Yield Curve

Highlights Duration: Last week’s bond market sell-off was a headfake and does not portend a sustained move higher in Treasury yields. We will need to see a stabilization in confirmed COVID-19 cases and signs of improving global growth before calling the bottom in yields. Keep portfolio duration close to benchmark. Yield Curve: A fed funds rate pinned at zero means that the yield curve will trade directionally with yields for the foreseeable future. The yield curve’s recent re-shaping also means that a barbelled Treasury portfolio now only offers a small yield advantage. We recommend shifting out of a barbell and into a position long the 5-year bullet and short a duration-matched 2/10 barbell. Corporate Spreads: High-yield spreads are now fairly priced for a default cycle of similar magnitude to the 2001/02 recession, and the Fed’s entrance into the corporate bond market is a potential game changer for investment grade spreads. Investors should increase exposure to investment grade corporates from neutral to overweight. High-yield investors with horizons of 12 months or more should also start adding exposure. Fed Policy: The Fed is frantically trying to mitigate the impact of three different (though related) shocks: An economic shock, a liquidity shock and a credit shock. We assess its progress to date and discuss what could be done next. Feature Headfake Chart 1Not A Reflationary Environment Not A Reflationary Environment Not A Reflationary Environment Bond yields jumped early last week, shortly after the Fed cut rates back to the zero bound. At one point the 10-year Treasury yield reached as high as 1.18%. But make no mistake, this was not the start of a protracted bond sell off. By Monday morning, the 10-year was back down to 0.75%. Evidently, the conditions for a sustained move higher in Treasury yields are not yet in place. To see why this is so, we need to look a little bit beyond the headline grabbing change in nominal yields and notice that, even when the nominal 10-year yield moved up early last week, the 10-year real yield increased much more quickly, causing the implied cost of inflation protection to fall (Chart 1). This is unusual behavior. Typically, real yields, nominal yields and breakeven inflation rates are all positively correlated. This is because an improving economic outlook usually leads investors to expect both higher inflation and a higher fed funds rate in the future, and vice-versa. When the correlation breaks down it is usually related to some policy action or constraint. For example, investors could come to believe that the Fed will keep interest rates too low for far too long, causing real yields to fall even as inflation expectations jump. Or, as is the case right now, the market could recognize the zero-lower-bound constraint on Fed policy and start to price-in a scenario where the Fed can’t cut rates far enough to jumpstart economic growth. Real yields move higher in this scenario, but inflation expectations crash. We are seeing the same dynamic of rising real yields and falling inflation expectations that was witnessed in 2008. This same dynamic of rising real yields and falling inflation expectations was witnessed in 2008, when the Fed was rapidly cutting rates but investors did not view that action as sufficient (Chart 2). Falling equity prices and a rising dollar further underscored that the environment was becoming more deflationary, not reflationary. A sustained rise in bond yields can only be caused by a reflationary environment. Chart 2Shades Of 2008 Shades Of 2008 Shades Of 2008 How Close To The Bottom? The relevant question then becomes: How close are we to returning to a reflationary environment? To answer this question we will rely on the checklist to call the bottom in bond yields that we unveiled two weeks ago.1 That checklist contains four factors: A stabilization in confirmed COVID-19 cases Improving global economic growth (particularly in China) Weaker US economic data A trigger from one or more technical trading rules Last week we started to see the first signs of weaker US economic data. Initial jobless claims spiked to 281k and both the New York and Philadelphia Fed regional manufacturing surveys plunged (Chart 3). We expect the bottom in bond yields will occur when the US economic data are very weak and when economies that experienced the outbreak earlier – such as China – are showing signs of rebounding. Investors will superimpose the Chinese experience onto the US. But it is still too early for that. Global growth bellwethers such as the CRB Raw Industrials commodity price index remain in freefall (Chart 3, bottom panel). We also noted that we want to see stabilization in the global number of confirmed COVID-19 cases. Essentially, this would mean the number of daily new cases falling close to zero. We are far from that point, as the daily number of new cases continues to rise exponentially (Chart 4). Chart 3Weaker US Data, But No Global Recovery Weaker US Data, But No Global Recovery Weaker US Data, But No Global Recovery Chart 4New Cases Still Rising New Cases Still Rising New Cases Still Rising We should also mention that we expect risk assets – equities and corporate credit – to bottom before Treasury yields, as the Fed will take care not to signal a premature removal of crisis stimulus measures. Finally, two weeks ago we described several technical trading rules that have demonstrated some success at calling troughs in Treasury yields in the past. Since last week, one of our three proposed trading rules was briefly triggered, but that signal was quickly reversed. Bottom Line: Last week’s bond market sell-off was a headfake and does not portend a sustained move higher in Treasury yields. We will need to see a stabilization in confirmed COVID-19 cases and signs of improving global growth before calling the bottom in yields. Keep portfolio duration close to benchmark. A Quick Note On TIPS In last week’s report we made the case for long-term investors to buy TIPS relative to equivalent-maturity nominal Treasuries.2  The reasoning is that TIPS breakeven inflation rates offer exceptional value relative to likely future inflation outcomes. For example, the 5-year TIPS breakeven inflation rate is currently 0.31% and the 10-year rate is 0.75%. This means that a buy-and-hold investor will make money owning TIPS versus nominals if inflation averages more than 0.31% per year for the next five years, or 0.75% per year for the next decade. Chart 51-Year TIPS Return Scenarios Life At The Zero Bound Life At The Zero Bound We also observed last week that TIPS breakeven inflation rates have turned negative at the front-end of the curve. We described this pricing as irrational because of the embedded deflation floors in TIPS. This was incorrect. While TIPS will always pay at least par at maturity, seasoned TIPS with only a year or two left to maturity already have inflation-adjusted principal values that are well above par. In other words, there is room for deflation to influence the returns from these securities before any floor is triggered. Specifically, we can take a look at the TIPS maturing in just over one year, on April 15 2021 (Chart 5). This note has an accumulated principal of just under $109 and is currently trading at an ask price of $97.63.3 According to our calculations, this security will earn 2.55% if headline CPI inflation is 0% over the next 12 months. It will only lose money if headline CPI inflation comes in at -2.49% or below. What’s more, it will return more than a 12-month nominal T-bill as long as inflation is above -2.4%. Note that the lowest year-over-year headline CPI inflation print during the Great Financial Crisis was -2.1%. TIPS offer exceptional value relative to nominal Treasuries for investors who are able to hold the trade for at least one year. Bottom Line: TIPS offer exceptional value relative to nominal Treasuries for investors who are able to hold the trade for at least one year.  Treasury Curve: Re-Visiting The Zero-Lower-Bound Playbook Chart 6Curve Will Trade Directionally With Yields Curve Will Trade Directionally With Yields Curve Will Trade Directionally With Yields The Fed’s aggressive policy easing has caused the yield curve to re-shape dramatically during the past few weeks. The 2/10 Treasury slope is up to 55 bps from a 2019 low of -4 bps. The 2/30 Treasury slope is up to 118 bps from a 2019 low of 42 bps, and the 2/5 Treasury slope is up to 15 bps from a 2019 low of -13 bps. Looking through the recent volatility, the fact that the fed funds rate is back to a range between 0% and 0.25% means that we can dust off our yield curve playbook from the last zero-lower-bound period. Fortunately, that playbook is quite straightforward. With the front-end of the curve pinned near zero, the slope of the yield curve will essentially trade directionally with the level of Treasury yields for the foreseeable future. Chart 6 shows that during the last zero-lower-bound period, the 2/30, 2/10 and 2/5 slopes were all positively correlated with the 5-year Treasury yield. This correlation suggests one obvious strategy. If you think yields will rise, put on steepeners. If you think they will fall, put on flatteners. Or if, like us, you suspect that bond yields will be higher in 12 months but are not quite ready to call the bottom, you could hedge benchmark or above-benchmark portfolio duration by entering a duration-neutral steepener. What About Value Across The Curve? Chart 7Bullets Looking Less Expensive Bullets Looking Less Expensive Bullets Looking Less Expensive Until recently, investors could earn large positive carry by owning a barbell consisting of the long and short ends of the Treasury curve (e.g. 2/30) and shorting the belly (e.g. 5yr), in duration-matched terms. But this has changed. The 2/10 barbell now only offers 6 bps of positive carry versus the 5-year bullet, while the 2/30 barbell and 5-year bullet offer approximately the same yield. Both the 2/5/10 and 2/5/30 butterfly spreads are also much closer to the fair values suggested by our models (Chart 7).4 Though we are not ready to call the bottom in Treasury yields, we think the 5-year yield is sufficiently attractive to initiate a duration-neutral curve steepener trade: go long the 5-year bullet and short a duration-matched 2/10 barbell. This trade should perform well if the 2/10 slope steepens going forward. Since a steeper curve is now positively correlated with the level of yields, this trade will profit if yields move higher. Viewed this way, the trade acts as a hedge when implemented alongside our conservative ‘At Benchmark’ portfolio duration recommendation. Bottom Line: A fed funds rate pinned at zero means that the yield curve will trade directionally with yields for the foreseeable future. The yield curve’s recent re-shaping also means that a barbelled Treasury portfolio now only offers a small yield advantage. We recommend shifting out of a barbell and into a position long the 5-year bullet and short a duration-matched 2/10 barbell. Corporate Spread Update Corporate spreads continue to widen very quickly. As such, our conclusions from last week about the amount of value in corporate bonds are already out of date. Our value assessment is based on our High-Yield Default-Adjusted Spread, which is the excess spread left over in the high-yield index after removing actual 12-month default losses. Table 1 shows how often the Default-Adjusted Spread has been in different 50 basis point intervals, and what sort of 12-month junk excess returns occurred during those periods. One conclusion from the table: To be confident that high-yield will outperform duration-matched Treasuries on a 12-month horizon, we would need to expect a Default-Adjusted Spread of at least 150 bps. Preferably, the spread would be greater than or equal to 250 bps, the historical average. The red numbers down the right-hand side of Table 1 indicate what the Default-Adjusted Spread will be for the next 12 months if the speculative grade default rate hits a specific value. For example, a default rate of 6%, which would correspond to a default cycle of a similar magnitude as 2015/16, implies a very attractive Default-Adjusted Spread of +633 bps. In contrast, a default rate of 14% or greater would lead to a negative Default-Adjusted Spread. For context, the default rate peaked at 15% and 11% in the 2008 and 2001/2 recessions, respectively. Table 1What's Priced In Credit Spreads? Life At The Zero Bound Life At The Zero Bound As of now, our base case scenario is that the current default cycle will be more severe than the 2015/16 episode but probably not as bad as the 2008 financial crisis. Something on the order of 9% - 11% seems plausible. If that’s the case, then the Default-Adjusted Spread will be somewhere between 216 bps and 394 bps. This looks quite attractive. Additionally, yesterday’s announcement that the Fed will effectively be entering the investment grade corporate bond market could be a game changer. As a result, we recommend increasing exposure to investment grade corporate bonds from neutral to overweight. For high-yield, it is possible that spreads will widen more in the near-term, but value is now sufficiently attractive for investors with investment horizons of 12 months or more to start adding exposure. We retain our neutral 6-12 month recommended allocation for now, but will re-visit the question in more detail in next week’s report.  To be confident that high-yield will outper­form duration-matched Treasuries on a 12-month horizon, we would need to expect a Default-Adjusted Spread of at least 150 bps.  Bottom Line: High-yield spreads are now fairly priced for a default cycle of similar magnitude to the 2001/02 recession, and the Fed’s entrance into the corporate bond market is a potential game changer for investment grade spreads. Investors should increase exposure to investment grade corporates from neutral to overweight. High-yield investors with horizons of 12 months or more should also start adding exposure. The Fed’s War On Three Fronts   Events continue to unfold rapidly in financial markets and in terms of the Fed’s response to the market turmoil. We conclude this week’s report with a brief discussion of the three main shocks that the Fed is frantically trying to contain. We also assess how successful the Fed’s responses might be. #1: The Economic Shock The first shock that the Fed is trying to contain is the pure shock to aggregate demand that is occurring as a result of widespread quarantine measures. In cutting rates to zero and signaling that rates will not rise any time soon, the Fed has effectively done all it can to help fight the economic shock. It should help a little. Lower interest rates will ease the debt burden of homeowners who can refinance their mortgages. They may also lower costs for firms that are able to issue debt to weather the current storm. But these effects are minor compared to the fiscal measures currently making their way through Congress.5 Next steps for the Fed: None. The Fed is effectively out of bullets to contain the economic shock. It’s all about fiscal policy now. #2: Market Liquidity Shock Chart 8Bond Market Liquidity Shock Bond Market Liquidity Shock Bond Market Liquidity Shock In addition to the economic shock, the Fed is also responding to a severe market liquidity shock. What we mean by a “market liquidity shock” is that investors are finding it more expensive (or difficult) to transact in certain markets because of the scarce amount of capital being deployed to those areas. This is different than credit risk (see Shock #3). We are not talking about investors having trouble transacting because there are few willing buyers of credit risk. We are talking about high transaction costs in otherwise risk-free parts of the bond market. The issue is critical because these risk-free parts of the bond market (overnight repo, for example) are often used to fund riskier investments. Disruption in funding markets can have ripple-on effects into other, less opaque, areas. We currently see several examples of disruptions to bond market liquidity (Chart 8): Repo rates have spiked relative to the overnight index swap curve (Chart 8, top panel). The iShares 20+ year Treasury Bond ETF (TLT) is suddenly trading at a huge discount to its net asset value (Chart 8, panel 2). Cross-currency basis swap spreads have turned deeply negative, meaning that it is more expensive for non-US actors to obtain US dollar funding (Chart 8, bottom panel). Wider-than-normal bid/ask spreads are being reported in the Treasury market (not shown). These disruptions are occurring because the financial system is not deploying enough capital to market-making activities in these areas. Essentially, nonfinancial firms have drawn on their revolving credit lines during the past few weeks and this has left the financial system short of cash to deploy toward market-making activities. To fix the problem, the Fed has started to transact directly (in large amounts) in both the repo and Treasury markets. This essentially replaces the function that banks were performing until a few weeks ago. But perhaps more importantly, the Fed is also encouraging banks to deploy the capital that already sits on their balance sheets. Unlike during the 2008 financial crisis, banks now carry a lot of capital – the result of Dodd-Frank and Basel III regulations. What the banks need now is tacit permission from regulators to deploy that capital into financial markets, without concern that they will face consequences during a future stress test. Table 2Banks Have Excess Capital Life At The Zero Bound Life At The Zero Bound Even without any specific changes to regulation, Table 2 shows that the big 5 US financial institutions all carry significant buffers above the regulatory minimum 100% Liquidity Coverage Ratio and 6% Supplementary Leverage Ratio. At a minimum, these excess buffers must be deployed to aid market liquidity. Next steps: The Fed is already transacting directly in both the repo and Treasury markets, and behind closed doors it is most certainly encouraging banks to deploy more capital toward market-making activities. If these actions prove insufficient, the next step would be for the Fed – along with other regulators and possibly Congress – to offer temporary regulatory relief for banks, lowering the required Liquidity Coverage and Supplementary Leverage ratios. We view this market liquidity problem as one that regulators will be able to solve. And given the Fed’s aggressive policy response to date, we expect that regulators will get a handle on the issue and restore bond market liquidity fairly soon. #3 Credit Shock Chart 9Can The Credit Shock Be Contained? Can The Credit Shock Be Contained? Can The Credit Shock Be Contained? We draw a distinction between spreads widening because of a lack of market liquidity and spreads widening because investors are unwilling to take credit risk. Though admittedly, it is not always easy to distinguish between these two factors in real time. But there is no doubt that the economy is also grappling with a credit shock, in addition to the economic and liquidity shocks we already mentioned. Some evidence that market players are less willing to take credit risk (Chart 9): The average option-adjusted spread on the Bloomberg Barclays Investment Grade Corporate Bond index has spiked (Chart 9, top panel). The spread between the 3-month commercial paper rate and the overnight index swap rate has surged (Chart 9, panel 2). The Municipal / Treasury yield ratio is higher than it was during the financial crisis (Chart 9, panel 3). The 30-year mortgage rate has so far not followed Treasury yields lower (Chart 9, bottom panel). The Fed can take some measures to mitigate the negative impacts of a credit shock, and it has already taken quite a few. The Fed has set up facilities to back-stop commercial paper and short-maturity municipal debt. It also announced yesterday morning that it will, in conjunction with the Treasury department, enter the investment grade corporate bond market out to the 5-year maturity point, effectively back-stopping a large portion of corporate issuance. The Fed has not yet set up a facility to purchase longer-maturity municipal bonds, but this could be forthcoming. The Fed is also directly purchasing large amounts of Agency MBS in an effort to tighten the spread between the mortgage rate and Treasury yields. The Fed’s measures to guarantee some risky debt can help solve some problems related to a credit shock. For example, if Fed purchases increase asset values for corporate and municipal bonds, then it lessens the risk of bankruptcy both for the issuing firms and for any systemically-important investment fund that may be levered to those markets. However, Fed purchases do not guarantee that stressed firms will be able to take out new debt, nor do they prevent firms from cutting payrolls in the face of lower demand. Only direct cash bailouts from the government can fix those problems. Next steps: The Fed could add another facility to purchase long-maturity municipal bonds. It could also implement a “funding for lending” scheme similar to what the Bank of England has done. These measures, along with what has already been announced, will help ease the credit shock at the margin. But ultimately, cash bailouts from Congress to firms and state & local governments will be required.    Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “When And Where Will Bond Yields Trough?”, dated March 10, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Buying Opportunities & Worst-Case Scenarios”, dated March 17, 2020, available at usbs.bcaresearch.com 3 Numbers quoted assuming a par value of $100. 4 For details on our yield curve models please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 5 The global fiscal response to the COVID crisis is discussed in more detail in Geopolitical Strategy Weekly Report, “De-Globalization Confirmed”, dated March 20, 2020, available at gps.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

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

Highlights Dear Client, This week, we had originally planned to publish a Special Report introducing a framework for modeling and selecting global yield curve trades. In light of the market turbulence of the past few days, however, we felt the need to provide a short note updating our current thoughts on the expanding threats to the global economy and financial markets from the coronavirus (a.k.a. 2019-nCoV, COVID-19). Thus, this week, you will be receiving two reports from BCA Research Global Fixed Income Strategy. Kind regards, Robert Robis Feature The news of more occurrences of the COVID-19 virus in countries outside China – South Korea, Italy, Iran, and Israel – has created a new wave of fear among investors who had started to see signs that the spread of the virus was losing some momentum in China. The appearance of COVID-19 infections in countries like Italy, where there was no obvious connection to the epicenter in China, raised new concerns that the outbreak could turn into a true global pandemic that would be a major negative shock to global growth. The latest market moves fit the profile of a major risk-off move driven by higher uncertainty. Global equities have sold off sharply over the past two trading sessions, and volatility measures like the VIX have spiked. The 10-year US Treasury yield reached a new all-time low (on an intraday basis) of 1.35% yesterday, leaving it -18bps below the 3-month US Treasury bill rate. That curve inversion has occurred alongside falling TIPS breakevens and rising expectations of Fed rate cuts in 2020, in a familiar parallel to the “tariff war shock” of 2019 that prompted the Fed to lower the funds rate by a cumulative 75bps. We see some similarities today to a more recent “black swan” event: the June 2016 UK Brexit vote, which was when the previous intraday all-time low in US Treasury yields was reached. Yield movements have been somewhat smaller in other countries where yields were already very low to begin with, like the 10-year German bund reaching -0.49% and 10-year UK Gilt hitting 0.54% yesterday. Global credit markets have also underperformed, with corporate bond spreads widening alongside spiking equity market volatility in the US and Europe. Amidst the fear, investors have been searching for a potential roadmap to follow, for economies and financial markets, based on past viral outbreaks like the 2003 SARS epidemic and the 2009 global swine flu (H1N1) pandemic. We see some similarities today to a more recent “black swan” event: the June 2016 UK Brexit vote, which was when the previous intraday all-time low for US Treasury yields was reached. After that stunning electoral outcome, investors worldwide tried to process the potential negative implications of an unexpected political outcome. Risk assets sold off and government bonds rallied sharply. Global policymakers responded with various easing measures, both direct (rate cuts and fresh QE from the Bank of England) and indirect (delayed Fed rate hikes, more QE from the ECB). This all came at a time when global growth momentum was already picking up before the Brexit vote, stoked by large-scale fiscal and monetary stimulus in China (Chart 1). In the end, the supportive monetary/fiscal backdrop, and not the political uncertainty, won out and the global economy – along with risk assets and bond yields – all recovered over the second half of 2016. Chart 1Doomsday? Or 2016 Revisited? The Pandemic Panic The Pandemic Panic Today, policymakers are starting to mobilize to fight the threat to growth from COVID-19, hinting at potential monetary easing measures. China is already set to deliver more monetary and fiscal easing, although it is not clear if those will be on the same massive scale as 2015/16. While the scale of the shock to global growth from a potential pandemic is obviously far different than the political uncertainty of Brexit, stimulus measures in 2020 could generate a similar positive response from financial markets if the coronavirus impacts growth less than currently feared. So what should investors expect next? We admit that we do not have a strong conviction level on near-term market moves, given how the coronavirus outbreak has set off an unpredictable chain of events that has gone against our base case expectation of a global growth rebound in 2020. Yet amidst all the uncertainty and fear, we can hazard a few guesses as to the potential future moves in global bond markets. For riskier borrowers, the ability to service debt is what matters most, and the majority of borrowers can still meet their interest payments with global borrowing costs near all-time lows. DURATION: A lot of bad news is discounted in current global bond yield levels, both in terms of absolute levels and expected rate cuts. Yet until there are signs of the virus being contained, both within and outside China, investors will continue to seek out hedges for the uncertainty. That means the any challenge to the current downward momentum in yields may not become evident until the economic data releases begin to show signs of a Q2 recovery from what is assuredly going to be an awful Q1 for the global economy. YIELD CURVE: A continuation of the risk-off momentum in global equity markets will put additional bull-flattening pressure on developed market government bond yield curves in the near term. The more medium-term move, however, should be towards steeper yield curves. Either the viral outbreak becomes contained and/or the growth shock is minimized, triggering a reversal of the latest risk-off bull flattening into risk-on bear-steepening; or the economic downturn and risk asset selloff intensifies and central banks deliver rate cuts that will bull-steepen global yield curves. CREDIT: Global corporate bond spreads should remain under upward pressure in the near term until the spread of the coronavirus outbreak begins to ease. However, the cumulative spread widening in credit markets could turn out to be surprisingly modest. The conditions that are typically in place before credit bear markets and periods of sustained spread widening – tight monetary policy and rapidly deteriorating corporate financial health – are not currently in place. This is true in both the US and Europe for high-yield, where our bottom-up Corporate Health Monitors are still sending a neutral message – thanks largely to interest coverage ratios that are still above typical pre-recessionary levels (Chart 2). For riskier borrowers, the ability to service debt is what matters most, and the majority of borrowers can still meet their interest payments with global borrowing costs near all-time lows - even in the event of a sharp, but short, global economic slowdown. Chart 2Low Yields Supporting High-Yield Borrowers The Pandemic Panic The Pandemic Panic   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com  

Highlights Butterfly Strategy: A butterfly fixed income strategy is a combination of a barbell (a weighted combination of long- and short-term bonds) and a bullet (the medium-term bonds that sit within the yield curve segment selected in the barbell) designed to provide investors exposure to specific yield curve changes while being insulated from parallel shifts. Yield Curve Models: Simple yield curve models, based on the positive relationship between the slope of the yield curve and butterfly spreads – and to a certain extent, implied interest rate volatility – can be used to identify which part of the yield curve is most attractively valued by comparing what change in the slope is being discounted with our own macro views. Current Valuation: The overall message from our new suite of global yield curve models is that trades favoring barbells over bullets are attractive across all the developed market countries covered in our analysis. Feature In February 2002, BCA Global Fixed Income Strategy (GFIS) introduced a framework for measuring market expectations for changes in short-term interest rates embedded in the slope of government bond yield curves.1 By comparing those discounted changes with our own macro view on where rates were headed, this framework provided signals on potential value in trades focusing on the shape of the yield curve. This analysis originally focused on one specific yield curve (butterfly) strategy across six developed markets; the US, Germany, the UK, Japan, Canada, and Australia. Table 1Most Attractive Butterfly Trades Global Yield Curve Trades: Follow The Butterflies Global Yield Curve Trades: Follow The Butterflies More recently, our sister service US Bond Strategy applied this framework to each different butterfly spread combination across the entire US Treasury curve, creating a tool to identify the most attractively valued parts of the US yield curve at any point in time.2 In this Special Report, we revisit the original GFIS methodology for identifying attractive yield curve trades in global government bond markets. Furthermore we extend the analysis to all butterfly combinations and add three additional European countries to the list - France, Italy and Spain. The overall message is that trades that favor barbells over bullets are attractive across all the developed markets covered in this analysis. Table 1 displays the most attractive combinations of barbells over bullets for each country. Going forward, we will rely on the readings from our refreshed yield curve models, combined with our macro views, to populate our new Tactical Trade Overlay framework with yield curve trades in global government bond markets. What Is A Butterfly Strategy? A butterfly fixed income strategy involves two main components: a barbell (a weighted combination of long-term and short-term bonds) and a bullet (a medium-term bond that sits within the yield curve segment selected in the barbell). This strategy owes its name to the resemblance that barbells and bullets can have with the wings and body of an actual butterfly, not to lepidopterology.3 To implement a butterfly strategy, a bond investor would go long (short) the barbell while simultaneously going short (long) the bullet. In general, barbells are expected to outperform bullets in a flattening yield curve environment, and vice-versa. The reason butterfly strategies are so widely used is that they provide fixed-income investors exposure to specific changes in the slope of the yield curve, while being neutral to small parallel shifts. This immunization to small parallel shifts is achieved by setting the weights of the short- and long-term bonds in the barbell such that the weighted sum of their dollar duration (referred to as DV01 – the dollar value of a basis point) equals the DV01 of the bullet. In the event of large parallel shifts in the yield curve – which are quite rare – the barbell will outperform the bullet since the former will always have a greater convexity than the latter in the absence of convexity-matching between each leg of the trade. We illustrate how a 2/5/10 butterfly strategy works for US Treasuries, using hypothetical constant-maturity par bond yields, in Table 2A.4 Table 2AThe Butterfly (Strategy) Effect Illustrated Global Yield Curve Trades: Follow The Butterflies Global Yield Curve Trades: Follow The Butterflies As can be seen in the ”Weighted DV01” column of Table 2A, the DV01 of each leg of the trade (the bullet and the two combined bonds in the barbell) are identical. Importantly, the weighted DV01 contribution to the barbell from the 2-year note and the 10-year bond differ substantially, meaning that the barbell is more sensitive to changes in the 10-year yield than changes in the 2-year yield. This mismatch is precisely what gives a butterfly strategy exposure to the slope of the curve. Table 2A also presents three yield curve scenarios to demonstrate the benefits of butterfly strategies. In the parallel shift scenario, yields across the entire yield curve rise by 10bps. This parallel shift is neutralized as the two legs of the strategy cancel out. In the steepening curve scenario, the 2-year yield falls by 10bps, the 10-year yield rises by 10bps and the 5-year yield remains flat. In this case, the small gains on the 2-year note cannot offset the losses on the 10-year bond; hence the barbell underperforms the 7-year bullet. Finally, the “Flattening” column in the table shows that the barbell outperforms the bullet when the curve flattens. Our government bond yield curve models rely on the positive relationship typically observed between the butterfly spread and the slope of the yield curve. Bottom Line: A butterfly fixed income strategy is a combination of a barbell (a weighted combination of long- and short-term bonds) and a bullet (the medium-term bonds that sit within the yield curve segment selected in the barbell) designed to provide investors exposure to specific yield curve changes while being insulated from parallel shifts. Dusting Off The GFIS Yield Curve Models Chart 1Butterfly Spreads & Yield Curves Butterfly Spreads & Yield Curves Butterfly Spreads & Yield Curves Our government bond yield curve models rely on the positive relationship typically observed between the butterfly spread and the slope of the yield curve. When the curve steepens, the butterfly spread widens, and vice-versa (Chart 1). This has to do with mean reversion: as the curve steepens, it increases the odds that the curve will flatten in the future since it cannot steepen indefinitely. Consequently, investors will ask for greater compensation to enter a curve steepener trade when the curve is already steepening. As a result, we can create simplified models of the yield curve by regressing any butterfly spread on its corresponding curve slope. Deviations from these fair value models indicate which butterfly strategies are cheap or expensive. While positive, the correlations between yield curve slopes and butterfly spreads vary widely across butterfly combinations and also among countries – in Japan, for example, the historical relationship seems dubious (Chart 1, panel 4). We can further improve the fit of some of our yield curve models by including the MOVE US bond volatility index as a second independent variable. As our colleagues at US Bond Strategy have pointed out, implied interest rate volatility is also positively correlated with the slope of the yield curve (Chart 2, top panel). This matters for butterfly trades because of the convexity mismatch between the barbell and the bullet, particularly given the fact that high convexity is beneficial when implied interest rate volatility is elevated. Simply put, a larger convexity mismatch between the two legs makes them more sensitive to changes in the slope of the curve, and therefore easier to model (Chart 2, bottom panel). Importantly, one other useful application of the relationship between yield curve slopes and butterfly spreads is that we can reverse the yield curve models to calculate what amount of curve steepening or flattening is being discounted in current butterfly spreads. In other words, our models allow us to calculate change in the curve slope that would force the butterfly spread to be equal to its fair value (Chart 3). Chart 2Taking Into Account Implied Vol Taking Into Account Implied Vol Taking Into Account Implied Vol Armed with that information, we can then apply our macro views to determine potential butterfly spread trades. Chart 3Case In Point: US 2/5/10 Spread Fair Value Model Case In Point: US 2/5/10 Spread Fair Value Model Case In Point: US 2/5/10 Spread Fair Value Model For example, the 2/5/10 butterfly spread in the US (the 5-year bullet yield minus the weighted combination of 2-year and 10-year yields) is, at the moment, below its fair value with 46bps of steepening discounted over the next six months (Chart 3, panels 2 & 3). That means the bullet is expensive as per our model and therefore the recommended butterfly strategy would be to go long the 2/10 barbell and short the bullet. However, in the event the 2/10 Treasury slope steepens by more than 46bps over the next six months, the 5-year bullet would be expected to outperform the barbell. In other words, when the butterfly is initially below its fair value, more curve steepening will be needed for the bullet to outperform the barbell. Conversely, if it is above fair value, more curve flattening will be required for the barbell to outperform. In light of this, let’s consider the example of curve steepening from before, but this time looking at two scenarios: the butterfly spread is at fair value the butterfly spread is initially different from its model-implied fair value, but is then expected to revert to fair value by the end of the investment horizon. Under the first scenario, the bullet outperforms the barbell when the curve steepens, as expected given that the butterfly spread is at fair value (Table 2B). Now, in the second scenario, the bullet actually ends up underperforming the barbell, although it is the same curve steepening environment. Table 2BButterfly Strategy Performance And Deviations From Model-Implied Fair Values Global Yield Curve Trades: Follow The Butterflies Global Yield Curve Trades: Follow The Butterflies The reason for this underperformance is that the butterfly spread is now below the fair value shown in scenario #1, thus requiring more steepening for the bullet to outperform the barbell. Ultimately, we have to rely on our macro view of how the slope of the yield curve will change alongside the message from our yield curve models to choose the right butterfly strategy. This means that, ultimately, we have to rely on our macro view of how the slope of the yield curve will change alongside the message from our yield curve models to choose the right butterfly strategy. Bottom Line: Simple yield curve models, based on the positive relationship between the slope of the yield curve and butterfly spreads – and to a certain extent, implied interest rate volatility – can be used to identify which part of the yield curve is most attractively valued by comparing what change in the slope is being discounted with our own macro views. The Message From Our Butterfly Strategy Valuations In the remaining pages of this Special Report, we present the current read-outs from of our yield curve models for each of the major developed market. More specifically, we provide the deviations from fair value for different combinations of bullets and barbells and highlight the most attractive butterfly strategy. The deviations from fair value shown in Tables 3-11 are standardized to facilitate comparison between the different butterfly combinations. Also, for each country we provide a quick assessment of the performance of these butterfly strategies over time by applying a simple mechanical trading rule. Every month, we enter the most attractive butterfly strategy, i.e. the one with the highest absolute standardized deviation from its model fair value. The overall message is that barbells appear attractive relative to bullets across all the countries shown. Trades that favor barbells over bullets are attractive across all the developed markets covered in our analysis. This is consistent with our near term macro view. Global government bond markets have been experiencing bull flattening pressures ever since the COVID-19 virus outbreak sparked a generalized flight-to-safety. Markets woke up to the recent news about the spread of the virus in countries outside of China – namely Italy, South Korea, Japan, Iran and Israel – and all traces of complacency have now vanished.5 There is too much uncertainty about COVID-19 in terms of severity and duration, and government bond yields may very well continue falling until the threat is contained. In the meantime, this may force major central banks to provide even easier monetary policy. While this may be difficult for the ECB and the BoJ, which both already seem out of ammunition, the other central banks could very well end up delivering the rate cuts currently discounted in the overnight index swap curves.6 Looking back at our Central Bank Discounters, the largest amount of rate cuts over the next year are now discounted in the US (-53bps), now discounted in the US (-53bps), Australia (-38bps), Canada (-37bps) and the UK (-23bps). At the same time, the fewest cuts are priced in Japan (-8bps), the euro area (-6bps) and New Zealand (-25bps). The resulting bull steepening would likely be mild, however; after all, rate cuts cannot fight a pandemic, but can only try and cushion the blow to growth. In the event COVID-19 virus does not turn into a pandemic and we observe a decline in the daily change of the number of cases, then global government bond yields would rebound from their current lows. Given the current valuation cushion, we would expect barbelled portfolios to do well, especially since we would not expect more steepening than what is currently being discounted (i.e. we do not expect the 2/30 Treasury slope to steepen by more than 73bps in the near term).   Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com US There are presently three butterfly combinations standing out in that they appear attractive according to our yield curve model. One of them is going long the 2/30 barbell and shorting the 10-year bullet, which currently displays a standardized residual of -1.42 (Table 3). Table 3US: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Follow The Butterflies Global Yield Curve Trades: Follow The Butterflies The bullet appears 21bps expensive according to our model and would only outperform its counterpart given a steepening in the 2/30 Treasury slope greater than 73bps, which we view as unlikely given the current environment (Chart 4A). Chart 4AUS: 2/10/30 Spread Fair Value Model US: 2/10/30 Spread Fair Value Model US: 2/10/30 Spread Fair Value Model Chart 4BUS Butterfly Strategy Performance US Butterfly Strategy Performance US Butterfly Strategy Performance Following the mechanical trading rule looks promising (Chart 4B). In fact, we observe few periods of negative year-over-year returns. Germany The most attractively valued butterfly combination currently on the German yield curve is going long the 2/30 barbell and shorting the 10-year bullet, which is currently a little bit more than one standard deviation above its implied-model fair value, with a standardized residual of -1.09 (Table 4). Table 4Germany: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Follow The Butterflies Global Yield Curve Trades: Follow The Butterflies The bullet appears 14bps expensive according to our model and would only outperform its counterpart given a steepening in the 2/30 German curve slope greater than 36bps (Chart 5A). Chart 5AGermany: 2/10/30 Spread Fair Value Model Germany: 2/10/30 Spread Fair Value Model Germany: 2/10/30 Spread Fair Value Model Chart 5BGerman Butterfly Strategy Performance German Butterfly Strategy Performance German Butterfly Strategy Performance Over time, picking the cheapest butterfly combinations based on our yield curve models works relatively well (Chart 5B). Importantly, we observe very few episodes of underperformance since 1990. France The most attractively valued butterfly combination currently on the French OAT yield curve is going long the 5/30 barbell and shorting the 10-year bullet, which currently displays a standardized residual of -1.13 (Table 5). Table 5France: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Follow The Butterflies Global Yield Curve Trades: Follow The Butterflies The 10-year bullet appears 11bps expensive according to our model and would only outperform its counterpart given a steepening in the 5/30 French OAT curve slope greater than 44bps (Chart 6A). Chart 6AFrance: 5/10/30 Spread Fair Value Model France: 5/10/30 Spread Fair Value Model France: 5/10/30 Spread Fair Value Model Chart 6BFrench Butterfly Strategy Performance French Butterfly Strategy Performance French Butterfly Strategy Performance The mechanical trading rule appears to also work relatively well when applied to butterfly combinations in the French OAT government bond market (Chart 6B). Italy & Spain Turning to European countries in the periphery, the most attractively valued butterfly combinations appear to be going long the 5/30 barbell and shorting the 7-year bullet in the Italian government bond yield curve (Table 6), and favoring the 7/30 barbell versus the 10-year bullet in the Spanish government bond market (Table 7). Table 6Italy: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Follow The Butterflies Global Yield Curve Trades: Follow The Butterflies Table 7Spain: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Follow The Butterflies Global Yield Curve Trades: Follow The Butterflies In the case of Italy, the 7-year bullet appears 7bps expensive according to our model and would only outperform its counterpart given a steepening in the 5/30 Italian curve slope greater than 41bps (Chart 7A). The mechanical trading rule appears to work well when applied to Italian butterfly combinations, displaying better excess returns than for most other countries we’ve looked at (Chart 7B). Chart 7AItaly: 5/7/30 Spread Fair Value Model Italy: 5/7/30 Spread Fair Value Model Italy: 5/7/30 Spread Fair Value Model Chart 7BItalian Butterfly Strategy Performance Italian Butterfly Strategy Performance Italian Butterfly Strategy Performance Looking at Spain, the 10-year bullet appears 8bps expensive according to our model and would only outperform its counterpart given a steepening in the 7/30 Spanish curve slope greater than 64bps, which seems highly unlikely at this point in time (Chart 8A). The mechanical trading rule works well when applied to Spanish butterfly combinations and shows very few periods of underperformance since the early 90s (Chart 8B). Chart 8ASpain: 7/10/30 Spread Fair Value Model Spain: 7/10/30 Spread Fair Value Model Spain: 7/10/30 Spread Fair Value Model Chart 8BSpanish Butterfly Strategy Performance Spanish Butterfly Strategy Performance Spanish Butterfly Strategy Performance UK The most attractively valued butterfly combination currently on the UK Gilts yield curve is holding a 2/30 barbell versus the 10-year bullet, which currently displays a standardized residual of -1.64 (Table 8). Table 8UK: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Follow The Butterflies Global Yield Curve Trades: Follow The Butterflies The 10-year bullet appears 21bps expensive according to our model and would only outperform its counterpart given a steepening in the 2/30 curve slope greater than 62bps (Chart 9A). Chart 9AUK: 2/10/30 Spread Fair Value Model UK: 2/10/30 Spread Fair Value Model UK: 2/10/30 Spread Fair Value Model Chart 9BUK Butterfly Strategy Performance UK Butterfly Strategy Performance UK Butterfly Strategy Performance Chart 9B shows that applying the simple mechanical trading rule works well over time. Canada The most attractively valued butterfly combination currently on the Canadian yield curve is favoring a 1/30 barbell versus the 10-year bullet, which currently displays a standardized residual of -1.11 (Table 9). Table 9Canada: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Follow The Butterflies Global Yield Curve Trades: Follow The Butterflies The 10-year bullet appears 18bps expensive according to our model and would only outperform its counterpart given a steepening in the 1/30 curve slope greater than 60bps (Chart 10A). Chart 10ACanada: 1/10/30 Spread Fair Value Model Canada: 1/10/30 Spread Fair Value Model Canada: 1/10/30 Spread Fair Value Model Chart 10BCanadian Butterfly Strategy Performance Canadian Butterfly Strategy Performance Canadian Butterfly Strategy Performance Once more, following the mechanical trading rule looks promising (Chart 10B). In fact, we observe only four periods of negative year-over-year returns. Japan The most attractively valued butterfly combination currently on the Japanese JGBs yield curve is going long the 5/10 barbell and shorting the 7-year bullet, which is currently below one standard deviation above its implied-model fair value, with a standardized residual of only -0.86 (Table 10). Table 10Japan: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Follow The Butterflies Global Yield Curve Trades: Follow The Butterflies The bullet appears slightly expensive, by 5bps, and would only outperform its counterpart given a steepening in the 5/10 JGB curve slope greater than 32bps (Chart 11A). Chart 11AJapan: 5/7/10 Spread Fair Value Model Japan: 5/7/10 Spread Fair Value Model Japan: 5/7/10 Spread Fair Value Model Chart 11BJapanese Butterfly Strategy Performance Japanese Butterfly Strategy Performance Japanese Butterfly Strategy Performance The mechanical trading rule also performs well when selecting the most attractive butterfly combinations in the Japanese government bond market (Chart 11B). Australia The most attractively valued butterfly combination currently on the Australian government bond yield curve is going long the 3/10 barbell and shorting the 7-year bullet, which presently displays a standardized residual of -1.52 (Table 11). Table 11Australia: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Follow The Butterflies Global Yield Curve Trades: Follow The Butterflies Please note that we excluded the 20- and 30-year government bonds from our analysis since they were first issued only a few years ago. Our yield curve model suggests that the bullet is 10bps expensive and would only outperform its counterpart given a steepening in the 3/10 Australian curve slope greater than a whopping 92bps (Chart 12A). Chart 12AAustralia: 3/7/10 Spread Fair Value Model Australia: 3/7/10 Spread Fair Value Model Australia: 3/7/10 Spread Fair Value Model Chart 12BAustralian Butterfly Strategy Performance Australian Butterfly Strategy Performance Australian Butterfly Strategy Performance The mechanical trading rule also performs well when picking the most attractive butterfly combinations in the Australian government bond market (Chart 12B).   Footnotes 1 Please contact your sales representative to request a copy. 2 Please see US Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com. 3 The scientific study of butterflies. 4 Using benchmark Treasury yields would only result in slightly different weightings for the bonds in the barbell without affecting the outcome. 5 Please see Global Investment Strategy Weekly Report, "Markets Too Complacent About The Coronavirus", dated February 21, 2020, available at gis.bcaresearch.com. 6 Please see Global Fixed Income Strategy Weekly Report, "What Central Banks Are (Or Should Be) Watching", dated February 19th, 2019, available at gfis.bcaresearch.com.

Highlights The coronavirus is a wild card that may have a significant impact on the global economy, … : The COVID-19 outbreak is unfolding in real time, half a world away, and its ultimate course is uncertain. For now, our China strategists think the worst-case scenarios are unlikely, but we will not remain constructive if the virus outlook materially worsens. … but as long as there is not a significantly negative exogenous event, the US economy will be just fine, … : From a domestic perspective, the US expansion is in very good shape. Easy monetary conditions will support a range of activities, and a potent labor market will give increasing numbers of households the confidence and wherewithal to ramp up consumption. … and if there’s no recession, there will not be a bear market: Recessions and equity bear markets coincide, with stocks typically peaking six months ahead of the onset of a recession. If the next recession doesn’t come before late 2021/early 2022, the bull market should remain intact at least through the end of this year. What We Do US Investment Strategy’s stated mission is to analyze the US economy and its future direction for the purpose of helping clients make asset-allocation and portfolio-management decisions. As important as the economic backdrop is, however, we never forget that we are investment strategists, not economic forecasters. We don’t belabor the state of every facet of the economy because neither we nor our clients care about 10- to 20-basis-point wiggles in real GDP growth in themselves. They do want us to keep them apprised of the general trend, though, and we are always trying to assess it. Ultimately, macro analysis benefits investors by providing them with timely recognition of the approach or emergence of an inflection point in the cycles that matter most for financial assets. We view investment strategy as the practical application of the study of cycles, and we are continuously monitoring the business cycle, the credit cycle, the monetary policy cycle and the squishy and only sporadically relevant sentiment cycle. This week, we turn our attention to the business cycle, and the ongoing viability of the expansion, which is already the longest on record at 128 months and counting. If it remains intact, risk assets are likely to continue to generate returns in excess of returns on Treasuries and cash. The Message From Our Simple Recession Indicator We have previously described our simple recession indicator.1 It has just three components, and all three of them have to be sounding the alarm to conclude that a recession is imminent. Our first input is the slope of the yield curve, measured by the difference between the yield on the 10-year Treasury bond and the 3-month T-bill.2 The yield curve inverts when the 3-month bill yield exceeds the 10-year bond yield, and a recession has followed all but one yield curve inversion over the last 50 years (Chart 1). The yield curve inverted from May through September last year, and the coronavirus outbreak (COVID-19) has driven it to invert again, but the unprecedentedly negative term premium (Chart 2) has made the curve much more prone to set off a false alarm. Chart 1An Inverted Curve May Not Be What It Used To Be ... An Inverted Curve May Not Be What It Used To Be ... An Inverted Curve May Not Be What It Used To Be ... Chart 2... When A Negative Term Premium Is Holding Down Long Yields ... When A Negative Term Premium Is Holding Down Long Yields ... When A Negative Term Premium Is Holding Down Long Yields The indicator’s second input is the year-over-year change in the leading economic index (“LEI”). When the LEI contracts on a year-over-year basis, a recession typically ensues. As with the inverted yield curve, year-over-year contractions in the LEI have successfully called all of the recessions in the last 50 years with just one false positive (Chart 3). The LEI bounced off the zero line thanks to January’s strong reading, and the year-ago comparisons are much easier than they were last year, but we are mindful that it is flirting with sending a recession warning. Chart 3Leading Indicators Are Wobbly, ... Leading Indicators Are Wobbly, ... Leading Indicators Are Wobbly, ... It takes more than tight monetary conditions to make a recession, but you can't have one without them. To confirm the signal from the yield curve and the LEI and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA’s model calculates an equilibrium rate, every recession has occurred when the fed funds rate has exceeded our estimate of equilibrium (Chart 4). Tight monetary policy isn’t a sufficient condition for a recession – expansions continued for six more years despite tight policy in the mid-‘80s and mid-'90s – but it is a necessary one. Our indicator will not definitively signal an approaching recession until monetary conditions turn restrictive. Chart 4... But The Fed Is Nowhere Near Inducing A Recession ... But The Fed Is Nowhere Near Inducing A Recession ... But The Fed Is Nowhere Near Inducing A Recession Bottom Line: In our view, the yield curve and the LEI both represent yellow lights, though the LEI has a greater likelihood of turning red, especially in the wake of COVID-19. Monetary policy is unambiguously green, however, and we will not conclude that a recession is imminent until the Fed deliberately attempts to rein in the economy. Bolstering Theory With Observation A potential shortcoming of our recession indicator is its reliance on a theoretical concept. The equilibrium (or natural) rate of interest cannot be directly observed, so our judgment of whether monetary policy is easy or tight turns on an estimate. To bolster our assessment of whether or not the expansion can continue, we have been tracking the drivers of the main components of US output. Going back to the GDP equation from Introductory Macroeconomics, GDP = C + I + G + (X - M), we look at the forces supporting Consumption (C), Investment (I) and Government Spending (G). (Because the US is a comparatively closed economy in which trade plays a minor role, we ignore net exports (X-M).) Consumption is by far the largest component, accounting for two-thirds of overall output, while investment and government spending each contribute a sixth. As critical as consumption is for the US economy, it is not the whole story; smaller but considerably more volatile investment is capable of plunging the economy into a recession on its own. The Near-Term Outlook For Consumption Chart 5Labor Market Slack Has Been Absorbed Labor Market Slack Has Been Absorbed Labor Market Slack Has Been Absorbed Consumption depends on household income, the condition of household balance sheets, and households’ willingness to spend. The labor market remains extremely tight, with the unemployment rate at a 50-year low, and “hidden” unemployment dwindling as the supply of discouraged (Chart 5, top panel) and involuntary part-time workers (Chart 5, bottom panel) has withered. The prime-age employment-to-population ratio trails only the peak reached during the dot-com era (Chart 6), which bodes well for household income. The historical correlation between the prime-age non-employment-to-population ratio and wage gains has been quite robust, and compensation growth has plenty of room to run before it catches up with the best-fit line (Chart 7). Chart 6Prime-Age Employment Has Surged, ... Prime-Age Employment Has Surged, ... Prime-Age Employment Has Surged, ... Chart 7... And Wages Will Eventually Follow Suit Back To Basics Back To Basics Chart 8No Pressing Need To Save, Or Pay Down Debt No Pressing Need To Save, Or Pay Down Debt No Pressing Need To Save, Or Pay Down Debt Households can use additional income to increase savings or pay down debt instead of spending it, but it doesn’t look like they will. The savings rate is already quite elevated, having returned to its mid-‘90s levels (Chart 8, top panel); households have already run debt down to its post-dot-com bust levels (Chart 8, middle panel); and debt service is less demanding than it has been at any point in the last 40 years (Chart 8, bottom panel). The health of household balance sheets, and the recent pickup in the expectations component of the consumer confidence surveys, suggest that households have the ability and the willingness to keep consumption growing at or above trend.   Household balance sheets are healthy enough to support spending income gains; there's even room to borrow to augment them.           The Near-Term Outlook For Investment Table 1GDP Equation Recession Probabilities Back To Basics Back To Basics Chart 9A Budding Turnaround A Budding Turnaround A Budding Turnaround We previously identified investment as the individual component most likely to decline enough to zero out trend growth from the other two components (Table 1), and it was a drag in 2019, declining in each of the last three quarters to end the year more than 3% below its peak. We expect it will hold up better this year, however, as the capital spending intentions components of the NFIB survey of smaller businesses (Chart 9, top panel) and the regional Fed manufacturing surveys (Chart 9, bottom panel) have both pulled out of declines. The trade tensions with China weighed heavily on business confidence in 2019, but the signing of the Phase 1 trade agreement lifted that cloud, and we expect that capex will revive in line with confidence once COVID-19 has been subdued. Government Spending In An Election Year Chart 10State And Local Revenues Are Well Supported State And Local Revenues Are Well Supported State And Local Revenues Are Well Supported Heading into the most hotly contested election in many years, we confidently assert that federal spending is not going to go away. Regardless of party affiliation, everyone in Congress sees the appeal of distributing pork to their constituents. Spending by state and local governments, which accounts for 60% of aggregate government spending, should also hold up well, as a robust labor market will support state income tax (Chart 10, top panel) and sales tax (Chart 10, middle panel) receipts. Healthy trailing home price gains will support property tax assessments, keeping municipal coffers full (Chart 10, bottom panel). Coronavirus Uncertainties The coronavirus epidemic (COVID-19) is unfolding in real time, generating daily updates on new infections, deaths and recoveries. Any opinion we offer on the economy’s future is conditioned on the virus' ongoing course. If it takes a sharp turn for the worse, with more severe consequences than we had previously expected, it is likely that we will downgrade our outlook. For now, we are operating under the projection that the virus will cause China’s first quarter output to contract sharply enough to zero out global growth in the first quarter. Our base-case scenario, following from the work of our China Investment Strategy service, is fairly benign from there. For now, we are expecting that the worst of the effects will be confined to the first quarter, and that the Chinese economy and the global economy will bounce back vigorously in the second quarter and beyond, powered by pent-up demand that will go unfilled until the outbreak begins to recede. Our China strategists continue to be heartened by Chinese officials' aggressive (albeit belated) measures to stem the outbreak, revealed in the apparent slowing of the rate of new infections in Hubei province, the epicenter of the outbreak (Chart 11, top panel), and in the rest of China (Chart 11, bottom panel). They also expect a determined policy response to offset the drag from the epidemic (Charts 12 and 13), as officials pursue the imperative of meeting their goal to double the size of the economy between 2010 and 2020. Chart 11Stringent Quarantine Measures May Be Gaining Traction Back To Basics Back To Basics Chart 12The PBOC Is Doing Its Part, ... The PBOC Is Doing Its Part, ... The PBOC Is Doing Its Part, ... Chart 13... By Easing Monetary Conditions ... By Easing Monetary Conditions ... By Easing Monetary Conditions If the economy is expanding, investors' bar for de-risking should be high. Bottom Line: Our China strategists’ COVID-19 view remains fairly optimistic, though it is subject to unfolding developments. Our US view is contingent on BCA’s evolving COVID-19 views. Investment Implications As we noted at the outset, we are not interested in the economy for the economy’s sake; we are only interested in its impact on financial markets. The key business-cycle takeaway for markets is that bear markets and recessions typically coincide, as it is difficult to get a 20% decline at the index level without a meaningful decline in earnings, and earnings only decline meaningfully during recessions. No recession means no bear market, and it also means no meaningful pickup in loan delinquencies and defaults. The bottom line is that it is premature to de-risk while the expansion remains intact. We reiterate our recommendation that investors should remain at least equal weight equities in balanced portfolios, and at least equal weight spread product within fixed income allocations, though we may turn more cautious as we learn more about the progression of COVID-19.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the August 13, 2018 US Investment Strategy Special Report, "How Much Longer Can The Bull Market Last?" available at usis.bcaresearch.com. 2 We use the 3-month/10-year segment instead of the more common 2-year/10-year because the 3-month bill is a cleaner proxy for short rates than the 2-year note, which incorporates estimates of the Fed’s future actions.

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

Please note that next week’s US Bond Strategy Weekly Report will be replaced by a Special Report on Commercial Real Estate that was produced jointly with our US Investment Strategy team. That report will be published on Monday instead of Tuesday. Highlights Duration: Financial markets have taken the Fed’s dovish guidance on board, and the asset prices that are most sensitive to monetary policy are rallying strongly. If we follow the typical pattern, as was the case in 2015/16, accommodative policy will soon lead to a rebound in our preferred global growth indicators and higher bond yields. Keep portfolio duration low. Credit: The macro environment for corporate bonds remains attractive, but investors should favor high-yield bonds – particularly Caa-rated and energy debt – where spreads still have room to narrow. Yield Curve: Barbelled Treasury portfolios still make sense in the current macro environment. Specifically, we recommend that investors overweight a duration-matched 2-year/30-year barbell and underweight the 5-year bullet. Feature Bond yields have mostly trended sideways during the past few weeks, even as the S&P 500 surged. The result is that a wide gulf has opened up between the equity and bond markets (Chart 1). At times like this it becomes popular to ask whether the stock market or bond market is “right”. That is, are equities bound to sell off and re-converge with bonds? Or, will the stock market pull bond yields higher? We agree with our Global Investment Strategy team that the risk of a near-term equity sell-off is high.1 But we also think that both the equity and bond markets are responding rationally to an economic environment characterized by abundant central bank liquidity and global growth that has yet to convincingly rebound. Tech stocks are responsible for the bulk of the recent rally. To see why, we can take a look at the relative performance of different equity sectors. Technology stocks are responsible for the bulk of the recent rally, while defensive sectors have performed in-line with the benchmark index and cyclical sectors have lagged (Chart 2). This is consistent with an environment of depressed global growth and plentiful central bank liquidity. Chart 1Stocks Versus##br## Bonds Stocks Versus Bonds Stocks Versus Bonds Chart 2Cyclical (or Growth Sensitive) Sectors Have Lagged ... Cyclical (or Growth Sensitive) Sectors Have Lagged ... Cyclical (or Growth Sensitive) Sectors Have Lagged ... Many technology firms trade off the promise of large cash flows that will only be delivered in the distant future. In a sense, we can think of these stocks as long duration assets whose prices are very sensitive to the discount rate. The Fed’s highly accommodative interest rate guidance is the main reason for the tech sector’s outperformance. In contrast, cyclical equity sectors – like materials, industrials and energy – are less sensitive to Fed policy and more geared toward global economic growth. These sectors have lagged because global growth has yet to put in a decisive bottom. Like cyclical equity sectors, Treasury yields are also most sensitive to trends in global growth. In fact, the 10-year Treasury yield closely tracks the relative performance of cyclical versus defensive equity sectors (Chart 3). Commodity prices are also consistent with this picture (Chart 4). Gold has rallied sharply, something that often results from a shift toward more dovish monetary policy, while the growth-sensitive CRB Raw Industrials commodity index has only just begun to hook up. Historically, bond yields only rise when gains in the CRB index start to outpace gains in gold (Chart 4, bottom panel). Chart 3... Consistent With Bond Yields ... Consistent With Bond Yields ... Consistent With Bond Yields Chart 4The CRB/Gold Ratio The CRB/Gold Ratio The CRB/Gold Ratio But we can’t think of monetary policy and global growth as completely separate issues. They tend to follow each other in a pattern explained by our Fed Policy Loop (Chart 5). Applying the Loop to the current environment, we see that the Fed eased policy after growth weakened last year and financial markets are currently responding to this shift in monetary conditions. The most interest rate sensitive assets – e.g. tech stocks and gold – are rallying. This represents an easing of financial conditions that will eventually lead to a rebound in global growth indicators. It is only when those global growth indicators increase that US bond yields will rise. Chart 5The Fed Policy Loop The Best Spot On The Yield Curve The Best Spot On The Yield Curve On that note, we also see signs that the economy is transitioning from the ‘Asset Price Inflation’ section of the Loop to the ‘Stronger Economic Growth’ section. The US ISM Manufacturing PMI is currently downbeat at 47.2, but it should be at 50.8 according to a model based on regional Fed manufacturing surveys (Chart 6). Further, the ISM non-Manufacturing index is well above 50 and moving higher (Chart 6, panel 2). Finally, industrial production growth is nowhere near as weak as it was in 2016, even though the PMI is lower (Chart 6, bottom panel). Chart 6ISM Will Soon Trough ISM Will Soon Trough ISM Will Soon Trough Bottom Line: Financial markets have taken the Fed’s dovish guidance on board, and the asset prices that are most sensitive to monetary policy are rallying strongly. If we follow the typical pattern, as was the case in 2015/16, accommodative policy will soon lead to a rebound in our preferred global growth indicators and higher bond yields. Keep portfolio duration low. Stay Long Junk It’s still early, but corporate bonds have so far not joined in with this year’s equity rally. Year-to-date, the investment grade corporate bond index is only up 8 bps versus Treasuries (Chart 7). High-yield bonds have fared better. They have outperformed duration-matched Treasuries by 48 bps so far this year, and the segments of the junk market that were most beaten down in 2019 are leading the charge. Caa-rated junk bonds have outperformed Treasuries by 108 bps so far in 2020.  The energy sector has also fared well since December, and is up a decent 43 bps versus Treasuries in January. Chart 7Corporate Bond Returns Corporate Bond Returns Corporate Bond Returns Chart 8Favor HY Over IG Favor HY Over IG Favor HY Over IG We see the divergence between investment grade and high-yield returns continuing during the next few months, due to large differences in valuation. The investment grade corporate index spread is well below our cyclical target, while the high-yield index spread still looks cheap (Chart 8).2  High-yield’s attractiveness is mostly due to Caa-rated securities which underperformed dramatically in 2019 even as junk bonds overall delivered solid returns (Chart 8, bottom panel). As we discussed in a recent report, the underperformance of Caa-rated debt was in large part due to weakness in the shale oil sector.3 The yield curve is no longer deeply inverted out to the 5-year maturity point. Bottom Line: Corporate bonds will deliver solid returns as the economy transitions from the ‘Asset Price Inflation’ stage to the ‘Stronger Economic Growth’ stage of our Fed Policy Loop. However, relative valuation dictates that returns will concentrated in high-yield, especially Caa-rated and energy debt. Finding The Best Spot On The Yield Curve We have been recommending that investors run barbelled Treasury portfolios for some time, favoring the long and short ends of the curve at the expense of the belly (5-year/7-year). However, the shape of the curve has changed a lot since the 2/10 slope briefly inverted last August. Specifically, the curve is no longer deeply inverted out to the 5-year maturity point (Chart 9A). In light of this shift, it is worth considering whether our recommended curve positioning still makes sense. First, we take a look at the 12-month rolling yield for each point on the Treasury curve (Chart 9B). The 12-month rolling yield equals each security’s coupon return plus rolldown return. It is essentially the return you would earn in each maturity if the yield curve stayed completely unchanged during the next 12 months. Despite recent curve shifts, we still see a significant pick-up in rolling yield beyond the 5-year maturity point, as was the case last August. Chart 9APar Coupon Yield Curve The Best Spot On The Yield Curve The Best Spot On The Yield Curve Chart 9B12-Month Rolling Yield Curve The Best Spot On The Yield Curve The Best Spot On The Yield Curve But yield pick-up is just one consideration. We also need to think about how the shape of the curve will change during the next 6-12 months. One way to do this is to look at a sample of recent data – we use the past six months – and calculate how sensitive each point on the Treasury curve has been to changes in our 12-month Fed Funds Discounter.4 That is, if the market moves to price-in fewer Fed rate cuts during the next 12 months, as we expect, how should we expect each point on the Treasury curve to respond? To answer this question, Chart 10 shows how sensitive weekly changes in each Treasury yield have been to changes in our Discounter during the past six months. Chart 10Risk & Reward Along The Treasury Curve The Best Spot On The Yield Curve The Best Spot On The Yield Curve The first thing we notice is that the 5-year yield is the most sensitive to changes in our Discounter and the 2-year yield is the least sensitive. The 20-year and 30-year yields are relatively insulated from changes in the Discounter, and offer the greatest rolling yields. The second and third panels of Chart 10 show how these sensitivities change if we consider increases and decreases in our Discounter differently. Here we see that maturities from 5-20 years have been similarly sensitive to increases in the Discounter during the past six months. Meanwhile, the 5-year yield has been most sensitive to declines in the Discounter. The 2-year yield is not sensitive at all to a rising Discounter, but is fairly exposed to a falling Discounter. In general, since we expect the Discounter to move up during the next 6-12 months, the 2-year note looks like the safest place to camp out. Meanwhile, the 30-year bond looks attractive in terms of its yield pick-up per unit of sensitivity. The 2-year yield is least sensitive to changes in our Fed Funds Discounter. Another approach we can take is to look at how different parts of the yield curve respond to “risk on” and “risk off” market environments. To do this, we classify months as “risk on” if both the stock-to-bond total return ratio rises and the high-yield index spread tightens. Conversely, we classify months as “risk off” if both the stock-to-bond total return ratio falls and the high-yield index spread widens. Chart 11A shows the cumulative changes in different yield curve slopes since 2010 during “risk on” months only. The chart shows that, recently, “risk on” financial market behavior has coincided with the yield curve steepening out to the 7-year/10-year part of the curve, and then flattening beyond the 10-year point. Similarly, Chart 11B shows that “risk off” months have recently coincided with yield curve flattening out to the 7-year/10-year part of the curve, and steepening beyond that. Chart 11ASlope Changes In "Risk On" Environments Slope Changes In "Risk On" Environments Slope Changes In "Risk On" Environments Chart 11BSlope Changes In "Risk Off" Environments Slope Changes In "Risk Off" Environments Slope Changes In "Risk Off" Environments In other words, if recent correlations hold, a “risk on” environment during the next few months would cause the 7-year and 10-year yields to rise the most, while the 2-year and 30-year yields would have less upside. Investment Conclusions We expect economic growth to strengthen during the next 6-12 months, leading to “risk on” financial market behavior and a rising Fed Funds Discounter. Based on this view and our analysis of rolling yields and curve sensitivities, we conclude that a barbelled Treasury portfolio still makes the most sense. We want to be overweight the 2-year note because it should have less upside in a “risk-on” environment, and overweight the 30-year bond to get some extra yield pick-up while taking less risk than in the 5-year, 7-year or 10-year notes. In general, we want to avoid the 5-year, 7-year and 10-year maturities. According to our yield curve models, all three of those maturities look expensive relative to a duration-matched 2/30 barbell (Chart 12).5 Chart 12Butterfly Spread Fair Value Models Butterfly Spread Fair Value Models Butterfly Spread Fair Value Models If we wanted to get even more precise, we could note that a duration-matched 2/30 barbell offers 5 bps of yield pick-up compared to the 5-year note, only 1 bp of yield pick-up relative to the 7-year note and about the same yield as the 10-year note. To split hairs, those extra few basis points give us a slight preference for being short the 5-year bullet compared to the 7-year and 10-year notes, though we would prefer to avoid all three. Bottom Line: Barbelled Treasury portfolios still make sense in the current macro environment. Specifically, we recommend that investors overweight a duration-matched 2-year/30-year barbell and underweight the 5-year bullet.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Time For A Breather”, dated January 10, 2020, available at gis.bcaresearch.com 2 For details on how we arrive at our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 4 Our 12-month Fed Funds Discounter measures the 12-month change in the fed funds rate that is currently priced into the overnight index swap curve. 5 For details on our yield curve models please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

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

Highlights Global growth will rebound in 2020, led by the US and China, putting upward pressure on global bond yields. Maintain below-benchmark overall duration exposure. Central banks will stay dovish until policy reflation has clearly turned into inflation, limiting how high bond yields can climb in 2020 but sowing the seeds for a far more bond-bearish backdrop in 2021. Expect mild bear-steepening pressure on global yield curves, led by rising inflation expectations. Accommodative monetary policy and faster growth will delay the peak in the aging global credit cycle. Stay overweight global corporate debt versus sovereign bonds. Returns on global fixed income will be far lower in 2020 than in 2019, given rich valuation starting points. Country and sector selection will be more important in driving fixed income outperformance. For sovereign bonds, favor countries where yields are less sensitive to change in overall global yields; for credit, favor sectors with lower interest rate durations and lower spread volatility. Feature BCA Research’s Outlook 2020 report, outlining the main investment themes for next year from the collective mind of our strategists, was sent to all clients in late November.1 In this report, we discuss the broad implications of those themes for the direction of global fixed income markets in 2020. In a follow-up report to be published in the first week of the new year, we will translate those themes into specific recommended allocations and weightings within our model bond portfolio framework. A Summary Of The 2020 Outlook Chart 1Expect A Cyclical Rise In Global Yields In 2020 Expect A Cyclical Rise In Global Yields In 2020 Expect A Cyclical Rise In Global Yields In 2020 The main conclusions from the Outlook 2020 report were cyclically bullish looking out over the next twelve months, but more cautious beyond that. The downturn in global growth seen in 2019 is projected to end in response to several headwinds that have become tailwinds: a small wave of Chinese stimulus and reflation; more stimulative global monetary policies; the substantial easing of global financial conditions as risk assets have rallied worldwide; a fading drag on global manufacturing from inventory destocking; both China (weak growth) and the US (the 2020 US election) have good reasons to de-escalate the trade war in 2020. This backdrop should push global bond yields moderately higher in 2020, while maintaining a backdrop that is once again favorable for risk assets on a relative basis versus government debt (Chart 1). A critical element to this story is the supportive monetary policy backdrop. Central banks worldwide, led by interest rate cuts from the US Federal Reserve and a resumption of asset purchases from the European Central Bank (ECB), are now running more stimulative policies in response to this year’s global manufacturing slump and elevated level of political uncertainty. Policymakers will maintain accommodative monetary policy through 2020 to try and bring depressed inflation expectations back up to central bank targets. This will create a “sweet spot” for global risk assets, with improving economic growth and accommodative monetary policy. A repeat of the spectacular total return numbers seen across the majority of asset classes in 2019 is unlikely, but global equity and credit markets should solidly outperform government bonds. Yet all that monetary stimulus does not come without a price. Policymakers will maintain accommodative monetary policy through 2020 to try and bring depressed inflation expectations back up to central bank targets. This will create a “sweet spot” for global risk assets, with improving economic growth and accommodative monetary policy.  A revival of inflationary pressures in 2021 will force central banks to raise rates much more aggressively. Combined with a China that remains wary of promoting excess leverage, this will drive the current prolonged global business cycle expansion to its recessionary endgame, taking equity and credit markets down with it. This will eventually trigger a new decline in global bond yields as policymakers shift back to easing mode, but from much higher levels than today. Our Four Main Key Views For Global Fixed Income Markets In 2020 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2020 BCA Outlook: Key View #1: Maintain below-benchmark overall duration exposure. The pickup in global growth that we expect in 2020 has its roots in two locations: China and the US. For China, policymakers are keenly aware that the current growth slowdown cannot continue, as it has already pushed nominal GDP growth below 8% (Chart 2). For an economy as highly leveraged as China, slowing nominal growth is lethal and must be avoided to prevent a surge in private sector defaults and rising unemployment. Already, China has delivered significant policy stimulus in 2019: the reserve requirement ratio has been cut by 400bps; taxes have been cut by 2.8% of GDP; capital spending at state-owned enterprises has increased; the currency has depreciated; and, more recently, monetary policy has been eased via traditional interest rate cuts. These measures have eased our index of Chinese monetary conditions and triggered a surge in the China credit impulse, which leads Chinese import growth (i.e. China’s most direct impact on the global economy) by nine months. There are signs that Chinese growth is already bottoming out, as evidenced by the recent pickup in the China manufacturing PMI. Expect more signs of improvement in the first half of 2020. The BCA global leading economic indicator (LEI) has been rising since January of this year, and the global LEI diffusion index is signaling that the upturn will continue in 2020 (Chart 3). With global financial conditions at highly stimulative levels thanks to the robust performance of risk assets in 2019, the backdrop is already conducive to faster global growth. BCA’s geopolitical strategists are of the view that a “détente” in the US-China trade war is still the most likely base case scenario, which would go a long way in reducing the growth-inhibiting effects of elevated uncertainty (bottom panel). Chart 2A Boost To Global Growth From China In 2020 A Boost To Global Growth From China In 2020 A Boost To Global Growth From China In 2020 Chart 3Lower Uncertainty + Easy Financial Conditions = Faster Growth Lower Uncertainty + Easy Financial Conditions = Faster Growth Lower Uncertainty + Easy Financial Conditions = Faster Growth As for the US, the lagged impact of the Fed’s 75bps of rate cuts this year has boosted domestic liquidity conditions in a pro-growth fashion. The BCA US Financial Liquidity Indicator, which leads not only US growth but also leads the BCA global LEI and commodity prices by 18 months, is already signaling that US economic momentum is set to bottom out in early 2020 (Chart 4). This signal is in addition to the leading properties of US financial conditions (middle panel), which suggests a reacceleration of real GDP growth back above trend is about to unfold. Chinese policy reflation has typically been a good leading indicator for US capex and is heralding a rebound in investment spending (bottom panel). The pickup in global growth would also help revive the dormant euro zone economy, which has been hit hard though plunging export demand and overall weakness in the manufacturing sector. The entire slump in euro area real GDP growth since the start of 2018 can be attributed to plunging net exports, while domestic demand has held steady (Chart 5). The increase in the China credit impulse and our global LEI diffusion index – both leading indicators of euro area export growth – are signaling that euro area export demand is already in the process of bottoming out (bottom two panels) and should gain momentum in the first half of 2020. Chart 4US Growth Is Poised To Accelerate US Growth Is Poised To Accelerate US Growth Is Poised To Accelerate Chart 5The Drag On European Growth From Trade Will Soon End The Drag On European Growth From Trade Will Soon End The Drag On European Growth From Trade Will Soon End This better growth backdrop will put moderate upward pressure on global bond yields in 2020. This better growth backdrop will put moderate upward pressure on global bond yields in 2020. Key View #2: Expect mild bear-steepening pressure on global yield curves, led by rising inflation expectations. While we expect bond yields to drift higher in the next 6-12 months, the upside will be capped with central banks likely to stay dovish until policy reflation has clearly turned into higher inflation. Interest rate markets will not begin to price in expectations of tighter monetary policy without evidence of actual inflation picking up. The Fed, ECB, Bank of Japan and other central banks have all stated publicly that they will maintain current accommodative policy settings until realized inflation has sustainably returned to target levels, typically around 2%. This would be a major change in the modus operandi of these policymakers, who have typically signaled rate hikes based simply on forecasts of higher inflation. The implication is that interest rate markets will not begin to price in expectations of tighter monetary policy without evidence of actual inflation picking up (Chart 6). Chart 6Central Banks Will Stay Dovish Until Inflation Sustainably Accelerates Central Banks Will Stay Dovish Until Inflation Sustainably Accelerates Central Banks Will Stay Dovish Until Inflation Sustainably Accelerates A critical ingredient for global inflation to begin moving higher again is a softer US dollar (USD). The year-over-year growth rate of the trade-weighted USD is correlated to global export price inflation and commodity price inflation, more generally (Chart 7). The typical drivers of the USD are all pointing in a more bearish direction: Chart 7The USD Is Critical For Global Reflation The USD Is Critical For Global Reflation The USD Is Critical For Global Reflation Chart 8Global Real Yields & Inflation Expectations Will Drift Higher In 2020 Global Real Yields & Inflation Expectations Will Drift Higher In 2020 Global Real Yields & Inflation Expectations Will Drift Higher In 2020 the Fed has cut interest rates multiple times since the summer and is expanding its balance sheet via repo operations and treasury bill purchases; global (non-US) growth is bottoming out, and capital tends to flow out of the USD into more cyclical currencies in Europe and EM when global growth is accelerating; elevated policy uncertainty, which tends to attract inflows into the safety of the USD, is starting to diminish. The combination of improving global growth and a softer USD would normally be enough to generate a significant increase in global bond yields. Yet we do not expect the sort of move higher in the real component of bond yields signaled by our global LEI diffusion index in 2020 (Chart 8, top panel). While real yields should move higher alongside faster growth, if there is no expected tightening of monetary policy as well, the move in real yields will be more limited. The grind higher in global bond yields that we expect in 2020 will come first through faster inflation expectations and, much later in the year, higher real bond yields when central bankers (starting with the Fed) begin to signal a need to turn more hawkish. The grind higher in global bond yields that we expect in 2020 will come first through faster inflation expectations and, much later in the year, higher real bond yields when central bankers (starting with the Fed) begin to signal a need to turn more hawkish. This suggests that inflation-linked bonds should perform reasonably well in countries where inflation is likely to accelerate the fastest, like the US. Faster inflation expectations will also result in some bear-steepening of global government bond yield curves in the first half of 2020 (Chart 9). There is very little curve steepening discounted in bond forward rates in the developed markets – a consequence of the general flatness of yield curves – which suggests that yield curve steepening trades could prove to be profitable in 2020. Chart 9Expect A Mild Bear-Steepening Of Global Yield Curves Expect A Mild Bear-Steepening Of Global Yield Curves Expect A Mild Bear-Steepening Of Global Yield Curves Chart 10The Fed Has Dis-Inverted The Treasury Curve The Fed Has Dis-Inverted The Treasury Curve The Fed Has Dis-Inverted The Treasury Curve In the case of the US, the Fed’s recent easing actions have pushed short-term interest rates below longer-term Treasury yields, removing the yield curve inversion that sparked recession fears among investors during the summer of 2019 (Chart 10). With the Fed likely to sit on its hands for most of next year, even as US growth and inflation are likely to improve, this will put additional bear-steepening pressure on the US Treasury curve. In Europe, bond markets have already discounted a very significant impact from the ECB restarting its Asset Purchase Program, which only began last month. Investment grade corporate bond spreads, as well as Italy-Germany government bond spreads, have narrowed substantially despite a weak euro area economy (Chart 11, bottom panel). Meanwhile, the term premium on 10-year German bunds is back to the deeply negative levels middle panel) seen when the ECB was expanding its balance sheet at a 30-40% pace, rather than the 5% pace implied by the current announced pace of purchases of 20 billion euros per month (top panel). This potentially leaves longer-term European yields exposed to the same bear-steepening pressures seen in other bond markets, even within the context of a renewed ECB bond-buying program. Chart 11European Bonds Already Discount A Very Dovish ECB European Bonds Already Discount A Very Dovish ECB European Bonds Already Discount A Very Dovish ECB Chart 12The Wild Card For Bonds Markets In 2020: Fiscal Policy The Wild Card For Bonds Markets In 2020: Fiscal Policy The Wild Card For Bonds Markets In 2020: Fiscal Policy A potentially big wild card for global bond markets next year will be fiscal policy, which can also exacerbate yield curve steepening pressures. Any sign of a push toward more government spending, particularly in Europe where there has been such reluctance to open the fiscal taps, would result in a sharper upward move in global bond yields than we are expecting. This is not because of a supply effect related to more government bond issuance that would require higher yields to attract buyers. It is because fiscal stimulus (Chart 12) would push growth to an even faster pace that would bring forward the date when inflation returns to policymaker targets and tighter monetary policy could commence. This would follow a similar path to the curve steepening dynamics described earlier, with a fiscal boost to growth pushing up longer-term inflation expectations before starting to push up short-term interest rate expectations. Key View #3: Stay overweight global corporate debt versus sovereign bonds. Investors should expect another year of corporate bond outperformance versus sovereign debt in the developed economies. The combination of faster global growth, somewhat higher inflation and accommodative monetary policies laid out in the BCA Outlook 2020 report will delay the peak in the aging global credit cycle. This means investors should expect another year of corporate bond outperformance versus sovereign debt in the developed economies. Low borrowing rates are already helping to extend the credit cycle by making it easier for highly indebted borrowers to service their debts. This can be seen in the US, where interest coverage ratios (using top-down data for the non-financial corporate sector) remain above the levels that have preceded previous recessions (Chart 13). Low borrowing rates are also helping indebted borrowers in Europe, particularly in Italy and Spain where the banking system is now far less exposed to non-performing loans than during the peak years of the 2011-12 European Debt Crisis (Chart 14). Chart 13Low Rates Helping Extend The US Credit Cycle Low Rates Helping Extend The US Credit Cycle Low Rates Helping Extend The US Credit Cycle Chart 14Low Rates Helping Ease Stress In European Banks Declining Non-Performing Loans Are A Positive For The European Periphery Low Rates Helping Ease Stress In European Banks Declining Non-Performing Loans Are A Positive For The European Periphery Low Rates Helping Ease Stress In European Banks Declining Non-Performing Loans Are A Positive For The European Periphery Chart 15A Cyclically Positive Backdrop For Global Corporates A Cyclically Positive Backdrop For Global Corporates A Cyclically Positive Backdrop For Global Corporates According to our checklist of indicators to watch for an end of the corporate credit cycle in the US – tight monetary policy, deteriorating corporate sector financial health, and tightening bank lending standards – only corporate financial health is flashing a warning signal according to our Corporate Health Monitor as we discussed in a recent report.2 In fact, our global Corporate Health Monitor is rolling over – a trend that should continue as growth improves in 2020 – which should support global corporate bond outperformance versus government debt next year (Chart 15). Key View #4: Returns on global fixed income will be far lower in 2020 than in 2019. Country and sector selection will be more important in driving fixed income outperformance in 2020. The start of 2020 looks far different in terms of fixed income valuations compared to the beginning of 2019. For example, the 10yr US Treasury yield started the year at 2.72% and is now 1.83%, while the 10yr German bund yield started this year at 0.24% and is now MINUS-0.31%. These lower yields reflect the slower pace of global economic growth and monetary policy easing delivered by the Fed and ECB. Yet at the same time, corporate credit spreads have narrowed in both the US (the high-yield index OAS is down from 526bps to 360bps) and the euro area (the investment grade index OAS is down from 152bps to 100bps). These massive rallies in global bond markets this year resulted in both lower government bond yields and tighter credit spreads - even with slower global growth that would normally be a trigger for wider spreads/higher risk premiums. Looking at the current valuation of government bond yields in the major developed markets from a long-run perspective, it is difficult to make the case that it is attractive. Medium-term real bond yields remain well below potential GDP growth rates, a consequence of central banks keeping policy rates well below neutral levels suggested by measures like the Taylor Rule (Chart 16). Chart 16Global Government Bonds Are Expensive 2020 Key Views: Delay Of Reckoning 2020 Key Views: Delay Of Reckoning Without the initial starting point of cheap valuations, fixed income return expectations for 2020 should be tempered. This means that rather than loading up on maximum duration risk and/or credit risk to capture big yield and spread moves, bond investors should be more selective in country, maturity and credit exposure to generate outperformance in 2020. Chart 17Favor Lower-Beta Government Bond Markets In 2020 Favor Lower-Beta Government Bond Markets In 2020 Favor Lower-Beta Government Bond Markets In 2020 For government bonds, that means focusing country exposures on lower-beta markets where yields are less correlated to moves in the overall level of global bond yields. Our preferred way to measure this is to look at the beta of monthly yield changes for the benchmark 10-year government yields of the major developed market countries to the overall Bloomberg Barclays Global Treasury index yield for the 7-10 year maturity bucket, over a rolling three-year window. We define a “high-beta” bond market as having a yield beta of 1.25 or higher, and a “low-beta” bond market as having a yield beta of 0.75 or lower. Under that definition, global bond investors should underweight higher-beta Canada, the US and Italy, and overweight low-beta Japan and Spain (Chart 17). Bond markets with betas between 1.25 and 0.75 (Germany, Australia, Sweden, the UK) can also be considered on their own fundamental merits. Of that list, we see Germany and Australia having a better chance of outperforming the UK and Sweden, given the greater odds that the Bank of England or Riksbank could signal a need to hike rates in 2020 compared to the ECB or Reserve Bank of Australia. Chart 18Stay Overweight Global Spread Product In 2020, But Be Selective 2020 Key Views: Delay Of Reckoning 2020 Key Views: Delay Of Reckoning For spread product, that means focusing exposure on sectors that are less risky, either defined by interest rate duration or spread volatility (i.e. spread duration). With credit spreads remaining near the low end of long-run historical ranges for nearly all major markets (Chart 18), it is hard to find examples of spread product being cheap in absolute terms. On a risk-adjusted basis, however, negatively-convex spread product like US and euro area high-yield debt and US agency MBS actually look more interesting in the rising yield environment we expect in 2020, since the interest rate durations of those fixed income sectors fell as bond yields declined in 2019. Thus, we recommend owning high-yield corporates over higher-duration investment grade corporates in the US and euro area, while also favoring US agency MBS over higher-quality credit tiers of US investment grade corporate credit.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst, “Outlook 2020: Heading Into The End Game”, dated November 22, 2019, available at bca.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, “The Lowdown On Low-Rated High-Yield”, dated November 27, 2019, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index 2020 Key Views: Delay Of Reckoning 2020 Key Views: Delay Of Reckoning Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Manufacturing PMIs Track Bond Yields Manufacturing PMIs Track Bond Yields Manufacturing PMIs Track Bond Yields November’s manufacturing PMI data were released yesterday, giving us an update for two of our preferred global growth indicators: the Global Manufacturing PMI and the US ISM Manufacturing PMI (Chart 1). Unfortunately, the two indicators sent conflicting signals, providing us with very little clarity on the global growth outlook. On the positive side, the Global Manufacturing PMI jumped back above 50 for the first time since April. China is the largest weighting in the global index, and its PMI rose for the fifth consecutive month. Conversely, the US ISM Manufacturing PMI dipped further into contractionary territory in November – from 48.3 to 48.1. Optimistically, the index’s inventory component contracted by more than the new orders component, meaning that the difference between new orders and inventories rose to its highest level since May. The difference between new orders and inventories often leads the overall ISM index by several months. All in all, we continue to see tentative signs of stabilization in our preferred global growth indicators. But a more significant rebound will be necessary to push bond yields higher in the first half of next year, as we expect. Stay tuned. Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 63 basis points in November, bringing year-to-date excess returns up to +494 bps. We consider three main factors in our credit cycle analysis: (i) corporate balance sheet health, (ii) monetary conditions and (iii) valuation.1 On balance sheets, our top-down measure of gross leverage is high and rising (Chart 2). In contrast, interest coverage ratios remain solid, propped up by the Fed’s accommodative stance. With inflation expectations still depressed, the Fed can maintain its “easy money” policy for some time yet. The third quarter’s tightening of C&I lending standards is a concern, because it suggests that monetary conditions may not be sufficiently stimulative for banks to keep the credit taps running (bottom panel). But the yield curve, another indicator of monetary conditions, has steepened significantly since Q3, suggesting that lending standards will soon move back into “net easing” territory. For now, we see valuation as the main headwind for investment grade credit spreads. Spreads for all credit tiers are below our targets, with the Baa tier looking less expensive than the others (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds, with a preference for the Baa credit tier. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher (see page 7). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Mixed Messages Mixed Messages Table 3BCorporate Sector Risk Vs. Reward* Mixed Messages Mixed Messages High-Yield Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 47 basis points in November, bringing year-to-date excess returns up to +671 bps. The index option-adjusted spread tightened 22 bps on the month and currently sits at 370 bps, 131 bps above our target (Chart 3). Ba and B rated junk bonds outperformed the Treasury benchmark by 79 bps and 76 bps, respectively, in November. But Caa-rated credit underperformed Treasuries by 89 bps. This continues the trend of Caa underperformance that has been in place since late last year (panel 3). We analyzed the divergence between Caa and the rest of the junk bond universe in last week’s report and came to two conclusions.3 First, the historical data show that 12-month periods of overall junk bond outperformance are more likely to be followed by underperformance if Caa is the worst performing credit tier. Second, we can identify several reasons for this year’s Caa underperformance that make us inclined to downplay any potential negative signal. Specifically, we note that the Caa credit tier’s exposure to the shale oil sector is responsible for the bulk of this year’s underperformance (bottom panel). With elevated spreads, accommodative monetary conditions and a looming recovery in global economic growth, we expect junk spreads to tighten during the next 6-12 months.    MBS: Overweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in November, bringing year-to-date excess returns up to +22 bps. The conventional 30-year zero-volatility spread tightened 3 bps on the month, as a 5 bps tightening of the option-adjusted spread (OAS) was offset by a 2 bps increase in expected prepayment losses (aka option cost). We recommend an overweight allocation to Agency MBS, particularly relative to corporate bonds rated A or higher, for three reasons.4 First, expected compensation is competitive. The conventional 30-year MBS OAS is now 50 bps (Chart 4). This is very close to its pre-crisis average and only 3 bps below the spread offered by Aa-rated corporate bonds (panel 4). Also, spreads for all investment grade corporate bond credit tiers trade below our targets. Second, risk-adjusted compensation heavily favors MBS. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most homeowners have already had at least one opportunity to refinance their mortgages. This burnout will keep refi activity low, and MBS spreads tight (panel 2). Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 14 basis points in November, bringing year-to-date excess returns up to +197 bps. Sovereign debt outperformed duration-equivalent Treasuries by 36 bps on the month, bringing year-to-date excess returns up to +513 bps. Local Authorities outperformed the Treasury benchmark by 24 bps, bringing year-to-date excess returns up to +245 bps. Meanwhile, Foreign Agencies outperformed by 4 bps, bringing year-to-date excess returns up to +266 bps. Domestic Agencies outperformed by 11 bps in November, bringing year-to-date excess returns up to +51 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +36 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to US corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.5 This is also true for Foreign Agencies and Local Authorities, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).6 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 70 basis points in November, bringing year-to-date excess returns up to +6bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell 4% in November, and currently sits at 83% (Chart 6). We upgraded municipal bonds in early October, as yield ratios had become significantly more attractive, especially at the long-end of the Aaa curve (panel 2).7 Specifically, 2-year and 5-year M/T yield ratios are somewhat below average pre-crisis levels at 68% and 72%, respectively. However, M/T yield ratios for longer maturities (10 years and higher) are all above average pre-crisis levels. M/T yield ratios for 10-year, 20-year and 30-year maturities are 84%, 93% and 97%, respectively. Fundamentally, state & local government balance sheets remain solid. Our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outnumber downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve shifted higher in November, steepening out to the 7-year maturity and flattening beyond that. The 2/10 Treasury slope was unchanged on the month. It currently sits at 17 bps. The 5/30 slope flattened 7 bps to end the month at 59 bps (Chart 7). In a recent report we discussed the 6-12 month outlook for the 2/10 Treasury slope.8 We considered the main macro factors that influence the slope of the yield curve: Fed policy, wage growth, inflation expectations and the neutral fed funds rate. We concluded that the 2/10 slope has room to steepen during the next few months, as the Fed holds down the front-end of the curve in an effort to re-anchor inflation expectations. However, we see the 2/10 slope remaining in a range between 0 bps and 50 bps, owing to strong wage growth and downbeat neutral rate expectations. Despite the outlook for modest curve steepening, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. This position offers strong positive carry (bottom panel), due to the extreme overvaluation of the 5-year note, and looks attractive on our yield curve models (see Appendix B). TIPS: Overweight   Chart 8TIPS Market Overview Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 47 basis points in November, bringing year-to-date excess returns up to -70 bps.The 10-year TIPS breakeven inflation rate rose 8 bps on the month and currently sits at 1.62%. The 5-year/5-year forward TIPS breakeven inflation rate rose 9 bps on the month and currently sits at 1.73%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations remains stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target for most of the year (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. As we have pointed out in prior research, it can take time for expectations to adapt to a changing macro environment.9 That being said, the 10-year TIPS breakeven inflation rate is currently 29 bps too low according to our Adaptive Expectations Model, a model whose primary input is 10-year trailing core inflation (panel 4). It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor inflation expectations near desired levels. We anticipate that the committee will do so, and maintain our view that long-dated TIPS breakevens will move above 2.3% before the end of the cycle. ABS: Underweight Asset-Backed Securities outperformed the duration-equivalent Treasury index by 7 basis points in November, bringing year-to-date excess returns up to +74 bps. Chart 9ABS Market Overview ABS Market Overview ABS Market Overview The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month. It currently sits at 34 bps; its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS rank among the most defensive US spread products and also offer more expected return than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends continue to shift in the wrong direction. The consumer credit delinquency rate is still low, but has put in a clear bottom. The is true for the household interest expense ratio (panel 3). Senior Loan Officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, our favorable outlook for global growth causes us to shy away from defensive spread products, and deteriorating ABS credit metrics are also a cause for concern. Stay underweight. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in November, dragging year-to-date excess returns down to +221 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month. It currently sits at 72 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate (CRE) is somewhat unfavorable, with lenders tightening loan standards (panel 4) in an environment of tepid demand. The Fed’s Senior Loan Officer Survey shows that banks saw slightly stronger demand for nonfarm nonresidential CRE loans in Q3, after four consecutive quarters of falling demand (bottom panel). CRE prices are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 7 basis points in November, bringing year-to-date excess returns up to +107 bps. The index option-adjusted spread tightened 2 bps on the month, and currently sits at 54 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this high-rated sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 26 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index.   To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Mixed Messages Mixed Messages Mixed Messages Mixed Messages Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of November 29 2019) Mixed Messages Mixed Messages Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of November 29, 2019) Mixed Messages Mixed Messages Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 45 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 45 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Mixed Messages Mixed Messages Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of November 29, 2019) Mixed Messages Mixed Messages Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2   For details on how we arrive at our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3  Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 4  Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 5  Please see US Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 6  Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 7  Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8  Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 9  Please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com   Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation