Corporate Bonds

Highlights Global Spread Product: The current low-volatility backdrop, triggered by more dovish central banks, will be maintained until there is more decisive evidence that global growth is rebounding. That will not occur until the latter half of 2019, thus keeping the window for corporate credit outperformance open for a few more months. Stay overweight global corporates versus governments, favoring the U.S. Canada: Much weaker-than-expected Canadian economic growth has surprised the Bank of Canada. Rate hikes are now off the table for at least the rest of 2019, and possibly longer. Upgrade Canadian government debt to neutral (3 out of 5) in global currency-hedged government bond portfolios. Feature Stick With A Tactical Overweight To Global Corporates We’ve dedicated our last few Weekly Reports to analyzing the outlook for government bond yields in the developed markets (DM), in light of the recent dovish shift in the policy stance of central banks. We concluded that yields had fully discounted a slower global growth backdrop, through lower inflation expectations and the pricing out of future interest rate hikes. Further declines in bond yields would require a deeper deceleration of activity than we are expecting, thus maintaining a below-benchmark medium-term duration stance is appropriate. That dovish shift by policymakers also took away a major roadblock for risk assets, namely the threat of a continued policy-induced rise in global yields at a time of slowing growth. The result has been sharp rallies in global equity and credit markets, with declining volatility (Chart of the Week). Chart of the WeekSlowing Growth Isn’t Always Bad For Risk Assets We upgraded global corporate debt, and downgraded global government bonds, on a tactical basis back on January 15 of this year.1 Since then, credit spreads have declined substantially across both DM and emerging markets (EM), most notably in Europe (Chart 2). Within our upgrade to overall global credit, we maintained a relative bias towards U.S. corporates versus non-U.S. equivalents, based on our expectation of relatively faster economic growth in the U.S. In our model bond portfolio, that meant moving U.S. corporates to an above-benchmark weighting, while reducing the size of the underweight in EM debt and only raising European credit to a neutral allocation. Looking at the performance of each of the major credit markets in excess return terms (versus duration-matched government bonds) since January 15, currency-hedged into U.S. dollars, there have not been huge differences between U.S. and non-U.S. returns. The exception is European high-yield which had an excess return of 4.4%, but only represents 0.8% of our custom benchmark index for our model portfolio (and where we are not underweight). Excess returns for investment grade and high-yield corporates in the U.S. have averaged 2.3%, compared to 2.2% for EM credit (averaging hard currency sovereign and corporate debt). We see the global “risk-on” dynamic continuing in next few months, fueled by benign monetary policies, thus we are sticking with our current overweight allocation to global corporates. With the benefit of hindsight, we know that the decision to upgrade overall global corporate debt versus government bonds has been far more important than adjusting any regional credit allocations. We see that global “risk-on” dynamic continuing in next few months, fueled by benign monetary policies, thus we are sticking with our current allocations to global corporates. Our cue to reverse our tactical overweight stance on corporates will come from the U.S. Any additional spread tightening and easing of overall financial conditions will keep U.S. economic growth above trend and eventually force the Fed to become more hawkish in the second half of 2019. This will turn global monetary policy from a tailwind for corporate credit to a headwind, justifying a downgrade of corporate allocations. In the meantime, we recommend continuing to earn carry in a policy-induced low volatility environment. Bottom Line: The current low-volatility backdrop, triggered by more dovish central banks, will be maintained until there is more decisive evidence that global growth is rebounding. That will not occur until the latter half of 2019, thus keeping the window for corporate credit outperformance open for a few more months. Stay overweight global corporates versus governments, favoring the U.S. Canada: Upgrade To Neutral Canadian government bonds have been clawing back much of the relative underperformance that occurred in 2017 and 2018 while the Bank of Canada (BoC) was delivering multiple rate hikes. The spread between the yields on the Bloomberg Barclays Canada Treasury index and the overall Global Treasury index has narrowed by -40bps since October 2018, after widening 69bps between May 2017 and October 2018 (Chart 3). Expressed as a relative return (duration-matched and currency-hedged into U.S. dollars), Canadian government debt has lagged the Global Treasury index by -232bps since May 2017. Chart 3Canadian Bonds No Longer Underperforming That underperformance was driven by the combination of a strong Canadian economy, accelerating inflation and tightening monetary policy. The year-over-year pace of real GDP growth reached 3.8% in mid-2017 and stayed above-trend for the following year. The unemployment rate fell to 5.8%, while core inflation accelerated back to the midpoint of the BoC’s 1-3% target band, alongside faster wage growth. The BoC – devotees of the Phillips Curve, like virtually every other DM central bank – took the message from the combination of tight labor markets and rising inflation and embarked on the long march away from a near-zero (0.5%) policy rate back in July 2017. Now, after 20 months and 125bps of rate hikes, Canada’s economy is weakening sharply. Real GDP only grew at a paltry 0.4% annualized pace in the 4th quarter of 2018, dragging the year-over-year pace to 1.6%. Inflation has followed suit, with headline CPI inflation falling from an early 2018 peak of 3% to 1.4% and the BOC’s median CPI index now growing at only a 1.8% pace. The most concerning part for the BoC is that the economy could be decelerating this rapidly with a policy rate of only 1.75%, which is well below the central bank’s estimated 2.5-3.5% range for the neutral rate. Our own BoC Monitor has rapidly fallen towards the zero line, indicating no pressure to either tighten or ease monetary policy (Chart 4). The more recent rapid decline in the BoC Monitor has been driven by the inflation-focused components of the indicator, while the growth-focused elements have been steadily drifting lower since that 2017 peak in real GDP growth. Chart 4Is The BoC Done, Well South Of Neutral? The BoC has been stunned by that shockingly weak Q4/2018 growth outturn. In the official policy statement released following the March 6 BoC meeting, the central bank’s Governing Council was forthright about how the growth uncertainty has put future rate hikes in question: “Governing Council judges that the outlook continues to warrant a policy interest rate that is below its neutral range. Given the mixed picture that the data present, it will take time to gauge the persistence of below-potential growth and the implications for the future inflation outlook. With increased uncertainty about the timing of future rate increases, Governing Council will be watching closely developments in household spending, oil markets and global trade policy.” Rising interest rates may be the big reason why growth has slowed so dramatically in Canada. The BoC’s economic projections for 2019 had already factored in some slowing global growth, as well a hit to business confidence and capital spending from global trade conflicts and last year’s decline in energy prices (a big deal for Canada’s huge oil industry). BoC officials, including Governor Stephen Poloz, have noted that a resolution of the U.S.-China trade tensions could therefore be a positive for the Canadian economy by removing a critical drag on Canadian business confidence and export demand. Yet when looking at the contribution to Canadian real GDP growth from the main components, there have been large drags on growth from consumer spending, capital spending and housing (Chart 5). That suggests that there is something more fundamental than just a series of external shocks at work here. Chart 5Broad-Based Weakness In Canadian Domestic Demand A look at the more interest-sensitive components of the Canadian economy suggests that rising interest rates may be a big reason why growth has slowed so dramatically. Consumer Durables Real consumer spending growth has plunged from a 4% pace in 2018 to 1.3% in Q4/2018, driven by a collapse in demand for consumer durables which contracted -1.2% year-over-year terms (Chart 6). Car sales plunged 7.5% on a year-over-year basis in Q4, suggesting that rising interest rates on auto loans may have been a major factor driving the weakness in durables spending. Softer incomes have also played a role, with wage growth rolling over even with the majority of evidence pointing to a very tight Canadian labor market that is getting even tighter (third panel). The fact that the drop was so focused on durables, however, suggests that higher interest rates were the more likely reason for the plunge in overall consumer spending. Chart 6Weak Canadian Consumption Concentrated In Durables Housing The overheated Canadian housing market has endured the double-whammy of rising mortgage interest rates and increasing macro-prudential changes to mortgage lending. House prices in the hottest Toronto and Vancouver markets – which should be most impacted by the changes in mortgage regulations – have stopped increasing, helping bring the growth in national house prices to only 1.9% (Chart 7). Yet the sharp deceleration of mortgage credit growth, alongside a contraction in housing starts and overall residential investment, suggests that higher mortgage rates could be the bigger driver of the housing weakness. Chart 7Some Long-Needed Cooling Of Canadian Housing The BoC has noted that it is difficult to disentangle the impact of regulatory changes in Canadian mortgages from that of rising interest rates. Yet the impact of higher mortgage rates on Canadian consumer spending power can be seen in the rising debt service ratio for Canadian households. As of Q4/2018, Canadians must now pay 14.5% of their household income to service their debts, an 0.53 percentage point increase over the past two years (Chart 8). For highly indebted Canadian households, who have mortgage debt equal to 107% of disposable income, even a modest pickup in mortgage rates can have a big impact on spending power through higher interest costs. Chart 8Leveraged Canadian Consumers Pinched By Higher Rates Does the fact that consumer spending has fallen so rapidly mean that the interest sensitivity of the Canadian economy is far greater than the BoC has assumed? If so, then the neutral range of 2.5-3.5% for the BoC policy rate may be too high, and the central bank could be closer to, if not already at, the end of its hiking cycle. The low level of the household savings rate – currently only 1.1%, a product of the housing bubble and the associated wealth effects on spending activity – makes Canadian consumers even more vulnerable to rate increases that diminish their spending power. For highly indebted Canadian households, even a modest pickup in mortgage rates can have a big impact on spending power through higher interest costs. Capital Spending Canadian companies have seen a steady decline in corporate profit growth over the past couple of years, decelerating from a 23% pace in 2017 to 2% late in 2018 on a top-down basis. Yet even allowing for that, the -8% contraction in year-over-year real non-residential investment spending in Q4/2018 is a shock. Particularly since the BoC’s Senior Loan Officer Survey showed that credit conditions have been easing, and our own Canadian Corporate Health Monitor is flashing that Canadian companies are in solid financial condition (Chart 9). Chart 9An Unusually Sharp Fall In Canadian Capex Business surveys from the BoC and the Conference Board did both show a sharp plunge in confidence and future sales expectations (bottom panel). This suggests that worries about global trade tensions and diminished trade activity may have weighed on Canadian business confidence and capital spending – especially coming alongside a big drop in oil prices as was seen last year, which hinders the ability of Canadian energy producers to ramp up investment. Canadian exports accelerated over the final half of 2018 while business confidence was falling. However, oil prices have now stabilized and, more importantly, Canadian exports accelerated over the final half of 2018 while business confidence was falling (Chart 10). That acceleration was seen for both energy and non-energy exports, but was also heavily concentrated in exports to China, which are now growing 24% on a year-over-year basis (a pace that is wildly at odds with the overall growth in Chinese imports, suggesting that Canadian exporters have increased their market share in China). Chart 10Should Canadian Companies Be Worried About Global Trade? Could higher corporate borrowing rates, rather than worries about plunging export demand, be the true reason why Canadian companies have so drastically cut back on capital spending? It is no surprise that the BoC has chosen to take a pause on its rate hiking cycle, given all those conflicting messages from the Canadian economic data. The growth slump could be related to global trade uncertainty, or regulatory changes in the housing market, or past declines in oil prices, or previous interest rate increases. Or all of the above. The BoC can also take some time before considering its next interest rate move given cooling inflation and wage growth (Chart 11). The central bank has reduced its estimate of the Canadian output gap to -0.5%, based off the downside surprises already seen in Canadian economic growth. A closed output gap, combined with accelerating inflation, was the main argument the BoC had been using to justify its interest rate increases over the past two years. Now, neither of those conditions is currently in place, and the BoC can take its time to assess the underlying trend of economic growth without having to worry about above-target inflation. Chart 11Slowing Inflation = More Dovish BoC The Governing Council next meets in April, when a new Monetary Policy Report and updated economic projections will be published. The 2019 growth and inflation forecasts will surely be downgraded, perhaps heavily as the European Central Bank just did in response to the sharp growth slowdown in Europe – which led to a new round of monetary easing measures. What will be more interesting from the point of view of Canadian bond investors will be the Bank’s assessment of the size of Canada’s output gap, the pace of trend growth and, perhaps, even the appropriate neutral range for the BoC policy rate. The lowering of any of those three elements would be supportive of Canadian bond yields staying lower for longer. We have maintained an underweight in Canadian government bonds since July 2017, based on our view that the BoC would follow in the Fed’s footsteps and attempt to normalize interest rates. A strong economy and rising inflation would allow them to do that. Now, both the Fed and BoC are on hold, with small probabilities of rate cuts now priced into Overnight Index Swap (OIS) curves (Chart 12). Chart 12BoC Now Less Likely To Follow The Fed Given the BCA view that Fed rate hikes will resume later this year on the back of a rebound in U.S. and global growth, we had been sticking with the bearish view on Canadian government bonds as well. Yet given the stunning drop in Canadian growth that startled the BoC, the odds now favor the BoC staying on hold for longer, even once the Fed begins to hike again. This would also provide additional easing of Canadian financial conditions through a soft Canadian dollar (bottom two panels). We are upgrading our recommended allocation to Canadian bonds to neutral(3 out of 5) this week from underweight (2 out of 5).  In light of this uncertainty over the BoC’s next move given the weak economy, the underlying rationale for our underweight Canada position is no longer applicable. Thus, we are upgrading our recommended allocation to Canadian bonds to neutral (3 out of 5) this week from underweight (2 out of 5). The excess return of Canadian government bonds versus the Global Treasury index since we went to underweight back in July 2017 was -0.83%, so our bearish recommendation did generate positive alpha. In our model bond portfolio, we are funding that additional Canadian allocation from a reduction of the overweight in Japanese government bonds. We are also closing our tactical trade of being long 10-year Canadian Real Return Bonds versus nominal 10-year government debt, at a loss as 10-year inflation breakevens are now 1.6%, or 16bps below the entry level on our trade (Chart 13). Chart 13Upgrade Canadian Government Bonds To Neutral We will contemplate any additional changes to our Canadian allocation after the releases of the latest BoC Business Outlook Survey and Senior Loan Officer Survey on April 15 and the new BoC Monetary Policy Report and economic projections at the April 24 monetary policy meeting. Bottom Line: Much weaker-than-expected Canadian economic growth has surprised the Bank of Canada. Rate hikes are now off the table for at least the rest of 2019, and possibly longer. Upgrade Canadian government debt to neutral (3 out of 5) in global currency-hedged government bond portfolios.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis”, dated January 15th 2019, available at gfis.bcarsearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights Corporate Default Rate: The trailing 12-month corporate default rate is too low according to our macro model. Further, the likely trajectories for corporate profit and debt growth suggest that the default rate is more likely to rise than fall during the next 12 months. We expect the corporate default rate to be above 3% during the next 12 months, higher than the Moody’s baseline forecast of 1.7%. Corporate Bond Valuation: Corporate bond investors are still adequately compensated for default risk, even under our more pessimistic scenario. However, some junk spread widening later this year is possible if market default rate expectations converge with our more pessimistic forecast. Investment Strategy: Corporate spreads have room to tighten in the near-term, due to accommodative Fed policy and a budding improvement in global growth. However, tighter Fed policy and a higher-than-expected corporate default rate could pressure spreads wider in the second half of 2019. We will be quick to back off our overweight corporate bond stance when our near-term spread targets are met. Feature Investors should remain overweight corporate bonds within U.S. fixed income portfolios, but be conscious that the window for outperformance may close quickly. While the Fed’s dovish turn and signs of global growth stabilization will allow spreads to tighten during the next few months, corporate default risk is rising in the background. This week’s report focuses on corporate default risk. We assess where the default rate is headed during the next 12 months and discuss the implications for investment strategy. Default Rate Near A Bottom Chart 1 shows that the trailing 12-month speculative grade default rate has been steadily falling since early 2017. However, it also shows that the fair value reading from our macro-driven default rate model has not fallen as much. The actual trailing 12-month default rate came in at 2.7% in February, the fair value reading from our model stands at a loftier 3.6%. Chart 1Corporate Default Rate Near A Bottom? Our default rate model is based on two factors, Commercial & Industrial bank lending standards and gross corporate leverage. The latter is defined as total nonfinancial corporate debt divided by pre-tax profits. With that in mind, our model provides a framework for assessing where the default rate is headed under different scenarios for corporate profit and debt growth. We consider each of these two factors in turn. Corporate Profit Growth Will Moderate Nonfinancial corporate pre-tax profits grew an astonishing 17% during the four quarters ending in Q3 2018, but all leading indicators point to deceleration in Q4 2018 and beyond. On the revenue side of the ledger, leading indicators are in universal agreement that growth is poised to slow (Chart 2): Chart 2Corporate Revenues Will Soften The ISM Manufacturing index has fallen to 54.2 from a recent peak above 60. The year-over-year growth rate in total business sales came in at 2% in December, down from a recent peak of 8.4%. The year-over-year growth rate in industrial production fell to 3.5% in February, from a September peak of 5.7%. The year-over-year growth rate in the U.S. Leading Economic Indicator is down to 3.2% as of January, from a September peak of 6.8%. Clearly, the global growth slowdown has migrated to the U.S. and the impact is being seen in the leading U.S. economic data. Some slowdown in corporate revenue growth is all but assured. All leading indicators point to deceleration in corporate profit growth in Q4 2018 and beyond. Corporate profit growth and investment spending are tightly linked in the sense that firms are more likely to take on new projects when they feel better about their future cash flow prospects. The upshot is that we can infer trends in corporate profits by looking at data on investment spending and firms’ investment plans. That data paint a similar picture of widespread deceleration (Chart 3): Chart 3Investment Indicators The year-over-year growth rate in core durable goods orders is down to 4% from a recent peak close to 9%. An average of firms’ capital spending plans as reported in regional Fed surveys remains elevated, but has declined markedly in recent months. Small business capital spending plans, as reported to the NFIB, have fallen sharply during the past few months. Periods of tightening lending standards coincide with decelerating corporate debt. Wage growth is another important driver of corporate profits. In particular, we can get a read on profit growth by looking at the difference between corporate selling prices and unit labor costs, aka our Profit Margin Proxy (Chart 4). Our Profit Margin Proxy remains at a high level because growth in unit labor costs has been tepid. Even though top-line wage growth has improved, this has been matched by an acceleration in productivity growth (Chart 4, bottom panel). The latter has kept unit labor costs low, even as nominal wages have risen. Chart 4Wage Growth A Drag On Profits Extremely tight labor markets will lead to a continued acceleration in wage growth during the next few quarters.1 Meanwhile, the prospect for continued rapid productivity growth is much more uncertain. It seems reasonable to expect that corporate profits will come under some downward pressure from rising unit labor costs during 2019. Finally, we can get a sense of the corporate profit outlook by looking at equity analyst net earnings revisions (Chart 5). Analyst earnings per share (EPS) upgrades outpaced downgrades for most of 2018, but that trend reversed sharply near the end of last year. Analysts are once again lowering EPS forecasts more often than they are raising them. Chart 5More EPS Downgrades Than Updgrades Debt Growth Should Also Slow Fortunately, some of the balance sheet impact from decelerating profits will likely be offset by slower debt growth during the next few quarters. Corporate debt growth has been robust and fairly stable since 2012, but C&I lending standards tightened slightly in the fourth quarter of last year. Typically, periods of tightening lending standards coincide with decelerating corporate debt (Chart 6). Chart 6Tighter Lending Standards Implies Slower Debt Growth Anecdotally, several high profile firms have recently taken steps to curtail debt growth. Most notably, General Electric just announced a major asset divestment to pay down debt, and the stock market rewarded them for doing so. If our default rate forecast turns out to be correct and the Moody’s forecast is eventually revised higher, it will likely coincide with some junk spread widening. More broadly, we observe that firms with low debt/asset ratios have been outperforming firms with high debt/asset ratios, a dynamic that tends to occur when lending standards are tightening and corporate debt growth is falling (Chart 7). Chart 7Low Leverage Firms Are Outperforming For a sense of scale, nonfinancial corporate debt grew 6.5% in the four quarters ending Q4 2018 and has averaged 6.3% since 2012. Some mild deceleration from these growth rates is likely during the next few quarters. Putting It All Together Table 1 shows that trailing 12-month profit growth of 17% and debt growth of 6.5% led to gross corporate leverage of 6.95, which translates to a fair value default rate of 3.6%. Table 1 also shows where the fair value default rate will head during the next 12 months based on different scenarios for profit and debt growth. Table 1Default Rate Scenarios For example, if profits grow by 5% and debt growth is between 0% and 8%, then the fair value default rate will be between 3.5% and 4.1% one year from now. This seems like a reasonable scenario based on our macro forecast. A scenario that would result in a default rate that is much higher than the current Moody’s baseline forecast of 1.7%. And One More Thing Though they are not included in our model, job cut announcements are a fairly reliable coincident indicator of corporate defaults. Recently, job cut announcements have clearly bottomed even as the default rate has continued to fall (Chart 8). This is a clear warning sign that the default rate might head higher in the coming months. Chart 8Warning Sign From Job Cuts Bottom Line: The trailing 12-month corporate default rate is too low according to our macro model. Further, the likely trajectories for corporate profit and debt growth suggest that the default rate is more likely to rise than fall during the next 12 months. We expect the corporate default rate to be above 3% during the next 12 months, higher than the Moody’s baseline forecast of 1.7%. It increasingly looks like the second half of 2019 will be more challenging for corporate credit. Are Investors Adequately Compensated For Default Risk? Forecasting the default rate is important, but it is only one side of the coin when it comes to corporate bond investing. The other relevant question is whether current spreads offer adequate compensation for expected defaults. At present, the average option-adjusted spread (OAS) on the Bloomberg Barclays High-Yield index is 388 bps. If we assume that defaults occur in line with the Moody’s baseline forecast during the next 12 months, then we would expect default losses of approximately 90 bps (assuming a 49% recovery rate).2 That translates to an excess junk spread of 298 bps, well above the historical average realized excess spread of 250 bps. In other words, investors should expect better than average excess junk returns if the Moody’s baseline default rate forecast turns out to be correct. However, our analysis suggests that the default will be significantly higher during the next 12 months. If we assume a 3.5% default rate, more in line with our macro forecast, and a slightly lower recovery rate of 45%, then the excess spread available in the high-yield index falls to 198 bps. This number is still positive, so unless there is significant spread widening investors should still earn a positive excess return versus Treasuries, but it is considerably below average historical levels. Another factor to consider is the historical correlation between junk spreads and the Moody’s baseline default rate forecast. We find that the average high-yield OAS has the strongest positive correlation with the 9-month forward Moody’s baseline default rate expectation (Chart 9). In other words, if our default rate forecast turns out to be correct and the Moody’s forecast is eventually revised higher, it will likely coincide with some junk spread widening. Chart 9Default Rate Revisions Will Lead To Wider Spreads Bottom Line: Corporate bond investors are still adequately compensated for default risk, even under our more pessimistic scenario. However, some junk spread widening later this year is possible if market default rate expectations converge with our more pessimistic forecast. Investment Strategy While this report has focused on detecting early warning signs of default risk, that is not the only thing that matters for corporate spreads. We continue to believe that spreads have room to tighten in the near-term, due to accommodative Fed policy and a budding improvement in global growth.3 The purpose of this report is to stress that our current overweight stance on corporate bonds is unlikely to last through to the end of the year. First, if spreads tighten during the next few months leading to an easing in overall financial conditions, then the Fed will probably turn more hawkish in the second half of 2019 and monetary policy will shift from being a tailwind for corporate credit to a headwind. This shift could occur at around the same time that corporate defaults start to exceed current expectations. As a matter of strategy, we have published spread targets for each corporate credit tier based on average spread levels seen during similar stages of past economic cycles (Charts 10A & 10B).4 We will be quick to move off our overweight stance once these spread targets are achieved. Note that Aaa spreads are already below target. We recommend that investors avoid Aaa-rated corporate bonds. Chart 10AInvestment Grade Spread Targets Chart 10BHigh-Yield Spread Targets While the current environment remains positive, it increasingly looks like the second half of 2019 will be more challenging for corporate credit. Stay tuned. Ryan Swift,  U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 For further details on the amount of labor market slack in the economy please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 2 We forecast the recovery rate based on its inverse historical relationship with the default rate. A higher default rate implies a lower recovery rate, and vice-versa. 3 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 4 For more details on our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com

Highlights Chart 1Track The CRB/Gold Ratio Earlier this year the Fed signaled a dovish policy shift in response to slowing global growth and tighter financial conditions. In large part due to the Fed’s move, financial conditions are now easing and the CRB Raw Industrials index – a timely proxy for global growth – is starting to perk up. But when will this improvement translate to higher Treasury yields? The CRB/gold ratio offers some clues. Gold moves higher when monetary policy eases. Then with a lag, that easier policy spurs stronger global growth and a rising CRB index. Eventually, that stronger growth puts rate hikes back on the table. A more hawkish Fed limits the upside in gold and sends Treasury yields higher. In fact, we find that the 10-year Treasury yield only starts to rise when the CRB index outpaces the gold price (Chart 1). The recent jump in the CRB index is a positive sign, but we shouldn’t expect Treasury yields to rise until the CRB/gold ratio heads higher. In the meantime, investors should maintain below-benchmark portfolio duration and initiate positive-carry yield curve trades (see page 10) to boost returns while we wait for the next upward adjustment in yields. Feature Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 59 basis points in February, bringing year-to-date excess returns up to +243 bps. The Federal Reserve’s pause opens a window for corporate spreads to tighten during the next few months. We recommend overweight positions in corporate bonds for now, but will be quick to reduce exposure once spreads reach our near-term targets (Chart 2). Chart 2Investment Grade Market Overview In last week’s report we published option-adjusted spread targets for each corporate credit tier.1 The targets are based on the median 12-month breakeven spreads during prior periods when the slope of the yield curve is quite flat but not yet inverted, what we call a Phase 2 environment.2 Currently, the Aa-rated spread of 59 bps is 3 bps above our target (panel 2). The A-rated spread of 91 bps is 6 bps above our target (panel 3). The Baa-rated spread of 156 bps is 28 bps above our target (panel 4). The Aaa-rated spread is already below our target. We advise investors to avoid the Aaa-rated credit tier. With profit growth poised to moderate during the next few quarters, it is unlikely that gross corporate leverage will continue to decline at its current pace (bottom panel). As such, we will be quick to reduce corporate bond exposure when spreads reach our targets. Renewed Fed hawkishness will be another headwind for corporate bonds in the second half of the year. High-Yield: Overweight High-Yield outperformed the duration-equivalent Treasury index by 175 basis points in February, bringing year-to-date excess returns up to +590 bps. In last week’s report we published near-term spread targets for each high-yield credit tier.3 The targets are based on the median 12-month breakeven spreads seen during periods when the yield curve is quite flat but not yet inverted, what we call a Phase 2 environment.4 At present, the Ba-rated option-adjusted spread is 224 bps, 37 bps above our target. The B-rated spread is 376 bps, 81 bps above our target. The Caa-rated spread is 780 bps, 208 bps above our target. Our default-adjusted spread is an alternative measure of high-yield valuation. It represents the excess spread available in the High-Yield index after accounting for expected default losses. It is currently 243 bps, very close to the historical average of 250 bps (Chart 3). In other words, if corporate defaults match the Moody’s baseline forecast during the next 12 months, high-yield bonds will return 243 bps in excess of duration-matched Treasuries, assuming no change in spreads. Chart 3High-Yield Market Overview The Moody’s baseline forecast calls for a default rate of 2.4% during the next 12 months. This appears a touch too optimistic, as our own macro model is calling for a default rate closer to 3.5%.5 In either case, junk bonds currently offer adequate compensation for default risk. MBS: Neutral Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in February, bringing year-to-date excess returns up to +39 bps. The conventional 30-year zero-volatility spread tightened 2 bps on the month, driven by a 5 bps decline in the compensation for prepayment risk (option cost). The fall in option cost was partially offset by a 3 bps widening in the option-adjusted spread (OAS). The recent drop in the 30-year mortgage rate led to a jump in mortgage refinancings from historically low levels, putting some temporary upward pressure on MBS spreads (Chart 4). However, the relatively tepid pace of new issuance during the past few years means that the existing MBS stock is not very exposed to refinancing risk, even if mortgage rates fall further. All in all, we view agency MBS as one of the safest spread products in the current macro environment. Chart 4MBS Market Overview The problem with MBS is that valuation remains unattractive. The index option-adjusted spread for conventional 30-year MBS is well below its average pre-crisis level (panel 3) and the sector offers less compensation than normal compared to corporate bonds (panel 4). We continue to recommend a neutral allocation to agency MBS. An upgrade will only be appropriate when value in the corporate sector is no longer attractive relative to expected default risk. Government-Related: Underweight The Government-Related index outperformed the duration-equivalent Treasury index by 38 basis points in February, bringing year-to-date excess returns up to +92 bps. Sovereign debt outperformed duration-equivalent Treasuries by 97 bps on the month, bringing year-to-date excess returns up to +320 bps. Local Authorities outperformed the Treasury benchmark by 54 bps in February, bringing year-to-date excess returns up to +86 bps. Foreign Agencies outperformed by 44 bps in February, bringing year-to-date excess returns up to +109 bps, while Domestic Agencies outperformed by 12 bps on the month, bringing year-to-date excess returns up to +9 bps. Supranationals outperformed by 10 bps in February, bringing year-to-date excess returns up to +13 bps. The USD-denominated sovereign debt of most countries continues to look expensive relative to equivalently-rated U.S. corporate credit. However, in a recent report we highlighted that Mexican sovereign debt is an exception (Chart 5).6 Chart 5Government-Related Market Overview Not only is Mexican sovereign debt cheap relative to U.S. corporate credit, but our Emerging Markets Strategy service highlights that the Mexican peso is very cheap as measured by the real effective exchange rate based on unit labor costs.7 This is not surprising given that the peso has been relatively flat versus the dollar during the past two years, despite real interest rates being much higher in Mexico than in the U.S. Municipal Bonds: Overweight Municipal bonds outperformed the duration-equivalent Treasury index by 85 basis points in February, bringing year-to-date excess returns up to +92 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 5% in February, and currently sits at 81% (Chart 6). This is more than one standard deviation below its post-crisis mean and right at the average level that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview In other words, municipal bonds on average are no longer cheap. Rather, they appear fairly valued compared to similar prior macro environments. But a pure focus on the average yield ratio across the curve hides an important distinction. The yield ratio for short maturities (2-year and 5-year) is very low relative to history, while the yield ratio for long maturities (10-year, 20-year and 30-year) remains quite cheap (panel 2). Investors should continue to focus on long-maturity municipal debt to add yield to U.S. bond portfolios. In our research into the phases of the credit cycle, we often divide the cycle based on the slope of the yield curve. Since 1983, in the middle phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and 50 bps (where it stands today), investment grade corporate bonds have delivered annualized excess returns of +3 bps. In contrast, municipal bonds have delivered annualized excess returns of +64 bps (before adjusting for the tax advantage).8 Given strong historical returns during the current phase of the cycle and the fact that our Municipal Health Monitor remains in “improving health” territory (bottom panel), we advocate an overweight allocation to municipal bonds. Treasury Curve: Favor 2/30 Barbell Over 7-Year Bullet Treasury yields rose in February, led by the long-end of the curve. The 2/10 Treasury slope steepened 3 bps on the month and currently sits at 21 bps. The 5/30 slope steepened 1 bp on the month and currently sits at 57 bps. Our 12-month fed funds discounter remains below zero, meaning that the market is priced for rate cuts during the next year (Chart 7). We continue to view rate hikes as more likely than cuts on this time horizon, and therefore recommend yield curve trades that will profit from a move higher in our discounter. In prior research we found that the 5-year and 7-year Treasury maturities are most sensitive to changes in our discounter, so any trade where you sell the 5-year or 7-year bullet and buy a duration-matched barbell consisting of the long and short ends of the curve will provide the appropriate exposure.9 Chart 7Treasury Yield Curve Overview An added benefit of implementing a barbell over bullet strategy in the current environment is that barbells currently offer higher yields than bullets, meaning that you earn positive carry as you wait for the market to price rate hikes back into the curve (bottom 2 panels).10 Not surprisingly, barbell strategies also look attractively valued on our yield curve models, the output of which is found in Appendix B. TIPS: Overweight TIPS outperformed the duration-equivalent nominal Treasury index by 36 basis points in February, bringing year-to-date excess returns up to +120 bps. The 10-year TIPS breakeven inflation rate rose 11 bps on the month and currently sits at 1.96%. The 5-year/5-year forward TIPS breakeven inflation rate rose 7 bps on the month and currently sits at 2.07%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. After last month’s increase, the 10-year TIPS breakeven inflation rate is currently very close to the fair value reading from our Adaptive Expectations model (Chart 8).11 This model is based on a combination of backward-looking and forward-looking inflation measures and is premised on the idea that investors’ inflation expectations take time to adjust to changing macro environments. The current fair value reading from the model is 1.97%, but that fair value will trend steadily higher as long as core CPI inflation remains above 1.84%. The 1.84% threshold is the annualized trailing 10-year growth rate in core CPI, and it is the most important variable in the model. Chart 8Inflation Compensation On that note, core CPI has increased at an annual rate of 2.58% during the past four months, well above the necessary threshold. And while some forward-looking inflation measures have moderated, notably the ISM Prices Paid index (panel 3), this is largely a reaction to the recent drop in energy prices. A drop that should reverse as global growth improves in the coming months. ABS: Neutral Cut To Underweight Asset-Backed Securities outperformed the duration-equivalent Treasury index by 22 basis points in February, bringing year-to-date excess returns up to +38 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 8 bps on the month and currently sits at 31 bps, 3 bps below its pre-crisis low (Chart 9). Chart 9ABS Market Overview Our excess return Bond Map, shown in Appendix C on page 18, shows that Aaa-rated ABS offer a relatively poor risk/reward trade-off compared to other U.S. bond sectors. Aaa-rated auto loan ABS in particular offer greater risk and lower potential return than the Aggregate Plus index (the Bloomberg Barclays Aggregate index plus high-yield).  Tight spreads look even more unattractive when you consider that the delinquency rate for consumer credit is rising, and according to the uptrend in household interest expense, will continue to march higher in the coming quarters (panel 4). Lending standards are also tightening for both credit cards and auto loans, a dynamic that often coincides with a rising delinquency rate and wider ABS spreads (bottom panel). Given the recent spread tightening, we advise investors to reduce consumer ABS exposure in U.S. bond portfolios. Other sectors, such as Agency CMBS, offer a more attractive risk/reward trade-off within high-rated spread product. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 74 basis points in February, bringing year-to-date excess returns up to +142 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 13 bps on the month and currently sits at 93 bps, below the average pre-crisis level but somewhat higher than the recent tights (Chart 10). Chart 10CMBS Market Overview The Fed’s Senior Loan Officer Survey showed that banks tightened lending standards on commercial real estate (CRE) loans in Q4 and witnessed falling demand (bottom 2 panels). This, coupled with decelerating CRE prices paints a relatively negative picture for non-agency CMBS. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Teasury index by 49 basis points in February, bringing year-to-date excess returns up to +77 bps. The index option-adjusted spread tightened 8 bps on the month and currently sits at 48 bps. The excess return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector continues to make sense. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 2 basis points of rate cuts during the next 12 months. Given that we expect the Fed to deliver rate hikes in the second half of this year, we recommend that investors maintain below-benchmark portfolio duration. Chart 11The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the change in the fed funds rate. 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. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. 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 +55 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 55 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of February 28, 2019) Table 5Butterfly Strategy Valuation: Standardized Residuals (As of February 28, 2019) Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return.   Ryan Swift,  U.S. Bond Strategist rswift@bcaresearch.com   Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 7 Please see Emerging Markets Strategy Weekly Report, “Dissecting China’s Stimulus”, dated January 17, 2019, available at ems.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 9  Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018 available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Fed: With financial conditions easing and core inflation more likely to rise than fall, the majority of Fed officials will feel justified lifting rates again in the second half of this year. The best way to position for the resumption of rate hikes is to sell the 5-year or 7-year part of the Treasury curve and buy a duration-matched barbell consisting of the short and long ends of the curve. These sorts of positions currently offer positive carry, meaning you get paid as you wait for the market to price rate hikes back in. Corporate Spreads: Maintain an overweight allocation to corporate bonds (both investment grade and high-yield) with the exception of the Aaa credit tier. But be prepared to reduce exposure when spreads reach our target levels. Economy: Tracking estimates for 2018 Q4 and 2019 Q1 real GDP have fallen significantly during the past two weeks. The decline in tracking estimates is heavily influenced by an abnormal December retail sales report. That impact will reverse in 2019. Feature The Federal Reserve’s “on hold” strategy is now well known and has been completely discounted in the market. In fact, the overnight index swap curve is priced for 9 bps of rate cuts during the next 12 months and 21 bps of cuts during the next 24 months (Chart 1). Chart 1Primary Dealers Still Looking For Hikes At this point, the only thing that’s unclear is how the Fed will respond to the economic data going forward. Will it be eager to re-start rate hikes at the first sign of calm? Or perhaps the Fed is leaning toward a strategy where the next move will be a rate cut in the face of flagging economic growth? Survey Says Unfortunately, last month’s FOMC meeting was not accompanied by an updated Summary of Economic Projections. We therefore don’t know how policymakers have revised their rate hike expectations since December. However, the New York Fed’s Survey of Primary Dealers was updated in January, and it shows that the median primary dealer still expects two rate hikes this year. The only change between the December and January surveys is that the median primary dealer now expects one of the 2019 rate hikes in June and the other in December. In the December survey, both 2019 rate hikes were anticipated before the end of June (Chart 1). Typically, the median primary dealer and the median FOMC participant have very similar views on the future interest rate trajectory. Counting The Minutes The next stop on our search for clarity is the minutes from the January FOMC meeting, which were released last week. The January minutes provide a lot of insight into the thought processes of different FOMC participants. Unfortunately, they also reveal a serious lack of cohesion amongst the group. All in all, the document might confuse more than it clarifies. A few key excerpts from the document drive this point home. Referring to “global economic and financial developments”: Many participants observed that if uncertainty abated, the Committee would need to reassess the characterization of monetary policy as “patient” and might then use different language. This suggests that many Fed participants view the pause in rate hikes as a result of slower non-U.S. growth and tighter financial conditions. They also suggest that if global growth improves and financial conditions ease it would be appropriate to abandon a “patient” stance. … several […] participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook. This second statement is much more dovish than the first. It suggests that several participants think that even improving global growth and an easing of financial conditions would not be sufficient to re-start rate hikes. They would also need to see inflation come in stronger than expected. Several other participants indicated that, if the economy evolved as they expected, they would view it as appropriate to raise the target range for the federal funds rate later this year. Finally, this last statement reveals that several other participants disagree with the view that an unexpected rise in inflation is a pre-condition for further rate hikes. What can we make of all this mess? The first thing that seems clear is that all Fed members view easier financial conditions as a pre-condition for further rate hikes. In this regard, we are already well on our way. Financial conditions have eased considerably since the start of the year, with the stock-to-bond total return ratio up sharply and credit spreads, the VIX and the dollar all off their highs (Chart 2). Chart 2Financial Conditions Are Easing Second, all FOMC participants need more confidence that inflation will return to target before re-starting rate hikes, but this bar seems higher for some than for others. Year-over-year core and trimmed mean CPI are currently running at 2.15% and 2.19%, respectively. This is slightly below the 2.4% level that is consistent with the Fed’s inflation target (Chart 3).1 The minutes suggest that some FOMC participants would be comfortable re-starting rate hikes as long as core inflation moves higher in the next few months and approaches the Fed’s target from below. Some others, however, may need to see an overshoot of the Fed’s inflation target before recommending rate hikes. Chart 3Core Inflation Needs To Move Higher Depressed inflation expectations, as seen in the TIPS market or the Michigan Consumer Sentiment survey, are a related issue (Chart 3, bottom 2 panels). The Fed will probably want to see upward movement in both of these measures before resuming rate hikes. In fact, New York Fed President John Williams warned last week that the “persistent undershoot of the Fed’s [inflation] target risks undermining the 2 percent inflation anchor.” He added that “the risk of the inflation expectations anchor slipping toward shore calls for a reassessment of the dominant inflation targeting framework.”2 Williams has long been an advocate for a monetary policy framework where the Fed targets an overshoot of its inflation target in the future to “make up” for undershooting its target in the past, i.e. some form of price level targeting. The Fed is currently conducting a year-long investigation into whether it should switch to this sort of regime and we learned last week that the Fed will announce the results of its investigation in the first half of 2020. Our own sense is that the Fed will eventually adopt some sort of “history dependent” inflation target as a way to avoid continuously bumping up against the zero-lower bound on interest rates. But this change will not occur this year and maybe not even next year. Of course, the more immediate concern for bond investors is whether inflation pressures will be meaningful enough in the next few months for the Fed to resume rate hikes in 2019. We expect they will be. We have previously shown that base effects alone will pressure year-over-year core CPI higher as we head toward mid-year.3 Meanwhile, other signs also point toward rising core inflation (Chart 4): Chart 4Inflation Pressures Building The New York Fed’s Underlying Inflation Gauge is running close to 3% (Chart 4, top panel). The ISM Manufacturing PMI is off its highs, but is still consistent with rising year-over-year core CPI (Chart 4, panel 2). Our CPI Diffusion Index is deep in positive territory, pointing to further near-term upside in the core measure (Chart 4, bottom panel). Bottom Line: With financial conditions easing and core inflation more likely to rise than fall, the majority of Fed officials will feel justified lifting rates again this year. January’s FOMC minutes imply that several Fed members want to see an overshoot of the inflation target before advocating for the resumption of rate hikes, but until the Fed changes its inflation targeting regime they will likely be out-voted. The Best Way To Trade The Fed We continue to recommend a below-benchmark duration bias in U.S. bond portfolios, on the view that rate hikes will exceed depressed market expectations on a 12-month horizon. However, this is not the most attractive way to position for the resumption of Fed rate hikes. The best way to trade the Fed in the current environment is by initiating a duration-neutral yield curve trade where you buy a barbell consisting of the long and short ends of the curve, and sell the 5-year or 7-year maturity. In a prior report we demonstrated that the 5-year and 7-year Treasury yields are most sensitive to changes in our 12-month fed funds discounter.4 That is, when the market starts to price-in more Fed rate hikes, the 5-year and 7-year Treasury yields increase more than other maturities. Similarly, the 5-year and 7-year yields fall the most when our discounter declines. Clearly, this means that if you are short the 5-year/7-year part of the curve versus the wings, you will make money as rate hikes are priced back into the market. Usually the problem with implementing such a trade is that it has negative carry. That is, the 5-year or 7-year bullet typically offers a greater yield than what you would earn on a duration-matched 2/10 or 2/30 barbell. If you don’t time the trade properly, you end up losing money waiting for Fed rate hike expectations to move. However, this is not a problem at the moment. In fact, duration-matched barbells are now positive carry propositions relative to 5-year and 7-year bullets (Chart 5). Chart 5 Barbell Yields Greater Than Bullet Yields In other words, if you think rate hikes will resume at some point, you are currently getting paid to wait for the market to catch on. The only way to lose money in this sort of trade is if our 12-month fed funds discounter falls further from its current -9 bps level. We view that as an unlikely scenario. Bottom Line: The best way to position for the resumption of Fed rate hikes is to sell the 5-year or 7-year part of the Treasury curve, and buy a barbell consisting of the long and short ends of the curve. We currently recommend being short the 7-year and long the 2/30 barbell. This trade has positive carry, meaning that you will earn money as you wait for rate hikes to get priced back in.  Corporate Spread Targets As we have discussed in prior reports, we think the Fed’s pause opens up a window where corporate bond spreads have room to tighten during the next few months.5 However, we also acknowledge that the window for outperformance is limited. Once financial conditions ease and the Fed resumes rate hikes, the environment will quickly become more difficult for corporate bonds. For this reason, in last week’s report we presented Chart 6. The diamonds in Chart 6 show where corporate 12-month breakeven spreads are today relative to past “Phase 2” periods, which are environments similar to today when the yield curve is quite flat but still positively sloped.6 We argued that we would be quick to reduce corporate bond exposure when the breakeven spreads reach the historical median for Phase 2 periods, i.e. when the diamonds fall to the 50% line in Chart 6. However, we acknowledge that this is not a helpful guide for investors who don’t have timely access to our valuation metrics. So this week we present Charts 7A and 7B. These charts estimate the option-adjusted spread (OAS) levels for each credit tier of the Bloomberg Barclays corporate bond indexes that would be consistent with the 50% line in Chart 6. To make these estimates we need to assume that the average duration of each index remains constant. The results show the following spread targets: For Aa we target 55 bps. The current OAS is 61 bps. For A we target 84 bps. The current OAS is 94 bps. For Baa we target 128 bps. The current OAS is 161 bps. For Ba we target 186 bps. The current OAS is 236 bps. For B we target 298 bps. The current OAS is 391 bps. For Caa we target 571 bps. The current OAS is 813 bps. We do not recommend an overweight allocation to Aaa-rated corporate bonds, where spreads are already expensive relative to past Phase 2 periods (Chart 7A, top panel). Chart 7aInvestment Grade Spread Targets Chart 7BHigh-Yield Spread Targets   Bottom Line: Maintain an overweight allocation to corporate bonds (both investment grade and high-yield) with the exception of the Aaa credit tier. But be prepared to reduce exposure when spreads reach our target levels. Economic Update We will finally receive GDP data for the fourth quarter of 2018 on Thursday, and investors should ready themselves for a weak number. In fact, the most recent tracking estimates from the New York Fed have real GDP coming in at 2.35% in Q4 and a mere 1.20% in 2019 Q1 (Chart 8). Chart 8Poor GDP Tracking Estimates ... It will come as no surprise that the trend in GDP growth is vital to our interest rate call. In fact, we showed in a recent report that when year-over-year nominal GDP growth falls below the 10-year Treasury yield it is often a good signal that monetary policy has turned restrictive and that interest rates have peaked for the cycle.7 With that in mind, if we add 1.2% expected real growth in Q1 to the 1.7% average growth rate of the GDP deflator (Chart 8, bottom panel), we can roughly estimate nominal GDP growth of 2.9% in Q1. This remains above the current 10-year Treasury yield, suggesting that monetary conditions would still be accommodative, but just barely. However, we expect the Q1 tracking forecast to improve as new data come in. According to the New York Fed’s model, the weak December retail sales report trimmed 0.41% from its Q1 growth forecast and this report increasingly looks like an aberration. In contrast to the retail sales number, the Johnson Redbook index of same-store sales is growing at a rate close to 5%, and indexes of consumer confidence remain elevated (Chart 9). Chart 9...Driven By Abnormal Retail Sales Even the Fed staff’s economic report, as presented in the January FOMC minutes, suggests that December should have been a good month for consumer spending: The release of the retail sales report for December was delayed, but available indicators – such as credit card and debit card transaction data and light motor vehicle sales – suggested that household spending growth remained strong in December. Bottom Line: However, we expect the Q1 tracking forecast to improve as new data come in. According to the New York it seems likely that the partial government shutdown influenced the collection of the December retail sales data and led to an abnormal print. Since the retail sales data feed directly into GDP, the impact will be felt in the next GDP report. But the impact will prove fleeting.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 The Fed’s target is for 2% PCE inflation. CPI tends to run about 0.4% above PCE. 12-month core PCE is currently 1.88%, but data only go to November. This is why we refer to CPI in this report, which has data through January. 2 https://www.newyorkfed.org/newsevents/speeches/2019/wil190222 3 Please see U.S. Bond Strategy Weekly Report, “Caught Offside”, dated February 12, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 6 For more detail on the different phases of the economic cycle please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “Running Room”, dated January 29, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Spread Product Valuation: Corporate bond spreads don’t look especially cheap relative to average historical levels. But they are far too elevated for the current phase of the economic cycle. Valuations in other spread products are not nearly as attractive. Investors should remain overweight corporate bonds (both investment grade and junk) within U.S. fixed income portfolios. Corporate Defaults: Slowing corporate profit growth during the next 12 months will cause corporate leverage to flatten-off and will lead to a slightly higher default rate than most baseline forecasts suggest. Junk spreads currently offer adequate compensation for the extra default risk, but that cushion will evaporate quickly if spreads tighten during the next few months. Mexican Sovereign Bonds: Mexico’s USD-denominated sovereign debt is attractively priced relative to similarly-rated U.S. corporate credit. U.S. fixed income investors should take the opportunity to add USD-denominated Mexican bonds to their portfolios. Feature Corporate bonds have been on fire since the start of the year. High-yield excess returns have already made back all of their lost ground from 2018, and investment grade credits are on their way (Chart 1). With the Fed’s rate hike cycle on hold and some signs of credit easing in China, the near-term backdrop is amenable to further spread compression. Especially from current elevated levels. Chart 1Corporate Bonds Having A Good Run In 2019 On the flipside, some indicators of corporate default risk are starting to deteriorate and we can easily envision a more difficult environment for corporate spreads in the second half of this year. Especially if the Fed re-starts rate hikes, as we expect.1 In this week’s report we illustrate the extent of undervaluation in corporate spreads, and also detail our concerns related to budding default risk. We conclude that investors should maintain an overweight allocation to corporate bonds (both investment grade and high-yield) for now, but be prepared to trim exposure once spreads reach more reasonable levels. Finally, we identify an opportunity in USD-denominated Mexican sovereign bonds. Too Cheap For Phase 2 In our Special Report from mid-December that laid out our key themes for 2019, we described how we split the economic cycle into different phases based on the slope of the yield curve (Chart 2).2 We define the three phases of the cycle as follows: Chart 2Expect To Stay In Phase 2 For Most (If Not All) Of 2019 Phase 1: From the end of the prior recession until the 3-year / 10-year Treasury slope flattens to below 50 bps Phase 2: When the 3/10 slope is between 0 bps and 50 bps Phase 3: From when the 3/10 slope inverts until the start of the next recession Dividing the cycle this way reveals a reliable pattern in corporate bond excess returns versus Treasuries. Excess returns tend to be highest in Phase 1. They tend to be quite low but still positive in Phase 2, and they tend not to turn negative until Phase 3. We argued in December that we are currently in Phase 2 and that we will probably stay there for most, if not all, of 2019. The main reason that excess returns are lower in Phase 2 than in Phase 1 is that corporate bond spreads are much tighter in Phase 2. Most of the cyclical spread compression occurs in Phase 1, in the immediate aftermath of the recession. With that in mind, consider the data presented in Chart 3. The chart shows 12-month breakeven spreads for each corporate bond credit tier as a percentile rank relative to history.3 For example, a percentile rank of 50% means that the breakeven spread has been tighter than its current level half of the time throughout history. Chart 3 also divides the historical data into two samples, showing how breakeven spreads rank relative to the entire history of available data, and also how they rank relative to other Phase 2 periods only. When the full historical sample is considered, only the B-rated and Caa-rated credit tiers have breakeven spreads above their historical medians. However, when we focus exclusively on Phase 2 environments we see that spreads for every credit tier other than Aaa look extremely cheap. Essentially, Chart 3 shows that today’s spread levels are more consistent with periods when the economy is either just exiting or entering a recession. Absent that sort of macro environment, there would appear to be an obvious buying opportunity in corporate bonds. Interestingly, other spread products don’t look nearly as cheap as corporate bonds. Chart 4 shows the same data as Chart 3 but for all non-corporate U.S. spread products with available data prior to 2000. It shows that Agency MBS and Consumer ABS spreads are close to median Phase 2 levels. USD-denominated Sovereign debt looks somewhat cheap. Meanwhile, Domestic Agencies and Supranationals both look expensive. What’s clear is that right now corporate credit offers the most attractive opportunity in U.S. fixed income. Bottom Line: Corporate bond spreads don’t look especially cheap relative to average historical levels. But they are far too elevated for the current phase of the economic cycle. Valuations in other spread products are not nearly as attractive. Investors should remain overweight corporate bonds (both investment grade and junk) within U.S. fixed income portfolios. Default Cycle At A Turning Point?  Another valuation tool in our arsenal is the High-Yield default-adjusted spread. This is the excess spread available in the high-yield index after accounting for expected 12-month default losses. It can also be thought of as the 12-month return earned by the High-Yield index in excess of a position in duration-matched Treasuries, assuming that default losses match expectations and that there are no capital gains (losses) from spread tightening (widening). Expected default losses are calculated using the Moody’s baseline default rate forecast and our own forecast of the recovery rate. Combining the Moody’s baseline default rate forecast of 2.4% and our recovery rate forecast of 45% gives expected 12-month default losses of 1.3%. Those expected default losses are then subtracted from the average High-Yield index option-adjusted spread to get a default-adjusted spread of 274 bps. This is slightly above the historical average of 250 bps (Chart 5). In other words, junk investors are currently being compensated at slightly above average levels to bear default risk. Chart 5A Look At The Default-Adjusted Spread Another way to conceptualize the default-adjusted spread is to ask what default rate would have to prevail over the next 12 months for junk investors to earn average historical excess compensation. This spread-implied default rate is denoted by the ‘X’ in the second panel of Chart 5. It is currently 2.8%, slightly above Moody’s baseline expectation. Is The Baseline Default Rate Forecast Reasonable? If we view the Moody’s 2.4% default rate forecast as reasonable, then we should conclude that junk bonds are attractively valued. However, some macro indicators suggest that 2.4% might be too optimistic. Chart 6 shows a model of the 12-month trailing speculative grade default rate based on gross leverage, which we define as total debt over pre-tax profits, and C&I lending standards. Chart 6A Simple Model Of The 12-Month Trailing Speculative Grade Default Rate Gross leverage has improved during the past few quarters as profit growth has outpaced corporate debt growth (Chart 6, panel 2). This has acted to push down the fair value reading from our default rate model. On the other hand, commercial & industrial (C&I) lending standards tightened in the fourth quarter of last year (Chart 6, bottom panel). A net tightening in C&I lending standards is consistent with a higher default rate. Overall, the fair value reading from our default rate model is currently 3.5%, above the current 12-month trailing default rate of 2.6%. For the purposes of valuation, where the default rate will be 12 months from now is more important than where it is currently. To get a sense of where the fair value from our model is headed we need forecasts for corporate profit and debt growth. Profit growth will almost certainly moderate from its current lofty levels (Chart 7). Pressures on revenues and expenses both point in that direction. Total business sales and the ISM Manufacturing PMI have both fallen sharply from their recent highs (Chart 7, panel 2), suggesting lower corporate revenue growth going forward. Meanwhile, wages continue to accelerate (Chart 7, bottom panel). Chart 7Forecasting Profit Growth Using a model based on nominal GDP growth, wage growth, industrial production and the trade-weighted dollar, if we forecast that nominal GDP growth slows to the same rate as wage growth over the next 12 months, then the model predicts that profit growth will fall into the mid-single digits (Chart 7, top panel). This would be more or less consistent with the recent growth rate in corporate debt, meaning that gross leverage would flatten-off and the fair value reading from our default rate model would stabilize near 3.5%. In summary, if profit growth moderates in line with our expectations during the next 12 months, then it is likely that the corporate default rate will be somewhat higher than the current Moody’s forecast of 2.4%, possibly as high as 3.5%. But even a 3.5% default rate would still translate to a default-adjusted junk spread of 211 bps. Positive compensation for default risk, though less than average historical levels. In that case we would still expect solid positive excess returns from junk bonds. However, it will be important to monitor our default-adjusted spread during the next few months. If junk spreads tighten in the near-term, as we anticipate, then the excess compensation for default risk will evaporate quickly. Bottom Line: Slowing corporate profit growth during the next 12 months will cause corporate leverage to flatten-off and will lead to a slightly higher default rate than most baseline forecasts suggest. Junk spreads currently offer adequate compensation for the extra default risk, but that cushion will evaporate quickly if spreads tighten during the next few months. Buy Mexican Bonds While most spread products have benefited from the Fed’s pause, delivering excellent year-to-date returns. We notice that the spreads on Mexico’s USD-denominated sovereign debt have not tightened alongside other comparable credits (Chart 8). This presents an attractive opportunity. Chart 8Mexican Bonds: An Attractive Opportunity When we compare 12-month breakeven spreads between the USD-denominated sovereign debt of different emerging market countries versus the spreads on equivalently-rated U.S. corporate bonds, we see that Mexico has now joined Argentina, Saudi Arabia, Qatar, UAE and Poland as the only countries that offer attractive compensation relative to the U.S. corporate sector (Chart 9). Why has this happened? Our Emerging Markets Strategy service postulates that many investors fear that the new political regime will bring fiscal profligacy, but in fact, the AMLO administration is proving to be less populist and more pragmatic than expected.4 The 2019 budget, for example, targets a primary surplus of 1% of GDP, and envisages a decline in nominal expenditures in 29 out of 56 categories. This commitment to sound fiscal policy should benefit Mexican sovereign bond spreads. More fundamentally, our Emerging Markets strategists note that the Mexican peso is very cheap as measured by the real effective exchange rate based on unit labor costs. This is not surprising given that the peso has been relatively flat versus the dollar during the past two years, despite interest rates being much higher in Mexico than in the U.S. The Mexican 10-year real yield is currently 4.1%, well above real GDP growth which was 2.6% during the past four quarters (Chart 10). Contrast that with the U.S., where the 10-year real yield is a meagre 0.8% versus real GDP growth of 3% during the past four quarters. In other words, interest rate differentials favor a stronger peso, which is positive for USD-denominated sovereign spreads. Chart 10Good Time To Add USD-Denominated Mexican Bonds To A Portfolio Though the Mexican/U.S. interest rate differential remains wide, it is likely to compress going forward. Elevated Mexican interest rates relative to growth signal that monetary policy is restrictive. A fact that is already evident in decelerating Mexican money supply (Chart 10, bottom panel). Meanwhile, low U.S. real yields relative to GDP suggest that further Fed tightening is necessary before U.S. rates are similarly restrictive. Bottom Line: Mexico’s USD-denominated sovereign debt is attractively priced relative to similarly-rated U.S. corporate credit. U.S. fixed income investors should take the opportunity to add USD-denominated Mexican bonds to their portfolios. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1      Please see U.S. Bond Strategy Weekly Report, “Caught Offside”, dated February 12, 2019, available at usbs.bcaresearch.com 2      Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 3      The 12-month breakeven spread is the spread widening required over the next 12 months for the corporate bond to break even with a duration-matched position in Treasury securities. We use the breakeven spread instead of the average index spread because it takes into account the changing duration of the bond indexes. 4      Please see Emerging Markets Strategy Weekly Report, “Dissecting China’s Stimulus”, dated January 17, 2019, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification