Fixed Income

Highlights Monetary Policy: Central bankers worldwide are promising to keeping policy rates near 0% for at least the next two years, even if inflation begins to rise again. This is an obvious form of forward guidance designed to keep borrowing costs as low as possible until the COVID-19 pandemic ends. It may also be the start of a true shift in policymaker strategy, tolerating a rise in inflation just as many of the secular forces that have dampened global inflation are fading. Bond Strategy: The recent divergence of inflation expectations and real bond yields can persist if central banks commit to their dovish forward guidance. Stay overweight inflation-linked bonds versus nominal government debt, particularly in the US, Canada and Italy. Feature “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.” – Fed Chairman Jerome Powell Central bankers have emptied their bags of tricks in recent months, providing extreme monetary policy accommodation to fight the deflationary impacts of the COVID-19 recession. 0% policy interest rates, large-scale asset purchases and liquidity support programs have all been implemented in some form by the major developed market central banks. Even more extreme options like yield curve control have been contemplated in the US and implemented in Australia. Perhaps the most important tool used by policymakers, however, is the most simple of all – dovish forward guidance on future interest rate moves. The Fed, European Central Bank (ECB), Bank of Japan (BoJ) and others are now committing to keep rates at current levels for at least the next two years. Additional “state-based” guidance, tying future rate hikes only to a sustainable return of inflation back to policymaker targets, is the likely next step, with the Bank of Canada already making that connection at last week’s policy meeting. Given how difficult it has been for central banks to reach those targets, policy rates can now potentially stay lower for much longer. Interest rate markets have already discounted such an outcome, with overnight index swap (OIS) curves pricing in no change in policy rates in the US, Europe, UK, Japan, Canada or Australia until at least mid-2022 and only very mild increases afterward (Chart of the Week). It remains to be seen if policymakers will actually follow through on their promises to sit on their hands and do nothing for that long, even as global growth and inflation continue what will likely be an extended and choppy recovery from the deep COVID-19 recession. Chart of the WeekAggressive Forward Guidance Is Working However, if central bankers are truly serious about keeping interest rates low even if inflation picks up, in an attempt to “catch up” from previous undershoots of inflation targets, that has major implications for global bond investors – in particular, raising the value of maintaining core holdings of inflation-linked bonds in fixed-income portfolios. The First Step To Higher Inflation: Stop Talking About Rate Hikes Central bankers are increasingly using the same arguments, and even the same language, to justify their current hyper-accommodative policy stance. Here are some examples, taken from speeches and policy meetings that took place last week: ECB President Christine Lagarde: “We expect interest rates to remain at their present or lower levels until we have seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within our projection horizon and such convergence has been consistently reflected in underlying inflation dynamics.” Federal Reserve Governor Lael Brainard: “Looking ahead, it likely will be appropriate to shift the focus of monetary policy from stabilization to accommodation by supporting a full recovery in employment and a sustained return of inflation to its 2 percent objective […] policy should not preemptively withdraw support based on a historically steeper Phillips curve that is not currently in evidence.” Bank of Canada Governor Tiff Macklem: "As the economy moves from reopening to recuperation, it will continue to require extraordinary monetary policy support. The Governing Council will hold the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved.” Chart 2Global Growth Expectations Have Rebounded We could have switched the names on those three quotes and the message would be the same. Policy rates will stay at current levels until inflation has sustainably returned to the 2% target. Raising rates on the back of a forecast of higher inflation, driven by an expectation of lower unemployment, will not be enough this time for policymakers that have been repeatedly burned by their belief in the Phillips Curve. Bond investors have taken note of the central bankers’ message and now expect both stable policy rates and higher inflation expectations. The latest data from the ZEW survey of economic and financial market sentiment, that was published last week and covers the period to mid-July, shows this shift in expectations. On the economy, the current conditions indices for the euro area, US, UK and Japan have stopped falling, while the expectations data have all soared to the highest levels seen since 2015 (Chart 2). The ZEW also poses questions on expectations for interest rates and inflation, and there the answers are more interesting for bond investors. The net balances on expectations for long-term interest rates have bottomed out for the US, euro area and UK, as have expectations for inflation over the next twelve months (Chart 3). At the same time, expectations for short-term interest rates have lagged the moves seen in the other two series, with the net balances hovering around zero for all four countries. One possible interpretation of this data is that a greater number of the financial professionals who take part in the ZEW survey are starting to “get the hint” about central bankers’ dovish messages, expecting higher inflation and bond yields but with no change in short-term policy rates. Bond investors have taken note of the central bankers’ message and now expect both stable policy rates and higher inflation expectations. We see similar pricing in inflation-linked bond markets. While nominal bond yields have stayed stable, the mix between inflation expectations and real bond yields has shifted. Breakevens on 10-year bonds have been slowly climbing across the major developed markets since the end of March, while real yields have fallen roughly the same amount as breakevens have widened (Chart 4). Chart 3Global Inflation Expectations Are Drifting Higher Chart 4Inflation Breakevens & Real Yields: Mirror Images This is a relatively unusual development in the global inflation-linked bond universe. More often, breakevens and real yields move in the same direction. Inflation expectations tend to rise when economic growth is improving, which also puts upward pressure on real bond yields – often in tandem with markets pricing in higher policy rates at the short end of yield curves. That is not the case today. The latest fall in real bond yields may simply be markets pricing in slower potential economic growth, and lower equilibrium real interest rates, in a world where the COVID-19 pandemic is likely to leave lasting scars. That would be consistent with Bloomberg growth and inflation forecasts for the major developed economies, which expect unemployment rates to remain above pre-COVID levels in 2022, with inflation rates struggling to reach 2% (Chart 5). Chart 5The Consensus Expects A Slow Global Recovery In a recent report, we presented some basic Taylor Rule estimates of the “appropriate” level of policy rates for the US, euro area, UK, Japan, Canada and Australia after the collapse in growth seen in response to the COVID-19 lockdowns. We used the most basic formulation of the Taylor Rule that put equal weight on deviations of headline inflation from central bank target levels, and deviations of unemployment from full-employment NAIRU measures. Chart 6Taylor Rules Suggest Rates Will Need To Head Higher Given the surge in unemployment and collapse in inflation due to the COVID-19 recession, Taylor Rule estimates were calling for negative nominal interest rates across the developed economies (Chart 6). The estimates were most severe in the US, where a fed funds rate of -3.8% is deemed “appropriate” with an unemployment rate of 11% and headline CPI inflation at 0.6%. When the Bloomberg consensus forecasts for the next two years are put into the Taylor Rule, a rising path for interest rates is projected but with rates remaining below pre-COVID levels. However, if policymakers stick to their current pledge to keep rates on hold for longer to ensure that inflation not only returns to 2%, but also stays there without the help from very easy monetary policy, then the implication is that a “below-appropriate” interest rate will be maintained for an extended period. Interest rate markets have already come to that conclusion. 5-year OIS rates, 5-years forward are trading between 0% and 1% across the developed economies – levels that are below the neutral interest rate estimates we are using in our Taylor Rule forecasts (Chart 7). Chart 7Markets Priced For An Extended Period Of Below-Neutral Rates With interest rates already at or near the zero bound, any rise in inflation from current levels also near 0% will result in real policy rates turning negative if central banks do nothing. This would be consistent with the messages sent by the ZEW survey, and global inflation linked bond markets where real yields are falling deeper into negative territory. That would be a major shift of global policymaker behavior, designed as a planned erosion of inflation-fighting credibility. This is especially true for the likes of the Fed, which has a well-established history of turning hawkish at the first sign of rising inflation pressures. The Fed has already hinted that it is considering shifting its policy strategy to allow overshoots of inflation after periods of undershooting the 2% target. Other central banks, like the ECB, have announced similar reviews of their inflation targets and strategy. Such a move to tolerate higher levels of inflation is a logical response to a global pandemic and deep global recession, coming on the heels of several years of low inflation. The timing may actually be ideal to run more dovish policies to boost inflation, with many of the structural factors that have helped restrain global inflation starting to turn in a more inflationary direction. That would be a major shift of global policymaker behavior, designed as a planned erosion of inflation-fighting credibility.  Bottom Line: Central bankers worldwide are promising to keep policy rates near 0% for at least the next two years, even if inflation begins to rise again. This is an obvious form of forward guidance designed to keep borrowing costs as low as possible until the COVID-19 pandemic ends. It may also be the start of a true shift in policymaker strategy, becoming more tolerant of faster inflation. Potential Reasons Why Inflation Could Return Central bankers are talking a good game right now, pledging not to turn too hawkish, too soon and allowing inflation to move back above policy targets. It remains to be seen if they would actually follow through and do nothing if realized inflation rates were to start climbing back to 2% or even higher. It is unlikely that policymakers will be facing that choice anytime soon. The COVID-19 pandemic is showing no signs of slowing in the US and large emerging market countries, global growth remains fragile and heavily reliant on monetary and fiscal policy support, and inflation rates worldwide are currently closer to 0% than 2%. Yet at the same time, there are structural disinflationary forces now changing in a way that may create a more inflationary world after the threat of the pandemic has faded. Demographics Chart 8Demographics Have Turned Less Disinflationary BCA Research Global Investment Strategy has noted that the global demographic trends that helped restrain inflation in recent decades are shifting.1 The ratio of the number of global workers to the number of global consumers – the global support ratio - peaked back in 2013 and is now steadily falling (Chart 8). There are structural disinflationary forces now changing in a way that may create a more inflationary world after the threat of the pandemic has faded. A rising support ratio implies there are more people producing through work than consuming which, on the margin, is disinflationary. Now, with baby boomers leaving the labor force in droves and becoming consumers in retirement (especially consuming services like health care), the support ratio is falling and becoming a potentially more inflationary force. Globalization Chart 9Globalization Has Turned Less Disinflationary One of the biggest disinflationary forces of the past quarter-century has been the rapid increase in global trade. As trade barriers fell and global supply chains expanded, companies were able to lower their costs of production. This allowed companies to widen profit margins without resorting to large price increases, helping to dampen overall inflation rates. Now, with global populism and protectionism on the rise, trade as a share of global GDP is declining (Chart 9). The COVID-19 pandemic will likely exacerbate this trend as more companies bring production closer to home, reversing the disinflationary impact of global supply chains, on the margin. A Strong US Dollar The relentless rise of the US dollar in recent years has exerted a major disinflationary headwind to the world economy, with a large share of global traded goods and commodities priced in dollars. Now, with the greenback finally showing signs of rolling over on a more sustainable basis (Chart 10), fueled by less favorable interest rate differentials and signs of improving global growth, the dollar is slowly becoming a more inflationary force. Chart 10USD Weakness Would Be Inflationary Chart 11Structural Reasons Why Policy Rates Need To Stay Low Of course, these factors are slow moving and will not necessarily result in an immediate increase in global inflation. Yet the trends now in place are more inflationary, on the margin, than has been the case for many years. Coming at a time when global productivity growth is anemic, the potential for an inflationary spark from overly easy monetary policies should not be ignored. Especially given the very high levels of private and public debt in the developed world, which puts more pressure on policymakers to choose inflation as a way to reduce debt burdens (Chart 11).   Investment Implication – Stay Overweight Inflation-Linked Bonds Central bankers are now signaling a desire to keep interest rates lower for longer, both to provide stimulus for virus-stricken economies and to boost weak inflation. Coming at a time when secular disinflationary forces are losing potency, this raises the risk of a protracted period of negative real policy rates as inflation rises and policymakers do little to stop it pre-emptively. Against this shifting backdrop, the value of owning global inflation-linked bonds as core holdings in fixed income portfolios is compelling. Chart 12Maintain A Core Overweight In Inflation-Linked Bonds Against this shifting backdrop, the value of owning global inflation-linked bonds as core holdings in fixed income portfolios is compelling. Inflation breakevens are more likely to creep upward than soar higher in the near term given the lingering economic threat from the COVID-19 pandemic. Yet inflation-linked bonds are likely to outperform nominal government debt over the next few years – if central bankers stay true to their word and keep rates unchanged while welcoming a pickup in inflation. The experience of the years following the 2008 financial crisis, when global policy rates were kept near 0% and central banks expanded balance sheets through quantitative easing, may be a template to follow. Global inflation linked bonds, as an asset class, steadily outperformed nominal government bonds from 2012-2016, shown in Chart 12 on a rolling 3-year annualized basis using benchmark indices from Bloomberg Barclays. A similar extended period of outperformance is not out of the question over the next few years, with central banks ramping up asset purchases once again and promising to keep policy easy until inflation returns. Bottom Line: The recent divergence of inflation expectations and real bond yields can persist if central banks commit to their dovish forward guidance. Stay overweight inflation-linked bonds versus nominal government debt, particularly in the US, Canada and Italy where our models show that breakevens are most undervalued.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Investment Strategy "Third Quarter 2020 Strategy Outlook, Navigating The Second Wave", dated June 30, 2020, available at gis.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

Special Report

Highlights IG Energy: Investors should overweight Energy bonds within an overweight allocation to investment grade corporate bonds overall. Within IG Energy, the Independent sub-sector should perform best, and we recommend avoiding the higher-rated Integrated space. HY Energy: Investors should overweight high-yield Energy relative to the overall junk index. In particular, investors should focus their exposure on the Independent sub-sector, while avoiding the distressed Oil Field Services space. Feature This week we present part 2 of our two-part Special Report on Energy bonds. Last week’s report showed how to develop a model for Energy bond excess returns (both investment grade and high-yield) based on overall corporate bond index spreads and the oil price.1 This week, we delve deeper into the characteristics of both the investment grade and high-yield Energy indexes to better understand how both are likely to trade in the coming months. Chart 1High-Yield Energy Bond Returns Have Bottomed Chart 2Energy Index Sub-Sector Composition* In this week’s deep dive, we don’t limit ourselves to an examination of the overall Energy index. We also consider the outlooks for its five main sub-sectors: Integrated: Major oil firms that are present along the entire supply chain – from exploration and production all the way down to refined products for consumers. Independent: Exploration & production firms. Oil Field Services: Support services for the Independent sector – notably drilling. Midstream: Transportation (pipelines), storage and marketing of crude oil. Refining Chart 2 shows the share of each sub-sector in both the investment grade and high-yield Energy indexes. Midstream (46%) and Integrated (31%) are the largest sub-sectors in the investment grade index. Independent (48%) and Midstream (36%) are the heavyweights in the high-yield space. Investment Grade Energy Risk Profile Overall, investment grade Energy bonds are highly cyclical. That is, they tend to outperform the corporate benchmark during periods of spread tightening and underperform during periods of spread widening. This cyclical behavior is due to Energy’s lower credit rating compared to the Bloomberg Barclays Corporate index. Sixty five percent of Energy’s market cap carries a Baa rating compared to 59% for the overall index (Chart 3). The sector’s cyclical nature is confirmed by its duration-times-spread (DTS) ratio,2 which is well above 1.0 (Chart 4A). Interestingly, Energy has only been a highly cyclical sector since the 2014-2016 oil price crash. Prior to that, Energy mostly tracked the corporate index’s performance and only slightly underperformed the benchmark during the 2008/09 financial crisis. More recently, Energy underperformed the corporate index dramatically when spreads widened in March, but has outperformed by 936 bps since spreads peaked on March 23 (Chart 4A, panel 3). Energy has only been a highly cyclical sector since the 2014- 2016 oil price crash. Turning to the sub-sectors, the Integrated sub-sector immediately stands out as the only one with a higher average credit rating than the corporate benchmark. Ninety-two percent of Integrated issuers are rated A or Aa (Chart 3). The presence of the global oil majors (Total SA, Royal Dutch Shell, Chevron, Exxon Mobil and BP) is what gives the sub-sector its higher average credit quality and makes it the only defensive Energy sub-sector. Notice that Integrated even proved resilient during the 2014-16 Energy bond turmoil (Chart 4B). The remaining four sub-sectors (Independent, Oil Field Services, Midstream and Refining) all have lower average credit ratings than the corporate index (Chart 3) and all trade cyclically relative to the benchmark with Independent (Chart 4C) and Oil Field Services (Chart 4D) being more cyclical than Midstream (Chart 4E) and Refining (Chart 4F). Interestingly, Independent trades more cyclically than Midstream and Refining despite having a greater concentration of high-rated issuers. This is likely due the fact that Independent (aka Exploration & Production) firms are more dependent on the level of oil prices, and typically require a certain minimum oil price to support capital spending and growth. Meanwhile, crude oil is an input for Refining firms and lower oil prices can boost margins, helping offset some of the negative impact from growth downturns. Chart 3Investment Grade Credit Rating Distributions* Chart 4AIG Energy Risk Profile Chart 4BIG Integrated Risk Profile Chart 4CIG Independent Risk Profile Chart 4DIG Oil Field Services Risk Profile Chart 4EIG Midstream Risk Profile Chart 4FIG Refining Risk Profile   Valuation In terms of value, we find that the Energy sector offers a spread advantage relative to the corporate index and its equivalently-rated (Baa) benchmark (Table 1). This advantage holds up after we control for duration differences by looking at the 12-month breakeven spread. The four cyclical sub-sectors (Independent, Oil Field Services, Midstream and Refining) all also look cheap, whether or not we control for duration differences. Integrated, the sole defensive sub-sector, is roughly fairly valued compared to the equivalently-rated (Aa) benchmark. Table 1IG Energy Valuation Balance Sheet Health The par value of outstanding investment grade Energy debt jumped sharply as oil prices plunged in 2014. But the sector has barely issued any debt since the 2014-16 collapse. Instead, Energy firms have relied on capital spending reductions, asset sales, equity issuance and dividend cuts to raise cash. This shift toward austerity explains why Energy’s weight in the index fell from 11% in 2015 to 8% today (Chart 5A). The median Energy firm’s net debt-to-EBITDA consequently improved between 2017 and 2019, but has once again started to rise as earnings have struggled in recent quarters (Chart 5A, bottom panel). At the issuer level, 15 out of the investment grade index’s 56 Energy issuers currently have a negative ratings outlook from Moody’s (Appendix A). Of the 23 Energy sector ratings that Moody’s has reviewed in 2020, 12 have been affirmed with a stable outlook and 11 were assigned negative outlooks. At the sub-sector level, Integrated debt growth lagged that of the corporate index during the last recovery (Chart 5B). Though the sub-sector has an average credit rating of Aa, most issuers carry negative ratings outlooks, including four of the five global oil majors (Total SA, Royal Dutch Shell, Exxon Mobil and BP). Interestingly, Independent trades more cyclically than Midstream and Refining, despite having a greater concentration of high-rated issuers. The outstanding par value of investment grade Independent debt had been stagnant since 2015, it then plunged this year as three sizeable issuers were downgraded from investment grade to high-yield (Chart 5C). EQT Corp, Occidental Petroleum and Apache Corp were all downgraded during the past few months. They currently account for 21% of the high-yield Energy index’s market cap. Encouragingly, only two of the 16 remaining investment grade Independent issuers currently have negative ratings outlooks. The situation is less favorable for Oil Field Services. This sub-sector’s outstanding debt has remained low since the 2014-16 collapse (Chart 5D), but four of the six investment grade Oil Field Services issuers have negative ratings outlooks. Midstream (Chart 5E) and Refining (Chart 5F) both continued to grow their outstanding debt levels throughout the entirety of the last recovery, including during the 2014-16 period. At present, only three of the 23 investment grade Midstream issuers have negative ratings outlooks, while two of the four Refining issuers have negative outlooks. Chart 5AIG Energy Debt Growth Chart 5BIG Integrated Debt Growth Chart 5CIG Independent Debt Growth Chart 5DIG Oil Field Services Debt Growth Chart 5EIG Midstream Debt Growth Chart 5FIG Refining Debt Growth   Investment Conclusions As per last week’s report, we recommend that investors overweight Energy bonds within their investment grade corporate bond allocations. This recommendation stems from our view that corporate bond spreads will tighten during the next 12 months and that the oil price will rise. As such, we want to favor cyclical investment grade bond sectors that will outperform during periods of spread tightening. With that in mind, we would advise investors to focus their investment grade Energy allocations on the most cyclical sub-sector: Independent. Not only does the Independent sub-sector have the highest DTS ratio of the five sub-sectors, but its weakest credits have already been purged from the index and further downgrades are less likely. Oil Field Services offer less spread pick-up than Independent, and also have a higher proportion of issuers with negative ratings outlooks.  By similar logic, we would avoid the Integrated sub-sector. This sub-sector trades defensively relative to the corporate benchmark and a high proportion of its issuers have negative ratings outlooks. High-Yield Energy Bonds Risk Profile On average, the High-Yield Energy index and the overall High-Yield corporate index have very similar credit ratings. However, the Energy sector has a more barbelled credit rating distribution with a greater proportion of Ba-rated securities (64% versus 55%) and a greater proportion of Ca-C rated issuers (8% versus 1%) (Chart 6). Chart 6High-Yield Credit Rating Distributions* Chart 7AHY Energy Risk Profile It is likely some combination of the larger presence of very low-rated credits and increased oil price volatility that has caused the sector to trade cyclically versus the junk benchmark since 2014 (Chart 7A). Notice that Energy outperformed the junk index during the 2008 sell off, but has since turned cyclical, underperforming in both the 2015/16 and 2020 risk-off episodes. At the sub-sector level, there is currently only one high-yield rated Integrated issuer (Cenovus Energy Inc., Ba-rated, negative outlook). Based on their DTS ratios, the Independent and Oil Field Services sub-sectors are the most cyclical (Charts 7B & 7C). This is because the lower-rated (Caa & below) issuers are concentrated in the these spaces. This is particularly true for Oil Field Services where 41% of the sub-sector’s market cap is rated Caa or below. The Midstream sub-sector also trades cyclically relative to the junk benchmark, but with somewhat less volatility than Independent and Oil Field Services, as evidenced by its DTS ratio of 1.2 (Chart 7D). Refining has traded like a cyclical sector so far this year, but that may not continue now that its DTS ratio has fallen close to 1.0 (Chart 7E). Chart 7BHY Independent Risk Profile Chart 7CHY Oil Field Services Risk Profile Chart 7DHY Midstream Risk Profile Chart 7EHY Refining Risk Profile   Valuation The Energy sector offers a significant spread advantage over the High-Yield index and also relative to other Ba-rated issuers (Table 2). Adjusting for duration differences by looking at the 12-month breakeven spread makes Energy look even more attractive. Energy spreads need to widen by 189 bps during the next 12 months to underperform duration-matched Treasuries. This compares to 93 bps for other Ba-rated issuers and 150 bps for the overall junk index. Table 2HY Energy Valuation Four of the five Energy sub-sectors (Integrated being the exception) also offer attractive value relative to the overall index and their equivalently-rated benchmarks. This remains true after adjusting for duration differences. Balance Sheet Health The high-yield Energy sector has added much more debt than the overall junk index since 2010 (Chart 8A). But of greater concern is that Moody’s has already changed its ratings outlook from stable to negative for 58 Energy issuers since the start of the year. Meanwhile, only 17 high-yield Energy issuers have seen their ratings outlooks confirmed as stable in 2020. Nevertheless, we take some comfort knowing that the Energy sector should benefit from having a large number of issuers able to take advantage of the Federal Reserve’s Main Street Lending facilities. As a reminder, to be eligible for the Main Street facilities issuers must have fewer than 15000 employees or less than $5 billion in 2019 revenue. They must also be able to keep their Debt-to-EBITDA ratios below 6.0, including any new debt added through the Main Street programs. The Energy sector offers a significant spread advantage over the High-Yield index and also relative to other Barated issuers. Of the 61 US high-yield Energy issuers with available data (we exclude 23 foreign issuers that won’t have access to US programs), we estimate that at least 48 are eligible to receive support from the Main Street facilities (Appendix B). This not only includes 15 out of 20 B-rated issuers, but also 12 out of 15 Caa-rated issuers and 4 out of 7 issuers rated below Caa. This broad access is the result of deleveraging that has occurred since the 2014-16 bust (Chart 8A, bottom panel) and it should go a long way toward limiting defaults in the Energy space. The Independent sub-sector’s weight in the index jumped sharply this year, the result of adding three sizeable fallen angels (Chart 8B). Importantly, 24 out of the 28 US Independent issuers appear eligible for Fed support. In contrast, the Oil Field Services sector is in distress. Its weight in the index has been declining for more than a year (Chart 8C), and a large proportion of its issuers are concentrated in lower credit tiers. However, we estimate that out of 19 issuers with available data, 13 are eligible for the Fed’s Main Street Lending facilities. Both Midstream and Refining have high concentrations of Ba-rated issuers and neither has aggressively grown its presence in the index during the past decade (Charts 8D & 8E), though Midstream’s index weight did jump this year. The high credit quality of both indexes means that most issuers will have access to the Main Street facilities, though three of the five Refining issuers are not US based. Chart 8AHY Energy Debt Growth Chart 8BHY Independent Debt GrowthChart 8CHY Oil Field Services Debt Growth Chart 8DHY Midstream Debt Growth Chart 8EHY Refining Debt Growth   Investment Conclusions The conclusion from the model we presented in last week’s report was that high-yield Energy should outperform the junk index during the next 12 months, assuming that overall junk spreads tighten and the oil price rises. However, we remain concerned that, despite the nascent economic recovery, some low-rated Energy names will go bust during the next few months, weighing on index returns. The pattern from the 2014-16 default cycle argues that our concerns may be overblown. In February 2016, high-yield Energy started to outperform the overall junk index slightly after the trough in oil prices and eleven months before the peak in the 12-month trailing default rate (Chart 1 on page 1). If oil prices are indeed already past their cyclical trough, then it may already be a good time to bottom-fish in the high-yield Energy space. The fact that the bulk of high-yield Energy issuers are eligible for support through the Main Street lending facilities tips the scales, and we recommend that investors overweight high-yield Energy relative to the overall junk index. In particular, we think investors should focus on the Independent sub-sector where value is very attractive and most issuers can tap the Fed for help if needed. We would, however, avoid the Oil Field Services sector where the bulk of Energy defaults are likely to come from. Midstream and Refining should perform well, but are less cyclical and less attractively valued than the Independent sub-sector. Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com   Footnotes 1 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, available at usbs.bcaresearch.com 2 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007.   Appendix A Investment Grade Energy Issuers Appendix B High-Yield Energy Issuers  

Highlights US consumer spending will stall this summer in response to the rising number of Covid cases. Worries about the looming fiscal cliff could also dampen sentiment. Markets are likely to trade nervously over the coming days, but ultimately, stocks will resume their uptrend. The number of new cases already seems to be peaking in some southern US states, and there is no political will to rescind fiscal stimulus. Many institutional investors missed out on the equity rally and will be keen to “buy the dip” on any opportunity. The drop in government bond yields since the start of the year has more than offset the decline in earnings expectations. As odd as it sounds, the pandemic may have raised the fair value of equities. If one wants to challenge this conclusion, one needs to demonstrate that: 1) earnings estimates have not fallen enough; 2) government bond yields have been artificially suppressed; or 3) the post-pandemic world justifies a higher equity risk premium. While there is some truth to all three arguments, they are unlikely to hold much sway over the next 12 months, provided that global growth rebounds and governments and central banks maintain ultra-accommodative fiscal and monetary policies. Investors should remain overweight global equities, while tilting their exposure to beaten-down cyclically-geared stocks and non-US markets. The equity bull market will only end when central banks get panicky about rising inflation, which is unlikely to happen for the next three years. From ROMO To FOMO People often talk about FOMO (the Fear of Missing Out). But for many institutional investors, the past four months has been more about ROMO – the Reality of Missing Out. Chart 1Many Investors Are Bearish On Stocks Many investment professionals missed the rally that began in March, and not much has changed since then. The July BofA Merrill Lynch Survey of Fund managers revealed that fund managers are almost one standard deviation overweight cash and nearly one standard deviation underweight equities. In fact, cash allocations increased further since June. The latest sentiment survey conducted by the American Association of Individual Investors (AAII) tells a similar story. Bears exceeded bulls by 15 points in this week’s tally, one of the highest spreads on record (Chart 1). This is not what market tops look like.   Near-Term Worries Granted, risks abound. The Google Mobility Index has hooked lower, reflecting the worsening Covid outbreak in the sunbelt states and parts of the Midwest. This real time index tends to track economic activity quite well (Chart 2). At this point, it is reasonable to expect the recovery in US consumer spending to stall this summer. Chart 2Covid Outbreak Is Weighing On Spending Worries about the fiscal cliff could also dampen sentiment. Unemployment benefits for the average American worker are set to fall by more than 60% at the end of July. The funds in the Paycheck Protection Program for small businesses are also running out. To make matters worse, many state and local governments, which began their fiscal year in July, are facing a severe cash crunch due to evaporating tax revenues and rising social spending obligations. Meanwhile, the US elections are only four months away. If the Democrats win the White House and take control of the Senate, the Trump tax cuts will be in jeopardy. Joe Biden has pledged to lift corporate tax rates halfway back to their original levels. This would reduce S&P 500 EPS by about 6%. Risks In Perspective While the discussion above suggests that stocks could trade nervously over the coming days, we should keep things in perspective. The number of new Covid cases has been trending lower in Arizona over the past week and may be close to peaking in the other southern states (Chart 3). Positive news on the vaccine front could also buoy sentiment.  Chart 3A Snapshot Of The Number Of New Cases In The Most Afflicted US States With respect to the fiscal cliff, there is a very high probability that Congress will reach a deal on a new aid package worth around $2.5 trillion. Table 1 shows stimulus remains politically popular nationwide and, more importantly, in the swing states. Table 1There Is Much Public Support For Fiscal Stimulus If Democrats prevail in November and raise corporate taxes, most of the revenue gained will be plowed back into the economy. Given that empirical estimates suggest that the spending multiplier from the corporate tax cuts was quite small, the net effect will probably be stimulative.1 The risk of an all-out trade war with China would also decline under a Biden administration, which is something the stock market would welcome. Some might contend that stocks are already pricing in a very rosy outlook. However, as we argue below, it is far from clear that this is the case. Has All The Good News Been Priced In? An NPV Analysis The fair value of the stock market can be represented as the expected stream of cash flows that shareholders will receive, deflated by an appropriate discount rate. The discount rate, in turn, can be expressed as a risk-free rate plus an equity risk premium (ERP). The ERP compensates investors for holding riskier stocks compared to safer government bonds. At the start of the year, Wall Street analysts expected S&P 500 earnings to increase by 9% in 2020 and by 11% in both 2021 and 2022. Today, analysts expect earnings to shrink by 23% in 2020, but then rebound by 29% in 2021. This would essentially take earnings back to last year’s levels. Looking further out, analysts expect earning to recover a further 17% in 2022, which would put them on track to reach their pre-pandemic trend by 2024. In contrast, market participants see little scope for a recovery in bond yields (Chart 4). According to the forward curve, the US 10-year is poised to rise from 0.62% at present to just 1.3% in five years’ time. At the start of 2020, investors thought the 10-year yield would be 2.5% in 2025. Along the same vein, the 30-year bond yield is down 106 bps since the start of the year. The 30-year TIPS yield has fallen by 82 bps. Since stocks are a long duration asset, the TIPS yield is a good proxy for the inflation-adjusted, risk-free component of the discount rate. Chart 4After Nosediving, Bond Yields Aren’t Expected To Rise By Much Chart 5 shows that if we combine the change in analyst earnings expectations with the drop in the TIPS yield, the net present value (NPV) of S&P 500 earnings has risen by a staggering 16.2% since the start of the year. Chart 5The Present Value Of Earnings: A Scenario Analysis Really? It might seem preposterous to conclude  that the fair value of the S&P 500 may have increased at a time when the US and the rest of the world have plunged into the deepest recession since the 1930s. Yet, it naturally flows from the premise that the hit to earnings from the pandemic will be temporary, while the decline in bond yields will be much longer lasting. If one wants to challenge this conclusion, one needs to demonstrate that: 1) earnings estimates have not fallen enough; 2) government bond yields have been artificially suppressed; or 3) the post-pandemic world justifies a much higher equity risk premium. Let us examine all three arguments in turn. Are Earnings Estimates Too Optimistic? The short answer is yes. However, this does not say very much. As Chart 6 shows, analysts are usually too optimistic. They typically start every year with overinflated estimates, and subsequently have to scale them down. This happens even during economic expansions. Thus, if estimates end up being trimmed over the coming months, this will not necessarily prevent stocks from moving higher. Chart 6Earnings Estimates Tend To Be Revised Down Even In The Best Of Times Of course, magnitudes matter a lot. If analysts end up having to revise estimates down more than usual, this could hurt stocks. But will they? That is far from a foregone conclusion. Earnings usually follow the path of nominal GDP. The Congressional Budget Office (CBO) expects the level of nominal GDP to be just half a percentage point lower in 2021 than it was in 2019. In this light, the notion that earnings next year will be on par with last year’s levels does not seem that farfetched. Moreover, one should also note that health care and technology are highly overrepresented on Wall Street compared to Main Street. Together, they account for 42% of S&P 500 market capitalization. Outside these two sectors, S&P 500 earnings are expected to be 9% lower in 2021 relative to 2019. In any case, the conclusion that the pandemic has increased the fair value of equities would not change much if we were to assume that earnings recover more slowly than anticipated. The red colored bar in Chart 5 shows the impact on the NPV in a scenario where earnings only return to their pre-pandemic trend by 2030: the NPV still rises by 13.5%. Even if we assume that earnings permanently remain 5% below their pre-pandemic forecast, the NPV would still increase by 9.2% (blue colored bar). In order to push down the NPV by a considerable amount, one would need to assume that the pandemic will not only reduce the level of corporate earnings, but it will reduce the growth rate of earnings as well. For example, if the pandemic reduces earnings growth by one percentage point, this would cause the NPV to fall by 7.5% (gray colored bar). Is this a sensible assumption, however? We don’t think so. While the pandemic will reduce capital spending temporarily, it is unlikely to damage the long-term growth rate of either productivity or the labor force, the two key drivers of potential output. Chart 7 shows that even after the Great Depression, per capita income eventually returned to its long-term trend. Chart 7No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth Are Bond Yields Distorted To The Downside? The notion that the pandemic may have increased the fair value of the stock market hinges critically on the view that the discount rate has fallen substantially this year. We will get to the question of what the appropriate level of the equity risk premium should be in a moment, but let us first examine the risk-free component of the discount rate. Many pundits argue that central bank bond purchases have pushed down yields below where they ought to be. That may be true, but it is not clear why that matters. If one is making present value calculations, one should look at the actual bond yield, not the yield that accords with one’s preconception of what is appropriate. Granted, if bond yields were to rise sharply in the future, the present value of future earnings would probably end up falling. However, this is unlikely to occur anytime soon. It will take a while for unemployment to return to pre-pandemic levels, during which time inflation will remain dormant. And even once inflation starts rising, central banks will likely refrain from hiking rates because they have been concerned about excessively low inflation for nearly two decades. Central banks could also face pressure from governments to keep rates low in order to suppress interest costs. As a result, real rates could fall initially, which would be supportive of stocks. The bull market in equities will only end when inflation reaches a level that makes markets nervous that central banks will have to raise rates. This is unlikely to happen for the next three years. The Equity Risk Premium Is More Likely To Fall Than Rise Chart 8Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields As noted above, there are many risks confronting investors. The key question is whether the stock market’s perception of these risks will subside or intensify. If it is the former, the equity risk premium will probably shrink, pushing stocks higher. If it is the latter, stocks will fall. Our bet is on the former. We have already learned a lot about the virus. We will learn even more over the coming months. This should reduce the cone of uncertainty investors are facing. On the economic side, central bank asset purchases, combined with large-scale fiscal stimulus, have reduced the tail risk of another market meltdown. If policy stays supportive for the next few years, as we expect, the equity risk premium will shrink. Starting points matter, too. Globally, the equity risk premium, which we calculate by subtracting the real bond yield from the cyclically-adjusted earnings yield, was quite high at the start of the year and is even higher now (Chart 8). This suggests that investors should favor stocks over bonds.   A Weaker Dollar Will Give Non-US Stocks An Edge The ERP is particularly elevated outside the US. Thus, valuations tend to favor non-US stocks. Of course, it helps to have factors other than valuations on your side when making investment decisions. In the case of regional and sector allocation, the outlook for the US dollar is critical. Chart 9 shows that cyclical stocks tend to outperform defensives when the dollar is weakening, while non-US stocks tend to do better than their US peers. There are five reasons to expect the US dollar to depreciate over the next 12 months. First, as a countercyclical currency, a revival in global growth should hurt the dollar (Chart 10). Second, the US has been harder hit by the virus over the past few months than most other economies. Thus, the spread between overseas growth and US growth is likely to widen more than usual (Chart 11). Chart 9Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Chart 10A Revival In Global Growth Should Hurt The Dollar Chart 11The Dollar Will Also Weaken On The Widening Gap Between Overseas Growth And US Growth Chart 12Interest Rate Differentials No Longer Favor The Dollar Third, interest rate differentials no longer favor the dollar, now that the Fed has brought rates down to zero (Chart 12). Fourth, momentum is not on the greenback’s side anymore (Chart 13). Fifth, the dollar is expensive based on measures such as purchasing power parity exchange rates (Chart 14). Chart 13Momentum Is Not On The Greenback’s Side   The right trade over the past few years was to be long the dollar and overweight US stocks. It is time to flip this trade and do the opposite. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Chart 14USD Is Not Cheap Footnotes 1  An IMF analysis of the use of funds of listed companies found that only about one fifth of the increase in corporate cash since the adoption of the Tax Cuts and Jobs Act (TCJA) was used for capex and R&D. The rest was utilized for share buybacks, dividend payouts, and other activities. The same study also noted that actual GDP and business investment growth in 2018 fell short of the predicted impact of the TCJA based on empirical studies of postwar US tax changes. Please see Emanuel Kopp, Daniel Leigh, Susanna Mursula, and Suchanan Tambunlertchai, "U.S. Investment Since the Tax Cuts and Jobs Act of 2017," IMF Working Paper, May 31, 2019. Global Investment Strategy View Matrix Current MacroQuant Model Scores

  Highlights Q2/2020 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark by +11bps during the second quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +8bps, led by overweights in the US (+4bps), Canada (+4bps) and Italy (+3bps). Spread product generated a small outperformance (+3bps), with overweights in US investment grade (+43bps) offsetting underweights in emerging market debt (-35bps). Scenario Analysis For The Next Six Months: We are sticking close to benchmark on overall duration and spread product exposure, focusing more on relative value between countries and sectors to generate outperformance amid economic uncertainties caused by the growing spread of COVID-19. We continue favoring markets where there is direct buying from central banks, but we are also increasing our recommended exposure to EM USD-denominated debt versus US investment grade corporates. Feature The first half of 2020 has been one of rapid market moves and regime shifts for global fixed income markets. In the first quarter, developed market government debt provided the best returns as bond yields plunged with central banks racing to support collapsing economies through rate cuts and liquidity injections. In Q2, corporate credit delivered the top returns, as economies started to emerge from the COVID-19 lockdowns and, more importantly, the Fed and other major central banks delivered direct support to frozen credit markets through asset purchases. Now, even as an increasing number of global growth indicators are tracing out a "V"-shaped recovery, new cases of COVID-19 are surging though the southern US and major emerging economies like Brazil and India. This raises new challenges for investors for the second half of 2020. A second wave of the coronavirus could jeopardize the nascent global economic recovery, even after the massive easing of monetary and fiscal policies, at a time when valuations on many risk assets appear stretched. In this report, we review the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the second quarter of 2020. We also present our recommended portfolio positioning for the next six months. Given the lingering uncertainties from the renewed spread of COVID-19, we continue to take a more measured approach in our portfolio allocations. That means focusing more on relative value between countries and sectors while staying closer to benchmark on overall global duration and spread product exposure versus government bonds (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2020 Model Portfolio Performance Breakdown: Slight Outperformance For Both Sovereigns And Credits Chart 1Q2/2020 Performance: Modest Gains From Relative Positioning The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was 3.22%, modestly outperforming the custom benchmark index by +11bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +8bps of outperformance versus our custom benchmark index while the latter outperformed by +3bps. That government bond return includes the small gain (+2bps) from inflation-linked bonds, which we added as a new asset class in our model portfolio framework on June 23.2 In a world of very low bond yields (Table 2), our preference for the higher-yielding government bond markets in the US, Canada, the UK and Italy was the main source of outperformance, delivering a combined excess return of +13bps (including inflation-linked bonds). Our underweight in Japan delivered a surprising positive excess return of +4bps as longer-dated JGB yields – which do not fall under the Bank of Japan’s yield curve control policy – rose during the quarter. Underweights in the low-yielding core euro area countries of Germany and France were a drag on the portfolio (a combined -10bps), particularly the latter where longer-maturity French bonds enjoyed a very strong rally in Q2. Table 2GFIS Model Bond Portfolio Q2/2020 Overall Return Attribution In spread product, our overweights in US investment grade corporates (+43bps), UK investment grade corporates (+7bps) and US commercial MBS (+5bps) squeezed out a combined small gain versus underweights in emerging markets (EM) USD-denominated credit (-35bps), euro area high-yield (-8bps) and lower-rated US high-yield (-6bps). In a world of very low bond yields (Table 2), our preference for the higher-yielding government bond markets in the US, Canada, the UK and Italy was the main source of outperformance. That modest outperformance of the model bond portfolio versus the benchmark is in line with our cautious recommended stance on what are always the largest drivers of the portfolio returns: overall duration exposure and the relative allocation between government debt and spread product. We have stuck close to benchmark exposures on both, eschewing big directional bets on bond yields or credit spreads while focusing more on relative opportunities between countries and sectors. This conservative approach is how we are approaching what we have dubbed “The Battle of 2020” between the opposing forces of coronavirus contagion (which is bullish for government bonds and bearish for credit) and policy reflation (vice versa).3 The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2020 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q2/2020 Spread Product Performance Attribution By Sector The most significant movers were: Biggest Outperformers Overweight US investment grade industrials (+28bps) Overweight US investment grade financials (+12bps) Overweight UK investment grade corporates (+7bps) Overweight US CMBS (+5bps) Underweight Japanese government bonds with maturity greater than 10 years (+5 bps) Biggest Underperformers Underweight EM USD denominated corporates (-24bps) Underweight EM USD denominated sovereigns (-10bps) Underweight EUR high-yield corporates (-8bps) Underweight French government bonds with maturity greater than 10 years (-5bps) Underweight US B-rated high-yield corporates (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2020. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2/2020 (red for underweight, dark green for overweight, gray for neutral).4 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio In Q2/2020 The top performing sectors in our model bond portfolio universe in Q2 were all spread product: EM USD-denominated sovereign (+12.9% in USD-hedged terms, duration-matched to the custom model portfolio benchmark index), EM USD-denominated corporate debt (+12.6%), UK investment grade corporates (+11.3%), US investment grade corporates (+10.9%), and high-yield corporates in the euro area (+6.7%) and US (+5.6%). The top performing sectors in our model bond portfolio universe in Q2 were all spread product. During the quarter, we maintained relative exposures to those sectors within an overall small above-benchmark allocation to global spread product – overweight US and UK investment grade versus underweight emerging market credit, neutral overall US high-yield (favoring Ba-rated debt) versus underweight euro area high-yield. Those allocations were motivated by our theme of “buying what the central banks are buying”, like the Fed purchasing US investment grade corporates. Importantly, we had limited exposure to the worst performing sectors during Q2: underweight government bonds in Japan (index return of -0.47% in USD-hedged, duration-matched terms) and Germany (+0.47%), a neutral allocation to Australian sovereign debt (-0.07%) and an underweight in US Agency MBS (+0.20%). The latter two positions came after we downgraded US MBS to underweight in early April and cut our long-held overweight in Australia to neutral in mid-May. Bottom Line: Our model bond portfolio modestly outperformed its benchmark index in the second quarter of the year by +11bps – a positive result driven by our relative positioning that favored higher yielding government debt and spread product sectors directly supported by central bank purchases. Future Drivers Of Portfolio Returns Chart 5Overall Portfolio Allocation: Slightly Overweight Credit Vs Governments Typically, in these quarterly performance reviews of our model bond portfolio, we make return forecasts for the portfolio based off scenario analysis and quantitative predictions of various fixed income asset classes. However, the current environment is unprecedented because of the COVID-19 outbreak. Not only is there now elevated economic uncertainty, but central banks are running extreme monetary policies in response - including direct intervention in markets through purchases of both government bonds and spread product. Thus, we are reluctant to rely on historical model coefficients and correlations to estimate expected fixed income returns. Instead, we will focus on the logic behind our current model portfolio allocations and the expected contribution to overall portfolio performance over the next six months. At the moment, the main factors that will drive the performance of the model bond portfolio over the next six months are the following: Our recommended overweight stance on relatively higher-yielding sovereigns like the US, Canada and Italy versus low-yielders like Germany, France and Japan; Our allocation to inflation-linked bonds out of nominal government debt in the US, Italy and Canada; Our recommended overweight stance on spread product backstopped by central bank purchases - US investment grade corporates, US Agency CMBS, US Ba-rated high-yield, and UK investment grade corporates; Our recommended underweight stance on riskier spread product - euro area high-yield, US B-rated and Caa-rated high-yield, and EM USD-denominated corporates and sovereigns. The portfolio currently has a small aggregate overweight allocation to spread product relative to government bonds, equal to three percentage points (Chart 5). We feel that is an appropriate allocation to credit versus sovereigns in an environment that is still highly uncertain concerning the spread of COVID-19 and how global growth will evolve over the next 6-12 months. This also leaves room to increase the spread product allocation should the news on the virus and the global economy take a turn for the better. We also remain neutral on overall portfolio duration exposure. Our Global Duration Indicator, which contains growth data like our global leading economic indicator and the global ZEW expectations index, has rebounded sharply and is signaling that bond yields should bottom out in the second half of 2020 (Chart 6). A rise in yields will take longer to develop, however, with virtually all major central banks signaling that policy rates will stay near 0% for an extended period. Chart 6Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 Chart 7Within Governments, Overweight Inflation-Linked Bonds Vs. Nominals The recent moves in developed market government bonds are interesting in terms of the underlying drivers of yields – real yields and inflation expectations. Longer-maturity inflation breakevens – the spread between the yields of nominal and inflation-linked government debt – have drifted higher since late March after major central banks began rapidly easing monetary conditions. At the same time, the actual yields on inflation-linked bonds, i.e. real yields, have moved lower and largely offset the gains in inflation breakevens (Chart 7). Nominal yields have been stuck in very narrow ranges as a result. We do not see that dynamic changing, at least in the near term. Inflation breakevens are too low on our models across all developed markets, and are likely to continue inching higher in the coming months on the back of a pickup in global growth and rising energy prices. At the same time, central banks will be staying on hold for longer while continuing to buy large quantities of nominal bonds, helping push real yields lower. Given these opposing forces on nominal government bond yields, we think it is far too soon to contemplate reducing overall duration – even with equity and credit markets having rallied sharply off the lows and global economic indicators rebounding. Thus, we are maintaining an overall duration exposure close to benchmark in the model portfolio (Chart 8). At the same time, we are playing for wider breakevens and lower real bond yields through allocations to markets where our models indicate better value in being long breakevens: US TIPS, Italian inflation-linked BTPs, and Canadian Real Return Bonds. Within the government bond side of the model bond portfolio, we continue to recommend focusing more on country allocation to generate outperformance. That means concentrating exposures in relatively higher yielding markets like the US, Canada and Italy while maintaining underweights in low-yielding core Europe and Japan. Turning to spread product allocations, we continue to recommend focusing more on policymaker responses to the COVID-19 recession, and its uncertain recovery, rather than the downturn itself. The now double-digit year-over-year growth in global central bank balance sheets - which has led global high-yield and investment grade excess returns by one year in the years after the Global Financial Crisis (Chart 9) – is pointing to additional global corporate bond market outperformance versus governments over the next 6-12 months. Chart 8Overall Portfolio Duration: Close To Benchmark In other words, we are focusing on global QE rather than global recession, while maintaining a modest recommended overall weighting on global spread product. That allocation could be larger, but we suggest picking the lowest hanging fruit in the credit universe rather than going for the highest beta credit markets like Caa-rated US high-yield that have already seen significant spread compression relative to higher-rated US junk bonds (bottom panel). Chart 9Global QE Supporting Credit Markets Chart 10Overall Credit Allocation: Keep Buying What The Central Banks Are Buying We continue to focus our recommended spread product allocations on the parts of global credit markets where central banks are directly buying. We continue to focus our recommended spread product allocations on the parts of global credit markets where central banks are directly buying (Chart 10). In the US, that means overweighting US investment grade corporate bonds (particularly those with maturities of less than five years), US Ba-rated high-yield that the Fed can hold in its corporate bond buying program, US Agency CMBS that is also supported by Fed programs, and UK investment grade corporate bonds that the Bank of England is buying. We also put Italian government bonds into this category, with the ECB buying greater amounts of BTPs as part of its COVID-19 monetary support efforts. What about emerging market debt? We have expressed reservations in recent months about upgrading EM USD-denominated sovereign and corporate debt, even within our portfolio theme of being “selectively opportunistic” about recommended spread product allocations. We have long felt that the time to buy those markets would be when the US dollar had clearly peaked and global growth had clearly bottomed. The latter condition now appears to be in place, and the strong upward momentum in the US dollar is starting to weaken. This forces us to reconsider our stance on EM debt in the model portfolio. Even after the powerful Q2 rally in EM corporate and sovereign debt, EM credit spreads still look relatively attractive using one of our favorite credit valuation metrics – the percentile rankings of 12-month breakeven spreads. Those breakeven spreads are calculated, as the amount of spread widening that would make the return of EM credit equal to duration-matched US Treasuries over a 12-month horizon. We then compare those spreads to their own history to determine how attractive current spread levels are now on a “spread volatility adjusted” basis. Current 12-month breakeven spreads for EM USD-denominated sovereigns and corporates are in the upper quartile of their own history. This compares favorably to other spread products in our model bond portfolio universe, particularly US investment grade corporates where the 12-month breakevens are now just below the long-run median (Chart 11). Chart 11A Comparison Of Credit Sectors Using 12-Month Breakeven Spreads The current Bloomberg Barclays EM corporate benchmark index option-adjusted spread (OAS) is around 300bps above that of the US investment grade corporate index OAS. That spread still has room to compress further if global growth continues to rebound and the US dollar softens versus EM currencies. Leading growth indicators like the China credit impulse, which has picked up sharply as Chinese authorities have ramped up economic stimulus measures, are now back to levels last seen in 2016 when EM credit strongly outperformed US investment grade corporates (Chart 12). Chart 12Upgrade EM Credit Versus US Investment Grade Chart 13Overall Portfolio Yield: Close To Benchmark This week we are upgrading our weighting on EM USD-denominated corporates and sovereigns to neutral, from underweight, in our model bond portfolio. Although we acknowledge that the EM story has been made more complicated by the rapid spread of COVID-19 through the major EM economies, an underweight stance – particularly versus US investment grade credit – is increasingly unwarranted. Therefore, this week we are upgrading our weighting on EM USD-denominated corporates and sovereigns to neutral, from underweight, in our model bond portfolio (see the updated table on pages 17-18). That new allocation will be “funded” by reducing our overweight in US investment grade corporates. Model bond portfolio yield and tracking error considerations Importantly, the selective global government bond and credit allocations we have just outlined do not come at a cost in terms of forgone yield. The portfolio yield after our upgrade of EM debt will be slightly above that of the custom benchmark index (Chart 13), indicating no “negative carry” even when avoiding parts of the US and euro area high-yield markets. Chart 14Overall Portfolio Risk: Moderate Finally, turning to the risk budget of the model portfolio, we are aiming for a “moderate” overall tracking error, or the gap between the portfolio’s volatility and that of the benchmark index. The portfolio volatility has fallen dramatically from the surge seen during the global market rout in March, moving lower alongside realized market volatility. The tracking error now sits at 64bps, well below our self-imposed limit of 100bps and within the 50-70bps range we are targeting as a “moderate” level of overall portfolio risk (Chart 14). Bottom Line: We are sticking close to benchmark on overall duration and spread product exposure, focusing more on relative value between countries and sectors to generate outperformance amid economic uncertainties caused by the growing spread of COVID-19. We continue favoring markets where there is direct buying from central banks. We are also increasing our recommended exposure on EM USD-denominated debt to neutral, funded by a reduced allocation to US investment grade corporates where valuations are less attractive.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations'", dated June 23 2020, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Contagion Vs. Reflation: The Battle Of 2020 Rages On", dated June 30, 2020, available at gfis.bcaresearch.com. 4 Note that sectors where we made changes to our recommended weightings during Q2/2020 will have multiple colors in the respective bars in Chart 4. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights Energy Bond Model: This report presents models for both investment grade and high-yield Energy bond excess returns. The models are based on overall corporate bond index spreads and the oil price. They can be used to generate Energy bond excess return forecasts for investment horizons up to 12 months. IG Energy Bonds: Our model suggests that investment grade Energy bond excess returns will be strong during the next 12 months under likely economic scenarios. We recommend an overweight allocation to investment grade Energy bonds.  HY Energy Bonds: Our models imply positive excess return outcomes for high-yield Energy bonds, but we remain concerned about near-term default risk for lower-rated issuers. We advise a cautious (neutral) allocation for now. Part 2 of this Special Report, to be published next week, will dig further into the high-yield Energy index on an issuer-by-issuer basis. Feature Table 1Energy Bond Excess Return* Scenarios (12-Month Investment Horizon) During the past couple of months we’ve published several reports that take more detailed looks at specific industry groups within both the investment grade and high-yield corporate bond markets. So far, we’ve published reports on: Banks1 Healthcare & Pharmaceuticals2 Technology3 This week and next week, we continue our series with a deep dive into Energy bonds that is split between two Special Reports. This week’s report develops a model for Energy bond excess returns based on overall corporate bond index excess returns and the oil price. In next week’s report, we look more deeply into the characteristics of the investment grade and high-yield Energy indexes. We also consider the outlooks for the five sub-categories of Energy debt: Independent, Integrated, Oil Field Services, Refining and Midstream. A Model Of Energy Bond Excess Returns A good starting point for modeling the excess returns of any corporate bond sector is to combine the sector’s Duration-Times-Spread (DTS) ratio with the excess returns of the overall corporate bond index.4 Please note that “excess returns” refers to returns relative to a duration-matched position in Treasury securities. The DTS-only model explains 86% of the variance in monthly investment grade Energy excess returns. Considering only a sector’s DTS ratio, we can define the following model for monthly investment grade Energy excess returns: EXSENRG = (DTSENRG / DTSCORP) * EXSCORP Where: EXSENRG = Monthly investment grade Energy excess returns versus duration-matched Treasuries (DTSENRG / DTSCORP) = The investment grade Energy sector’s DTS ratio EXSCORP = Monthly investment grade corporate index excess returns versus duration-matched Treasuries For example, the current DTS for the investment grade Energy sector is 18. The DTS for the overall corporate index is 12. This means that the DTS ratio for the Energy sector is 18/12 = 1.5. According to our simple model, we would expect Energy sector excess returns to be 1.5 times corporate index excess returns in any given month. It turns out that our simple model performs quite well. Chart 1 shows monthly investment grade Energy sector excess returns versus our model’s prediction. Our sample period spans from 1997 to the present. Specifically, we find that our model explains 86% of the variance in monthly investment grade Energy excess returns. Chart 1Investment Grade Energy Monthly Excess Returns*: DTS-Only Model** The simple (DTS-only) model’s performance is admirable, but we can do slightly better if we also incorporate the oil price. Chart 2 shows a statistically significant relationship between the residual from the DTS-only model and the monthly change in the Brent crude oil price. Chart 2Residual From DTS-Only Model* Versus Oil Price Combining the models shown in Charts 1 and 2, we get a model for investment grade Energy monthly excess returns based on both corporate index excess returns and the oil price: EXSENRG = (DTSENRG / DTSCORP) * EXSCORP + (376.84 * ∆ ln Oil) – 1.0587 Where excess returns are measured in basis points and (∆ ln Oil) = the monthly change in the natural logarithm of the Brent crude oil price. Chart 3 shows the historical performance of this complete model. Note that the model now explains 91% of the historical variance of investment grade Energy excess returns, 5% more than the initial DTS-only model. Chart 3Investment Grade Energy Monthly Excess Returns*: Complete Model (DTS & Oil)** Robustness Checks We performed the same analysis for 3-month, 6-month and 12-month excess returns and found very consistent results (Table 2). The oil price adds significant explanatory power to the model in each case, but the bulk of variation in investment grade Energy excess returns is determined by trends in the overall corporate index spread. Table 2Investment Grade Energy Excess Returns*: Model Results Using Different Return Frequencies (1997 - Present) We also find consistent results when looking at high-yield Energy returns (Table 3). Once again, the bulk of excess return variation is explained by multiplying the DTS ratio and the benchmark index’s excess returns. The oil price also adds a statistically significant amount of extra explanatory power. Table 3High-Yield Energy Excess Returns*: Model Results Using Different Return Frequencies (1997 - Present) One final observation is that oil explains a greater proportion of the variation in Energy sector excess returns if we limit our sample period to the past few years. Specifically, we re-ran the monthly iterations of both the investment grade and high-yield models from July 2014 to present. We found that the DTS component of the model explains the same amount of excess return variation as it did for the full sample. However, we also found that the oil price has a much greater impact if the sample is limited to the past six years (Table 4). Table 41-Month Excess Return* Models: Full Sample (1997 - Present) Versus Recent Sample (2014 - Present) Energy Excess Return Scenarios Finally, using our 12-month excess return models for investment grade and high-yield Energy, we can project likely outcomes for Energy excess returns versus Treasuries for the next 12 months. All we have to do is assume different outcomes for the overall benchmark index spread (either the investment grade or High-Yield index, depending on the model) and the oil price.5 The results of this scenario analysis are shown in Table 1. Starting with investment grade Energy, we see that all scenarios where the investment grade corporate index spread tightens lead to positive Energy excess returns. This is true even in a scenario where the oil price falls by $20 during the next year. Our model also suggests that a $10-$20 increase in the oil price during the next 12 months will keep Energy excess returns positive, even in a modest “risk off” scenario where the corporate index spread widens by 25 bps. All scenarios where the investment grade corporate index spread tightens lead to positive Energy excess returns. The story is similar in high-yield, though returns are much more variable. For example, high-yield Energy is projected to lose money relative to Treasuries in a scenario where the junk index spread tightens 50 bps and the oil price falls by $20. There are no scenarios where benchmark index spread tightening coincides with negative Energy excess returns in the investment grade model. Chart 4Watch For Falling Inventories In terms of likely scenarios for the next 12 months, we anticipate further spread tightening for corporate bonds rated Ba & above. But we also view B-rated and lower spreads as too tight given the default outlook for the next 12 months and the fact that these lower-rated issuers usually can’t access the Fed’s emergency lending facilities.6 With that in mind, we would confidently bet on investment grade index spread tightening during the next 12 months, but can envision high-yield spread widening driven by the lower credit tiers. On oil, our Commodity & Energy Strategy service forecasts an average Brent crude oil price of $65 in 2021, a sizeable increase relative to the current price of $43.27.7 Our strategists expect a significant supply contraction in the second quarter of this year that will cause the oil market to enter a physical deficit in the second half of 2020. Investors can look for falling storage levels in the coming months to confirm whether that forecast is playing out (Chart 4). Escalating tensions between the US and Iran pose an additional near-term upside risk to oil prices. This risk increased during the past few weeks as a string of mysterious explosions struck several Iranian military and economic facilities.8 However, with major oil producers now operating significantly below capacity, any net impact on oil prices from a supply disruption in the Persian Gulf would likely be short-lived. Investment Conclusions All in all, our bullish outlook for both investment grade corporate bond spreads and the oil price makes us inclined to overweight investment grade Energy bonds on a 12-month horizon. Within high-yield, our model also suggests that we should have a bullish bias toward Energy, but we remain concerned about default risk for lower-rated (B & below) Energy issuers during the next few months. We will dig into the high-yield Energy index on an issuer-by-issuer basis in Part 2 of this report, to be published next week. For now, we advise a more cautious stance toward high-yield Energy.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 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 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 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007. 5 We translate changes in benchmark index spread into 12-month excess returns using the formula: excess return = option-adjusted spread – (duration * change in option-adjusted spread) 6 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 7 Please see Commodity & Energy Strategy Weekly Report, “Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks”, dated June 18, 2020, available at ces.bcaresearch.com 8 Please see Geopolitical Strategy Special Alert, “Cyber-Rattling In The Middle East”, dated July 10, 2020, available at gps.bcaresearch.com