U.S. Treasury yields will continue to grind higher, favoring lower duration assets like agency MBS over higher duration investment grade corporates makes sense. 3) Macro risks are reduced Mortgage refinancing activity remains the biggest macro driver of MBS spreads, particularly in an environment when mortgage rates are falling and prepayments are accelerating. There was a pickup in refinancing activity over the past year as mortgage rates fell, but the increase has been small relative to similar-sized rate declines in the past (Chart 9). We interpret this as an indication that, after the sustained period of low mortgage rates seen in the decade since the Great Financial Crisis, most homeowners have already had an opportunity to refinance. In other words, the so-called “refi burnout“ is now quite high. Chart 9Muted Refi Activity Keeping Nominal U.S. MBS Spreads Low Muted Refi Activity Keeping Nominal U.S. MBS Spreads Low Muted Refi Activity Keeping Nominal U.S. MBS Spreads Low Beyond refinancing, the other macro risks for agency MBS are subdued. The credit quality of outstanding U.S. mortgages remains solid. The median credit (FICO) score for newly-issued mortgages remains high and stable near the post-2008 crisis highs, while mortgage lending standards have mostly been easing over that same period according to the Federal Reserve Senior Loan Officers Survey. In addition, U.S. housing activity remains solid, with the most reliable indicators like single-family new home sales and the National Association of Home Builders activity surveys all up solidly following this year’s sharp drop in mortgage rates (Chart 10). This makes MBS less risky for two reasons: a) stronger housing activity typically leads to higher mortgage rates, which limits future refi activity; and b) more robust housing demand will boost home prices, the value of the underlying collateral for MBS securities. Chart 10U.S. Housing Activity Hooking Up U.S. Housing Activity Hooking Up U.S. Housing Activity Hooking Up Chart 11Relative Value Favoring U.S. MBS Over U.S. Corporates Relative Value Favoring U.S. MBS Over U.S. Corporates Relative Value Favoring U.S. MBS Over U.S. Corporates Given the improved risk-reward balance of agency MBS versus higher-quality U.S. corporates, we recommend that dedicated fixed income investors make this shift within bond portfolios, reducing allocations to Aaa-rated, Aa-rated and A-rated corporates while increasing exposure to agency MBS. Agency MBS is part of the investment universe of our model bond portfolio. Thus, we are increasing the recommended weighting of agency MBS while reducing the exposure to U.S. investment grade corporates in the portfolio. The changes can be seen in the table on Page 11. We do not split out the investment grade exposure by credit tier in the portfolio, as we prefer to allocate by broad sector groupings (Financials, Industrials, Utilities). So we cannot implement the precise “MBS for high-rated corporates” switch in the model portfolio. There is still a case for reducing overall investment grade exposure and adding to MBS weightings, however. The relative option-adjusted spread of agency MBS and investment grade corporates typically leads the relative excess returns (over duration-matched U.S. Treasuries) between the two by around one year (Chart 11). Thus, the compression of the spread differential between MBS and corporates over the past year is signaling that agency MBS should be expected to outperform the broad U.S. investment grade universe over the next twelve months. Bottom Line: U.S. agency MBS spreads are now attractive relative to high-quality U.S. corporate bonds, both in absolute terms and on a risk-adjusted basis. Increase allocations to agency MBS, while reducing exposure to Aaa-, Aa- and A-rated U.S. corporates. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “Cracks Are Forming In The Bond-Bullish Narrative”, dated October 23, 2019, available at gfis.bcaresearch.com. 2 Please see BCA Research U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresarch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Big Mo(mentum) Is Turning Positive Big Mo(mentum) Is Turning Positive Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. Fed: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. Negative Convexity: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Feature Chart 1Positive Surprises Driven By The Hard Data Positive Surprises Driven By The Hard Data Positive Surprises Driven By The Hard Data The next two months are crucial for the U.S economy. Measures of sentiment, on both the business and consumer side, are sending recessionary signals. However, measures of actual economic activity paint a more benign picture (Chart 1). This divergence between the “hard” and “soft” data will likely resolve itself within the next couple of months, and the outcome of U.S./China trade negotiations will play a major part in determining whether that resolution is positive or negative. On the “Hard” And “Soft” Data There is a ton of economic data available to investors these days, but all of it can generally be classified as either “soft” or “hard”. We call measures of actual economic activity, such as housing starts or retail sales, “hard” data. These are the sorts of measures used to calculate a nation’s GDP. Alternatively, we use the term “soft” data to describe survey measures where firms or consumers are asked to describe whether activity is improving or deteriorating, or whether they are becoming more or less optimistic about the future. Some examples of soft data are PMI surveys and measures of consumer confidence. Both sorts of measures have value. Soft data are usually timelier and often lead the hard data. However, they are also more prone to whipsaws. The hard data tend to be more reliable, but don’t always provide enough lead time to be actionable. The soft and hard data are sending very different signals. At present, the soft and hard data are sending very different signals. On the consumer side, core retail sales are growing at the robust year-over-year pace of 4.8%, even though consumer confidence has declined during the past year (Chart 2). On the business side, the ISM manufacturing PMI survey came in at 47.8 in September, the lowest print since 2009. However, industrial production has fallen by only 0.1% during the past year. Industrial production growth got as low as -4% during the 2015/16 period, when the ISM was at a higher level (Chart 3). Similarly, actual orders for core durable goods have barely contracted, even though CEO confidence is at recessionary levels (Chart 3, panel 2). Capacity utilization also remains fairly strong, well above its 2016 low (Chart 3, bottom panel) Chart 2Hard Vs. Soft Data: On The Consumer Side Hard Vs. Soft Data: On The Consumer Side Hard Vs. Soft Data: On The Consumer Side Chart 3Hard Vs. Soft Data: On The Business Side Hard Vs. Soft Data: On The Business Side Hard Vs. Soft Data: On The Business Side Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. All measures of housing activity are growing strongly, a rapid snapback following last year’s weakness (Chart 4). Chart 4Housing Activity Summary Housing Activity Summary Housing Activity Summary Trade Negotiations Are Pivotal The soft data started to lag the hard data at around the same time as the Global Economic Policy Uncertainty index shot higher last year (Chart 5). This leads us to conclude that worries about the trade war’s negative consequences have caused sharp declines in measures of sentiment and confidence, even though the trade war’s actual impact on the hard data has been minor. This is what makes the outcome of November’s U.S./China trade talks so important. If an agreement is reached that makes it clear that no new tariffs will be implemented, we expect that would remove enough uncertainty for the soft data to improve, converging with the hard data. However, if things fall apart, then we would expect the negative survey data to eventually drag the hard data lower. Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. Our sense at the moment is that the looming 2020 U.S. election provides enough incentive for both sides to strike a deal, but the outcome could still go either way. Last Friday’s report from our Global Investment Strategy service discussed the outlook for trade negotiations in more detail.1 For bond investors, we are confident that a removal of trade uncertainty would lead to a rebound in important soft data measures such as the ISM manufacturing PMI and the CRB Raw Industrials index. Any increase in those measures would also send bond yields sharply higher. The ratio between the CRB Raw Industrials index and Gold continues to track the 10-year Treasury yield closely (Chart 6). Chart 5Trade War Worries Affecting ##br##Sentiment Trade War Worries Affecting Sentiment Trade War Worries Affecting Sentiment Chart 6Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bottom Line: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. The Fed Next Week The dichotomy between hard and soft data fits nicely with how the Fed has been describing the economic outlook for most of the year. That is, an economy who’s baseline outlook is favorable but that faces some downside risks. While that outlook doesn’t immediately suggest a policy response, low inflation expectations make it pretty clear what the Fed’s course of action will be during the next few months. The 5-year/5-year forward TIPS breakeven inflation rate is currently 1.68%, well below the 2.3%-2.5% range that is consistent with the Fed’s inflation target (Chart 7). What’s more, the median 3-year inflation forecast from the New York Fed’s Survey of Consumer Expectations just hit an all-time low (Chart 7, bottom panel). The Fed must take appropriate action to drive inflation expectations higher. At present, this means that it must ensure that financial conditions stay accommodative so that the economic recovery can continue. Eventually, continued economic recovery will lead to higher realized inflation (Chart 7, panel 2), and inflation expectations will follow realized inflation higher. Chart 7Low Inflation Expectations Equals Accommodative Fed Low Inflation Expectations Equals Accommodative Fed Low Inflation Expectations Equals Accommodative Fed In order to keep financial conditions accommodative, the Fed must at least match the market’s current rate cut expectations. An October rate cut is more or less fully priced, and it is therefore highly likely that the Fed will cut rates next week. After that, the market is pricing in roughly 50/50 odds of a fourth rate cut in December. But those expectations will certainly change as we learn the outcome of November’s trade talks and as the economic data roll in. Ultimately, we expect that enough good news will hit the wire between now and December that a fourth rate cut will be unnecessary. But the more important message is that, as long as inflation expectations are low, the Fed will not risk upsetting market expectations. Balance Sheet Update The Fed decided not to wait until next week to unveil its revamped balance sheet policy. It didn’t really have the luxury of time, given the turmoil in money markets that we discussed in a recent report.2 The main conclusion from our report is that the Fed must inject more bank reserves into the economy if it wants to maintain control of interest rates. This is exactly what the Fed will do going forward. It announced that it will purchase Treasury bills at least until the second quarter of 2020, starting at an initial pace of $60 billion per month. It will also continue to reinvest the proceeds from maturing Treasury notes/bonds and MBS into newly issued Treasury notes/bonds. Continued economic recovery will lead to higher realized inflation. Assuming the pace of $60 billion per month stays constant, and making some other assumptions about the growth rates of non-reserve liabilities, we project that the Fed’s actions will cause the supply of reserves to rise from $1.53 to $1.63 trillion by next June, and that its securities holdings will rise from $3.59  to $4.05 trillion (see Chart 8 and Table 1). Chart 8The Fed's Balance Sheet Over Time The Fed's Balance Sheet Over Time The Fed's Balance Sheet Over Time Table 1Fed's Balance Sheet: Projections Crisis Of Confidence Crisis Of Confidence As we have argued in the past, now that the link between the Fed’s balance sheet and its interest rate policy has been severed, we see no investment implications from the Fed’s new balance sheet strategy. As per our Golden Rule of Bond Investing, changes in the fed funds rate relative to expectations will continue to drive bond yields.3 Since the Fed’s balance sheet strategy tells us nothing about its future interest rate plans, it should mostly be ignored. Bottom Line: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. A Good Time To Buy Negative Convexity We have repeatedly mentioned the attractiveness of high-yield bonds and Agency MBS during the past few weeks. The one thing those sectors have in common is that they are negatively convex. That is, unlike most fixed income instruments, their durations are positively correlated with yields. As a result, this year’s big drop in yields has led to large declines in duration for both high-yield and agency MBS (Chart 9). But despite this lower duration, junk spreads have remained relatively flat while MBS spreads have actually widened. In other words, expected return has not fallen even as the risk embedded in negatively convex securities has declined markedly. Chart 9Negatively Convex Products Are Attractive Negatively Convex Products Are Attractive Negatively Convex Products Are Attractive Last week we unveiled a new way of measuring risk for U.S. spread products.4 The Risk Of Losing 100 bps can be thought of as the number of standard deviations of annual spread change necessary for a sector to underperform duration-matched Treasuries by more than 100 basis points. A higher value means the sector is at a lower risk of losing 100 bps, and vice-versa. Chart 10 shows our new risk measure plotted against expected return for the investment grade and high-yield credit tiers, as well as for conventional 30-year Agency MBS. The y-axis shows each sector’s 12-month expected excess return, which we calculate as OAS less an adjustment for expected default losses. The x-axis shows the Risk Of Losing 100 bps. To put recent market moves in context, we show how each sector has moved within Chart 10 since spreads last troughed, about one year ago. Notice that last October, Ba and B rated junk bonds offered more expected return than Baa-rated corporates, with similar risk. Now, Ba and B offer a similar return advantage, but with much less risk. Caa-rated junk now strictly dominates the Baa sector in terms of risk and reward. Chart 10Risk-Reward Tradeoff Favors Negatively Convex Securities Crisis Of Confidence Crisis Of Confidence Turning to Agency MBS, we see again that the large fall in duration has led to a substantial risk reduction since last October. This is why we recently recommended upgrading Agency MBS at the expense of Aaa, Aa, and A corporates.5 Bottom Line: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Kumbaya”, dated October 18, 2019, available at gis.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “What’s Up In U.S. Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Duration & Fed: Our late-1990s & 2015/16 roadmap for the economy still holds, but risks are mounting. Despite the risks, we expect that trade tensions will calm enough for the economic data to improve during the next few months. The result will be one more Fed rate cut this month, followed by an extended on-hold period. Investors should keep portfolio duration low in that environment. Junk Quality Spreads: This year’s divergence between the Caa/Ba quality spread and the high-yield index spread is highly unusual, but has more to do with movements in Treasury yields and changing index duration than with broader concerns about corporate credit quality. Investment Grade Risk & Reward: We present a novel approach for assessing the risk/reward trade-off among investment grade corporate bond sectors. We note that Saudi Arabian and Mexican Sovereign bonds, Foreign Agency bonds and Conventional 30-year Agency MBS look particularly attractive in risk-adjusted terms. Feature Contagion? This publication has repeatedly pointed to the late-1990s and the 2015/16 periods as appropriate comparables for today’s global growth slowdown. That is, we expect that the current spate of weakness will stay confined within the manufacturing sector and will not spread into the broader economy, leading the U.S. into recession. This call is important from an investment perspective because it implies that the Fed is not currently engaged in an easing cycle that will bring the funds rate back to zero. Rather, we anticipate only three rate cuts this year (we’ve already seen two), followed by the eventual resumption of hikes. Bond yields will not make new lows in that environment. Chart 1Manufacturing Weakness Spreading? Manufacturing Weakness Spreading? Manufacturing Weakness Spreading? Chart 2"Hard" Data Still Firm "Hard" Data Still Firm "Hard" Data Still Firm But some data received this month challenge our economic narrative. Specifically, September’s drop in the ISM Non-Manufacturing PMI from 56.4 to 52.6 and the year-over-year decline in the Conference Board’s survey of consumer confidence (Chart 1). Both are sending tentative signals that economic weakness might be spreading from the manufacturing sector into the broader U.S. economy. The Fed is worried about the same thing, as evidenced by this passage from the September FOMC minutes: One risk that the economy faced was that the softness recorded of late in firms’ capital formation, manufacturing, and exporting activities might spread to their hiring decisions, with adverse implications for household income and spending. Participants observed that such an eventuality was not embedded in their baseline outlook; however, a couple of them indicated that this was partly because they assumed that an appropriate adjustment to the policy rate path would help forestall that eventuality. This passage makes two important points. First, it stresses the risk of contagion from manufacturing into services and consumer spending as a precondition for recession. This risk has clearly increased, but we are not yet ready to abandon our base case outlook. For one thing, Chart 1 shows that the ISM Non-Manufacturing survey printed at 51.8 for one month in 2016, before rebounding sharply. Second, the “hard” economic data paint a much rosier picture that the “soft” survey data (Chart 2). Industrial production has already bounced off its lows and, unlike the ISM Manufacturing PMI, has not yet approached 2015/16 levels. Similarly, new orders for capital goods are much stronger than during the 2015/16 period. As for consumer spending, it continues to grow at a rapid pace despite the drop in confidence. Chart 3Expect One Rate Cut In October Expect One Rate Cut In October Expect One Rate Cut In October The most logical explanation for the divergence between “hard” and “soft” data is that business and consumer sentiment are being pulled down by concerns about the ongoing trade war. Our sense is that some positive news on that front is now required to bring the survey data back into line with the “hard” numbers. On that note, we anticipate that the looming 2020 election will provide enough incentive for President Trump to reach some sort of détente with China. In fact, as we go to press, optimism about a potential trade deal has pushed the 10-year Treasury yield up above 1.70%. If this optimism is not vindicated, then weak survey data will eventually drag the “hard” data lower. The economy is at a critical and highly uncertain juncture. Amidst so much uncertainty, and with so much hinging on near-term political decisions, how should we expect the Fed to respond? The above passage from the September FOMC minutes gives us a strong clue. It illustrates that the Fed believes that sufficiently accommodative monetary policy will help mitigate the risk of contagion from manufacturing into services and consumer spending. In other words, the Fed must help weather the current storm by ensuring that financial conditions remain supportive. This means refraining from delivering hawkish surprises to market expectations.1 The Fed believes that sufficiently accommodative monetary policy will help mitigate the risk of contagion from manufacturing into services and consumer spending. With that in mind, we note that the market has mostly priced-in an October rate cut (Chart 3), and we expect the Fed to deliver on that expectation. Assuming an October cut, the market is only pricing-in a 28% chance of another cut in December. Overall, the market is priced for 59 basis points of rate cuts during the next 12 months. We anticipate a 25 bps cut this month, followed by an improvement in the economic data that will make further cuts unnecessary. Bottom Line: Our late-1990s & 2015/16 roadmap for the economy still holds, but risks are mounting. Despite the risks, we expect that trade tensions will calm enough for the economic data to improve during the next few months. The result will be one more Fed rate cut this month, followed by an extended on-hold period. Investors should keep portfolio duration low in that environment. High-Yield Quality Spreads: Less Than Meets The Eye Corporate bonds have generally performed quite well this year, but oddly, the lowest tier of junk has not kept pace (Chart 4). Investment grade excess returns have followed a typical risk-on pattern. That is, the lowest rated / riskiest credit tiers have performed best in a bull market. However, in the high-yield space, Caa-rated debt has bucked the trend and actually underperformed the duration-matched Treasury index by 33 bps. Chart 4Caa-Rated Junk Is Not Keeping Pace Caa-Rated Junk Is Not Keeping Pace Caa-Rated Junk Is Not Keeping Pace Is this a potentially worrying sign for corporate spreads more generally? To consider the question, we looked at the historical relationships between quality spreads – the spread differential between low-rated and high-rated credit tiers – and the overall index spreads for both investment grade and high-yield. We found a strong positive correlation in both cases, but no leading or lagging properties. That is, quality spreads tend to follow the same trend as the overall index spread, but do not flag signs of trouble before the overall index. Nonetheless, the current divergence between the Caa/Ba quality spread and the high-yield index spread is highly unusual (Chart 5). Our sense, however, is that the divergence has less to do with concerns about credit quality and more to do with this year’s large moves in Treasury yields and changes to bond index duration. Chart 5De-Coupling In Quality Spreads... De-Coupling In Quality Spreads... De-Coupling In Quality Spreads... Chart 6...Is Due To Duration ...Is Due To Duration ...Is Due To Duration   Specifically, we note that this year’s large decline in Treasury yields has caused junk index duration to plunge, but the drop has been greater for the Ba credit tier than the Caa credit tier (Chart 6). Ba index duration has fallen by 0.8 this year (from 4.4 to 3.5), while Caa index duration has fallen by 0.6 (3.4 to 2.8). The result is that if we control for changes in duration by looking at a 12-month breakeven spread instead of the average index option-adjusted spread (OAS), we see that the quality spread widening is roughly consistent with the overall index (Chart 6, panel 3).2 In other words, the steep drop in Treasury yields has not led to the same reduction in risk in the Caa credit tier as it has in the other junk credit tiers. Caa spreads have widened on a relative basis, as a result. This year’s large decline in Treasury yields has caused junk index duration to plunge. It’s also interesting to note that the opposite dynamic is afoot within the investment grade corporate space. The Baa/Aa quality spread is more or less consistent with the overall index spread in OAS terms (Chart 5, top panel), but the quality spread widening is exacerbated when the impact of changing duration is considered (Chart 6, panels 1 & 2). That is, index duration has lengthened by more for the upper credit tiers than it has for the Baa credit tier. This makes Baa corporates look particularly attractive in risk-adjusted terms, as we have noted in prior research.3 From a big picture perspective, it is unusual for Treasury yields to fall so much without a concurrent widening in credit risk premiums. Eventually, this anomaly will be resolved by either: Higher Treasury yields in the event that recession is avoided, or Wider credit spreads in the event of a contraction in U.S. economic activity But in the meantime, negatively convex sectors such as high-yield corporates and Agency MBS look particularly attractive on a risk-adjusted basis. These sectors have benefited from the drop in Treasury yields by seeing their durations fall. They should perform well as long as the current environment of low Treasury yields and stable credit spreads persists. We take a more detailed look at the prospects for risk-adjusted performance within the different investment grade bond sectors in the next section. Risk And Reward In Investment Grade Bond Sectors As mentioned above, in this week’s report we present a novel approach for considering the risk/reward trade-off between different investment grade sectors of the U.S. bond market. We consider 23 sectors in total: 4 corporate credit tiers Conventional 30-year Agency MBS and Agency CMBS Aaa-rated non-Agency CMBS, credit card ABS and auto loan ABS Domestic and Foreign Agency bonds Supranationals Local Authority bonds (mostly taxable munis and USD-denominated Canadian provincial debt) USD-denominated Sovereign bonds for 10 different emerging markets Reward First, we consider the reward side of the equation. We do not impose any macro view, but instead, use the average index OAS as the best estimate for each sector’s 12-month expected excess returns relative to a duration-matched position in Treasuries. Chart 7 shows the expected excess returns for each sector. Right away, the attractiveness of Mexican sovereign debt is apparent. Mexico carries an A rating, but offers a greater spread than the Baa corporate index. Chart 7Expected Returns A Perspective On Risk And Reward A Perspective On Risk And Reward Risk We decided to assess risk using a breakeven spread framework. We calculate a 12-month breakeven spread for each sector. This spread represents the basis point spread widening required for each sector to break even with a duration-matched position in Treasury securities on a 12-month horizon. We calculate the breakeven spread using the following equation: 0 = OAS – D(B) + 0.5*CVXs*(dYs)2 - 0.5*CVXT*(dYT)2 Where: OAS = the sector’s option-adjusted spread D = the sector’s duration B = the breakeven spread CVXs = the sector’s convexity CVXT = the convexity of a duration-matched Treasury security dYs = trailing 1-year volatility of the sector’s yield dYT = trailing 1-year volatility of the duration-matched Treasury yield Chart 8 shows each sector’s 12-month breakeven spread, and it illustrates that the breakeven spread is a sub-optimal measure of risk. In theory, the highest breakeven spreads should be the least likely to see losses, but this is obviously not the case. Baa-rated South African Sovereign debt carries the largest breakeven spread, but it should be among the riskiest of the sectors. Chart 812-Month Breakeven Spreads A Perspective On Risk And Reward A Perspective On Risk And Reward The missing piece of the puzzle is spread volatility. South African sovereign spreads need to widen by 39 bps before losses are incurred, while Aaa-rated credit card ABS spreads only need to widen by 13 bps. However, if spread volatility is much higher for South African sovereigns than for credit card ABS, then the sovereign sector still might be more likely to see losses. To control for this difference we calculate the standard deviation of annual spread changes for each sector, starting from May 2014 when all sectors have available data. We then divide each sector’s breakeven spread by the result. This calculation gives us a volatility-adjusted 12-month breakeven spread. In other words, it is the number of standard deviations of spread widening required for each sector to see losses on a 12-month horizon (Chart 9). Chart 912-Month Volatility-Adjusted Breakeven Spreads A Perspective On Risk And Reward A Perspective On Risk And Reward Risk & Reward We bring risk and reward together in Charts 10-12. Chart 10 shows expected returns on the y-axis and the vol-adjusted 12-month breakeven spread on the x-axis. Sectors plotting near the top-right of the chart give the best returns and lowest risk of losses, while sectors plotting near the bottom-left provide low expected returns and high risk of losses. Immediately, Saudi Arabian sovereigns and Foreign Agency debt stand out as offering high expected returns for their risk levels. Note that South African sovereigns plot off the charts, toward the top-left of Charts 10-12, as indicated by the arrows. Chart 10Expected Returns Vs. Risk Of Negative Excess Returns A Perspective On Risk And Reward A Perspective On Risk And Reward Chart 11Expected Returns Vs. Risk Of Losing 100 BPs A Perspective On Risk And Reward A Perspective On Risk And Reward Chart 12Expected Returns Vs. Risk Of Losing 200 BPs A Perspective On Risk And Reward A Perspective On Risk And Reward In Charts 11 and 12 we make one further refinement to our risk measure. In these charts, instead of calculating 12-month breakeven spreads, we calculate the spread change necessary for each sector to underperform Treasuries by 100 bps and 200 bps, respectively. Saudi Arabian sovereigns and Foreign Agency debt stand out as offering high expected returns for their risk levels. This adjustment arguably gives a more useful perspective on risk. For example, because spreads are quite narrow in the Supranational and Domestic Agency sectors, the risk of negative returns versus Treasuries is quite elevated. However, these sectors also carry high credit ratings and low spread volatility, making it exceedingly unlikely that they would deliver losses of 100 bps or more. Considering Charts 11 and 12, we look for sectors that clearly dominate other ones, i.e. plotting both higher and further to the right. Once again, Foreign Agencies and Saudi Arabian sovereigns both look very appealing. Mexican sovereign debt also offers very high expected return, and less risk that the Baa corporate sector. We would also like to point out the attractiveness of Agency MBS. As we noted in a recent report, Agency MBS offer considerably less risk than high-rated corporate debt, and similar expected returns. Note that this analysis doesn’t impose any macroeconomic view, and our sense is that the macro back-drop is more favorable for MBS spreads than for corporates.4 All in all, we reiterate our recommendation to favor Agency MBS over Aaa-, Aa- and A-rated corporate bonds. We will continue to refine this approach to measuring the risk/reward trade-off in the coming weeks, including incorporating high-yield debt into our analysis. Stay tuned. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 For further discussion on this topic please see U.S. Bond Strategy Weekly Report, “Act As Appropriate”, dated August 27, 2019, available at usbs.bcaresearch.com 2 The 12-month breakeven spread is the spread widening required on a 12-month horizon to break even with a duration-matched position in Treasury securities. It can be approximated by dividing the option-adjusted spread by duration, as is done in Chart 6. 3 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification