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In mid-April we boosted the S&P internet retail index to overweight as it was poised to benefit from the shifting consumer spending habits due to the COVID-19 outbreak. True, the “amazonification” of the economy is not a new phenomenon, but COVID-19 acted as an accelerant to an already powerful uptrend in online retail sales (see chart). Today, our overweight in the S&P internet retail index surpassed the 29% relative return mark since the mid-April inception, which compels us to protect profits by instituting a stop at the 20% mark. Bottom Line: We remain overweight the S&P internet retail index, but from a portfolio risk management perspective today we add a stop at the 20% relative return mark in order to protect profits.   ​​​​​​​

Highlights Butterflies & Yield Curve Models: With bond market volatility now back to the subdued levels seen prior to the COVID-19 market turbulence earlier in 2020, it is a good time to update our global yield curve valuation models to look for attractive butterfly trade ideas. Valuations: The models generally indicate that flattener trades offer better value across all countries. Our medium-term strategic bias, however, is towards steeper yield curves with policy rates on hold and depressed global inflation expectations likely to continue drifting higher over the latter half of the year. Yield Curve Trades: We are initiating the first set of yield curve trades within our rebooted Tactical Trade Overlay: going long a 7-year bullet vs. a 5-year/10-year barbell in the US; long a 2-year/30-year barbell vs. a 5-year bullet in France; long a 5-year/30-year barbell vs. a 10-year bullet in Italy; and long a 3-year/20-year barbell vs. a 10-year bullet in the UK. Feature In a Special Report published back in February of this year, we dusted off our model-based framework to find value in trades focused on the shape of government bond yield curves.1 By comparing the market-implied short-term interest rate expectations extracted from our curve models to our own macro views, we are able to come up with actionable buy or sell signals across the yield curve in nine developed markets: the US, Germany, France, Italy, Spain, the UK, Japan, Canada, and Australia. Table 1Most Attractive Butterfly Trades Given the extreme market turbulence around the time we published that report, as the full scope of the COVID-19 pandemic was becoming evident, we chose not to recommend any curve trades from our models until global volatility subsided to acceptable levels. The vigorous action from central banks to manipulate bond yields since then - quantitative easing, aggressive forward guidance, outright yield curve control in Japan and Australia, and other unconventional monetary policy measures - introduced another layer of difficulty in implementing successful curve trades using models estimated in more normal times. With global bond market volatility now back down to pre-COVID levels, we feel that the time is right to use our curve models to help identify opportunities. Specifically, we are implementing new recommended yield curve trades in the US, France, Italy, and the UK. Table 1 shows the most attractive butterfly trades across all the markets covered in this analysis. Note that three of the four trades we are initiating include very long-dated bonds where yields are less susceptible to direct central bank influence. The only exception is our US long 7-year bullet vs. 5-year/10-year barbell trade, the reasoning for which we outline later in this report. Three of the four trades we are initiating include very long-dated bonds where yields are less susceptible to direct central bank influence. The only exception is our US long 7-year bullet vs. 5-year/10-year barbell trade. Before delving into our analysis proper, a quick note: in the interest of brevity, we will limit ourselves to a simple explanation of butterfly strategies and our yield curve models in this report. For those interested in a deeper explanation of the curve modeling framework, please refer to our February 25, 2020 Special Report. A Recap On Butterflies And An Update On Our Yield Curve Models A butterfly fixed income strategy involves two main components: a barbell (a weighted combination of long-term and short-term bonds) and a bullet (a medium-term bond that sits within the yield curve segment selected in the barbell). To implement a butterfly strategy, a bond investor would go long (short) the barbell while simultaneously going short (long) the bullet. By weighting the combination of the long- and short-term bonds in the butterfly such that the weighted sum of their duration equals the duration of the medium-term bond in the bullet, we achieve immunization to parallel shifts in the yield curve. At the same time, due to the relatively higher duration of the longer-term component of the butterfly, we get exposure to specific changes in the slope of the yield curve. In general, the barbell will outperform the bullet in a flattening yield curve environment, and vice-versa. Chart of the WeekButterfly Spreads & Yield Curves To actually decide how, and on which parts of the yield curve, to implement our butterfly strategies, we make use of our yield curve models. These models rely on the positive relationship typically observed between the butterfly spread and the slope of the yield curve. When the curve steepens, the butterfly spread widens, and vice-versa (Chart of the Week). This has to do with mean reversion: as the curve steepens, it increases the odds that the curve will flatten in the future since it cannot steepen indefinitely. Consequently, investors will ask for greater compensation to enter a curve steepener trade when the curve is already steepening. As a result, we can create simplified models of the yield curve by regressing any butterfly spread on its corresponding curve slope. Deviations from these fair value models indicate which butterfly strategies are cheap or expensive. However, the model output does not by itself constitute a buy or sell signal and must be integrated with our macro view on the slope of the curve. For example, a butterfly strategy with an expensive bullet implies that there is already a certain amount of steepening discounted in the yield curve. If the yield curve flattens, or even steepens by an amount smaller than what is discounted in the yield curve over the investment horizon, the barbell will outperform, as expected. However, if we see more steepening than is discounted in the yield curve, the bullet will outperform, even though it was already at relatively expensive levels. Therefore, it is crucial to integrate our macro view on how much the curve will steepen or flatten over the investment horizon into our curve trade selection framework. In recent reports, we have emphasized our high-conviction view that global inflation expectations will drift higher in the coming months, driven by reflationary fiscal and monetary policy and a continued rebound in global commodity prices (most notably, oil).2 However, a rise in inflation expectations does not necessarily translate to a “one-to-one” rise in nominal yields if it is offset by a compression in real bond yields. To disentangle this, we look at the 3-year rolling betas of nominal 10-year government bond yields to the corresponding 10-year breakeven inflation rates using inflation-linked bonds (Chart 2). The data suggest a currently weaker relationship between inflation expectations and nominal yields, with all betas well below their post-crisis maxima. Our overall macro bias is towards a global steepening in yield curves, but given our strong belief in a rebound in inflation expectations, we would be more willing to enter steepener trades in higher-beta regions such as Germany, Canada, the US, and Australia where it is more likely that a rise in inflation expectations will translate to higher nominal yields. Conversely, we are less hesitant to enter flatteners in the lower-beta regions such as the UK, France, Italy, and Japan. Chart 2The Link Between Nominal Yields And Inflation Expectations Has Weakened When we said earlier this year that we were “dusting off” our yield curve models, that was not just a figure of speech. The models date back originally to 2002, meaning that they are old enough to vote—perhaps even for a popular rapper. Even though we have been refining and updating it along the way, one of our concerns was that this model was estimated for a pre-crisis sample period before near-zero rates became ubiquitous in developed markets. Our overall macro bias is towards a global steepening in yield curves, but given our strong belief in a rebound in inflation expectations, we would be more willing to enter steepener trades in higher-beta regions such as Germany, Canada, the US, and Australia. To test that the curve relationships within our models are maintained when global central banks are pinning policy rates near 0%, we have re-estimated all the regressions for the post-financial crisis period from 2009 to 2017 when most central banks kept rates near the zero bound. Chart 3 shows the results for the representative 2-year, 5-year and 10-year portions of the yield curve. On the whole, the coefficients are weaker but still positive with the exception of Japan, where many years of zero rates and quantitative easing have caused the 2-year/5-year/10-year butterfly spread to become largely unmoored from the 2-year/10-year slope. Chart 3Looking For Structural Shifts In Our Yield Curve Models Therefore, we still see value in our curve modeling approach, even in the current environment where central banks are likely to be on hold for a period measured in years, not months. Bottom Line: Butterfly strategies are an effective way to position for changes in the slope of the yield curve without exposure to shifts in the curve. Our current strategic bias is to expect steepening of developed market yield curves through rising longer-term inflation expectations, but our global yield curve models indicate better value in most flattening trades. Thus, we need to be extremely selective in recommending trades based on the results of our yield curve models. Yield Curve Models And Trades By Region In the remaining pages of this report, we present the current read-outs from of our yield curve models for each of the major developed markets. More specifically, we provide the deviations from fair value for different combinations of bullets and barbells and highlight the most attractive butterfly strategy. The deviations from fair value shown in Tables 2-10 are standardized to facilitate comparisons between the different butterfly combinations. In addition, for each country we provide a quick assessment of the performance of these butterfly strategies over time by applying a simple mechanical trading rule. Every month, we enter the most attractive butterfly strategy, i.e. the one with the highest absolute standardized deviation from its model fair value. The overall message from the models is that barbells appear attractive relative to bullets across all the countries shown. However, we will only initiate trades in cases where the model output and our macro outlook complement each other. US Looking solely at our model output, US Treasury curve flatteners appear most attractive, with the long 3-year/30-year barbell vs. 5-year bullet trade displaying the greatest deviation from fair value with a residual of -1.55 (Table 2). However, we are inclined to agree with our colleagues at BCA Research US Bond Strategy on how to interpret Treasury curve valuation in the current environment. They argue that even though steepeners in the US are currently expensive, valuations can become even more overstretched with the Fed signaling no rate increases for at least the next two years and the market priced for an extended period of near-zero rates.3 Table 2US: Butterfly Strategy Valuation: Standardized Residuals Our fundamental bias is towards US Treasury curve steepening, with the Fed locking down the front end of the curve and rising inflation expectations putting upward pressure on longer-term yields. Thus, we are entering into the long 7-year bullet vs. 5/10 barbell trade which has a small but positive model residual of +0.17. That represents a better valuation starting point than the other US butterfly spreads, and is therefore a more efficient and profitable way to position for steepeners becoming even more expensive going forward. As highlighted earlier, nominal yields in the US are also more sensitive to rising inflation expectations—another reason to enter into a curve steepener. The specific securities used to execute this trade, as well as the weights for the barbell component used to the make both legs of the trade duration-equivalent, can be found on Page 27 within our Tactical Trade Overlay table. Nominal yields in the US are also more sensitive to rising inflation expectations—another reason to enter into a curve steepener.  The 7-year bullet appears just 1bp cheap according to our model and would only underperform its counterpart given a flattening in the 5-year/10-year Treasury slope greater than 22bps, which we believe is unlikely given the reasons outlined above (Chart 4A). Chart 4AUS 5/7/10 Spread Fair Value Model Chart 4BUS Butterfly Strategy Performance Following the mechanical trading rule has delivered steady returns with only a few periods of negative year-over-year returns (Chart 4B). Germany The most attractively valued butterfly combination on the German yield curve is going long the 1-year/30-year barbell and shorting the 5-year bullet, which is almost one standard deviation above its model-implied fair value, with a standardized residual of -0.97 (Table 3). Table 3Germany: Butterfly Strategy Valuation: Standardized Residuals The 5-year bullet appears 29bps expensive according to our model and would only outperform its counterpart given a steepening in the 1-year/30-year German curve slope greater than 50bps (Chart 5A). Chart 5AGermany 1/5/30 Spread Fair Value Model Chart 5BGermany Butterfly Strategy Performance Following the mechanical trading rule has been quite profitable, delivering consistently positive year-over-year returns for all but the initial period of our sample (Chart 5B). France The most attractively valued butterfly combination on the French OAT yield curve is going long the 2-year/30-year barbell and shorting the 5-year bullet (Table 4). This combination is a little less than one standard deviation over its model-implied fair value with a standardized residual of -0.84. Nominal yields in France are also relatively less correlated with inflation expectations, which makes this a prime candidate for a flattener trade. The specific securities used to execute this trade, as well as the weights for the barbell component used to the make both legs of the trade duration-equivalent, can be found on Page 27 within our Tactical Trade Overlay table. Table 4France: Butterfly Strategy Valuation: Standardized Residuals The 5-year bullet appears 21bps expensive according to our model and would only outperform its counterpart given a steepening in the 2-year/30-year French curve slope greater than 48bps (Chart 6A). Chart 6AFrance 2/5/30 Spread Fair Value Model Chart 6BFrance Butterfly Strategy Performance As with Germany, following the mechanical trading rule in the French OAT market has also been profitable, with only three periods of negative year-over-year returns in our sample period (Chart 6B). Italy And Spain In Italy, the most attractively valued butterfly combination is going long the 5-year/30-year barbell and shorting the 10-year bullet – a combination with a standardized residual of -0.79 (Table 5). In Spain, going long the 3-year/30-year barbell and short the 5-year bullet seems most attractive with a standardized residual of -0.83 (Table 6). Of the two peripheral euro area countries, we are choosing to put on a trade in the relatively larger and more liquid Italian government bond market. As with France, Italian nominal yields also display a relatively low beta to inflation breakevens. The specific securities used to execute this trade, as well as the weights for the barbell component used to the make both legs of the trade duration-equivalent, can be found on Page 27 within our Tactical Trade Overlay table. Table 5Italy: Butterfly Strategy Valuation: Standardized Residuals Table 6Spain: Butterfly Strategy Valuation: Standardized Residuals In Italy, the 10-year bullet appears 22bps expensive according to our model and would only outperform its counterpart given a steepening in the 5-year/30-year Italian curve slope greater than 153bps (Chart 7A). Following the mechanical trading rule in Italy has yielded strong excess returns, with only one very short period of negative year-over-year returns in our sample period (Chart 7B).  As with Italy, following the mechanical trading rule in Spain has yielded some of the strongest excess returns on a cumulative and year-over-year basis. Chart 7AItaly 5/10/30 Spread Fair Value Model Chart 7BItaly Butterfly Strategy Performance In Spain, the 5-year bullet appears 14bps expensive according to our model and would only outperform its counterpart given a steepening in the 3-year/30-year Spanish curve slope greater than 47bps (Chart 8A). As with Italy, following the mechanical trading rule in Spain has yielded some of the strongest excess returns on a cumulative and year-over-year basis (Chart 8B). Chart 8ASpain 3/5/30 Spread Fair Value Model Chart 8BSpain Butterfly Strategy Performance UK On the UK Gilt yield curve, the most attractive butterfly combination is holding a 3-year/20-year barbell versus a 10-year bullet, which currently displays a standardized residual of -1.08 (Table 7). As with France and Italy, not only is this flattener trade attractively valued, the UK is also one of the countries where inflation breakevens are relatively less correlated with nominal yields, making this another excellent candidate for our Tactical Trade Overlay. The specific securities used to execute this trade, as well as the weights for the barbell component used to the make both legs of the trade duration-equivalent, can be found on Page 27. Table 7UK: Butterfly Strategy Valuation: Standardized Residuals The 10-year bullet appears 13bps expensive according to our model and would only outperform its counterpart given a steepening in the 3-year/20-year Gilt curve slope greater than 52bps (Chart 9A). Chart 9AUK 3/10/20 Spread Fair Value Model Chart 9BUK Butterfly Strategy Performance Following the mechanical trading rule in the UK has produced consistent returns on a year-over-year basis (Chart 9B). Canada The most attractively valued butterfly combination on the Canadian yield curve is favoring the 5-year/30-year barbell versus the 7-year bullet, which currently displays a standardized residual of -1.41 (Table 8). Table 8Canada: Butterfly Strategy Valuation: Standardized Residuals The 7-year bullet appears 7bps expensive according to our model and would only outperform its counterpart given a steepening in the 5-year/30-year Canadian curve slope greater than 42bps (Chart 10A). Chart 10ACanada 5/7/30 Spread Fair Value Model Chart 10BCanada Butterfly Strategy Performance Following the mechanical trading rule in Canada has historically been a good strategy, but we do note two periods of minor losses in 2013 and 2019 (Chart 10B). Japan The most attractively valued butterfly combination on the JGB yield curve is the 5-year/20-year barbell versus the 7-year bullet, which currently has a standardized residual of -1.03 (Table 9). As we noted earlier, however, valuations in the JGB market are likely distorted due to the Bank of Japan’s long-running programs of quantitative easing, zero policy rates and Yield Curve Control that aims to keep the 10-year JGB yield around 0%. Table 9Japan: Butterfly Strategy Valuation: Standardized Residuals The 7-year bullet appears 6bps expensive according to our model and would only outperform its counterpart given a steepening in the 5-year/20-year Japan curve slope greater than 23bps (Chart 11A). Following our mechanical trading rule has produced decent returns, especially given the dormant nature of the JGB market, with only a couple minor periods without positive year-over-year returns. Chart 11AJapan 5/7/20 Spread Fair Value Model Chart 11BJapan Butterfly Strategy Performance Following our mechanical trading rule has produced decent returns, especially given the dormant nature of the JGB market, with only a couple minor periods without positive year-over-year returns (Chart 11B). Australia The most attractively valued butterfly combination on the Australian yield curve is going long the 2-year/10-year barbell versus the 7-year bullet, displaying a standardized residual of -1.73 (Table 10). Table 10Australia: Butterfly Strategy Valuation: Standardized Residuals The 7-year bullet appears 15bps expensive according to our model and would only outperform its counterpart given a steepening in the 2-year/10-year Australian curve slope greater than 101bps (Chart 12A). Chart 12AAustralia 2/7/10 Spread Fair Value Model Chart 12BAustralia Butterfly Strategy Performance Compared to the other markets in our analysis, following the mechanical trading rule in Australia has not produced stellar returns (Chart 12B). However, excess returns on a year-over-year basis have been positive barring two periods.   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Special Report, "Global Yield Curve Trades: Follow The Butterflies", dated February 25, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research 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 Research US Bond Strategy Weekly Report, "Take A Look At High-Yield Technology Bonds", dated June 23, 2020, available at usbs.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 1More Stimulus Required The unemployment rate fell for the second consecutive month in June, down to 11.1% from a peak of 14.7%. Bond markets shrugged off the news, and rightly so, as this recent pace of improvement is unlikely to continue through July and August. The main reason for pessimism is that the number of new COVID cases started rising again in late June, consistent with a pause in high-frequency economic indicators (Chart 1). This second wave of infections will slow the pace at which furloughed employees are returning to work, a development that has been responsible for all of the unemployment rate’s recent improvement. Beneath the surface, the number of permanently unemployed continues to rise (Chart 1, bottom panel). The implication for policymakers is that it is too early to back away from fiscal stimulus. In particular, expanded unemployment benefits must be extended, in some form, beyond the July 31 expiry date. We are confident that Congress will eventually pass another round of stimulus, though it may not make the July 31 deadline. For investors, bond yields are still biased higher on a 6-12 month horizon, but their near-term outlook is now in the hands of Congress. We continue to recommend benchmark portfolio duration, along with several tactical overlay trades designed to profit from higher yields. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 189 basis points in June, bringing year-to-date excess returns up to -529 bps. The average index spread tightened 24 bps on the month. We still view investment grade corporates as attractively valued, with the index’s 12-month breakeven spread only just below its historical median (Chart 2). With the Fed providing strong backing for the market, we are confident that investment grade corporate bond spreads will continue to tighten. As such, we want to focus on cyclical segments of the market that tend to outperform during periods of spread tightening (panel 2). One caveat is that the Fed’s lending facilities can’t prevent ratings downgrades (bottom panel). Therefore, we also want to avoid sectors and issuers that are mostly likely to be downgraded. High-quality Baa-rated issues are the sweet spot that we want to target. Those securities will tend to outperform the overall index as spreads tighten, but are not likely to be downgraded. Subordinate bank bonds are a prime example of securities that exist within that sweet spot.1 In recent weeks we published deep dives into several different industry groups within the corporate bond market. In addition to our overweight recommendation for subordinate bank bonds, we also recommend an overweight allocation to investment grade Healthcare bonds.2 We advise underweight allocations to investment grade Technology and Pharmaceutical bonds.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral High-Yield outperformed the duration-equivalent Treasury index by 90 basis points in June, bringing year-to-date excess returns up to -855 bps (Chart 3A). The average index spread tightened 11 bps on the month and has tightened 500 bps since the Fed unveiled its corporate bond purchase programs on March 23. We reiterated our call to overweight Ba-rated junk bonds and underweight bonds rated B and below in a recent report.4 In that report, we noted that high-yield spreads appear tight relative to fundamentals across the board, but that the Ba-rated credit tier will continue to perform well because most issuers are eligible for support through the Fed’s emergency lending facilities. Specifically, we showed that “moderate” and “severe” default scenarios for the next 12 months – defined as a 9% and 12% default rate, respectively, with a 25% recovery rate – would lead to a negative excess spread for B-rated bonds (Chart 3B). The same holds true for lower-rated credits. Chart 3AHigh-Yield Market Overview Chart 3BB-Rated Excess Return Scenarios We appear to be on track for that sort of outcome. Moody’s recorded 20 defaults in May, matching the worst month of the 2015/16 commodity bust and bringing the trailing 12-month default rate up to 6.4%. Meanwhile, the trailing 12-month recovery rate is a meagre 22%. At the industry level, in recent reports we recommended an overweight allocation to high-yield Technology bonds5 and underweight allocations to high-yield Healthcare and Pharmaceuticals.6 MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 13 basis points in June, dragging year-to-date excess returns down to -44 bps. The conventional 30-year MBS index option-adjusted spread (OAS) has tightened 5 bps since the end of May, but it still offers a pick-up relative to other comparable sectors. The MBS index OAS stands at 95 bps, greater than the 81 bps offered by Aa-rated corporate bonds (Chart 4), the 54 bps offered by Aaa-rated consumer ABS and the 76 bps offered by Agency CMBS. At some point this spread advantage will present a buying opportunity, but we think it is still too soon. As we wrote in a recent report, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare in the second half of this year (bottom panel).7 The primary mortgage rate did not match the decline in Treasury yields seen earlier this year. Essentially, this means that even if Treasury yields are unchanged in 2020 H2, a further 50 bps drop in the mortgage rate cannot be ruled out. Such a move would lead to a significant increase in prepayment losses, one that is not priced into current index spreads. While the index OAS has widened lately, expected prepayment losses (aka option cost) have dropped (panels 2 & 3). We are concerned this decline in expected prepayment losses has gone too far and that, as a result, the current index OAS is overstated. Government-Related:  Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 78 basis points in June, bringing year-to-date excess returns up to -399 bps. Sovereign debt outperformed duration-equivalent Treasuries by 112 bps on the month, bringing year-to-date excess returns up to -828 bps. Foreign Agencies outperformed the Treasury benchmark by 37 bps in June, bringing year-to-date excess returns up to -764 bps. Local Authority debt outperformed Treasuries by 268 bps in June, bringing year-to-date excess returns up to -439 bps. Domestic Agency bonds outperformed by 14 bps, bringing year-to-date excess returns up to -58 bps. Supranationals outperformed by 12 bps, bringing year-to-date excess returns up to -19 bps. We updated our outlook for USD-denominated Emerging Market (EM) Sovereign bonds in a recent report.8 In that report we posited that valuation and currency trends are the primary drivers of EM sovereign debt performance (Chart 5). On valuation, we noted that the USD sovereign bonds of: Mexico, Colombia, UAE, Saudi Arabia, Qatar, Indonesia, Malaysia and South Africa all offer a spread pick-up relative to US corporate bonds of the same credit rating and duration. However, of those countries that offer attractive spreads, most have currencies that look vulnerable based on the ratio of exports to foreign debt obligations. In general, we don’t see a compelling case for USD-denominated sovereigns based on value and currency outlook, although Mexican debt stands out as looking attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 68 basis points in June, bringing year-to-date excess returns up to -582 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries widened in June and continue to look attractive compared to typical historical levels. In fact, both the 2-year and 10-year Aaa Muni yields are higher than the same maturity Treasury yield, despite municipal debt’s tax exempt status (Chart 6). Municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.9 In that report we also mentioned our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push muni yields lower from current levels. Despite the MLF’s shortcomings, we aren’t yet ready to downgrade our muni allocation. For one thing, federal assistance to state & local governments will probably be the centerpiece of the forthcoming stimulus bill. The Fed could also feel pressure to reduce MLF pricing if the stimulus is delayed. Further, while the budget pressure facing municipal governments is immense, states are also holding very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve was mostly unchanged in June. Both the 2-year/10-year and 5-year/30-year slopes steepened 1 bp on the month, reaching 50 bps and 112 bps, respectively. With no expectation – from either the Fed or market participants – that the fed funds rate will be lifted before the end of 2022, short-maturity yield volatility will stay low and the Treasury slope will trade directionally with the level of yields for the foreseeable future. The yield curve will steepen when yields rise and flatten when they fall. With that in mind, we continue to recommend duration-neutral yield curve steepeners that will profit from moderately higher yields, but that won’t decrease the average duration of your portfolio. Specifically, we recommend going long the 5-year bullet and short a duration-matched 2/10 barbell.10 In a recent report we noted that valuation is a concern with this recommended position.11 The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet also looks expensive on our yield curve models (Appendix B). However, we also noted that the 5-year bullet traded at much more expensive levels during the last zero-lower-bound period between 2010 and 2013 (bottom panel). With short rates once again pinned at zero, we expect the 5-year bullet will once again hit levels of extreme over-valuation. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 99 basis points in June, bringing year-to-date excess returns up to -400 bps. The 10-year TIPS breakeven inflation rate rose 19 bps on the month and currently sits at 1.39%. The 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps on the month and currently sits at 1.62%. TIPS breakevens have moved up rapidly during the past couple of months, but they remain low compared to average historical levels. Our own Adaptive Expectations Model suggests that the 10-year TIPS breakeven inflation rate should rise to 1.53% during the next 12 months (Chart 8).12 On inflation, it also looks like we are past the cyclical trough. The WTI oil price is back up to $41 per barrel after having briefly turned negative (panel 4), and trimmed mean inflation measures suggest that the massive drop in core is overdone (panel 3). If inflation has indeed troughed, then the real yield curve will continue to steepen as near-term inflation expectations move higher. We have been advocating real yield curve steepeners since the oil price turned negative in April.13 The curve has steepened considerably since then, but still has upside relative to levels seen during the past few years (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 103 basis points in June, bringing year-to-date excess returns up to -2 bps. Aaa-rated ABS outperformed duration-equivalent Treasuries by 8 bps in June, bringing year-to-date excess returns up to +7 bps. Meanwhile, non-Aaa ABS outperformed by 233 bps in June, bringing year-to-date excess returns up to -88 bps (Chart 9). Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Securities Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS and we recommend owning those securities as well. This is despite the fact that non-Aaa bonds are not eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a recent report.14  We noted that the stimulus received from the CARES act caused real personal income to increase significantly during the past few months and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further fiscal stimulus will be needed to sustain those recent income gains. But we are sufficiently confident that a follow-up stimulus bill will be passed that we advocate moving down in quality within consumer ABS. Non-Agency CMBS:  Overweight  Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 211 basis points in June, bringing year-to-date excess returns up to -501 bps. Aaa CMBS outperformed Treasuries by 164 bps in June, bringing year-to-date excess returns up to -233 bps. Non-Aaa CMBS outperformed by 407 bps in June, bringing year-to-date excess returns up to -1451 bps (Chart 10). Our view of non-agency CMBS has not changed during the past month, but we realize that it is more accurately described as a “Neutral” allocation as opposed to “Overweight”. Our view is that we want an overweight allocation to Aaa-rated CMBS because that sector offers an attractive spread relative to history and benefits from Fed support through TALF. However, we advocate an underweight allocation to non-Aaa non-agency CMBS. Those securities are not eligible for TALF and, unlike consumer ABS, their fundamental credit outlook has deteriorated significantly as a result of the COVID recession.15  Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 104 basis points in June, bringing year-to-date excess returns up to -58 bps. The average index spread tightened 19 bps on the month to 77 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Performance Since March 23 Announcement Of Emergency Fed Facilities Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of July 3, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of July 3, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 57 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 57 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of July 3, 2020) Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 10 The rationale for why this position will profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 11 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 12 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 We discussed our outlook for CMBS in more detail in US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation