Fixed Income

Highlights Risk assets have rallied thanks to a healthy dose of economic stimulus and mounting evidence that the number of new COVID-19 cases has peaked. Unfortunately, the odds of a second wave of infections remain high. In the absence of a vaccine or effective treatment, only mass testing can keep the virus at bay. Such testing will become available, but probably not for a few more months.  Meanwhile, the global economy remains depressed. As earnings estimates are revised lower, stocks could give up some of their recent gains. Despite the fact that the supply of goods and services has fallen sharply during this recession, the overall effect has been deflationary. Deflationary pressures should subside later this year as demand picks up, commodity prices rise, and the US dollar weakens. Looking several years out, deglobalization and the increasing politicization of central banking could lead to accelerating inflation. Long-term investors should maintain a structurally below-benchmark duration stance in fixed-income portfolios, and position for steeper yield curves. Now What? Imagine being chased through the woods by an angry bear. You manage to climb a tree, getting high enough so that the bear cannot reach you. You breathe a sigh of relief. You are out of harm's way. Or so you think. You look down, and the bear is waiting for you at the base of the tree. You have no weapons. You feel cold and hungry. It is getting dark. This is the state the world finds itself in today. We have climbed up the tree. The number of new infections has peaked in Italy and Spain, the first large European countries hit by the virus. Hospital admissions in New York are falling. This, combined with a generous dose of economic stimulus, has allowed stocks to rally by 28% from their March 23 intraday lows. Yet, we have neither a vaccine nor a cure for the virus (although as we go to press, unconfirmed news reports suggest that Gilead’s drug, remdesivir, has had success in treating patients at a Chicago hospital). Chart 1Widespread Social Distancing Dampened The Spread Of All Flus And Colds COVID-19 is part of the coronavirus family, which includes four members that are responsible for up to 30% of common colds (most other colds are caused by rhino-viruses). Social distancing has driven the number of cold and influenza-like cases in the US to very low levels (Chart 1). But does anyone really think that the common cold or flu will be permanently eradicated because of recent measures? If not, what will prevent COVID-19, which is no less contagious than these other illnesses, from resurfacing? In short, the bear is still there, waiting for us to reopen the economy. A Deep Recession As we wait, the economic damage continues to mount. The IMF’s baseline scenario foresees the global economy contracting by 3% in 2020, with advanced economies shrinking by 6.1%. This is far deeper than during the 2008/09 financial crisis (Chart 2). The IMF’s projections assume that the pandemic subsides in the second half of 2020, allowing containment measures to be relaxed. If the pandemic were to last longer than that, global output would fall by an additional 3% in 2020 relative to the Fund’s already bleak baseline. A second outbreak next year would push global GDP almost 5% below the IMF’s baseline in 2021, while the combination of a longer outbreak this year and a second outbreak next year would cause the level of output to fall 8% below the 2021 baseline (Chart 3). Chart 2Severe Damage To The Global Economy This Year Chart 3Downside Risks To The IMF's Projections The Ties That Bind The sudden stop in economic activity has led to a dramatic surge in unemployment. US initial unemployment claims have risen by a cumulative 22 million over the past four weeks. The true scale of layoffs is probably higher than that, given that some state websites have been unable to handle the flood of insurance applications. Chart 4Only About One-Third Of Those Who Lose Their Jobs Apply For Benefits Historically, only about one-third of those laid off have applied for benefits (Chart 4). While the take-up rate will be higher this time – the CARES Act increases weekly unemployment compensation, while expanding eligibility to self-employed workers – it is still reasonable to assume that the claims data do not capture how much of the workforce has been laid idle. The one piece of good news is that at least so far, temporarily laid-off workers account for the vast majority of the increase in unemployment. This is encouraging because it implies that in most cases, the ties that bind workers to firms have not been permanently severed. In this respect, the recovery in employment following this recession may end up resembling that of another “man-made” recession: the 1982 downturn (Chart 5). Back then, policymakers felt that a recession was a price worth paying to quash inflation. Once inflation fell, central banks were able to cut rates, allowing economic activity to recover. Today, the hope is that by shutting down all nonessential businesses, the virus will be quashed, and life will return to normal. Chart 5Comparing The 1982 Recession Versus Today: Employment Edition Exit Plans It remains to be seen whether vanquishing the virus will be as straightforward as vanquishing inflation was in the early 1980s. As we noted last week, in the absence of a vaccine or an effective treatment, our best hope is that mass testing will allow businesses to reopen.1 The technology for such tests already exists; it just has yet to become available on a large enough scale. Just like during the Second World War, the production of weapons necessary to fight the virus will grow at an exponential pace (Chart 6). Chart 6Now Let's Do The Same For Test Kits Near-Term Pressures On Risk Assets Exponential change is a difficult concept for the human mind to grasp. What seems painfully slow at first can quickly become unfathomably fast later on. The apocryphal story about the origins of the game of chess comes to mind.2 This puts investors in a bit of a quandary. Growth is likely to recover in the latter half of 2020 as COVID-19 testing becomes pervasive and the effects of fiscal and monetary stimulus make their way through the economy. But, the near-term picture could be soured by news stories of continued acute shortages of medical supplies and delays in providing financial assistance to hard-hit households and businesses, not to mention dire corporate earnings performance. The one piece of good news is that at least so far, temporarily laid-off workers account for the vast majority of the increase in unemployment. Indeed, bottom-up analyst earnings estimates still have further to fall. The Wall Street consensus expects S&P 500 companies to earn $142 per share this year and $174 in 2021. Our US equity strategists are projecting only $100 and $140 in EPS, respectively. Stock prices and earnings estimates generally travel together (Chart 7). On balance, we continue to favor global equities over bonds on a 12-month horizon, owing to the fact that the cyclically-adjusted earnings yield is quite a bit higher than the bond yield (Chart 8). However, we have less conviction about the near-term (3-month) direction of stocks, and would recommend that investors maintain above-average cash levels for now which can be deployed on any major selloff. Chart 7Negative Earnings Revisions Will Weigh On Stocks In The Near Term Chart 8Favor Equities Over Bonds Over A 12-Month Horizon   Inflation And Supply Shocks: A Keynesian Paradox? One of the distinguishing features of this recession is that it has involved a simultaneous supply shock and a demand shock. Businesses have had to curb supply in order to allow workers to stay at home, while workers have reduced spending out of fear of going to stores or other venues where they could inadvertently contract the virus. Worries about job losses have further dented demand.  There is no question about what happens to output when both demand and supply decline: output falls. In contrast, the impact on the price level depends on which shock dominates (Chart 9). Chart 9Inflation And Supply Shocks As Appendix 1 illustrates with a set of simple numerical examples, in theory, a negative supply shock spread evenly across all sectors of the economy should cause the price level to rise. This is because unemployed workers, who are no longer contributing to output, will still end up consuming some goods and services by tapping into their savings, taking on new debt, or by receiving income transfers from the government. In the current situation, however, the supply shock has not been spread evenly throughout the economy. Some businesses have been completely shuttered, while others deemed essential have been allowed to operate. As the appendix shows, in such cases, the drop in aggregate demand is likely to be larger than if all sectors were equally impacted. In fact, it is possible for a supply shock to trigger a demand shock that is larger than the supply shock itself, leading to a perverse situation where a decline in supply results in a surfeit of output. A recent paper by Guerrieri, Lorenzoni, Straub, and Werning argues that the current pandemic represents such a “Keynesian supply shock.”3 Intuitively, such perverse supply shocks can arise if workers are cut off from purchasing many of the goods that they would normally buy. When the menu of available goods shrinks, even workers who are still employed could end up saving much of their income. Deflationary For Now All this implies that the pandemic is likely to be deflationary until more businesses reopen. The data seem to bear this out. The US core consumer price index fell by 0.1% month-over-month in March on a seasonally adjusted basis, led by steep declines in airfares and hotel lodging prices. High-frequency indicators, as well as the prices paid components of various purchasing manager indices, suggest that deflationary pressures have persisted into April (Chart 10). Chart 10Deflation Reigns For NowShelter inflation was reasonably firm in March but should soften over the coming months. A number of major apartment operators have announced rent freezes. In addition, the lagged effects from a stronger dollar and lower energy prices will contribute to lower goods inflation, while higher unemployment will hold back service inflation. Inflation Should Bounce Back In 2021 The discussion of Keynesian supply shocks suggests that aggregate demand will increase faster than supply as more sectors of the economy reopen. This should ease deflationary pressures. In addition, a rebound in global growth starting in the second half of 2020 will prompt a recovery in commodity prices. The forward oil curve is predicting that Brent and WTI crude prices will rise by 42% and 79%, respectively, over the next 12 months (Chart 11). Inflation expectations and oil prices tend to move closely together (Chart 12). Chart 11H2 2020 Rebound In Growth Will Lift Oil Prices Chart 12Inflation Expectations And Oil Prices Tend To Move Closely Together As a countercyclical currency, the US dollar will weaken over the next 12-to-18 months as global growth rebounds, providing an additional reflationary impulse (Chart 13). Falling unemployment will also eat into labor market slack, helping to support wages. Chart 13Stronger Global Growth In The Back Half Of The Year Will Weaken The Dollar, Putting Upward Pressure On US Inflation The Structural Outlook For Inflation… And Bond Yields Looking further out, the outlook for inflation will depend on whether the structural forces that have suppressed the rise in consumer prices over the past few decades intensify or abate. On the one hand, it is possible that the pandemic will cast a pall over consumer and business sentiment for years to come. If households and firms restrain spending, this would exacerbate deflationary pressures. Likewise, if governments tighten fiscal policy in order to pay off the debts incurred during the pandemic, this could weigh on growth. On the other hand, high government debt levels may increase the political pressure on central banks to keep rates low, even once the labor market recovers. This could eventually lead to economic overheating in two-to-three years. Chart 14Global Trade Was Already Stagnating A partial roll back in globalization could also cause consumer prices to rise. Global trade was already stagnant even before the trade war flared up (Chart 14). The pandemic may further inflame nationalist sentiment. Against the backdrop of high unemployment, Donald Trump is likely to campaign as a “war president,” relentlessly chiding Joe Biden for having too cozy a relationship with China. On balance, we suspect that inflation will rise more than expected over the long haul. This is not a particularly high bar to clear. Investors currently expect US inflation to average only 1.2% over the next decade based on TIPS breakevens. Market-based inflation expectations are even more subdued in most other advanced economies. If inflation does surprise to the upside, long-term bond yields are likely to increase by more than expected. Investors should maintain a structurally below-benchmark duration stance in fixed-income portfolios, and position for steeper yield curves.   APPENDIX 1: Keynesian Supply Shocks Suppose there are two sectors, A and B. The economy consists of 2,000 workers, with each sector employing 1,000 workers. To keep things simple, assume that workers in each sector evenly split their consumption between the two sectors. Thus, a worker in sector A spends as much on goods from sector A as from sector B, and vice versa. Also assume that each worker, if employed, produces $1,000 of goods and receives a salary of $1,000 for his or her efforts. With this in mind, let us consider three scenarios: Scenario 1: Both Sectors Are Open For Business In this scenario, $1 million of good A and $1 million of good B are produced and supplied to the market. Since each of the 2,000 workers spends $500 on good A and $500 on good B, a total of $1 million of both goods are demanded. Aggregate demand equals aggregate supply. Scenario 2: Partial Closure Of Both Sectors Suppose that half the workers in both sectors are laid off. While the unemployed workers do not earn any income, they still spend half as much as they used to by tapping into their savings ($250 on good A and $250 on good B for each unemployed worker). Each employed worker continues to spend $500 on good A and $500 on good B. Now there is $500,000 in total of each good produced, but $750,000 of each good demanded. Aggregate demand exceeds supply. Scenario 3: Sector A, Deemed The Essential Sector, Remains Completely Open, While B Is Closed In this case, all sector A workers are still employed, earning $1,000 each. Since good B is no longer available for purchase, sector A workers increase spending on good A by 20% (from $500 to $600 per worker). Workers in sector B are all unemployed. However, they continue to tap into their savings. Rather than spending $250 on good A as they did in scenario 2, they increase their expenditures on good A by 20% (from $250 to $300). A total of $900,000 of good A is now demanded ($600*1,000+$300*1,000), which is less than the $1 million of good A supplied. Aggregate supply now exceeds demand for the part of the economy that is still open. The chart and table below summarize the results. The key insight is that a 50% shock to the entire economy curbs aggregate demand less than a 100% shock to half the economy. This implies that demand is likely to grow faster than supply as mass testing allows more of the economy to reopen. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Testing Times,” dated April 9, 2020. 2  In one account, the King of India was so impressed when the game of chess was demonstrated to him that he offered its inventor any reward he desired. After thinking for a while, the inventor said “Your Highness, please give me one grain of rice for the first square on the chessboard, two grains for the next square, four grains for the one after that, doubling the number of grains until the 64th square.” Stunned that the inventor would ask for such a puny reward, the King quickly agreed. A week later, the King’s treasurer informed His Highness that he would need to give the inventor 18 quintillion grains of rice, which is more than enough rice to cover the entire planet’s surface. “Holy Ganges, what have I done?” the King exclaimed, before having the inventor executed. 3  Veronica Guerrieri, Guido Lorenzoni, Ludwig Straub, and Iván Werning, “Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages?” NBER Working Paper No. 26918 (April 2020). Global Investment Strategy View Matrix Current MacroQuant Model Scores  

Special Report

Highlights The Fed has been awfully busy since the middle of March, … : Over the last 30 days, the Fed has unleashed a barrage of measures to support market liquidity and alleviate economic hardship. … unveiling a package of facilities to keep credit flowing to consumers, businesses and municipalities, … : The Fed is building a sizable firewall against market seizure, touching on commercial paper, money market funds, asset-backed securities, small business loans, municipal notes, investment-grade corporate bonds and ETFs and high-yield corporate ETFs. … and loosening regulatory strictures to encourage banks to put their capital buffers to work: The Fed and other major bank regulators have eased some of the post-2008 rules to encourage banks to ramp up market-making activity and increase lending to cushion the shock to the economy. Investors should buy what the Fed is buying: Fixed income investors should look to capture excess spreads in markets that have not yet priced in the full effect of the Fed’s indemnity. Banks and agency mortgage REITs offer a way to implement this theme in equities. Feature What A Difference A Pandemic Makes “Whatever it takes” is clearly the order of the day for Jay Powell and company, as well as Congress and the White House, to mitigate the potentially pernicious second-round economic damage from COVID-19. In this Special Report, we detail the Fed’s key initiatives. Central banks are neither omniscient nor omnipotent, and they cannot stave off all of the pressure from mass quarantines, but we do expect the Fed’s measures will cushion the economic blow, and reflate prices in targeted asset markets. The Fed began pulling out all the stops to fight the virus on Sunday, March 15th with what have now become stock emergency responses: zero rates and purchases of Treasuries and agency mortgage-backed securities (MBS). Although the MBS purchases began the week of March 23rd, and have continued at a steady clip despite appearing to have swiftly surpassed their $200 billion target, they have not yet achieved much traction in the mortgage market. The spread between the current coupon agency MBS and the 10-year Treasury yield has come down a bit, but the average 30-year fixed-rate home mortgage rate does not reflect the 150 basis points ("bps") of rate cuts since the beginning of March (Chart 1). The Fed’s measures are intended to help direct the flow of credit to adversely affected constituencies with a pressing need for it. Other measures to relieve liquidity pressures, like the Fed’s ongoing overnight repo operations, have achieved their aim. The signal indicator of liquidity strains, the effective fed funds rate, was bumping up against the top of the Fed’s target range for several days after the return to zero interest rate policy. Over the last week, however, it has settled around 5 bps, near the bottom of its range (Chart 2), suggesting that the formerly tight overnight funding market is now amply supplied. Chart 1MBS Purchases Haven't Helped Main Street Yet Chart 2Overnight Funding Stresses ##br##Have Eased The rest of the Fed’s measures (Table 1) have been more finely targeted, intended to help direct the flow of credit to adversely affected constituencies with a pressing need for it. We focus on the most important measures in the following section and summarize their common elements in Table 2. The following discussions of the individual programs highlight their intent, their chances of success, and yardsticks for tracking their progress. We conclude with the fixed income and equity niches that are most likely to benefit from the Fed’s efforts. Table 1A Frenzied Month Of Activity Table 2The 2020 Federal Reserve Emergency Programs A Field Guide To The Acronym Jungle Money Market Mutual Fund Liquidity Facility (MMLF) Under the MMLF, which started on March 23rd, US banks can borrow from the Fed to purchase eligible assets mainly from prime money market funds. These assets are in turn pledged to the Fed as collateral, effectively allowing the Fed to lend to prime money market funds via banks. Assets eligible for purchase from these funds include: US Treasuries & fully guaranteed agencies Securities issued by US GSEs Asset-backed commercial paper (ABCP) rated A1 or its equivalent, issued by a US issuer US municipal short-term debt (excluding variable rate demand notes) Backed by $10 billion of credit protection from the Treasury, the Fed will lend at the primary credit rate (the discount rate, currently 0.25%) for pledged asset purchases of US Treasuries, fully guaranteed agencies or securities issued by US GSEs. For any other assets pledged, the Fed will charge an additional 100 bps – with the exception of US municipal short-term debt to which the Fed only applies a 25-bps surcharge. Chart 3The MMLF Already Providing Some Relief Loans made under the MMLF are fully non-recourse (the Fed can recover nothing more from the borrower than the pledged collateral). Banks borrowing from the Fed under the MMLF bear no credit risk and have therefore been exempted from risk-based capital and leverage requirements for any asset pledged to the MMLF, an important element that should promote MMLF participation. This facility is a direct descendant of the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), which operated from September 2008 to February 2010 to prevent a run on prime money market funds after a prominent fund “broke the buck.” Its objective is to help prime money market funds meet redemption requests from investors and increase liquidity in the markets for the assets held by these funds – most notably commercial paper where prime money market funds represent 21% of the market. Those funds have experienced large outflows in the midst of the coronavirus pandemic and building economic crisis – erasing $140 billion, or 18%, of the fund segment’s total net assets in a matter of days (Chart 3, top panel). Since it started, the MMLF has extended $53 billion of credit to prime money funds, about a third of AMLF’s output in its first 10 days of operation. The financial sector is suffering a big shock, but it is not the source of the problem like it was in 2008, so the situation is not as dire as it was in late 2008, and we are already seeing a tentative stabilization of asset outflows from money market funds. Commercial paper spreads have also narrowed, implying that the combination of the MMLF and the CPFF (see below) is having the intended effect (Chart 3, bottom panel). Commercial Paper Funding Facility (CPFF) Starting today, April 14th, the Fed will revive 2008’s Commercial Paper Funding Facility (CPFF) with the aim of restoring liquidity to a market where investment grade corporate borrowers raise cash to finance payroll, inventories, accounts payable and other short-term liabilities. The 2020 iteration applies to municipalities as well, extending its reach across the real economy. Via a Special Purpose Vehicle (SPV) (see Box) funded with a $10 billion equity investment from the Treasury Department, the CPFF will purchase US dollar-denominated investment-grade (A1/P1/F1) three-month asset-backed, corporate and municipal commercial paper priced at the overnight index swap rate (OIS) plus 110 bps. Lower-rated issuers are not eligible, but investment-grade borrowers who were downgraded to A2/P2/F2 after March 17th, 2020 can be grandfathered into the program at a higher spread of OIS+200 bps. The pricing is tighter than it was in 2008, when unsecured investment grade and asset-backed issues were priced at OIS+100 bps and OIS+300 bps, respectively, and the Fed did not have the loss protection provided by an equity investment in the SPV.   Box 1 - SPV Mechanics The Fed has set up Special Purpose Vehicles (SPV) in connection with most of the facilities we examine here. Each SPV has been seeded by the Treasury department to carry out the facility’s work. The Fed lends several multiples of the Treasury’s initial equity investment to each SPV to provide it with a total capacity of anywhere from eight to fourteen times its equity capital, based on the riskiness of the assets the SPV is purchasing or lending against. The result is that most of the cash used to operate the facilities will come from the Fed in the form of loans with full recourse to the SPVs’ assets, but the Treasury department will own the equity tranche. The Treasury therefore bears the first credit losses, should any occur. Issuers are only eligible if they have issued three-month commercial paper in the twelve months preceding the March 17th announcement of the program. The Federal Reserve did not set an explicit limit on the size of the program, but funding for any single issuer is limited to the amount of outstanding commercial paper it had during that twelve-month period. The 2020 CPFF could therefore max out above $750 billion, the peak size of the domestic commercial paper market over the past year (Chart 4). If the first CPFF’s experience is any guide, however, it’s unlikely that its full capacity will be needed. Its assets peaked at $350 billion in January 2009, around a quarter of 2008’s $1.5 trillion average outstanding balance. A similar proportion today would cap the fund at $175-200 billion. As in 2008 (Chart 5, bottom panel), the mere announcement of the program has driven commercial paper spreads significantly below their previously stressed levels (Chart 5, top panel). Chart 4Pressure On The Domestic Commercial Paper Market... Chart 5...Is Being Relieved Ahead Of The CPFF Implementation Term Asset-Backed Securities Loan Facility (TALF) The asset-backed securities (ABS) market funds a significant share of the credit extended to consumers and small businesses. The Fed’s TALF program that started on March 23rd aims to provide US companies holding AAA collateral with funding of up to $100 billion, in the form of 3-year non-recourse loans secured by AAA-rated ABS. It will be conducted via an SPV backed by a $10 billion equity investment from the US Treasury Department. Chart 6Narrower Spreads Promote Easier Financial Conditions At The Margin Eligible collateral includes ABS with exposure to auto loans, student loans, credit card receivables, equipment loans, floorplan loans, insurance premium finance loans, SBA-guaranteed loans and leveraged loans issued after March 23rd, 2020. Last week, the Fed added agency CMBS issued before March 23rd, 2020 and left the door open to further expansion of the pool of eligible securities. The rate charged on the loans is based on the type of collateral and its weighted average life. Depending on the ABS, the spreads will range from 75 bps to 150 bps over one of four different benchmarks (LIBOR, SOFR, OIS or the upper 25-bps bound of the target fed funds range). The spreads are reasonable, and will not keep ABS holders away from the facility, but they’re not meant to be giveaways. The 2009 TALF program originally had a $200 billion capacity, which was later expanded to $1 trillion. Those numbers make the current iteration’s $100 billion limit look awfully modest, but only $71 billion worth of loans were eventually granted the first time around. ABS spreads have already narrowed significantly (Chart 6), suggesting the program is already making a difference. Although an incremental $100 billion of loans is not likely to move the needle much for the US economy, narrower spreads will promote easier financial conditions at the margin. Secondary Market Corporate Credit Facility (SMCCF) Though no firm start date has been given, the Fed will soon enter the secondary market and start purchasing corporate bonds. As with all of the other facilities discussed in this section except the MMLF, the SMCCF is set up as an SPV. It will have up to $250 billion of buying power, anchored by $25 billion of equity funding from the Treasury department. Once it’s up and running, the SMCCF will buy non-bank corporate bonds in the secondary market that meet the following criteria: Issuer rated at least BBB-/Baa3 (the lowest investment grade tier) as of March 22nd, 2020 A remaining maturity of 5 years or less Issuer is a US business with material operations, and a majority of its employees, in the US Issuer is not expected to receive direct financial assistance from the federal government The SMCCF can own a maximum of 10% of any single firm’s outstanding debt, and it may dip into the BB-rated market for securities that were downgraded from BBB after March 22nd. In addition to cash bonds, the SMCCF will also buy ETFs that track the broad corporate bond market. The Fed says that the “preponderance” of SMCCF ETF purchases will be of ETFs tracking investment grade corporate bond benchmarks (like LQD), but it will also buy some high-yield ETFs (like HYG). We expect that the SMCCF will be able to achieve its direct goal of driving down borrowing costs for otherwise healthy firms that may struggle to access credit markets in the current environment. One way to track the program’s success is to monitor investment grade corporate credit spreads (Chart 7). Spreads have been tightening aggressively since the Fed announced the program on March 23rd but are still elevated compared to average historical levels. The slope of the line of investment grade corporate bond spreads plotted by maturity will be another important metric (Chart 8). An inverted spread slope tends to coincide with a sharply rising default rate, since it signals that investors are worried about near-term default risk. By purchasing investment grade bonds with maturities of 5 years or less, the Fed hopes to maintain a positively sloped spread curve. Chart 7SMCCF Announcement Marked The Peak In Spreads Chart 8Fed Wants A Positive ##br##Spread Slope Primary Market Corporate Credit Facility (PMCCF) The PMCCF employs the same structure as the SMCCF, but it is twice as large. The Treasury’s initial equity investment will be $50 billion and Fed loans will scale its capacity up to $500 billion. As a complement to the SMCCF, the PMCCF will purchase newly issued non-bank corporate bonds. The eligibility criteria are the same as the SMCCF’s, but the PMCCF will only buy bonds with a maturity of 4 years or less. The new issuance purchased by the PMCCF can be new debt or it can be used to refinance existing debt. The only caveat is that the maximum amount of borrowing from the facility cannot exceed 130% of the issuer’s maximum debt outstanding on any day between March 22nd, 2019 and March 22nd, 2020. Essentially, eligible firms can use the facility to refinance their entire stock of debt and then top it up by another 30% if they so choose. The goals of the PMCCF are to keep the primary issuance markets open and to prevent bankruptcy for firms that were rated investment grade before the virus outbreak. Investment grade corporate bond issuance shut down completely for a stretch in early March, but then surged once the Fed announced the PMCCF and SMCCF on March 23rd. The PMCCF will have achieved lasting traction if gross corporate bond issuance holds up in the coming months (Chart 9). It should also meet its bankruptcy-prevention goal, since firms will be able to refinance their maturing obligations and tack on some new debt to get through the next few months. Given the large amount of outstanding BBB-rated debt, a lot of fallen angel supply is poised to hit the high-yield bond market. While we expect the PMCCF will succeed in achieving its primary aims, it is unlikely to prevent a large number of ratings downgrades. If a given firm only makes use of the facility to refinance its existing debt at a lower rate, then its ability to service its debt will improve at the margin and its rating should be safe. However, any firm that increases its debt load via this facility will end up with a riskier balance sheet. Ratings agencies will not look through an increased debt burden, and we expect a significant number of ratings downgrades in the coming months (Chart 10, top panel). Chart 9Primary Markets Have Re-Opened Chart 10Fed Actions Won't Prevent Downgrades Given the large amount of outstanding BBB-rated debt, a lot of fallen angel supply is poised to hit the high-yield bond market (Chart 10, middle and bottom panels). The Fed will try to contain the surge by allowing the SMCCF to purchase fallen angel debt, and by providing some support to the upper tiers of high-yield credits through its Main Street Lending Programs. Main Street New Loan Facility (MSNLF) and Main Street Expanded Loan Facility (MSELF) The goal of the MSNLF and MSELF is to provide relief to large firms that are not investment grade credits. Both facilities will draw from the same SPV, which will be funded by a $75 billion equity stake from the Treasury and will then be levered up to a total size of “up to $600 billion” by the Fed. The Main Street facilities are structured differently than the PMCCF and SMCCF in that the Fed will not transact directly with nonfinancial corporate issuers. Rather, the Fed will purchase 95% of the par value of eligible loans from banks (which will retain 5% of the credit risk of each loan), hoping to free up enough extra room on bank balance sheets to promote more lending. To be eligible for purchase by the Main Street New Loan Facility, loans must be issued after April 8th, 2020 and meet the following criteria: Borrowers have less than 10,000 employees or $2.5 billion of 2019 revenue Borrowers are US firms with significant operations, and a majority of employees, in the US Loans are unsecured and have a maturity of 4 years Loans are made at an adjustable rate of SOFR + 250-400 bps Principal and interest payments are deferred for one year Loan size of $1 million to the lesser of $25 million or the amount that keeps the borrower’s Debt-to-EBITDA ratio below 4.01 Loan proceeds cannot be used to refinance existing debt Borrowers must commit to “make reasonable efforts to maintain payroll and retain employees during the term of the loan” The Main Street Expanded Loan Facility applies similar criteria to existing loans that banks will upsize before transferring 95% of the incremental risk to the Fed. The MSELF allows for loans up to the lesser of $150 million, 30% of the borrower’s existing debt (including undrawn commitments) or the amount keeps the borrower’s Debt-to-EBITDA ratio below 6.0. Borrowers can participate in only one of the MSNLF, MSELF and PMCCF, though they can tap the PPP alongside one of the Main Street lending facilities. Chart 11Main Street Programs Will Spur Bank Lending The Main Street facilities endeavor to have banks adopt an “originate to distribute” model. With the Fed assuming 95% of each loan’s credit risk, banks will have nearly unlimited balance sheet capacity to continue originating these sorts of loans. Retaining 5% of each loan ensures that the banks will have enough skin in the game to perform proper due diligence. We expect to see a significant increase in commercial bank C&I loan growth in the coming months once these facilities are up to speed (Chart 11). Crucially for high-yield investors, the debt-to-EBITDA constraints ensure that the Main Street facilities will aid BB- and some B-rated issuers but will not bail out high-default-risk issuers rated CCC and below. BB-rated firms typically have debt-to-EBITDA ratios between 3 and 4, while B-rated issuers typically fall in a range of 4 to 6. For the most part, BB-rated firms will be able to make use of either the MSNLF or MSELF, while B-rated firms will be limited to the MSELF. By leaving out issuers rated CCC & below, the Fed is acquiescing to a significant spike in corporate defaults over the next 12 months. The bulk of corporate defaults come from firms that were rated CCC or below 12 months prior (Chart 12). Chart 12A Significant Increase In Corporate Defaults Is Coming As with the PMCCF, we note that the Main Street facilities offer loans, not grants. While they will address firms’ immediate liquidity issues, they will do so at the cost of more indebted balance sheets. Downgrade risk remains high for BB- and B-rated companies. Paycheck Protection Program Liquidity Facility (PPPLF) The Paycheck Protection Program (PPP) is a component of the CARES Act that was designed to forestall layoffs by small businesses.  PPP loans are fully guaranteed by the Small Business Association (SBA), which will forgive them if the borrower maintains its employee headcount for eight weeks. The size of the PPPLF has yet to be announced, along with the details of its funding, but its intent is to get PPP loans off of issuers’ balance sheets so as to free up their capital and allow them to make more loans, expanding the PPP’s reach. The Fed will lend on a non-recourse basis at a rate of 0.35% to any depository institution making PPP loans,2 taking PPP loans as collateral at their full face value. PPP loans placed with the Fed are exempt from both risk-weighted and leverage-based capital adequacy measures (please see “Easing Up On The Regulatory Reins,” below). PPP is meant to be no less than a lifeline for households and small businesses, but the devil is in the details. Banks were reportedly overwhelmed with demand for PPP loans over the first five business days that they were available, suggesting that many small businesses still qualify, despite 17 million initial unemployment claims over the last three weeks. Media reports about the program highlighted that there are quite a few kinks yet to be worked out, and it has arrived too late to stave off the first waves of layoffs. Success may be most easily measured by the size of the PPPLF, which should eventually translate into fewer layoffs and bankruptcies than would otherwise have occurred. Municipal Liquidity Facility (MLF) Chart 13State & Local Governments Need Support The Municipal Liquidity Facility is similar in structure to the PMCCF, only it is designed to support state and local governments. The MLF SPV will be funded by a $35 billion equity investment from the Treasury, and the Fed will lever it up to a maximum size of $500 billion to purchase newly issued securities directly from state and local governments that meet the following criteria: All states (including D.C.) are eligible, as are cities with populations above 1 million and counties with populations above 2 million. The newly issued notes will have a maximum maturity of 2 years. The MLF can buy new issuance from any one state, city or county up to an amount equal to 20% of that borrower’s fiscal year 2017 general revenue. States can request a higher limit to procure funds for political subdivisions or instrumentalities that aren’t eligible themselves for the MLF. The MLF’s goal is to keep state and local governments liquid as they deal with the COVID-19 pandemic. The large size of the facility – $500 billion is five times 2019’s aggregate muni issuance – should allow it to meet its goal. However, as with the Fed’s other facilities, the support comes in the form of loans, not grants. The lost tax revenue and increased pandemic expenditures cannot be recovered. State and local government balance sheets will emerge from the recession weaker. We can track the program’s success by looking at the spread between municipal bond yields and comparable US Treasury yields. These spreads widened to all-time highs in March, but have since come in significantly, even for longer maturities (Chart 13). If this tightening does not continue, the Fed may eventually enter the secondary market to purchase long-maturity municipal bonds. Supporting such a fragmented market will be tricky, and the Fed may be hoping that more aid will come from Capitol Hill. Central Bank Liquidity Swaps Chart 14US Dollar Debt Is A Global Problem The global economy is loaded with USD-denominated debt issued by entities outside of the US. As of 3Q19, there was roughly $12 trillion of outstanding foreign-issued US dollar debt, exceeding the domestic nonfinancial corporate sector’s total issuance (Chart 14). As the sole provider of US dollars, the Fed has a role to play in supporting foreign dollar-debt issuers during this tumultuous period. Currency swap lines linking the Fed with other central banks can help alleviate the pressure on foreign borrowers to access the US dollars they need to service their debt. For example, once the Fed exchanges dollars for euros using its swap line with the European Central Bank (ECB), the ECB can then direct those US dollars toward USD-denominated borrowers within the Euro Area. Widening cross-currency basis swap spreads are a tried-and-true signal that US dollars are becoming too scarce. The Fed responded to widening basis swap spreads by instituting swap lines during the financial crisis and again during the Eurozone debt crisis of 2011. In both instances, the swap lines eventually calmed the market and basis swap spreads moved back toward zero (Chart 15). Chart 15The Cost Of US Dollars Since 2013, the Fed has maintained unlimited swap lines with the central banks of the Euro Area, Canada, UK, Japan and Switzerland. On March 19th, it extended limited swap lines to the central banks of Australia, Brazil, Denmark, Korea, Mexico, Norway, New Zealand, Singapore and Sweden. These swap lines will help ease stresses for some foreign issuers of US dollar debt, but not all. One potential problem is that the foreign central banks that acquire dollars via the swap lines may be unwilling or unable to direct those dollars to debtors in their countries. Another problem is that several emerging markets (EM) countries do not have access to the Fed’s swap facility. EM issuers account for roughly one-third of foreign-issued dollar debt (Chart 14, bottom panel). For example, the governments of the Philippines, Colombia, Indonesia and Turkey all carry large US dollar debt balances, not to mention US dollar debt issued by the EM corporate sector in non-swap line countries. Currency swap lines linking the Fed with other central banks can help alleviate the pressure on foreign borrowers to access the US dollars they need to service their debt. The swap lines that are already in place have led to basis swap spread tightening in developed markets. If global growth eventually rebounds and the dollar weakens, EM dollar-debt burdens will become easier to service. However, until that happens, a default by some foreign issuer of US dollar debt remains a non-trivial tail risk. The Fed may need to extend swap lines to more countries to mitigate this risk in the months ahead. Easing Up On The Regulatory Reins As we’ve argued in US Investment Strategy Special Reports the last two weeks, the largest US banks are extremely well capitalized.3 The Fed agrees, and over the last 30 days, it has issued six separate statements encouraging the banks to lend or to work with struggling borrowers, all but one of them in concert with its fellow banking regulators. Although the largest banks have amassed sizable capital cushions that would support increased lending, post-GFC regulations often crimp incentives to deploy them. Over the last 30 days, the Fed and the other federal regulators have granted banks relief from the key binding constraints. Those constraints fall into two broad categories: risk-based requirements, which are based on risk weightings assigned to individual assets, and leverage requirements, which are based on total assets or total leverage exposure. All banks are required to maintain minimum ratios of equity capital to risk-weighted assets under the former and to total leverage, which includes some off-balance-sheet exposures, under the latter. The three federal banking regulators have amended rules to exclude MMLF and PPP exposures from the regulatory capital denominator used to calculate risk-weighted and leverage ratios. The Fed also made a similar move by excluding Treasury securities and deposits held at the Fed from the denominator of the supplementary leverage ratio large banks must maintain (3% for banks with greater than $250 billion in assets, 5% for SIFIs). Reducing the denominators increases the banks’ ratios and expands their lending capacity. Community banks’ capital adequacy is determined by their leverage ratio (equity to total assets), and regulators have temporarily cut it to 8% from 9%. We expect that easing capital constraints will spur the banks to lend more in the coming weeks and months, but it’s not a sure thing. A clear lesson from the Bernanke Fed’s three rounds of quantitative easing is that the Fed can lead banks to water, but it can’t make them drink. A considerable amount of the funds the Fed deployed to buy Treasury and agency securities was simply squirreled away by banks, and wound up being neither lent nor spent. Lending is not the Fed’s sole focus, though: it hopes that easing capital regulations will also encourage banks and broker-dealers to ramp up their market-making activity, improving capital market liquidity across a range of instruments. Investment Implications While all of the programs discussed above have expiration dates, they can be extended if necessary. Flexible end dates illustrate the open-ended nature of the Fed’s (and Congress’) support, and help underpin our contention that more aid will be forthcoming at the drop of a hat. Confronting the most severe recession in 90 years and an especially competitive election, policymakers can be counted upon to err to the side of providing too much stimulus. That is not to say, however, that the measures amount to a justification for loading up on all risk assets. Every space will not be helped equally. Spreads for all corporate credit tiers are cheap compared to history, but only BB-rated and higher benefit from the Fed’s programs. Within US fixed income, investors should look for opportunities in sectors that offer attractive spreads and directly benefit from Fed support. In the corporate bond market this means owning securities rated BB or higher and avoiding debt rated B and below. Spreads for all corporate credit tiers are cheap compared to history (Charts 16A & 16B), but only BB-rated and higher benefit from the Fed’s programs. Some B-rated issuers will be able to access the MSELF, but Fed support for the B-rated credit tier is limited. Fed support is non-existent for securities rated CCC or lower. Chart 16AInvestment Grade Valuation Chart 16BHigh-Yield Valuation Elsewhere, several traditionally low-risk spread sectors also meet our criteria of offering attractive spreads and benefitting from Fed support. AAA-rated Consumer ABS spreads are wide and will benefit from TALF. Agency CMBS spreads are also attractive and those securities are being directly purchased by the Fed (Chart 17). We also like the opportunity in Agency bonds (the debt of Fannie Mae and Freddie Mac) and Supranationals, where spreads are currently well above historical levels (Chart 17, third panel). Chart 17Opportunities In Low-Risk Spread Product Chart 18Not Enough Value In Agency MBS Agency MBS are less appealing. Spreads have already tightened back to pre-COVID levels and while continued Fed buying should keep them low, returns will be much better in the investment grade corporate space (Chart 18).  Meanwhile, we would also advocate long positions in municipal bonds. Spreads are wide and the Fed is now providing support out to the 2-year maturity point (see Chart 13). We also see potential for the Fed to start purchasing longer-maturity municipal debt if spreads don’t tighten quickly enough. Chart 19Look For Attractive Spreads In Countries With Swap Lines Finally, we would also consider the USD-denominated sovereign debt of countries to which the Fed has extended swap lines, with Mexico offering a prime example. Its USD-denominated debt offers an attractive spread and it has been extended a swap line (Chart 19). In equities, agency mortgage REITs – monoline lenders that manage MBS portfolios 8-10 times the size of their equity capital – are a levered play on buying what the Fed’s buying. They were beaten up quite badly throughout March, and have been de-rated enough to deliver double-digit total returns as long as the repo market doesn’t flare up again, and agency MBS spreads do not widen anew. We see large banks as a direct beneficiary of policymakers’ efforts to limit credit distress and expect that their loan losses could ultimately be less than markets fear. While lenders have an incentive to be the first to push secured borrowers into default in a normal recession to ensure they’re first in line to liquidate collateral, they now have an incentive to keep borrowers from defaulting lest they end up having to carry the millstone of seized collateral on their balance sheets for an indefinite period. Regulatory forbearance may end up being every bit as helpful for bank book values as the ability to move securities into the Fed’s non-recourse facilities. Footnotes 1 This calculation uses 2019 EBITDA and includes undrawn loan commitments in total debt. 2 The Fed plans to expand the program to include non-bank SBA-approved lenders in the near future. 3 Please see the US Investment Strategy Special Reports, “How Vulnerable Are US Banks? Part 1: A 50-Year Bottom-Up Case Study,” and “How Vulnerable Are US Banks? Part 2: It’s Complicated,” published March 30 and April 6, 2020, respectively, available at usis.bcaresearch.com. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Jennifer Lacombe Associate Editor jenniferl@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com

Highlights US Corporates: The Fed continues to expand the reach of its extraordinary monetary policies designed to combat the COVID-19 recession, now giving itself the ability to hold BB-rated US high-yield bonds within its corporate bond buying programs. Raise allocations to US BB-rated corporates to overweight, within a neutral overall strategic (6-12 months) allocation to US high-yield. Euro Area Corporates: European investment grade corporate debt has seen significant spread widening over the past month, but spreads have stabilized with the ECB introducing a new asset purchase program with fewer restrictions. Upgrade euro area investment grade corporates to neutral from underweight on both a tactical (0-6 months) and strategic (6-12 months) basis. Favor debt from beaten-up sectors that are already priced for severe economic weakness like Energy, Transportation and non-bank Financials. Central Banks Are A Corporate Bond Investor’s Best Friend Right Now Chart of the WeekThe Fed & ECB Are Supporting Bond Markets The actions of policymakers worldwide to help mitigate the severe economic shock from the COVID-19 recession have helped boost global risk assets over the past couple of weeks. This is particularly notable in US corporate bond markets, where credit spreads have tightened for both shorter-maturity investment grade bonds and Ba-rated high-yield (Chart of the Week). It is not a coincidence that those are the parts of the US corporate bond market that the Fed is now explicitly backstopping through its off-balance-sheet investment programs. Last week, the Fed unveiled yet another “bazooka” to help ease US financial conditions, broadening the scope of its previously investment grade-only corporate bond purchase programs to include Ba-rated high-yield corporate bonds and high-yield ETFs. In Europe, meanwhile, the European Central Bank (ECB) is also providing additional monetary support through increased asset purchases of both government and corporate debt. Those purchases are focused more on the weakest links in the euro area financial and economic chain like Italian sovereign bonds. This has helped to stabilize credit spreads for both Italian government bonds and euro area investment grade corporate debt. This support from policymakers is critical to prevent a further tightening of financial conditions during a severe global recession (Chart 2). The excess return (over government bonds) for the Bloomberg Barclays global high-yield bond index is now down 15% on a year-over-year basis. High-yield corporate bond spreads are well above the lows seen earlier this year on both sides of the Atlantic, across all credit quality tiers. In the US, spreads between credit quality tiers had widened to levels not seen in several years. Within the US investment grade universe, the gap between Baa-rated and Aa-rated spreads had widened from 20bps to 60bps (Chart 3), a level last seen in September 2011, but now sits at 39bps. Chart 2Junk Bonds Already Discount A Big Recession Chart 3The Fed Wants These Spreads To Tighten Looking in the other direction of the credit quality spectrum, the spread between Baa-rated and Ba-rated corporates – the line of demarcation between investment grade and high-yield bonds – had blown out from 132bps in February to 556bps, but is now at 360bps. This is the market pricing in the growing risk of fallen angels being downgraded from investment grade to junk. In our view, the Ba-Baa spread is the best indicator to follow to see if the Fed’s extension of its bond purchase program to high-yield is working to reduce borrowing costs for lower-rated US companies. Both in the US and Europe, we continue to recommend a credit investment strategy that favors the parts of the markets that the Fed and ECB are most directly involved in now. That means staying overweight US investment grade corporate bonds with maturities of less than five years (the Fed’s maturity limit for its bond buying program). It also means staying overweight Italian government debt versus core European equivalents. The Fed’s new extension into high-yield corporates within its buying programs means we need to upgrade our recommendation on US BB-rated high-yield to overweight within our recommended neutral strategic (6-12 months) allocation to US junk bonds. We are making that change on a tactical basis in our model bond portfolio, as well, as can be seen on pages 14-15. As the title of this Weekly Report suggests, buy what the central banks are buying. The Fed’s new extension into high-yield corporates within its buying programs means we need to upgrade our recommendation on US BB-rated high-yield to overweight within our recommended neutral strategic (6-12 months) allocation to US junk bonds. In Europe, there is now scope to also raise allocations to euro area corporate bonds, as well, as we discuss over the remainder of this report. Bottom Line: The Fed continues to expand the reach of its extraordinary monetary policies designed to combat the COVID-19 recession, now giving itself the ability to hold BB-rated US high-yield bonds within its corporate bond buying programs. Raise allocations to US BB-rated corporates to overweight within a neutral overall strategic (6-12 months) allocation to US high-yield. Looking For Value In Euro Area Investment Grade Bonds The outlook for euro area spread product does not have as clean-cut a story as is the case for US credit. The ECB is not explicitly supporting European corporate credit markets to the same degree as the Fed is with its open-ended off-balance sheet investment vehicles. While the ECB has introduced a new large €750bn asset purchase program, the Pandemic Emergency Purchase Program (PEPP), to help ease financial conditions in the euro area, no specific details have yet been provided specifying how much of the PEPP will go towards corporate debt versus sovereign bonds. The ECB has already loosened the country and issuer limit restrictions it has imposed on its existing Asset Purchase Program (APP), however, which means that the central bank will be very flexible with the PEPP purchases. That means helping reduce sovereign risk premiums in Peripheral Europe by buying greater amounts of Italian, Spanish and even Greek government debt. That also likely means buying more corporate debt in the most stressed sectors of the euro area economy, as needed. Greater ECB bond purchases would make euro area investment grade credit – which has seen some value restored after the recent bout of spread widening - more attractive over both tactical and strategic investment horizons. This is true even with much of the euro area now in a deep recession because of COVID-19 lockdowns, which has already been discounted in the poor investment performance of euro area corporates. Greater ECB bond purchases would make euro area investment grade credit – which has seen some value restored after the recent bout of spread widening - more attractive over both tactical and strategic investment horizons. Year-to-date, euro area corporate credit markets have been hit hard by the global credit selloff (Table 1). In total return terms denominated in euros, the Bloomberg Barclays euro area investment grade corporate bond index is down -5.0% so far in 2020. The numbers are slightly better relative to duration-matched euro area government bonds (the pure credit component), with the index excess return down -5.5% year-to-date. At the broad sector level, the laggards so far in 2020 have been the sectors most exposed to the sharp downturn in European (and global) economic growth. In excess return terms, the worst performing sectors year-to-date within the eleven major groupings shown in Table 1 have been Consumer Cyclicals (-8.5%), Transportation (-8.1%), Energy (-7.2%). The best performing sectors are those that would be categorized as less cyclical and more “defensive”, like Utilities (-4.3%), Technology (-4.3%) and Financials (-4.7%). In many ways, this is a mirror image of 2019, when Consumer Cyclicals and Transportation were among the top performers while Technology was the worst performer. Table 1Euro Area Investment Grade Corporate Bond Returns Chart 4Euro Area Corporate Spreads Are Relatively Subdued Vs. Past Credit Cycles When looking at the differences in spreads between credit tiers in the euro area, the gaps are not as wide as in the US (Chart 4). The index spread on Baa-rated euro area corporates is only 44bps above that of Aa-rated credit, far below the 100bps gap seen at the peak of the 2001 and 2011 spread widening episodes and well below the 200bps witnessed in 2008. Looking at the difference between Ba-rated and Baa-rated euro area spreads paints a similar picture, with the gap between the highest high-yield credit tier and lowest investment grade credit tier now sitting at 297bps after getting as wide as 431bps in late March – close to the 500bps peak seen in 2011 but far below the 1000bps levels seen in 2001 and 2007 The broad conclusion looking strictly at credit tiers is that euro area corporates have cheapened up a bit during the COVID-19 selloff, but on a more modest scale compared to previous euro area credit cycles. A similar conclusion is reached when looking at industry-level credit spreads. The broad conclusion looking strictly at credit tiers is that euro area corporates have cheapened up a bit during the COVID-19 selloff, but on a more modest scale compared to previous euro area credit cycles. A similar conclusion is reached when looking at industry-level credit spreads. In Charts 5 & 6, we show the history of option-adjusted spreads (OAS) for the major industrial sub-groupings of the Bloomberg Barclays euro area investment grade corporate indices. Unsurprisingly, spreads look relatively wide for the biggest underperforming sectors like Energy, Consumer Cyclicals and Transportation. The spread widening has been more contained in the better performing sectors like Technology. Chart 5A Mixed Performance For Euro Area Investment Grade Spreads By Industry … Chart 6…. With Spreads Well Below 2001 And 2008 Credit Cycle Peaks When looking at the individual country corporate bond indices within the euro area, the current levels of spreads do not look particularly wide in an historical context. In Chart 7, we show a bar chart of the range of index OAS for the six largest euro area countries (Germany, France, Italy, Spain, the Netherlands, Belgium and Austria). The current OAS is shown within that historical range. The chart shows that current spreads are in the middle of that range for most countries, suggesting some better value has been restored by the COVID-19 selloff but with spreads remaining relatively subdued compared to past euro area credit cycles.1 Chart 7Euro Area Investment Grade Corporate Spreads By Country On a relative basis, investment grade spreads are tightest in France (203bps), the Netherlands (202bps) and Belgium (226bps), and widest in Germany (255bps), Italy (255bps), Austria (251bps) and Spain (234bps). With the ECB already promising greater flexibility in the country allocations of its sovereign bond purchases within the PEPP, Italian corporates may offer the best value within the major euro area countries. With the ECB already promising greater flexibility in the country allocations of its sovereign bond purchases within the PEPP, Italian corporates may offer the best value within the major euro area countries. We can get a better sense of relative corporate bond spread valuation at the country level by looking at the 12-month breakeven spread percentile rankings of those spreads. This is one of the tools we use to assess value in global credit spreads, as measured by historical “spread cushions”. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. In Charts 8 & 9, we show the 12-month breakeven spread percentile rankings for Germany, France, Italy, Spain, Belgium and Austria. On this basis, the current level of spreads looks most historically attractive in Germany, Italy and France, with the breakeven spread in the upper quartile versus its history dating back to the year 2000. Spreads in Spain, Belgium and Austria also look relatively wide versus their own history, but to a lesser extent than in Germany, France and Italy. Chart 8German, Italian & French Investment Grade Corporates Offer Better Value On A Breakeven Spread Basis …. Chart 9… Than Spanish, Belgian & Austrian Investment Grade Corporates Chart 10Euro Area Investment Grade Corporate Spreads Are Relatively Wide Across All Credit Tiers So while there are some modest differences in value to exploit within the euro area investment grade corporate bond universe at the country level, there is less to choose from across credit tiers. The 12-month breakeven spreads for Aaa-rated, Aa-rated, A-rated and Baa-rated euro area corporates are all within the upper quartiles of their own history (Chart 10). One other tool we can use to assess value across euro area investment grade corporates is our sector relative value framework. Borrowing from the methodology used by our colleagues at BCA Research US Bond Strategy to assess US investment grade corporates, the sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall euro area investment grade universe. The methodology takes each sector's individual OAS and regresses it in a cross-sectional regression with all other sectors. The independent variables in the model are each sector's duration, trailing 12-month spread volatility, and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. The latest output from the euro area relative value spread model can be found in Table 2. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot in Chart 11 shows the tradeoff between the valuation residual from our model and each sector's DTS. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation We can then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. The strongest overweight candidates (a DTS score equal to or greater than that of the overall index with the highest positive valuation residual) are the following euro area investment grade sectors: Packaging, Tobacco, Other Industrials, Media Entertainment, Supermarkets, Integrated Energy, Consumer Cyclical Services and all non-bank Financials (Insurance, REITs, Brokerages and Finance Companies). Against the current backdrop of euro area corporate spreads offering relatively wide spreads on a breakeven spread basis, and with the ECB providing a highly accommodative monetary backdrop that includes more purchases of both government and corporate debt, we think targeting an overall portfolio DTS greater than that of the euro area investment grade corporate bond index is reasonable. On that basis, we are looking to go overweight sectors with relatively higher DTS and positive risk-adjusted spread residuals from our relative value model (and vice versa). Those overweight candidates would ideally be located in the upper right quadrant of Chart 11. Chart 11Euro Area Investment Grade Corporate Sectors: Valuation Versus Risk Based on the latest output from the relative value model, the strongest overweight candidates (a DTS score equal to or greater than that of the overall index with the highest positive valuation residual) are the following euro area investment grade sectors: Packaging, Tobacco, Other Industrials, Media Entertainment, Supermarkets, Integrated Energy, Consumer Cyclical Services and all non-bank Financials (Insurance, REITs, Brokerages and Finance Companies). The least attractive sectors within this framework (negative risk-adjusted valuations) are: Senior Bank Debt, Natural Gas, Other Utilities, Metals and Mining, Chemicals, Construction Machinery, Lodging, Cable and Satellite, Restaurants, Food/Beverage, Health Care, Oil Field Services, Building Materials and Aerospace/Defense. Bottom Line: European investment grade corporate debt has seen significant spread widening over the past month, but spreads should stabilize with the ECB introducing a new asset purchase program with fewer restrictions. Upgrade euro area investment grade corporates to neutral from underweight on both a tactical (0-6 months) and strategic (6-12 months) basis. Favor debt from beaten-up sectors that are already priced for severe economic weakness like Energy, Transportation and non-bank Financials.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 For the Netherlands, there is a much shorter history of corporate bond index data available from Bloomberg Barclays than the other euro area countries shown in Chart 7. The OAS range only encompasses about seven years of data, while the other countries go back as far as the early 2000s. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Europe’s dirty little secret: Euro area debt is already mutualised. Investment implication: Overweight Italian BTPs, underweight German bunds, and overweight the euro on a structural (2-year plus) horizon. ESM plus ECB plus OMT equals a compromise solution to fund stimulus at a mutualised euro area interest rate. Investment implication: Overweight Italian BTPs, underweight German bunds on a cyclical (6-12 month) horizon. Spain’s high early peak in morbidity means that it has taken its pain upfront, at least compared to other countries.  Investment implication: upgrade Spain’s IBEX to a tactical overweight – and remove it from the cyclical underweight basket. Feature Chart of the WeekThe Underperformances Of China, Italy And Spain Were A Mirror-Image Of Their Covid-19 Morbidity Curves More About Morbidity Curves Most analyses of the pandemic tend to focus on the grim daily mortality statistics. Yet the key to the pandemic’s evolution is not its mortality rate, but rather its morbidity (severe illness) rate. This is because, without a vaccine, the total area underneath the morbidity curve is fixed. The cumulative number of people who will fall severely ill is pre-determined at the outset (Figures 1-3). Figure I-1The Area Under The Morbidity Curve Is Fixed, A High First Peak Means A Low Second Peak Figure I-2A Low First Peak Means An Extended First Peak…   Figure I-3…Or A High Second Peak Very optimistically assuming a Covid-19 morbidity rate of 1 percent, and that 65 percent of the population must get infected to exhaust the pandemic, we know that Covid-19 will ultimately make 0.65 percent of the population severely ill. Absent a vaccine, this number is set in stone. But the number of deaths is not set in stone. It depends on the availability of emergency medical treatment for those that are severely ill. For Covid-19 this means access to ventilation in an intensive care unit (ICU). Yet even the best equipped countries only have ICUs for 0.03 percent of the population. Therefore, the emergency treatment must be rationed either by supply or by demand. Without a Covid-19 vaccine, we cannot change the cumulative number of people who will become severely ill. Rationing by supply means that we must deny emergency treatment to the severely ill – not just Covid-19 patients but victims of, say, heart attacks or car crashes. Accept more deaths. Rationing by demand means that we must flatten the demand (morbidity) curve so that demand is always satisfied by the limited ICU supply. During the pandemics of 1918-19 and 1957, countries could ration emergency medical treatment by supply. Not in 2020. In an era of universal healthcare, everybody is entitled to, and expects to get, emergency medical care. Which means we must ration emergency medical treatment by demand. As such, we must analyse the 2020 response differently to the responses in 1918-19 and 1957. To repeat, without a vaccine, we cannot change the area under the morbidity curve. There is no way of escaping this truth. A low first peak requires a very elongated peak or a high second peak (Chart I-2). Conversely, countries that have suffered a high first peak will need a shorter peak and small (or no) second peak. Chart I-2Japan's Early Stabilisation Was A False Dawn Turning to an equity market implication, the underperformances of highly cyclical and domestically exposed Spain and Italy have closely tracked their morbidity curves (Chart I-1). Given that both countries have suffered very high first peaks in morbidity, the strong implication is that they have taken their pain upfront – at least compared to other countries. In the case of Spain, the market is also technically oversold (see Fractal Trading System). Investment implication: upgrade Spain’s IBEX to a tactical overweight – and remove it from the cyclical underweight basket. How Europe Could Unite Europe is dithering on its fiscal response to the pandemic. Specifically, Germany and the Netherlands are pushing back against the concept of mutualised euro area debt in the form of ‘corona-bonds’. But a pandemic is an act of nature, an indiscriminate exogenous shock. What is the point of the economic and monetary union if Italy must fund its response to an act of nature at the Italian 10-year yield of 1.5 percent rather than the euro area 10-year yield of 0 percent? (Chart I-3 and Chart I-4) Chart I-3To Fight An Act Of Nature Why Should Italy Borrow At A Higher Rate... Chart I-4...When It Could Borrow At A Lower Mutualised Rate? The good news is there is a compromise solution to fund stimulus at a mutualised interest rate. It uses the euro area’s €500 billion bailout fund, the European Stability Mechanism (ESM). But the compromise solution carries two problems which need mitigation. First, ESM credit lines come with conditionality. Italy would rightly balk if it were shackled like Greece, Portugal, and Ireland were after the euro debt crisis. Luckily, the ESM is likely to regard the current ‘act of nature’ crisis very differently to the debt crisis and impose only minimum and appropriate conditionality – for example, that credit lines should be used for healthcare and social welfare spending. Second, ESM credit lines come with a stigma. Taking fright that Italy is tapping the ESM, the bond market might drive up the yields on Italian BTPs. If this pushed up Italy’s overall funding rate, it would defeat the purpose of using the ESM in the first place. ESM plus ECB plus OMT equals a compromise solution to borrow at a mutualised interest rate. The hope is that the bond market, realising that Italy is using the bailout facility to counter an act of nature, would not drive up BTP yields. But if it did, the ECB could counter this by buying BTPs. One option would be to use its Outright Monetary Transactions (OMT) facility. Set up during the euro debt crisis, the OMT’s specific function is to counter bond market attacks when they are not justified by the economic fundamentals. In other words, to prevent a liquidity crisis escalating into a solvency crisis. Thereby, ESM plus ECB plus OMT equals a compromise solution to fund stimulus at a mutualised euro area interest rate. Investment implication: Overweight Italian BTPs, underweight German bunds on a cyclical (6-12 month) horizon. Europe’s Dirty Little Secret Outwardly, Germany and the Netherlands are reluctant to go down the slippery slope to mutualised euro area debt. But here’s the dirty little secret they don’t want you to know. Euro area debt is already mutualised. The stealth mutualisation has happened via the Target2 banking imbalance which now stands at €1.5 trillion. This imbalance is an accounting identity showing that Italy is owed ‘German euros’ via its large quantity of bank deposits in German banks while Germany is symmetrically owed ‘Italian euros’ via its large effective holding of Italian government bonds. The imbalance is irrelevant if a German euro equals an Italian euro. But if Italy defaulted on its bonds – by repaying them in a reinstated and devalued lira – then Target2 means that Germany must pick up the bill (Chart I-5). Chart I-5Target2 Means That If Italy Defaults, Germany Picks Up The Bill The Target2 imbalance is the result of the ECB’s QE program, in which the central bank has bought hundreds of billions of Italian bonds. If Italy repaid those bonds in a devalued lira, then the ECB would become insolvent, and the central bank’s remaining shareholders would have to plug the hole. The biggest shareholder would be Germany. Could Germany force Italy to repay its bonds in euros? No. According to a legal principle called ‘lex monetae’ Italy can repay its debt in its sovereign currency, whatever that is. Meanwhile, because of the fragility of the Italian banking system, the Italians who sold the bonds to the ECB deposited the cash in German banks. Legally, these depositors must be paid back in whatever is the German currency. Euro area debt is already mutualised. If euro area debt is already mutualised, why do policymakers continue to pretend that it isn’t? There are three reasons. First no policymaker would want to publicise that Germany is now on the hook if Italy left the euro. Second, no policymaker would want to publicise that the ECB has put Germany in this position (Chart I-6). Chart I-6ECB QE Has Created The Target2 Imbalance Third, and most important, policymakers would point out that the mutualisation of debt only happens if the euro breaks up. They would argue that because the euro is irreversible, the debt is not mutualised. In fact, their argument is completely back to front. The truth is: Because euro area debt is now mutualised, the euro has become irreversible. Investment implication: Overweight Italian BTPs, underweight German bunds, and overweight the euro on a structural (2-year plus) horizon. Fractal Trading System* As already discussed, this week’s recommended trade is long Spain’s IBEX 35 versus the Euro Stoxx 600. The profit target is 3 percent with a symmetrical stop-loss. Meanwhile our other trade, long Australia versus New Zealand has moved into a 2 percent profit. The rolling 12-month win ratio now stands at 66 percent. Chart I-7IBEX 35 Vs. EUROSTOXX 600 When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com   Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights Please note that we are publishing an analysis on Vietnam below. The unprecedented depth of this recession entails that many businesses will likely be operating below their break-evens for a while, even after the confinement measures are eased. Consequently, the process of bottoming in this bear market will be drawn out, and share prices will gyrate substantially in the interim. Elevated foreign currency debt levels among some EM corporations, plunging revenues and local currency depreciation combine for a perfect storm in EM corporate credit. Continue underweighting EM stocks and credit within global equity and credit portfolios, respectively. Take profits on the long EM currency volatility trade. Feature If history is any guide, the speed of the rebound in global equities is more consistent with a bear market rally than the beginning of a new bull market. Typically, for a new durable bull market to emerge after a vicious bear market, a consolidation period or a base-building phase is needed. As of now, share prices have not formed such a base. Playing bear market rallies is all about timing, in which fundamental analysis is not useful. Rebounds die as abruptly as they begin. Hence, it is all about chasing momentum on either side. The unprecedented depth of this recession heralds that many businesses will likely be operating below their break-evens for a while, even after the confinement measures are eased. We closed our absolute short position in EM equities on March 19 but we have continued shorting EM currencies versus the US dollar. Even though EM share prices have become cheap based on their cyclically-adjusted P/E ratio (Chart I-1), valuation is not a good timing tool. This is especially true for this structural valuation indicator. Chart I-1EM Equities Are As Cheap As In Previous Bottoms Why The Rebound? After the massive selloff, investor sentiment on risk assets in general, and cyclicals specifically, has become very depressed. In particular: Sentiment of traders and investment advisors on US stocks has plummeted (Chart I-2). That said, net long positions in US equity futures are still above their 2016 and 2011 lows, as we noted last week. Traders’ sentiment on cyclical currencies such as the CAD and AUD as well as on copper and oil has dropped to their previous lows (Chart I-3).  Chart I-2Investor Sentiment On US Equities Is Poor Chart I-3Investor Sentiment On Copper And Oil Is Depressed   Consistently, net long positions of investors in both copper and oil have been trimmed substantially (Chart I-4A and I-4B). Chart I-4AInvestors’ Net Long Positions In Copper... Chart I-4B…And Oil   On the whole, it should not be surprising that after having become very oversold, risk assets rebounded in the past two weeks. Nevertheless, depressed investor sentiment is a necessary but not sufficient condition for a major bear market bottom. As illustrated in Chart I-3, sentiment on oil and copper was extremely depressed in late 2014. Yet with the exception of brief rebounds, both oil and copper prices continued to plunge for about a year before bottoming in January 2016. The necessary and sufficient condition for a durable bottom in global cyclical assets is an improvement in global demand. Chart I-5The S&P 500 And VIX In The Last Two Bear Markets Given the US and Europe are still in strict confinement and the Chinese economy remains quite weak (please see our more detailed discussion on this below), the global recession is still deepening. Further, while the enormous amounts of stimulus injected by policymakers is certainly positive, it is not yet clear whether these efforts are sufficient to entirely offset the collapse in the level of economic activity and its second round effects. Nevertheless, the Federal Reserve and the European Central Bank have probably contained the acute phase of the financial market crisis by buying financial assets and providing credit to the real economy. Odds are that the VIX and other volatility measures will not retest their recent highs. However, this does not mean that risk assets cannot retest their lows or make fresh ones. For example, in the previous 2001-2002 and 2008 bear markets, the S&P 500 re-tested its low in early 2003 and made a deeper trough in early 2009 even though the VIX drifted lower (Chart I-5). Finally, as we discuss below, a unique feature of this recession makes it unlikely that a definite equity market bottom has been established so quickly. How This Recession Is Distinct From an investor viewpoint, this global recession stands out from others in a particularly distinct way: In an average recession, nominal output levels do not contract. In the US, since 1960 it was only during 2008 that the level of nominal GDP contracted (Chart I-6). Presently, we are experiencing the gravest collapse in nominal output/sales since the 1930s – much worse than what transpired in 2008. Chart I-6US Nominal GDP And Corporate Profits Growth When a company’s sales shrink, a critical threshold for sustainability is the level of its revenues relative to its break-even point. The latter is the level of sales where total revenue is equal to total cost – i.e., where profits are nil. Break-even points have ramifications for share prices and the shape of a potential recovery. In an average recession, break-even points for the majority of companies are not breached – i.e., they remain profitable. As a result, a moderate and sequential revival in sales boosts profits, often exponentially. Share prices react positively to even modest sequential growth. Besides, when profits are expanding, managers and owners of these businesses are often quick to augment their capital spending and hiring. A marginal and sequential recovery from this very low point is not sufficient to produce a durable bull market for stocks or corporate credit. When a company’s sales drop below its break-even level, a moderate sequential recovery in sales could be insufficient to make the company profitable. In such a case, the share price may not rally vigorously unless they had priced in a much worse outcome – i.e., a bankruptcy. Crucially, a moderate sequential revival in activity may not lead to more capital spending and hiring. Given US and global nominal GDP are presently contracting at an unprecedented double-digit pace, the revenue of a majority of companies has fallen below costs – i.e., they are presently operating below their break-evens (experiencing losses). This makes this recession distinct from others. On the whole, the loosening of confinement measures and the resumption of business operations may not be sufficient reasons to turn bullish on equities. So long as a company operates below its break-even, its share price may not rally much in response to marginal sequential growth. In short, the pace of recovery will be crucial. Yet, there is considerable uncertainty with respect to these dynamics. Such uncertainty also warrants a high equity risk premium. A U-shaped recovery is most likely, but the latter assumes that many companies will be operating with losses for some time. Consequently, odds are that the process of bottoming in this bear market will be drawn out, and share prices will gyrate substantially in the interim. Taking Pulse Of The Global Economy In our March 19 report, we argued that this global recession is much worse than the one in 2008. High-frequency data are confirming our view: The weekly US economic index from the New York Fed has plunged more than it did in 2008 (Chart I-7). Capital spending plans have been shelved around the world. Odds are many businesses will be operating below their break-evens even after confinement measures are eased. Therefore, they will not rush to invest in new capacity and equipment, or rush to hire. China is a case in point. Commodities prices on the mainland remain in a downtrend, despite the resumption of business activity (Chart I-8). This is a sign of lingering weakness in construction/capital spending. Chart I-7An Unprecedented Plunge In Economic Activity Chart I-8Commodities Prices In China Are Drifting Lower   The world’s oil consumption is presently probably down by more than 35%.  According to INRIX, US car traffic last week was 47% below its level in late February before the confinement measures were introduced. Plus, airline travel has literally ground to a halt worldwide. In China’s major cities, traffic during rush hour is re-approaching its pre-pandemic levels. However, automobile congestion data from TomTom shows that in the afternoons and evenings, traffic remains well below where it was before the lockdown. This reveals that people go to work, spend most of their time at the office, and then quickly return home. They do not go out during lunch time or in the evenings. Hence, we infer that China’s service sector remains in recession.  Chart I-9EM ex-China, Korea And Taiwan: Nominal Growth Was Very Weak Before The Pandemic  The Chinese manufacturing and service PMI indexes registered 51 and 47 respectively in March, revealing that their economic recoveries are very subdued. As per our discussion above, we suspect revenues for many businesses in February dropped below break-even levels. The fact that only about a half of both manufacturing and service sector companies said their March activity improved from February is rather underwhelming. EM ex-China, Korea and Taiwan nominal GDP and core consumer price inflation were at very low levels before the pandemic (Chart I-9). The ongoing plunge in economic activity will produce the worst nominal output recession for many developing economies. Consequently, corporate profits of companies exposed to domestic demand will crash in local currency terms. Bottom Line: The unprecedented depth of this recession heralds that many businesses will likely be operating below their break-evens for a while, even after the confinement measures are eased. Thus, a marginal and sequential recovery from this very low point is not sufficient to produce a durable bull market for stocks or corporate credit. Credit Markets Hold The Key Solvency concerns for companies become acute and doubt about their debt sustainability persist when their revenues drop below their break-evens. Thus, a marginal improvement in revenue – as lockdowns worldwide are relaxed – may not suffice to produce a material tightening in EM corporate credit spreads. Playing bear market rallies is all about timing, in which fundamental analysis is not useful. Rebounds die as abruptly as they begin. Interestingly, equity markets often take their cues from credit markets. Chart I-10 demonstrates that EM US dollar corporate bond yields (inverted on the chart) correlate with equity prices. This chart unambiguously expounds that what matters for EM share prices is not US Treasurys yields but rather their own borrowing costs in US dollars. Chart I-10EM US Dollar Corporate Bond Yields And Stock Prices Presently, there are no substantive signs that US dollar borrowing costs for EM companies or sovereigns are declining. Chart I-11 illustrates that investment and high-yield corporate bond yields for aggregate EM and emerging Asia remain elevated. Remarkably, bank bond yields in overall EM and emerging Asia have not eased much (Chart I-12). The latter is crucial as banks’ external high borrowing costs will dampen their appetite to originate credit domestically. Chart I-11EM US Dollar Corporate Bond Yields Chart I-12EM Banks US Dollar Bond Yields Chart I-13EM Credit Spreads, Currencies And Commodities In turn, the direction of EM corporate and sovereign credit spreads is contingent on EM exchange rates and commodities prices, as demonstrated in Chart I-13. Credit spreads are shown inverted in both panels of this chart. We remain negative on both EM currencies and commodities prices, and argue for a cautious approach to EM credit markets.  Bottom Line: Elevated foreign currency debt levels among some EM corporations, plunging revenues and local currency depreciation combine for a perfect storm in EM corporate credit. To make matters worse, this asset class as well as EM sovereign credit were extremely overbought before this selloff. Therefore, there could be more outflows from these markets as adverse fundamentals persist.  Investment Strategy And Positions We continue to recommend underweighting EM stocks and credit versus their DM counterparts. Importantly, the EM equity index has been underperforming the global equity benchmark in the recent rebound (Chart I-14). Aggressive policy stimulus in the US and Europe have improved investor sentiment towards their credit and equity markets. Yet, the Chinese stimulus has so far been less aggressive than in the past. This will weigh on the growth outlook for emerging Asia and Latin America. The outlook for oil prices is currently a coin toss. Price volatility will remain enormous and it is not worth betting on either the long or short side of crude. Apart from oil, industrial metal prices remain at risk due to subdued demand from China. In general, this is consistent with lower EM currencies (Chart I-15).   Chart I-14Continue Underweighting EM Stocks Versus The Global Benchmark Chart I-15EM Currencies Correlate With Industrial Metals Prices Chart I-16Book Profits On Long EM Currency Volatility Trade In accordance with our discussion above that the most acute phase of this crisis might be over, we are booking profits on our long EM currency volatility trade. We recommended this trade on January 23, 2020 and the JP Morgan EM currency implied volatility measure has risen from 6% to 12% (Chart I-16). While EM currencies could still sell off, we doubt this volatility measure will make a new high. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Vietnamese Stocks: Stay Overweight Like many EM bourses, Vietnamese stocks have plunged 35% over the past two months in US dollar terms. How should investors now position themselves with regard to Vietnamese equities, in both absolute and relative terms? In absolute terms, there are near-term risks to Vietnamese equities: Vietnam’s economy is highly dependent on exports, which amount to more than 100% of the country’s GDP. The deepening global recession entails that overseas demand for Vietnamese exports will be decimated. Chart II-1 illustrates how share prices often swing along with export cycles. Customers from the US and EU, which together account for 40% of Vietnamese exports, have been cancelling their orders. In addition, the number of visitor arrivals has already dropped significantly, and tourism revenue – which amounts to about 14% of GDP – will continue to contract (Chart II-2). Chart II-1Vietnamese Stocks: Risks Are External Chart II-2Tourism Has Crashed   Nevertheless, we expect Vietnamese stocks to outperform the EM benchmark, in USD terms, both cyclically and structurally. First, Vietnam has solid macro fundamentals. The country’s annualized trade surplus has ballooned, reaching $12 billion in March (Chart II-3). Even as exports contract, the current account balance is unlikely to turn negative. Notably, Vietnam imports many of the materials required to produce its exported goods. As such, its imports will shrink along with its exports, which will support its current account balance. Meanwhile, the year-on-year growth of domestic nominal retail sales of goods has slowed down, but remains at 8% as of March, which is quite remarkable (Chart II-4). Chart II-3Vietnam Has Large Trade Surplus Chart II-4Consumer Spending To Slow But Not Contract   Second, the government has announced a sizable policy stimulus package. On March 16, the State Bank of Vietnam cut its policy rate by 50bps, from 4% to 3.5%, and its refinancing rate by 100bps, from 6% to 5%. On April 3, Vietnam's Ministry of Finance passed a fiscal stimulus package worth VND180 trillion (equal to US$7.64 billion, or 2.9% of its GDP). Third, Vietnam has contained the COVID-19 outbreak better than many other countries. With aggressive testing and isolation, the country has so far limited the infection rate to only three out of one million citizens, and reported zero deaths. This reduces the probability that Vietnam will be forced to adopt severe confinement measures that would derail its economy. This nation’s success also contrasts with the difficulties that many emerging and frontier economies are having in their struggle with COVID-19 containment.  We continue to overweight Vietnamese stocks relative to EM due to healthy fundamentals, attractive valuations, a large current account balance and a successful economic and health response to the COVID-19 outbreak. Fourth, the country remains quite competitive in global trade. For some time, multinational companies have been moving their supply chains to Vietnam in order to take advantage of its cheap and productive labor, inexpensive land and supportive government policies. As a result, Vietnamese exports have been outpacing those of China across many industries (Chart II-5). Given the geopolitical confrontation between the US and China is likely to persist over many years, more manufacturing will shift from China to Vietnam. Investment Recommendations In absolute terms, we believe Vietnamese stocks are still at risk. Stock prices falling to their 2016 low is possible over the coming weeks and months, which corresponds to a 10-15% downslide from current levels (Chart II-6, top panel). Chart II-5Vietnam Continues Gaining Export Market Share Chart II-6Vietnamese Stocks: Absolute & Relative Performance   Relative to the EM equity benchmark, however, we continue overweighting Vietnam equities, both cyclically and structurally. Technically, this bourse’s relative performance has declined to a major support line and it could be bottoming at current levels (Chart II-6, bottom panel). Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Bond Yield Differentials: The deepening global recession has prompted aggressive monetary easing measures by virtually every developed economy central bank. With policy rates now near zero everywhere, government bond yield differentials between countries have been reduced substantially. Currency Hedged vs Unhedged Yields: Opportunities still exist in some countries to create synthetically “higher” yields relative to low local rates by hedging the currency exposure of foreign bonds. Country Allocation: Italy and Spain government bonds offer the most attractive yields, hedged into any of the major currencies (USD, EUR, GBP, JPY). Among the lower yielders, Canadian, Australian, French and Japanese government bonds offer the most attractive yield pickups, on a currency-hedged basis, versus yields in the US, Germany, and the UK. Feature Chart 1A Synchronized Collapse The COVID-19 economic downturn is already shaping up to be one of the deepest global recessions in history. While there have been worldwide industrial slowdowns and manufacturing recessions in the past, what is happening now is different in that all countries are suffering sharp contractions in activity in the much larger services sectors that employ far more workers. The result will be massive increases in unemployment, as is already happening in the US where a staggering 10 million workers have filed for jobless benefits over just the past two weeks. Central bankers have responded to the shock to growth by following essentially the same playbook: cutting interest rates to zero as rapidly as possible, followed up with quantitative easing and other programs to support financial markets. With a synchronized economic collapse leading to policy convergence, government bond yields have plunged worldwide, but yield differentials between countries have also fallen sharply as a result (Chart of the Week). In this report, we will present the case for using currency hedging more actively than usual to create more attractive global bond yields. What can a global government bond investor do in this environment of tiny-but-highly-correlated bond yields to squeeze out some incremental additional return? In this report, we will present the case for using currency hedging more actively than usual to create more attractive global bond yields. A Fundamentally Driven Yield Convergence Chart 2Yields Are Low Everywhere As a simple starting point, just looking at the level of government bond yields in the developed economies is a good indication of how little there is to choose from between countries right now. For example, a 10-year government bond in the US was yielding 0.67% yesterday, compared to a 10-year yield in Australia, Canada and the UK of 0.82%, 0.75%, and 0.33% respectively (Chart 2). Not only are those low absolute yields, but those spreads versus US Treasuries are very narrow in an historical context. Another way to see how similar interest rate structures have become within the major developed markets is by looking at market expectations of future policy rates. Our proxy for the market’s pricing of the terminal nominal policy rate – the 5-year overnight index swap (OIS) rate, 5-years forward – shows that interest rate markets are expecting policy rates to stay very low over the next few years. The fall in the terminal rate estimate has been the largest in the US and Canada, where the markets were still pricing in a “peak” policy rate level around 2% as late as December – the figure is now 0.6% in the US and 1.1% in Canada (Chart 3). Chart 3Global Policy Rate Convergence So if the bond markets now believe that the current levels of bond yields will be sustained for longer, is that a realistic belief? There is already a considerable amount of both monetary and fiscal stimulus that has been introduced by policymakers. At some point, this stimulus should begin to stabilize and boost economic growth, but only after the immediate public health crisis of the COVID-19 outbreak has begun to subside. That will eventually help put a floor under developed market government bond yields. Chart 4The Backdrop Remains Conducive To Global Bond Yields Staying Low As we discussed in a recent weekly report, three elements must all happen before a true and lasting bottom for both risk assets and bond yields can begin to take place (Chart 4):1   The net number of new COVID-19 cases must begin to slow in critical countries like the US and Italy, a first step before the lockdown restrictions can start to be lifted; The US dollar (USD) must peak out and begin to roll over, taking stress off non-US borrowers of USD-denominated debt; The VIX must sustainably fall back from the levels above 40 that imply very volatile markets and continued investor nervousness about the future. Global government bond yields are likely to remain relatively range bound over the next month or two, at least.  Out of this list, the slowing in the number of new cases of the virus in Italy is a positive sign, as is the VIX falling back to the mid-40s. The sticky USD is still a major issue, however, particularly for borrowers with major dollar debts in the emerging world. There is not yet an “all clear” from this checklist, suggesting that global government bond yields are likely to remain relatively range bound over the next month or two, at least. This means bond investors need to consider alternative strategies to boost the yield of their government bond portfolios. Bottom Line: The deepening global recession has prompted similar monetary easing measures by virtually every developed economy central bank. With policy rates near zero everywhere, government bond yield differentials between countries have been largely eliminated. Searching For More Attractive Yields - With Currency Hedging When discussing our country allocation strategy, we have always looked at the yields and relative returns of government bonds in each country in hedged currency terms rather than in local currency terms. This is to remove the significant return volatility coming from currency exposure, while also making an appropriate “apples-to-apples” comparison of the yields on offer in each country. We have chosen the USD as the “base currency” for all these comparisons. In Chart 5, we show a static snapshot of the government bond yield curves, in local currency terms, for the US, Germany, France, Italy, the UK, Japan, Canada and Australia. The US, Canada and Australia remain the relative high-yielders within the major developed markets, although the “riskier” credits of Italy and Spain offer the highest outright yields. Unhedged German yields look particularly unattractive here, with the entire yield curve offering yields below 0%. Chart 5Currency-Unhedged Global Government Bond Yield Curves Chart 6USD-Hedged Global Government Bond Yield Curves In Chart 6, we show those same yield curves, but with the non-US yields all shown on a USD-hedged basis. The yields include the net gain/cost of hedging foreign currency back into US dollars using 3-month currency forwards. Shown this way, the non-US yield curves can be more directly compared to the “base” US Treasury curve. Looking at those yields shows that there is a much tighter convergence of yields with the US for most countries, but in a relative narrower range between 0.5% and 1.25% across the full maturity spectrum. The Fed’s rapid easing cycle, which started with the 75bps of rate cuts in the summer of 2019 and continued with the rapid move to a near-zero funds rate during the COVID-19 crisis, has dramatically altered the calculus for both global bond country allocation and currency hedging. Chart 7Fed Rate Cuts Have Reduced The Yield Advantage of USTs Chart 8Fed Rate Cuts Have Taken The Carry Out Of The USD First, the Fed’s easing cycle triggered a major decline in US Treasury yields that was not matched in other countries, eliminating much of the unhedged yield advantage of Treasuries over non-US peers (Chart 7). At the same time, the Fed’s rate cuts eliminated much of the interest rate “carry” of owning US dollars versus other currencies. The amount of that reduction was significant, with the gain of hedging a euro or yen currency exposure into dollars reduced from nearly around 250bps in the spring of 2019 to just over 100bps today (Chart 8). That dramatically alters the attractiveness of even negative-yielding German and Japanese government bonds, whose yields could once have been transformed into a relatively high USD-based yield via currency hedging. The Fed’s easing cycle triggered a major decline in US Treasury yields that was not matched in other countries, eliminating much of the unhedged yield advantage of Treasuries over non-US peers.  At the same time, the Fed’s rate cuts eliminated much of the interest rate “carry” of owning US dollars versus other currencies. Country Allocation Strategy Implications For dedicated global government bond investors, the only way to earn meaningfully higher yields in the current environment is to consider selective currency hedging of bond exposures. In Tables 1-4, we show 2-year, 5-year, 10-year and 30-year government bond yields for the major developed economy bond markets. The yields are hedged into USD, EUR, GBP and JPY, to allow comparisons of foreign yields for investors with those four base currencies. Table 1Currency-Hedged 2-Year Government Bond Yields Table 2Currency-Hedged 5-Year Government Bond Yields Table 3Currency-Hedged 10-Year Government Bond Yields Table 4Currency-Hedged 30-Year Government Bond Yields For USD-based investors, there are still some interesting opportunities available to find a USD-hedged foreign yield that can exceed that of US Treasuries. The higher-yielding European markets like Italy and Spain are the obvious places to find yield, and we continue to recommend those bonds with the ECB now buying more of the riskier euro area government bonds as part of its new Pandemic Emergency Purchase Program. However, Canadian, Australian and French bonds – hedged into USD – all offer intriguing yield pickups over US Treasuries. Even the negative yields available in Japan and Switzerland look interesting when expressed in USD terms, although that is not the case for negative yielding German bonds. Canadian, Australian and French bonds – hedged into USD – all offer intriguing yield pickups over US Treasuries. Even the negative yields available in Japan and Switzerland look interesting when expressed in USD terms, although that is not the case for negative yielding German bonds. In Tables 5-8, the currency-hedged yields for each country are shown as a spread to the relevant “base” bond yield for each currency. For example, under the “EUR” column in Table 6, the cells show the yield spread between 5-year government bonds hedged into euros and 5-year German bonds. Here, we can see that there are far fewer opportunities for euro-based bond investors to find non-European yields that offer adequate yield pickups versus German yields. The pickings are even less slim for Japanese investors, with many non-Japanese yields trading below Japanese yields on a JPY-hedged basis. Table 5Currency-Hedged 2-Year Govt. Bond Yield Spreads Versus The Table 6Currency-Hedged 5-Year Govt. Bond Yield Spreads Versus The Table 7Currency-Hedged 10-Year Govt. Bond Yield Spreads Versus The Table 8Currency-Hedged 30-Year Govt. Bond Yield Spreads Versus The In sum, looking across all eight tables shown, the most consistently attractive yields, across all currencies and maturities, can be found in Australia, Canada, France, Italy and Spain. Bottom Line: Opportunities still exist in some countries to create synthetically “higher” yields relative to low local rates by hedging the currency exposure of foreign bonds. Italy and Spain government bonds offer the most attractive yields, hedged into any of the major currencies (USD, EUR, GBP, JPY). Among the lower yielders, Canadian, Australian, French and Japanese government bonds offer the most attractive yield pickups, on a currency-hedged basis, versus yields in the US, Germany, and the UK.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Central Banks To Markets: Redefining "Whatever It Takes"", dated March 24, 2020, available at gfis.bcaresearch.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

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