Fixed Income Quarterly Guidance

Global Investment Strategy Global Fixed Income Strategy: Quarterly Guidance

August 22, 2019 Quarterly guidance on global fixed income investments Brian Rehling, CFA Co-Head of Global » Yields remain relatively low on a historical basis. Fixed Income Strategy » We believe that investors should consider positioning George Rusnak, CFA duration (a bond’s price sensitivity to interest-rate changes) Co-Head of Global to match that of their individually selected benchmarks. Fixed Income Strategy » We favor raising average credit quality in fixed-income Peter Wilson portfolios. Global Fixed Income Strategist » We believe that investors should maintain fixed-income exposure at targeted allocations and remain broadly and Luis Alvarado globally diversified. Investment Strategy Analyst Quarterly Fixed Income Guidance: Third Quarter 2019 In this report, we share our current tactical (6-18 month) guidance for fixed-income classes and sectors. We no longer recommend strategic allocations to Developed Market (ex-U.S.) Fixed Income. We also do not favor holding tactical positions in Developed Market (ex-U.S.) Fixed Income at this time.

Global Fixed Income Indices: Total Returns as of June 30, 2019 Global Fixed Income Indices: Total Returns as of June 30, 2019 WFII Guidance WFII Guidance Most Unfavorable Most Favorable YTD 1 Year Most Unfavorable Most Favorable YTD 1 Year U.S. Taxable Investment 6.1% 7.9% Government Securities 5.2% 7.2% Grade Fixed Income U.S. Short Term Taxable Fixed 2.7% 4.3% Treasury Securities 5.2% 7.2% Income U.S. Intermediate Term 5.2% 7.5% Agencies 4.2% 6.1% Taxable Fixed Income U.S. Long Term Taxable Fixed Inflation-Linked Fixed 13.5% 13.9% 6.2% 4.8% Income Income High Yield Taxable Fixed 9.9% 7.5% Investment-Grade Credit 9.4% 10.3% Income Developed Market Ex-U.S. Investment-Grade 5.6% 4.4% 9.9% 10.7% Fixed Income (Unhedged) Corporate Emerging Market Fixed 10.6% 11.3% Preferred Stock 10.9% 4.9% Income (U.S. Dollar) Municipal 5.1% 6.7% Securitized 4.2% 6.2% Residential Mortgage- 4.2% 6.2% WFII Guidance Legend: Backed Securities (MBS) Commercial Mortgage- NA NA Most Favorable Favorable Neutral Backed Securities Asset-Backed Securities NA NA Unfavorable Most Unfavorable Sources: Wells Fargo Investment Institute (WFII), Bloomberg, June 30, 2019. WFII Guidance updated on August 19, 2019. Past performance is no guarantee of future results. See end of report for important risk information, index definitions, and Wells Fargo Investment Institute guidance definitions. Inflation-Linked Fixed Income equates to Treasury Inflation-Protected Securities. Asset classes in blue are tactical recommendations, and specific tactical allocation models can be found in the most recent Asset Allocation Strategy Report. Asset classes in gold represent sector guidance and do not have specific allocations within tactical asset allocation models. YTD = year to date.

Investment and Insurance Products: NOT FDIC Insured NO Bank Guarantee MAY Lose Value

U.S. Taxable Investment-Grade Fixed Income Neutral Our economic growth expectations remain modest, and we have seen a significant dovish Federal Reserve (Fed) pivot year to date. As we currently forecast additional federal funds rate cuts by year-end and do not expect meaningfully higher interest rates, we favor a neutral stance in U.S. Taxable Investment Grade Fixed Income. While we believe that investors’ taxable total-return expectations should be tempered, high-quality fixed income remains an important portfolio diversifier and can provide a portfolio shock absorber during times of market stress. A neutral tactical guidance position can help to better position portfolios should the economic slowdown unexpectedly deepen. Additionally, if rates increase to a level that is near (or above) the midpoint of our year-end 2019 target ranges, we would have the opportunity to add additional exposure to investment-grade (IG) fixed income.

U.S. Short Term Taxable Fixed Income Favorable Short-term interest rates (as measured by 2-year Treasury yields) fell during the second quarter as the market continued to price in future Fed interest-rate cuts. Recent Fed guidance has led to a dovish market view of future Fed action. Investing in short-term, fixed-income securities typically offers a lower volatility profile than for longer duration fixed-income instruments, helping to mitigate the potential risk of any unexpected interest-rate increases. We maintain our favorable view of U.S. Short Term Taxable Fixed Income as an attractive alternative to excess holdings of cash alternatives in portfolios.

U.S. Intermediate Term Taxable Fixed Income Neutral Modest growth and inflation expectations, along with a dovish Fed, suggest that a neutral view of U.S. Intermediate Term Taxable Fixed Income is appropriate. With the prospect of meaningfully higher long-term rates now unlikely, we look for low- to mid-single-digit 2019 returns for investors in intermediate fixed income.

U.S. Long Term Taxable Fixed Income Neutral

Modest growth and inflation expectations, along with a dovish Fed, suggest that a neutral view of U.S. Long Term Taxable Fixed Income is appropriate. With the prospect of meaningfully higher long-term rates now unlikely, we look for mid- to upper-single-digit returns for investors in long-term fixed income. Longer-dated, high quality fixed income can be an important portfolio diversifier that has tended to perform well during periods of market stress.

Duration Neutral We believe that duration positioning is important for fixed-income investors. Bonds with shorter duration are less sensitive to changes in interest rates (assuming a parallel shift in the yield curve). We hold a neutral duration stance in both taxable and tax-exempt bond sectors. Portfolio Positioning Structure We expect modest global inflation and an uneven global recovery to keep interest rates relatively low overall. In June, interest rates fell across the yield curve, with maturities of one year and less declining the most. This has resulted in portions of the yield curve becoming more inverted (for issues from three months to three years). However, there are other segments of the yield curve that have been steepening (i.e., the yield difference between 10-year and 30-year Treasury securities has increased).We generally expect the Treasury yield curve to remain relatively flat for the foreseeable future, but yield-curve movement may prove to be somewhat volatile as the market grapples with the expected pace of Fed interest-rate cuts and the growth and inflation outlook. Our current analysis suggests that U.S. taxable interest rates could remain at low levels for at least the next six months as uncertainty continues to cloud the market. We believe that investors should consider utilizing multiple positions along the yield curve in the current environment. As noted, we favor a neutral duration position.

Credit Quality

As we reach the latter stages of the economic cycle, we believe that investors should exercise care in security selection. Lower-rated credits within the IG universe underperformed higher-rated credits by a wide margin late in 2018, but they have had strong year-to-date returns in 2019. Given the price appreciation driven by the recently strong performance of lower-rated taxable bonds, and our position late in the economic cycle, we continue to favor a higher-quality bias, with an emphasis on diligent credit analysis for fixed-income portfolios today.

Government Securities Unfavorable The Fed has ended its balance-sheet normalization. This should provide some stability to U.S. government securities. We recommend that investors hold government security allocations for diversification, liquidity, and situations in which investors choose to de-risk portfolios. Government securities may offer a hedge in the event of unexpected geopolitical developments or an economic slowdown and are generally the beneficiary of risk-off market events.

Treasury Securities Neutral Despite the substantial yield decline in recent weeks, yields on U.S. Treasury securities still appear relatively attractive versus those in developed sovereign bond markets abroad (but less so when hedging costs are taken into account). Overall, Treasury securities appear fairly valued relative to their risk profile and continue to offer an attractive liquidity profile.

Agencies Unfavorable The yield spread offered by agency securities over Treasury yields has tightened (declined) recently. Given the higher liquidity of Treasury issues and the fact that agency securities currently offer only a modest yield pickup versus Treasury securities, we do not see compelling value in agency securities today.

Inflation-Linked Fixed Income Neutral Inflation expectations, as measured by the breakeven rate for 10-year Treasury Inflation-Protected Securities (TIPS), have declined steadily since the end of April. We currently view TIPS as fairly valued; however, with breakeven rates that are in line with (or even below) the Consumer Price Index (CPI), TIPS can offer an attractive hedge against unexpected inflation over the medium-to-long term.

Investment-Grade Credit Favorable (was neutral) High quality IG credit can allow fixed-income portfolios to generate excess yield through spread premium (also known as “carry”) that is meant to compensate investors for perceived issuer credit risk. We believe that, at times, high-grade corporate debt offers investors better carry and liquidity per unit of risk than can be found in many other credit offerings in the fixed-income markets, such as high-yield debt. We reiterate our bias toward higher quality in the current market. Investment-Grade Corporate Favorable (was neutral) IG corporate securities offer reasonably attractive carry potential in a market segment that offers better liquidity than several other sectors (in our view). We believe that investors should emphasize sound credit analysis, with a focus on higher-quality issuers and sectors (as we are late in the economic cycle). Given the relative steepness of the IG corporate yield curve relative to the Treasury yield curve today, we see some incremental value in intermediate-term corporate bonds. Foreign demand for U.S. credit markets has remained strong. Overall, IG corporate bonds have delivered positive year-to-date total returns as well as duration-adjusted returns through June 30, 2019.

Preferred Stock Favorable

While the preferred security sector is not “cheap,” it does present some opportunities to purchase securities offering higher coupons. Yet, this must be weighed against the interest-rate risk inherent in long maturity or perpetual preferred securities. In our view, preferred-security investors should focus on income opportunities, rather than on the potential for return through principal appreciation. Should the market adopt a more risk-adverse view, we would expect preferred securities to fall in value. Securitized Favorable Yield is an important component of an investor’s sector selection, and the securitized sector offers investors potential income opportunities that cannot be found in other highly-rated, fixed-income securities.1 This sector can provide diversification to a fixed-income portfolio and generally has lower correlation to other sectors. We recently upgraded the securitized sector from neutral to favorable, since a large portion of the securitized sector is the residential mortgage-backed securities subsector, and we have upgraded residential mortgage-backed securities to favorable from neutral.

Residential Mortgage-Backed Securities Favorable

Residential mortgage-backed securities (RMBS) historically have offered strong liquidity and relatively low credit risk. We recently upgraded this sector to favorable (from neutral). RMBS are currently offering yields that are relatively more attractive than those in other sectors. Further, this sector is displaying better credit quality than some components of the IG corporate bond market. IG corporate spreads (over Treasury security yields) recently have tightened. Although credit fundamentals have not deteriorated much in recent quarters, they have deteriorated over the past five years. Our belief is that RMBS are better positioned to outperform (than other sectors) if there is a continued flight-to-quality or risk-off event. Additionally, foreign demand for RMBS has been strong.

The Fed has indicated that it will continue to let its mortgage-backed security (MBS) holdings gradually decrease over time as it aims to hold mostly Treasury securities on its balance sheet. We believe that this expectation is largely priced into MBS markets. With the recent decline in interest rates, MBS prepayment risk has returned to the forefront. We currently favor a balanced view of coupon structure across the MBS market.

Commercial Mortgage-Backed Securities Neutral

We favor a neutral stance on commercial MBS, given reasonable spread levels, healthy demand, and a likely reduction in new issue supply this year. Credit research is critical for investors purchasing commercial MBS, in our view. Commercial MBS represent less than 2% of the Bloomberg Barclays U.S. Aggregate Bond Index. Investors should be aware that these investments can be somewhat illiquid. We believe investors should weigh their benchmark allocation when considering purchases of these securities.

Asset-Backed Securities Unfavorable Although they represent a very small part of the Bloomberg Barclays U.S. Aggregate Bond Index, asset- backed securities (ABS) have been a steady outperformer for an extended period of time. ABS sector performance has benefited from generally strong U.S. economic growth and reduced consumer leverage over the past few years. In recent months, however, auto loan delinquencies have risen modestly. We view the ABS sector as fully valued, and we do not expect significant spread tightening from today’s levels. We recently downgraded this sector to unfavorable (from neutral). Although the ABS sector has

1 Fixed-income securities whose interest and principal payments are backed by cash flows from a pool (or portfolio) of other securities are securitized fixed-income assets. Examples include mortgage-backed securities and asset-backed securities.

© 2019 Wells Fargo Investment Institute. All rights reserved. Page 4 of 13 Global Investment Strategy—|—Quarterly Fixed Income Guidance—|—Third Quarter 2019 been sought as a “safe haven” in periods of corporate-bond volatility, we believe that current valuations make the sector less attractive. Current yield spreads are close to multi-decade lows. Nonetheless, we believe that ABS can provide investors with reasonable yields, important sector diversification, and relative stability. We favor higher quality, AAA-rated credit card and auto issues.2 We recommend avoiding subprime auto and private student-loan issues, for which investors are not adequately compensated for potential risk (in our view).

Municipal Favorable Municipal yields (for 10-year issues) continued to fall in June and neared a two-year low. Treasury securities also rallied last month, and municipal-to-Treasury yield ratios rose again from the April lows. These ratios are nearing fair-value levels relative to the 12-month average for a number of maturities, including 5-year and 10-year issues (which moved to 74.4% and 81.5% last month, respectively).3 These issues offer attractive valuation, while other maturities, such as 1-year issues, are currently rich based on municipal-to-Treasury yield levels. We believe that recently improved valuations on several short-to- intermediate issues make these maturities attractive. This summer, the municipal market is expected to be supported by seasonal factors, including falling supply and rising demand. The visible supply of municipals declined in June to $2.2 billion.4 We expect redemptions from maturing and called debt to lead to net negative supply in the near term. Year-to-date mutual fund inflows exceeded $40 billion at the end of the second quarter.5 Overall, the net supply of municipals should remain negative this year; but it is expected to be less negative than it was last year. Technical support continues (with a dovish Fed outlook and strong demand). This may continue to drive longer-term performance. Additionally, the potential infrastructure plan may influence supply in the coming months. We believe that issuers will be paying close attention to developments as the plan continues to take shape. The federal municipal tax exemption should remain valuable as several tax deductions have been eliminated or reduced. In-state bonds have become a higher priority for buyers in high-tax states, including California and New York—as the federal deduction for state income taxes has been capped. We favor selectivity, higher quality, and essential service revenue bonds with dedicated revenue streams. As noted, we continue to see value in the more defensively positioned short-to-intermediate areas of the municipal yield curve (particularly in the 8-13 year part of the municipal curve).

Portfolio Positioning

Duration Neutral We have a neutral duration stance, and we believe that investors should position duration equal to that of their individually selected benchmark. We slightly favor short-to-intermediate municipal maturities over long-term issues, but we favor diversification along the yield curve. As long as individual portfolios remain aligned with their duration targets, we see value in the 8-13 year part of the municipal curve. The municipal yield curve fell, and also steepened in June. While it currently is steeper than the Treasury yield curve, it remains relatively flat, given historical averages. The spread between 2- and 10-year municipal maturities stood at 38 basis points6 in late June (as it steepened by 24 basis points), while the 2- to 30-year municipal yield spread was unchanged at 140 basis points. In general, municipal bond benchmark indices are slightly longer in duration than are the standard taxable fixed-income benchmarks.

2 Ratings noted throughout this report are based on S&P Global Ratings. 3 Thomson Municipal Market Monitor, June 2019. 4 Thomson Municipal Market Monitor, June 2019. 5 Investment Company Institute, June 2019. 6 One hundred basis points equal 1.00%. © 2019 Wells Fargo Investment Institute. All rights reserved. Page 5 of 13 Global Investment Strategy—|—Quarterly Fixed Income Guidance—|—Third Quarter 2019

Structure We believe that investors should exercise caution with longer maturity, low-coupon (near par) bonds. While we favor premium coupon structure, there may be value in the extra spreads offered for securities with 3% to 4% coupons, relative to 5%. Premium-coupon callable bonds often offer higher yields relative to duration, and they can provide an income “cushion” to help mitigate volatility. Yet balance is needed, as too may short-callable securities in a portfolio can put stable income flows at risk.

Curve Positioning

The outperformance on the short end of the yield curve stood out in June, and the recent rally resulted in several parts of the municipal yield curve reflecting fair value now, based on municipal-to-Treasury yield curve averages.7 Although the municipal yield curve remains steeper than the Treasury curve, we believe that it offers investors only fair value—as continued Treasury issuance on the short part of the curve likely will keep pressure on short-maturity Treasury security yields—and on short-maturity municipal yields. As always, when evaluating curve positioning, we believe investors should take account of the duration targets for the portfolio as a whole. With that being said, we do see value in the 8-13 year part of the municipal yield curve, which has seen strong year-to-date performance and where investors have the potential to pick up as much as 75% of the yield of longer-dated high grade bonds, while taking on less duration risk than for longer- dated securities.

Credit Quality Credit spreads continued to compress in June. Spreads on BBB-rated bonds remain at the low end of the 12-month range, as do single A and AA-rated bonds. We continue to recommend paying close attention to credit quality, given our belief that we are in the latter stage of the business cycle. Although the credit spread on BBB-rated issues is generally less appealing, some stable BBB credits may be an option for certain investors with a higher risk tolerance (that can look at the lower-quality portion of the IG space). We prefer to emphasize the underlying credit, particularly as bond insurers work through their Puerto Rico exposures or deal with the less advantageous economics of a tight-spread environment.

Revenue (Essential Service) Favorable We believe that fundamentals are stable-to-improving in essential-service sectors, given their lower leverage and relatively consistent operating margins, and their lower vulnerability to broader budgetary concerns. We believe that essential-service revenue bonds generally are better equipped (than other types of municipal bonds) to deal with extreme market events, should they occur. Like general obligation bonds (below), some revenue sectors such as health care and education may have greater exposure to broad matters of political policy than traditional essential-service revenue bonds. Fixed- income market participants are watching developments in Puerto Rico’s bankruptcy case as it pertains to special revenue bonds. General Obligation (State and Local) Neutral We believe that state and local general-obligation (GO) holdings offer both opportunity and sources of concern. Generally speaking, we favor state (over local) GO issues, but we would caution that there is a wide degree of credit discrepancy in those categories. There are unique cases that should be closely watched going forward, particularly where unfunded pension liabilities are an issue. Additionally, we are closely monitoring possible nearer-term policy impacts on both GO and revenue debt arising from the new tax legislation. Tax-policy changes carry potential impacts on state and local revenues and expenses. Federal treatment of state and local taxes, reduced federal support of programs and projects

7 Thompson Municipal Market Monitor, June 2019. © 2019 Wells Fargo Investment Institute. All rights reserved. Page 6 of 13 Global Investment Strategy—|—Quarterly Fixed Income Guidance—|—Third Quarter 2019 that are shared with states and localities, any changes in health care support, and other potential downstream effects all could impact various municipal issuers. Following the passage of tax reform, in-state bonds have become a priority for investors in high-tax states. We note relatively high demand and lower yields in two of the highest-taxed states, New York and California. Some recent bond issues in these states have offered less compelling pricing, and we believe that, for these states, opportunities (on a relative basis) may exist in out-of-state bonds.

Taxable Municipal Favorable

We have a favorable view of taxable municipals today. Issuance rose during the first six months of 2019, versus the same period last year. As of July 1, year-to-date taxable new issue volume was $14.4 billion.8 Similar to the tax-exempt municipal market, demand remains very high. Higher issuance has created improved price discovery and a broader set of opportunities in the sector. We prefer shorter-term taxable municipals as we believe that they offer a combination of improved credit characteristics and attractive yield potential versus their taxable counterparts. We recommend caution in this sector, especially in lower-rated issues. Pre-Refunded Neutral We are neutral on pre-refunded municipals, given their recent outperformance and the prospects for average performance going forward. Pre-refunded municipals are currently fairly priced relative to non- refunded municipals, with yields on pre-refunded municipals equal to those of AAA-rated municipals, and 1-5 basis points more expensive than AA-rated municipals, depending on maturity. We don’t expect this market to strengthen as current demand for yield continues to drive the municipal market.

Crossover Opportunities Unfavorable

The measures that we monitor for municipal-to-corporate crossover opportunities do not show opportunities for municipal bond investors to cross over to corporate bonds at this time (although we favor well-diversified fixed income portfolio exposure). However, there are some after-tax yield advantages in corporate bonds for investors in the lower to mid-range federal tax brackets.

High Yield Taxable Fixed Income Unfavorable Although high-yield corporate bond spreads (over Treasury security yields) increased dramatically in late 2018, most of that spread widening has reversed in 2019. At the end of June, spreads remained below their five-year average. However, a repeat of the December and May swing toward “risk-off” positioning, or an unexpected economic-growth slowdown, could push high-yield spreads considerably higher. This could result in performance that could lag higher-quality fixed income sectors. However, the duration of the high-yield corporate market recently has fallen, causing the amount of yield or “carry” per unit of interest rate risk to rise to a level that is more compelling in the current market.

Bank Loans Unfavorable Bank loans are higher in the capital structure than traditional high-yield bonds, and they can help to diversify a high-yield allocation. Their coupons can reset to higher-interest-rate index settings as rates rise. However, with the Fed’s move to a more dovish stance (reflected in its communications), this potential benefit has been diminished. Given our expectation that the Fed will cut the fed funds rate this year, bank loans appear to offer a less compelling value proposition. Heavy new issuance volume, and declining covenant and subordination protections supporting recent transactions, are also of concern.

8 Thomson Municipal Market Monitor, June 2019. © 2019 Wells Fargo Investment Institute. All rights reserved. Page 7 of 13 Global Investment Strategy—|—Quarterly Fixed Income Guidance—|—Third Quarter 2019

High Yield Tax-Exempt Fixed Income Unfavorable

High-yield municipal issues have performed well year to date, returning 6.6% through June 30, 2019 (based on the Bloomberg Barclays High Yield Bond Index) as investors continued their search for yield. Yet, underlying fundamentals in the high-yield municipal market continue to present some risk. The rally in municipal high yield debt has brought yields down to historically low levels. As noted, we believe that most of the recent municipal high-yield market strength is due to the “search for yield” (without a full appreciation of the credit risks that this sector can entail). We don’t believe that the future prospects for growth in this sector warrant the volatility we expect in the near term. We hold an unfavorable view of the sector, which is consistent with our broader view on high-yield fixed income.

Developed Market Ex-U.S. Fixed Income Unfavorable

We no longer recommend strategic allocations to Developed Market Ex-U.S. Fixed Income. In this context, our tactical rating of unfavorable means that we do not favor tactically allocating to this asset class at this time. We are unfavorable toward developed market (DM) debt as many DM yields remain far below Treasury yields. Yields have reached historic lows, and the yield differential is still too wide to make DM bonds attractive, in our view. The risk of further declines in growth and inflation rates, especially in the eurozone, may push yields lower still. Also, specific risks (including the failure to achieve an orderly Brexit, for example, or rising Middle East tensions) may depress sovereign yields in the event of a sharp flight-to-quality market response. We also are cautious because DM bonds entail high foreign-exchange risk. We are broadly neutral on the dollar, so currency gains are not likely to enhance limited income or appreciation prospects. We have an unfavorable DM-debt view, since foreign-exchange risk is insufficiently compensated by income or capital-gain prospects (the strategic index is unhedged in terms of currency exposure). Regional

The sharp fall in sovereign yields in May and June has seen Italian bond yields return to the 2% level prevailing before the inauguration of a populist government in May 2018. Yet even with German bund yields at deeply negative levels, Italian spreads have remained wide. Now the European Central Bank has raised the possibility of further rate cuts (even as yield curves flatten and other sovereign spreads narrow sharply in a renewed hunt for yield), but we remain cautious on Italy. Political risks remain high, and a snap Italian election cannot be ruled out if the Lega seeks to capitalize on European Parliament success to consolidate its power as the leading populist party. Calls for increased budget deficits and the renewed talk about the issuance of “mini-BOTs” (small-denomination Treasury bills, which some fear could become a parallel currency) will likely prevent Italian yields near 2% from falling back to the recent lows.

Developed Market Sovereigns Unfavorable Core eurozone sovereign yields have continued to fall, and they have reached historically low levels. The likely succession of ex-IMF (International Monetary Fund) head Christine Lagarde when European Central Bank (ECB) President Draghi’s term expires at the end of October, has done nothing to reverse bullish sentiment and expectation of rate cuts, in our view. The yield on the strategic benchmark (the J. P. Morgan Global Bond Index ex-U.S.), is close to its all-time low of 40 basis points, and the largest sovereign markets within the benchmark index (the eurozone and Japan) have yields close to zero or negative across much of the yield curve. Therefore, in our view, neither absolute nor relative value (versus corporate bonds) is attractive, and we remain unfavorable toward sovereigns.

Developed Market Investment-Grade Corporates Unfavorable (was neutral)

(Euro-denominated)

With more sovereign and corporate yields moving into negative territory, as anticipated the growing investor hunt for yield has compressed euro-denominated IG credit spreads and taken absolute yields on IG corporates to very low levels (around 50 basis points). In these circumstances, even with IG fundamentals stable (as credit metrics do not look worrisome in most sectors), valuations are less attractive. We therefore have shifted our view on this sector from neutral to unfavorable. Ultra-low yields could be vulnerable to either a renewed rise in sovereign yields if the economy improves, or to spread-widening on a broad shock to risk assets. This could come if trade-dispute escalation continues to hit risk assets generally, or if U.S. tariff action, currently focused on China, rotates to Europe.

Emerging Market Fixed Income Neutral We are neutral on U.S.-dollar-denominated Emerging Market (EM) Fixed Income. Falling U.S. bond yields and tighter credit spreads have rapidly lowered index yields, resulting in strong performance and making valuations less attractive. Although fiscal and credit fundamentals in many major index constituents remain firm, reduced EM growth expectations and a rise in global uncertainty mean that we now see risks as more balanced for this fixed-income class. The U.S.-China trade dispute, and declines in other EM asset classes (such as currencies) suggest that the uncertain outlook for trade and for global growth may be more protracted than anticipated.

Emerging Market U.S.-Dollar-Denominated Favorable Sovereigns

EM sovereign spreads (for U.S.-dollar-denominated debt) of 350-400 basis points are above average for the post-2008 period. The difference in spread over U.S. Treasury yields between the EM sovereign index and the BB-rated U.S. corporate index, remains in a 100-150-basis-point range (i.e. well off last year’s high near 200 basis points). This has somewhat reduced EM sovereigns’ valuation advantage.

Fundamentally, EM sovereigns have an aggregate government debt/gross domestic product (GDP) ratio of around 50%, less than half the ratio for developed markets. Dollar-denominated debt makes up only a small portion of financing for most major EM sovereigns. We modestly favor U.S.-dollar- denominated EM sovereigns over corporates—in part because these make up the strategic benchmark, and corporates are therefore an off-benchmark position. But this also is because of better fiscal fundamentals and more attractive valuations on a spread basis. The largest risk factor for the sector remains a deterioration in global trade, stemming from escalating tariff conflicts, which would worsen the environment for emerging markets in general.

Emerging Market U.S.-Dollar-Denominated Unfavorable Corporates

Whereas sovereign spreads over Treasury security yields appear fairly valued relative to their recent history, corporate index spreads of 300-350 basis points are still below their average for the post-2008 period. This is at least in part due to the lesser liquidity of corporate issues. Over the medium term, we continue to prefer U.S.-dollar-denominated EM sovereigns over EM corporates. The large increase in corporate leverage over the past few years (especially in China) put corporates more at risk of defaults than sovereigns if the global environment deteriorates and/or U.S. interest rates rise sharply. Aggregate nonfinancial corporate debt has risen by 30-40 percentage points (of GDP) in the past decade.

© 2019 Wells Fargo Investment Institute. All rights reserved. Page 9 of 13 Global Investment Strategy—|—Quarterly Fixed Income Guidance—|—Third Quarter 2019 Risk Factors Investments in fixed-income securities are subject to interest rate, credit, liquidity, prepayment, extension and other risks. Interest rates change over time due to market conditions and changes in government policies. Bonds with longer durations are generally more price sensitive and volatile than those with shorter durations. Because bond prices generally fall as interest rates rise, the current low interest rate environment can increase the bond’s interest rate risk. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility than investment grade securities. Liquidity risk is the risk that an investor may have difficulty selling a particular bond and thereby be forced to sell at a significant discount to market value. This risk is greater for thinly traded securities. If sold prior to maturity, all fixed income securities are subject to market risk and may be worth less than their original cost.

Bank loans are subject to interest rate and credit risk. They are generally below investment grade and are subject to defaults and downgrades. These loans have the potential to hedge exposure to interest rate risk but they also carry significant credit and call-risk. Call risk is the risk that the issuer will redeem the issue prior to maturity. This may result in reinvestment risk which means the proceeds will generally be reinvested in a less favorable environment. Bank loans are difficult to value, have long settlement times and are relatively illiquid. As a result, they could face liquidity challenges.

U.S. government securities, including Treasury securities, are backed by the full faith and credit of the federal government as to payment of principal and interest. Unlike U.S. government securities, agency securities carry the implicit guarantee of the U.S. government but are not direct obligations. Payment of principal and interest is solely the obligation of the issuer. If sold prior to maturity, both types of debt securities are subject to market risk.

Treasury Inflation-Protected Securities (TIPS) are subject to interest rate risk, especially when real interest rates rise. This may cause the underlying value of the bond to fluctuate more than other fixed income securities. TIPS have special tax consequences, generating phantom income on the “inflation compensation” component of the principal. A holder of TIPS may be required to report this income annually although no income related to “inflation compensation” is received until maturity.

Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income.

The yield, average life and the expected maturity of mortgage-related, commercial mortgage-backed securities and asset- backed securities are based on prepayment assumptions that may or may not be met. Changes in prepayments may significantly affect yield, average life and expected maturity.

There are special risks associated with investing in preferred securities. Preferred securities generally offer no voting rights with respect to the issuer. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer’s capital structure, subjecting them to a greater risk of non-payment than more senior securities. In addition, the issue may be callable which may negatively impact the return of the security. Preferred dividends are not guaranteed and are subject to deferral or elimination.

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater price volatility. These risks are heightened in emerging markets. In addition to the risks associated with investing in international and emerging markets, sovereign debt involves the risk that the issuing entity may not be able or willing to repay principal and/or interest when due in accordance with the terms of the debt agreement.

Sovereign debt is generally a riskier investment when it comes from a developing country and tends to be a less risky investment when it comes from a developed country. The stability of the issuing government is an important factor to consider, when assessing the risk of investing in sovereign debt, and sovereign credit ratings help investors weigh this risk.

Forecasts are based on certain assumptions and on views of market and economic conditions which are subject to change.

WFII Guidance Definitions Most favorable: WFII’s highest conviction guidance that indicates a strong desire to overweight an asset class (or sector) within a portfolio. It also communicates that, over a tactical time frame, WFII views the asset class (or sector) as offering investors a very attractive risk/reward opportunity.

Favorable: Guidance that indicates a desire to overweight an asset class within a portfolio. It also communicates that, over a tactical time frame, WFII views the asset class (or sector) as providing investors with an attractive risk/ reward opportunity.

© 2019 Wells Fargo Investment Institute. All rights reserved. Page 10 of 13 Global Investment Strategy—|—Quarterly Fixed Income Guidance—|—Third Quarter 2019 Neutral: Guidance that indicates a desire to maintain an asset class near the long-term (strategic) allocation guidance within a portfolio. It also communicates that, over a tactical time frame, WFII views the asset class (or sector) as providing investors with an acceptable risk/reward opportunity.

Unfavorable: This WFII guidance level indicates a desire to underweight an asset class (or sector) within a portfolio. It also communicates that, over a tactical time frame, WFII does not view the asset class (or sector) as providing investors with an attractive risk/reward opportunity.

Most unfavorable: WFII’s highest conviction guidance indicating a strong belief in underweighting an asset class within a portfolio. This also communicates that, over a tactical time frame, WFII views the asset class (or sector) as offering investors a very unattractive risk/reward opportunity.

Rating Definitions from S&P Global Ratings AAA/Aaa rating: The highest quality debt, with minimal credit risk. AA rating: High quality and subject to very low credit risk. A rating: Upper-medium grade and subject to low credit risk. BB rating: Judged to have speculative elements; subject to substantial credit risk. BBB rating: Obligations are subject to moderate credit risk; considered medium-grade, and as such may possess certain speculative characteristics.

Index Definitions An index is unmanaged and not available for direct investment.

The Consumer Price Index (CPI) produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services.

Agencies: Bloomberg Barclays U.S. Agency Index measures the performance of the agency sector of the U.S. government bond market and is comprised of investment-grade, native-currency U.S- dollar-denominated debentures issued by government and government-related agencies, including FNMA. The index includes both callable and non- callable agency securities that are publicly issued by U.S. government agencies, quasi-federal corporations, and corporate and foreign debt guaranteed by the U.S. government.

Developed-Market Ex-US Fixed Income (Unhedged): JPMorgan GBI Global ex-U.S. Index (Unhedged) is an unmanaged market index that is representative of the total- return performance in U.S. dollars on an unhedged basis of major non-U.S. bond markets.

Emerging-Market Fixed Income (U.S. Dollar): JP Morgan Emerging Markets Bond Index (EMBI Global) currently covers 27 emerging market countries. Included in the EMBI Global are U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local-market debt instruments issued by sovereign and quasi-sovereign entities.

Government Securities: Bloomberg Barclays U.S. Government Bond Index is comprised of the U.S. Treasury and U.S. Agency Indices. The index includes U.S. dollar-denominated, fixed-rate, nominal U.S. Treasury securities and U.S. agency debentures (securities issued by U.S.-government-owned or government-sponsored entities, and debt explicitly guaranteed by the U.S. government). The U.S. Government Index is a component of the U.S. Government/Credit and U.S. Aggregate Indices.

High Yield Taxable Fixed Income: Bloomberg Barclays U.S. Corporate High-Yield Index covers the universe of fixed rate, non-investment-grade debt.

Intermediate Term Taxable Fixed Income: Bloomberg Barclays U.S. Aggregate 5-7 Year Bond Index is unmanaged and is composed of the Bloomberg Barclays U.S. Government/Credit Index and the Bloomberg Barclays U.S. Mortgage- Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 5-7 years.

© 2019 Wells Fargo Investment Institute. All rights reserved. Page 11 of 13 Global Investment Strategy—|—Quarterly Fixed Income Guidance—|—Third Quarter 2019 Investment-Grade Corporate Bonds: Bloomberg Barclays U.S. Corporate Index includes publicly-issued U.S. corporate and Yankee debentures and secured notes that meet specified maturity, liquidity, and quality requirements.

Investment Grade Credit: Bloomberg Barclays U.S. Credit Index measures the investment grade, U.S.-dollar-denominated, fixed-rate, taxable corporate and government-related bond markets. It is comprised of the U.S. Corporate Index and a non- corporate component that includes foreign agencies, sovereigns, supra-nationals and local authorities.

Long Term Taxable Fixed Income: Bloomberg Barclays U.S. Aggregate 10+ Year Bond Index is unmanaged and is composed of the Bloomberg Barclays U.S. Government/Credit Index and the Bloomberg Barclays U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 10 years or more.

Mortgage-Backed Securities: Bloomberg Barclays U.S. Mortgage Backed Securities (MBS) Index includes mortgage-backed pass-through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The MBS Index is formed by grouping the universe of more than 600,000 individual fixed rate MBS pools into approximately 3,500 generic aggregates.

Municipal Bonds: Bloomberg Barclays U.S. Municipal Index represents municipal bonds with a minimum credit rating of at least Baa, an outstanding par value of at least $3 million and a remaining maturity of at least one year. The index excludes taxable municipal bonds, bonds with floating rates, derivatives and certificates of participation.

Preferred Stock: S&P U.S. Preferred Stock Index is an unmanaged index consisting of U.S.-listed preferred stocks.

Securitized: Bloomberg Barclays U.S. Mortgage-Backed Securities (MBS) Index tracks agency mortgage backed pass- through securities (both fixed-rate and hybrid ARM) guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The index is constructed by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage.

Short Term Taxable Fixed Income: Bloomberg Barclays U.S. Aggregate 1-3 Year Bond Index is unmanaged and is composed of the Bloomberg Barclays U.S. Government/Credit Index and the Bloomberg Barclays U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 1-3 years.

Treasury Inflation-Protected Securities (TIPS): Bloomberg Barclays U.S. TIPS Index consists of Inflation-Protection securities issued by the U.S. Treasury.

Treasury Securities: Bloomberg Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury with a remaining maturity of one year or more.

U.S. Taxable Investment Grade Fixed Income: Bloomberg Barclays U.S. Aggregate Bond Index is an index composed of the Government Bond Index, the Asset- Backed Securities Index and the Mortgage-Backed Securities Index and includes U.S. Treasury issues, agency issues, corporate bond issues and mortgage-backed issues.

High Yield Tax-Exempt Fixed Income: Bloomberg Barclays U.S. Municipal High Yield Index measures the non-investment grade and non-rated U.S. dollar-denominated, fixed-rate, tax-exempt bond market within the 50 United States and four other qualifying regions (Washington DC, Puerto Rico, Guam and the Virgin Islands).

© 2019 Wells Fargo Investment Institute. All rights reserved. Page 12 of 13 Global Investment Strategy—|—Quarterly Fixed Income Guidance—|—Third Quarter 2019 General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client- specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors.

Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.

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