Developed Countries

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

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

Special Report

Highlights The potential range of book value outcomes for large banks is enormous, … : Total credit losses will be a function of the virus’ persistence, the intensity and duration of the social distancing actions taken to combat it, and the efficacy of monetary and fiscal policy measures meant to mitigate the economic pain. … making it almost impossible to assess their equity valuations: With the uncertainty around each of the three independent variables, estimating default rates and recovery rates is a guessing game. This is the most sudden recession on record, … : Nearly 10 million people have filed initial jobless claims in the last two weeks, more than the average over the first 26 weeks of the last seven recessions. … but the biggest banks have entered it on more stable footing than they typically would, and they have a few things going for them: The biggest banks are nowhere near as extended as they typically are after expansions, with unusually conservative asset portfolios and a large stockpile of equity capital. Feature “It depends” is always the answer to quite a few questions in economics, but right now, it’s the answer to just about all of them. Global economic activity is hostage to the COVID-19 outbreak, and the social distancing measures that have been implemented in an attempt to impede its progress. No one can say for sure how long those measures will have to remain in place, though their impact has been starkly apparent on the broad swath of businesses that they have rendered unviable. Non-essential retailers, pro sports leagues, movie theaters, concert venues, gyms, barbers, nail salons, bars and restaurants have had their revenue streams cut off entirely. Nearly all of them have some fixed costs: rent if they don’t own their space; maintenance, mortgage payments and property taxes if they do. Table 1A Half-Year Of Jobless Claims In Two Weeks Monthly rent and mortgage obligations pose a thorny issue for the banking system, because they could lead to a surge of defaults among retailers and their landlords. The unprecedentedly rapid rise in unemployment (Table 1) could trigger a tsunami of home mortgage, credit card and auto loan delinquencies. Congress, the Fed, and various executive-branch departments and agencies are doing their best to protect the individuals and businesses sucked into the vortex, but the ultimate success of their efforts is uncertain. That uncertainty makes it impossible to project the SIFI banks’ credit losses within a reasonably useful confidence interval. To take an extreme example, what if the collateral securing auto loans were reduced to its scrap value because consumers developed an aversion to previously-owned vehicles? Getting less far-fetched, what if all used cars had to be marked down by 20 or 30% to entice drivers to swallow their discomfort, and the value of soon-to-be-vacant homes and apartments faced similar haircuts? Neither is our base-case scenario, but the fact that the markdown scenario is at least plausible illustrates the difficulty of estimating credit losses, and the challenge of coming up with decent estimates of SIFI banks’ earnings and capital adequacy. For the time being, we cannot say if the SIFI banks are better bought or sold at their current prices because we don’t know how 1Q loan-loss provisions will affect their March 31st book value, or what June 30th book might be. Our thinking has evolved in the week since we published Part 1 of this Special Report on the biggest US banks’ vulnerability. Initially, 50 years of Wells Fargo’s financials led us to believe that the SIFI bank de-rating over the last month and a half was excessive, and we concluded that buying SIFI banks at or below their December 31st tangible book value provided investors with a significant margin of safety. The chance to buy at or below tangible book would be a gift even in a bad recession, but the current episode threatens to go well beyond bad. Though we still lean to buying the SIFIs rather than selling them, we now recommend that investors watch and wait before committing, as they should with risk assets more generally. We hold to that bias because our review of system-wide data revealed ample instances of how the largest banks have entered this recession in better shape than normal. We also take heart from the idea that the Fed and elected officials will vigorously pursue policies that directly and indirectly benefit the banks. The banking system is considerably more solid than it was ahead of the 2007-8 crisis. It’s not immune to the shocks that are roiling the economy, but it will not be a driver of them. A Lack Of Banking Excesses Back in 2007, the last time that a recession/financial crisis was taking aim at the US, a bank-examiner-turned-analyst told us that, “Banks create value on the liability side of the balance sheet [via deposits], and destroy it on the asset side.” At the time, the destruction was centered on subprime mortgages and the securities they spawned, but the story plays itself out in every cycle. Bad loans are made in good times, as bankers let their guard down after an extended period of low defaults and market share takes precedence over lending standards. Banks exercised more restraint over the last 10-plus years than they have in any prior postwar expansion. 11 years of zero- and negative-interest-rate policy have promoted plenty of credit excesses, as many investors have gone far afield in search of yield. Bond covenants have been shredded, and corporate leverage has duly risen. Yet banks have largely stayed out of the fray. Bank lending grew at a markedly slower rate between July 2009 and February 2020 than it has in any other postwar expansion1 (Chart 1, top panel). Chart 1An Especially Restrained Expansion Total loan growth slid all the way to 3.8% annualized versus 9.7% in prior postwar expansions. While real estate lending slowed the most, following the frenzy that precipitated the 2007-8 crisis (Chart 1, bottom panel), C&I (Chart 1, second panel) and consumer lending (Chart 1, third panel) also fell well short of their postwar expansion pace, and only consumer lending failed to set a new postwar expansion low (Table 2). From the examiner-analyst’s perspective, banks behaved less self-destructively in the last ten-plus years than they have in any other postwar expansion. Regulatory efforts to curb banking excesses really did get some traction. Table 2Core Bank Lending Growth During Expansions Setting An Uncharacteristically Good Example Historically, the largest banks are at the center of the excesses that make the banking system vulnerable and help set the stage for crises. It wasn’t a community banker, after all, who smugly declared that countries don’t go bust after having plunged headfirst into lending to shaky Latin American governments. It has been the biggest players who have hatched dubious financial innovations and scaled them to the extremes that trigger systemic rumbles. Since the 2007-8 crisis, however, the biggest banks have demonstrated uncommon restraint. As we noted in Part 1, loan-to-deposit ratios around 100% and above are a sign of instability because they have to be funded with capital flows that are here today but gone tomorrow. Lower loan-to-deposit ratios hold down profits, but they buffer banks’ exposure to the business cycle, provided that deposit funding isn’t diverted to uses that are riskier than straightforward loans. The FDIC and the Fed maintain data series that offer insight into different-sized banks’ use of their lending capacity. The FDIC’s Quarterly Banking Profile, published since the mid-‘90s, breaks out total system loan-to-deposit ratios into categories based on the size of individual banks’ assets. Using its data, we were able to compare the largest banks’ activity with all other FDIC-insured banks’ activity since 1997. The comparison showed that the largest banks performed an about-face after the subprime crisis, going from operating with uniformly higher loan-to-deposit ratios than all other banks to operating with uniformly – and significantly – lower loan-to-deposit ratios (Chart 2). Chart 2The Biggest Banks Are Using Less Of Their Lending Capacity ... The Fed’s commercial bank balance sheet data covering large and small banks extend back another decade. The data do not align perfectly with the FDIC’s, as the Fed’s large-bank subset (the top 25 banks by assets) has been broader than the FDIC’s since 2016 (top 9 or 10 banks) and was narrower in prior years (the FDIC’s top subset included 66 to 119 banks). The Fed’s data do not show large banks making fuller use of their deposit capacity in the ‘90s and most of last decade, but they echo the post-2007-8 drop-off in the FDIC data (Chart 3). The biggest banks have operated with less risk under the Basel 3/Dodd-Frank/Volcker Rule regime, allocating less of their capacity to loans, and considerably more to Treasuries, agencies and cash (Chart 4). Chart 3... No Matter How They're Defined ... Chart 4... And They're Directing It To Safer, More Liquid Assets Banks Are Better Capitalized Than They Used To Be The overall banking system is operating with considerably less leverage than it did in the ‘80s or ‘90s, as equity capital now accounts for 12% of total assets (Chart 5). Wells Fargo’s leverage history as shown in Part 1 suggests that banks were even more thinly capitalized in the ‘70s. An increased proportion of equity capital makes a bank more resilient to loan losses and other operational stumbles. Critically for the stability of the system, the SIFI banks are forced to maintain additional capital buffers. The combination of increased equity capital and increased holdings of liquid assets with little to no credit risk like Treasury and agency securities has made all of the largest banks safer. Chart 5Increased Equity Financing Has Made Banks More Resilient Some Fears Seem Overblown We reiterate from Part 1 that larger banks do not borrow short to lend long, and have not for a long time. According to the latest Quarterly Banking Profile, barely a sixth of the 4,400 banks with assets of less than $1 billion report having any derivatives exposure. A considerable majority of community banks must therefore take their asset and liability maturity profiles as given, leaving them exposed to the vagaries of shifts in the yield curve. No management team at a decently-sized publicly traded bank would dare to run anything more than a very narrow mismatch in asset and liability duration, however, as evidenced by the gargantuan interest-rate swaps market. Bank stocks may trade with 10-year Treasury yields, but the slope of the curve has very little bearing on bank earnings.2 During recessions, banks usually encounter more customers trying to park money than businesses trying to borrow it.  