Munis/S&L tax exempt

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

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

Highlights Chart 1Bond Yields Have Upside In A Blue Sweep Today’s US election has important implications for the near-term path of bond yields. In particular, a “blue sweep” outcome where the Democrats win control of the House, Senate and White House will probably cause yields to jump (Chart 1), as such an outcome virtually guarantees a large fiscal relief package early next year. Fiscal negotiations will be more contentious if the Republicans maintain control of the Senate, and yields could decline this evening if that occurs. However, no matter the election outcome, our 6-12 month below-benchmark portfolio duration recommendation will not change tomorrow. The economic recovery appears to be on track and some further fiscal stimulus is likely next year no matter who prevails tonight. The stimulus will just be smaller if a divided government necessitates compromise. In any case, bond investors should keep portfolio duration below-benchmark and stay overweight TIPS versus nominal Treasuries. They should also maintain positions in nominal and real yield curve steepeners and inflation curve flatteners. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 99 basis points in October, bringing year-to-date excess returns up to -300 bps. Corporate bonds are certainly not as cheap as they were back in March, but we still see acceptable value in the sector. The corporate index’s 12-month breakeven spread is at its 20th percentile since 1995 and the equivalent Baa spread is at its 28th percentile (Chart 2). Both levels appear somewhat expensive at first blush. However, considering the strong tailwinds from the Fed’s extraordinarily accommodative interest rate policy and emergency lending facilities, we see a lot of room for further tightening. Corporate bond issuance increased in September, though it remains well below the extreme levels seen in the spring (panel 4). The fact that the Financing Gap – the difference between capital expenditures and retained earnings – turned negative in the second quarter suggests that firms have enough cash to cover their investment needs (bottom panel). This will keep issuance low in the coming months. At the sector level, we continue to recommend overweight allocations to subordinate bank bonds,1  Healthcare and Energy bonds.2  We also advise underweight allocations to Technology3 and Pharmaceutical bonds.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 outperformed the duration-equivalent Treasury index by 86 basis points in October, bringing year-to-date excess returns up to -373 bps. Ba-rated bonds outperformed lower-rated credits in October, and they remain the best performing corporate credit tier since the March 23 peak in spreads (See Appendix A). In terms of value, if we assume a 25% recovery rate on defaulted debt and a minimum required spread of 150 bps in excess of default losses, then the High-Yield index is priced for a default rate of 4.8% during the next 12 months (Chart 3). Such a large drop in the default rate cannot be ruled out completely, but it would necessitate a rapid pace of economic recovery. We are not yet confident enough in the recovery to position for such a fast drop-off in defaults, especially with Job Cut Announcements still well above pre-COVID levels (bottom panel). We therefore continue to recommend an overweight allocation to the Ba-rated credit tier – where access to the Fed’s emergency lending facilities is broadly available – and an underweight allocation to bonds rated B and below. At the sector level, we advise overweight allocations to high-yield Technology5 and Energy bonds.6 We are underweight the Healthcare and Pharmaceutical sectors.7   MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 12 basis points in October, bringing year-to-date excess returns up to -39 bps. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 11 bps on the month to land at 72 bps. This is now slightly below the 76 basis point spread offered by Aa-rated corporate bonds but well above the 62 bps offered by Agency CMBS and the 29 bps offered by Aaa-rated consumer ABS. Despite the relatively attractive OAS, we remain concerned that the elevated primary mortgage spread is a warning that refinancing risk is greater than what is currently being priced in the market (Chart 4). Yes, the mortgage spread has tightened during the past few months, but it remains 35 bps above its average 2019 level. This suggests that the mortgage rate could fall another 35 bps due to spread compression alone, even if Treasury yields are unchanged. Such a move would lead to a significant increase in prepayment losses. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government intervention to either support household incomes or extend the forbearance period would mitigate the risk. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 30 basis points in October, bringing year-to-date excess returns up to -284 bps. Sovereign debt outperformed duration-equivalent Treasuries by 151 bps on the month, bringing year-to-date excess returns up to -420 bps. Foreign Agencies outperformed the Treasury benchmark by 18 bps in October, bringing year-to-date excess returns up to -690 bps. Local Authority debt underperformed Treasuries by 21 bps in October, dragging year-to-date excess returns down to -362 bps. Domestic Agency bonds outperformed by 7 bps, bringing year-to-date excess returns up to -33 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to -7 bps. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, this year’s dollar weakness has been relative to other Developed Market currencies. In recent months, the dollar has actually strengthened versus EM currencies (Chart 5). Value also remains poor for EM Sovereigns, which continue to offer a lower spread than Baa-rated corporate debt (panel 4). We looked at EM Sovereign valuation on a country-by-country basis in a recent report.8 We concluded that Mexican and Russian bonds offer the most compelling risk/reward trade-offs relative to the US corporate sector. Of those two countries, Mexican debt offers the best opportunity as US politics remain a concern for the Russian currency. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 41 basis points in October, bringing year-to-date excess returns up to -464 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries tightened in October, but value remains exceptional with most maturities trading at a positive before-tax spread. As we showed in a recent report, municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum.9 On a duration-matched basis, the Bloomberg Barclays General Obligation and Revenue Bond indexes trade at before-tax premiums relative to corporate bonds of the same credit rating, an extremely rare occurrence (Chart 6). Extraordinary valuation is the main reason for our recommendation to overweight municipal bonds. The severe ongoing state & local government credit crunch is a concern, but it is a risk we are willing to take. If the Democrats win the House, Senate and White House this evening – a fairly likely scenario – federal aid for state & local governments will be delivered in January. This would alleviate a lot of concern. But even in the absence of federal assistance, the combination of austerity measures (bottom panel) and all-time high State Rainy Day Fund balances should help stave off a wave of municipal downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-steepened in October, largely due to rising expectations of a “blue sweep” election outcome. The 2/10 and 5/30 Treasury slopes steepened 18 bps and 9 bps, respectively, to reach 74 bps and 127 bps. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. More bear steepening is likely if the Democrats win the House, Senate and White House tonight, as this would mean that a large amount of fiscal stimulus is coming early next year. But we will stick with our curve steepening recommendation regardless of the election outcome. No matter who wins the election, some further fiscal stimulus is likely on a 6-12 month horizon. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 38 basis points in October, bringing year-to-date excess returns up to -93 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 7 bps and 5 bps on the month. They currently sit at 1.71% and 1.82%, respectively. Core CPI rose 0.19% in September and the year-over-year rate held steady at 1.73%. The 12-month trimmed mean CPI ticked down from 2.48% to 2.37%, so the gap between core and trimmed mean continued to narrow (Chart 8). We anticipate further narrowing in the months ahead, and therefore expect core CPI to come in relatively hot. For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven rate is no longer cheap according to our Adaptive Expectations Model (panel 2).10 Inflation pressures may moderate once core and trimmed mean inflation measures converge, and this could give us an opportunity to tactically reduce TIPS exposure sometime next year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in October, bringing year-to-date excess returns up to +72 bps. Aaa-rated ABS outperformed the Treasury benchmark by 6 bps on the month, bringing year-to-date excess returns up to +59 bps. Non-Aaa ABS outperformed by 29 bps, bringing year-to-date excess returns up to +157 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a June report.11  We noted that stimulus received from the CARES act caused disposable income to increase significantly since February. Then, faced with fewer spending opportunities, households used much of that windfall to pay down consumer debt (panel 4). Granted, further income support from fiscal policymakers is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in October, bringing year-to-date excess returns up to -250 bps. Aaa Non-Agency CMBS underperformed Treasuries by 10 bps on the month, dragging year-to-date excess returns down to -73 bps. Non-Aaa Non-Agency CMBS outperformed by 72 bps, bringing year-to-date excess returns up to -738 bps (Chart 10). We continue to recommend an overweight allocation to Aaa Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate (CRE) continues. Without Fed support, non-Aaa CMBS will struggle to deal with tightening CRE lending standards and falling demand (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 29 basis points in October, bringing year-to-date excess returns up to +17 bps. The average index spread tightened 6 bps on the month. It currently sits at 62 bps, well above typical historical levels (bottom panel). At its last meeting, the Fed decided to slow its pace of Agency CMBS purchases. It will no longer seek to increase its Agency CMBS holdings, but will instead purchase only what is “needed to sustain smooth market functioning”. This is nonetheless a Fed back-stop of the market, and it does not change our overweight recommendation. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities 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 October 30TH, 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 October 30TH, 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 63 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 63 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 October 30TH, 2020)   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Trading Bonds In A Dollar Bear Market”, dated September 22, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Political Risk Will Dominate In A Pivotal Month For The Bond Market”, dated October 13, 2020, available at usbs.bcaresearch.com 10 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 11 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Duration: Prospects for more pre-election fiscal stimulus are slim. But with the Democrats gaining ground in the polls, the bond market will stay focused on rising odds of a blue sweep election and greater fiscal stimulus in early 2021. Municipal Bonds: Municipal bonds offer exceptional value relative to both US Treasuries and corporate credit. Not only that, but rising odds of a blue sweep election make state & local government fiscal relief increasingly likely. Investors should overweight municipal bonds in US fixed income portfolios. Economy: The economic recovery continues to roll on, but it will be some time before the output gap is closed and inflation starts to rise. Slow consumer and corporate credit growth suggest that animal spirits have not yet taken hold. Meanwhile, the falling unemployment rate masks a persistent uptrend in the number of permanently unemployed. Feature Chart 1Breakout After having been lulled to sleep by several months of stagnant yields, bond investors experienced a minor shockwave in early October. The 10-year Treasury yield and 2/10 slope both broke out of well-established trading ranges and implied interest rate volatility bounced off all-time lows to reach its highest level since June (Chart 1). We suspect this might turn out to be just the first small tremor in a tumultuous month leading up to the US election. Specifically, there are two main political risks that will be resolved within the next month. Both have major implications for the bond market. Bond-Bullish Risk: No More Stimulus Before The Election  The first risk is the possibility that the current Congress will not deliver any more fiscal stimulus. This increasingly looks like less of a possibility and more of a likelihood, especially after the president tweeted that he is halting negotiations with House Democrats. While he partially walked those comments back the next day, the fact remains that there is very little time between now and November 3rd, and the two sides remain at loggerheads. We have argued that more household income support from Congress is necessary. Otherwise, consumer spending will massively disappoint during the next year.1 However, it could take a few more months before this becomes apparent in the consumer spending data. Real consumer spending still rose in August, though much less quickly than it did in June and July (Chart 2). Meanwhile, August disposable income remained above pre-COVID levels, as it continued to receive a boost from facilities related to the CARES act (Chart 2, bottom panel). This boost will fade as the CARES act’s money is doled out, pushing spending lower. That is, unless Congress enacts a follow-up bill. There are two main political risks that will be resolved within the next month and both have major implications for the bond market. It looks less and less likely that a bill will be passed this month but, depending on the election outcome, a follow-up stimulus bill could become more likely in January. If consumer spending can hang in for the next couple of months, then the bond market might look past Congress’ near-term failure. This appears to be what is happening so far. The stock market fell 1.4% last Tuesday after Trump tweeted about halting negotiations. The 10-year Treasury yield, however, dropped only 2 bps on the day. More generally, long-dated bond yields rose during the past month, even as stocks sold off and prospects for immediate fiscal relief dimmed (Chart 3). Chart 2September's Consumer Spending Report Is Critical Chart 3Bonds Ignore Stock ##br##Market... With all that in mind, we think September’s consumer spending data – the last month of data we will see before the election – are very important. If spending collapses, it might re-focus the market’s attention on Congress’ failure, sending bond yields down. However, we think the market would see through a modest drop in spending, especially if the election looks poised to bring us a larger bill in 2021. Bond-Bearish Risk: A Blue Sweep Election Chart 4...Take Cues From Election Odds This brings us to the second big political risk that could influence bond yields during the next month: The possibility of a “blue sweep” election where the Democrats win control of the House, Senate and White House. This would clearly be a bearish outcome for bonds, as an unimpeded Democratic party would enact a large stimulus package – likely worth $2.5 to $3.5 trillion – shortly after inauguration. It appears that the bond market is already tentatively pricing-in this outcome. While the recent increase in bond yields is hard to square with weak equity prices and souring expectations for immediate stimulus, it is consistent with rising betting market odds of a blue sweep election (Chart 4). To underscore the bond bearishness of this potential election outcome, consider that not only would a unified Congress be able to quickly deliver another fiscal relief bill, but Joe Biden’s platform calls for even more spending on infrastructure, healthcare, education and other Democratic priorities. In total, Biden is proposing new spending of around 3% of GDP, only about half of which will be offset by tax increases (Table 1). Table 1ABiden Would Raise $4 Trillion In Revenue Over Ten Years Table 1BBiden Would Spend $7 Trillion In Programs Over Ten Years How likely is a “blue sweep” election? It is our Geopolitical Strategy service’s base case.2 Also, fivethirtyeight.com’s poll-based forecasting model sees a 68% chance that Democrats win the Senate, a 94% chance that they win the House and an 85% chance that Joe Biden wins the presidency. Investment Strategy These two political risks appear to put bond investors in a bit of a conundrum. On the one hand, if no stimulus bill is passed this month and September’s consumer spending data are weak, then bond yields could fall in the near-term. However, we are inclined to think that if all that occurs against the back-drop of rising odds of a blue sweep election outcome, the bond market will look beyond the near-term and yields will move higher on expectations of larger stimulus coming in January. As such, we retain our relatively pro-reflation investment stance. We recommend owning nominal and real yield curve steepeners, inflation curve flatteners and maintaining an overweight position in TIPS versus nominal Treasuries. All these positions are designed to profit from a rising yield environment.3 Municipal bonds look extremely cheap compared to other US fixed income sectors. We retain an “at benchmark” portfolio duration stance for now, for two reasons. First, while a blue sweep election outcome looks like the most likely scenario, it is not a guarantee. Second, even against the backdrop of greater government stimulus and continued economic recovery, the US economy will still be dealing with a large output gap next year that will temper inflationary pressures. This will keep the Fed on hold, limiting the upside in bond yields. That being said, the odds of another significant downleg in bond yields look increasingly slim. We will likely shift to a more aggressive “below-benchmark” duration stance this month, if our conviction in a blue sweep election outcome continues to rise. A Rare Buying Opportunity In Municipal Bonds No matter how you slice it, municipal bonds look extremely cheap compared to other US fixed income sectors. First, we can look at the spread between Aaa-rated munis and maturity-matched US Treasury yields (Chart 5). When we do this, we find that 2-year and 5-year municipal bonds trade at about the same yields as their Treasury counterparts. This is despite municipal debt’s tax-exempt status. Munis look even more attractive further out the curve, with 10-year and 30-year bonds trading at a before-tax premium relative to Treasuries. Chart 5Aaa Munis Versus ##br##Treasuries Table 2Muni/Corporate Breakeven Effective Tax Rates (%) Next, we can look at how municipal bonds stack up compared to corporates. We do this in a couple different ways. In Table 2, we start with the Bloomberg Barclays Investment Grade Corporate Index split by credit tier. We then find the General Obligation (GO) municipal bond that matches each corporate index’s credit rating and maturity and calculate the breakeven effective tax rate between the two yields. The breakeven effective tax rate is the effective tax rate that would make an investor indifferent between owning the municipal bond and the corporate bond. For example, if an investor faces an effective tax rate of 7%, they will observe the same after-tax yield in a 12-year A-rated GO municipal bond as they do in a 12-year A-rated corporate bond. If their effective tax rate is more than 7%, the muni offers an after-tax yield advantage. Alternatively, we can look at the relative value between munis and credit using the Bloomberg Barclays Municipal Indexes. In Chart 6A, we start with the average yield on the Bloomberg Barclays General Obligation indexes by maturity. We then find the US Credit index that matches the credit rating and duration of the municipal index and calculate the yield differential.4 We find that in all cases, for GO bonds ranging from 6 years to maturity and higher, the muni offers a before-tax yield advantage compared to the Credit Index. This is also true when we perform the same exercise using municipal revenue bonds instead of GOs (Chart 6B). Chart 6AGO Munis Versus Credit Chart 6BRevenue Munis Versus Credit You may notice that municipal bonds trade at a before-tax premium to credit in Charts 6A and 6B, but at a discount in Table 2. This is because we compare bonds by maturity in Table 2 and by duration in Charts 6A and 6B. Unlike investment grade corporates, municipal bonds often carry call options making them negatively convex and giving them a duration that is much shorter than their maturity. Cheap For A Reason, Or Just Plain Cheap? Chart 7State & Local Balance Sheets Will Weather The Storm We have effectively demonstrated that municipal bonds offer value relative to both Treasuries and corporate credit. But attractive value is not enough to warrant an overweight allocation. Ideally, we would also like some degree of confidence that wide spreads won’t eventually be justified by a wave of downgrades and defaults. While state & local government balance sheets are certainly stressed, we see strong odds that the muni market will emerge from the COVID recession relatively unscathed. For starters, state & local governments were experiencing strong revenue growth prior to the pandemic (Chart 7, top panel). This allowed them to build rainy day funds up to all-time highs (Chart 7, panel 4). Second, income support for households from the CARES act helped prop up state & local income tax revenues in the second quarter (Chart 7, panel 2), though sales tax revenues took a significant hit (Chart 7, panel 3). Going forward, a blue sweep election scenario would not only provide more income support for households – helping income tax revenues – but a Democratic controlled Congress would also quickly deliver fiscal aid directly to state & local governments. In fact, it is this aid for state & local governments that is currently the key sticking point in fiscal negotiations. In the meantime, state & local governments will continue to clamp down on spending. This can already be seen in the massive drop in state & local government employment (Chart 7, bottom panel). This is obviously a drag on economic growth, but the combination of austerity measures and high rainy day fund balances will help municipal bonds avoid downgrades and defaults, at least until a fiscal relief bill is passed next year. While state & local government balance sheets are certainly stressed, we see strong odds that the muni market will emerge from the COVID recession relatively unscathed. Bottom Line: Municipal bonds offer exceptional value relative to both US Treasuries and corporate credit. Not only that, but rising odds of a blue sweep election make state & local government fiscal relief increasingly likely. Investors should overweight municipal bonds in US fixed income portfolios. Economy: Credit Growth & The Labor Market Credit Growth Slowing Chart 8No Animal Spirits Of notable economic data releases during the past two weeks, we find it particularly interesting that both consumer credit and Commercial & Industrial (C&I) bank lending continue to slow (Chart 8). On the consumer side, massive income support from the CARES act and few spending opportunities caused households to pay down debt this spring. Then, after two months of modest gains, consumer credit fell again in August (Chart 8, top panel). This strongly suggests that, even as lockdown restrictions have eased, consumers aren’t yet ready to open up the spending taps. On the corporate side, firms received much less of a direct cash injection from Congress and were forced to take on massive amounts of debt to get through the spring and early summer months. But as of the second quarter, we recently observed that nonfinancial corporate retained earnings now exceed capital expenditures.5 This strongly suggests that firms have taken out enough new debt and that C&I bank lending will remain slow in the coming months. Cracks Showing In The Labor Market Chart 9Far From Full Employment Finally, we should mention September’s employment report that was released two weeks ago (Chart 9). It is certainly positive that the unemployment rate continues to fall, but the main takeaway for bond investors should be that the US economy remains far from full employment, and therefore far away from generating meaningful inflationary pressure. While the unemployment rate fell for the fifth consecutive month, it is now dropping much less quickly than it did early in the summer (Chart 9, panel 2). Also, we continue to note that labor market gains are entirely concentrated in temporarily unemployed people returning to work. The number of permanently unemployed continues to rise (Chart 9, bottom panel). Bottom Line: The economic recovery continues to roll on, but it will be some time before the output gap is closed and inflation starts to rise. Slow consumer and corporate credit growth suggest that animal spirits have not yet taken hold. Meanwhile, the falling unemployment rate masks a persistent uptrend in the number of permanently unemployed. Appendix The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 3Performance Since March 23 Announcement Of Emergency Fed Facilities Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, “It Ain’t Over Till It’s Over”, dated October 9, 2020, available at gps.bcaresearch.com 3 For more details on these recommended positions please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 4 Note that we use the US Credit Index in Charts 6A and 6B. This index includes the entire US corporate bond index but also some non-corporate credit sectors like Sovereigns and Foreign Agency bonds. 5 Please see US Bond Strategy Weekly Report, “Out Of Bullets”, dated September 29, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Spending Held Up In August The bulk of the CARES act’s income support provisions expired at the end of July and Congress has still not reached consensus on a follow-up package. Unsurprisingly, consumer spending responded by growing much more slowly in August, but at least so far, absolute calamity has been avoided (Chart 1). The failure of consumer spending to collapse has caused some, like St. Louis Fed President Jim Bullard, to question whether more stimulus is even necessary.1 We are less optimistic. The most recent personal income report shows that households still received $867 billion (annualized) of CARES act stimulus in August and the recovery in consumer confidence has been tepid at best (see page 12), suggesting that the savings rate will not drop quickly. We expect Congress to ultimately deliver more fiscal support, which will lead to a bear-steepening Treasury curve and spread product outperformance on a 6-12 month horizon. But continued brinkmanship warrants a more cautious near-term stance. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 40 basis points in September, dragging year-to-date excess returns down to -394 bps. Last month’s sell-off caused some value to return to the sector. The overall index’s 12-month breakeven spread is back up to its 31st percentile since 1995 and the equivalent Baa spread is at its 38th percentile (Chart 2). Both levels appear somewhat expensive at first blush. However, considering the strong tailwinds from the Fed’s extraordinarily accommodative interest rate policy and emergency lending facilities, we see a lot of room for further spread tightening. Corporate bond issuance was up in August, but nowhere near the extreme levels seen in the spring (panel 4). The fact that the Financing Gap – the difference between capital expenditures and retained earnings – turned negative in the second quarter suggests that firms have sufficient cash to cover their investment needs, and that further debt issuance is unnecessary (bottom panel). At the sector level, we continue to recommend overweight allocations to subordinate bank bonds,2 Healthcare and Energy bonds.3 We also advise underweight allocations to Technology4 and Pharmaceutical bonds.5   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 107 basis points in September, dragging year-to-date excess returns down to -455 bps. Oddly, Ba-rated was the worst performing credit tier on the month and the lowest-rated (Caa & below) credits actually beat the Treasury benchmark by 42 bps. As we wrote last week, this suggests that there remains scope for low-rated junk to sell off in the event of a shock to economic growth expectations.6 Such a development could arise if Congress fails to pass a new stimulus bill. In terms of value, if we assume a 25% recovery rate on defaulted debt and a minimum required spread of 150 bps in excess of default losses, then the High-Yield index is priced for a default rate of 4.8% during the next 12 months (Chart 3). Such a large drop in the default rate would necessitate a rapid economic recovery and we are not yet confident that such a recovery can be achieved. Job Cut Announcements – a variable that correlates tightly with the default rate – ticked higher in September and they remain well above pre-COVID levels (bottom panel). At the sector level, we advise overweight allocations to high-yield Technology7 and Energy bonds.8 We are underweight the Healthcare and Pharmaceutical sectors.9   MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in September, dragging year-to-date excess returns down to -51 bps. The conventional 30-year MBS index option-adjusted spread (OAS) widened 4 bps on the month, and it continues to trade at a premium compared to other similarly risky sectors. The MBS index OAS is currently 80 bps. This compares to an OAS of 79 bps for Aa-rated corporate bonds, 66 bps for Agency CMBS and 30 bps for Aaa-rated consumer ABS. Despite the OAS advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare during the next few months (Chart 4). Even if Treasury yields are unchanged, a further 50 bps drop in the mortgage rate due to spread compression cannot be ruled out. Such a move would lead to a significant increase in prepayment losses. With that in mind, we are concerned about the low level of expected prepayment losses (option cost) priced into the MBS index (panel 3). A fourth quarter refi wave would undoubtedly send that option cost higher, eating into the returns implied by the OAS. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government intervention to either support household incomes or extend the forbearance period would mitigate the risk.   Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 18 basis points in September, dragging year-to-date excess returns down to -313 bps. Sovereign debt underperformed duration-equivalent Treasuries by 99 bps on the month, dragging year-to-date excess returns down to -562 bps. Foreign Agencies underperformed the Treasury benchmark by 13 bps in September, dragging year-to-date excess returns down to -706 bps. Local Authority debt underperformed Treasuries by 4 bps in September, dragging year-to-date excess returns down to -341 bps. Domestic Agency bonds outperformed by 15 bps, bringing year-to-date excess returns up to -39 bps. Supranationals underperformed by 3 bps, dragging year-to-date excess returns down to -12 bps. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, most of this year’s dollar depreciation has occurred against other Developed Market currencies, not EMs (Chart 5). Added to that, dollar weakness against all trading partners helps US corporate sector profits, and Baa-rated corporate bonds continue to offer a spread pick-up versus EM Sovereigns (panel 4). We looked at EM Sovereign valuation on a country-by-country basis two weeks ago and concluded that Mexican and Russian Sovereigns offer the most compelling risk/reward trade-offs relative to the US corporate sector.10 Of those two countries, Mexican debt offers the best opportunity as the peso is on an appreciating trend versus the dollar. The Russian Ruble has been depreciating versus the dollar, and is vulnerable in the case of a Democratic sweep in November.     Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 12 basis points in September, dragging year-to-date excess returns down to -503 bps (before adjusting for the tax advantage). Short-dated municipal bond spreads versus Treasuries were stable in September, but long-maturity spreads widened. The entire Aaa muni curve remains above the Treasury curve, despite municipal debt’s tax-exempt status (Chart 6). Municipal bonds also remain attractively priced relative to corporate bonds across the entire investment grade credit spectrum. Aaa munis offer more after-tax yield than Aaa corporates for investors facing an effective tax rate above 15%. The breakeven effective tax rates for Aa, A and Baa-rated munis are 11%, 13% and 17%, respectively. Extremely attractive valuation causes us to stick with our municipal bond overweight, even as state and local governments face a credit crunch. State & local government payrolls shrank in September and, without federal support, cutbacks will no doubt continue (bottom panel). However, we expect that the combination of austerity measures and all-time high State Rainy Day Fund balances will be sufficient to prevent a wave of municipal ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened somewhat in September, though even the 30-year yield only fell 3 bps on the month. The 2/10 and 5/30 Treasury slopes flattened 2 bps and 3 bps, reaching 56 bps and 118 bps, respectively. One easy way to think about nominal Treasury yields is as the market’s expectation of future changes in the fed funds rate.11 With that in mind, the Fed’s recent shift toward a regime of average inflation targeting will likely lead to nominal yield curve steepening on a 6-12 month horizon. That is, the Fed will keep a firm grip on the front-end of the curve but long-maturity yields will rise as investors price-in eventual Fed tightening in response to higher inflation. We recommend positioning for this outcome by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. We expect the economic recovery to be maintained over the next 6-12 months, allowing this steepening to play out. However, we also see near-term risks related to the passage of a follow-up stimulus bill. Those not already invested in steepeners are advised to wait until a deal is struck. Valuation is a concern with our recommended curve steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year yield looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 54 basis points in September, dragging year-to-date excess returns down to -130 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates fell 18 bps and 16 bps on the month. They currently sit at 1.65% and 1.83%, respectively. Core CPI printed a strong +0.4% in August and the large divergence between core and trimmed mean inflation measures leads us to conclude that inflation will continue to rise quickly during the next few months (Chart 8). For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven rate is no longer cheap according to our Adaptive Expectations Model (panel 2).12 We could see inflation pressures moderating once core and trimmed mean inflation measures re-converge.13 This could give us an opportunity to reduce our exposure to TIPS sometime later this year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, this means that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 10 basis points in September, bringing year-to-date excess returns up to +63 bps. Aaa-rated ABS outperformed the Treasury benchmark by 7 bps on the month, bringing year-to-date excess returns up to +53 bps. Non-Aaa ABS outperformed by 32 bps, bringing year-to-date excess returns up to +128 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a June report.14 We noted that stimulus received from the CARES act caused disposable income to increase significantly between February and July. Then, faced with fewer spending opportunities, households used much of that windfall to pay down consumer debt (panel 4). Granted, further income support from fiscal policymakers is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 63 basis points in September, bringing year-to-date excess returns up to -259 bps. Aaa Non-Agency CMBS outperformed Treasuries by 46 bps on the month, bringing year-to-date excess returns up to -63 bps. Non-Aaa Non-Agency CMBS outperformed by 119 bps, bringing year-to-date excess returns up to -803 bps (Chart 10). We continue to recommend an overweight allocation to Aaa Non-Agency CMBS and an underweight allocation to Non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate continues. Without Fed support, Non-Aaa CMBS will struggle to deal with a climbing delinquency rate (panel 3).15 Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 9 basis points in September, dragging year-to-date excess returns down to -12 bps. The average index spread widened 2 bps on the month to 68 bps, well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table Performance Since March 23 Announcement Of Emergency Fed Facilities 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 October 2nd, 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 October 2nd, 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 63 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 63 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 October 2nd, 2020)   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1https://www.bloomberg.com/news/articles/2020-09-30/fed-s-bullard-says-debate-on-fiscal-aid-can-be-delayed-to-2021?sref=Ij5V3tFi 2 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Out Of Bullets”, dated September 29, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Trading Bonds In A Dollar Bear Market”, dated September 22, 2020, available at usbs.bcaresearch.com 11 For more details on this forecasting framework please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 12 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 For a deeper dive into the outlook for US commercial real estate please see Global Investment Strategy Special Report, “Working From Home, Urban Flight, And Commercial Real Estate Loans: How Bad Can Things Get?”, dated August 28, 2020, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Chart 1Permanent Job Losses Still Rising The biggest event in bond markets last month was the Fed’s shift toward a regime of average inflation targeting. Treasuries sold off in the days following the announcement and, overall, the Bloomberg Barclays Treasury index underperformed cash by 111 basis points in August (Chart 1). We view this market reaction as sensible, since it seems clear that the Fed’s new commitment to tolerate an overshoot of its 2% inflation target will be bearish for bonds in the long run. However, for this bond bear market to play out the US economy must first generate some inflation. This will take time. Despite the drop in the headline U3 unemployment rate, August’s employment report showed that permanent job losses continue to rise (bottom panel). This is a clear sign that the economic recovery is not yet on a solid footing. We advise bond investors to keep portfolio duration close to benchmark for the time being. We also recommend several yield curve trades across the nominal, real and inflation compensation curves (see pages 10 & 11). Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 5 basis points in August, bringing year-to-date excess returns up to -356 bps. Spreads on Baa-rated corporate bonds continued their tightening trend through August, even as spreads were roughly flat for bonds rated A and above. As a result, Baa-rated bonds outperformed duration-matched Treasuries by 30 bps on the month while higher-rated credits underperformed. Valuation remains more attractive for the Baa space than for higher-rated credits (Chart 2), but spreads for all credit tiers look cheaper than they did near the end of 2019. Given the Fed’s strong support for the market through both its emergency lending facilities, and now, its extraordinarily dovish forward rate guidance, we see further room for spread compression across all credit tiers. At the sector level, we continue to recommend a focus on high-quality Baa-rated issuers. That is, Baa-rated bonds that are unlikely to face a ratings downgrade during the next 12 months. Subordinate bank bonds are a prime example of debt that falls into this sweet spot.1 We also recommend overweight allocations to Healthcare and Energy bonds2 and underweight allocations to Technology3 and Pharmaceutical bonds.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 outperformed the duration-equivalent Treasury index by 121 basis points in August, bringing year-to-date excess returns up to -351 bps. All junk credit tiers delivered strong returns in August, but the lowest-rated credits performed best. Caa-rated & below junk bonds outperformed Treasuries by 255 bps on the month compared to 98 bps of outperformance for Ba-rated bonds (Chart 3). The recent strong performance of low-rated junk bonds makes us question whether our focus on the Ba-rated credit tier is overly conservative. If the economy is indeed on a quick road to recovery, then we are leaving some return on the table by avoiding the B-rated and lower credit tiers. However, we aren’t yet confident enough in the economic recovery to move down in quality. Last week’s employment report showed that permanent job losses continue to rise and Congress has still not passed a much needed follow-up to the CARES act. What’s more, current junk spreads imply a very rapid decline in the corporate default rate during the next 12 months, from its current level of 8.4% all the way to 4.4% (panel 3).5  In this regard, August’s steep drop in layoff announcements is a positive development (bottom panel), though job cuts are still running well above pre-pandemic levels. At the sector level, we advise overweight allocations to high-yield Technology6 and Energy7 bonds. We are underweight the Healthcare and Pharmaceutical sectors.8 MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in August, bringing year-to-date excess returns up to -37 bps. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 7 bps in August, but it still offers a small spread pick-up compared to other similarly risky sectors. The MBS OAS of 77 bps is greater than the 75 bps offered by Aa-rated corporate bonds, the 67 bps offered by Agency CMBS and the 35 bps offered by Aaa-rated consumer ABS. Despite the spread advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare later this year  (Chart 4). Even if Treasury yields are unchanged, a further 50 bps drop in the mortgage rate due to spread compression cannot be ruled out. Such a move would lead to a significant increase in prepayment losses. With that in mind, we are concerned about the low level of expected prepayment losses (option cost) priced into the MBS index (panel 3). A fourth quarter refi wave would undoubtedly send that option cost higher, eating into the returns implied by the OAS. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government action to either support household incomes or extend the forbearance period could mitigate the risk. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 31 basis points in August, bringing year-to-date excess returns up to -295 bps. Sovereign debt outperformed duration-equivalent Treasuries by 105 bps on the month, bringing year-to-date excess returns up to -468 bps. Foreign Agencies outperformed the Treasury benchmark by 13 bps in August, bringing year-to-date excess returns up to -694 bps. Local Authority debt outperformed Treasuries by 33 bps in August, bringing year-to-date excess returns up to -337 bps. Domestic Agency bonds outperformed by 8 bps, bringing year-to-date excess returns up to -54 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to -9 bps. US dollar weakness is usually a boon for Sovereign and Foreign Agency returns. However, most of the dollar’s recent depreciation has occurred against other Developed Market currencies, not Emerging Markets (Chart 5). Added to that, dollar weakness against all trading partners helps US corporate sector profits, and Baa-rated corporate bonds continue to offer a spread pick-up versus EM sovereigns (panel 4). Within the Emerging Market Sovereign space: Turkey, South Africa, Mexico, Colombia and Russia all offer a spread pick-up relative to quality and duration-matched US corporate bonds. Of those attractively priced countries, Mexico stands out as particularly compelling on a risk/reward basis.9 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 19 basis points in August, dragging year-to-date excess returns down to -492 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries have widened during the past month, more so at the long-end than at the short-end, and the entire Aaa muni curve remains above the Treasury curve, despite municipal debt’s tax-exempt status (Chart 6). Municipal bonds also remain attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.10 The Fed reduced the pricing on its Municipal Liquidity Facility (MLF) by 50 basis points last month. Most likely, it felt pressure to act as Congress has still not passed a state & local government aid package. However, the Fed’s move will not have much impact on municipal bond spreads. Even after the reduction, municipal yields continue to run well below the cost offered by the MLF (panel 3). Extremely attractive valuation causes us to stick with our municipal bond overweight, though spreads will widen in the near-term if much needed stimulus doesn’t arrive soon. In the long-run, we remain optimistic that elevated state rainy day funds will help cushion the fiscal blow and lessen the risk of ratings downgrades (bottom panel).    Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-steepened in August. The 2/10 and 5/30 Treasury slopes steepened 14 bps and 22 bps, reaching 58 bps and 121 bps, respectively. One easy way to think about nominal Treasury yields is as the market’s expectation of future changes in the federal funds rate.11 With that in mind, the Fed’s recent shift toward a regime of average inflation targeting will likely lead to nominal yield curve steepening. That is, the Fed will keep a firm grip on the front-end of the curve, but long-maturity yields could rise as investors price-in the possibility that the Fed will have to eventually respond to high inflation by quickly tightening policy. For this reason, we retain a core position in nominal yield curve steepeners. Specifically, we recommend buying the 5-year bullet and shorting a duration-matched 2/10 barbell. This position is designed to profit from 2/10 Treasury curve steepening, which should play out over the next 6-12 months, assuming the economic recovery is sustained. Valuation is a concern with this recommended positioning. The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet looks expensive on our yield curve models (Appendix B).     However, the 5-year bullet traded at much more expensive levels during the last zero-lower-bound period between 2010 and 2013 (bottom panel). With short rates once again pinned at zero, we expect the 5-year to once again hit extreme levels of overvaluation. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 240 basis points in August, bringing year-to-date excess returns up to -76 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 25 bps and 22 bps on the month. They currently sit at 1.67% and 1.78%, respectively. TIPS breakeven inflation rates have moved up rapidly during the past couple months, a trend that was supercharged by the Fed’s Jackson Hole announcement. In fact, the 10-year TIPS breakeven inflation rate is now right around fair value according to our Adaptive Expectations Model (Chart 8).12 TIPS will soon turn expensive if current trends continue. That is, unless stronger CPI inflation sends our model’s fair value reading higher. We place strong odds on the latter occurring during the next few months, with trimmed mean inflation measures still running well above core (panel 3). However, we cautioned in a recent report that inflation is likely to moderate in 2021 after core inflation re-converges with the trimmed mean.13 In addition to our overweight stance on TIPS, we continue to recommend real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also keeping a firmer grip over short-dated nominal yields than over long-dated ones, this means that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 30 basis points in August, bringing year-to-date excess returns up to +53 bps. Aaa-rated ABS outperformed the Treasury benchmark by 24 bps on the month, bringing year-to-date excess returns up to +46 bps. Non-Aaa ABS outperformed by 73 bps, bringing year-to-date excess returns up to +95 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a recent report.14  We noted that the stimulus received from the CARES act caused real disposable personal income to increase significantly between February and July and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further income support from fiscal policymakers is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies.  Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 77 basis points in August, bringing year-to-date excess returns up to -320 bps. Aaa Non-Agency CMBS outperformed Treasuries by 57 bps on the month, bringing year-to-date excess returns up to -108 bps. Non-Aaa Non-Agency CMBS outperformed by 160 bps, bringing year-to-date excess returns up to -1008 bps (Chart 10). We continue to recommend an overweight allocation to Aaa non-agency CMBS and an underweight allocation to non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate continues. Without Fed support, non-Aaa CMBS will struggle to deal with a climbing delinquency rate (panel 3).15 Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 38 basis points in August, bringing year-to-date excess returns up to -4 bps. The average index spread tightened 6 bps on the month to 66 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities​​​​​​​ 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 September 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 September 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 72 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 72 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 September 3, 2020)   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 5 We assume a 25% recovery rate and target a spread of 150 bps in excess of default losses. For more details on this calculation please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020, and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 11 For more details on this forecasting framework please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 12 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 For a deeper dive into the outlook for US commercial real estate please see Global Investment Strategy Special Report, “Working From Home, Urban Flight, And Commercial Real Estate Loans: How Bad Can Things Get?”, dated August 28, 2020, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Chart 1How Much Lower For Real Yields? Treasury yields moved lower last month even as the overall bond market priced-in a more reflationary economic environment. Spread product outperformed Treasuries and inflation expectations rose, but nominal bond yields still fell as plunging real yields offset the rising cost of inflation compensation (Chart 1). This sort of market behavior is unusual, but it is also easily explained. The market is starting to believe in the economic recovery, and it is pushing inflation expectations higher as a result. However, it also believes that the Fed will keep the nominal short rate pinned at zero even as inflation rises. Falling real yields result from rising inflation expectations and stable nominal rate expectations. This combination of market moves can’t go on forever. Eventually, inflation expectations will rise enough that the market will price-in policy tightening. This will push real yields higher, starting at the long-end of the curve. However, it’s difficult to know when this will occur, especially with the Fed doing its best to convey a dovish bias. In this environment, we advise investors to keep portfolio duration near benchmark and to play the reflation trade through real yield curve steepeners (see page 11). Real yield curve steepeners will profit in both rising and falling real yield environments, as long as the reflation trade remains intact. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 177 basis points in July, bringing year-to-date excess returns up to -361 bps. Spreads continue to tighten and investment grade corporate bond valuation is turning expensive, particularly for the highest credit tiers. The 12-month breakeven spread for the overall corporate index has been tighter 29% of the time since 1996 (Chart 2). The similar figure for the Baa credit tier is a relatively cheap 38% (panel 3). With the Fed providing a strong back-stop for investment grade corporates – one that has now officially been extended until the end of the year – we should expect spreads to turn even more expensive, likely returning to the all-time stretched valuations seen near the end of 2019. With that in mind, we want to focus our investment grade corporate bond exposure on high quality Baa-rated bonds. These are bonds that offer greater expected returns than those rated A and above, but that are also unlikely to be downgraded into junk (panel 4). Subordinate bank bonds are prime examples of securities that exist within this sweet spot.1 At the sector level, we also recommend overweight allocations to Healthcare and Energy bonds,2 as well as underweight allocations to Technology3 and Pharmaceutical bonds.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 outperformed the duration-equivalent Treasury index by 425 basis points in July, bringing year-to-date excess returns up to -466 bps. All junk credit tiers delivered strong returns on the month with the exception of the lowest-rated (Ca & below) bonds (Chart 3). These securities underperformed Treasuries by 267 bps, as a rising default rate weighs on the weakest credits. We are sticking with our relatively cautious stance toward high-yield, favoring bonds only from those issuers that will be able to access the Fed’s emergency lending facilities if need be. This includes most of the Ba-rated credit tier, some portion of the B-rated credit tier, and very few bonds rated Caa & below. We view the Fed back-stop as critically important because junk spreads are far too tight based on fundamentals alone. For example, current market spreads imply that the default rate must come in below 4.5% during the next 12 months for the junk index to deliver a default-adjusted spread consistent with positive excess returns versus Treasuries (panel 3).5 This would require a rapid improvement in the economic outlook. At the sector level, we advise overweight allocations to high-yield Technology6 and Energy7  bonds. We are underweight the Healthcare and Pharmaceutical sectors.8 MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 2 basis points in July, dragging year-to-date excess returns down to -46 bps. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 12 bps in July, but it still offers a pick-up relative to other comparable sectors. The MBS OAS of 86 bps is greater than the 75 bps offered by Aa-rated corporate bonds (Chart 4), the 47 bps offered by Aaa-rated consumer ABS and the 72 bps offered by Agency CMBS. Despite this spread advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare later this year (bottom panel). Even if Treasury yields are unchanged, a further 50 bps drop in the mortgage rate due to spread compression cannot be ruled out. Such a move would lead to a significant increase in prepayment losses. With that in mind, we are concerned about the low level of expected prepayment losses (option cost) priced into the MBS index (panel 3). A refi wave in the second half of this year would undoubtedly send that option cost higher, eating into the returns implied by the lofty OAS.   Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 77 basis points in July, bringing year-to-date excess returns up to -325 bps. Sovereign debt outperformed duration-equivalent Treasuries by 285 bps on the month, bringing year-to-date excess returns up to -567 bps. Foreign Agencies outperformed the Treasury benchmark by 62 bps in July, bringing year-to-date excess returns up to -706 bps. Local Authority debt outperformed Treasuries by 74 bps in July, bringing year-to-date excess returns up to -368 bps. Domestic Agency bonds underperformed by 4 bps, dragging year-to-date excess returns down to -62 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to -14 bps. The US dollar’s recent weakness, particularly against EM currencies, is a huge boon for Sovereign and Foreign Agency returns (Chart 5). However, US corporate spreads will also perform well in an environment of improving global growth and dollar weakness and, for the most part, value remains more compelling in the US corporate space (panel 3). Within the Emerging Market Sovereign space: South Africa, Mexico, Colombia, Malaysia, UAE, Saudi Arabia, Qatar, Indonesia, Russia and Chile all offer a spread pick-up relative to quality and duration-matched US corporate bonds. Of those attractively priced countries, Mexico stands out as particularly compelling on a risk/reward basis.9   Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 115 basis points in July, bringing year-to-date excess returns up to -473 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries tightened in July, but remain elevated compared to typical historical levels. In fact, both the 2-year and 10-year Aaa Muni yields are above equivalent-maturity Treasury yields, despite municipal debt’s tax exempt status (Chart 6). Municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.10 In that report we also mentioned our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push Muni yields lower from current levels. Despite the MLF’s shortcomings, we stick with our overweight allocation to municipal bonds. For one thing, federal assistance to state & local governments will be included in the forthcoming stimulus bill. The Fed will also feel increased pressure to reduce MLF pricing the longer the passage of that bill is delayed. Further, while the budget pressure facing municipal governments is immense, states hold very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull flattened in July. The 2/10 and 5/30 Treasury slopes flattened 6 bps and 13 bps, reaching 44 bps and 99 bps, respectively. Unusually, the bull flattening of the Treasury curve that occurred last month was not the result of a deflationary market environment. Rather, the inflation compensation curve bear flattened – the 2-year and 10-year CPI swap rates increased 25 bps and 16 bps, respectively – while the real yield curve underwent a large parallel shift down. It will be difficult for the nominal yield curve to keep flattening if this reflationary back-drop continues. Eventually, rising inflation expectations will pull up real yields at the long-end of the curve. For this reason, we retain our bias toward duration-neutral yield curve steepeners on a 6-12 month horizon. Specifically, we advise going long the 5-year bullet and short a duration-matched 2/10 barbell. In a recent report we noted that valuation is a concern with this positioning.11 The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet looks expensive on our yield curve models (Appendix B). However, the 5-year bullet traded at much more expensive levels during the last zero-lower-bound period between 2010 and 2013 (bottom panel). With short rates once again pinned at zero, we expect the 5-year to once again hit extreme levels of overvaluation.   TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 95 basis points in July, bringing year-to-date excess returns up to -309 bps. The 10-year TIPS breakeven inflation rate rose 21 bps on the month to hit 1.56%. The 5-year/5-year forward TIPS breakeven inflation rate rose 18 bps on the month to hit 1.71%. TIPS breakeven inflation rates have moved up rapidly during the past couple of months, and the 10-year breakeven is now within 6 bps of the fair value reading from our Adaptive Expectations Model (Chart 8).12 TIPS will soon turn expensive if current trends continue. That is, unless stronger CPI inflation sends our model's fair value estimate higher. We place strong odds on the latter occurring. Month-over-month core CPI bottomed in April, as did the oil price. In addition, trimmed mean inflation measures suggest that core has room to play catch-up (panel 3). As mentioned on page 1, we continue to recommend real yield curve steepeners as a way to take advantage of the ongoing reflation trade. With the Fed now targeting a temporary overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to eventually trade above the cost of 10-year inflation protection (panel 4). With the Fed also keeping a firmer grip over short-dated nominal yields than over long-dated ones, this means that short-maturity real yields will come under downward pressure relative to the long-end (bottom panel).13   ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 25 basis points in July, bringing year-to-date excess returns up to +23 bps. Aaa-rated ABS outperformed the Treasury benchmark by 15 bps on the month, bringing year-to-date excess returns up to +22 bps. Non-Aaa ABS outperformed by 111 bps, bringing year-to-date excess returns up to +22 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Securities Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a recent report.14 We noted that the stimulus received from the CARES act caused real personal income to increase significantly during the past four months and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further fiscal stimulus is needed to sustain recent income gains. But we expect the follow-up stimulus bill to be passed soon. Our Geopolitical Strategy service has shown that the new bill will likely contain sufficient income support for households.15   Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 112 basis points in July, bringing year-to-date excess returns up to -395 bps. Aaa CMBS outperformed Treasuries by 43 bps on the month, bringing year-to-date excess returns up to -111 bps. Non-Aaa CMBS outperformed by 256 bps, bringing year-to-date excess returns up to -1042 bps (Chart 10). We continue to recommend an overweight allocation to Aaa non-agency CMBS and an underweight allocation to non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate continues. Without Fed support, non-Aaa CMBS will struggle as the delinquency rate continues to climb (panel 3).16 Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 17 basis points in July, bringing year-to-date excess returns up to -42 bps. The average index spread tightened 5 bps on the month to 72 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table Performance Since March 23 Announcement Of Emergency Fed Facilities 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 July 31, 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 July 31, 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 57 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 57 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 July 31, 2020)   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 For our outlook on Energy bonds please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 5 We assume a 25% recovery rate and target a spread of 150 bps in excess of default losses. For more details on this calculation please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 11 Please see US Bond Strategy Weekly Report, "Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 12 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 13 For more details on our recommended real yield curve steepener trade please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 Please see Geopolitical Strategy Weekly Report, “A Tech Bubble Amid A Tech War (GeoRisk Update)”, dated July 31, 2020, available at gps.bcaresearch.com 16 We discussed our CMBS outlook in more detail in US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Special Report

Highlights The Fed’s emergency lending facilities have successfully stabilized markets … : Credit spreads have tightened dramatically since March and liquidity has been restored to the US Treasury market. … at very little cost to the central bank: Just the announcement of Fed lending facilities has been enough to push spreads lower in most cases. The facilities themselves have seen very little actual uptake. The only cost borne by the Fed has been a dramatic expansion of its balance sheet due to purchases of Treasury securities. We still want to “buy what the Fed is buying”: In US fixed income, we want to favor those sectors that are eligible for Fed support. This includes corporate bonds rated Ba and higher, municipal bonds and Aaa-rated securitizations. Keep portfolio duration at neutral: The Fed will be much more cautious about raising interest rates than in the past, and could wait until inflation is above its target before lifting off zero. Feature Back in April, we published a detailed explainer of the extraordinary actions taken by the Federal Reserve to combat the pandemic-induced recession.1 This week, we re-visit that Special Report to assess what the Fed has accomplished during the past three months and to speculate about what lies ahead. Overall, the Fed’s response has been highly effective. Stability was restored to financial markets almost immediately after the most dramatic policy interventions were announced, and it turns out that the announcements themselves did most of the work. The ultimate usage of the Fed’s Section 13(3) emergency lending facilities has been extremely low relative to their stated maximum capacities (Table 1). If you are the Fed, it is apparently enough to marshal overwhelming force and announce your willingness to deploy it. Like the ECB demonstrated in the fraught Eurozone summer of 2012, a bazooka can restore order without being fired.2 Table 1Usage Of The 2020 Federal Reserve Emergency Lending Facilities The only possible cost borne by the Fed has been an explosion in the size of its balance sheet, mostly attributable to purchases of Treasury securities. The ultimate usage of the Fed’s facilities has been extremely low relative to their stated maximum capacities. This report looks at how the Fed’s actions have influenced (and will influence) interest rates, Treasury market liquidity, the corporate bond market and other fixed income spread products. It also considers the potential impact of the size of the Fed’s balance sheet on the economy and financial markets. Interest Rates The Fed dropped the funds rate to a range of 0% to 0.25% on March 15, and since then it has aggressively signaled that rates will stay pinned at the zero-lower-bound for a long time. Investors quickly took this message on board (Chart 1). The median estimate from the New York Fed’s Survey of Market Participants has the funds rate holding steady at least through the end of 2022. Meanwhile, the overnight index swap curve isn’t pricing-in a rate hike until 2024. Chart 1The Fed And Market Agree: No Hikes Through 2022 Chart 2Better Signaling From The Fed The market adjusted much more quickly to the Fed’s zero interest rate policy this year than it did during the last zero-lower-bound episode (Chart 2). The MOVE index of Treasury yield volatility has already plunged to below 50. It took several years for it to reach those levels after the Fed cut rates to zero at the end of 2008. Similarly, the yield curve is much flatter today than it was during the last zero-lower-bound episode. This partly reflects the market’s expectation that rates will stay at zero for longer and partly the downward revisions to estimates of the long-run neutral fed funds rate that have occurred during the past few years. The bottom line is that the Fed has successfully achieved its goal on interest rate policy. The funds rate is at its effective lower bound and the entire term structure is priced for it to stay there for a very long time. There are two main reasons for this success. First, the Fed’s forward guidance has been more dovish this year than at any point during the last zero-lower-bound episode, with many FOMC participants calling for the Fed to target a temporary overshoot of the 2% inflation target. Second, the market is more skeptical about inflation ever returning to that target, as evidenced by much lower long-dated inflation expectations (Chart 2, bottom panel). What’s Next? The Fed has already made it clear that it won’t pursue negative interest rates. With those off the table, the next step will be for the Fed to make its forward rate guidance more explicit. In all likelihood this will involve the return of some form of the Evans Rule that was in place between 2012 and 2014. The Evans Rule was a commitment to not lift rates at least until the unemployment rate moved below 6.5% or inflation moved above 2.5%.3 The new version of the Evans Rule will be much more dovish. In a recent speech, Governor Lael Brainard favorably cited research suggesting that the Fed should refrain from liftoff until inflation reaches the 2% target.4 That may very well be the rule that ends up becoming official Fed guidance. If the Fed wants to strengthen its commitment to low rates even more, it could follow the Reserve Bank of Australia’s lead and implement a Yield Curve Control policy. This policy would involve setting caps for Treasury yields out to a 2-year or 3-year maturity. The Fed would pledge to buy as many securities as necessary to enforce the caps and would only lift the caps when the criteria of its new Evans Rule are met. While spreads have tightened across all credit tiers, investment grade corporates have become much more expensive than high-yield. For the time being, there is no rush for the Fed to deliver more explicit forward guidance and/or Yield Curve Control. As we noted above, bond yields are already pricing-in an extremely lengthy period of zero rates. But these policies will become more important as the economic recovery progresses and market participants start to speculate about an eventual exit from the zero bound. Explicit forward guidance and/or Yield Curve Control would then prevent a premature rise in bond yields and tightening of financial conditions. With all that in mind, we would not be surprised to see more explicit (Evans Rule-style) forward guidance rolled out at some point this year, but unless bonds sell off significantly beforehand, it probably won’t have an immediate impact on yields. The same is true for Yield Curve Control, though the odds of that being announced this year are lower as it is a tool with which the Fed is less comfortable. Treasury Market Liquidity Chart 3When Treasury Market Liquidity Evaporated As the COVID-19 crisis flared in March, there were several tense days when liquidity in the US Treasury market evaporated. Bond yields jumped even as the equity market plunged (Chart 3). Meanwhile, liquidity markers showed that it had become much more difficult to transact in US Treasuries. Treasury Bid/Ask spreads widened dramatically and the iShares 20+ Year Treasury ETF (TLT) traded at a huge discount to its net asset value (Chart 3, panel 3). During the past four months, researchers have identified hedge fund selling of Treasuries to meet margin calls and foreign bank selling of Treasuries to meet demands for US dollar funding as the proximate causes of March’s Treasury rout. However, it is clearly a failure of market structure that the Treasury market was unable to accommodate that selling pressure without liquidity disappearing. In a recent paper from The Brookings Institution, Darrell Duffie explains why the Treasury market was unable to maintain its liquidity during this tumultuous period.5 Essentially, he argues that it is the combination of rising Treasury supply and post-2008 regulations imposed on dealer banks that has led to an environment where there is a large and growing amount of Treasury supply, but where dealers have less balance sheet capacity to intermediate trading. To illustrate, Chart 4 shows the ratio between the outstanding supply of Treasury securities and the quantity of Treasury inventories for which primary dealers obtained financing. Quite obviously, the dealers’ intermediation activities have not kept pace with the expanding size of the market. Chart 4Primary Dealers Have Not Kept Up With Treasury Issuance What’s Next? Without changes to Treasury market structure or bank capital requirements (Duffie recommends abandoning the system of competing dealer banks altogether and moving all Treasury trades through one central clearinghouse), we are likely to see more episodes like March where a spate of Treasury selling leads to an evaporation of market liquidity. When that happens, the Fed will be forced to step in and buy Treasuries, as it did in March (Chart 3, bottom panel). The goal of that intervention is simply to remove enough supply from the market so that the remaining trading volume can be handled by the dealers. As this pattern repeats itself over time, it will cause the Fed’s presence in the Treasury market to grow. Bottom Line: Unless structural changes are made to the Treasury market or bank capital regulations are rolled back, we should expect more episodes of Treasury market illiquidity like we saw in March. We should also expect the Fed to respond to those episodes with aggressive Treasury purchases, and for the Fed’s presence in the Treasury market to grow over time. Corporate Bonds The Fed’s intervention in the corporate bond market consists of three lending facilities: The Secondary Market Corporate Credit Facility (SMCCF) where the Fed purchases investment grade corporate bonds and recent Ba-rated fallen angels in the secondary market. This facility also purchases investment grade and high-yield ETFs. The Primary Market Corporate Credit Facility (PMCCF) where the Fed buys new issuance from investment grade-rated issuers (and recent fallen angels) in the primary market. The Main Street Lending Facility (MSLF) where the Fed purchases loans off of bank balance sheets. The loans must be made to small or medium-sized firms with Debt-to-EBITDA ratios below 6.0. Chart 5Corporate Issuance Surged Following The Fed's Announcements As mentioned above, these facilities have barely been tapped. As of July 1, the Fed had purchased $1.5 billion of corporate bonds and just under $8 billion of ETFs through the SMCCF, while the PMCCF had not been used at all. However, the impact of the Fed’s promise to back-stop such a large portion of the corporate debt market has been immense. Corporate bond issuance surged following the announcement of the Fed’s facilities, and set monthly post-2008 records in March, April and May (Chart 5). The effect on corporate bond spreads has been just as dramatic. Spreads peaked on March 23, the day that the SMCCF and PMCCF were announced, and have tightened significantly since then. Further underscoring the importance of the SMCCF, PMCCF and MSLF announcements is that those segments of the corporate bond market most likely to have access to the Fed’s lending facilities have seen the most spread compression. Recall that investment grade issuers and recent fallen angels have access to the SMCCF and PMCCF, while the MSLF will benefit most issuers rated Ba or higher. Some B-rated issuers are able to tap the MSLF, but not the majority. Issuers rated Caa or below are much less likely to benefit from any of the Fed’s programs. Table 2 shows how the impact of the Fed’s facilities has played out across the different corporate credit tiers. It shows each credit tier’s option-adjusted spread and 12-month breakeven spread as of March 23 and today. It also shows the percentile rank of those spreads since 2010 (100% indicating the widest spread since 2010 and 0% indicating the tightest). While spreads have tightened across all credit tiers, investment grade corporates have become much more expensive than high-yield. The B-rated and below credit tiers are particularly cheap, with 12-month breakeven spreads all above their 80th percentiles since 2010. Table 2The Fed's Impact On Corporate Spreads Chart 6Spread Curve Back To Normal The market impact of the Fed’s corporate lending facilities is also apparent across the corporate bond term structure. In March, the investment grade corporate bond spread slope inverted, as 1-5 year maturity corporate bond spreads widened relative to spreads of securities with more than 5 years to maturity (Chart 6).6 The Fed concentrated its lending facilities on securities with less than 5 years to maturity, and it has successfully re-steepened the corporate spread curve. But the Fed’s corporate lending facilities are not all powerful. As Chair Powell likes to say: “the Fed has lending powers, not spending powers”. So while the promise of Fed lending is a big help, it still means that troubled firms will have to increase their debt loads to survive the economic downturn. Those firms that take on debt may still see their credit ratings downgraded as their balance sheet health deteriorates. Indeed, this is exactly what has happened. Ratings downgrades have jumped during the past few months, as have defaults (Chart 7). There has also been a spike in the number of fallen angels – firms downgraded out of investment grade – but not as big a jump as was seen during the last recession (Chart 7, panel 2). The Fed’s emergency lending facilities have likely prevented some downgrades, but not all. Chart 7Fed Can't Prevent Downgrades What’s Next? The Fed’s lending facilities are responsible for a huge portion of the spread compression we’ve seen since late March. That said, it is a potential problem for corporate bonds that those facilities are scheduled to expire at the end of September. Our sense is that the expiry date will be extended, and that the facilities will only be wound down after a significant period of time where they see zero usage. At that point, the Fed should be able to halt the facilities without unduly impacting markets. In terms of investment implications, we think that the Fed’s back-stop will continue to be the most important driver of corporate bond spreads during the next few months. This means we would avoid chasing the attractive valuations in bonds rated B & below, and would continue to focus our corporate bond exposure on bonds rated Ba and above. We make an exception to our “buy what the Fed is buying” rule when it comes to positioning across the corporate bond term structure. Here, we are inclined to grab the extra spread offered by longer-maturity securities even though Fed secondary market purchases are concentrated at the front-end. Our rationale is that the Fed’s secondary market purchases are already low and will likely decline as time goes on. Meanwhile, if firms with long-maturity debt outstanding need help they can still access the PMCCF if needed.  Other Fed Lending Facilities & Fixed Income Sectors Outside of the three programs geared toward the corporate bond market, the Fed also rolled out emergency lending facilities meant to back-stop: money market mutual funds (MMLF), the commercial paper market (CPFF), the asset-backed securities market (TALF), the municipal bond market (MLF) and the federal government’s new Paycheck Protection Program (PPPLF). Once again, the announcement effect did most of the work for all of these facilities and the Fed managed to quickly restore stability to each targeted market without doing much actual lending. For starters, the MMLF successfully halted a flight out of prime money market funds with a relatively modest $53 billion in loans (Chart 8). The CPFF caused the commercial paper/T-bill spread to normalize with only $4 billion of lending, and the LIBOR/OIS spread also tightened soon after the Fed rolled out its facilities (Chart 8, bottom panel). The Fed has dramatically expanded the size of its balance sheet through purchases of Treasury securities and agency MBS. In the asset-backed securities market, the Fed decided that only Aaa-rated securitizations are eligible for TALF. With that in mind, Aaa-rated consumer ABS and CMBS spreads have tightened considerably since TALF’s announcement (Chart 9). Non-Aaa consumer ABS spreads have tightened modestly despite the lack of Fed support. This is because fiscal stimulus has, so far, kept households flush with cash and prevented a wave of consumer bankruptcies. Non-Aaa CMBS, on the other hand, have struggled due to lack of Fed support and a sharp increase in commercial real estate delinquencies. Chart 8Stability Restored Chart 9Consumer ABS & CMBS Spreads Tightened Considerably...   The announcement of the MLF also successfully led to compression in municipal bond spreads (Chart 10), though the Aaa muni curve still trades cheap relative to Treasuries. Like the other facilities, the MLF has seen very low take-up. In this instance, low MLF usage results from its expensive pricing. Municipal governments can access loans through the MLF for a period of up to three years at a cost of 3-year OIS plus a fixed spread that varies depending on the municipality’s credit rating. However, current market pricing is well below the MLF rate for all credit tiers (Chart 10, bottom 2 panels). This means that the MLF provides a nice back-stop in case muni spreads widen again, but it is not currently an effective means of getting cash to struggling state & local governments. Chart 10...As Have Municipal Bond Spreads Finally, the PPPLF is a facility that purchases loans made through the Paycheck Protection Program (PPP) off of bank balance sheets. Essentially, it is an insurance policy designed to make sure that banks have the necessary balance sheet capacity to deliver all of the PPP loans authorized by Congress. It has achieved this goal with relatively little usage. Banks have doled out more than $500 billon of PPP loans and the Fed has purchased only $68 billion. What’s Next? As with the corporate lending facilities discussed above, there is a risk surrounding the scheduled expiry of these other lending facilities at the end of September. Once again, we see the Fed being very cautious in this regard. All facilities will be extended until they have seen long periods of no usage. In the near-term, we think it’s possible that the Fed will make MLF loans cheaper. They will likely feel intense pressure to do so if Congress fails to pass sufficient stimulus to state & local governments in the next bailout package. In terms of investment strategy, we want to stick with what has worked so far. We are overweight Aaa consumer ABS and Aaa CMBS due to the TALF back-stop. We are also overweight municipal bonds, especially in the Aaa-rated space where yields are attractive versus Treasuries and the risk of default is low. We would also advise taking some extra risk in non-Aaa consumer ABS. These securities have no TALF back-stop, but we expect Congress to deliver enough government stimulus to keep the underlying borrowers solvent. The Size Of The Fed’s Balance Sheet As this report has made clear, the Fed’s emergency lending facilities have accomplished a lot during the past four months with the Fed taking very little actual risk onto its balance sheet. But while its usage of the emergency lending facilities has been low, the Fed has dramatically expanded the size of its balance sheet through purchases of Treasury securities and agency MBS. To restore stability to the Treasury and MBS markets, the Fed avidly bought Treasuries and agency MBS from mid-March to mid-April, ballooning the size of its balance sheet by $2 trillion in just five weeks. Tacked onto the QE programs undertaken to battle the GFC, the Fed’s balance sheet expansion has been massive, and it is roughly six times larger as a share of GDP than it was in the three decades preceding the subprime crisis (Chart 11). Chart 11Massive Expansion Of The Fed's Balance Sheet Investors and citizens may ask what that balance sheet expansion has achieved so far, and what it’s likely to achieve going forward. Are there unintended consequences that haven’t yet made their presence felt? What constitutes a normalized Fed balance sheet, and when will the Fed be able to get back to it? The immediate consequence many investors attribute to the balance sheet expansion is higher stock prices (Chart 12). Fans of the balance sheet/equities link are undeterred by the decoupling after 2015, arguing that standing pat/tapering the balance sheet by 15% helped precipitate its vicious sell-off in the fourth quarter of 2018. It probably has not escaped their notice that the spectacular bounce from March’s lows has occurred alongside a 70% balance sheet expansion. The money supply boost may prove short-lived, though, as it appears that businesses are borrowing to ensure their continued liquidity, rather than to spend or invest. We don’t think there is much to the observed relationship, however. Correlation is not causation and we have a hard time seeing how the Fed’s purchases of Treasuries, agencies and agency MBS flowed into the equity market. While the Fed’s pre-pandemic QE purchases turbo-charged the size of the monetary base, it only gently expanded the money supply, because the banks that sold securities to the Fed largely handed the proceeds right back to it as deposits (Chart 13). The net effect mainly filled the Fed’s vaults with the new money it had conjured up via its open-market operations. Chart 12Fed Balance Sheet & Stock Prices: Correlation Is Not Causation Chart 13Only A Modest Expansion Of Money Supply   Banks were not the only counterparties to the Fed’s QE purchases, of course. Fixed income mutual funds, insurance companies and pension funds must also have trimmed their holdings to accommodate the Fed. They were likely obligated by prospectus mandates or regulatory oversight to redeploy the proceeds into other bonds. Surely some unconstrained investors turned QE cash into new equity investments, but the larger QE effect on financial markets was likely to narrow credit spreads as dedicated fixed income investors redeployed their proceeds further out the risk curve. Tighter spreads helped reduce corporations’ cost of servicing newly issued debt, boosting corporate profits at the margin, but we think it’s a stretch to say QE drove the equity rally. What’s Next? Chart 14Wave Of Bank Deposits The picture is slightly different today, with the money supply popping amidst frenzied corporate borrowing. The money supply boost may prove short-lived, though, as it appears that businesses are borrowing to ensure their continued liquidity, rather than to spend or invest. The largest banks were inundated with deposits in the second quarter (Chart 14), possibly driven by corporations stashing their issuance proceeds in cash just as banks previously stashed their QE proceeds in excess reserves. With households actively paying down their debt and businesses having already pre-funded two or three years of cash needs, the deposits may not be lent out, hemming in the money multiplier and limiting the self-reinforcing magic of fractional-reserve banking. Liquidity that is being hoarded is not available to drive up equity multiples, so we don’t expect the Fed’s new balance sheet expansion will directly boost stock prices any more than we think it did post-crisis. Indirectly, we think it does contribute to economic growth and risk asset appreciation because we view QE and other extraordinary easing measures as a signal that zero interest rate policy will remain in place for a long time. The importance of that signal, and the possibility that nineteen months of tapering at the start of Jay Powell’s term as Fed chair did promote volatility and increased equities’ vulnerability to a sharp downdraft, may well keep the Fed from attempting to normalize the balance sheet any time soon. An outsized Fed balance sheet may well be the new normal, and it may well breed unintended consequences, but we don’t think that kiting stock prices will be one of them. Ryan Swift US Bond Strategist rswift@bcaresearch.com Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Associate Editor JenniferL@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com   Footnotes 1 Please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usis.bcaresearch.com and usbs.bcaresearch.com 2 The Outright Monetary Transactions facility at the heart of ECB President Mario Draghi’s “whatever it takes” pledge was never actually used. The ECB did eventually purchase government securities through a separate facility. But this didn’t occur until 2015, after sovereign bond yields had already fallen. 3 This explicit forward guidance was the brainchild of Chicago Fed President Charles Evans. It was official Fed forward guidance between December 2012 and March 2014. 4 https://www.federalreserve.gov/newsevents/speech/brainard20200714a.htm 5 https://www.brookings.edu/wp-content/uploads/2020/05/WP62_Duffie_v2.pdf 6 This inversion of the corporate spread curve is typical during default cycles. For more details on this dynamic please see US Bond Strategy Special Report, “On The Term Structure Of Credit Spreads”, dated July 10, 2013, available at usbs.bcaresearch.com

Highlights Chart 1More Stimulus Required The unemployment rate fell for the second consecutive month in June, down to 11.1% from a peak of 14.7%. Bond markets shrugged off the news, and rightly so, as this recent pace of improvement is unlikely to continue through July and August. The main reason for pessimism is that the number of new COVID cases started rising again in late June, consistent with a pause in high-frequency economic indicators (Chart 1). This second wave of infections will slow the pace at which furloughed employees are returning to work, a development that has been responsible for all of the unemployment rate’s recent improvement. Beneath the surface, the number of permanently unemployed continues to rise (Chart 1, bottom panel). The implication for policymakers is that it is too early to back away from fiscal stimulus. In particular, expanded unemployment benefits must be extended, in some form, beyond the July 31 expiry date. We are confident that Congress will eventually pass another round of stimulus, though it may not make the July 31 deadline. For investors, bond yields are still biased higher on a 6-12 month horizon, but their near-term outlook is now in the hands of Congress. We continue to recommend benchmark portfolio duration, along with several tactical overlay trades designed to profit from higher yields. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 189 basis points in June, bringing year-to-date excess returns up to -529 bps. The average index spread tightened 24 bps on the month. We still view investment grade corporates as attractively valued, with the index’s 12-month breakeven spread only just below its historical median (Chart 2). With the Fed providing strong backing for the market, we are confident that investment grade corporate bond spreads will continue to tighten. As such, we want to focus on cyclical segments of the market that tend to outperform during periods of spread tightening (panel 2). One caveat is that the Fed’s lending facilities can’t prevent ratings downgrades (bottom panel). Therefore, we also want to avoid sectors and issuers that are mostly likely to be downgraded. High-quality Baa-rated issues are the sweet spot that we want to target. Those securities will tend to outperform the overall index as spreads tighten, but are not likely to be downgraded. Subordinate bank bonds are a prime example of securities that exist within that sweet spot.1 In recent weeks we published deep dives into several different industry groups within the corporate bond market. In addition to our overweight recommendation for subordinate bank bonds, we also recommend an overweight allocation to investment grade Healthcare bonds.2 We advise underweight allocations to investment grade Technology and Pharmaceutical bonds.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral High-Yield outperformed the duration-equivalent Treasury index by 90 basis points in June, bringing year-to-date excess returns up to -855 bps (Chart 3A). The average index spread tightened 11 bps on the month and has tightened 500 bps since the Fed unveiled its corporate bond purchase programs on March 23. We reiterated our call to overweight Ba-rated junk bonds and underweight bonds rated B and below in a recent report.4 In that report, we noted that high-yield spreads appear tight relative to fundamentals across the board, but that the Ba-rated credit tier will continue to perform well because most issuers are eligible for support through the Fed’s emergency lending facilities. Specifically, we showed that “moderate” and “severe” default scenarios for the next 12 months – defined as a 9% and 12% default rate, respectively, with a 25% recovery rate – would lead to a negative excess spread for B-rated bonds (Chart 3B). The same holds true for lower-rated credits. Chart 3AHigh-Yield Market Overview Chart 3BB-Rated Excess Return Scenarios We appear to be on track for that sort of outcome. Moody’s recorded 20 defaults in May, matching the worst month of the 2015/16 commodity bust and bringing the trailing 12-month default rate up to 6.4%. Meanwhile, the trailing 12-month recovery rate is a meagre 22%. At the industry level, in recent reports we recommended an overweight allocation to high-yield Technology bonds5 and underweight allocations to high-yield Healthcare and Pharmaceuticals.6 MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 13 basis points in June, dragging year-to-date excess returns down to -44 bps. The conventional 30-year MBS index option-adjusted spread (OAS) has tightened 5 bps since the end of May, but it still offers a pick-up relative to other comparable sectors. The MBS index OAS stands at 95 bps, greater than the 81 bps offered by Aa-rated corporate bonds (Chart 4), the 54 bps offered by Aaa-rated consumer ABS and the 76 bps offered by Agency CMBS. At some point this spread advantage will present a buying opportunity, but we think it is still too soon. As we wrote in a recent report, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare in the second half of this year (bottom panel).7 The primary mortgage rate did not match the decline in Treasury yields seen earlier this year. Essentially, this means that even if Treasury yields are unchanged in 2020 H2, a further 50 bps drop in the mortgage rate cannot be ruled out. Such a move would lead to a significant increase in prepayment losses, one that is not priced into current index spreads. While the index OAS has widened lately, expected prepayment losses (aka option cost) have dropped (panels 2 & 3). We are concerned this decline in expected prepayment losses has gone too far and that, as a result, the current index OAS is overstated. Government-Related:  Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 78 basis points in June, bringing year-to-date excess returns up to -399 bps. Sovereign debt outperformed duration-equivalent Treasuries by 112 bps on the month, bringing year-to-date excess returns up to -828 bps. Foreign Agencies outperformed the Treasury benchmark by 37 bps in June, bringing year-to-date excess returns up to -764 bps. Local Authority debt outperformed Treasuries by 268 bps in June, bringing year-to-date excess returns up to -439 bps. Domestic Agency bonds outperformed by 14 bps, bringing year-to-date excess returns up to -58 bps. Supranationals outperformed by 12 bps, bringing year-to-date excess returns up to -19 bps. We updated our outlook for USD-denominated Emerging Market (EM) Sovereign bonds in a recent report.8 In that report we posited that valuation and currency trends are the primary drivers of EM sovereign debt performance (Chart 5). On valuation, we noted that the USD sovereign bonds of: Mexico, Colombia, UAE, Saudi Arabia, Qatar, Indonesia, Malaysia and South Africa all offer a spread pick-up relative to US corporate bonds of the same credit rating and duration. However, of those countries that offer attractive spreads, most have currencies that look vulnerable based on the ratio of exports to foreign debt obligations. In general, we don’t see a compelling case for USD-denominated sovereigns based on value and currency outlook, although Mexican debt stands out as looking attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 68 basis points in June, bringing year-to-date excess returns up to -582 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries widened in June and continue to look attractive compared to typical historical levels. In fact, both the 2-year and 10-year Aaa Muni yields are higher than the same maturity Treasury yield, despite municipal debt’s tax exempt status (Chart 6). Municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.9 In that report we also mentioned our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push muni yields lower from current levels. Despite the MLF’s shortcomings, we aren’t yet ready to downgrade our muni allocation. For one thing, federal assistance to state & local governments will probably be the centerpiece of the forthcoming stimulus bill. The Fed could also feel pressure to reduce MLF pricing if the stimulus is delayed. Further, while the budget pressure facing municipal governments is immense, states are also holding very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve was mostly unchanged in June. Both the 2-year/10-year and 5-year/30-year slopes steepened 1 bp on the month, reaching 50 bps and 112 bps, respectively. With no expectation – from either the Fed or market participants – that the fed funds rate will be lifted before the end of 2022, short-maturity yield volatility will stay low and the Treasury slope will trade directionally with the level of yields for the foreseeable future. The yield curve will steepen when yields rise and flatten when they fall. With that in mind, we continue to recommend duration-neutral yield curve steepeners that will profit from moderately higher yields, but that won’t decrease the average duration of your portfolio. Specifically, we recommend going long the 5-year bullet and short a duration-matched 2/10 barbell.10 In a recent report we noted that valuation is a concern with this recommended position.11 The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet also looks expensive on our yield curve models (Appendix B). However, we also noted that the 5-year bullet traded at much more expensive levels during the last zero-lower-bound period between 2010 and 2013 (bottom panel). With short rates once again pinned at zero, we expect the 5-year bullet will once again hit levels of extreme over-valuation. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 99 basis points in June, bringing year-to-date excess returns up to -400 bps. The 10-year TIPS breakeven inflation rate rose 19 bps on the month and currently sits at 1.39%. The 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps on the month and currently sits at 1.62%. TIPS breakevens have moved up rapidly during the past couple of months, but they remain low compared to average historical levels. Our own Adaptive Expectations Model suggests that the 10-year TIPS breakeven inflation rate should rise to 1.53% during the next 12 months (Chart 8).12 On inflation, it also looks like we are past the cyclical trough. The WTI oil price is back up to $41 per barrel after having briefly turned negative (panel 4), and trimmed mean inflation measures suggest that the massive drop in core is overdone (panel 3). If inflation has indeed troughed, then the real yield curve will continue to steepen as near-term inflation expectations move higher. We have been advocating real yield curve steepeners since the oil price turned negative in April.13 The curve has steepened considerably since then, but still has upside relative to levels seen during the past few years (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 103 basis points in June, bringing year-to-date excess returns up to -2 bps. Aaa-rated ABS outperformed duration-equivalent Treasuries by 8 bps in June, bringing year-to-date excess returns up to +7 bps. Meanwhile, non-Aaa ABS outperformed by 233 bps in June, bringing year-to-date excess returns up to -88 bps (Chart 9). Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Securities Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS and we recommend owning those securities as well. This is despite the fact that non-Aaa bonds are not eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a recent report.14  We noted that the stimulus received from the CARES act caused real personal income to increase significantly during the past few months and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further fiscal stimulus will be needed to sustain those recent income gains. But we are sufficiently confident that a follow-up stimulus bill will be passed that we advocate moving down in quality within consumer ABS. Non-Agency CMBS:  Overweight  Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 211 basis points in June, bringing year-to-date excess returns up to -501 bps. Aaa CMBS outperformed Treasuries by 164 bps in June, bringing year-to-date excess returns up to -233 bps. Non-Aaa CMBS outperformed by 407 bps in June, bringing year-to-date excess returns up to -1451 bps (Chart 10). Our view of non-agency CMBS has not changed during the past month, but we realize that it is more accurately described as a “Neutral” allocation as opposed to “Overweight”. Our view is that we want an overweight allocation to Aaa-rated CMBS because that sector offers an attractive spread relative to history and benefits from Fed support through TALF. However, we advocate an underweight allocation to non-Aaa non-agency CMBS. Those securities are not eligible for TALF and, unlike consumer ABS, their fundamental credit outlook has deteriorated significantly as a result of the COVID recession.15  Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 104 basis points in June, bringing year-to-date excess returns up to -58 bps. The average index spread tightened 19 bps on the month to 77 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Performance Since March 23 Announcement Of Emergency Fed Facilities 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 July 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 July 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 57 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 57 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 July 3, 2020) Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 10 The rationale for why this position will 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 11 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 12 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 We discussed our outlook for CMBS in more detail in US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation