High-Yield

Highlights Chart 12015 Repeat? 2015 Repeat? 2015 Repeat?   Credit spreads widened as Treasury yields rose in October, bringing to mind the experience of 2015 when tight monetary policy and flagging global growth combined to cause a large drawdown in spread product excess returns. Chart 1 shows the familiar pattern. The market's rate hike expectations held constant throughout most of 2015. Meanwhile, falling commodity prices signaled weakness in global demand. Eventually, the combination of tight money and slowing growth was too much for the market to bear. Junk sold off in late-2015 and didn't recover until after the Fed scaled back its rate hike plans. It's hard to ignore today's similar set-up. Commodity prices are once again falling and the Fed appears committed to lifting rates. Unless global demand rebounds, we could be in for a repeat of late-2015's ugly price performance. The best way to position U.S. bond portfolios for this risk is to maintain below-benchmark portfolio duration, and to scale back exposure to credit risk. We advocate nothing more than a neutral allocation to spread product, with an up-in-quality bias. Feature Investment Grade: Neutral Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 82 basis points in October, dragging year-to-date excess returns down to -98 bps. The index option-adjusted spread widened 12 bps on the month, and currently sits at 117 bps. Recent spread widening has returned some value to the corporate bond space. The 12-month breakeven spread for Baa-rated corporate bonds is back up to its 36th percentile relative to history, while the same spread for A-rated securities is at its 18th percentile (Chart 2). Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Though spreads are somewhat more attractive, caution remains warranted in the corporate bond space. Corporate profit growth has only just managed to keep pace with debt growth during the past few quarters (bottom panel). In other words, even a mild deceleration in profits will be enough for leverage to resume its uptrend (panel 4). As we observed in last week's report, Q3's sharp decline in non-residential investment spending might signal that weak foreign growth is finally starting to weigh on profits.1 The possibility of rising leverage in the coming quarters leads us to recommend an up-in-quality bias within our neutral allocation to corporate bonds. To pick up extra spread we prefer a strategy of favoring long-maturity credits over short maturities. In last week's report we showed that the long-end of the credit curve outperforms (in excess return terms) when Treasury yields rise. High-Yield: Neutral High-Yield underperformed the duration-equivalent Treasury index by 159 basis points in October, dragging year-to-date excess returns down to +161 bps. The average index option-adjusted spread widened 55 bps on the month, and currently sits at 363 bps. Our measure of the excess spread available in the High-Yield index after accounting for default losses is currently 259 bps, above the long-run mean of 247 bps (Chart 3). This tells us that if default losses are in line with our expectations during the next 12 months and junk spreads remain constant, we should expect high-yield returns of 259 bps in excess of duration-matched Treasuries. If we assume that spreads tighten enough to bring our default-adjusted spread back to its long-run average, we would expect an excess return of 306 bps. Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview The main reason for continued caution on junk bonds is that the default loss expectation embedded in our excess spread calculation is extremely low relative to history (panel 4). Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.04% during the next 12 months. Default losses have rarely come in below that level. Further, the recent trend in job cut announcements makes it even more likely that default losses surprise to the upside during the next 12 months. Job cut announcements are highly correlated with the default rate, and while they remain low relative to history, they have clearly formed a trough this year (bottom panel). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Toxic Combination Toxic Combination   Table 3BCorporate Sector Risk Vs. Reward* Toxic Combination Toxic Combination MBS: Neutral Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 37 basis points in October, dragging year-to-date excess returns down to -44 bps. The conventional 30-year zero-volatility MBS spread increased 2 bps on the month. A 4 bps widening of the option-adjusted spread (OAS) was partially offset by a 2 bps decline in the compensation for prepayment risk (option cost). The OAS has widened in recent months, though it remains tight compared to its average pre-crisis level (Chart 4). The overall nominal MBS spread remains very low, but for good reason (panel 4). Chart 4MBS Market Overview MBS Market Overview MBS Market Overview The two most important drivers of MBS excess returns are: (i) mortgage refinancing activity and (ii) bank lending standards. Refi activity is already depressed and will stay muted as interest rates rise. Bank lending standards eased in Q2 for the 17th consecutive quarter, but remain tight relative to history. In response to a special question from the Fed's July Senior Loan Officer Survey, respondents noted that mortgage lending standards are in the tighter end of the range since 2005. This suggests that further gradual easing is likely going forward. With lending standards easing and refi activity low, the macro environment is consistent with tight MBS spreads. We maintain only a neutral allocation to the sector for now, but will look to upgrade when it comes time to further pare exposure to corporate credit risk. Government-Related: Underweight The Government-Related index underperformed the duration-equivalent Treasury index by 55 basis points in October, dragging year-to-date excess returns down to -16 bps. Sovereign debt underperformed the Treasury benchmark by 184 bps, dragging year-to-date excess returns down to -118 bps. Foreign Agencies underperformed by 94 bps on the month, dragging year-to-date excess returns down to -60 bps. Local Authorities underperformed by 28 bps, dragging year-to-date excess returns down to +63 bps. Supranationals underperformed Treasuries by 3 bps, dragging year-to-date excess returns down to +13 bps. Domestic Agency bonds underperformed by 4 bps, dragging year-to-date excess returns down to +5 bps. Sovereign debt has underperformed this year, but spreads remain expensive compared to U.S. corporate credit. In a recent report we looked at USD-denominated Emerging Market Sovereign debt by country and found that only a few nations offer excess spread compared to equivalently-rated U.S. corporates.2 Those countries being Argentina, Turkey, Lebanon and Ukraine at the low-end of the credit spectrum and Saudi Arabia, Qatar and UAE at the upper-end. We continue to view the Local Authority sector as very attractive. Not only does the sector offer elevated spreads (Chart 5), but it is dominated by taxable municipal securities which are insulated from weak foreign growth and U.S. dollar strength. Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview Municipal Bonds: Overweight Municipal bonds underperformed the duration-equivalent Treasury index by 47 basis points in October, dragging year-to-date excess returns down to +105 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 1% in October, and currently sits at 87% (Chart 6). This is about one standard deviation below its post-crisis mean and only slightly above the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview But despite the low yield ratio, we see tax-exempt municipal yields as quite attractive, especially at the long-end of the curve. For example, we observe that a 5-year Aa-rated municipal bond carries a yield of 2.55% versus a yield of 3.62% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 30% should be indifferent between the two bonds. Moving further out the curve, the breakeven tax rate falls to 23% at the 10-year maturity point and is even lower at the 20-year maturity point. Further, unlike the corporate sector, state & local government balance sheets are relatively insulated from weakening foreign economic growth and a rising U.S. dollar. While our Municipal Health Monitor has bounced in recent quarters, it remains below zero, consistent with ratings upgrades outpacing downgrades (bottom panel). Treasury Curve: Favor The 7-Year Bullet Over The 1/20 Barbell The Treasury curve bear-steepened in October. The 2/10 slope steepened 4 bps and the 5/30 slope steepened 16 bps. As a result of the large curve steepening, our position long the 7-year bullet and short the 1/20 barbell returned +67 bps on the month, and is now up +107 bps since inception. However, the curve steepening also means that steepener trades focused on the belly (5-7 year) of the curve are no longer attractive according to our models (see Tables 4 & 5). The 7-year bullet is now fairly valued relative to the 1/20 barbell, meaning that the butterfly spread is priced for an unchanged 1/20 slope during the next six months (Chart 7). Our baseline macro assessment is that the yield curve slope will remain near current levels during that timeframe. As such, we close our position long the 7-year bullet and short the 1/20 barbell. Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview Absent attractive value, the only reason to focus curve exposure on the 5-7 year maturity point is as a hedge against an unexpected pause in Fed rate hikes. In prior research we showed that the belly of the curve performs best when the 12-month discounter falls.3 But with our discounter priced for only 61 bps of rate hikes for the next 12 months, this risk may not be worth hedging. Instead, we prefer to go long the 2-year bullet and short a duration-matched 1/5 barbell. This trade is attractively priced on our model (bottom panel) and should outperform in a rising yield environment. The 1/5 slope tends to steepen when our 12-month discounter rises, and vice-versa. TIPS: Overweight TIPS underperformed the duration-equivalent nominal Treasury index by 61 basis points in October, dragging year-to-date excess returns down to +76 bps. The 10-year TIPS breakeven inflation rate fell 9 bps on the month and currently sits at 2.06%. The 5-year/5-year forward TIPS breakeven inflation rate also fell 9 bps on the month and currently sits at 2.21%. Both the 10-year and the 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. We think it is only a matter of time before inflation expectations adjust higher into that range, and we therefore maintain an overweight position in TIPS versus nominal Treasuries. The catalyst for wider TIPS breakevens will be persistent inflation readings near the Fed's 2% target. Trimmed mean inflation has only just returned to the Fed's 2% target (Chart 8), but will probably remain close to that level for the next six months. While base effects will pose a higher hurdle for year-over-year inflation during this time, pipeline inflation pressures are also building, as evidenced by the prices paid component of the ISM Manufacturing survey (panel 4).4 Chart 8Inflation Compensation Inflation Compensation Inflation Compensation ABS: Neutral Asset-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in October, dragging year-to-date excess returns down to +23 bps. The index option-adjusted spread for Aaa-rated ABS widened 5 bps on the month and now stands at 38 bps, 4 bps above its pre-crisis low. The excess return Bond Map on page 15 shows that consumer ABS offer attractive return potential compared to both Supranationals and Domestic Agencies, but carry a substantially higher risk of losses. Agency CMBS appear much more attractive than consumer ABS on a risk/reward basis, offering approximately the same expected return with less risk. From a credit quality perspective, the consumer credit delinquency rate remains low by historical standards but has clearly put in a bottom (Chart 9). The household interest coverage ratio has been rising for 10 consecutive quarters, suggesting that the delinquency rate will continue to increase. Chart 9ABS Market Overview ABS Market Overview ABS Market Overview We remain neutral on consumer ABS for now, but prefer Local Authorities, Municipal Bonds and Agency-backed CMBS when it comes to high-quality spread product. If consumer credit delinquencies continue to rise without a commensurate increase in ABS spreads, then our next move will likely be a reduction to underweight. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 47 basis points in October, dragging year-to-date excess returns down to +120 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 10 bps on the month and currently sits at 94 bps (Chart 10). Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview A typical negative environment for CMBS is characterized by tightening bank lending standards on commercial real estate loans as well as falling demand. The Fed's Q2 Senior Loan Officer Survey showed that both lending standards and demand are close to unchanged. In other words, the macro picture for CMBS is decidedly mixed. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 31 basis points in October, dragging year-to-date excess returns down to +23 bps. The index option-adjusted spread widened 7 bps on the month and currently sits at 51 bps. The Bond Maps on page 15 show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of November 2, 2018) Toxic Combination Toxic Combination   Chart 12Total Return Bond Map (As Of November 2, 2018) Toxic Combination Toxic Combination   Table 4Butterfly Strategy Valuation (As Of September 28, 2018) Toxic Combination Toxic Combination   Table 5Discounted Slope Change During Next 6 Months (BPs) Toxic Combination Toxic Combination Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?", dated October 30, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Oil Supply Shock Is A Risk For Junk", dated October 9, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 4 For details on our base effects indicator for PCE inflation, please see U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges", dated September 4, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Duration: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. High-Yield: A supply shock in the oil market would most likely lead to steep backwardation in the oil futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads. Emerging Market Sovereigns: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Feature Bond Breakout Chart 1The Long End Breaks Out The Long End Breaks Out The Long End Breaks Out Bond markets sold off sharply last week and long-dated Treasury yields took out some noteworthy technical levels in the process. The 10-year Treasury yield broke above its May 2018 peak of 3.11% and settled at 3.23% as of last Friday. The next big test for the 10-year's cyclical uptrend is the 2011 peak of 3.75% (Chart 1). The 30-year yield similarly broke above its May 2018 peak of 3.25%, settling at 3.39% as of last Friday. The next resistance for the 30-year occurs at the early-2014 peak of 3.96%. Removing our, admittedly uncomfortable, technical analysis hat, it is instructive to note which macro factors were responsible for last week's large bear-steepening of the Treasury curve and which weren't. Strong U.S. economic data - the non-manufacturing ISM survey hit its highest level since 1997 (Chart 2) - and Fed Chairman Powell commenting that the fed funds rate is "a long way from neutral at this point, probably" were the key drivers of the move.1 Taken together, these two developments suggest that the Fed is further behind the curve than was previously thought. This is consistent with an upward revision to the market's assessment of the neutral fed funds rate, which explains why the yield curve steepened and the price of gold edged higher.2 But it's equally important to note the factors that didn't drive the increase in yields. In this case, yields weren't driven by a rebound in growth outside of the U.S., which continues to flag (Chart 2, panel 2). The Global Manufacturing PMI fell for the fifth consecutive month in September. While our diffusion index based on the number of countries with PMIs above versus below the 50 boom/bust line ticked higher (Chart 2, panel 3), our diffusion index based on the number of countries with rising versus falling PMIs remained deeply negative (Chart 2, bottom panel). Chart 2Growth Divergences Deepen Growth Divergences Deepen Growth Divergences Deepen Chart 3Global PMIs Global PMIs Global PMIs Taken together, our diffusion indexes are consistent with an environment where most countries are experiencing decelerating growth from high levels. This message is confirmed by looking at the PMIs from the five largest economic blocs (Chart 3). The Eurozone PMI continues to fall rapidly, though it remains well above 50. The Emerging Markets (ex. China) PMI is also trending lower from a relatively high level, while the Chinese PMI is threatening to break below 50. Only the U.S. and Japan have healthy looking PMIs. The precariousness of non-U.S. growth leads us to reiterate the biggest risk to our below-benchmark duration view. The risk is that weak foreign growth eventually migrates to the U.S. via a stronger dollar and forces the Fed to pause its +25 bps per quarter rate hike cycle. If current trends continue, it is highly likely that U.S. growth will slow in the first half of next year, though it is unclear whether such a slowdown would be severe enough for the Fed to pause rate hikes.3 In any event, the bond market is only priced for the Fed to maintain its quarterly rate hike pace until June of next year (3 more hikes) before going on hold (Chart 4). Essentially, the market already discounts a rate hike pause, even after last week's large increase in yields. Chart 4Market's Rate Expectations Still Too Low Market's Rate Expectations Still Too Low Market's Rate Expectations Still Too Low For this reason, we prefer to maintain our below-benchmark portfolio duration stance, and to hedge the risk of weakening foreign growth by owning curve steepeners,4 and maintaining only a neutral allocation to spread product. Bottom Line: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. In Case You Needed Another Reason To Be Nervous About Junk As Treasury yields broke higher last week, the average high-yield index option-adjusted spread tightened to a fresh cyclical low of 303 bps. It has since rebounded to 316 bps (Chart 5). Our measure of the excess spread available in the high-yield index after adjusting for expected default losses is now at 196 bps, well below its historical average of 247 bps (Chart 5, panel 2). We have previously pointed out that even this below-average excess spread embeds a very low 12-month default loss expectation of 1.07%.5 Rarely have default losses been below that level. With job cut announcements forming a tentative bottom (Chart 5, bottom panel), we see high odds that default losses surprise to the upside during the next 12 months. In the absence of further spread tightening, that would translate to 12-month excess junk returns of 196 bps or less. But this week we want to highlight an additional risk to junk spreads. That risk being our Commodity & Energy Strategy service's view that crude oil prices could experience a positive supply shock in the first quarter of next year. At present, our strategists see high odds of $100 per barrel Brent crude oil in the first quarter of next year, and are forecasting an average price of $95 per barrel for 2019. At publication time, the Brent crude oil price was $85.6 At first blush it isn't obvious why high oil prices would pose a risk to junk spreads, and in fact there is no consistent correlation between the level of oil prices and junk spreads. However, there is a correlation between implied volatility in the crude oil market and junk spreads, with higher implied vol coinciding with wider spreads and vice-versa (Chart 6). Chart 5Default Loss Expectations Too Low Default Loss Expectations Too Low Default Loss Expectations Too Low Chart 6Higher Oil Vol = Wider Junk Spreads Higher Oil Vol = Wider Junk Spreads Higher Oil Vol = Wider Junk Spreads Would higher oil prices necessarily induce a spike in implied volatility? Not necessarily. It turns out that what matters for implied oil volatility is the slope of the futures curve.7 A contangoed futures curve where long-dated futures trade at a higher price than short-dated futures tends to be associated with high implied volatility. A steeply backwardated futures curve where long-dated futures trade well below short-dated futures is equally associated with elevated implied vol (Chart 7). Implied volatility tends to be lowest when the futures curve is in mild backwardation. A mild backwardation is typical when crude prices are in a gradual uptrend, as is the case at present. All in all, the following features provide a reasonable description of the current environment: Gradual uptrend in crude oil price Mild oil futures curve backwardation Low implied crude volatility Tight junk spreads However, as we head into next year, our commodity strategists anticipate that supply constraints will bite in the oil market. The U.S. is poised to implement an oil embargo against Iran in November, and Venezuela - another important oil exporter - remains on the brink of collapse. With global oil inventories already tight, and the loss of further production from Venezuela and Iran looming, our strategists anticipate that the number of days of demand covered by crude oil inventories will decline sharply. This decline will lead to a steep backwardation of the futures curve (Chart 8). Chart 7Brent Crude Oil Volatility Vs. Forward Slope Oil Supply Shock Is A Risk For Junk Oil Supply Shock Is A Risk For Junk Chart 8Supply Shock Will Lead To Steep Backwardation Supply Shock Will Lead To Steep Backwardation Supply Shock Will Lead To Steep Backwardation The bottom line for junk investors is that a supply shock in the oil market would most likely lead to a steep backwardation in the futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads. We continue to recommend only a neutral allocation to high-yield in U.S. bond portfolios. We will await a signal that profit growth is set to deteriorate before advocating for a further reduction in exposure. Still No Buying Opportunity In EM Sovereigns Chart 9EM Index Spread Looks Cheap EM Index Spread Looks Cheap EM Index Spread Looks Cheap As growth divergences between the U.S. and the rest of the world increase, we are on high alert for an opportunity to shift some allocation out of U.S. corporate credit and into USD-denominated emerging market (EM) sovereign debt. However, so far EM spreads are simply not wide enough to merit attention from U.S. bond investors. This is not apparent from the average index spreads. In fact, a quick glance at the indexes shows that EM sovereign spreads have widened a lot relative to duration- and quality-matched U.S. corporates, and actually offer a healthy spread pick-up (Chart 9). However, a more detailed look at the spreads from individual countries shows that the spread advantage in EM is only available in a select few markets (Charts 10A & 10B). At the lower-end of the credit spectrum: Turkey, Argentina, Ukraine and Lebanon all offer higher breakeven spreads than comparable U.S. corporates. In the upper credit tiers: Saudi Arabia, Qatar and United Arab Emirates (UAE) look attractive. All other EM countries off lower breakeven spreads than comparable U.S. corporates. Chart 10ABreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates Oil Supply Shock Is A Risk For Junk Oil Supply Shock Is A Risk For Junk Chart 10BBreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates Oil Supply Shock Is A Risk For Junk Oil Supply Shock Is A Risk For Junk We would be very reluctant to shift any allocation out of U.S. corporates and into either Turkey or Argentina. Both of those countries are highly exposed to the tightening in global liquidity conditions that occurs alongside a strengthening U.S. dollar. Our Foreign Exchange and Global Investment Strategy teams created a Vulnerability Heat Map to identify which EM countries are likely to struggle as the U.S. dollar appreciates (Chart 11).8 These tend to be countries with large current account deficits and high external debt balances, though several other factors are also considered. The results show that Argentina and Turkey are the two most exposed nations. Chart 11Vulnerability Heat Map For Key EM Markets Oil Supply Shock Is A Risk For Junk Oil Supply Shock Is A Risk For Junk At the upper-end of the credit spectrum, the USD bonds from Saudi Arabia, Qatar and UAE are more interesting. Our geopolitical strategists anticipate an escalation of tensions between the U.S. and Iran following the U.S. midterm elections, and such tensions could increase the political risk premium embedded in all Middle Eastern debt. But for longer-term U.S. fixed income investors, it is worth noting that extra spread is available in the hard currency sovereign debt of Saudi Arabia, Qatar and UAE compared to A-rated U.S. corporates. Bottom Line: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Powell's full interview can be viewed here: https://www.youtube.com/watch?v=-CqaBSSl6ok 2 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com, where we note that every time the Global (ex. US) LEI has dipped below zero since 1993, the U.S. LEI has eventually followed. 4 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 6 Please see Commodity & Energy Strategy Weekly Report, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at usbs.bcaresearch.com 7 Please see Commodity & Energy Strategy Weekly Report, "Calm Before The Storm In Oil Markets", dated August 2, 2018, available at ces.bcaresearch.com 8 Please see Foreign Exchange Strategy/Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Second Half Rebound Second Half Rebound Second Half Rebound The leveling-off of bullish sentiment toward the dollar and the perception of fading political risk have caused spread product to rally hard since the end of June. Indeed, corporate bonds are almost back into the black versus Treasuries for the year (Chart 1). We caution against buying into either of these trends. We have demonstrated that divergences between the U.S. and the rest of the world usually end with weaker U.S. growth,1 and our geopolitical strategists warn that American tensions with both Iran and China are poised to ramp up after the November midterms.2 Add in persistent monetary tightening and corporate profit growth that is barely keeping pace with debt growth, and it becomes clear that the corporate spread environment is turning more negative. Investors should maintain below-benchmark portfolio duration and only a neutral allocation to spread product versus Treasuries. Evidence of deteriorating profit growth is required before turning more negative on spread product. 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 78 basis points in September, bringing year-to-date excess returns up to -16 bps. The index option-adjusted spread tightened 8 bps on the month, and currently sits at 114 bps. Corporate bonds remain expensive with 12-month breakeven spreads for both A and Baa-rated credit tiers below their 25th percentiles since 1989 (Chart 2). Further, with inflation now at the Fed's target, monetary policy will provide less and less support for corporate bond returns going forward. These are the two main reasons we downgraded our cyclical corporate bond exposure to neutral in June.3 Gross leverage for the nonfinancial corporate sector declined in Q2, for the third consecutive quarter (panel 4), though the declines have been quite modest. Dollar strength and accelerating wage growth will weigh on corporate profits in the second half of the year, and with corporate profit growth just barely keeping pace with debt growth (bottom panel), odds are that leverage will start to rise. Midstream and Independent Energy companies remain attractively valued after adjusting for duration and credit rating (Table 3). These two sectors stand to benefit from rising oil prices into next year, as is expected by our commodity strategists.4 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Complacent Complacent Table 3BCorporate Sector Risk Vs. Reward* Complacent Complacent High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 104 basis points in September, bringing year-to-date excess returns up to +326 bps. The average index option-adjusted spread tightened 22 bps on the month, and currently sits at 316 bps. Our measure of the excess spread available in the High-Yield index after accounting for default losses is currently 209 bps, below the long-run mean of 247 bps (Chart 3). This tells us that if default losses are in line with our expectations during the next 12 months, we should expect high-yield returns of 209 bps in excess of duration-matched Treasuries, assuming also no capital gains/losses from spread tightening/widening. But the default loss expectations embedded in our calculation are also extremely low relative to history (panel 4). Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.07% during the next 12 months. Default losses have rarely come in below that level. While most indicators suggest that default losses will remain low for the next 12 months, historical context clearly demonstrates that the risks are to the upside. Meanwhile, with gross corporate leverage likely to rise in the second half of the year,5 and job cut announcements already trending higher (bottom panel), current default loss forecasts appear overly optimistic. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in September, bringing year-to-date excess returns up to -7 bps. The conventional 30-year zero-volatility MBS spread tightened 5 bps on the month, driven by a 4 bps decline in the compensation for prepayment risk (option cost) and a 1 bp tightening in the option-adjusted spread. The excess return Bond Map on page 15 shows that MBS offer a relatively poor risk/reward trade-off, particularly compared to Aaa-rated non-Agency CMBS, High-Yield and Sovereigns. However, our Bond Map does not account for the macro environment, which remains favorable for the sector. Refi activity is tepid, and continued Fed rate hikes will ensure that it stays that way (Chart 4). Meanwhile, lending standards have been slowly easing since 2014 (bottom panel). Despite the steady easing, the Fed's most recent Senior Loan Officer Survey reports that mortgage lending standards remain at the tighter end of the range since 2005. This suggests that further easing is likely going forward. In a recent report we noted that residential investment has decelerated in recent months, with the weakness mostly stemming from multi-family construction.6 Demand for single-family housing remains robust, and we see no potential negative impact on MBS spreads during the next 6-12 months. 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 48 basis points in September, bringing year-to-date excess returns up to +38 bps. Sovereign debt outperformed the Treasury benchmark by 151 bps, bringing year-to-date excess returns up to +67 bps. Foreign Agencies outperformed by 70 bps on the month, bringing year-to-date excess returns up to +34 bps. Local Authorities outperformed by 50 bps, bringing year-to-date excess returns up to +91 bps. Supranationals outperformed Treasuries by 4 bps, bringing year-to-date excess returns up to +16 bps. Domestic Agency bonds outperformed by 6 bps, bringing year-to-date excess returns up to +10 bps. After adjusting for differences in credit rating and duration, the average spread available from the USD-denominated Sovereign index is unattractive compared to the U.S. corporate bond space (Chart 5). Dollar strength should also cause Sovereign debt to underperform U.S. corporates in the coming months (panel 3). But the outlook could be worse for the Sovereign index. Mexico, Colombia and the Philippines make up approximately 50% of the index's market cap, and our Emerging Markets Strategy team has found that none of those countries are particularly vulnerable to a slowdown in Chinese aggregate demand.7 Mexico and Columbia are particularly insulated. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 36 basis points in September, bringing year-to-date excess returns up to +153 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 2% in September, and currently sits at 87% (Chart 6). This is about one standard deviation below its post-crisis mean and only slightly above the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. In a recent report we demonstrated that while M/T yield ratios are low, municipal bonds offer attractive yields compared to corporate bonds.8 For example, we observe that a 5-year Aa-rated municipal bond carries a yield of 2.40% versus a yield of 3.42% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 30% should be indifferent between the two bonds. Moving further out the curve, the breakeven tax rate falls to 23% at the 10-year maturity point and is even lower at the 20-year maturity point. The greater attractiveness of long-maturity munis is consistent across credit tiers, and investors should favor long-dated over short-dated municipal debt (bottom panel). Treasury Curve: Favor The 7-Year Bullet Over The 1/20 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve underwent a roughly parallel upward shift in September. While the 10-year Treasury yield rose 19 bps, the 2/10 slope was unchanged at 24 bps and the 5/30 slope flattened 3 bps to reach 25 bps. The yield curve is already quite flat, and our models suggest that a lot more flattening is discounted. For example, our 1/7/20 butterfly spread model shows that 32 bps of 1/20 flattening is priced into the 1/7/20 butterfly spread for the next six months (Chart 7).9 With the U.S. economy growing strongly and the Fed moving at a gradual +25 bps per quarter pace, the curve is likely to flatten by less than is currently discounted on a cyclical (6-12 month) horizon. This argues for positioning in curve steepeners. In a recent report we also made the case for owning steepeners as a hedge against the risk that weak foreign growth infiltrates the U.S. via a stronger dollar.10 We found that the yield pick-up is similar for the different steepener trades we considered, and also that the 7-year yield has the most downside in the event of a pause in the Fed's tightening cycle. This argues for maintaining our position long the 7-year bullet and short the 1/20 barbell, a position that has earned +37 bps since it was initiated in May. TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 16 basis points in September, bringing year-to-date excess returns up to +138 bps. The 10-year TIPS breakeven inflation rate rose 6 bps on the month and currently sits at 2.14%. The 5-year/5-year forward TIPS breakeven inflation rate rose 7 bps and currently sits at 2.25%. Both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. TIPS breakeven rates have held firm in recent months, despite the sharp drop in commodity prices (Chart 8). This suggests that investors' inflation expectations are increasingly being swayed by U.S. core inflation, which is now more or less consistent with the Fed's target (bottom panel). In recent reports we showed that year-over-year core inflation (both CPI and PCE) is likely to flatten-off during the next six months.11 But continued inflation prints near the Fed's target should be sufficient to drive long-dated breakevens higher, into our target range. This will occur as persistent prints near target cause investors' fears of deflation to gradually ebb. ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in September, bringing year-to-date excess returns up to +29 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 4 bps on the month and now stands at 33 bps, just below its pre-crisis minimum. The excess return Bond Map on page 15 shows that consumer ABS offer attractive return potential compared to other high-rated spread products - such as Agency CMBS and Domestic Agencies - but also carry a greater risk of losses. The Bond Map also reveals that Aaa-rated credit card ABS offer a more attractive risk/reward trade-off than Aaa-rated auto loan ABS. We continue to recommend favoring the former over the latter. Credit quality trends have been slowly moving against the ABS sector and we think caution is warranted. The consumer credit delinquency rate bottomed in 2015, albeit from a very low level, and it should continue to head higher based on the trend in household interest coverage (Chart 9). Average consumer credit bank lending standards have also been tightening for nine consecutive quarters (bottom panel). Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 41 basis points in September, bringing year-to-date excess returns up to +167 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month and currently sits at 83 bps (Chart 10). In a recent report we showed that the macro picture for CMBS is decidedly mixed.12 A typical negative environment for CMBS is characterized by tightening bank lending standards for commercial real estate loans and falling demand. At present, both lending standards and demand for nonresidential real estate loans are close to unchanged (bottom two panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 13 basis points in September, bringing year-to-date excess returns up to +54 bps. The index option-adjusted spread tightened 1 bp on the month and currently sits at 44 bps. The Bond Maps on page 15 show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of September 28, 2018) Complacent Complacent Chart 12Total Return Bond Map (As Of September 28, 2018) Complacent Complacent Table 4Butterfly Strategy Valuation (As Of September 28, 2018) Complacent Complacent Table 5Discounted Slope Change During Next 6 Months (BPs) Complacent Complacent Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "A Story Told Through Charts: The U.S. Midterm Election", dated September 19, 2018, available at gps.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at ces.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 7 Please see Emerging Markets Strategy Special Report, "Deciphering Global Trade Linkages", dated September 27, 2018, available at ems.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 9 For further details on our yield curve models please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, "No Excuses", dated September 18, 2018, available at usbs.bcaresearch.com 12 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Duration: The housing market is the key channel through which monetary policy impacts the economy. As such, it is unlikely that Treasury yields will peak until housing shows meaningful weakness. While residential investment has decelerated in recent quarters, we expect this weakness will prove temporary and that Treasury yields have further cyclical upside. Maintain below-benchmark portfolio duration. Yield Curve: The Fed will maintain its 25 bps per quarter rate hike pace for the time being, but could be forced to pause next year if weak foreign growth migrates to the U.S. via a stronger dollar. We recommend hedging this risk via a long position in the 7-year bullet versus a short position in the 1/20 barbell. Corporate Health: Strong profit growth - both organic and as a result of corporate tax cuts - has led to a significant improvement in corporate balance sheet health during the past few quarters. This improvement will not persist for much longer. We recommend only a neutral allocation to corporate bonds, both investment grade and junk. Feature This time last week the 10-year Treasury yield was bumping up against 3% and money markets were on the cusp of discounting an extra rate hike between now and the end of 2019. Both resistance levels broke during the past seven days. The 10-year yield is now 3.07% and the January 2020 fed funds futures contract is fully priced for four rate hikes (Chart 1). Chart 1Past Resistance Levels Past Resistance Levels Past Resistance Levels With the 10-year yield back above 3%, many investors are once again speculating about where it will ultimately peak for the cycle. Any answer to this question relies on an assumption about the neutral fed funds rate, the level of interest rates above which monetary policy turns restrictive and acts to slow economic growth and inflation. In past reports we have suggested several measures investors can track to help decide whether interest rates are close to breaking above neutral.1 In this week's report we focus on one particularly important indicator - the housing market. In his essential 2007 paper "Housing Is The Business Cycle", Edward Leamer notes that of the ten post-WWII U.S. recessions, eight were preceded by a significant slowdown in residential investment.2 Given that recessions are also typically preceded by tightening monetary policy, it is not a stretch to connect the two. In fact, there is good reason to believe that housing is the main channel through which monetary policy impacts the economy. Since leverage is employed in the acquisition of new homes, interest rates impact the cost of homeownership more directly than other assets. A similar claim could be made about leveraged investment from the corporate sector, but business investment is also beholden to swings in expected future demand. Households can easily postpone the acquisition of a new home if the interest rate environment makes it uneconomical, businesses need to act when the market demands it. But most importantly, Leamer's paper demonstrates that, unlike residential investment, weaker business investment does not consistently provide advance warning of recession. The State Of U.S. Housing Turning to the data, we see that Leamer's claim is validated by the top panel of Chart 2. Residential investment tends to decline in the year preceding a U.S. recession. Housing starts and new home sales display a similar pattern (Chart 2, panels 2 & 3). Chart 2The Housing Market Predicts Recessions The Housing Market Predicts Recessions The Housing Market Predicts Recessions What's worrying is that residential investment has barely grown at all during the past year (Chart 2, bottom panel). If this weakness continues it would signal that interest rates are too high for the housing market, and that we are likely very close to the cyclical peak in bond yields. However, we doubt the current weakness will persist. For one, the recent decline in construction activity has been concentrated in the multi-family sector while single-family construction continues to expand at a steady rate (Chart 3). This could simply reflect a shift in demand away from multi-family toward single-family, reversing the trend witnessed between 2010 and 2012. It's possible that some households who were forced into the rental market in the aftermath of the Great Recession now find themselves able to switch back. But even if we focus on the multi-family sector exclusively, there is little reason to believe that construction will see significantly more downside. The rental vacancy rate remains very low, and the National Multi Housing Council's Survey of Apartment Market Conditions suggests that there is no strong upward or downward pressure on the vacancy rate at the moment (Chart 3, bottom 2 panels). The fact that single-family housing starts have not declined casts some doubt on the notion that higher mortgage rates are to blame for the deceleration in residential investment. This is further borne out by the fact that, while higher mortgage rates have certainly increased the cost of homeownership, mortgage payments as a percent of median income are not stretched compared to history (Chart 4). The demand back-drop for housing also remains robust, with household formation in a clear uptrend (Chart 4, panel 2) and homebuilders as optimistic as ever about future sales activity (Chart 4, bottom panel). Chart 3A Temporary Weakness In Residential Investment A Temporary Weakness In Residential Investment A Temporary Weakness In Residential Investment Chart 4Higher Mortgage Rates Are Not The Culprit Higher Mortgage Rates Are Not The Culprit Higher Mortgage Rates Are Not The Culprit We conclude that interest rates are still too low to meaningfully impact the housing market. Residential investment will re-accelerate in the coming quarters and Treasury yields have plenty of room to rise before reaching their cyclical peak. Bottom Line: The housing market is the key channel through which monetary policy impacts the economy. As such, it is unlikely that Treasury yields will peak until housing shows meaningful weakness. While residential investment has decelerated in recent quarters, we expect this weakness will prove temporary and that Treasury yields have further cyclical upside. Maintain below-benchmark portfolio duration. Hedging Weak Foreign Growth With Steepeners The resilience of the U.S. housing market makes it likely that interest rates will continue to rise for quite some time. However, this does not preclude weak foreign growth - and the resultant dollar strength - from forcing the Fed to slow its 25 basis point per quarter rate hike pace at some point during the next 6-12 months. In fact, we have flagged in recent reports that, since 1993, every time the Global (ex. U.S.) Leading Economic Indicator (LEI) has fallen below zero, the U.S. LEI has eventually followed (Chart 5).3 Unless foreign growth suddenly recovers, it is quite likely that dollar strength will drag the U.S. LEI lower in the first half of next year. At that point, the Fed may be forced to pause its rate hike cycle in order to take some shine off the dollar, allowing the recovery to continue. Chart 5Weak Global Growth Could Bring Down The U.S. Weak Global Growth Could Bring Down The U.S. Weak Global Growth Could Bring Down The U.S. Drops in the U.S. LEI to below zero almost always coincide with a recommendation for easier monetary policy from our Fed Monitor (Chart 5, bottom panel). Although one notable exception did occur in 2005. An examination of the three components of our Fed Monitor reveals that a falling LEI caused the economic growth component of our monitor to decline in 2005 (Chart 6). However, this was offset by an elevated inflation component and extremely easy financial conditions (Chart 6, bottom 2 panels). Chart 6The Three Components Of Our Fed Monitor The Three Components Of Our Fed Monitor The Three Components Of Our Fed Monitor As in 2005, inflation pressures are once again elevated and financial conditions remain accommodative. It follows that it could take a significant deterioration in economic growth before the Fed is forced to pause its 25 bps per quarter rate hike cycle, one that is not yet evident in the data. Nevertheless, we cannot ignore the risk that weak foreign growth will infiltrate the U.S. via a stronger dollar, forcing the Fed to pause. With only two 25 basis point rate hikes currently discounted for 2019, some pause is already in the price. This makes us reluctant to advocate shifting away from below-benchmark portfolio duration. We think a better way to hedge the risk of a Fed pause is through yield curve steepeners. Since short-dated yields are more heavily influenced by the expected near-term pace of rate hikes than long-dated yields, any Fed pause will cause the yield curve to steepen. Steepeners are also very attractively priced at the moment, meaning that they should even perform well in a mild curve flattening environment.4 Our preferred method for implementing a curve steepener is to go long a bullet maturity near the middle of the curve and short a duration-matched barbell consisting of the very short and very long ends of the curve.5 With that in mind, we can determine the best yield curve trade to implement by answering the following two questions: Which bullet over barbell combination offers the most attractive value? Which bullet over barbell combination is most likely to outperform in the "Fed pause" scenario we are trying to hedge? In response to the first question, we consider the 2-year, 3-year, 5-year and 7-year bullet maturities all relative to a duration-matched 1/20 barbell. All of those butterfly spreads offer approximately the same yield pick-up (Chart 7). They also all offer approximately the same yield pick-up relative to our fair value models, which are based on regressions of the butterfly spread versus the 1/20 slope of the curve (Chart 8).6 To answer the second question, we try to identify which of the 2-year, 3-year, 5-year or 7-year yields is likely to decline the most in response to the market pricing-in a pause in Fed rate hikes. To do this we look at the historical correlations between different yield curve slopes and our 12-month Fed Funds Discounter - the change in the fed funds rate that is priced into the market for the next 12 months. The correlations are displayed in Chart 9, and they show that monthly changes in the 7/10 slope are almost always negatively correlated with monthly changes in the 12-month discounter. In other words, when the discounter falls, the 7-year yield falls by more than the 10-year yield. Chart 7Different Bullets, Similar Yield Pick-Up I Different Bullets, Similar Yield Pick-Up I Different Bullets, Similar Yield Pick-Up I Chart 8Different Bullets, Similar Yield Pick-Up II Different Bullets, Similar Yield Pick-Up II Different Bullets, Similar Yield Pick-Up II Chart 9Hedging The "Fed Pause" Scenario Hedging The "Fed Pause" Scenario Hedging The "Fed Pause" Scenario Monthly changes in the 5/7 slope are also usually negatively correlated with changes in the discounter, though the correlation has been closer to zero in recent years. This makes it difficult to say with certainty whether the 5-year or 7-year yield would fall by more in response to a decline in the discounter. Chart 9 also shows that changes in both the 2/3 and 3/5 slopes are positively correlated with changes in the 12-month discounter. This means that when the discounter falls, the 3-year yield falls by more than the 2-year yield and the 5-year yield falls by more than the 3-year yield. In general, we can safely conclude that the 5-year and 7-year bullets are better hedges against a Fed pause than the 2-year or 3-year bullets. The 7-year in particular appears to be a safe bet. Given that the differences in valuation between the different options are miniscule, we are inclined to maintain our current yield curve position: long the 7-year bullet and short the 1/20 barbell. This week we also close our recommendation to favor the 5/30 barbell over the 10-year bullet for a small loss of 2 bps. This trade was designed to hedge the risk of Fed overtightening leading to an inverted yield curve. This trade would underperform in the event of a Fed pause, which we now view as the greater risk. Bottom Line: The Fed will maintain its 25 bps per quarter rate hike pace for the time being, but could be forced to pause next year if weak foreign growth migrates to the U.S. via a stronger dollar. We recommend hedging this risk via a long position in the 7-year bullet versus a short position in the 1/20 barbell. Corporate Balance Sheet Reprieve Last week's release of the second quarter U.S. Financial Accounts (formerly Flow of Funds) allows us to update our indicators of nonfinancial corporate balance sheet health. Overall, there has been a significant improvement in our Corporate Health Monitor (CHM) since the end of 2016. It has fallen from deep in "deteriorating health" territory to close to the "improving health" zone (Chart 10). By far, the biggest driver of the CHM's improvement has been the sharp increase in after-tax cash flows (Chart 10, panel 2). This is partly due to the recent corporate tax cuts, but also reflects a significant rebound in pre-tax cash flows (Chart 10, bottom panel). Despite the rebound in profits, we remain cautious on the outlook for corporate balance sheets going forward. First, our bottom-up samples of firms included in the investment grade and high-yield Bloomberg Barclays bond indexes both show that the median firm's net debt-to-EBITDA has improved in recent quarters, but remains elevated compared to history (Chart 11). Chart 10After-Tax Cash Flows Drive CHM Improvement After-Tax Cash Flows Drive CHM Improvement After-Tax Cash Flows Drive CHM Improvement Chart 11Debt Levels Still High Debt Levels Still High Debt Levels Still High Second, we see increasing headwinds to profit growth going forward. The positive impact from tax cuts is set to wane, while the stronger dollar and faster wage growth will both weigh on pre-tax profits during the next year.7 It is important to note that it will not take much deceleration in pre-tax profits for corporate balance sheets to worsen. Our measure of gross leverage - total debt over pre-tax profits - has only managed to flatten-off during the past few quarters, even as profit growth has surged. This means that the rapid gains in profits have only managed to keep pace with the rate of debt growth. Even a small deceleration in profits will cause leverage to rise, and rising leverage tends to occur alongside an increasing default rate (Chart 12). Chart 12Gross Leverage And Corporate Defaults Gross Leverage And Corporate Defaults Gross Leverage And Corporate Defaults Bottom Line: Strong profit growth - both organic and as a result of corporate tax cuts - has led to a significant improvement in corporate balance sheet health during the past few quarters. This improvement will not persist for much longer. We recommend only a neutral allocation to corporate bonds, both investment grade and junk. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Tracking The Two-Stage Treasury Bear", dated August 14, 2018, available at usbs.bcaresearch.com 2http://www.nber.org/papers/w13428 3 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Playing Catch-Up", dated September 11, 2018, available at usbs.bcaresesarch.com 5 For further details on why we prefer this trade construction, please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 6 We calculate the butterfly spread as: the bullet yield minus the yield of the duration-matched barbell. 7 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights A sovereign debt default in Argentina is unlikely in the next 12 months, the primary reason being IMF financing. The peso and the stock market appear close to two standard deviations cheap. Consequently, it makes sense to argue that financial market adjustments in Argentina are probably advanced, and investors should avoid temptation to become more bearish. However, we are not yet comfortable taking unhedged bets. For fixed income and currency investors, we recommend the following relative positions: short Brazilian / long Argentine sovereign credit, and long Argentine peso / short Brazilian real. Feature Chart I-1The Argentine Peso Is Cheap The Argentine Peso Is Cheap The Argentine Peso Is Cheap Argentine financial markets have plunged dramatically, and the question is whether the country is heading into another sovereign default. Argentina has defaulted eight times and devalued its currency many times in the past 60 years. Hence, odds of a government debt default cannot be dismissed lightly. This is also a valid question, given that Argentina's foreign currency public debt stands at $220 billion, and that after the latest currency devaluation, it is equal to 71 % of GDP. Total public (foreign and local currency) debt stands at 87% of GDP. Yet, our assessment is that a sovereign debt default is not likely in the next 12 months because of IMF financing. The latter will be ready to increase the size of its funding to Argentina's current government, if needed, for both political and economic reasons. The IMF has a good working relationship with Argentine President Mauricio Macri's government, which is packed with orthodox economists who share the IMF's philosophies. Besides, the U.S. administration will welcome IMF financial support for Argentina, as it will not want the latter country to request credit lines from China, like it did under its previous government. Given that a sovereign debt default is likely to be avoided in the next 12 months before Macri's current term expires, should investors buy Argentine financial assets? On one hand, the currency seems to have become quite cheap - Chart I-1 illustrates that the peso's real effective exchange rate has plunged close to 40% below its fair value. On the other hand, both the near-term domestic outlook and broader EM dynamics remain risky. What Went Wrong? Argentina's woes this year have been due to excessive reliance on foreign financing as well as tardy fiscal tightening. The government had been delaying crucial fiscal tightening due to political considerations. Further, it used its access to global capital markets last year to raise an immense amount of foreign funds to finance its ballooning fiscal deficit. In particular, portfolio net inflows amounted to $35 billion in 2017 amid the buying frenzy in emerging markets (Chart I-2). Meantime, net FDI inflows were meager. The outstanding amount of portfolio debt securities and portfolio equity investment owned by foreigners has risen sharply since Macri's government came to power in December 2015 (Chart I-3). The most recent data points on this chart are as of the end of March 2018. Hence, they do not incorporate security liquidations that have occurred by foreigners since that time. Chart I-2Argentina: Heavy Reliance On##br## Foreign Portfolio Flows Argentina: Heavy Reliance On Foreign Portfolio Flows Argentina: Heavy Reliance On Foreign Portfolio Flows Chart I-3Securities Holdings By Foreigners Have ##br##Surged Since Macri's Election Securities Holdings By Foreigners Have Surged Since Macri's Election Securities Holdings By Foreigners Have Surged Since Macri's Election In brief, Macri's government relied on plentiful global portfolio flows into EM to finance the country's large fiscal deficit in 2016 and 2017. As soon as foreign portfolio inflows into EM reversed, Argentina immediately began to feel the punch. Some commentators blame the central bank for excessive money printing, and have recommended Argentina dollarizing its economy: i.e., adopting the U.S dollar.1 These accusations and recommendations are misplaced and misguided. In the short term, commercial banks have expanded their loans aggressively in the past 18 months (Chart I-4). This is what has contributed to the peso's plunge. The central bank was late to hike interest rates accommodating this credit binge and the collapse in the exchange rate value was the price to be paid for this mistake. From a structural perspective, however, local currency broad money (M3) supply in Argentina is not excessive at all. It is equal to mere 24% of GDP, which is a very low ratio compared to Turkey's 52%, Brazil's 90% and China's 240% (Chart I-5). Therefore, there has structurally been no excessive money creation. Chart I-4Private Credit Boom This Year Private Credit Boom This Year Private Credit Boom This Year Chart I-5Money Supply Is Not Excessive In Argentina Money Supply Is Not Excessive In Argentina Money Supply Is Not Excessive In Argentina The currency meltdown can be attributed to persistent hyperinflation that makes residents reluctant to hold and save in pesos. Inflation is a structural problem in Argentina, and it is not due to excessive demand, but rather due to lack of supply. Structural supply deficiency - the inability of the economy to produce goods and services efficiently - is the primary reason for structurally high inflation and large current account deficits. Each time demand recovers in Argentina, it can only be satisfied by ballooning imports and a widening current account deficit since domestic production/supply is weak. Chronic supply deficiency can be cured by structural reforms, though it will take years to show progress. It cannot be solved by fiscal and monetary policies within a year or two. Painful Adjustments Are In The Making In near term, the currency will remain volatile but over the next six months, it will likely find a floor because of the following. First, the nation's foreign debt obligations (FDO) will drop from $68 billion this year to $40 billion in 2019 (Chart I-6, top panel). This will alleviate pressure on the balance of payments that has been severe this year. Therefore, the outlook for foreign funding should improve over the next year. The negotiated new tranche from the IMF of about $30-35 billion will cover a considerable portion of Argentina's foreign funding needs over the next 16 months. If more funding is required, the IMF will likely provide it as well. Second, in the past year the government has already been reducing its primary fiscal spending - i.e. excluding interest payments on public debt (Chart I-7). The crisis has forced Macri's government to slash public expenditures more aggressively. In recent weeks alone the government announced cuts in several government ministries and raised taxes on exports of agricultural goods. Overall, the primary deficit target for 2019 has been revised in from -1.3% of GDP to a balanced budget (Chart I-8). Chart I-6Argentina: Lower Foreign Debt ##br##Obligations Due Next Year Argentina: Lower Foreign Debt Obligations Due Next Year Argentina: Lower Foreign Debt Obligations Due Next Year Chart I-7Argentina: Government Spending Has##br## Been Substantially Curtailed Argentina: Government Spending Has Been Substantially Curtailed Argentina: Government Spending Has Been Substantially Curtailed Chart I-8Argentina: No Primary ##br##Fiscal Deficit In 2019 Argentina: No Primary Fiscal Deficit In 2019 Argentina: No Primary Fiscal Deficit In 2019 The key risk to this target is government revenues that may underwhelm because the economy is in a major recession. If this occurs, additional spending cuts are likely. This is bad for the economy, but if the government implements these expenditure cuts it will be positive for the currency and government creditors. Third, the current account and trade balances will improve in the next 12 months as the peso's plunge and higher interest rates are already crashing domestic demand and imports (Chart I-9). Imports of both consumer and capital goods are already plunging, and total imports will likely drop by at least 30-35% in the next 12 months (Chart I-10). Finally, given the peso's 50% plunge this year, inflation is set to surge. Based on the regression of inflation on the exchange rate, consumer price inflation could reach 55% by year end (Chart I-11). This will impair household purchasing power - erode their income in real terms - as the government will likely maintain the growth ceiling of 13% for minimum wages in 2018. The minimum wage serves as a benchmark for wage negotiations nationwide. In real terms, wage diminution will reinforce a contraction in consumer spending. Chart I-9Argentina: Current Account Balance ##br##Was Unsustainably Wide Argentina: Current Account Balance Was Unsustainably Wide Argentina: Current Account Balance Was Unsustainably Wide Chart I-10Argentina: Imports Are##br## Set To Plummet Argentina: Imports Are Set To Plummet Argentina: Imports Are Set To Plummet Chart I-11Argentina: Inflation Will Surge##br## To About 50% Argentina: Inflation Will Surge To About 50% Argentina: Inflation Will Surge To About 50% In a nutshell, the unfolding crash in domestic demand will cap inflation next year. Bottom Line: A dramatic domestic demand retrenchment (a major recession) along with lower foreign debt obligations in 2019 will reduce the country's foreign funding requirements next year. Besides, the IMF will likely disburse the remaining $35 billion in the next 16 months. It will, in our opinion, also be disposed to providing additional funding to avoid a public debt default in Argentina in the next 12 months at least. In this vein, investors should be asking whether the peso and asset prices have become sufficiently cheap to warrant bottom-fishing. What Is Priced In? There is little doubt that economic growth and corporate profits in Argentina will be disastrous in the months ahead. Nevertheless, financial markets have already crashed and investors should be looking to make a judgment on whether the peso, equities and sovereign credit are cheap enough to warrant bottom-fishing. We have the following observations: Currency: The peso is about 40% below its fair value, according to our valuation model (Chart 1 on page 1). This model is built using the real effective exchange rate (REER) based on consumer and producer prices. Previous episodes of devaluation drove the peso's REER 40-55% below its fair value. Hence, there still could be up to 15% of downside in the REER or in the peso's total return adjusted for carry. However, from a big-picture perspective, the peso may not be too far from bottoming in real inflation-adjusted terms. This does not mean that the nominal exchange rate will appreciate. It entails that the peso will bottom in real terms or adjusted for the carry (on a total return basis). Stocks: The aggregate Argentine equity index has plunged by 60% in dollar terms, and bank stocks have dropped by 75% in dollar terms. As a result, our cyclically adjusted P/E ratio has fallen to 5 for the overall bourse and to 3 for bank stocks (Chart I-12A & Chart I-12B). Chart I-12AOverall Equities Are Cheap... Overall Equities Are Cheap... Overall Equities Are Cheap... Chart I-12B... As Are Bank Stocks ...As Are Bank Stocks ...As Are Bank Stocks Yet there might be a tad more downside before these cyclically-adjusted P/E ratios reach two standard deviations below their fair value. Furthermore, if we were to compare the magnitude of the crash in Argentine share prices relative to the Asian crisis (specifically, Thailand and Korea), there seems to be further downside in Argentine equities (Chart I-13). Sovereign credit: Argentine sovereign credit spreads have reached 850 basis points (Chart I-14, top panel), which is 450 basis points wider than the spread for the aggregate EM benchmark (Chart I-14, bottom panel), but they are still well below their 2013 highs. Clearly valuations are not yet sufficiently attractive in the credit space to warrant bottom-fishing. However, assuming our call that the IMF will do everything to preclude a public debt default, at least in the next 12 months, sovereign credit spreads may not widen excessively from current levels. Chart I-13There Is More Downside When Compared With Asian Crisis There Is More Downside When Compared With Asian Crisis There Is More Downside When Compared With Asian Crisis Chart I-14Sovereign Credit Spreads: Absolute And Relative To EM Sovereign Credit Spreads: Absolute And Relative To EM Sovereign Credit Spreads: Absolute And Relative To EM Investment Conclusions The peso and stock market appear close to two standard deviations cheap. Consequently, it makes sense to argue that financial market adjustments in Argentina are probably advanced, and that investors should avoid the temptation to become more bearish. For investors who own the currency, stocks, or sovereign credit, and can withstand further volatility, it likely makes sense to stay the course. Even though the economy has entered yet another major recession, investors should keep in mind that financial markets are forward looking and may have already priced in a major economic contraction. In the equity space, we will wait before recommending a long position in the overall market or in bank stocks, as disastrous corporate profits could produce a final down leg in share prices. Our negative view on EM risk assets also argues for being patient. In the sovereign credit space, we are not yet comfortable taking a unhedged absolute bet, and continue to recommend maintaining the following relative position: short Brazilian / long Argentine sovereign credit (Chart I-15). Chart I-15Argentina Versus Brazil: Sovereign Credit Spreads Argentina Versus Brazil: Sovereign Credit Spreads Argentina Versus Brazil: Sovereign Credit Spreads Relative to Argentina, Brazil's financial markets are expensive at a time when Brazil's macro fundamentals and politics are problematic. We discussed our view on Brazil in detail in our July 27, 2018 Special Report,2 and will not repeat it here. Our recommendation - from January 16th 2017 - of buying Argentine long-dated local currency bonds has incurred large losses. We are closing this position and opening a new trade going long the peso to earn the high carry at the front end of the curve. The high carry could provide enough downside protection. Yet we do not have strong conviction as to whether the peso has reached an ultimate bottom. Therefore, we recommend a relative currency trade: long Argentine peso / short Brazilian real. This trade has a 35% positive carry, and certainly the selloff in the Argentine peso is far more advanced than that of the real. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com 1 Please refer to Wall Street Journal article entitled: Argentina Needs to Dollarize, dated September 10th 2018. 2 Please see BCA Emerging Markets Strategy Special Report, "Brazil: Faceoff Time," dated July 27, 2018, available on page 18. South African Rand: Engulfed In A Downward Spiral? 13 September 2018 Chart II-1Risks Are To The Downside For The Rand Risks Are To The Downside For The Rand Risks Are To The Downside For The Rand From the beginning of 2016 to early 2018, the South African rand enjoyed various tailwinds: rising metal prices, an improving trade balance, strong foreign portfolio inflows and lastly, hopes that the new president Ramaphosa would implement structural reforms, in turn enhancing the country's structural backdrop. These tailwinds have turned into headwinds since early this year and seem likely to persist. Hence, we believe the rand will remain in a downward spiral for now. First and foremost, metal prices have been under serious downward pressure. Typically, they correlate with the South African rand. Chart II-1 illustrates our new indicator for the rand, which is calculated as the annual growth rate in metal prices minus South Africa's broad money (M3) impulse. When the indicator drops below zero, like it has done recently, the rand tends to sell-off. In short, the bear market in the rand is not yet over. The broad money impulse in this indicator serves as a proxy for underlying domestic demand, and hence, import growth. Also, we use the average of the Goldman Sachs industrial and precious metal price indexes for metal prices. The latter is used as a proxy for export growth. Worryingly, not only export prices are plummeting but export volumes are also weak and mining production is contracting (Chart II-2). As a result, the trade and current account deficits will widen again. Chart II-3 illustrates that the rand depreciates when the annual change in trade balance turns down. It will be difficult for South Africa to finance its widening trade and current account deficits given the poor global backdrop and the slowing fund flows to EM. Since 2013, foreign capital inflows have by and large been comprised of volatile portfolio inflows rather than stable foreign direct investments (Chart II-4). Presently, the gap between the two stands at its widest in history. Additionally, foreign ownership of domestic bonds remains extremely elevated. Our big picture view is that the liquidation in EM financial markets will persist and foreign investors in South African domestic bonds will be under pressure to reduce their holdings or hedge their currency risk exposure. Chart II-2Mining Output ##br##Is Shrinking Mining Output Is Shrinking Mining Output Is Shrinking Chart II-3Trade Balance Momentum Points ##br## To Currency Depreciation Trade Balance Momentum Points To Currency Depreciation Trade Balance Momentum Points To Currency Depreciation Chart II-4Excessive Reliance On ##br##Foreign Portfolio Inflows Excessive Reliance On Foreign Portfolio Inflows Excessive Reliance On Foreign Portfolio Inflows Politics served as a justification for investors to buy South African risk assets at the start of the year. We downplayed that optimism back then and still remain negative on politics today. Ramaphosa has recently endorsed a constitutional change that would allow the confiscation of land without compensation. Whether this policy will actually materialize and get implemented is impossible to know. That said, as outlined in our June 28 2017 Special Report entitled South Africa: Crisis of Expectations,3 our fundamental political analysis suggests that the median voter in South Africa will continue favoring populism. As such, populist policies are likely to continue being proposed to appease the ANC base, and some of them might be implemented. Constant pressure on the ANC from South Africa's far-left political party Economic Freedom Fighters, before next year's election, entails a very low likelihood that painful structural reforms will be enacted. As such, the productivity outlook will remain poor for now. On the fiscal front, there has been little to no improvement since Ramaphosa assumed office in February of this year (Chart II-5). In terms of valuation, South African risk assets are not particularly attractive at the moment. The rand is not very cheap (Chart II-6) and neither are equities (Chart II-7). Odds are that the rand will become as cheap as in 2015 based on its real effective exchange rate - before a bottom is reached. Chart II-5There Has Been No Improvement##br## In Fiscal Accounts There Has Been No Improvement In Fiscal Accounts There Has Been No Improvement In Fiscal Accounts Chart II-6The Rand Will Likely Get ##br##Cheaper Before It Bottoms The Rand Will Likely Get Cheaper Before It Bottoms The Rand Will Likely Get Cheaper Before It Bottoms Chart II-7South African Equities##br## Are Not Cheap Yet South African Equities Are Not Cheap Yet South African Equities Are Not Cheap Yet Putting all these factors together, the path of least resistance for South African risk assets is down. We recommend EM dedicated equity and fixed-income (both local currency and sovereign credit) investors to maintain an underweight allocation on South Africa. We also continue recommending shorting general retailer stocks. For currency traders, we suggest maintaining the following trades: short ZAR vs. USD and short ZAR vs. MXN. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 3 Please see BCA Emerging Markets Strategy & Geopolitical Strategy Special Report, "South Africa: Crisis Of Expectations," dated June 28, 2017, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Chart 1Wage Growth Playing Catch-Up To Curve Wage Growth Playing Catch-Up To Curve Wage Growth Playing Catch-Up To Curve Last Friday's employment report confirmed that the U.S. economy remained on a solid footing through August, even as leading indicators outside of the U.S. have weakened. Our back-of-the-envelope GDP tracking estimate - the year-over-year growth in aggregate weekly hours worked (2.14%) plus average quarterly productivity growth since 2012 (0.86%, annualized) - points to U.S. growth of approximately 3%. But strong GDP growth is old news for markets. Rather, it was the 0.4% month-over-month increase in average hourly earnings that caused bond yields to jump last Friday. Rising wage growth is usually a bear-flattener, consistent with both higher yields and a flatter curve (Chart 1). But in recent years the yield curve has flattened considerably while wage growth has lagged. The curve's front-running suggests that continued gains in wage growth will keep the Fed on its current tightening path, but may not translate into much curve flattening. Investors should maintain below-benchmark duration, but look for attractively valued curve steepeners. We also recommend only a neutral allocation to spread product to hedge the risk from weakening global growth. 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 43 basis points in August, dragging year-to-date excess returns down to -93 bps. The index option-adjusted spread widened 5 bps on the month, and currently sits at 113 bps. Despite recent spread widening, corporate bonds remain expensive with 12-month breakeven spreads for both the A and Baa-rated credit tiers near their 25th percentiles since 1989 (Chart 2). Further, with inflation now close to the Fed's target, monetary policy will provide much less support for corporate bond returns going forward. These are the two main reasons we downgraded our cyclical corporate bond exposure to neutral in June.1 On a positive note, gross leverage for the non-financial corporate sector likely declined for the third consecutive quarter in Q2 (panel 4), but we remain pessimistic that such declines will continue in the back-half of the year. As we noted in a recent report, weaker foreign economic growth and the resultant dollar strength will eventually weigh on corporate revenues.2 Accelerating wage growth will also hurt profits if it is not completely passed through to higher prices. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Playing Catch-Up Playing Catch-Up Table 3BCorporate Sector Risk Vs. Reward* Playing Catch-Up Playing Catch-Up High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 14 basis points in August, bringing year-to-date excess returns up to +220 bps. The average index option-adjusted spread widened 2 bps on the month, and currently sits at 336 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 226 bps, slightly below the long-run mean of 247 bps (Chart 3). This tells us that if default losses are in line with our expectations during the next 12 months, we should expect excess high-yield returns of 226 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in a recent report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).3 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.15% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance were in much better shape than today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks are to the upside. It will be critical to track real-time indicators of the default rate such as job cut announcements, which have increased since mid-2017 (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in August, dragging year-to-date excess returns down to -18 bps. The conventional 30-year zero-volatility MBS spread widened 5 bps on the month, driven by a 3 bps increase in the compensation for prepayment risk (option cost) and a 2 bps widening of the option-adjusted spread. The excess return Bond Map shows that MBS offer a relatively poor risk/reward trade-off, particularly compared to Aaa-rated non-Agency CMBS, High-Yield and Sovereigns. However, our Bond Map does not account for the macro environment, which remains very favorable for the sector. In a recent report we showed that the two main factors that influence MBS spreads are mortgage refinancing activity and residential mortgage lending standards.4 Refi activity is tepid, and continued Fed rate hikes will ensure that it stays that way (Chart 4). Meanwhile, lending standards have been slowly easing since 2014 (bottom panel), but the Fed's most recent Senior Loan Officer Survey reports that standards remain at the tighter end of the range since 2005. The still-tight level of lending standards suggests that further easing is likely going forward. The amount of MBS running off the Fed's balance sheet has failed to exceed its cap in recent months, meaning that the Fed has not needed to enter the market to purchase MBS. This will probably continue to be the case going forward, due to both limited run-off and increases in the monthly cap. 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 12 basis points in August, dragging year-to-date excess returns down to -10 bps. Sovereign debt underperformed the Treasury benchmark by 48 bps on the month, dragging year-to-date excess returns down to -83 bps. Foreign Agencies underperformed by 14 bps on the month, dragging year-to-date excess returns down to -36 bps. Local Authorities underperformed by 20 bps on the month, dragging year-to-date excess returns down to +41 bps. Supranationals performed in line with Treasuries in August, keeping year-to-date excess returns at +12 bps. Domestic Agency bonds outperformed by 5 bps, bringing year-to-date excess returns up to +4 bps. Despite poor returns relative to Treasuries, Sovereign debt managed to outperform similarly-rated U.S. corporate debt in recent months. The outperformance is particularly puzzling given the unattractive relative valuation and the strengthening U.S. dollar (Chart 5). We reiterate our underweight allocation to Sovereign debt. The excess return Bond Map shows that both Local Authorities and Foreign Agencies offer exceptional risk/reward trade-offs compared to other U.S. bond sectors. We remain overweight both sectors. The excess return Bond Map also shows that while Supranational and Domestic Agency sectors are very low risk, expected returns are feeble. Both sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 70 basis points in August, dragging year-to-date excess returns down to +116 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 3% in August, and currently sits at 85% (Chart 6). This is more than one standard deviation below its post-crisis mean and only slightly higher than the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. In a recent report we demonstrated that while M/T yield ratios are low, municipal bonds offer attractive yields compared to corporate bonds.5 For example, we observe that a 5-year Aa-rated municipal bond carries a yield of 2.29% versus a yield of 3.35% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 32% should be indifferent between the two bonds. Moving further out the curve, the breakeven tax rate falls to 23% at the 10-year maturity point and is even lower at the 20-year maturity point. What's more, municipal bonds are also more insulated from the risk of weak foreign growth than the U.S. corporate sector, and recent enacted revenue increases at the state level should lead to lower net borrowing in the coming quarters (bottom panel). All in all, attractive relative yields and lower risk make municipal bonds preferable to corporates in the current environment. Remain overweight. Treasury Curve: Favor The 7-Year Bullet Over The 1/20 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve has flattened since the end of July, with yields at the short-end of the curve slightly higher and yields at the long-end slightly lower. The 2/10 Treasury slope currently sits at 23 bps and the 5/30 slope is currently 29 bps. The yield curve is already quite flat, consistent with a late-cycle economy. However, the economic data do not yet synch up with the curve's assessment. Chart 1 shows that wage growth is lagging the yield curve, while another yield curve indicator - nominal GDP growth less the fed funds rate - is moving in the opposite direction (Chart 7). We are likely to see both accelerating wage growth and decelerating nominal GDP growth during the next few quarters, but such outcomes are to a large extent in the price. In other words, the pace of curve flattening is likely to moderate in the coming months. With that in mind, we maintain our position long the 7-year bullet versus a duration-matched 1/20 barbell. That position is priced for 20 bps of 1/20 flattening during the next six months (Table 5). Table 4Butterfly Strategy Valuation (As Of August 3, 2018) Playing Catch-Up Playing Catch-Up Table 5Discounted Slope Change During Next 6 Months (BPs) Playing Catch-Up Playing Catch-Up Curve flatteners look more attractive at the long-end of curve. For example, the 5/30 barbell over 10-year bullet is priced for no change in 5/30 slope during the next six months. We also continue to hold this position to take advantage of the attractive value, and as a partial hedge to our position in the 1/7/20. TIPS: Overweight Chart 8TIPS Market Overview Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 17 basis points in August, dragging year-to-date excess returns down to +122 bps. The 10-year TIPS breakeven inflation rate declined 4 bps on the month and currently sits at 2.10%. The 5-year/5-year forward TIPS breakeven inflation rate declined 6 bps on the month and currently sits at 2.22%. Both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. TIPS breakevens have remained relatively firm in recent weeks even as commodity prices have declined sharply (Chart 8). This suggests that breakevens are increasingly taking cues from the U.S. inflation data, and might now be less sensitive to the global growth outlook. Core inflation should remain close to the Fed's 2% target going forward. This will gradually wring deflationary expectations out of the market, allowing long-dated TIPS breakevens to reach our 2.3% to 2.5% target range. While the macro back-drop remains highly inflationary - pipeline inflation measures are elevated (panel 4) and the labor market is tight - we noted in a recent report that the rate of increase in year-over-year core inflation will probably moderate in the months ahead, due to base effects that have become less supportive.6 ABS: Neutral CHart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in August, bringing year-to-date excess returns up to 18 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 1 basis point on the month and now stands at 37 bps, 10 bps above its pre-crisis low. The excess return Bond Map shows that consumer ABS offer attractive return potential compared to other high-rated spread products - such as Agency CMBS and Domestic Agencies - but also carry a greater risk of losses. Further, credit quality trends have been slowly moving against the sector and we think caution is warranted. The consumer credit delinquency rate bottomed in 2015, albeit from a very low level, and it should continue to head higher based on the trend in household interest coverage (Chart 9). Average consumer credit bank lending standards have also been tightening for nine consecutive quarters (bottom panel). The New York Fed's Household Debt and Credit report showed that consumer credit growth increased at an annualized rate of 4.6% in the second quarter, compared to 3.3% in Q1. However, the prospects for further acceleration in consumer credit are probably limited. A rising delinquency rate and tightening lending standards will both weigh on future credit growth (panel 3). Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 28 basis points in August, bringing year-to-date excess returns up to +126 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps on the month and currently sits at 68 bps (Chart 10). In a recent report we showed that the macro picture for CMBS is decidedly mixed.7 A typical negative environment for CMBS is characterized by tightening bank lending standards for commercial real estate loans and falling demand. At present, both lending standards and demand for nonresidential real estate loans are close to unchanged (bottom two panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in August, bringing year-to-date excess returns up to +41 bps. The index option-adjusted spread was flat on the month and currently sits at 45 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of September 7, 2018) Playing Catch-Up Playing Catch-Up Chart 12Total Return Bond Map (As Of September 7, 2018) Playing Catch-Up Playing Catch-Up Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges", dated September 4, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights It has not been a lot of fun being a corporate bond investor in 2018. Global credit markets have struggled to deliver positive returns, amid a news flow that has been overwhelming at times. Geopolitical uncertainty, shifting monetary policy biases, greater inflation pressures, intensifying trade tensions, a rising U.S. dollar, slowing Chinese growth - all have combined to form a backdrop where investors should require wider risk premiums to own risky assets like corporate debt. Yet are wider spreads justified relative to the underlying financial health of companies? Feature Chart 1Global Corporates: Fading Support From##BR##Growth & Monetary Policy Global Corporates: Fading Support From Growth & Monetary Policy Global Corporates: Fading Support From Growth & Monetary Policy Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. The broad conclusion from the latest readings on our CHMs is that global credit quality has been enjoying a cyclical improvement across countries, regions and credit tiers. The U.S. has delivered the biggest improvement in corporate health, compared to the recent past and to bearish investor perceptions as well. Much of that can be attributed to the impact of the Trump corporate tax cuts, though. At the same time, there have even been significant improvements in profitability metrics in regions that have lagged during the current global economic expansion, like Peripheral Europe. We recently downgraded our overall global spread product allocation to neutral.1 This reflected the increased concerns of the BCA Strategists that valuations on global risk assets looked rich compared to growing geopolitical risks (U.S.-China trade tensions, U.S.-Iran military tensions). Yet it also was related to the ongoing development of our biggest investment theme for 2018 - the eventual likely collision between tightening global monetary policy and rich valuations on global risk assets. Looking ahead, the tailwinds that have been supportive for corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds (Chart 1). The overall OECD leading economic indicator, which is well correlated to the annual excess returns of global high-yield debt, has peaked. Central banks are either delivering rate hikes, talking about rate hikes, or cutting back on the pace of balance sheet expansion. All of these factors will weigh on corporate bond returns over the next 6-12 months. U.S. Corporate Health Monitors: Improving Thanks To Resilient Growth & Tax Cuts Chart 2Top-Down U.S. CHM:##BR##Boosted By Cyclically Strong Profits Top-Down U.S. CHM: Boosted By Cyclically Strong Profits Top-Down U.S. CHM: Boosted By Cyclically Strong Profits Our top-down CHM for the U.S. has been in the "deteriorating health" region for fifteen consecutive quarters dating back to the middle of 2014 (Chart 2). That streak appears set to end soon, as the indicator has been falling since peaking in 2016 and now sits just above the zero line. The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. It is important to note that the top-down CHM uses after-tax earnings measures in several of the ratios the go into the indicator: return on capital, profit margin and debt coverage. All three of those ratios saw significant upticks in the first quarter of 2018, which is the latest available data for the top-down CHM. The Trump tax cuts did take effect at the start of the year, but given the robust results seen in reported second quarter profits reported so far, a bigger impact will likely be visible once we are able to update the CHM for the most recently completed quarter. The ability for U.S. companies to continue expanding margins will be tested in the next 6-12 months. The tight U.S. labor market is pushing up wage growth, which will pressure margins and prompt some firms to try and raise prices to compensate. Firming U.S. inflation is already keeping the Fed on a 25bps-per-quarter pace of rate hikes, and perhaps more if U.S. inflation continues to accelerate without any slowing of U.S. economic growth. If the Fed starts actively targeting a slower pace of U.S. growth to cool off inflation, credit markets will take notice and U.S. corporate debt will underperform. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. There are no imminent domestic pressures on U.S. corporate finances that should require wider credit spreads to compensate for rising default risk. The bottom-up versions of the U.S. CHMs for investment grade (IG) corporates (Chart 3) and high-yield (HY) companies (Chart 4) have also both improved, with the HY indicator now crossing over the zero line into "improving health" territory. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term issues of high leverage and low interest/debt coverage are not going away, suggesting that potential problems are being stored up for the next U.S. economic downturn. What also remains worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of U.S. corporate debt is now so large that the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to rise significantly or if U.S. earnings growth slows sharply. We moved our recommended stance on U.S. IG and HY to neutral at the end of June as part of our downgrade of overall global spread product exposure. We may consider a move back to overweight (versus U.S. Treasuries) on any meaningful spread widening given our optimistic view on U.S. economic growth and the positive measure on credit risk signaled by our CHMs. Yet it may be difficult to get such an opportunity. The U.S. is reaching a more challenging point in the monetary policy cycle with the Fed likely to shift to a restrictive stance within the next 6-12 months. At the same time, there are risks to the U.S. economy stemming from the widening U.S.-China trade conflict, a stronger U.S. dollar and, potentially, the growing turmoil in emerging markets. Yet the state of U.S. corporate health has improved substantially, leaving companies less immediately vulnerable to any of those shocks. Given this balance of risks, a neutral stance on U.S. corporates remains appropriate (Chart 5). Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##Stable, But Watch Profit Margins Bottom-Up U.S. Investment Grade CHM: Stable, But Watch Profit Margins Bottom-Up U.S. Investment Grade CHM: Stable, But Watch Profit Margins Chart 4Bottom-Up U.S. High-Yield CHM:##BR##Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Cyclical Improvement Chart 5U.S. Corporates:##BR##Stay Neutral IG & HY U.S. Corporates: Stay Neutral IG & HY U.S. Corporates: Stay Neutral IG & HY Euro Corporate Health Monitors: Strong Economy, Big Improvements Our top-down euro area CHM remains in "improving health" territory, as has been the case for the past decade (Chart 6). The indicator had been worsening towards the zero line during 2016-17, but rebounded in the first quarter of 2018 thanks to a pickup in profit margins and debt coverage. Those positive developments are even more impressive since they occurred during a quarter when there was some cooling from the robust pace of economic growth seen in 2017. Chart 6Top-Down Euro Area CHM: Modestly Improving Top-Down Euro Area CHM: Modestly Improving Top-Down Euro Area CHM: Modestly Improving Interest coverage and liquidity remain in structural uptrends, supported by the super-easy monetary policies of the European Central Bank (ECB) that have lowered corporate borrowing costs (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Our bottom-up versions of the CHMs for euro area IG (Chart 7) and HY (Chart 8), which are based on individual company earnings data, both confirm the positive message from the top-down CHM. For IG, a noticeable gap has opened up between domestic and foreign issuers in the euro area corporate bond market. Return on capital, operating margins, interest coverage and debt coverage all ticked higher in the first quarter of this year, while leverage slightly declined. Those developments were not repeated among the foreign issuers in our sample. Within the Euro Area, our bottom-up CHMs show that the gap has closed between IG issuers from the core countries versus the periphery, but both remain in the "improving health" zone. (Chart 9). Somewhat surprisingly, the only ratios where there is a material difference are leverage (150% and falling in the periphery, 100% and stable in the core countries) and interest coverage (rising sharply toward 5x in the periphery, stable just above 6x in the core). Despite the improvement in the CHMs, credit spreads for euro area IG and HY have both widened over the course of 2018, while excess returns have been negative year-to-date (Chart 10). Looking ahead, we see the biggest threat for euro area corporate bond performance to come from a shift in ECB policy. We expect the ECB to follow through on its commitment to fully taper net new government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. We doubt that the ECB would want to make such a distinction that would artificially suppress corporate borrowing costs relative to government yields. The ECB is more likely to end both programs concurrently at the end of the year, which will remove a major prop under the euro area corporate bond market. This is a main reason why we are currently recommending an underweight stance on euro area corporates versus U.S. corporates. Chart 7Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Chart 8Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Chart 9Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Yet the bigger reason why we prefer corporates from the U.S. over the euro area is that the relative improvement in corporate health has been bigger in the U.S. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs Europe (Chart 11). That CHM gap continues to favor U.S. credit, which has been outperforming over the past several months (on a common currency basis compared to euro area debt hedged in USD). Chart 10Euro Area Corporates:##BR##Stay Underweight IG & HY Euro Area Corporates: Stay Underweight IG & HY Euro Area Corporates: Stay Underweight IG & HY Chart 11Relative Top-Down CHMs:##BR##Continue To Favor U.S. over Europe Relative Top-Down CHMs: Continue To Favor U.S. over Europe Relative Top-Down CHMs: Continue To Favor U.S. over Europe U.K. Corporate Health Monitor: Deteriorating Amid Rising Domestic Risks The U.K. CHM saw a significant deterioration in the first quarter of 2018, thanks largely to slowing U.K. growth that has impacted all the profit-focused ratios (Chart 12). The CHM is still in the "improving health" zone, but just barely. Seeing the return on capital, profit margin, interest coverage and debt coverage ratios all roll over at historically low levels is a worrying sign for future U.K. credit quality. This is especially true given the extremely stimulative monetary policy run by the Bank of England (BoE) since the 2008 Global Financial Crisis. The only ratio in the U.K. CHM that has seen steady improvement over the past decade is short-term liquidity (bottom panel), which has been boosted by steady increases in working capital. The performance of U.K. credit has benefited from the BoE's additional monetary policy measures taken after the shock Brexit vote in 2016. This involved both interest rate cuts and asset purchases, which included buying of U.K. corporate bonds. The BoE has shifted its policy bias from easing to tightening over the past year, even with sluggish U.K. economic growth and still-unresolved uncertainty about the future U.K. trading relationship with the European Union. This has raised the risks that the BoE could commit a policy error through additional interest rate hikes over the next 6-12 months, especially if policymakers focus more on targeting higher real policy rates as we discussed in a recent Weekly Report.2 U.K. corporates have been a laggard among global credit markets throughout 2018 and especially so in the month of July during a generally positive month for global corporate debt (Chart 13). We see the underperformance continuing in the coming months, as wider spreads will be required given the uncertainties surrounding Brexit, economic growth and BoE monetary policy. Stay underweight U.K. corporate debt within an overall neutral allocation to global spread product. Chart 12U.K. Top-Down CHM: Cyclical Deterioration U.K. Top-Down CHM: Cyclical Deterioration U.K. Top-Down CHM: Cyclical Deterioration Chart 13U.K. Corporates: Stay Underweight U.K. Corporates: Stay Underweight U.K. Corporates: Stay Underweight Japan Corporate Health Monitor: No Problems Here We added Japan to our suite of global CHMs earlier this year.3 Although the Japanese corporate bond market is small (the Bloomberg Barclays Japan Corporates index only has a market capitalization of $116bn), the asset class does provide opportunities for investors to pick up a bit of yield versus zero-yielding Japanese government bonds (JGBs) Japanese corporate health has been excellent for the past decade, with the CHM steadily holding in "improving health" territory (Chart 14). The trends in the Japan CHM ratios since 2008 are quite different than those seen in the CHMs for other countries. Leverage has been steadily falling, return on capital has been steadily rising (and has now converged to the 6% level seen in other countries' CHMs), and the interest coverage multiple of 9.6x is by far the largest in our CHM universe. Default risk is non-existent in Japan. Only pre-tax operating margins for our bottom-up Japan CHM have lagged those in other countries, languishing at 6% for the past three years. Yet Japanese corporate profits are at all-time highs, a logical outcome when companies can borrow at less than 50bps and earn a return on capital of 6%. That wide gap should allow Japanese companies to continue to earn steady, strong profits even with wage inflation finally showing life in Japan alongside a 2.3% unemployment rate. Japanese corporate bond spreads have widened a bit in 2018, but remain far more stable compared to corporates in other developed markets (Chart 15). The lack of spread volatility has allowed Japanese corporates to steadily outperform JGBs since 2011, even as all Japanese bond yields have collapsed. That trend is likely to continue, as the Bank of Japan (BoJ) is still a long way from being able to credibly pull off any upward adjustment of the current 0% BoJ yield target on 10-year JGBs. Chart 14Japan Bottom-Up CHM: Still Healthy,##BR##But Has Cyclical Improvement Peaked? Japan Bottom-Up CHM: Still Healthy, But Has Cyclical Improvement Peaked? Japan Bottom-Up CHM: Still Healthy, But Has Cyclical Improvement Peaked? Chart 15Japan Corporates:##BR##Stay Overweight vs JGBs Japan Corporates: Stay Overweight vs JGBs Japan Corporates: Stay Overweight vs JGBs Importantly, the BoJ recently introduced new forward guidance that states there will be no interest rate hikes until at least 2020. This will positively affect Japanese corporate health by keeping borrowing costs extremely low and preventing any unwanted strength in the yen that could damage Japanese competitiveness. There is a risk that increasing global trade tensions could impact the export-heavy Japanese economy and damage corporate profit growth and corporate bond performance. We do not yet see that as a major risk that could derail the Japanese economy and we continue to recommend an overweight stance on Japanese corporate debt vs JGBs. Canada Corporate Health Monitor: Faster Growth Hiding Structural Warts We introduced both top-down and bottom-up CHMs for Canada in our previous CHM Chartbook in April. As was the case then, both CHMs are in "improving health" territory (Chart 16). These CHMs are typically correlated to the price of oil, as befits Canada's status as a major energy exporter. Yet the strong CHMs also reflect the solid pace of overall Canadian economic growth. Looking at the individual components of the Canada CHMs, the leverage ratios for both measures have been steadily rising and currently sit above 100%. The return on capital has been in a structural downtrend, as is the case for most countries in our CHM universe (excluding Japan), but has ticked up alongside faster economic growth over the past couple of years. There was a noticeable drop in the margin ratio for the bottom-up CHM, coming entirely from the HY firms within our sample group of companies. Interest coverage and debt coverage ratios remain depressed, even with some improvement in corporate profits. This is partially due to rising interest rates as the Bank of Canada (BoC) has been tightening monetary policy - a trend that we expect to continue over the next 6-12 months. Canadian corporate bond spreads have widened slightly since the start of 2018, but remain tight relative to a longer-term history (Chart 17). Excess returns over Canadian government bonds have flattened out after enjoying a very solid period of outperformance in 2016-17. Looking ahead, there are balanced risks to the outlook for Canadian corporate debt. Chart 16Canada CHMs: Cyclically Improving,##BR##But Longer-Term Problems Are Building Canada CHMs: Cyclically Improving, But Longer-Term Problems Are Building Canada CHMs: Cyclically Improving, But Longer-Term Problems Are Building Chart 17Canadian Corporates:##BR##Stay Neutral Vs Canadian Government Debt Canadian Corporates: Stay Neutral Vs Canadian Government Debt Canadian Corporates: Stay Neutral Vs Canadian Government Debt We continue to expect the BoC to hike rates because of solid growth and faster inflation in Canada. Yet we do not see the BoC moving rapidly to a restrictive monetary stance that would damage growth expectations and trigger some credit spread widening. At the same time, we also see risks stemming from Canada-U.S. trade disagreements that could hurt Canadian growth and cause investors to demand cheaper valuations for Canadian corporate bonds. Adding it all up, a neutral stance on Canadian corporates versus government debt remains appropriate, largely as a carry trade. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.4 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. Table 1Definitions Of Ratios That Go Into The CHMs BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News 1 Please see BCA Global Fixed Income Weekly Report, "Time To Take Some Chips Off The Table; Downgrade Global Corporate Bond Exposure To Neutral", dated June 26 2018, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "An R-Star Is Born", dated August 7th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 4 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors APPENDIX 2: ENERGY SECTOR APPENDIX 2: ENERGY SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: UTILITIES SECTOR APPENDIX 2: UTILITIES SECTOR Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Yield Curve Suggests GDP Growth Has Peaked Yield Curve Suggests GDP Growth Has Peaked Yield Curve Suggests GDP Growth Has Peaked Last month we learned that the U.S. economy grew 4.1% in the second quarter, the fastest pace since 2014. The gap between year-over-year nominal GDP growth and the fed funds rate - a reliable recession indicator - also widened considerably (Chart 1). However, our sense is that this might be as good as it gets for the U.S. economy. With fewer unemployed workers than job openings and businesses reporting difficulties finding qualified labor, strong demand will increasingly translate into higher prices rather than more output. Higher interest rates and a stronger dollar will also start to weigh on demand as the Fed responds to rising inflation. For bond investors, it is still too soon to position for slower growth by increasing portfolio duration. Markets are priced for only 83 basis points of Fed tightening during the next 12 months, below the current "gradual" pace of +25 bps per quarter. Maintain below-benchmark portfolio duration and a neutral allocation to spread product. 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 133 basis points in July, bringing year-to-date excess returns up to -50 bps. The index option-adjusted spread tightened 14 bps on the month, and currently sits at 109 bps. Corporate bonds remain expensive with 12-month breakeven spreads for both the A and Baa credit tiers near their 25th percentiles since 1989 (Chart 2). Further, with inflation now close to the Fed's target, monetary policy will provide much less support for corporate bond returns going forward. These are two main reasons why we downgraded our cyclical corporate bond exposure to neutral near the end of June.1 Recent revisions to the U.S. National Accounts reveal that gross nonfinancial corporate leverage declined in Q4 2017 and Q1 2018, though from an elevated starting point (panel 4). While strong Q2 2018 profit growth should lead to a further decline when the second quarter data are reported in September, the downtrend in leverage will probably not last through the second half of the year. A rising wage bill and stronger dollar will soon drag profit growth below the rate of debt growth. At that point, leverage will rise. Historically, rising gross leverage correlates with rising corporate defaults and widening corporate bond spreads. The Fed's Senior Loan Officer Survey for the second quarter was released yesterday, and it showed that banks continue to ease standards on commercial & industrial loans (bottom panel). Rising corporate defaults tend to coincide with tightening lending standards (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Peak Growth? Peak Growth? Table 3BCorporate Sector Risk Vs. Reward* Peak Growth? Peak Growth? High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 128 basis points in July, bringing year-to-date excess returns up to +205 bps. The average index option-adjusted spread tightened 27 bps on the month, and currently sits at 334 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 213 bps, below its long-run mean of 247 bps (Chart 3). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 213 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in a recent report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).2 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.2% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance sheets were in much better shape than today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks are to the upside. It will be critically important to track real-time indicators of the default rate such as job cut announcements, which declined last month but remain above 2017 lows (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in July, bringing year-to-date excess returns up to -4 bps. The conventional 30-year zero-volatility MBS spread tightened 3 bps on the month, driven by a 2 bps decline in the compensation for prepayment risk (option cost) and a 1 bp tightening of the option-adjusted spread (OAS). The excess return Bond Map shows that MBS offer a relatively poor risk/reward trade-off, particularly compared to Aaa-rated non-Agency CMBS, High-Yield and Sovereigns. However, our Bond Map analysis does not account for the macro environment, which remains very favorable for the sector. In a recent report we showed that the two main factors that influence MBS spreads are mortgage refinancing activity and residential mortgage bank lending standards.3 Refi activity is tepid (Chart 4) and will likely stay that way for the foreseeable future. Only 5.8% of the par value of the Conventional 30-year MBS index carries a coupon above the current mortgage rate, and even a drop in the mortgage rate to below 4% (from its current 4.6%) would only increase the refinanceable percentage to 38%. As for lending standards, yesterday's second quarter Senior Loan Officer Survey showed that they continue to ease (bottom panel), though banks also reported that they remain at the tighter end of the range since 2005. The still-tight level of lending standards suggests that further gradual easing is likely going forward. That will keep downward pressure on MBS spreads. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 37 basis points in July, bringing year-to-date excess returns up to +2 bps. Sovereign debt outperformed the Treasury benchmark by 179 bps on the month, bringing year-to-date excess returns up to -35 bps. Foreign Agencies outperformed by 24 bps on the month, bringing year-to-date excess returns up to -22 bps. Local Authorities outperformed by 33 bps on the month, bringing year-to-date excess returns up to +61 bps. Supranationals outperformed by 6 bps on the month, bringing year-to-date excess returns up to +13 bps. Domestic Agency bonds broke even with duration-matched Treasuries in July, keeping year-to-date excess returns steady at -1 bp. The strengthening U.S. dollar is a clear negative for hard currency Sovereign debt (Chart 5) and valuation relative to U.S. corporates remains negative (panel 2). Maintain an underweight allocation to Sovereigns. In contrast, the Foreign Agency and Local Authority sectors continue to offer a favorable risk/reward trade-off compared to other fixed income sectors (please see the Bond Maps on page 15). Maintain overweight allocations to both sectors. The Bond Maps also show that while the Supranational and Domestic Agency sectors are very low risk, expected returns are feeble. Both sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 66 basis points in July, bringing year-to-date excess returns up to +187 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 3% in July to reach 83% (Chart 6). This is more than one standard deviation below its post-crisis mean and only slightly higher than the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. The total return Bond Map shows that municipal bonds still offer an attractive risk/reward profile for investors who are exposed to the top marginal tax rate. For investors who cannot benefit from the tax exemption there are better alternatives - notably Supranationals, Domestic Agency bonds and Agency CMBS. While value is dissipating, the near-term technical picture remains positive. Fund inflows are strong (panel 2) and visible supply is low (panel 3). Fundamentally, revisions to the GDP data reveal that state & local government net borrowing has been fairly flat in recent years, and in fact probably increased in the second quarter (bottom panel). At least so far, ratings downgrades have not risen alongside higher net borrowing, but this will be crucial to monitor during the next few quarters. Stay tuned. Treasury Curve: Buy The 5/30 Barbell Versus The 10-Year Bullet Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve's bear flattening trend continued in July. The 2/10 Treasury slope flattened 4 bps and the 5/30 slope flattened 2 bps, as yields moved higher. Despite the curve flattening, our position long the 7-year bullet and short the 1/20 barbell returned +8 bps on the month and is now up +30 bps since inception.4 The trade's outperformance is due to the extreme undervaluation of the 7-year bullet versus the 1/20 barbell. As of today, the bullet still plots 12 bps cheap on our model (Chart 7), which translates to an expected 42 bps of 1/20 flattening during the next six months. We view that much flattening as unlikely.5 Table 4 of this report shows that curve steepeners are also cheap at the front-end of the curve, particularly the 2-year bullet over the 1/5 and 1/7 barbells. Meanwhile, barbells are more fairly valued relative to bullets at the long-end of the curve. The 5/30 and 7/30 barbells look particularly attractive relative to the 10-year bullet. We recommend adding a position long the 5/30 barbell and short the 10-year bullet. The 5/30 barbell is close to fairly valued on our model (panel 4), which implies that the 5/10/30 butterfly spread is priced for relatively little change in the 5/30 slope during the next six months. This trade should perform well in the modest curve flattening environment we anticipate, and it provides a partial hedge to our 1/7/20 trade that is geared toward curve steepening. Table 4Butterfly Strategy Valuation (As Of August 3, 2018) Peak Growth? Peak Growth? TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 10 basis points in July, bringing year-to-date excess returns up to +139 bps. The 10-year TIPS breakeven inflation rate increased 1 bp on the month and currently sits at 2.12%. The 5-year/5-year forward TIPS breakeven inflation rate increased 8 bps on the month and currently sits at 2.24% (Chart 8). Both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. We expect breakevens will return to that target range as investors become increasingly convinced that the risk of deflation has faded. Consistent inflation prints at or above the Fed's 2% target will be the deciding factor that eventually leads to this upward re-rating of inflation expectations. In that regard, core PCE inflation was relatively weak in June, growing only 0.11% month-over-month. That pace is somewhat below the monthly pace of 0.17% that is necessary to sustain 2% annualized inflation (panel 4). Nevertheless, 12-month core PCE inflation at 1.9% is only just below the Fed's target, and the 6-month rate of change is above 2% on an annualized basis. These readings are confirmed by the Dallas Fed's trimmed mean PCE inflation measure (bottom panel). Maintain an overweight allocation to TIPS relative to nominal Treasury securities for now. We will reduce exposure to TIPS once both the 10-year and 5-year/5-year forward breakeven rates reach our target range of 2.3% to 2.5%. ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in July, bringing year-to-date excess returns up to +9 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 5 bps on the month and now stands at 38 bps, only 11 bps above its pre-crisis low. The Bond Maps show that consumer ABS continue to offer relatively attractive return potential compared to other low-risk spread products. However, we maintain only a neutral allocation to this space because credit quality trends have started to move against the sector. Despite the large upward revision to the personal savings rate that accompanied the second quarter GDP report, the multi-year uptrend in the household interest coverage ratio remains intact (Chart 9). This will eventually translate into more frequent consumer credit delinquencies, and indeed, the consumer credit delinquency rate appears to have put in a bottom. The Fed's Senior Loan Officer Survey for Q2 was released yesterday and it showed that average consumer credit lending standards tightened for the ninth consecutive quarter (bottom panel). Credit card lending standards tightened for the fifth consecutive quarter, while auto loan standards eased after having tightened in each of the prior eight quarters. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 37 basis points in July, bringing year-to-date excess returns up to +98 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 5 bps on the month and currently sits at 71 bps (Chart 10). In a recent report we showed that the macro picture for CMBS is decidedly mixed.6 A typical negative environment for CMBS is characterized by tightening bank lending standards for commercial real estate loans and falling demand. Yesterday's Q2 Senior Loan Officer Survey reported that both lending standards and demand for nonresidential real estate loans were very close to unchanged (bottom two panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 24 basis points in July, bringing year-to-date excess returns up to +31 bps. The index option-adjusted spread tightened 5 bps on the month and currently sits at 47 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of August 3, 2018) Peak Growth? Peak Growth? Chart 12Total Return Bond Map (As Of August 3, 2018) Peak Growth? Peak Growth? Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Ryan Swift, Vice President U.S. Bond Strategy Highlights Chart 1Inflations Expectations Hard To Shake Inflations Expectations Hard To Shake Inflations Expectations Hard To Shake Low inflation expectations are proving difficult to shake. Year-over-year core PCE inflation moved to within 5 bps of the Fed's 2% target in May, but long-maturity TIPS breakeven inflation rates barely budged (Chart 1). Instead, breakevens are taking cues from commodity prices which are being held down by flagging global growth (bottom panel). The minutes from the June FOMC meeting revealed that "one participant" advocated postponing rate hikes in an attempt to re-anchor inflation expectations, but we do not expect the Fed to pursue this course. Instead, the Fed will continue to lift rates at a pace of 25 bps per quarter until a risk-off episode in financial markets prompts a delay, hoping that the incoming inflation data are strong enough to send TIPS breakevens higher in the meantime. Ultimately we think that strategy will be successful, but Fed hawkishness in the face of weakening global growth threatens the near-term performance of corporate credit. We recommend only a neutral allocation to spread product versus Treasuries, while maintaining a below-benchmark duration bias. 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 60 basis points in June, dragging year-to-date excess returns down to -181 bps. Value is no longer stretched in the investment grade corporate bond market, though it is not attractive enough to compensate for being in the late stages of the credit cycle or for the looming collision between a hawkish Fed and decelerating global growth. These factors led us to reduce exposure to corporate bonds two weeks ago.1 With inflation running close to the Fed's 2% target and the 2/10 Treasury slope between 0 bps and 50 bps, our research shows that small positive excess returns are the best case scenario for corporate bonds. The likelihood that leverage will rise in the second half of this year is also a concern (Chart 2). Profit growth is only just keeping pace with debt growth and will soon have to contend with rising wage costs and the drag from recent dollar strength. The Fed's staunch hawkishness in the face of decelerating global growth is reminiscent of 2015. Then, the end result was a period of spread widening that culminated in the Fed pausing its rate hike cycle. In recent weeks we also explored how to position within the investment grade corporate bond sector, considering both the maturity spectrum and the different credit tiers.2 We concluded that in the current environment investors should favor long maturities and maintain a balanced or slightly up-in-quality bias (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Deflationary Mindset The Deflationary Mindset Table 3BCorporate Sector Risk Vs. Reward* The Deflationary Mindset The Deflationary Mindset High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 40 basis points in June, bringing year-to-date excess returns up to +76 bps. The average index option-adjusted spread widened 1 bp on the month, and currently sits at 365 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses has widened to 262 bps, just above its long-run mean (Chart 3). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 262 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in last week's report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).3 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.03% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance sheets were in much better shape than they are today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks to that forecast are to the upside. It will be critically important to track real-time indicators of the default rate such as job cut announcements, which remain low relative to history but have perked up in recent months (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in June, bringing year-to-date excess returns up to -24 bps. The conventional 30-year zero-volatility MBS spread widened 1 bp on the month, driven entirely by a 1 bp widening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. The MBS option-adjusted spread has widened since the beginning of the year (Chart 4), though by much less than the investment grade corporate bond spread (panel 3). The year-to-date OAS widening has been offset by a contraction in the option cost component of spreads, and this has kept the overall nominal MBS spread flat at very tight levels (bottom panel). Going forward, rising interest rates will limit mortgage refinancing activity and this will ensure that MBS spreads remain low. In other words, while MBS valuation is not attractive, the downside is limited. Our Bond Maps show an unfavorable risk/reward trade-off in the MBS sector. This analysis, based on volatility-adjusted breakeven spreads, shows that only 7 days of average spread widening are required for the MBS sector to lose 100 bps versus duration-matched Treasuries. While this speaks to the low spread buffer built into current MBS valuations, the message from the Bond Map must be weighed against the macro outlook which suggests that the odds of significant spread widening are quite low. 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 5 basis points in June, bringing year-to-date excess returns up to -35 bps. Sovereign debt outperformed the Treasury benchmark by 33 bps on the month, bringing year-to-date excess returns up to -210 bps. Foreign Agencies outperformed by 10 bps on the month, bringing year-to-date excess returns up to -46 bps. Local Authorities underperformed by 9 bps on the month, dragging year-to-date excess returns down to +28 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +7 bps. Domestic Agency bonds underperformed by 7 bps, dragging year-to-date excess returns down to zero. The escalating tit-for-tat trade war and increasing divergence between U.S. and non-U.S. growth is a clear negative for USD-denominated Sovereign debt. Relative valuation also shows that U.S. corporate bonds are more attractive than similarly rated Sovereigns (Chart 5). Maintain an underweight allocation to Sovereign debt. Within the universe of Emerging Market Sovereign debt, we showed in a recent report that only Russian debt offers an attractive spread relative to the U.S. corporate sector.4 In contrast, the Foreign Agency and Local Authority sectors continue to offer a favorable risk/reward trade-off compared to other fixed income sectors (please see the Bond Maps). Maintain overweight allocations to these two sectors. The Bond Maps also show that the Supranational and Domestic Agency sectors are very low risk, but offer feeble return potential compared to other sectors. The Supranational and Domestic Agency sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 10 basis points in June, bringing year-to-date excess returns up to +120 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio fell 1% in June to reach 85%, close to one standard deviation below its post-crisis mean. It is also only slightly higher than the average 81% level that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. The technical picture remains favorable for Muni / Treasury yield ratios. Fund inflows increased in recent weeks, and visible supply has contracted substantially compared to this time last year (Chart 6). State & local government credit fundamentals are also fairly robust. Net borrowing is on the decline and this should ensure that municipal ratings upgrades continue to outpace downgrades (bottom panel). Despite relatively tight valuation compared to history, the Total Return Bond Map on page 16 shows that municipal bonds offer a fairly attractive risk/reward trade-off compared to other U.S. fixed income sectors, particularly for investors exposed to the top marginal tax rate. Given the favorable reading from our Bond Map and the steadily improving credit fundamentals, we recommend an overweight allocation to Municipal bonds. Treasury Curve: Favor 7-Year Bullet Over 1/20 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in June. The 2/10 Treasury slope flattened 10 bps and the 5/30 slope flattened 7 bps. At present, the 2/10 slope sits at 29 bps, its flattest level of the cycle. The yield curve has flattened relentlessly in recent months as the impact of Fed rate hikes at the short-end of the curve have not been offset by higher inflation expectations at the long end. As explained in a recent report, we think it is unlikely that curve flattening can maintain this rapid pace.5 At 2.34%, the 1-year Treasury yield is already priced for 100 bps of Fed rate hikes during the next 12 months, assuming no term premium. Meanwhile, long-maturity TIPS breakeven inflation rates remain below levels that are consistent with the Fed's 2% inflation target. While curve flattening will proceed as the Fed lifts rates, higher breakeven inflation rates at the long-end of the curve will offset some flattening pressure during the next few months. With that in mind, we continue to recommend a position long the 7-year bullet and short the duration-matched 1/20 barbell. According to our models, this butterfly spread currently discounts 41 bps of 1/20 curve flattening during the next six months (Chart 7). This is considerably more than what is likely to occur. Table 4 of this report shows the output from our valuation models for each butterfly combination across the entire yield curve, as explained in a recent Special Report.6 Table 4Butterfly Strategy Valuation (As Of July 6, 2018) The Deflationary Mindset The Deflationary Mindset TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 35 basis points in June, bringing year-to-date excess returns up to +129 bps. The 10-year TIPS breakeven inflation rate increased 4 bps on the month and currently sits at 2.12%. The 5-year/5-year forward TIPS breakeven inflation rate increased 5 bps and currently sits at 2.16% (Chart 8). Both the 10-year and 5-year/5-year TIPS breakeven inflation rates remain below the range of 2.3% to 2.5% that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. We expect breakevens will return to that target range as investors become increasingly convinced that the risk of deflation has faded. Consistent inflation prints at or above the Fed's 2% target will be the deciding factor that eventually leads to this upward re-rating of inflation expectations. In that regard, the current outlook is promising. Core PCE inflation has printed above the 0.17% month-over-month level that is consistent with 2% annual inflation in four of the past five months (panel 4). Year-over-year trimmed mean PCE inflation is at 1.84% and should continue to rise based on the 2.03% reading from the 6-month trimmed mean PCE (bottom panel). Finally, our Pipeline Inflation Indicator continues to point toward mounting inflationary pressures in the economy (panel 3). Maintain an overweight allocation to TIPS relative to nominal Treasury securities. We will reduce exposure to TIPS once long-maturity TIPS breakeven inflation rates return to our 2.3% to 2.5% target range. ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in June, bringing year-to-date excess returns up to -2 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month and now stands at 43 bps, 16 bps above its pre-crisis low. The Bond Maps show that consumer ABS continue to offer relatively attractive return potential compared to other low-risk spread products. However, we maintain only a neutral allocation to this space because credit quality trends are moving against the sector. The household debt service ratio on consumer credit ticked down slightly in the first quarter, but its multi-year uptrend remains intact (Chart 9). Consumer credit delinquency rates follow the household debt service ratio with a lag. Meanwhile, banks are noticing the decline in credit quality and have begun tightening lending standards (bottom panel). Tighter lending standards tend to coincide with upward pressure on delinquencies and spreads. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 11 basis points in June, dragging year-to-date excess returns down to +61 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 4 bps on the month and currently sits at 74 bps (Chart 10). The gap between decelerating commercial real estate prices and tight CMBS spreads continues to send a worrying signal for CMBS (panel 3). However, delinquencies continue to decline and banks recently started to ease lending standards on nonfarm nonresidential loans (bottom panel). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in June, dragging year-to-date excess returns down to +6 bps. The index option-adjusted spread widened 2 bps on the month and currently sits at 51 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of July 6, 2018) The Deflationary Mindset The Deflationary Mindset Chart 12Total Return Bond Map (As Of July 6, 2018) The Deflationary Mindset The Deflationary Mindset Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, for further details on positioning across different credit tiers. Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, for further details on positioning across the maturity spectrum. Both reports available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Threats & Opportunities In Emerging Markets", dated June 12, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Global Growth: The divergence between strong U.S. and weak non-U.S. growth will increase in the coming months and culminate in wider credit spreads. The Fed's reaction to wider credit spreads will determine how Treasuries perform. High-Yield: High-Yield bonds will deliver excess returns in line with the historical average as long as default losses occur at close to historically low levels. This points to an unfavorable risk/reward balance in junk. Credit Curve: Investors should maintain a below-benchmark duration bias in their overall bond portfolios, but should lengthen maturities within their corporate bond allocations as much as possible while also maintaining a balanced or slightly up-in-quality allocation across credit tiers. Feature Chart 1Growth Divergence Redux Growth Divergence Redux Growth Divergence Redux Two factors influenced our recent decision to reduce the recommended exposure to credit risk in our U.S. bond portfolio.1 First, our indicators show that we are in the late stages of the credit cycle, meaning that small positive excess returns are the best case scenario for corporate bonds. Second, a large divergence in growth has emerged between the United States and the rest of the world, much like in 2014/15 (Chart 1). As was the case in 2014/15, such a divergence will put upward pressure on the U.S. dollar and eventually lead to a period of turmoil in U.S. risk assets - i.e. wider credit spreads and lower equity prices. Whether this turmoil translates into a playable rally in U.S. Treasuries will depend on how the Fed responds. First Spreads, Then (Maybe) Yields Chart 2The 2015 Template The 2015 Template The 2015 Template Using the 2015 episode as a template, we see that credit spreads widened sharply beginning in mid-2015. But despite the risk-off sentiment in credit markets, Treasury yields stayed roughly flat (Chart 2). This should not be too surprising. Since the weakness in global growth was concentrated outside the United States and a significant proportion of corporate profits are driven by foreign demand, a non-U.S. growth shock will have a more immediate impact on the U.S. corporate sector than it will on overall U.S. aggregate demand. Most of the latter is driven by the U.S. consumer who actually stands to benefit from a stronger dollar. Treasury yields and the Federal Reserve take their cues from overall GDP growth, not corporate profits. In fact, we contend that the 2015 widening in credit spreads was exacerbated by the fact that the Fed maintained its focus on overall U.S. growth and continued to signal a relatively steady pace of rate hikes. Spreads widened even further as the notion that the Fed would not bail out corporate bond investors took hold. Eventually, credit spreads widened enough by early 2016 that the Fed was forced to conclude that tighter financial conditions weighed significantly on the growth outlook. It then signaled a slower pace for rate hikes (Chart 2, panel 2), and only then did Treasury yields fall (Chart 2, bottom panel). The Fed's retreat also marked the peak in corporate bond spreads. We envision a similar pattern playing out this time around. Weaker foreign growth will first impact corporate credit, and eventually financial conditions may tighten so much that the Fed is forced to back away from its "gradual" 25 bps per quarter rate hike pace. However, with inflation much closer to target than in 2015, the Fed will be more reluctant to respond. A Less Responsive Fed Our Fed Monitor shows why this is the case (Chart 3). The Monitor is composed of indicators related to economic growth, inflation and financial conditions. It is designed so that a reading above zero signals that the Fed should be hiking rates and a reading below zero signals that it should be cutting. If we consider the three components of the Fed Monitor individually, it is clear that we have recently seen a fairly substantial tightening of financial conditions (Chart 3, bottom panel), but this has barely made a dent in the overall Monitor. The reason is that the components related to economic growth and inflation are on solid footing, and they are offsetting the message from the financial conditions component. In other words, with the output gap much narrower and inflation much closer to target than in 2015, the Fed will need to see more market pain before putting rate hikes on hold. Even if financial conditions tighten so much that a pause in rate hikes is justified, it is highly unlikely that such a delay will last for more than a quarter or two. The end result could be that Treasury yields see only limited downside, even as credit spreads widen. Chart 3Fed Can Tolerate More Market Pain Fed Can Tolerate More Market Pain Fed Can Tolerate More Market Pain China To The Rescue? Another possibility is that we never even reach the point of significant market turmoil and much tighter financial conditions. Non-U.S. growth might recover in the months ahead, ushering in a renewed synchronized global recovery that prevents corporate bond spreads from widening. The most likely driver of such a revival would be significant policy easing from China that puts a floor under global growth before U.S. financial markets feel much pain. Chart 4 shows that China did ease monetary conditions dramatically in 2015 as U.S. credit spreads widened. That easing was achieved through a combination of lower real interest rates, stronger credit growth and a weaker exchange rate. The evidence also suggests that Chinese authorities have started to devalue the renminbi in recent weeks, but so far the weakness is limited and overall monetary conditions have not eased at all. If China is attempting to spur a rebound in global growth, a lot more easing will be required in the coming months and it is not at all obvious that policymakers are willing to go down that path.2 If China does engage in a significant currency devaluation, it will obviously increase the foreign demand for U.S. Treasuries. However, in general, we think that foreign demand will exert less downward pressure on U.S. Treasury yields than it did during the 2014/15 period. This has less to do with Chinese official demand than with the simple fact that U.S. government bonds are now a much less attractive investment vehicle for conventional non-U.S. fixed income investors. After we account for the cost of currency hedging on a 3-month horizon, a typical European investor who wants to gain exposure to the U.S. bond market without taking currency risk is faced with a lower realized yield from a 10-year U.S. Treasury note than from a 10-year German bund (Chart 5). This was not the case at all in 2014/15 when hedged U.S. yields offered a huge advantage over bunds. Japanese investors are faced with a similar quandary. The 10-year U.S. Treasury yield hedged into yen still looks attractive relative to a 10-year JGB, but the yield advantage is nowhere near the levels seen in 2014/15 (Chart 5, panel 3). Chart 4Policy Easing In China? Policy Easing In China? Policy Easing In China? Chart 5Less Foreign Demand For USTs Less Foreign Demand For USTs Less Foreign Demand For USTs U.S. bonds are much less enticing for foreign investors on a currency hedged basis because the Fed has raised rates seven times since 2015, while European and Japanese interest rates are still at the floor. This large rate divergence means that investors must pay a lot more to swap foreign currency for dollars. Essentially, foreign investors are faced with an unpalatable choice. They can gain access to elevated un-hedged U.S. Treasury yields only if they are willing to take on the substantial currency risk. If not, then they are better off keeping their money at home. The end result should be less foreign demand for U.S. bonds. Bottom Line: The divergence between strong U.S. and weak non-U.S. growth will increase in the coming months and culminate in wider credit spreads. The Fed's reaction to wider credit spreads will determine how Treasuries perform. High-Yield: The Good News Is Priced In Our measure of the excess spread available in the High-Yield index after accounting for default losses has recently widened to 260 bps, slightly above its long-run historical average (Chart 6). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 260 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. While the default-adjusted spread suggests that junk bonds are fairly valued relative to history, it's important to also consider the balance of risks surrounding our default loss assumptions. To calculate the default-adjusted spread we start with the Moody's baseline default rate projection for the next 12 months. It is currently 1.99% (Chart 6, panel 2). Then, we project the recovery rate based on its historical relationship with the default rate. This gives us a forecasted recovery rate of 48% (Chart 6, panel 3). Combined, the forecasted default rate and recovery rate give us expected high-yield default losses of 1.03% for the next 12 months (Chart 6, bottom panel). The only historical period to show significantly lower default losses was 2007, a time when non-financial corporate balance sheets were in much better shape than they are today. This is not to suggest that our default forecasts are unrealistically low. The economic and corporate landscape is consistent with a relatively low default rate. But that outlook can change quickly, and the historical record shows that the risk that we are underestimating future default losses is far greater than the risk that we are overestimating them. Gross non-financial corporate leverage is highly correlated with the default rate over time (Chart 7, top panel). It has flattened off during the past few quarters, but is likely to rise modestly in the second half of the year. As we have discussed in prior reports, corporate revenue growth is elevated but close to peaking, and labor costs are just now starting to ramp up. Even a small moderation in profit growth will be enough for leverage to start moving higher.3 Chart 6High-Yield Expected Returns High-Yield Expected Returns High-Yield Expected Returns Chart 7Macro Drivers Of The Default Rate Macro Drivers Of The Default Rate Macro Drivers Of The Default Rate Interest coverage is also still consistent with a low default rate (Chart 7, panel 2). But the combination of peaking profit growth and rising interest rates clearly biases it lower going forward. Other indicators that correlate strongly with corporate defaults, such as layoff announcements and C&I lending standards, also remain supportive for the time being (Chart 7, bottom 2 panels). Bottom Line: High-Yield bonds will deliver excess returns in line with the historical average as long as default losses occur at close to historically low levels. This points to an unfavorable risk/reward balance in junk. Considering The Credit Curve Two weeks ago we examined the risk/reward proposition of moving down in quality within an allocation to investment grade corporate bonds.4 We concluded that a move down the rating scale has a greater positive impact on risk-adjusted portfolio performance when excess return volatility and index duration-times-spread (DTS) are low. With index DTS currently elevated, now is not the best time to move down-in-quality. This week we perform a similar analysis using the maturity buckets of the investment grade corporate bond index. Charts 8-11 show four excess return Bond Maps. The horizontal axes of these maps show the number of months of average spread widening required for each maturity bucket to underperform duration-matched Treasuries by the return threshold indicated in the chart's title. Buckets plotting further to the left require more months of spread widening, and are thus less risky. Chart 8Investment Grade Corporate Excess Return ##br##Bond Map: +/- 50 BPs Threshold Out Of Sync Out Of Sync Chart 9Investment Grade Corporate Excess Return ##br##Bond Map: +/- 100 BPs Threshold Out Of Sync Out Of Sync Chart 10Investment Grade Corporate Excess Return##br## Bond Map: +/- 200 BPs Threshold Out Of Sync Out Of Sync Chart 11Investment Grade Corporate Excess Return ##br##Bond Map: +/- 300 BPs Threshold Out Of Sync Out Of Sync The vertical axes of the maps show the number of months of average spread tightening required for each maturity bucket to outperform duration-matched Treasuries by the return threshold indicated in the chart's title. Buckets plotting closer to the top require fewer months of spread tightening, and thus provide greater potential reward. Much like what we found with the different credit tiers, the maturity buckets tend to cluster together when we set a low return threshold. The risk/reward trade-off becomes more linear as the return threshold increases. We can therefore conclude that shorter maturities offer similar return potential to longer maturities when return volatility is low, along with less risk. The risk-adjusted advantage in low maturity buckets disappears as we transition into higher volatility environments. At the moment, average index DTS is elevated compared to other non-recession periods. There is no obvious advantage to maintaining a bias toward the short maturity buckets. Fundamental Drivers In addition to the risk/reward trade-offs shown in our Bond Maps, we also identify two fundamental drivers of relative performance across the corporate maturity spectrum. First, we notice that while long maturities offer a substantial spread advantage over short maturities, the advantage is entirely driven by differences in duration (Chart 12). Logically, if the duration difference between the short and long ends of the curve were to decline, then the option-adjusted spread term structure would flatten. In fact, this is exactly what should transpire as Treasury yields rise (Chart 12, bottom panel). The second factor that can influence the credit spread curve is the outlook for default losses. Short-maturity spreads widen more than long-maturity spreads when default losses increase. This is because only the highest quality firms are able to issue long maturity debt. Chart 13 shows that, after controlling for differences in duration, the credit spread curve is inversely correlated with default losses. Higher default losses coincide with a flatter spread curve, and vice-versa. A model of the credit spread curve (duration-adjusted) versus expected default losses shows that the curve is currently fairly valued relative to our optimistic default loss assumptions (Chart 13, bottom panel). In other words, if default losses were to surprise to the upside, then the credit spread curve would appear too steep. Chart 12IG Term Structure Is Steep IG Term Structure Is Steep IG Term Structure Is Steep Chart 13Rising Defaults Flatten The Spread Curve Rising Defaults Flatten The Spread Curve Rising Defaults Flatten The Spread Curve All in all, our outlook for higher Treasury yields and the negative balance of risks surrounding our default loss forecast both suggest that investors should favor the long-end of the maturity spectrum within an allocation to investment grade corporate bonds. Bottom Line: Investors should maintain a below-benchmark duration bias in their overall bond portfolios, but should lengthen maturities within their corporate bond allocations as much as possible while also maintaining a balanced or slightly up-in-quality allocation across credit tiers. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Now What?", dated June 27, 2018, available at cis.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification