Munis/S&L tax exempt

Highlights Chart 1Back To Fair Value Back To Fair Value Back To Fair Value February was a terrible month for the bond market. In fact, the Bloomberg Barclays Treasury Master Index returned -1.8%, its worst month since November 2016. The 5-year/5-year forward Treasury yield rose 37 bps. At 2.19%, it is now fairly valued for the first time since 2019, at least according to survey estimates of the long-run neutral fed funds rates (Chart 1). We outlined a checklist for increasing portfolio duration in our Webcast two weeks ago. So far, only two of the five items on our list have been checked. In particular, dollar sentiment and cyclical economic indicators continue to point toward higher yields, even though the market is now priced for a rate hike cycle that is slightly more hawkish than the Fed’s median forecast from December. We anxiously await this month’s revisions to the Fed’s interest rate forecasts. If the Fed’s forecasts remain unchanged from December, then we may get an opportunity to add some duration back into our recommended portfolio. Stay tuned. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 65 basis points in February, bringing year-to-date excess returns up to +68 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. Though Treasury yields have risen in recent weeks, this does not yet pose a risk for credit spreads. The 5-year/ 5-year forward TIPS breakeven inflation rate remains below 2%. We won’t be concerned about restrictive monetary policy pushing credit spreads wider until it reaches a range of 2.3% to 2.5%. Despite the positive macro backdrop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is down to its 2nd percentile (Chart 2). This means that the breakeven spread has only been tighter 2% of the time since 1995. The same measure shows that Baa-rated bonds have only been more expensive 3% of the time (panel 3). We don’t anticipate material underperformance versus Treasuries, but we see better value outside of the investment grade corporate space.1 Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration. We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration. Finally, the supportive macro environment means we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors to pick up the additional spread offered by high-yield corporates. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Stay Bearish On Bonds Stay Bearish On Bonds Table 3BCorporate Sector Risk Vs. Reward* Stay Bearish On Bonds Stay Bearish On Bonds High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 115 basis points in February, bringing year-to-date excess returns up to +178 bps. Ba-rated credits outperformed duration-matched Treasuries by 111 bps on the month, besting B-rated bonds which outperformed by only 104 bps. The Caa-rated credit tier delivered 138 bps of outperformance versus duration-matched Treasuries. We view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We noted in our 2021 Key Views Special Report that the additional spread earned from moving down in quality below Ba is merely in line with historical averages.2 Assuming a 25% recovery rate on defaulted debt and a minimum required risk premium of 150 bps, we calculate that the junk index is priced for a default rate of 2.3% for the next 12 months (panel 3). This represents a steep drop from the 8.3% default rate observed during the most recent 12-month period. However, only 2 defaults occurred in January, down from a peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, have also fallen dramatically (bottom panel). Overall, we see room for spread compression across all junk credit tiers in 2021 but believe that Ba-rated bonds offer the best opportunity in risk-adjusted terms. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 26 basis points in February, dragging year-to-date excess returns down to -2 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries widened 6 bps in February, but it remains low relative to the recent pace of mortgage refinancings (Chart 4). The MBS option-adjusted spread (OAS) tightened 1 bp on the month to 24 bps. This is considerably below the 57 bps offered by Aa-rated corporate bonds and the 42 bps offered by Agency CMBS. It is only slightly above the 22 bps offered by Aaa-rated consumer ABS. The plummeting primary mortgage spread was a key reason for the elevated refi activity seen during the past year. However, the spread has now recovered back to more typical levels (bottom panel). The implication is that further increases in Treasury yields will likely be matched by higher mortgage rates. This means that mortgage refinancings are likely close to a peak. A drop in refi activity would be a positive development for MBS returns, but we aren’t yet ready to turn bullish on the sector. First, relative OAS valuation favors Aa-rated corporates and Agency CMBS over MBS. Second, the gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2) meaning that we could still see spreads adjust higher. Last year’s spike in the mortgage delinquency rate is alarming (panel 4), but it will have little impact on MBS returns. The increase was driven by household take-up of forbearance granted by the federal government. Our US Investment Strategy service has shown that a considerable majority of households will remain current on their loans once the forbearance period ends, causing the delinquency rate to fall back down.3  Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 3 basis points in February, dragging year-to-date excess returns down to +21 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 95 bps in February, dragging year-to-date excess returns down to -116 bps. Foreign Agencies outperformed the Treasury benchmark by 31 bps on the month, bringing year-to-date excess returns up to +25 bps. Local Authority bonds outperformed by 63 bps in February, bringing year-to-date excess returns up to +203 bps. Domestic Agency bonds outperformed by 1 bp, bringing year-to-date excess returns up to +16 bps. Supranationals underperformed by 2 bps, dragging year-to-date excess returns down to +5 bps. We recently took a detailed look at valuation for USD-denominated Emerging Market (EM) Sovereigns.4 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage versus US corporates for all credit tiers except Ba. We recommend that investors take advantage of this spread pick-up by favoring investment grade EM Sovereigns over investment grade US corporates. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico, Russia and Colombia. We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over EM Sovereigns and the extra spread available in B-rated and lower EMs comes from distressed credits in Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 6 basis points in February, dragging year-to-date excess returns down to +102 bps (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past few months and Aaa-rated Munis now look expensive compared to Treasuries, with the exception of the short-end of the curve (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit. Both GO and Revenue Munis offer a before-tax spread pick-up relative to US Credit for maturities above 12 years (bottom panel), the same goes for Revenue bonds in the 8-12 year maturity bucket (panel 3). Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 0.3%. GO bonds in the 8-12 year and 6-8 year maturity buckets offer breakeven effective tax rates of 1% and 10%, respectively. All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in January. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury yields moved up dramatically in February, with the curve steepening out to the 7-year maturity point and flattening thereafter. The 2/10 Treasury slope steepened 30 bps on the month to reach 130 bps. The 5/30 slope, meanwhile, held steady at 142 bps. Slopes across the entire yield curve traded directionally with yields for the bulk of February. That is, until last Thursday when a surge in bond yields occurred alongside flattening beyond the 5-year maturity point. As a result, the 2/5/10 butterfly spread spiked (Chart 7), moving into positive territory for the first time in a while (panel 4). This curve behavior raises an interesting question. Was last week’s sharp underperformance in the belly a one-off move driven by convexity selling and other technical factors, as many have suggested?5 Or, are we now close enough to a potential Fed liftoff date that we should expect some segments of the yield curve to flatten on days when yields rise? We will be watching the correlations between different yield curve segments and the overall level of yields closely during the next few weeks, but as of today, we think it’s premature to declare that the 5/10 slope has transitioned into a regime where it flattens on days when yields move higher. That being the case, we expect further increases in bond yields to coincide with a falling 2/5/10 butterfly spread, and we retain our recommended position long the 5-year bullet and short a duration-matched 2/10 barbell. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 39 basis points in February, bringing year-to-date excess returns up to +183 bps. The 10-year TIPS breakeven inflation rate rose 2 bps on the month to hit 2.17%. The 5-year/5-year forward TIPS breakeven inflation rate fell 15 bps in February to reach 1.91%. February’s TIPS outperformance was concentrated at the front-end of the curve, as investors started to price-in the possibility of higher inflation during the next year or two that eventually subsides. It’s interesting to note that, despite last month’s surge in bond yields, the 5-year/5-year forward TIPS breakeven inflation rate fell, moving further away from the Fed’s 2.3% to 2.5% target range in the process (Chart 8). The Fed will continue to strive for an accommodative policy stance at least until this target is met. Last month’s price action caused our recommended positions in inflation curve flatteners and real yield curve steepeners to perform very well, but we think further gains are possible in the coming months. The 2/10 CPI swap slope has only just dipped into negative territory (panel 4). With the Fed officially targeting a temporary overshoot of its 2% inflation target, this slope should remain inverted for some time yet. With the Fed also continuing to exert more control over short-dated nominal yields than over long-term ones, short-maturity real yields will continue to come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in February, bringing year-to-date excess returns up to +20 bps. Aaa-rated ABS outperformed by 2 bps on the month, bringing year-to-date excess returns up to +13 bps. Non-Aaa ABS outperformed by 9 bps on the month, bringing year-to-date excess returns up to +58 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed last April. This excess savings has still not been spent, and now another round of checks is pushing the savings rate higher again (Chart 9). The large stock of household savings means that the collateral quality of consumer ABS is very high, with many households using their windfall to pay down debt (bottom panel). Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 12 basis points in February, bringing year-to-date excess returns up to +87 bps. Aaa Non-Agency CMBS underperformed Treasuries by 5 bps in February, dragging year-to-date excess returns down to +37 bps. Meanwhile, non-Aaa CMBS outperformed by 75 bps, bringing year-to-date excess returns up to +262 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus won’t be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 11 basis points in February, bringing year-to-date excess returns up to +39 bps. The average index option-adjusted spread tightened 3 bps on the month to reach 42 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. This is especially true when you consider the Fed’s continued pledge to purchase as much Agency CMBS as “needed to sustain smooth market functioning”. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of February 26TH, 2021) Stay Bearish On Bonds Stay Bearish On Bonds Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of February 26TH, 2021) Stay Bearish On Bonds Stay Bearish On Bonds Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 39 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 39 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Stay Bearish On Bonds Stay Bearish On Bonds Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of February 26th, 2021) Stay Bearish On Bonds Stay Bearish On Bonds Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a look at alternatives to investment grade corporates please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, January 2021”, dated January 25, 2021, available at usis.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 5 https://www.bloomberg.com/news/articles/2021-02-25/convexity-hedging-haunts-markets-already-reeling-from-bond-rout?sref=Ij5V3tFi Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (today at 10:00 AM EST, 3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist  

Highlights Chart 1Inflation Indicators Hook Up Inflation Indicators Hook Up Inflation Indicators Hook Up There’s no doubt that inflationary pressures are building in the US economy. The latest piece of evidence is January’s ISM Manufacturing PMI which saw the Prices Paid component jump above 80 for the first time since 2011 (Chart 1). Large fiscal stimulus is clearly leading to bottlenecks in certain industries that were not negatively impacted by the pandemic, and this could cause consumer price inflation to rise during the next few months. However, the Fed will not view a spike in inflation as sustainable unless it is accompanied by a labor market that is close to maximum employment. The Fed estimates that “maximum employment” corresponds to an unemployment rate of 3.5% to 4.5%, and we calculate that average monthly payroll growth of about +500k is required to reach that target by the end of the year. The bottom line is that rising inflation will not lead to Fed tightening this year. We continue to expect liftoff in late-2022 or the first half of 2023. 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 3 basis points in January. The index option-adjusted spread widened 1 bp on the month, leaving it 4 bps above its pre-COVID low. As discussed in last week’s report, the combination of above-trend economic growth and accommodative monetary policy means that the runway for spread product outperformance remains long.1 However, given that investment grade corporate bond spreads are extremely tight, investors should look to other spread products when possible. One valuation measure, the investment grade corporate index’s 12-month breakeven spread – with the index re-weighted to maintain a constant credit rating distribution over time – is down to its 4th percentile (Chart 2). This means that the breakeven spread has only been tighter 4% of the time since 1995. The same measure shows that Baa-rated bonds have also only been more expensive 4% of the time (panel 3). While we don’t anticipate material underperformance versus Treasuries, we see better value outside of the investment grade corporate space. Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration (see page 9). We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration (see page 8). Finally, the supportive macro environment means that we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors pick up the additional spread offered by high-yield corporates, particularly the Ba credit tier where spreads remain wide compared to average historical levels (see page 6). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* No Tightening In 2021 No Tightening In 2021 Table 3BCorporate Sector Risk Vs. Reward* No Tightening In 2021 No Tightening In 2021 High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 62 basis points in January. The average index option-adjusted spread widened 2 bps on the month, leaving it 47 bps above its pre-COVID low. Ba-rated credits outperformed duration-matched Treasuries by 50 bps on the month, besting B-rated bonds which outperformed by only 33 bps. The Caa-rated credit tier delivered 157 bps of outperformance versus duration-matched Treasuries. We view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We noted in our 2021 Key Views Special Report that the additional spread earned from moving down in quality below Ba is merely in line with historical averages.2 Assuming a 25% recovery rate on defaulted debt and a minimum required risk premium of 150 bps, we calculate that the junk index is priced for a default rate of 2.8% for the next 12 months (panel 3). This represents a steep drop from the 8.4% default rate observed during the most recent 12-month period. However, only six defaults occurred in December, down from a peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, have also fallen dramatically (bottom panel). Overall, we see room for spread compression across all junk credit tiers in 2021 but believe that Ba-rated bonds offer the best opportunity in risk-adjusted terms. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in January. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened sharply in January, despite a continued rapid pace of refinancing activity (Chart 4). The option-adjusted spread adjusted downward in January and it now sits at 25 bps (panel 3). This is considerably below the 61 bps offered by Aa-rated corporate bonds and the 45 bps offered by Agency CMBS. It is only slightly above the 20 bps offered by Aaa-rated consumer ABS. The primary mortgage spread has tightened dramatically during the past few months (bottom panel), a key reason why refinancing activity has been so strong despite the back-up in Treasury yields. With the mortgage spread now closer to typical levels, it stands to reason that further increases in Treasury yields will be matched by higher mortgage rates. As such, mortgage refinancing activity could be close to its peak. While a drop in refinancing activity would be a reason to get more bullish on MBS, we aren’t yet ready to pull that trigger. The gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2), and we could still see spreads adjust higher. Last year’s spike in the mortgage delinquency rate is alarming (panel 4), but it will have little impact on MBS returns. The increase was driven by household take-up of forbearance granted by the federal government. Our US Investment Strategy service recently showed that a considerable majority of households will remain current on their loans once the forbearance period expires, causing the delinquency rate to fall back down.3 Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 24 basis points in January (Chart 5). Sovereign debt and Foreign Agencies underperformed duration-equivalent Treasuries by 21 bps and 7 bps, respectively, in January. Local Authority bonds outperformed the Treasury benchmark by 140 bps while Domestic Agency bonds and Supranationals outperformed by 15 bps and 7 bps, respectively. Last week’s report contains a detailed look at valuation for USD-denominated EM Sovereigns.4 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage versus US corporates for all credit tiers except Ba. We recommend that investors take advantage of this spread pick-up by favoring investment grade EM Sovereigns over investment grade US corporates. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico, Russia and Colombia. We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over EM Sovereigns and the extra spread available in B-rated and lower EMs comes from distressed credits in Turkey and Argentina.   Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 108 basis points in January (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past couple of months and Aaa-rated Munis no longer look cheap compared to Treasuries (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit. Both GO and Revenue Munis offer a before-tax spread pick-up relative to US Credit for maturities above 12 years (bottom panel). Revenue bonds in the 8-12 year and 6-8 year maturity buckets offer an after-tax yield pick-up versus Credit for investors with effective tax rates above 3% and 16%, respectively. GO bonds in the 8-12 year and 6-8 year maturity buckets offer breakeven effective tax rates of 21% and 33%, respectively.    All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in last week’s report. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in January. The 2/10 Treasury slope steepened 20 bps to 100 bps. The 5/30 Treasury slope steepened 13 bps to 142 bps. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. A timely vaccine roll-out and stimulative fiscal policy will serve to speed this process along. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on a duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels.       TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 143 basis points in January. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 14 bps and 1 bp on the month. They currently sit at 2.15% and 2.06%, respectively. Core CPI rose 0.09% in December, causing the year-over-year rate to dip from 1.65% to 1.61%. Meanwhile, 12-month trimmed mean CPI ticked up from 2.09% to 2.10%, widening the gap between trimmed mean and core (Chart 8). We expect 12-month core inflation to jump during the next few months, narrowing the gap between core and trimmed mean. As such, we remain overweight TIPS versus nominal Treasuries, even though the 10-year TIPS breakeven inflation rate looks expensive on our Adaptive Expectations Model (panel 2).5 We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect short-maturity real yields to come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in January. Aaa-rated ABS outperformed the Treasury benchmark by 11 bps in January, while non-Aaa issues outperformed by 48 bps (Chart 9). The stimulus from the CARES act led to a significant increase in household income when individual checks were mailed out last April. Since then, households have used this stimulus to build up a considerable buffer of excess savings (panel 4). The large stock of household savings means that the collateral quality of consumer ABS is very high, and this situation won’t change any time soon with even more fiscal stimulus on the way. Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 75 basis points in January. Aaa Non-Agency CMBS outperformed Treasuries by 42 bps in January, while non-Aaa issues outperformed by 185 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus will not be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 28 basis points in January. The average index spread tightened 4 bps on the month to reach 45 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. This is especially true when you consider the Fed’s continued pledge to purchase as much Agency CMBS as “needed to sustain smooth market functioning”. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of January 29TH, 2021) No Tightening In 2021 No Tightening In 2021 Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of January 29TH, 2021) No Tightening In 2021 No Tightening In 2021 Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 86 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 86 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) No Tightening In 2021 No Tightening In 2021 Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of January 29th, 2021) No Tightening In 2021 No Tightening In 2021 Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, January 2021”, dated January 25, 2021, available at usis.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 5 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Fed: We will use the monthly US employment data to track progress toward the first Fed rate hike. At present, our base case outlook calls liftoff in late-2022 or the first half of 2023. Investors should maintain below-benchmark portfolio duration. Corporate Bonds: The macro environment is supportive for spread product returns, but there are better opportunities than in investment grade corporate bonds. We prefer high-yield over investment grade within the US corporate space, particularly the Ba credit tier. Munis: Muni value has deteriorated markedly, but the sector still looks attractive compared to investment grade corporate bonds. EM Sovereigns: We recommend owning investment grade USD-denominated EM Sovereign bonds instead of investment grade US corporates. Within high-yield, US corporates still offer a better opportunity than EM Sovereigns. Using Employment Data To Time Fed Liftoff The current debate raging in fixed income circles revolves around whether large-scale fiscal stimulus will cause inflation to flare this year, possibly leading to a much earlier fed funds liftoff date than is currently priced into the yield curve (Chart 1). Chart 1Fed Liftoff Priced For July 2023 Fed Liftoff Priced For July 2023 Fed Liftoff Priced For July 2023 Last week’s report discussed our outlook for inflation in 2021.1 In short, our base case calls for 12-month PCE inflation to peak above the Fed’s 2% target in April but to then fall back below 2% by the end of the year. However, there is a compelling case to be made that inflation could rise more quickly. Table 1A Checklist For Liftoff Searching For Value In Spread Product Searching For Value In Spread Product Last week, our Global Investment Strategy service pointed out that the combined effect of December’s fiscal stimulus deal and President Biden’s newly proposed American Rescue Plan would inject an average of $300 billion per month into the economy through the end of September.2 The Congressional Budget Office estimates that the monthly output gap – the difference between what the economy is capable of producing and what it is actually producing – is currently $80 billion. In that environment, it’s not hard to see how excess demand could lead to price increases in certain sectors. Chart 2How Far From "Maximum Employment"? How Far From "Maximum Employment"? How Far From "Maximum Employment"? Of course, for bond investors what matters is not just the path of inflation but how the Fed responds. If rising inflation prompts the Fed to lift rates before July 2023 – the liftoff date currently priced into the market – then bonds will sell off. If liftoff occurs later, then yields will fall. This makes timing the liftoff date critical, and fortunately, the Fed has given us three explicit criteria that must be met before liftoff will occur (Table 1). This week’s report focuses, not on inflation, but on the condition related to “maximum employment.” Our sense is that if the Fed does not think the economy is at “maximum employment” it will ignore modest overshoots of its 2% inflation target on the view that the large amount of labor market slack will eventually cause inflationary pressures to wane. We define “maximum employment” as an unemployment rate of 4.5%, consistent with the upper-bound of the Fed’s most recent range of NAIRU estimates (Chart 2). Using that assumption, and an assumption for the path of the labor force participation rate (Chart 2, bottom panel), we can calculate the average monthly payroll gains that must occur for the unemployment rate to hit the 4.5% target by specific future dates. Our results are shown in Table 2. We use four different scenarios for the labor force participation rate. The lowest estimate assumes that the participation rate remains at its current level. The highest estimate assumes that it re-converges to its pre-COVID level at the same time as the unemployment rate hits 4.5%. The two middle estimates assume smaller increases of 1% and 0.5%, respectively. Table 2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% Over The Given Horizon Searching For Value In Spread Product Searching For Value In Spread Product We expect the participation rate to rise as the economy recovers and people are drawn back into the labor force, but some workers have likely been permanently displaced by the pandemic and a full convergence back to pre-COVID levels may not occur until well after the unemployment rate reaches 4.5%, if at all. With that in mind, the “Convergence To Pre-COVID” scenario probably overstates the monthly payroll gains necessary to hit full employment and the “Stays At 61.5%” scenario almost certainly understates them. If we focus on the two middle scenarios, we see that average monthly payroll gains of between 472k and 572k are required for the unemployment rate to hit 4.5% by the end of this year. This range falls to 346k - 413k if we push the liftoff date out until mid-2022 and to 283k – 334k if we move out until the end of 2022. At first blush, these numbers look unattainable. Between 2010 and 2019, average monthly payroll growth averaged a mere +97k. But, given the downturn that just occurred, employment growth will likely be much stronger going forward. Our research into past economic cycles has found that the two main determinants of average monthly employment growth during the first year following a recession are: The drawdown in employment that occurred during the recession (a larger drawdown correlates with greater payroll growth in the first 12 months of recovery) Real GDP growth during the first 12 months of recovery Chart 3 shows the correlation between the peak-to-trough decline in nonfarm payrolls during the past eight US recessions and the average monthly payroll gains seen during the first 12 months of economic recovery. The correlation is quite linear except for the 2008 recession where the peak-to-trough decline in payrolls was 8.7 million but the bounce-back was incredibly weak. Chart 4 explains why the 2008 recession looks like such an outlier in Chart 3. Real GDP growth during the first 12 months of recovery coming out of the 2008 recession was very low, only 2.6%. Chart 3Large Payroll Drawdowns Tend To Be Followed By Strong Gains… Searching For Value In Spread Product Searching For Value In Spread Product Chart 4…And Occur Alongside Strong Economic Recovery Searching For Value In Spread Product Searching For Value In Spread Product Thinking about the current recovery from the COVID recession. Nonfarm payrolls fell by about 22 million from peak to trough in 2020. This is literally off the charts (looking at Chart 3), about 2.5 times the job loss seen in 2008. Then, the Fed’s most recent median estimate for real GDP growth in 2021 is a robust 4.2%, and this estimate was made before Democrats took control of the Senate and proposed a massive new stimulus bill. Considering both the large drawdown in employment and the outlook for rapid GDP growth in 2021, average monthly payroll gains should be quite strong this year. A return to a 4.5% unemployment rate by the end of 2021 is probably a long shot, but we can easily envision average monthly payroll gains on the order of 300k to 400k per month, enough to prompt Fed tightening by late-2022 or the first half of 2023. Whatever transpires, we will monitor monthly payroll growth in the coming months and use this analysis to continuously reassess our liftoff expectations. For the time being, investors should keep portfolio duration low. Alternatives To Investment Grade Corporates Another conclusion that falls out of the above analysis is that the runway for spread product outperformance remains long. With Fed tightening unlikely until late-2022 or the first half of 2023, monetary conditions will remain accommodative for some time. This will drive a continued search for yield, supporting the outperformance of spread product relative to Treasuries. But despite the supportive macro environment, bond investors face a problem that the most popular US spread sector – investment grade corporate bonds – looks very expensive. The average option-adjusted spread for the Bloomberg Barclays investment grade corporate index is only 2 bps above its pre-COVID low, and the spread on Baa-rated bonds is exactly equal to its pre-COVID low. Aa- and A-rated bonds appear somewhat cheaper (Chart 5). The valuation picture is even bleaker after adjusting the index to ensure a constant average credit rating and average duration over time. The 12-month breakeven spread for the credit rating-adjusted corporate index has only been tighter 3% of the time since 1995 (Chart 6). Chart 5IG Spreads Are Tight... IG Spreads Are Tight... IG Spreads Are Tight... Chart 6...Especially After Adjusting For Risk ...Especially After Adjusting For Risk ...Especially After Adjusting For Risk The remainder of this report discusses potential alternatives to investment grade corporate bonds. Specifically, we’re looking for spread products that will benefit from the same macro environment as investment grade corporates, but where investors can pick up some additional risk-adjusted value. Candidate #1: Junk Bonds Chart 7Ba-Rated Corporates Are Cheap Ba-Rated Corporates Are Cheap Ba-Rated Corporates Are Cheap One obvious thing investors might consider is a move down the quality spectrum into high-yield bonds. This move comes with greater credit risk, but we believe the incremental spread pick-up provides more than fair additional compensation. The Bloomberg Barclays High-Yield index’s average option-adjusted spread is still 33 bps above its pre-COVID low, and the spread pick-up in the Ba credit tier relative to the Baa credit tier looks particularly compelling (Chart 7). The supportive macro environment makes us less worried about taking additional credit risk in a portfolio, and we recommend that investors pick up the additional spread offered in the high-yield space. The elevated incremental spread pick-up in Ba bonds makes that credit tier look like the best risk-adjusted opportunity. Candidate #2: Tax-Exempt Municipal Bonds Municipal bond spreads have tightened dramatically during the past couple of months and Aaa-rated Munis no longer look cheap compared to Treasuries (Chart 8). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit. Both GO and Revenue Munis offer a before-tax spread pick-up relative to US Credit for maturities above 12 years (Chart 9), the same goes for Revenue bonds with 8-12 year maturities. Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate of 10% or higher. GO bonds in the 8-12 year and 6-8 year maturity buckets offer breakeven effective tax rates of 14% and 26%, respectively. Chart 8Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Chart 9Munis Still Attractive Versus Corporates Munis Still Attractive Versus Corporates Munis Still Attractive Versus Corporates All in all, municipal bond value has deteriorated markedly in recent months and we therefore downgrade our recommended allocation slightly from “maximum overweight” (5 out of 5) to “overweight” (4 out of 5). Investors should still prefer tax-exempt municipal bonds relative to investment grade corporate bonds with the same credit rating and duration. Candidate #3: USD-Denominated Emerging Market Sovereigns For all of last year we advised investors to favor investment grade corporate bonds over USD-denominated EM Sovereigns of equivalent credit rating and duration. This positioning worked out well. Since the March 23rd peak in credit spreads, the A3/Baa1-rated EM Sovereign index has only outperformed the duration-matched A-rated US Credit index by 159 bps while it has underperformed the Baa-rated US Credit index by 571 bps (Chart 10). In the high-yield space, the B1/B2-rated EM Sovereign index has significantly underperformed both the Ba and B-rated US junk bond indexes. Chart 10EM Sovereigns Underperformed US Corporates In 2020 EM Sovereigns Underperformed US Corporates In 2020 EM Sovereigns Underperformed US Corporates In 2020 But now, after nine months of poor relative performance, value is starting to look more compelling in the EM Sovereign space. Chart 11 shows that EM Sovereigns offer a yield pick-up versus duration-matched US corporate bonds for all credit tiers except Ba. At the country level, the yield advantage in the A and Aa credit tiers is attributable to opportunities in Qatar, UAE and Saudi Arabia (Chart 12). In the Baa credit tier, investors should look for opportunities in Mexico, Russia and Colombia, while avoiding the Philippines. Chart 11USD-Denominated EM Sovereign Spreads Versus Credit Rating And Duration-Matched US Credit: By Credit Rating Searching For Value In Spread Product Searching For Value In Spread Product Chart 12USD-Denominated EM Sovereign Spreads Versus Credit Rating And Duration-Matched US Credit: By Country Searching For Value In Spread Product Searching For Value In Spread Product All in all, investors should shift some allocation away from investment grade corporates and into USD-denominated EM Sovereigns with equivalent duration and credit rating, focusing on the countries that offer a yield pick-up. Turning to high-yield, we would rather own junk-rated US corporate bonds than junk-rated EM Sovereigns. US corporates offer a yield pick-up over EM Sovereigns in the Ba credit tier, and the sky-high spreads offered by B and Caa-rated EMs are due to overly risky opportunities in Turkey and Argentina. We don’t see these countries benefiting from the supportive US macro environment in the same way as US corporate credit, and therefore recommend overweighting US corporate junk bonds over EM Sovereign junk bonds. Bottom Line: Investors should continue to overweight spread product versus Treasuries in US fixed income portfolios but should look for opportunities outside of investment grade corporate bonds. We recommend owning municipal bonds and USD-denominated EM Sovereign bonds in place of investment grade US corporate bonds with the same credit rating and duration. We also recommend taking additional credit risk in US junk bonds, particularly in the Ba credit tier. Investors should prefer US junk bonds over junk-rated EM Sovereigns.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “Trust The Fed’s Forward Guidance”, dated January 19, 2021, available at usbs.bcaresearch.com 2  Please see Global Investment Strategy Weekly Report, “Stagflation In A Few Months?”, dated January 22, 2021, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Rates: The Democratic sweep of the election has caused the uptrend in bond yields to accelerate and has benefited our recommended rates positions (below-benchmark duration, nominal and real curve steepeners, inflation curve flatteners). We aren’t yet ready to exit any of these positions, and our medium-term target of 2% - 2.25% for the 5-year/5-year forward nominal Treasury yield remains unchanged. Municipal Bonds: Though valuation has become more expensive, we continue to recommend a maximum overweight allocation to municipal bonds. In particular, investors should favor municipal bonds over investment grade corporate bonds with equivalent credit rating and duration. Economy: December’s employment report showed the first monthly contraction in nonfarm payrolls since April. However, this negative headline reflects the transitory impact of the latest COVID wave. It does not signal renewed weakness in the pace of economic recovery. Feature A Politically Driven Bond Rout In a Special Report last October, we argued that the bond market was vulnerable in a scenario where the November 3rd election resulted in the Democratic party winning the House, Senate and White House.1 It took some time, but after Democrats won both of Georgia’s Senate seats in last week’s special election, we are finally seeing the impact on the bond market. Nominal Treasury Yields First, the 10-year nominal Treasury yield moved above 1% for the first time since March. It currently sits at 1.13% (Chart 1). Meanwhile, the front-end of the Treasury curve held steady as the Fed continued to signal that liftoff is unlikely to occur within the next two years. The result has been a persistent steepening of the nominal curve (Chart 1, bottom panel). The 10-year nominal Treasury yield moved above 1% for the first time since March. We are positioned for a bear-steepening of the nominal Treasury curve, but the speed of this most recent move raises the question of how much further the bond sell-off can run. As we wrote in our year-end Special Report, we see yields continuing to rise until the 5-year/5-year forward Treasury yield reaches levels consistent with survey estimates of the long-run equilibrium fed funds rate (Chart 2).2 This would be in line with where yields peaked during the prior two global growth recoveries (2013/14 and 2017/18). At present, survey responses put our target for the 5-year/5-year forward Treasury yield at roughly 2% to 2.25%, still 18 to 43 bps above current levels. Chart 1Nominal Curve Bear-Steepening Nominal Curve Bear-Steepening Nominal Curve Bear-Steepening Chart 2How Much Upside For Yields? How Much Upside For Yields? How Much Upside For Yields? The prospect of greater fiscal stimulus under a Democratic government doesn’t necessarily translate into a higher ceiling for Treasury yields, but it does increase the speed with which yields will reach our target. All in all, we remain positioned for a bear-steepening of the nominal Treasury curve but will re-consider this stance if the 5-year/5-year forward yield reaches a range of 2% to 2.25%. Inflation Compensation Chart 3Stay Overweight TIPS For Now Stay Overweight TIPS For Now Stay Overweight TIPS For Now The recent 20 bps jump in the 10-year nominal Treasury yield was driven by a 15 bps increase in the 10-year TIPS yield and a 5 bps increase in the 10-year TIPS breakeven inflation rate. Notably, the 10-year and 5-year/5-year forward TIPS breakeven inflation rates have both pushed above 2% and are sitting at 2.08% and 2.06%, respectively. While these long-maturity TIPS breakevens have recovered nicely, the Fed won’t be tempted to adopt a more hawkish policy stance until they reach a range of 2.3 – 2.5 percent, a range that has been consistent with “well-anchored” inflation expectations in the past (Chart 3).. While TIPS breakeven inflation rates aren’t yet high enough to worry the Fed, they are starting to look elevated compared to actual inflation. At 2.08%, the 10-year TIPS breakeven inflation rate is 27 bps above the fair value reading from our Adaptive Expectations Model (Chart 3, panel 3).3 Given this expensive valuation, we are currently looking for an opportunity to tactically reduce our allocation to TIPS. We expect that opportunity will come when the 12-month core and trimmed mean inflation rates re-converge (Chart 3, bottom panel). The low level of core CPI inflation relative to the trimmed mean suggests that inflation has near-term upside as some downtrodden sectors that are excluded from the trimmed mean recover from the pandemic. But inflation will moderate once that “snapback phase” is over, and we should get an opportunity to reduce our TIPS allocation.4   Along with an overweight allocation to TIPS versus nominal Treasuries, we also recommend owning inflation curve flatteners. The inflation curve tends to flatten when the cost of inflation protection rises, and this has indeed been the case during the past few weeks (Chart 4). It will make sense to exit this flattener when we tactically reduce our TIPS allocation, but this will only be a temporary move. In the long run, the inflation curve will eventually invert and then remain in negative territory for an extended period. This is the result of the Fed’s plan to engineer an overshoot of its 2% inflation target. If the Fed is successful, it means that it will be attacking its inflation target from above for the first time since the 1980s. In such an environment, it makes sense for the inflation curve to be inverted. Chart 4Inflation Curve Flattening Inflation Curve Flattening Inflation Curve Flattening Real Yield Curve Chart 5Real Curve Steepening Real Curve Steepening Real Curve Steepening Our final rates curve recommendation is a real yield curve steepener. This position has also performed well during the recent bond rout, as a 14 bps increase in the 10-year real yield occurred alongside a 13 bps drop in the 2-year real yield (Chart 5). As with our other rates positions, we are inclined to stay the course. A 2/10 real yield curve steepener can be thought of as the combination of a 2/10 nominal curve steepener and a 2/10 inflation curve flattener. During the recent bond sell-off, the 2/10 real curve has steepened by 27 bps, split between 17 bps of nominal curve steepening and 10 bps of inflation curve flattening. We will likely maintain our real yield curve steepener as a core portfolio position even if we eventually close our inflation curve flattener. Gradual progress toward fed funds liftoff and the resulting steepening of the nominal curve should be sufficient to steepen the real yield curve, even if inflation takes a pause. Corporate Credit Chart 6Move Down In Quality Move Down In Quality Move Down In Quality Corporate spreads have reacted well to the news of a Democratic sweep, even though it means that a corporate tax hike is coming in 2021. All else equal, the one-time hit to profits from a tax hike is negative for corporate balance sheets, but this is a minor consideration when the macro back-drop remains so positive for spread product. The combination of above-trend economic growth and highly accommodative monetary policy will encourage investors to keep adding credit risk, and the average investment grade and high-yield index spreads have still not quite recovered to their pre-COVID tights (Chart 6). We continue to view the Ba credit tier as the most attractive from a risk/reward perspective, as the incremental spread pick-up in Ba compared to Baa is elevated compared to what we’ve seen in recent years (Chart 6, panel 3). Bottom Line: The Democratic sweep of the election has caused the uptrend in bond yields to accelerate and has benefited our recommended rates positions (below-benchmark duration, nominal and real curve steepeners, inflation curve flatteners). We aren’t yet ready to exit any of these positions, and our medium-term target of 2% - 2.25% for the 5-year/5-year forward nominal Treasury yield remains unchanged. Fiscal Policy In 2021 Chart 7Organic Household Income Has Recovered Organic Household Income Has Recovered Organic Household Income Has Recovered Our US Political Strategy service debuted last week with a report that considers the outlook for fiscal policy in 2021 given that Democrats now have control of the House, Senate and White House.5 In short, the Democrats now have complete control of the government but their majorities in the House and Senate are thin. This means that the most radical parts of the Democratic agenda, like the Green New Deal, will be hard to pass. However, the Democrats will be able to deliver two reconciliation bills in 2021. The first bill could come soon and will likely focus on additional COVID relief and social support, such as $2000 checks to individuals instead of $600 ones. After that, the Democrats will focus on expanding and entrenching the Affordable Care Act (Obamacare). They will partially repeal the Trump tax cuts to help finance these priorities. On the issue of COVID relief, we are no longer concerned about the US economy receiving enough stimulus to avoid a double-dip recession. We had previously estimated that a further $600 billion to $1 trillion of income support for households would be required to support consumer spending at reasonable levels.6 This estimate now looks too high because non-CARES act household income has recovered much more quickly than we had anticipated. Non-CARES act household income is already back to pre-COVID levels (Chart 7). In our prior research, we assumed this wouldn’t happen until July 2021. In any event, another round of $2000 checks will provide more than enough income support to sustain a recovery in consumer spending. A Democratic sweep suggests big fiscal thrust in 2021 and less contraction in 2022. More generally, our US Political Strategy team has estimated the medium-term path for the US deficit under a “Democratic Status Quo” scenario that assumes another round of $2000 checks and that the remaining $2.5 trillion of the proposed HEROES Act will be enacted. It also considers a “Democratic High” scenario that adds Joe Biden’s $5.6 trillion policy agenda on top of the Democratic Status Quo (Chart 8). Biden will not achieve all of his agenda, so the reality will lie somewhere between the Democratic Status Quo and Democratic High scenarios. In either case, we will see considerably more fiscal thrust compared to the Republican Status Quo and Baseline scenarios. Chart 8Democratic Sweep Suggests Big Fiscal Thrust In FY2021 And Less Contraction FY2022 A Blue Sweep After All A Blue Sweep After All Municipal Bonds The prospect of federal government aid for challenged state & local governments is a crucial issue for municipal bond investors. Fortunately, the Democratic party’s HEROES act contains more than $1 trillion of aid to state & local governments and this will likely form the basis of the next COVID relief package. On top of that, further support for household incomes will also help support state & local tax revenues that are already recovering (Chart 9). Chart 9State & Local Austerity Will Continue State & Local Austerity Will Continue State & Local Austerity Will Continue That said, we are likely still in for a considerable period of state & local austerity given the large budget gaps that have opened during the past nine months. However, the expectation of help from the federal government makes us even more confident that state & local governments will muddle through without a spate of muni downgrades or defaults. We maintain our “maximum overweight” recommendation for tax-exempt municipal bonds, though valuation is turning more expensive by the day. Muni yield spreads versus Treasuries are contracting, particularly at the long end of the curve (Chart 10A) and valuations appear more expensive if we look at yield ratios instead of spreads (Chart 10B). In both cases, value looks better at the front end of the curve than at the long end. Chart 10AMuni / Treasury Yield Ratios Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Chart 10BMuni / Treasury Yield Ratios Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Bottom Line: The new Democratic government will deliver more than enough income support to sustain the recovery in consumer spending. Aid for state & local governments is also forthcoming and it will help sustain municipal bond outperformance versus both Treasuries and investment grade corporates. Though valuation has become more expensive, we continue to recommend a maximum overweight allocation to municipal bonds. In particular, investors should favor municipal bonds over investment grade corporate bonds with equivalent credit rating and duration. December Payrolls Only A Temporary Setback At first blush, last week’s December employment report looks disastrous. Nonfarm payrolls fell by 140 thousand, the first monthly contraction since April. The contraction looks especially worrying when you consider that payrolls remain almost 10 million below pre-COVID levels and should be rising quickly at this stage of the economic recovery (Chart 11). Chart 11Payrolls Contracted In December Payrolls Contracted In December Payrolls Contracted In December Chart 12Permanent Unemployment Fell In December Permanent Unemployment Fell In December Permanent Unemployment Fell In December The grim headline numbers, however, severely overstate the magnitude of the problem. Rather than implying underlying economic weakness, the drop in payrolls reflects the transitory impact of the pandemic’s latest violent wave. December’s job losses came from the Leisure and Hospitality sector (-498k), the sector most impacted by the virus. Job gains remained solid elsewhere in the economy (+358k). The unemployment rate held flat at 6.7% in December, but encouragingly, this stable number masks both an increase in the number of temporarily unemployed (or furloughed) workers and a drop in the number of permanently unemployed workers (Chart 12). Those furloughed workers will return to work once the virus is better contained. Meanwhile, the drop in the number of permanently unemployed suggests that the economic recovery is taking hold. It will only gain momentum as the COVID vaccine is rolled out and additional fiscal stimulus is delivered in 2021.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Beware The Bond-Bearish Blue Sweep”, dated October 20, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 4 For more details on inflation’s “snapback phase” please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com 5 Please see US Political Strategy Weekly Report, “Buy Reflation Plays On Georgia’s Blue Sweep”, dated January 6, 2021, available at usps.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 12020 Returns 2020 Returns 2020 Returns After a tumultuous start to the year, corporate bonds rallied in 2020 H2, managing to eke out small annual gains versus Treasuries. Specifically, investment grade corporates outperformed duration-equivalent Treasuries by 4 basis points in 2020 and high-yield outperformed by 185 bps (Chart 1). Treasuries, for their part, bested cash by 7% on the year but returns have been trending down since August. As we look forward to 2021, the economic cycle is in what we call a sweet spot for spread product returns. Economic growth is above trend, but inflation is low and monetary conditions are highly accommodative. This macro back-drop will lead to positive spread product returns versus Treasuries and a moderate bear-steepening of the Treasury curve in 2021. However, stretched valuations for investment grade corporates mean that investors must be selective within spread product. We think the Ba credit tier offers the best risk-adjusted opportunity in the corporate bond space, and also recommend favoring tax-exempt municipal bonds over equivalent-quality investment grade corporates. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-matched Treasury index by 79 basis points in December and by 4 bps in 2020. The investment grade corporate index eked out a small gain relative to the duration-matched Treasury index in 2020. Corporates underperformed Treasuries by 18% from the beginning of the year until March 23, the day that the Fed stopped the bleeding in credit markets by unveiling its suite of emergency lending facilities. With the Fed’s backstops in place, the corporate index went on to outperform Treasuries by 22% between March 23 and the end of the year (Appendix A). As we noted in our 2021 Key Views Special Report, the corporate bond index option-adjusted spread is not quite back to its pre-COVID low.1 However, valuation is close to all-time expensive after adjusting for changes in the index’s average credit rating and duration. The 12-month breakeven spread for the Bloomberg Barclays Corporate Index (adjusted to keep the average credit rating constant) has only been tighter 4% of the time since 1995 (Chart 2). The same figure for the Baa-rated credit tier is 5%. As noted, the macro environment of above-trend growth and accommodative Fed policy is very positive for spread product returns. However, better value exists outside of the investment grade corporate space. In particular, we advise investors to look at Ba-rated high-yield corporates and tax-exempt municipal bonds. High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 190 basis points in December and by 185 basis points in 2020. Ba-rated junk bonds outperformed duration-matched Treasuries by 431 bps in 2020, while B-rated and Caa-rated bonds lagged by 13 bps and 238 bps, respectively. Since the March 23 peak in spreads, Ba-rated bonds outperformed Treasuries by 33%, B-rated bonds outperformed by 30% and Caa-rated bonds outperformed by 36% (Appendix A). We view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We noted in our 2021 Key Views Special Report that the additional spread earned from moving down in quality below Ba is in line with historical averages.2   Assuming a 25% recovery rate on defaulted debt and a minimum required risk premium of 150 bps, we calculate that the junk index is priced for a default rate of 2.8% for the next 12 months (panel 3). This represents a steep drop from the 8.4% default rate observed during the most recent 12-month period. However, only seven defaults occurred in November, down from a peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, are also falling rapidly (bottom panel). Overall, we see room for spread compression across all junk credit tiers in 2021 but believe that Ba-rated bonds offer the best opportunity in risk-adjusted terms.    Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Cyclical Sweet Spot The Cyclical Sweet Spot Table 3BCorporate Sector Risk Vs. Reward* The Cyclical Sweet Spot The Cyclical Sweet Spot   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 22 basis points in December but underperformed by 17 bps in 2020. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 10 bps on the month to reach 61 bps (Chart 4). This is higher than the 58 bps offered by Aa-rated corporate bonds, the 49 bps offered by Agency CMBS and the 24 bps offered by Aaa-rated consumer ABS. Despite the relatively attractive OAS, we continue to view the elevated primary mortgage spread as a material risk for MBS investors. The elevated spread suggests that mortgage rates need not rise alongside Treasury yields in the near-term, meaning that mortgage refinancings can continue at their current rapid pace (panel 3). Our view is that expected prepayment losses embedded in MBS spreads (aka the option cost) are too low relative to this pace of refinancing. Last year’s spike in the mortgage delinquency rate was driven by households that were granted forbearance by the federal government’s CARES act (panel 4). The risk for MBS holders is that these households will not be able to resume their regular mortgage payments when the forbearance period ends this spring. While the situation bears close monitoring, our sense is that excess savings built up during the past nine months will be sufficient to prevent a surge of bankruptcies when the forbearance period ends. The recent stimulus package provides households with even more assistance. 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 62 basis points in December but underperformed by 161 bps in 2020. Sovereign debt outperformed duration-equivalent Treasuries by 176 bps in December but underperformed by 98 bps in 2020. Foreign Agencies outperformed the Treasury benchmark by 7 bps in December but underperformed by 640 bps in 2020. Local Authority debt outperformed Treasuries by 146 bps in December but underperformed by 86 bps in 2020. Domestic Agency bonds outperformed by 14 bps in December but underperformed by 9 bps in 2020. Supranationals outperformed by 2 bps in December and by 3 bps in 2020. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, 2020’s dollar weakness was mostly relative to other Developed Market currencies (Chart 5). Value has improved somewhat for EM Sovereigns during the past few weeks, but the index continues to offer less spread than the Baa-rated US Credit index (panel 4). At the country level, Turkey, Colombia, Mexico, Russia, South Africa and Indonesia are the only countries that offer a spread pick-up relative to duration and quality-matched US corporates. Of those, only Mexico looks attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 56 basis points in December but underperformed by 286 bps in 2020 (before adjusting for the tax advantage). We upgraded municipal bonds to “maximum overweight” in our recent 2021 Key Views Special Report.3 Attractive valuations are the main reason for this move. First, spreads between Aaa-rated municipal bonds and equivalent-maturity Treasuries are elevated compared to history across the entire yield curve (Chart 6). Second, municipal bonds look even more attractive relative to duration and quality-matched credit. The Bloomberg Barclays Revenue Bond index offers a greater yield than the quality-matched Credit index across the entire maturity spectrum (before adjusting for the tax advantage). The same is true for the Bloomberg Barclays General Obligation index beyond the 12-year maturity point (panel 3). While the failure to include state & local government aid in the recent relief bill is a big blow to municipal budgets that are already stretched, we think municipal bond spreads offer more-than-adequate compensation for default/downgrade risk. State & local governments are already engaging in austerity measures that will help protect bondholders (bottom panel) and State Rainy Day Fund balances were at all-time highs heading into the COVID downturn. Both of these things should help stave off a wave of municipal downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in December. The 2/10 Treasury slope steepened 13 bps to 81 bps. The 5/30 Treasury slope steepened 7 bps to 129 bps. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. A timely vaccine roll-out and the recently passed fiscal relief bill will serve to speed this process along. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar levels.        TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 141 basis points in December and by 117 bps in 2020. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 22 bps and 18 bps on the month. They currently sit at 2.01% and 2.07%, respectively. Core CPI rose 0.22% in November, pushing the year-over-year rate from 1.63% to 1.65%. Meanwhile, 12-month trimmed mean CPI fell from 2.22% to 2.09%, narrowing the gap between trimmed mean and core (Chart 8). We anticipate further narrowing in 2021 Q1 and therefore expect core CPI to print relatively hot. For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven inflation rate looks somewhat elevated on our Adaptive Expectations Model (panel 2).4 Inflation pressures may moderate once the core and trimmed mean inflation measures converge, and this could give us an opportunity to tactically reduce TIPS exposure in the first half of this year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect short-maturity real yields to come under downward pressure relative to the long end (bottom panel).   ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in December and by 98 bps in 2020. Aaa-rated ABS outperformed the Treasury benchmark by 12 bps in December and by 81 bps in 2020. Non-Aaa ABS outperformed by 33 bps in December and by 207 bps in 2020 (Chart 9). On paper, the Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 is quite negative for ABS. However, as we explained in a recent report, we don’t anticipate a material impact on spreads.5 For one thing, Aaa ABS spreads are already well below the borrowing cost offered by TALF. But more importantly, consumer credit quality is strong. As we first explained last June, the stimulus received from the CARES act led to a significant increase in disposable income and a jump in the savings rate (panel 4).6 Faced with an income boost and few spending opportunities, many households paid down consumer debt. Given the recently passed additional fiscal support and the substantial savings that have already accrued, we see household balance sheets as being in a good place. As such, we advise moving down-in-quality to pick up extra spread in non-Aaa ABS.   Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 113 basis points in December but underperformed by 57 bps in 2020. Aaa Non-Agency CMBS outperformed Treasuries by 58 bps in December and by 56 bps in 2020. Non-Aaa Non-Agency CMBS outperformed Treasuries by 277 bps in December but underperformed by 360 bps in 2020 (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus will not be negatively impacted.7 Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 50 basis points in December and by 105 bps in 2020. The average index spread tightened 7 bps in December to reach 49 bps (bottom panel). At its September meeting, the Fed decided to slow its pace of Agency CMBS purchases. It is no longer looking to increase its Agency CMBS holdings, but rather, will only purchase what is “needed to sustain smooth market functioning”. This is nonetheless a backstop of the market, and it does not change our overweight recommendation.   Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities The Cyclical Sweet Spot The Cyclical Sweet Spot Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of December 31ST, 2020) The Cyclical Sweet Spot The Cyclical Sweet Spot Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of December 31ST, 2020) The Cyclical Sweet Spot The Cyclical Sweet Spot Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 85 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 85 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Cyclical Sweet Spot The Cyclical Sweet Spot Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of December 31ST, 2020) The Cyclical Sweet Spot The Cyclical Sweet Spot   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 4 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Below-Benchmark Portfolio Duration: The economic recovery will continue (and even accelerate) in 2021. Meanwhile, the Fed’s forward interest rate guidance is already as dovish as it will get. Keep portfolio duration below-benchmark in 2021, targeting a level of 1.25% to 1.5% for the 10-year Treasury yield.  Overweight TIPS Versus Nominal Treasuries: We remain overweight TIPS versus nominal Treasuries for the time being but are actively looking for an opportunity to get tactically underweight. This opportunity could emerge in the first half of 2021 when core and trimmed mean inflation re-converge and when the 10-year TIPS breakeven inflation rate looks expensive on our model.  Own Nominal Yield Curve Steepeners, Real Yield Curve Steepeners And Inflation Curve Flatteners: The nominal yield curve will continue to trade directionally with yields. Therefore, higher yields will coincide with a steeper nominal curve in 2021. Rising inflation and the Fed’s new Average Inflation Target both argue for a flatter inflation curve in 2021. We also recommend a real yield curve steepener as a high octane play on both a steeper nominal curve and flatter inflation curve. Overweight Spread Product Versus Treasuries: We see the economy as entering what we call “Phase 1” of the economic cycle in 2021, an environment of above-trend growth, low inflation and accommodative monetary policy. This is an environment where spread product typically performs very well relative to Treasuries. Move Down In Quality Within Corporates: Investment grade corporates will outperform Treasuries in 2021, but the potential for further spread compression is limited. Junk spreads have more room to tighten, and the Ba credit tier looks particularly attractive from a risk/reward perspective A Maximum Overweight Allocation To Municipal Bonds: Tax-exempt municipal bonds offer the best opportunity in the US fixed income space. Investors should adopt a maximum overweight allocation, and in particular, they should shift some allocation out of investment grade corporates and into Munis with the same credit rating and duration, but with a greater after-tax yield. Feature BCA published its 2021 Outlook on November 30. That report lays out the main macroeconomic themes that our strategists see driving markets next year. This Special Report explains how investors can profit from those themes in US fixed income markets. Specifically, we offer six key US fixed income views for 2021. This report is limited to the six key investment views listed on page 1, and only discusses Fed policy in the context of how it influences those views. Next week we will publish a more comprehensive “Fed In 2021” report that will delve into our outlook for the Fed next year. Outlook Summary First, a brief summary of the main economic views presented in BCA’s 2021 Outlook:1 The third wave of COVID infections will be a drag on economic activity in 2020 Q4 and 2021 Q1, but inventory re-stocking and the large build-up of household savings will prevent the US economy from falling into a double-dip recession. Ultimately, the vaccine roll-out will cause US GDP to grow well above trend in 2021. Inflation is likely to spike in the first half of 2021 due to base effects and the re-opening of some service sectors that were shuttered during the pandemic. But this initial surge will dissipate in the second half of the year. The wide output gap that opened in 2020 will persist in 2021 and will prevent a broad-based acceleration in consumer prices. The Fed’s forward interest rate guidance is as dovish as it will get. A large portion of the Outlook is devoted to considering longer-run economic and political trends that were accelerated by the global policy response to COVID-19. Specifically, rising populism, heavier corporate regulation and a greater appetite for MMT-like taxing and spending policies. The ultimate outcome of these trends will be significantly higher inflation, on the order of 3% to 5%, in the second half of the decade. Key View #1: Below-Benchmark Portfolio Duration Chart 1Treasury Yields In 2020 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The economic recovery will continue (and even accelerate) in 2021. Meanwhile, the Fed’s forward interest rate guidance is already as dovish as it will get. Keep portfolio duration below-benchmark in 2021, targeting a level of 1.25% to 1.5% for the 10-year Treasury yield. Our recommendation to maintain below-benchmark portfolio duration rests on two key pillars. The first is BCA’s view that the economic recovery will continue in 2021 and will even accelerate once enough of the population has received the COVID vaccine. The second pillar is our view that the Federal Reserve’s reaction function is as dovish as it will get. In other words, having already laid out the conditions that must be in place for it to begin the next rate hike cycle, the Fed will not undertake further efforts to guide interest rates lower in the face of economic recovery. Chart 1 provides a bit more context for our assessment of Fed policy. This year, economic growth and inflation expectations troughed in March and moved rapidly higher throughout the summer. Bond yields, however, stayed relatively flat between March and August. The reason is that, even as the economic outlook improved, the Fed was steadily guiding markets towards a dramatic shift in its forward interest rate guidance. Specifically, the adoption of an Average Inflation Target – a pledge to allow a moderate overshoot of the 2% inflation target to make up for past downside misses. The result of the Fed’s dovish shift is that the increase in inflation expectations between March and August was entirely offset by falling real yields (Chart 1, panel 3), leaving nominal yields close to unchanged. However, the Fed made its Average Inflation Target official at the Jackson Hole Symposium in August. Then, in September, it formalized its forward rate guidance by promising not to lift rates off the zero bound until inflation reaches 2% and is expected to moderately overshoot for a while. These events changed the dynamic in the bond market. The Fed is no longer trying to guide markets towards a more dovish reaction function. That reaction function is now officially in place, and presumably in the market price. Indeed, nominal bond yields have risen in concert with improving economic conditions since August, and we expect that trend to continue in 2021. Our Golden Rule of Bond Investing states that we should set portfolio duration by considering our own expectations for future changes in the fed funds rate relative to what is already priced in the yield curve. Appendix A at the end of this report shows that the Golden Rule once again performed well in 2020. Looking ahead, the market is currently pricing-in one full 25 basis point rate hike by mid-2023 and then only one more by mid-2024 (Chart 2). We see high odds that inflation could sustainably reach 2% – the Fed’s stated criteria for lifting off the zero bound – before that, necessitating some Fed tightening in 2022. Chart 2Market Priced For Liftoff In 2023 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income How High Could Yields Go In 2021? To answer this question, we first look at the 5-year/5-year forward Treasury yield relative to survey estimates of the longer-run equilibrium fed funds rate. In theory, long-dated forward yields should be relatively insulated from near-term shifts in the policy rate and should settle near levels consistent with estimates of the equilibrium fed funds rate. In practice, we find that the 5-year/5-year forward Treasury yield does settle near these levels, but only during periods of global economic recovery when investors are presumably more inclined to envision the closing of the output gap and an eventual neutralizing of monetary policy. Notice that during the past two global growth upturns, 2013/14 and 2017/18, the 5-year/5-year forward Treasury yield peaked close to survey estimates of the long-run equilibrium fed funds rate from the New York Fed’s Survey of Market Participants and the Survey of Primary Dealers (Chart 3A). If the same thing happens next year, the 5-year/5-year forward Treasury yield will rise to a range of roughly 2% to 2.25%, 54 bps to 79 bps above current levels. Chart 3AHow High Can Yields Rise? 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart 3BLess Upside In 10y Than In 5y5y 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income We see less upside next year for the benchmark 10-year yield than for the 5-year/5-year forward. Long-dated forward rates are not mathematically influenced by the near-term outlook for the policy rate, but the yield on the 10-year Treasury note embeds those expectations. Since it is unlikely that inflation will be strong enough to prompt a Fed rate hike in 2021, the yield curve will steepen as the economic outlook improves and the 10-year yield will rise by less than the 5-year/5-year forward. Looking at Chart 3B, next year’s bond market moves will look a lot more like 2013/14 than like 2017/18. The Fed kept rates at zero in 2013/14. This led to yield curve steepening and caused the 10-year Treasury yield to peak at a level well below survey estimates of the long-run equilibrium fed funds rate. In contrast, the Fed was hiking rates in 2017/18. This led to a flatter yield curve and caused the 10-year yield to peak at around the same level as the 5-year/5-year forward. All in all, while we could see the 5-year/5-year forward Treasury yield reach a range of 2% to 2.25% next year, we expect the 10-year Treasury yield to reach a range of 1.25% to 1.5%. Will The Fed Use Its Balance Sheet To Stop Treasury Yields From Rising? By far, the most common disagreement we’ve received from clients on our call for higher bond yields is that the Fed will simply use its balance sheet to prevent any increase in long-maturity yields. We don’t see this as having a meaningful impact. For one, the Fed will only take significant steps to ease monetary policy if it looks like the economic recovery is under threat. This would require a large tightening of financial conditions, meaning significantly lower stock prices and wider corporate bond spreads. We don’t see a 1.25% to 1.5% 10-year Treasury yield in the context of a steepening yield curve, low inflation and improving economic growth as likely to cause such an event. Granted, the Fed could take more minor actions, like keeping the same pace of purchases but shifting them further out the curve, but a significant tightening of financial conditions is likely required for them to increase the monthly pace of bond buying. Second, even if the Fed does decide to ramp up the pace of bond buying (either overall or only at the long-end of the curve), if it keeps the same forward interest rate guidance, then bond yields will be driven by the market’s perceived progress toward the conditions that would prompt the start of the next tightening cycle. It won’t matter how many bonds the Fed buys in the meantime. Our Golden Rule of Bond Investing has a strong track record that it achieves by focusing only on changes in the fed funds rate relative to expectations. It does not consider asset purchases at all, and we are also inclined to view them more as a distraction. Key View #2: Overweight TIPS Versus Nominal Treasuries Chart 4Adaptive Expectations Model 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income We remain overweight TIPS versus nominal Treasuries for the time being but are actively looking for an opportunity to get tactically underweight. This opportunity could emerge in the first half of 2021 when core and trimmed mean inflation re-converge and when the 10-year TIPS breakeven inflation rate looks expensive on our model. TIPS breakeven inflation rates fell dramatically when the COVID crisis struck in March, but they then rebounded just as quickly and are now near fair value according to our Adaptive Expectations Model (Chart 4). Our model forecasts the future 12-month change in the 10-year TIPS breakeven inflation rate based on where the rate currently sits relative to several different measures of actual CPI inflation. Right now, our model is looking for a 12 basis point decline in the 10-year breakeven rate during the next year, but this forecast will rise if CPI prints strongly in the coming months, which is exactly what we expect. Chart 5Expect Higher Inflation In H1 2021 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income As noted in the above Outlook Summary, base effects and the re-opening of some service sectors will cause inflation to jump in the first half of 2021. A good way to see this is to look at the gap between 12-month core and trimmed mean CPI (Chart 5). Core inflation fell dramatically in March and April and is now in the process of bouncing back. Meanwhile, trimmed mean inflation measures were much more stable in the spring because they filtered out those sectors that experienced huge negative inflation prints during quarantine.   We think the gap between core and trimmed mean CPI is a good guidepost for our TIPS strategy. As long as the gap remains wide, we see upside risks to inflation. However, once the gap closes, that will signal that the “snapback phase” from re-opening the economy is over and that inflation pressures will moderate in line with the wide output gap. Shelter inflation is one of the components of inflation that is most sensitive to the output gap, and it has already been rolling over in line with the rising unemployment rate (Chart 5, bottom panel). Overall, our TIPS strategy in 2021 is to remain overweight TIPS versus nominal Treasuries for the time being. However, we are actively looking for an opportunity to get tactically short TIPS versus nominals. This could occur sometime in the first half of 2021 when core and trimmed mean inflation have re-converged and when (hopefully) the 10-year TIPS breakeven inflation rate looks more expensive on our model. Key View #3: Own Nominal Yield Curve Steepeners, Real Yield Curve Steepeners and Inflation Curve Flatteners Chart 62/5/10 Butterfly Spread Valuation 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The nominal yield curve will continue to trade directionally with yields. Therefore, higher yields will coincide with a steeper nominal curve in 2021. Rising inflation and the Fed’s new Average Inflation Target both argue for a flatter inflation curve in 2021. We also recommend a real yield curve steepener as a high octane play on both a steeper nominal curve and flatter inflation curve. Nominal Yield Curve With the funds rate pinned at zero and the Fed unlikely to actually lift it until 2022 (at the earliest), it is quite clear that the slope of the nominal yield curve will continue to trade directionally with yields as we head into 2021. That is, with volatility at the front-end of the curve completely suppressed, the yield curve will steepen when yields rise and flatten when they fall. In that context, we recommend complementing our below-benchmark portfolio duration view with nominal yield curve steepeners. Our preferred way to implement a nominal yield curve steepener is to buy the 5-year Treasury note and short a barbell consisting of the 2-year note and 10-year note. Allocations to the 2-year and 10-year should be weighted so that the duration of the 2/10 barbell matches that of the 5-year note. As we have explained in prior research, this sort of position is designed to profit from 2/10 yield curve steepening and it has worked well during the past few months (Chart 6).2  The one problem with this 5 over 2/10 trade is that it is not cheap. The 5-year yield is below the yield on the 2/10 barbell (Chart 6, panel 3) and the 5-year bullet looks expensive on our fair value model (Chart 6, bottom panel). However, we should also note that the 5-year looked much expensive during the last period of zero-bound rates in 2012. Given today’s very similar policy environment, we could see the 5-year yield getting even more expensive in 2021. Inflation Curve Chart 7Favor Inflation Curve Flatteners... 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Our second recommended yield curve position relates to the inflation curve, either the TIPS breakeven inflation curve or the CPI swap curve. Here, we recommend owning inflation curve flatteners for two reasons. First, short-maturity inflation expectations are more sensitive to the actual inflation data than long-maturity expectations. We saw a prime example of this relationship in 2020. The 2-year CPI swap rate plunged into negative territory when inflation fell in March while the 10-year CPI swap rate held relatively stable in comparison (Chart 7). Subsequently, the 2-year CPI swap rate rose much more quickly than the 10-year rate this summer as inflation rebounded. Looking ahead, with inflation biased higher in the first half of 2021, we should see greater upside in short-maturity inflation expectations than in long-maturity ones. The Fed’s adoption of an Average Inflation Target is the second reason to favor inflation curve flatteners. If the Fed is ultimately successful at achieving an overshoot of its 2% inflation target, it will mean that the Fed will be attacking its inflation target from above rather than from below for the first time since the 1980s. Logically, the inflation curve should be inverted in this sort of environment. This means that the inflation curve still has a lot of room to flatten from current levels (Chart 7, bottom panel). Real Yield Curve Chart 8...And Real Yield Curve Steepeners 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The Fisher Equation tells us that real yields are simply the difference between nominal yields and inflation expectations. Viewed that way, it is easy to see that – all else equal – a steeper nominal curve will lead to a steeper real yield curve. Meanwhile, a flatter inflation curve will also lead to a steeper real yield curve. In that sense, a real yield curve steepener is just a combination of the nominal curve steepener and inflation curve flattener that we already mentioned (Chart 8). As inflation rises, it will pressure short-dated inflation expectations higher relative to long-dated ones. This will exert bull-steepening pressure on the real yield curve. Meanwhile, investors starting to price-in eventual rate hikes will lead to nominal yield curve steepening. This will exert bear-steepening pressure on the real yield curve. With that in mind, a real yield curve steepener is a high conviction position for us in 2021. We have less conviction on the outright direction for real yields, though we suspect that long-maturity real yields have already troughed for the cycle. Key View #4: Overweight Spread Product Versus Treasuries We see the economy as entering what we call “Phase 1” of the economic cycle in 2021, an environment of above-trend growth, low inflation and accommodative monetary policy. This is an environment where spread product typically performs very well relative to Treasuries.  Most spread sectors will likely end the year having underperformed duration-equivalent Treasuries in 2020. However, this simple fact obscures the actual pattern of spread movements that was witnessed during the year. Spreads widened sharply when COVID struck but they peaked on March 23, the same day that the Federal Reserve announced its slew of emergency lending facilities.3 Spread product has been outperforming Treasuries since then (see Appendix B), a trend we expect will continue in 2021. The phase of the economic cycle when the economy is just emerging from a recession is typically one where risk assets perform well. The principal reason to expect spread product outperformance to continue is that the phase of the economic cycle when the economy is just emerging from a recession is typically one where risk assets perform well. It tends to be an environment where economic activity is growing at an above-trend pace, but inflation is still low and monetary conditions are accommodative. This is the perfect environment for credit spreads to tighten. The slope of the yield curve is a useful variable for summarizing the above macro conditions and we often use it to define three phases of the economic cycle (Chart 9): Chart 9The Three Phases Of The Cycle 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Phase 1 is defined as the time between the end of the last recession and when the 3-year/10-year Treasury slope flattens to below 50 bps. Phase 2 is defined as when the 3-year/10-year Treasury slope is between 0 bps and 50 bps. Phase 3 is defined as the time between when the 3-year/10-year Treasury slope turns negative and the start of the next recession. As we are just now emerging from recession and the 3-year/10-year slope is above 50 bps and steepening, we see the economy as being firmly in Phase 1 of the cycle. Historically, this phase has been the best one for spread product returns relative to duration-matched Treasuries (Table 1). Table 1Corporate Bond Performance In Different Phases Of The Cycle 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The main risk to this view of spread product is that we are not yet emerging from the recession and the corporate default rate may have another leg higher. Our sense, however, is that the default rate has already peaked. Gross leverage (the ratio between total corporate debt and pre-tax corporate profits) and job cut announcements are two variables that correlate very tightly with the default rate (Chart 10). Starting with leverage, net earnings revisions – a leader profit indicator – have already troughed and the corporate financing gap has turned negative (Chart 11). A negative financing gap means that the corporate sector has sufficient retained earnings to cover its capital expenditures. In other words, most firms are flush with cash and they won’t need to issue more debt in the coming quarters. Further, job cut announcements have come down sharply during the past few months (Chart 11, bottom panel). Chart 10The Default Rate Correlates With Gross Leverage And Job Cuts 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart 11Firms Have Enough Cash 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The above trends in corporate profits, corporate debt and job cut announcements are consistent with what we’re already seeing on the default front. The US corporate sector was experiencing upwards of 20 default events per month back in May, June and July. But only seven defaults occurred in November, following five in October and six in September (Chart 12). Chart 12The Default Rate Has Peaked 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The bottom line is that the macro environment of above-trend growth, low inflation and accommodative monetary policy is one where we should expect spread product to outperform Treasuries. Relative valuation dictates which spread sectors we prefer over other ones, and the next two Key Views address this issue. Key View #5: Move Down In Quality Within Corporates Investment grade corporates will outperform Treasuries in 2021, but the potential for further spread compression is limited. Junk spreads have more room to tighten, and the Ba credit tier looks particularly attractive from a risk/reward perspective. As noted in the previous section, the macroeconomic environment is one where spread product should flourish. However, valuation in certain sectors could limit how much further spread tightening is possible. In particular, valuation looks to be a constraint for investment grade corporates. In absolute terms, investment grade corporate spreads look like they still have some room to compress (Chart 13). The overall index spread is 12 bps above its pre-COVID level. The Aa, A and Baa-rated spreads are 16 bps, 11 bps and 13 bps above, respectively. Only seven defaults occurred in November, following five in October and six in September. However, valuation looks much worse in risk-adjusted terms. Chart 14 shows the 12-month breakeven spread, i.e. the spread widening required for the sector to underperform Treasuries on a 12-month investment horizon. In addition, we re-weight the overall corporate index to ensure that it maintains a constant credit rating distribution over time, and we show all breakeven spreads as percentile ranks relative to their own histories. For example, a reading of 8% for the Baa credit tier means that the 12-month breakeven spread for the Baa credit tier has only been lower than it is today 8% of the time since our data begin in 1995. Chart 13IG Spreads Still Above ##br##Pre-COVID levels 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart 14IG Looks More Expensive In Risk-Adjusted Terms 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Adding it all up, we think there is scope for investment grade corporates to modestly outperform Treasuries in 2021, but there are also more attractively priced sectors that investors may want to consider. Municipal bonds are one particularly attractive alternative to investment grade corporates (we discuss our view on municipal bonds in the next section), but investors are also advised to pick-up additional spread by moving down in quality within the corporate credit space. High-Yield corporate bonds have significantly more scope for tightening than their investment grade counterparts, with the overall junk index spread still 69 bps above its pre-COVID level (Chart 15). Within junk, the Ba credit tier looks like the best place to camp out from a risk/reward perspective. The incremental spread offered by Ba-rated junk bonds compared to Baa-rated corporates is elevated compared to history, 111 bps above its 2019 low (Chart 15, panel 2). In contrast, the additional spread pick-up you get from moving into the lower junk tiers (B & Caa) is more in line with typical historical levels (Chart 15, bottom 2 panels). Chart 15Ba-Rated Bonds Look Best 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Another reason to be cautious about chasing the extra spread in the B-rated and below credit tiers is that the High-Yield index is pricing-in a fairly rapid decline in the default rate for the next 12 months (Chart 16). If we assume a 25% recovery rate and target an excess spread of 150 bps above default losses,4 then we calculate a spread-implied default rate of 3.1%. That is, we should only expect junk bonds to outperform duration-matched Treasuries if the default rate comes in below 3.1% during the next 12 months. This would represent a steep decline of 5.3% from the 8.4% default rate we just witnessed during the past 12 months, but this sort of big drop in the default rate would not be out of line with what typically happens when the economy emerges from recession. For example, in the last recession, the 12-month default rate peaked at 14.6% in November 2009 and then fell to 3.6% by November 2010, a decline of 11%! Chart 16Spread-Implied Default Rate 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income All in all, we view the Ba-rated credit tier as the sweet spot within corporate credit in terms of offering the best combination of risk and reward. We also expect the default rate to fall quickly enough that the lower-rated junk credit tiers will outperform Treasuries, but the risk here is greater and the potential additional compensation is not historically elevated. Investment grade corporate spreads will remain tight, but have limited room to compress further. Investors are advised to look at Ba-rated corporates and municipal bonds instead.  Key View #6: A Maximum Overweight Allocation To Municipal Bonds Tax-exempt municipal bonds offer the best opportunity in the US fixed income space. Investors should adopt a maximum overweight allocation, and in particular, they should shift some allocation out of investment grade corporates and into Munis with the same credit rating and duration, but with a greater after-tax yield. At present, we think that tax-exempt municipal bonds represent the best opportunity in US fixed income. Muni spreads have certainly tightened since March, but valuation remains attractive relative to both Treasuries and investment grade corporates. First, let’s consider value relative to Treasuries (Chart 17). Spreads between Aaa-rated municipal bonds and maturity-matched Treasuries are elevated compared to history across the entire yield curve. 2-year Munis even offer a 3 bps yield pick-up over 2-year Treasuries before adjusting for the tax advantage. Further out the curve, value is worst at the 5-year part of the curve where the breakeven effective tax rate between Munis and Treasuries is 42%, slightly above the top marginal tax rate of 37%. But value improves again for longer maturities. The breakeven effective tax rate between 10-year Munis and Treasuries is 24% and it is a mere 10% for 30-year bonds.5 Next, we can look at relative value between Munis and credit. This is where the attractiveness of munis really stands out (Chart 18). After controlling for credit rating and duration, municipal revenue bonds offer a yield advantage over the Bloomberg Barclays Credit Index across the entire yield curve, before any adjustment is made for the municipal tax exemption. General Obligation (GO) Munis only offer a before-tax yield advantage over credit beyond the 12-year maturity point, but the GO Muni/credit spread is nonetheless historically elevated for all maturity buckets. Chart 17Muni/Treasury Yield Spreads 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart 18Munis Versus Credit 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income This is all well and good, but it could easily be countered that municipal bonds only offer such attractive valuations because the COVID recession has been an historically challenging period for state & local government balance sheets. If this period leads to a spate of downgrades and defaults, then municipal bonds no longer look cheap. All this is true, but we think investors’ worst fears in this regard will not be realized. For one thing, state & local governments have been very quick to clamp down on spending and cut employment (Chart 19). Coming out of the last recession, Muni/Treasury yield spreads had almost fully recovered by the time that state & local government austerity began. Also, state budgets were in pretty good shape heading into the COVID downturn, with all-time high Rainy Day Fund balances (Chart 19, bottom panel). Chart 19State & Local Austerity Has Begun 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income We recommend that investors take advantage of historically attractive municipal bond spreads by adopting a maximum overweight allocation. In particular, investors should shift allocation out of investment grade rated corporate bonds, where valuations are stretched, and into municipal bonds that offer the same credit rating and duration with a greater yield pick-up. Finally, Chart 20 shows the spread between different municipal bond sectors and the Bloomberg Barclays US Credit Index. We match the credit rating and duration in each case, but we make no adjustments for the municipal tax exemption. The message from Chart 20 is that the yield advantage in investment grade Munis is broad based, with the exception of the Electric sector. We also see that attractive valuations do not extend to high-yield Munis, which appear expensive relative to High-Yield Credit. Chart 20Municipal Bond Sector Valuation 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Appendix A:  The Golden Rule Of Bond Investing Our Golden Rule of Bond Investing says that we should determine what change in the fed funds rate is priced into the overnight index swap curve for the next 12 months, and then decide whether the Fed will deliver a hawkish or dovish surprise relative to that expectation. We contend that if the Fed delivers a hawkish surprise, then a below-benchmark portfolio duration positioning will pay off. Conversely, if the Fed delivers a dovish surprise, then an above-benchmark portfolio duration positioning will profit. Chart A1 shows how the Golden Rule has performed in every calendar year going back to 1990. We include year-to-date performance for 2020. In 31 years of historical data, our Golden Rule performed well in 23. It provided the wrong recommendation in 8 years, though 3 of those years were during the zero-lower-bound period between 2009 and 2015 when 12-month rate expectations were essentially pinned at zero.6 Chart A1The Golden Rule's Track Record 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income At the beginning of this year, the market was priced for 13 bps of rate cuts in 2020. The funds rate actually fell by 146 bps, leading to a dovish surprise of 133 bps. Based on a historical regression, we would expect a dovish surprise of 133 bps to coincide with a Treasury index yield that falls by 81 bps. In actuality, the index yield fell by 122 bps, more than our Golden Rule predicted. Chart A2 shows how close changes in the Treasury index yield have been to our Golden Rule’s prediction in each of the past 31 years. This regression between the change in Treasury index yield and the monetary policy surprise is the main source of error in our Treasury return forecasts. Chart A2Treasury Index Yield Changes Versus Fed Funds Surprises 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Based on our expected -81 bps index yield change, we would have expected the Treasury index to deliver 6.5% of total return in 2020 and to outperform cash by 5.5%. In actuality, the index earned 7.9% of total return and outperformed cash by 7%. Charts A3 and A4 show how index total and excess returns have performed relative to our Golden Rule’s expectations in each of the past 31 years. Chart A3Treasury Index Total Returns Versus The Golden Rule’s Predictions 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart A4Treasury Index Excess Returns Versus The Golden Rule’s Predictions 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Appendix B: Spread Product Performance In 2020 Table B1Spread Product Year-To-Date Performance 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Table B2Performance Since March 23 Announcement Of Emergency Fed Facilities 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst, “Outlook 2021: A Brave New World”, dated November 30, 2020, available at bca.bcaresearch.com 2 Please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 3 We discussed these facilities in detail in two Special Reports published jointly this year with our US Investment Strategy team. US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020 and US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup Part 2: Shocked And Awed”, dated July 28, 2020. Both reports available at usbs.bcaresearch.com 4 Our research has shown that this is the minimum excess spread investors should require to be confident that junk bonds will outperform duration-matched Treasuries. For more details please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 5 The breakeven effective tax rate is the effective tax rate that makes the after-tax muni yield the same as the Treasury yield. If the investor’s personal tax rate is above the breakeven effective tax rate, they will get an after-tax yield pick-up from owning the municipal bond over the Treasury. 6 We say the Golden Rule “worked” if a dovish surprise coincided with positive Treasury index excess returns versus cash, or if a hawkish surprise coincided with negative Treasury excess returns versus cash. Recommended Portfolio Specification

Highlights Chart 1Bond Yields & The CRB/Gold Ratio Bond Yields & The CRB/Gold Ratio Bond Yields & The CRB/Gold Ratio In our last report of November, we noted that the rising COVID case count was likely to lead to a challenging few months for the US economy, but we also questioned whether financial markets would pay attention or whether they would stay focused on the vaccine roll-out and eventual economic recovery. We now have our answer. November’s employment report was the worst since April, but the Treasury curve has bear-steepened, credit spreads have come in and TIPS have outperformed nominals. What’s more, the jump in the CRB Raw Industrials / Gold ratio suggests that the 10-year Treasury yield has even more near-term upside (Chart 1). With a vaccine on the horizon and Congress closing in on a fiscal relief package, investors should stay positioned for the reflation trade on a 6-12 month horizon: below-benchmark portfolio duration, nominal and real yield curve steepeners, inflation curve flatteners, overweight TIPS versus nominals and overweight corporate bonds rated Ba and higher. Feature Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 233 basis points in November, bringing year-to-date excess returns up to -74 bps. The strong rally in corporate bonds since March has culminated in extremely tight valuations for investment grade corporates. The 12-month breakeven spread for the Bloomberg Barclays Corporate Index (adjusted to keep the average credit rating constant) has only been tighter 4% of the time since 1995 (Chart 2). The same figure for the Baa-rated credit tier is 5%. We retain a positive outlook on corporate credit despite these stretched valuations. In our view, an environment where the economy is recovering and where the Fed will be very cautious about scaling back accommodation is the exact sort of environment where we should expect a lot of enthusiasm for spread product and, as a result, extremely tight spreads. We will not be surprised if our 12-month breakeven spread percentile rank valuation measure reaches its all-time expensive level within the next couple of months. While the macro environment makes it difficult to turn negative on investment grade corporates, we acknowledge that other sectors may offer better opportunities, particularly in the higher credit tiers. Specifically, we find better value in tax-exempt municipal bonds than in corporates and recommend that investors favor the former over the latter. At the sector level, we continue to recommend overweight allocations to subordinate Bank bonds, Healthcare and Energy bonds. We also advise underweight allocations to Technology and Pharmaceutical bonds. Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Stay Positioned For Reflation Stay Positioned For Reflation Table 3BCorporate Sector Risk Vs. Reward* Stay Positioned For Reflation Stay Positioned For Reflation High-Yield: Neutral High-Yield outperformed the duration-equivalent Treasury index by 382 basis points in November, bringing year-to-date excess returns up to -5 bps. After last month’s strong outperformance, Ba-rated junk bonds are now beating duration-equivalent Treasuries by 267 bps, year-to-date. The B and Caa credit tiers are lagging by 179 bps and 548 bps, respectively. We still view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We remain underweight B-rated and lower junk bonds for now as those securities are pricing-in a relatively optimistic outlook for the default rate. But, an imminent vaccine roll-out makes that outlook appear more realistic and we could soon upgrade the lower-rated junk credit tiers when we think the value is exhausted in the Ba-rated and higher securities. Looking at value for the junk index as a whole, we see that the index is pricing-in a default rate of 3% for the next 12 months, significantly below the 8.3% that was observed during the most recent 12-month period (panel 3). However, only four corporate issuers defaulted in October down from a monthly peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, are also falling rapidly (bottom panel). At the sector level, we advise overweight allocations to high-yield Technology and Energy bonds. We are underweight the Healthcare and Pharmaceutical sectors. Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview MBS: Underweight Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by one basis point in November, dragging year-to-date excess returns down to -39 bps. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 1 bp on the month, and it currently sits at 64 bps (Chart 4). This is significantly higher than the 59 bps offered by Aa-rated corporate bonds, the 53 bps offered by Agency CMBS and the 25 bps offered by Aaa-rated consumer ABS. Despite the relatively attractive OAS, we continue to view the elevated primary mortgage spread as a risk for MBS investors. It suggests that mortgage rates need not rise alongside Treasury yields in the near-term, meaning that mortgage refinancings can continue at their current rapid pace (panel 3). All else equal, this elevated refinancing activity will pressure MBS spreads wider. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government intervention to either support household incomes or extend the forbearance period would mitigate the risk. Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Government-Related: Underweight The Government-Related index outperformed the duration-equivalent Treasury index by 64 basis points in November, bringing year-to-date excess returns up to -222 bps. Sovereign debt outperformed duration-equivalent Treasuries by 157 bps on the month, bringing year-to-date excess returns up to -269 bps. Foreign Agencies outperformed the Treasury benchmark by 46 bps in November, bringing year-to-date excess returns up to -647 bps. Local Authority debt outperformed Treasuries by 139 bps in November, bringing year-to-date excess returns up to -228 bps. Domestic Agency bonds outperformed by 10 bps, bringing year-to-date excess returns up to -23 bps. Supranationals outperformed by 9 bps, bringing year-to-date excess returns up to +2 bps. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, this year’s dollar weakness has occurred mostly relative to other Developed Market currencies (Chart 5). Value has improved somewhat for EM Sovereigns during the past few weeks, but the index continues to offer less spread than the Baa-rated US Credit index (panel 4). At the country level, Turkey, Colombia, Mexico, Russia and South Africa are the only countries that offer a spread pick-up relative to duration and quality-matched US corporates. Of those, only Mexico looks attractive on a risk/reward basis. Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview Municipal Bonds: Overweight Municipal bonds outperformed the duration-equivalent Treasury index by 130 basis points in November, bringing year-to-date excess returns up to -340 bps (before adjusting for the tax advantage). Municipal bond spreads tightened sharply relative to both Treasuries and Corporates in November, but they remain exceptionally attractive relative to history (Chart 6). In fact, as we showed in a recent report, the Bloomberg Barclays Revenue Bond index offers a greater yield than the quality-matched Credit index across the entire maturity spectrum (before adjusting for the tax advantage).1 This is also true for the Bloomberg Barclays General Obligation (GO) index beyond the 12-year maturity point. Eight-to-twelve-year maturity GO bonds trade only 1 basis point through the Credit index, implying a breakeven effective tax rate of 4%. Six-to-eight-year maturities trade 11 bps through the Credit index, implying a breakeven effective tax rate of 16%. Extraordinary valuation is the main reason for our recommendation to overweight municipal bonds. The severe ongoing state & local government credit crunch is a concern, but it is a risk we are willing to take. It now looks possible that a relief package containing some federal funds for state & local governments will be passed before the end of the year. This would alleviate a lot of the concern. But even in the absence of federal assistance, the combination of austerity measures (bottom panel) and all-time high State Rainy Day Fund balances should help stave off a wave of municipal downgrades. Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell The Treasury curve bull-flattened in November, but then bear-steepened sharply during the first week of December. All told, the 2/10 Treasury slope is currently 81 bps, 7 bps steeper than at the end of October. The 5/30 Treasury slope is 131 bps, 4 bps steeper than at the end of October. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. A timely vaccine roll-out and/or further fiscal stimulus will speed this process up. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year note and 10-year notes. This position is designed to profit from 2/10 curve steepening.     Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar levels. Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview TIPS: Overweight TIPS outperformed the duration-equivalent nominal Treasury index by 70 basis points in November, bringing year-to-date excess returns up to -23 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 8 bps and 5 bps on the month. They currently sit at 1.91% and 1.96%, respectively. Core CPI was flat in October and the year-over-year rate dropped from 1.73% to 1.63%. The 12-month trimmed mean CPI fell even more – from 2.37% to 2.22% – so the gap between core and trimmed mean inflation continued to narrow (Chart 8). We expect further narrowing in the months ahead, and therefore expect core CPI to come in relatively hot. For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven rate is now somewhat expensive according to our Adaptive Expectations Model (panel 2).2 Inflation pressures may moderate once core and trimmed mean inflation measures converge, and this could give us an opportunity to tactically reduce TIPS exposure sometime next year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview ABS: Overweight Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in November, bringing year-to-date excess returns up to +82 bps. Aaa-rated ABS outperformed the Treasury benchmark by 10 bps on the month, bringing year-to-date excess returns up to +68 bps. Non-Aaa ABS outperformed by 17 bps, bringing year-to-date excess returns up to +174 bps (Chart 9). On paper, the Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of the year is quite negative for ABS. However, as we explained in a recent report, we don’t expect a material impact on spreads.3 For one thing, Aaa ABS spreads are already well below the borrowing cost offered by TALF. But more importantly, consumer credit quality remains quite robust. As we first explained back in June, the stimulus received from the CARES act led to a significant increase in disposable income and a jump in the savings rate (panel 4).4  Faced with an income boost and few spending opportunities, many households took the opportunity to pay down consumer debt. Granted, further income support from Congress is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies. Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 85 basis points in November, bringing year-to-date excess returns up to -168 bps. Aaa Non-Agency CMBS outperformed Treasuries by 71 bps on the month, bringing year-to-date excess returns up to -2 bps. Non-Aaa Non-Agency CMBS outperformed by 127 bps, bringing year-to-date excess returns up to -620 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the imminent expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus will not be negatively impacted.5  Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 38 basis points in November, bringing year-to-date excess returns up to +55 bps. The average index spread tightened 6 bps on the month. It currently sits at 53 bps, above typical historical levels (bottom panel). At its September meeting, the Fed decided to slow its pace of Agency CMBS purchases. It is no longer looking to increase its Agency CMBS holdings, but rather, it is only purchasing what is “needed to sustain smooth market functioning”. This is nonetheless a Fed back-stop of the market, and it does not change our overweight recommendation.    Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table Performance Since March 23 Announcement Of Emergency Fed Facilities Stay Positioned For Reflation Stay Positioned For Reflation Appendix B: Butterfly Strategy Valuations  The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of December 4TH, 2020) Stay Positioned For Reflation Stay Positioned For Reflation Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of December 4TH, 2020) Stay Positioned For Reflation Stay Positioned For Reflation Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 70 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 70 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Stay Positioned For Reflation Stay Positioned For Reflation Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Chart 11Excess Return Bond Map (As Of December 4TH, 2020) Stay Positioned For Reflation Stay Positioned For Reflation Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Political Risk Will Dominate In A Pivotal Month For The Bond Market”, dated October 13, 2020, available at usbs.bcaresearch.com 2 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Please note that there will be no US Bond Strategy report next week. We will publish December’s Portfolio Allocation Summary on December 8th, followed by our Key Views For 2021 on December 15th and a Special Report titled “The Fed In 2021” on December 22nd. Highlights Duration: Weaker Q4 economic growth could cause Treasury yields to fall in the near-term, but knowledge of a vaccine coming in 2021 will limit the downside. Investors should maintain below-benchmark portfolio duration on a 6-12 month horizon. Fed: The Treasury’s decision to let the Fed’s emergency lending facilities expire is unlikely to have a meaningful impact on credit spreads, and it may even increase the odds of getting another fiscal stimulus bill through Congress. Spread Product: Value is quickly disappearing from high-rated corporate bonds, and municipal bonds look like an attractive alternative. Stay overweight municipal bonds and corporate bonds rated Ba and higher. Avoid junk bonds rated B and lower. Feature Increasingly, financial markets look caught in a tug-of-war between two competing economic outlooks. On the one hand, the US sits on the precipice of what is likely to be a dark winter. COVID hospitalizations are breaking through prior peaks and deaths are following closely behind (Chart 1). On the other hand, excellent results from vaccine trials offer a ray of light in the not-too-distant future. Focusing on the next 1-to-2 months, economic activity is poised to slow. This is partly because many states will respond to the surging case count by enacting stricter lock-down measures (Chart 2). In fact, New York shuttered schools just last week. But even in the absence of stricter quarantine laws, consumers will certainly exercise greater caution this holiday season. Already, consumer sentiment looks to be waning at a time when more than 700 thousand people are filing new unemployment claims each week (Chart 2, bottom 2 panels). Chart 1A Dark Winter A Dark Winter A Dark Winter Chart 2Look For Slower Growth In Q4 Look For Slower Growth In Q4 Look For Slower Growth In Q4 With consumer sentiment souring at a time when the household income support from the CARES act has expired, it is only a matter of time before consumer spending dips. Added to that, last week’s decision by the Treasury Department to call in the funds used to back-stop the Fed’s emergency lending facilities demonstrates that Donald Trump’s administration will be increasingly erratic during the next two months.1 Chart 3Treasury & Corporate Excess Returns Treasury & Corporate Excess Returns Treasury & Corporate Excess Returns Heightened political uncertainty during a period of slowing economic growth should point to lower bond yields and wider credit spreads in the near term. But, at least so far, the market reaction has been muted (Chart 3). Treasuries have strengthened somewhat during the past week. Treasury returns in excess of cash are running at +735 bps, year-to-date. This is up from +617 bps on November 10th. However, year-to-date investment grade corporate returns in excess of duration-matched Treasuries just hit -121 bps, the highest since February. Year-to-date High-Yield excess returns have dipped to -72 bps, after peaking at -39 bps on November 9th. It’s possible that investors need more evidence of weakening economic growth before the market impact is really felt. Or, it could simply be that forward-looking markets are much more focused on news about the COVID vaccine, and that investors are willing to tolerate a couple months of poor growth if they are confident that better times lie ahead. It’s also conceivable that financial markets would look through a spate of poor economic data if investors believed that more fiscal stimulus is on the way. Given the protracted nature of fiscal negotiations so far, it’s fair to be skeptical that a deal can be struck. But with the election now over, the House Democrats and Senate Republicans may have a greater incentive to compromise on a small relief bill, on the order of $1 trillion or less. According to surveys, a compromise deal would curry favor with voters of all political stripes. Most Republicans, Democrats and Independents support further fiscal aid (Table 1). What’s more, having a timeline for vaccine distribution could make negotiations less contentious, since any stimulus can be sold as the final COVID relief bill before a vaccine is available. Finally, it’s possible that Treasury Secretary Steve Mnuchin’s gambit will pay off, and that policymakers will view the funds being returned by the Fed as “free money” that should be re-deployed in the form of fiscal support. All in all, we are optimistic that a moderately-sized relief bill will be passed, if not this year then early next year. Table 1The Public Supports Another Round Of Stimulus Preparing For A Dark Winter … But Do Markets Care? Preparing For A Dark Winter … But Do Markets Care? Investment Implications Chart 4Better Value In Munis Than IG Corporates Better Value In Munis Than IG Corporates Better Value In Munis Than IG Corporates With regards to our outlook for Treasury yields, we could see yields dip during the next month or two as the economic data weaken. However, we expect the knowledge that a vaccine is on the horizon will prevent yields from falling that much. We also could see progress made on a fiscal stimulus package, which would offset any downward pressure on yields. With that in mind, we advise investors to maintain below-benchmark portfolio duration on a 6-12 month horizon. On spread product, our investment conclusion is similarly colored by the tug of war between a negative near-term economic outlook and the positive news of a COVID vaccine. We recommend maintaining our current positioning: overweight investment grade corporates and Ba-rated junk, underweight junk bonds rated B and lower. If we do get some spread widening during the next month or two, driven by negative economic news or the expiry of the Fed’s emergency lending facilities, we would view that as an opportunity to get more aggressive by upgrading the lower-rated junk credit tiers. One caveat to our positive view on corporate credit is that value has deteriorated markedly in recent months, particularly for higher-rated investment grade corporates (Chart 4). At the same time, tax-exempt municipal bonds offer an exceptional spread pick-up relative to both Treasuries and equivalently-rated corporate bonds (Chart 4, bottom panel). We recommend that investors favor municipal bonds over corporate credit, particularly at the upper-end of the credit spectrum. The value in high-rated investment grade corporates has deteriorated markedly. Bottom Line: Maintain below-benchmark portfolio duration on a 6-12 month horizon. Stay overweight investment grade corporates and Ba-rated junk, while avoiding high-yield bonds rated B and below. Stand ready to upgrade low-rated junk bonds if spreads widen significantly during the next two months. Favor municipal bonds over equivalently-rated corporate credit, particularly at the upper-end of the credit spectrum. Treasury – Fed Disaccord As mentioned above, last week’s big news was that Treasury Secretary Steve Mnuchin sent a letter to the Federal Reserve saying that he would (a) not authorize an extension of some of the Fed’s emergency lending facilities beyond December 31st and (b) would like the Fed to return the unused funds that the Treasury Department had allocated to serve as the equity back-stop for those facilities. Though the Fed issued a statement saying that it would prefer to extend the facilities, Chair Powell eventually acceded to both requests. This means that the Secondary and Primary Market Corporate Credit Facilities (SMCCF & PMCCF), the Municipal Liquidity Facility (MLF), the Main Street Lending Facilities (MSLF) and the Term Asset-Backed Securities Loan Facility (TALF) will all cease operations at the end of the year.2 Gone For Good? Given the Fed’s stated desire for the facilities to continue and the fact that a new Treasury Secretary – presumably one that will show greater deference to the Fed – will take over in January. It’s conceivable that the facilities could be quickly re-started. If the Treasury had simply not authorized an extension of the facilities without taking its money back, this would be as simple as flicking a switch. The fact that the Fed will return the money makes the process slightly more complicated, but by no means impossible. The facilities in question are all structured as Special Purpose Vehicles (SPVs) to which the Treasury Department supplies some amount of equity financing. The Fed then loans money to the SPVs, levering them up dramatically in the process. Crucially, there is no statutory limit on the amount of leverage the Fed can provide to the SPVs. This means that the Fed could ramp them back up, even if it gets only a small injection of capital from the Treasury. A new Treasury Department could easily find enough money in the Exchange Stabilization Fund for the Fed to re-start the facilities in January, without seeking Congressional approval. While the Fed and Treasury will be able to re-start the facilities in January, we aren’t sure they will feel the need to do so. While the Fed and Treasury will be able to re-start the facilities in January, we aren’t sure they will feel the need to do so. In our view, Secretary Mnuchin has a point when he writes that markets are functioning well enough on their own. Simply look at how little the emergency facilities have been used (Table 2). The Fed has purchased only $13 billion of corporate bonds in the SMCCF. TALF has only been tapped for $3.75 billion and both the MSLF and MLF are operating at less than 1% of their maximum capacities. The PMCCF, which the Fed can use to purchase new issuance in the corporate bond market, has never been accessed! Table 2Usage Of The 2020 Federal Reserve Emergency Lending Facilities Preparing For A Dark Winter … But Do Markets Care? Preparing For A Dark Winter … But Do Markets Care? Even the SMCCF, the facility through which the Fed buys corporate bonds and corporate bond ETFs in the secondary market, has significantly scaled back its purchases during the past few months. It also hasn’t purchased an ETF since August (Chart 5). Chart 5The Fed Is Not Very Active In The Corporate Bond Market Preparing For A Dark Winter … But Do Markets Care? Preparing For A Dark Winter … But Do Markets Care? At a certain point, if the facilities aren’t being used, it is entirely reasonable to ask whether they are still necessary. They would no doubt prove useful if we hit another crisis – like in March – where spreads widen sharply and primary markets shut down. But that seems like a relatively low-risk tail event at this stage of the recovery. Finally, Secretary Mnuchin made the case in his letter that the returned funds from the Fed could be re-deployed as fiscal stimulus by Congress. This argument doesn’t make a lot of sense economically. When it scored the CARES act, the Congressional Budget Office assumed that the Treasury would take no losses on the money used to finance the Fed’s emergency lending facilities, so clawing those funds back has no impact on the deficit. But this may not matter. What matters is whether Senate Republicans can use the Treasury’s maneuver as political cover to justify voting for more fiscal relief. We think they might be able to do so, and we therefore see the Treasury’s move as increasing the odds of getting another fiscal relief bill through Congress. Investment Implications Chart 6MLF And TALF Aren't Pushing Yields Lower MLF And TALF Aren't Pushing Yields Lower MLF And TALF Aren't Pushing Yields Lower This development does not immediately influence our recommended investment strategy. On corporate bonds, we can’t definitively rule out the possibility that the expiry of the facilities will cause spreads to widen in the near-term. But if that does occur, we will view it as an opportunity to quickly increase exposure. For municipal bonds, the MLF allows municipal governments to place new debt with the Fed at a rate that varies depending on the municipality’s credit rating. At present, that MLF rate is well above municipal bond yields for all credit ratings (Chart 6), meaning that it would only become important in the event of a crisis that caused municipal yields to rise sharply. Similarly, TALF allows participants to take out loans from the Fed using Aaa-rated securitizations as collateral. But the current yields on Aaa-rated consumer ABS and Aaa-rated non-agency CMBS are 91 bps and 33 bps below this rate, respectively (Chart 6, bottom panel). In other words, spreads would need to widen fairly sharply for TALF to be relevant for investors. The expiry of TALF is more concerning for CMBS than consumer ABS. Commercial real estate is structurally challenged by the current crisis, while consumer balance sheets are in good shape. We recommend overweighting consumer ABS across the entire credit spectrum but would limit non-agency CMBS exposure to the Aaa credit tier. Appendix: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities Preparing For A Dark Winter … But Do Markets Care? Preparing For A Dark Winter … But Do Markets Care? Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The second section of this report (titled “Treasury – Fed Disaccord”) examines the specific market implications of the Treasury Department’s decision to not authorize an extension of the Fed’s emergency lending facilities. 2  For details on how these facilities are structured and what they are designed to do please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020 and US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup Part 2: Shocked And Awed”, dated July 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Economy: The Democrats did not sweep the US election, but the Democratic House and Republican Senate will likely find some middle ground on a stimulus deal. This will keep the economic recovery on track. A highly effective COVID vaccine that becomes widely available would supercharge it. Rates: Investors should continue to position for a bear-steepening nominal Treasury curve on a 6-12 month horizon. They should also overweight TIPS versus nominal Treasuries, favor inflation curve flatteners and real yield curve steepeners. Treasury Supply & Fed Demand: The Treasury department will continue to increase coupon issuance at the expense of bills. If current policy remains in place, Fed purchases will decline as a percent of coupon issuance in the coming quarters. But the Fed could take steps to modify its asset purchase strategy during the next few months. Feature We’ve seen enough. After a week of checking and re-checking the numbers, BCA’s US Bond Strategy service has concluded that a moderate bear-steepening of the Treasury curve remains the most likely outcome for the next 6-to-12 months. Of course, the dust has not completely settled on the US election. President Trump has issued several legal challenges and control of the Senate won’t be decided until early January when two run-off elections take place in Georgia. However, it now looks safe to assume that Joe Biden will take over as President next year. We also expect, with slightly less conviction, that the Republican party will keep control of the Senate, as Democrats need to win both Georgia races in order to secure a majority. In this week’s report, we assess the fall-out from the election on different sectors of the US bond market. We also consider how the election result impacts the outlook for fiscal stimulus and provide an update on supply and demand trends in the Treasury market. The Election Fall-Out In Bond Markets Nominal Yields Chart 1A Moderate Bear-Steepening A Moderate Bear-Steepening A Moderate Bear-Steepening The 10-year Treasury yield got as high as 0.90% in advance of election day, as the market was pricing-in a Democratic sweep that would have led to a substantial increase in government spending. This outcome is still technically possible, but it now looks unlikely. The 10-year Treasury yield fell back to 0.78% as the election results came in but returned to 0.90% yesterday morning on news that Pfizer’s COVID vaccine was 90% effective in phase 3 trials. This market action affirms our recommended positioning. The Bloomberg Barclays Treasury Index has been underperforming cash since August, the uptrend in the 10-year Treasury yield remains intact and the yield curve continues to steepen (Chart 1). All these trends will remain in place as long as the economic recovery continues, and timely distribution of an effective COVID vaccine will certainly speed that process up. The biggest risk to our view is that a Democrat-controlled House and Republican-controlled Senate are unable to agree on a follow-up fiscal stimulus package during the next few months, and that the economic recovery stalls as a result. This is possible, but our base case scenario is that a compromise will be easier to reach now that the election is over. We expect a moderately-sized relief bill to be delivered relatively soon, possibly even before the end of the year. The Inflation Curve Chart 2Own Inflation Curve Flatteners... Own Inflation Curve Flatteners... Own Inflation Curve Flatteners... The 10-year TIPS breakeven inflation rate fell 8 bps immediately after the election, but unlike with nominal yields, the trend in the cost of inflation compensation had been relatively flat heading into election day (Chart 2). It’s not hard to see why. Inflationary pressures in the economy have clearly moderated compared to the summer. The oil price has taken a step down (Chart 2, panel 3) and month-over-month CPI growth has been trending lower (Chart 2, bottom panel). We don’t expect this deceleration in inflation to continue. Global economic recovery will keep commodities well bid, and core inflation will slowly recover back to target. This argues for staying overweight TIPS versus nominal Treasuries. We also recommend owning inflation curve flatteners. The inflation curve has been steepening since August, as the short-dated cost of inflation compensation has fallen by more than the long-dated cost (Chart 2, panel 2). This steepening is typical for periods when TIPS breakeven rates are falling, and it will reverse when breakevens start rising again. Looking further out, the Fed’s commitment to allow a temporary overshoot of its 2% inflation target means that we should expect the inflation curve to invert. This means that inflation curve flatteners have a lot of room to run. Real Yields With almost no volatility in short-maturity nominal yields, short-maturity real yields are simply the mirror image of short-maturity inflation expectations. For this reason, the 2-year real yield has been moving up since August as the 2-year cost of inflation compensation has declined (Chart 3). This dynamic doesn’t hold for long maturities, where nominal yields have been rising as markets price-in eventual Fed tightening (Chart 3, top panel). Inflationary pressures in the economy have clearly moderated compared to the summer. The different behavior of long- and short-maturity real yields gives us high conviction in recommending a real yield curve steepener (Chart 3, bottom panel). A recovery in inflation expectations will push short-maturity real yields lower but will not have the same impact at the long-end where nominal yields will also rise. Chart 3…And Real Yield Curve Steepeners ...And Real Yield Curve Steepeners ...And Real Yield Curve Steepeners Corporate Credit Chart 4Credit Spreads Welcomed The Election Results Credit Spreads Welcomed The Election Results Credit Spreads Welcomed The Election Results Interestingly, the election result of a Biden presidency and divided House and Senate was viewed positively by both the “risk-free” Treasury market and risky credit spreads (Chart 4). Treasury yields fell on expectations of less fiscal stimulus, but credit spreads also tightened because a Republican Senate will keep corporate tax hikes at bay and a Biden presidency will ratchet down trade tensions with China. We maintain our positive outlook on credit and continue to recommend overweight allocations to corporate bonds rated Ba and higher. We remain underweight low-rated junk bonds (B & below) for now, because those spreads are pricing-in a rapid drop in the default rate. We may soon shift into low-rated junk as well, depending on how quickly an effective vaccine can be distributed. One less discussed risk for corporate spreads is the expiration of the Fed’s emergency lending facilities at the end of the year. The facilities are currently scheduled to expire on December 31st, though Fed Chair Powell seemed to imply last week that he would like to extend them. The one hitch could be that the Treasury department will also have to sign-on to an extension. It is currently unclear whether it is interested in doing so. Municipal Bonds Chart 5Munis Still Very Attractive Munis Still Very Attractive Munis Still Very Attractive The strong relative performance of municipal bonds since election day has been the most confounding market move (Chart 5). All logic tells us that Municipal / Treasury yield spreads should have widened as it became clear that the Republicans will likely keep control of the Senate. A Republican Senate will prevent Joe Biden from raising income taxes, which would have made tax-advantaged munis look more attractive on a relative basis. A Republican Senate has also been staunchly opposed to providing federal aid to cash-strapped state & local governments. But munis have outperformed Treasuries despite these obvious negative catalysts, possibly in part due to Mitch McConnell’s post-election comments that suggested he is open to compromise on a fiscal relief bill and would even be open to including some funds for state & local governments. Despite McConnell’s comments, the prospect of federal funds for state & local governments is uncertain at best. But we nonetheless maintain an overweight allocation to municipal bonds due to continued extraordinary valuations relative to both Treasuries (Chart 5, panel 2) and corporates (Chart 5, bottom panel). The Stimulus Risk As we alluded to above, the biggest risk to our bond-bearish view is that the failure to pass a follow-up to the CARES act results in a spate of negative economic data that spooks investors. This negative data would likely first show up in consumer spending, which so far continues to recover (Chart 6). However, we think the odds are that, in the absence of stimulus, we will see a disappointing consumer spending report within the next few months. How markets react to that news will depend on the status of stimulus talks at that time, as well as news about a potential vaccine roll-out. Disposable personal income was still above pre-COVID levels in September, but it continues to be buttressed by income support from the federal government. Notice that non-transfer income remains below pre-COVID levels (Chart 6, panel 3). Further, the drop in the savings rate during the past few months has outpaced the improvement in consumer sentiment (Chart 6, bottom panel). This suggests that any excess savings that households may have accumulated in the spring are now close to being exhausted. In the absence of stimulus, we will see a disappointing consumer spending report within the next few months. Elsewhere, the labor market continues to make steady improvements, but it could also use some help from policymakers. Excluding temporary census employment, nonfarm payrolls rose 786k in October, slightly above September’s pace but below the rapid gains seen in May and June (Chart 7). Further, initial jobless claims remain above 700k per week and real-time employment data from Homebase has been steady at a low level. All this to say that the labor market is making only modest gains and there remains a gap of 10 million jobs between current nonfarm payrolls and those from February (Chart 7, top panel). Chart 6Keep Monitoring Consumer Spending Keep Monitoring Consumer Spending Keep Monitoring Consumer Spending Chart 7A Slow Recovery In Employment A Slow Recovery In Employment A Slow Recovery In Employment The bottom line is that, without further fiscal stimulus, the odds are high that the economic data will disappoint at some point during the next few months. This will cause bond yields to fall and credit spreads to widen, unless it looks like Congress is close to a deal or like a vaccine will be available in a timely manner. Fortunately, we do think the odds are relatively high that a Republican Senate and Democratic House will be able to reach a compromise stimulus deal, albeit a modest one in the range of $700 billion to $1 trillion. The political incentives against compromise have faded now that the election is over, and we expect a deal either this year or early next year. Treasury Supply And Fed Demand The Treasury department recently released its financing estimates for the next two quarters. A few trends are worth mentioning. First, the Treasury will continue to increase coupon issuance as it seeks to extend the average maturity of the outstanding debt (Chart 8, top panel). Chart 8The Path For Treasury Supply And Fed Demand Bond Bear Intact Bond Bear Intact Second, the Treasury will continue to operate with an historically elevated cash balance, but it will seek to reduce its cash holdings to $800 billion from $1.6 trillion currently (Chart 9). Chart 9Treasury Will Deploy Some Cash Treasury Will Deploy Some Cash Treasury Will Deploy Some Cash Third, the Treasury assumed in its projections that Congress will deliver another $1 trillion of stimulus. The combination of (i) increased coupon issuance, (ii) a falling cash balance and (iii) stimulus projections that may be too high, points to a continued drop in T-bill issuance (Chart 10). In fact, the Treasury acknowledged that bill issuance will likely fall going forward and said that it would be comfortable with a distribution where bills account for 15%-20% of the outstanding debt (Chart 11). Chart 10Expect T-Bill Issuance To ##br##Keep Falling… Expect T-Bill Issuance To Keep Falling... Expect T-Bill Issuance To Keep Falling... Chart 11…And To Settle At Around 15-20% Of Outstanding Debt ...And To Settle At ArouNd 15-20% Of Oustanding Debt ...And To Settle At ArouNd 15-20% Of Oustanding Debt Fed Chairman Powell also addressed the media last week, after the conclusion of the November FOMC meeting, and announced that the Fed made no changes to its asset purchases. For the time being, the Fed will continue to purchase “at least” $80 billion of Treasuries and $40 billion of MBS per month. However, Powell did indicate that FOMC participants discussed different ways in which they might modify the asset purchase program in the future. Presumably this means that if the Committee feels the need to deliver further monetary stimulus it will do so by either shifting its Treasury purchases to the long-end of the curve – in order to remove more duration risk from the market – or by increasing the outright pace of purchases. Powell made it clear that he sees these sorts of balance sheet moves as viable forms of monetary stimulus, though the tone of the questions he received during the press conference suggests that the consensus increasingly senses that the Fed might be out of ammo. Several questioners noted Powell’s repeated calls for fiscal stimulus and asked directly whether the Fed has done all it can. In conclusion, if the Fed maintains the current pace and distribution of Treasury purchases (Chart 8, panel 2), its asset purchases will continue to trend down compared to gross Treasury issuance (Chart 8, bottom panel). However, we could see the Fed taking a step to mitigate that decline at the long-end of the curve by shifting the maturity distribution of its asset purchases towards longer maturities. This move could occur as early as next month. The Treasury will continue to operate with an historically elevated cash balance, but it will seek to reduce its cash holdings to $800 billion from $1.6 trillion currently. The bar for actually increasing the monthly pace of purchases is likely much higher, and it would require a significant tightening of financial conditions or drop in economic activity to push the Fed into action. The bigger question, however, is whether the market even cares anymore about tweaks to the Fed’s asset purchase program. The tone of questions at last week’s press conference suggests it might not. Appendix: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities Bond Bear Intact Bond Bear Intact Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification