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APR Fixed Income Viewpoints 2021

6% and 7% as of April. A brighter outlook has indeed become TheViewpoints series gives investors Lazard’s perspectives “the base case,” as Powell noted. on the latest macroeconomic and fixed income news and trends. It reflects the views of the firm’s dedicated Our experts agreed that the biggest downside risk remains the specialists, who independently manage portfolios across the course of the COVID-19 pandemic as outbreaks continue around entire range of and sectors. the world. At their meeting this month, therefore, they focused on the right-tail, or upside, risk, which is hotly debated in the financial markets: Will the US economy grow so much and so Will the Economy Overheat? quickly in 2021 that it overheats, resulting in significantly higher After rising abruptly in February and March, US Treasury inflation and rates? yields had stabilized when Lazard’s fixed income professionals US: Money-Based Fear gathered in April for their monthly meeting. The pause was At the root of the concern over the US economy is the massive welcome and afforded our bond experts time to reexamine their amount of fiscal and monetary stimulus in the United States in expectations for 2021, especially for the United States. response to the pandemic over the past year. According to a US As Chairman Jerome Powell noted in an interview bond portfolio manager, the result has been an “astronomical” in mid-April, the outlook has “brightened substantially.” With the rise in the money supply—specifically M2, which includes cash in passage of $1.9 trillion in fiscal stimulus in early March, another circulation as well as savings accounts under $100,000 and money $2.25 trillion in infrastructure and jobs spending proposed by mutual funds. Indeed, M2 is at its highest level ever. Yet the Biden administration, and faster-than-expected progress bond yields are not offering investors much compensation for the on COVID-19 vaccinations in the United States, risk of higher inflation. participants are trying to figure out just how high growth could Although the issue is widely debated in the United States, Lazard’s go. Forecasts for US GDP growth in 2021 have been continuously US fixed income specialists saw reasons why the economy may revised upward, from 4.5% in early January to anywhere between not overshoot this year despite the abundant money supply. First,

HB30294 2 the velocity of M2 money has accelerated its downtrend, meaning 25%, which generated many multiple-notch downgrades. money simply does not have the same power to generate growth as Instead, awash in fiscal stimulus, state revenues were down only in the past. Previously, putting $1 into the system could eventually 1% last year, and some states will now run surpluses in the near create $8–$12 through lending, but when growth lingered at stall term, propelling the muni sector into a stable-to-upgrade credit speed for many years after the Global Financial Crisis, money lost environment. “From a fundamental perspective, things look great,” that power. Also, the pandemic has dealt such a blow to GDP and our muni specialist concluded. employment that economic overheating seems unlikely to Lazard’s All Eyes on Corporate Earnings US analysts; companies’ excess capacity remains very high, and anecdotal evidence from store closings and empty cruise ships to markets have also seen the glass as half-full lately. lack of business travel and waning demand for office space suggests spreads in corporate bonds have returned to pre-pandemic to them that the recovery will take time. “We do not believe we are levels almost across the board. The lack of a comfortable spread just going back to 2019,” as one US specialist put it. “cushion” has increased the importance of underlying Treasury yield movements for corporate investors, however, and Lazard’s Still, the signals from the economy are confusing, our bond experts were awaiting clues on prospective growth through first- professionals conceded. The has been singular: “When quarter corporate earnings reports, which were set to begin shortly have you seen a recession in which incomes went up, house prices after this month’s fixed income meeting. went up, and people had $1,400 checks in their pockets?” an analyst asked. In addition, it will be difficult to get a true reading With spreads so tight, opportunities for above-market returns lie on US inflation over the next two-to-three months due to base in , our analysts agreed—picking winners and effects—price increases will be high compared with the same losers and anticipating credit rating upgrades and downgrades. period last year when the economy essentially shut down due to After a record number of downgrades and outlook changes to the pandemic. Gauging how much costs are truly rising due to “negative” by the rating agencies in 2020, the corporate market, higher demand will be challenging until base effects diminish in too, has made an about-face this year, with the most upgrades the second half of this year, our bond teams pointed out. and changes to positive outlooks since 2013, our experts noted. Corporate defaults, which peaked at just over 8% last year, are now Lazard’s US experts anticipate that the US 10-year Treasury yield forecast to drop below 4%. “No one thought the market would will climb again this year, from its current range around 1.60% to come back this quickly,” an analyst added. 2%–2.25% as the recovery progresses. The “fear bids” lingering in the 10-year Treasury bond market should decline, they added, A few sectors have been left behind in the rally, however, including when investors gain more clarity on big unknowns like the aerospace and defense, leisure and travel, and real estate implications of Brexit, geopolitical tensions between the United trusts (REITs). The European high yield sector is also lagging due States and several countries, and the course of COVID-19 in to the recent lockdowns and slower-than-expected vaccine rollouts Europe, where lockdowns have been reinstated. there. In contrast to the Treasury bond market, the US municipal market US high yield bonds have returned about 1.5% year to date, in showed no real divergence in views: All systems were go. With line with the Lazard team’s forecast for a mid-single digit return federal support for state and local governments abundant, demand in 2021. Of note, the lower quality, CCC sector outperformed for munis up, and supply down, valuations were high—even significantly, with a 5.4% return. Several energy companies are “stretched,” as one muni bond professional noted. in this category, and the 23% rise in the price of West Texas Intermediate (WTI) crude oil so far this year was a big factor; Including the $1.9 trillion fiscal rescue package enacted last higher quality sectors also tend to be more sensitive to rising month, unprecedented total fiscal stimulus in excess of $5 trillion Treasury yields, which has damped their returns in 2021, our high should help keep muni bond resilient over the next yield analyst added. two years, according to Lazard estimates, and the proposed $2 trillion-plus infrastructure and jobs plan would add even more Although high yield bond issuance set a record in March at $65 fiscal benefit to state coffers. There is also interest in reinstating billion, many bonds have been called over the past 12 months as Build America Bonds (BABs)—a federally subsidized taxable companies have refinanced, and demand has outpaced supply. bond program for muni issuers successfully used in 2009–2010. Many new deals have been three-to-five times oversubscribed, and Although the flexibility for issuers would be welcomed, BABs coupons that might have previously ranged from 5%–6% have may not even be needed with tax-exempt rates so low, our muni sunk below 3% in a few cases. “I never thought I’d see a in specialist pointed out. the 2s,” a Lazard high yield expert commented. Since issuers have the upper hand, covenants on new issues have also become lighter The sunny outlook for munis is an about-face from a year ago and lighter. when, to assess the potential impact of the global pandemic, our municipal team stress-tested state revenues by dropping them 3

The strong demand could drive spreads somewhat tighter, but with The fate of emerging markets bonds denominated in domestic the current average high yield -adjusted spread on the ICE this year will depend mostly on valuations BofA US High Yield Index around 325 basis points (bps) and the against the US dollar. Despite US exceptionalism this year—in long-term average at 536 bps, there is also room for weakening if growth, vaccinations, and stimulus—the dollar has lagged its vaccine rollouts or stimulus programs hit any bumps. strong fundamentals somewhat, strengthening only about 2%. Emerging Markets: Currencies Leading the Way “The dollar is missing one piece: exceptional monetary policy response,” a Lazard currency analyst explained. Indeed, Fed Lazard’s emerging markets experts brought a different officials have said several times that the central will not raise perspective to the growth debate: When Treasury yields are interest rates until it sees actual evidence of sustainable, higher marching toward 2%, it is not the best time to dive into an inflation and continued improvement in unemployment numbers interest-rate sensitive asset class like emerging markets bonds. to pre-pandemic levels. In contrast, some emerging markets central They believe defense is the best course of action now because any are ready to fight inflation now; Brazil and Russia, for upside growth “surprises” in the US are most likely to happen over example, have already lifted rates. the next couple of months, with many sets of employment, retail sales, and inflation data to come before the Federal Open Market A reflationary environment without Fed action is very positive for Committee (FOMC) meets to discuss the policy rate in mid-June. emerging markets currencies, our analyst summarized. As long as growth begins to rise in emerging markets in the second half and If Treasury yields front-run the Fed’s rate-hiking cycle and vaccine distribution moves into higher gear as expected, domestic even overshoot it, as they have historically, spreads on emerging currencies should continue to benefit. markets debt are likely to widen further from current levels, which supports a defensive stance now, our emerging markets specialist Catching Its Breath pointed out. Later this year when the markets reach “the point It is little wonder that the bond market has paused recently. The of maximum optimism over the US and maximum pessimism US has steepened at its fastest pace in memory, with over emerging markets” should offer a much better entry point. A the yield difference between 2-year and 10-year Treasuries rising to shift to rising growth in emerging markets and more progress in 150 bps from 82 bps at the beginning of the year. The benchmark vaccinations there should follow, our specialist added. 10-year Treasury yield itself jumped from 0.93% to a high of In the meantime, pockets of emerging markets debt are attractive, 1.74% in late March before slipping back. notably short-term high yield sovereign and corporate bonds. How long can the calm last? Lazard’s fixed income professionals These issuers’ market access and ability to repay their are believe that Treasury yields will move higher once again as growth excellent, and corporate profit margins have been increasing, accelerates. Over the next two months or so, CPI data, Treasury according to our experts. bond auction results, and corporate earnings should signal how fast the ride up will be. Lazard Fixed Income Viewpoints

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Global Fixed Income The Lazard Global Fixed Income strategy seeks to enhance returns by rotating through and credit markets, taking currency risk when appropriate. The portfolios invest in global investment grade government, agency/supranational, corporate, municipal, mortgage, and asset-backed bonds. US Fixed Income The Lazard US Fixed Income team manages the US Short Duration, US Core, US Tax Exempt, and US Corporate Income strategies. The team seeks to derive benefits from the mispricing of securities based on various factors, including but not limited to, their assessment of credit quality, structure, and market sponsorship. European Fixed Income The Lazard European Fixed Income team manages the Scandinavian & Euro High Quality, Euro Covered Bonds, Euro Corporate and Euro Total Return Balanced strategies. Within these strategies the team seeks to generate performance through active management in European capital markets. Emerging Markets Debt The Lazard Emerging Markets Debt team manages the Emerging Markets Debt—Blend; Emerging Markets Debt—Core; Emerging Markets Debt—Corporate; Emerging Markets Debt—Local Debt; and Emerging Markets Debt—Total Return strategies. These strategies offer exposure to emerging markets bonds in local and/or hard currencies across regions. Emerging Income The Lazard Emerging Income team offers the Emerging Income and Emerging Markets Income strategies, which seek to invest in local emerging markets instruments, including currency forwards and local currency debt. Lazard Frères Gestion The Lazard Frères Gestion (LFG) Fixed Income team provides a range of strategies covering the full credit spectrum: Investment Grade, High Yield, . The team seeks to generate alpha through an active and flexible approach of and . The team also manages Fixed Income Credit strategies.

For last month’s discussion on fixed income markets, which focused on a sudden rise in interest rates, consult our March Fixed Income Viewpoints.

This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm.

Important Information Published on 19 April 2021. The ICE BofA US High Yield Index is a broad-based index consisting of all US dollar–denominated high-yield corporate bonds with a minimum outstanding amount of $250 million and maturity of no less than one year. The index is unmanaged and has no fees. One cannot invest directly in an index. This document reflects the views of Lazard Asset Management LLC or its affiliates (“Lazard”) based upon information believed to be reliable as of the publication date. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates (“Lazard”) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any , commodity, , service, or investment product. in securities, derivatives, and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard’s investment portfolios, in particular portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard’s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard’s local regulatory authorizations. Please visit www.lazardassetmanagement.com/globaldisclosure for the specific Lazard entities that have issued this document and the scope of their authorized activities. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the published date and are subject to change. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond’s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of , which is the risk that the is unable to make further income and principal payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. High yield securities (also referred to as “junk bonds”) inherently have a higher degree of market risk, default risk, and credit risk. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one’s home market. The values of these securities may be affected by changes in currency rates, application of a country’s specific tax laws, changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in these countries. Derivatives transactions, including those entered into for hedging purposes, may reduce returns or increase volatility, perhaps substantially. Forward currency contracts, and other derivatives investments are subject to the risk of default by the counterparty, can be illiquid and are subject to many of the risks of, and can be highly sensitive to changes in the value of, the related currency or other reference asset. As such, a small investment could have a potentially large impact on performance. Use of derivatives transactions, even if entered into for hedging purposes, may cause losses greater than if an account had not engaged in such transactions.