Unused loan commitments have provoked much agita among investors in recent weeks. A floundering company, desperately trying to stay afloat, may well draw down all of its available credit lines. Line drawdowns could force banks to make good on loan commitments made in better times that now have little prospect of repayment. While they do not appear to have been a significant issue in the ’90-’91 or 2001 recessions, lines were drawn down sharply in 2007-8 (Chart 6). Chart 6Much Ado About Nothing? The positive news for banks is that their exposure to untapped commitments is considerably smaller than it was heading into the last recession. They may also be less likely to be drawn, thanks to multiple Fed initiatives aimed at ensuring the availability of credit, like its ambitious plan to backstop investment-grade corporate borrowers, and the CARES Act’s expansion of Small Business Administration funding and provision of loans and loan guarantees for ailing companies in industries related to national security. There are going to be considerably more strapped borrowers, but they will have more non-bank avenues to obtain funding than they have had in prior recessions. Banks know that line demand may spike soon after the business cycle peaks; they reserve for unused commitments and will not be caught entirely unawares. Finally, not all of the unused commitments are to suffering C&I borrowers that investors most fear; Wells Fargo’s commitment history suggests that the largest share of the outstanding commitments are to individual credit card borrowers. Despite rising distress, lending has increased at a fairly modest rate during recessions, as households and businesses broadly shrink from risk, while deposits have grown at a faster rate, as the safety of FDIC-insured accounts gains appeal (Table 3). We do not expect that increased consumption of credit line capacity will materially alter the banking system’s credit exposures. Table 3Core Bank Lending And Deposit Growth During Recessions Investment Implications The banking system, anchored by the SIFI banks, is in considerably better shape now than it was in 2007, and does not pose an active threat to the financial system this time around. The banking system is not only better capitalized than it has been in the past, but large banks have invested far more conservatively. We cannot assess how expensive SIFI stocks are without having a better handle on potential loan losses, however, and we need to get a sense at how successful the Fed’s and Congress’ interventions to stem the building economic distress will be. We hope for the best, but the last-mile issues are complicated, and we expect that the mitigation efforts will have to work out some kinks before they begin to get traction. Don't worry about the banks, but give it some time before buying them. Congress and the Fed are trying to perform challenging new routines, and it's unlikely they'll stick the landing on their first try. Table 4Comfortably In The Money Our no-rush-to-buy take on the broad market applies to the SIFI banks, as well. We have high conviction that Congress and the administration will do whatever it takes to shore up the most vulnerable parts of the economy as they reveal themselves, and the Fed has already moved to a war footing. Stocks can go lower as they climb the learning curve, and may have to do so to signal the need for further intervention. We would not be concerned in the slightest if the SIFI banks were to cut or suspend their dividends. Husbanding cash is a good idea in times of uncertainty, and a couple of quarters without dividends is far preferable to shareholders than a dilutive secondary equity offering or rights issue. To the extent that it may leave elected officials more favorably disposed to the banking sector, it would be a plus. One may as well stay on the good side of legislators doling out goodies. Finally, our newly increased sense of caution does not extend to the put-writing idea we detailed two weeks ago. If implied volatility in the SIFI banks’ stocks returns to the triple-digit level, investors selling put options would be generously compensated for assuming the inherent risks. Even though the SIFIs have stumbled over the last six sessions, time decay and the steep decline in the VIX have the contracts we highlighted well in the money (Table 4).   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Until the NBER makes the official designation, our working assumption is that the recession began in March. 2 Please see the February 28, 2011 US Investment Strategy Special Report, "Banks And The Yield Curve," available at usis.bcaresearch.com.