Bond Market Monthly

September 2018

Fundamentals trumped Kris Xippolitos Global Head of Fixed Income Strategy • Despite solid US fundamentals and rising inflation, long-dated US Treasury (UST) +1-212-559-1277 yields remain contained by trade wars, emerging market volatility, relatively weaker [email protected] non-US growth and US pension fund demand. With the Fed raising policy rates, the UST curve remains flat. As such, extending duration for yield pick-up has become less Joseph Kaplan fruitful. We favor short and intermediate durations. Fixed Income Strategy +1-212-559-3772 • The volatility in emerging market assets has become “front and center” in nearly every [email protected] media outlet today. Words like “collapse” and “contagion” have created a sense of investor fear, which has led to fund outflows. At the benchmark level, bond performance may appear to confirm these concerns. However, certain countries with very specific problems, should not be considered homogenous across the entire EM world. In fact, the fundamentals of many beaten down EM’s are vastly different than during the 2013 Taper Tantrum or the 2016 oil recession. • We remain overweight US IG corporates, favoring short-dated bonds. Today, the yield difference between short and long-term IG has reached its flattest level since 2009. We also remain constructive on US HY bonds and higher quality HY bank loans which benefit from rising short-term rates and lower volatility. In Europe, we remain underweight high quality markets, where interest rate risks are rising and absolute yields are low. We stay neutral Euro high yield markets, though favor lower quality bonds.

Figure 1. Long term market performance views1 Figure 2. Market performance, year-to-date (local currency, %)

-1 0 1 Global Aggregate Index 0.3 Developed market sovereign US Aggregate Index -1.2 -0.5 EU periphery sovereign Pan-Euro Aggregate Index Developed Sovereign -0.1 Emerging market sovereign (USD) EU Periphery Sovereign -0.1 Emerging market sovereign (local) EM (USD) Sov -6.1 Inflation-linked EM (Local) Govt -0.3 Global Inflation-linked Mortgage-backed securities 0.4 US MBS -0.7 High grade corporates Global Securitized -0.2 High yield corporates Global HG Corp -1.0 Global HY Corp Hybrid debt securities -1.2 Hybrid/Preferreds 1.1 Municipal bonds US Municipals 0.2 -7 -6 -5 -4 -3 -2 -1 0 1 2 Total Return (%) -1=Underperform, 0=Neutral, 1=Outperform. Source: Citi Private Bank as of September 7, 2018. 1) Long-term views are meant to express our confidence in the asset class’s Source: Bloomberg Barclays Indices; Merrill Lynch as of September 7, 2018. performance versus a relative benchma rk over the next 12 to 18 months. Light blue indicates total return on benchmark indices. Dark blue indicates Outperform implies a positive view, while underperform implies a negative total return on sub-indices. Past performance is no guarantee of future view. A neutral view implies our confidence is neither positive nor negative. results. Real results may vary.

INVESTMENT PRODUCTS: NOT FDIC INSURED • NOT CDIC INSURED • NOT GOVERNMENT INSURED • NO BANK GUARANTEE • MAY LOSE VALUE

Market performance views and recommendations1

Sectors Long-term view2 Focus comments/recommendations US Treasury: Expect a flatter US yield curve from tighter Fed policy; Our base case remains for at least one more rate hike this year, followed by at least three more rate Developed market (DM) Neutral - US hikes in 2019 core sovereigns Underperform – Europe/Japan Core Eurozone: Underweight due to low yields and heightened interest rate risks

UK Gilts: Underweight due to low yields and uncertainty over Brexit negotiations

EU periphery sovereigns3 Underperform Low yields, ECB tapering and Italian political risks keep us underweight; Progress in Spain could fuel further spread compression

External debt: Significant underperformance in countries with large index weights has External: Outperform heavily influenced benchmarks; Still constructive, as fundamentals still appear much Emerging market debt more robust when compared to previous EM downturns; Remain overweight

Local: Outperform Local bonds: Valuations appear to have disconnected from fundamentals; We believe markets have discounted a significant amount of risk; Remain overweight

US TIPS: If trade wars escalate, there will likely be impacts to domestic consumer Inflation-linked debt Neutral inflation; Immediate impacts would be modest, though breakeven spreads do not price in these risks; Removing trade fears, current spot breakevens are not compelling

US agency MBS: Relative value versus US IG corporates has weakened Mortgage-related debt Neutral Non-agency RMBS: Still offers attractive yields and low correlations to rising US rates; Remain constructive as US housing market, despite recent weakness in data

US IG: Yield levels at 7-year highs have created an attractive opportunity, particularly at the short-end; Favor energy and financials High grade corporates Outperform (USD only) Euro IG: Underweight; Spreads supported near-term by ECB QE, though likely to widen as the program concludes later this year

US HY: Continue to favor lower quality HY bonds where solid credit fundamentals and appetite for risk has driven CCC-rated issuers to outperform; Favor US bank loans over High yield bonds/loans Outperform high quality HY bonds

Euro HY: Favor Single-B rated issuers over Double-B which continues to outperform; Prefer HY bank loans (or euro CLO’s) over bonds, as absolute yields are higher

US preferreds: Valuations are supported by the lack of net new supply; Price upside is 4 somewhat limited, though attractive current yields can complement portfolios Hybrid debt securities Neutral European hybrids: Sell-off from Italy volatility has created value in higher quality banks; Recapitalization will eventually lead to tighter spreads, as banks issue less

Though the lack of new issuance has been a significant technical driver of muni Municipal bonds Outperform performance all year, any loosening of these dynamics may soften yield ratios further; We’d consider opportunities between the 10-15yr part of the muni curve, where you can pick up 80% of the curve steepness, with less duration risk Source: Citi Private Bank Global Fixed Income Strategy as of September 7, 2018. 1) Views are in the context of a fixed-income only portfolio; 2) Long-term views are meant to express our confidence in the asset class’s performance versus a relative benchmark over the next 12 to 18 months. Outperform implies a positive view, while underperform implies a negative view. A neutral view implies our confidence is neither positive nor negative; 3) Ireland, Italy, Portugal, and Spain; 4) Hybrids are securities that generally combine both debt and equity characteristics, and can include preferred stock, fixed-to-floating rate bonds or other convertible debt.

Figure 3. Global fixed income and select equity index returns, year-to-date (local currency, %)

12.0 9.5 10.0 8.0 6.0 4.7

4.0 2.0 1.1 1.4 2.0 0.2 0.2 0.3 0.4 0.5 0.0 -2.0 -0.5 -0.3 -0.2 -0.2 -0.1 -0.1 -0.1 -1.2 -1.0 -0.7 -0.6 -0.6 -4.0 -2.3 TotalReturn (%) -2.6 -6.0 -8.0 -6.1 -10.0 -8.4

Source: Bloomberg Barclays Indices, Merrill Lynch, MSCI as of September 7, 2018. Light blue indicates an equity index. “**Global Agg Index” is benchmark global fixed income index. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  2

Asset class update: Developed market (DM) rates

US interest rates • Summary: Despite solid US fundamentals and rising inflation, long-dated US Treasury (UST) yields remain contained by trade wars, EM fears, relatively weak non-US growth and pension fund demand. With the Fed raising policy rates, the UST curve remains flat. As such, extending duration for yield pick-up has become less fruitful. We favor short and intermediate durations.

• If we only focused on US fundamentals, the outlook for long-term Treasury rates might look a little different. Indeed, the economic environment for the US remains robust. Unemployment is below 4.0%, 2Q GDP growth is trending above 4.0% and core inflation has reached the Federal Reserve’s 2.0% mandate. Even an August report on US manufacturing jumped to its highest level since 2004, showing that domestic demand remains healthy. However, despite the supportive economic environment, 10-year Treasury yields have been challenged to meaningfully breakout above 3.0%.

• There is a long line of culprits which can easily be blamed for containing long-term US rates. First and foremost, US conflicts over trade have provoked investor anxiety. Though informal agreements on new trade deals with Mexico and the European Union have been announced, other clashes with Canada and China remain unsettled. While this has failed to hamper US equity markets from reaching new highs, European stocks have fallen 4% on the year, while emerging markets have lost around 10% (Chinese stock markets have dropped ~20%).

• Trade wars are also coinciding with weaker non-US growth, as global PMI’s (Purchasing Managers’ Index) continue to show relative weakness. Also, political and economic volatility in several emerging markets (i.e., Turkey, Argentina, South Africa), has created skepticism over the entire EM asset class. This has driven risk aversion flows into the safety of US Treasury debt, which still happens to be one of the highest yielding (and most liquid) developed bond markets in the world.

• November’s US mid-term elections should also be considered. As highlighted in the August Quadrant, in the months leading into midterms, higher quality bonds tend to outperform lower quality bonds. Though that’s not guaranteed to be the case this year (considering the strength of US credit markets), Treasury debt may attract flows if polls foresee political uncertainty. Indeed, according to prognosticators at FiveThirtyEight, there is a 75% probability that Democrats take the House in November.

• Though difficult to quantify, US pension funds may also be playing a role suppressing long-term yields. Since the change in US tax law, corporations have been incentivized to make voluntary contributions by September 15. Indeed, contributions can be deducted from income tax returns (being filed for 2017) at the previous 35% corporate tax rate. Moreover, funding rates among the top 100 pension funds have reached a 10-year high of 93.4% (source: Milliman). This will likely encourage portfolio managers to shift allocations from equity to fixed income to reduce risk. This is meaningful, when you consider that pension funds are large buyers of long-dated fixed income, in an effort to match longer-term liabilities.

• The aforementioned market dynamics are unlikely to be resolved over the near term. However, economic surprises in the Eurozone have been moving higher since June. If global growth concerns abate, and trade wars are resolved, we should expect long-dated UST yields to become more representative of US fundamentals. Also, with the ECB ending balance sheet expansion in 2019, the Fed reducing theirs, and the Bank of Japan contemplating their own QE program, this could add additional pressure on long-end rates. As such, while we remain allocated to the entire US yield curve, we favor the higher yields (and lower interest rate sensitivity) in short and intermediate maturities. Indeed, 5-year yields are only 15bp less than 10yr yields (Fig. 4).

• The short-end of the US curve remains in the control of the Federal Reserve. Markets are fully discounting a 25 basis point (bp) rate hike on September 26, while futures have moved up to nearly 80% probability for an additional hike in December. With the Fed expected to follow its projected path toward neutral, the market will need to close this gap. This will likely push short-term Treasury rates higher (including LIBOR rates), and the yield curve flatter. We still expect at least one more rate hike in 2018, followed by at least three more in 2019.

• The yield difference between 2-year and 10-year Treasury yields breached 20bp for the first time since 2007. In our view, this has largely been driven by the aforementioned dynamics holding down the long-end of the yield curve (Fig. 5). If trade wars fade, some flatness could reverse. Nevertheless, subsequent (and expected) policy tightening will eventually put the shape of the yield curve back on its journey toward inversion in 2019.

Figure 4. 5yr UST yields are only 15bp lower than 10yr UST Figure 5. Anchored long US rates has largely driven curve flattening

160 3.5

140 3.0

120 2.5 US Treasury 5s10s spread 100 Yield (%) 2.0 US Treasury yield curve (current) 80 1.5 US Treasury yield curve (Jan 2018)

1.0 Spread(bp) 60 0 5 10 15 20 25 30 Tenor 40 100 YTD yield change 80 20 60 40 0 Basis Points 20 '13 '14 '15 '16 '17 '18 1m 3m 5m 12m 2y 3y 5y 7y 10y 30y Tenor Source: FactSet as of September 5, 2018. Source: Bloomberg as of September 5, 2018. Past performance is no guarantee of future events. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  3

Asset class update: Developed market rates

European rates • Summary: Despite the announced end of quantitative easing (QE), core long-term euro rates in the Eurozone (EZ) remain low. Despite encouraging macro data, European bond markets are still contending with ECB QE technicals, trade conflicts, and Italian political risks. Heightened attention on Brexit negotiations is likely to persist. We remain underweight the entire region.

• Since the ECB announced in June their intention to end QE in 2019, core long-term rates in the EZ have moved lower. Though somewhat counter-intuitive, there are a number of factors dissuading investors from discounting the likely increase in net government supply. We will touch on a few, however, we expect markets to eventually price in the end of QE, pushing long-term rates higher. Considering 30% of the EZ sovereign bond market still trades with negative yields, and 7-10 year maturities average less than 1%, we remain underweight. In our view, even the slightest increase in yield will have a significant negative impact on euro fixed income performance.

• On the macro front, recent economic data has been encouraging. Eurozone PMI’s continue to signal expansion, despite falling from much higher levels. 2Q real GDP growth of 0.4% (2.2% year-over-year) beat market consensus, and Citi economists remain confident that growth will exceed expectations. Unemployment also continues to fall, with the latest Eurostat reading hitting 8.2%, its lowest since 2009. However, core inflation remains below the ECB’s mandate. With the advanced reading for August core CPI showing a decline to 1.0%, the ECB’s need to provide relatively accommodative policy becomes reaffirmed.

• As announced in June, the ECB is expected to taper monthly bond purchases in October, then cease expanding balance sheet in January 2019. However, ongoing central bank purchases continue to provide meaningful technical support. Excluding France, net government bond supply for the Eurozone (after ECB purchases) is expected to remain negative this year. This will likely change in 2019, pressing euro rates higher. However, the ECB will be reinvesting maturing assets for an extended period beyond the end of QE. In our view, reinvestment can still play a role in keeping local yields relatively contained, albeit minor.

• Trade conflicts between US/China and US/European Union (EU) have also spilled over into European risk assets, driving flight to quality. With the external dependencies between China and Germany significant, trade-related weakness in China data has negatively impacted German equity markets. Indeed, Germany equities has declined 6.5% this year, underperforming the region. Additionally, US threats to place tariffs on all EU car imports has fueled a 15% decline in the European equity auto sector (Fig. 6). While US/China trade negotiations will be fluid, we do not expect the US to impose auto tariffs on the EU. That said, upon a US/EU trade deal, it’s likely we could see some relief in core euro rates.

• Markets also still need to contend with the instability in Italian politics. As we highlighted in our last Bond Market Monthly, an EZ referendum is a low probability. However, fiscal and growth concerns are rising. As such, non-domestic investors continue to reduce exposure, pressing spreads (to Bunds) wider. Guidance over deficit targets will be watched closely, with expectations between 1.5-2.0%. This would likely calm bond investors on the issue of debt sustainability. Indeed, Italy’s debt-to-GDP ratio is among the highest in the world at 130%. Markets will also keep a close eye on Moody’s and S&P ratings reviews, expected in October. Downgrades could lead to further outflows and wider spreads. Italy remains our deepest underweight in the EZ.

• Despite relatively higher yields and wider spreads, we prefer to avoid Italian sovereign markets. Though political leaders seem content on maintaining reasonable deficit-to-GDP targets for 2019, others may still prefer a more confrontational approach. In our view, market confidence will remain critical for Italian bonds. A decline in confidence can further impact spreads, which in turn could negatively impact financial conditions and hamper growth. While recent auction demand was encouraging, potential downgrades by rating agencies can create renewed outflows, creating further pressures on valuations.

• As highlighted in CPB’s most recent strategy update on Brexit, investors will likely be focused on whether we see any deal between the EU and UK. Our base-case view is that the two sides reach an agreement (and Gilt yields rise). However, risks of “no deal” are not negligible. If negotiations fall apart, it’s likely that Gilt yields drop sharply, as recession risks rise and rate cuts are priced in. However, the subsequent currency weakness may eventually fuel a rise in inflation, or create outflows from concerned investors. This type of asymmetric outcome leaves us underweight. Of course, we are not alone. Recent Bank of England data shows that foreign investors were net sellers of Gilts by the largest monthly amount since 1982 (Fig. 7).

Figure 6. Threats of US auto tariffs impacting core euro rates Figure 7. Foreign Gilt outflows have picked up amid Brexit fears 25 60 1.00 10-Year German Bund (Left) 1.75 Non-residents' net purchases of UK Gilts (left) Autos / Eurostoxx (Right) 20 Rolling 6mo total (Right) 50 0.80 15 1.65 40 0.60 10 30 1.55 5 0.40 20 0

0.20 (£) Billions 10 (£) Billions 1.45 -5 0 0.00 -10

Year German Bund Yield (%)YearYield GermanBund 1.35 - -15 -10

-0.20 Euro Stoxx Autos / Euro Stoxx 10 -20 -20 -0.40 1.25 Sep-15 Mar-16 Sep-16 Mar-17 Sep-17 Mar-18 Sep-18 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jul-18 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Source: FactSet as of September 6, 2018. Source: Bank of England as of September 6, 2018. Past performance is no guarantee of future results. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  4

Asset class update: Emerging markets

Emerging markets (EM) • Summary: Fears of market contagion in emerging market assets is overdone, in our view. Poor external debt performance at the benchmark level has been driven by the largest EM issuers. However, performance in the rest of the EM complex is far less troublesome. In local markets, FX weakness is largely responsible for performance, as hedged returns are nearly flat on the year. Valuations are even more attractive, though selectivity and diversification is critical.

• The volatility in EM assets (both equity and fixed income) has become “front and center” in nearly every media outlet today. Words like “collapse” and “contagion” have created a sense of investor fear, which has led to fund outflows. At the benchmark level, bond performance may appear to confirm these concerns. However, certain countries with very specific problems, should not be considered homogenous across the entire EM world. In fact, the fundamentals of many beaten down EM’s are vastly different than during the 2013 Taper Tantrum or the 2016 oil recession.

• Thus far in 2018, returns in EM fixed income has been poor. To us, this is clear. External (US dollar denominated) sovereign debt indices have declined 6.0%, with spreads widening nearly 100bp since February to 300bp. Along with the rise in US Treasury rates, EM USD index yields have risen 130bp to 6.1%, its highest level since the peak of the 2016 oil crisis. Both Asia and Latin America regions have underperformed, falling 7-8%. While Eastern Europe, Middle East and Africa have lost 3-4%.

• We think it’s important to put YTD performance in perspective. Turkey, Argentina, Indonesia, Brazil and South Africa account for nearly 30% of US dollar EM sovereign benchmarks. As a result, exposures to these markets are relatively higher in most global EM bond strategies. YTD returns among these countries range from -5% to -22%. If we exclude these countries, the rest of the EM USD market has only declined 3.5%. Not necessarily what we would define as a collapse. For comparison, long-dated US IG corporates have lost 4.5% YTD. Additionally, 47 out of the 69 countries in our EM USD sovereign benchmark have lost less than 3.0%.

• In local EM bond markets, it’s all about the currency. Yes, local currency government bonds have lost 8.0% (unhedged to US dollars), with LatAm falling 10% and Eastern Europe/Africa declining over 14%. However, hedged returns look quite different. Indeed, global local EM debt performance is nearly flat on the year, when looking at performance hedged to US dollars (Fig. 8). The Asia region has actually been able to produce a slight gain YTD (+1.1%). Not surprising, Argentina and Turkey are the main exceptions, as these countries are dealing with legitimate idiosyncratic crisis.

• In our view, the sell-off in EM fixed income assets has created opportunities, both in external debt and local bond markets. However, EM is not “one size fits all”. Selectivity, active management and global diversification remains critical. For example, Turkey is likely to remain under pressure as a weak currency exacerbates domestic inflation. Despite short-term local rates above 20%, the lack of any credible proposed reforms is unlikely to improve investor confidence. Or in Peru, where 10-year US dollar sovereign bonds yield 3.6%, significantly lower than similarly rated US IG corporate bonds.

• On the other hand, Brazil fixed income markets are cheap, in our view. Though upcoming Presidential elections are expected to drive volatility across markets, the decline in bond valuations and the Brazilian real (BRL) appears to have exceeded potential risks. 5-year local yields have risen 150bp over the last month to 11.5%, near its highest level since 2016. Intermediate-term USD sovereign debt spreads have breached 300bp, which is also the widest since 2016 (Fig. 9). Even high quality corporate bonds have sold off dramatically, and present opportunities. We also continue to favor local Mexico rates, where 5-year sovereign yields are now just under 8.0%. The peso (MXN) will likely remain volatile, though current nominal levels appear attractive. Especially in real- effective terms, where MXN is still one of the cheapest currencies in the EM complex.

• China also remains a high conviction market, despite rising trade tensions with the US. Though local yields are not overly compelling (5yr at 3.4%), the 10% decline in the renminbi since March should help the economy absorb a trade shock (See August Asia Strategist). More important to our view, we continue to expect foreign investment in local bonds to grow. Indeed, offshore investors lifted their holdings of Chinese government bonds (CGB) to a record high in August, surpassing 1 trillion yuan. With the help of the Bond Connect platform, foreign holdings of CGB have increased for 18 consecutive months, and now account for 8% of

total CGB’s outstanding.

Figure 8. Local bond returns have been driven primarily by FX Figure 9. Brazil USD spreads are back to 2016 wides

6 550

4 500

2 450 10yr Brazil USD sov 0 400 spread to Treasury

-2 350

-4 Spread(bp) 300

Total Return (%) EM local currency bond total -6 return (hedged to USD) 250

-8 EM local currency bond total 200 return (unhedged to USD) -10 150 Jan Feb Mar Apr May Jun Jul Aug Sep '16 '17 '18

Source: Bloomberg Barclays Indices as of September 6, 2018. Source: Bloomberg as of September 6, 2018. Past performance is no guarantee of future events. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  5

Asset class update: Corporate credit

US investment grade (IG) corporates • Summary: Over the last several months, US IG corporates have benefitted from a strong US economy and relatively contained long-term US rates. Higher short-term yields and flatter credit curves supports our overweight in short-dated IG bonds. Look for opportunities in floating-rate debt, while financials and energy remain our favored sectors.

• A strong US macro environment, coupled with US rates being contained by trade fears, has allowed US IG corporates to recover from its worst 6-month start since 1996. Since the lows in May, IG corporate benchmarks have gained 2%, bringing YTD performance to -2.3%. Performance was led by long-duration (+2.7%) and BBB-rated issuers (+2.1%). Though still wider on the year, index spreads have recovered some (currently +114bp). In our view, spreads are neither rich nor cheap. While still 20bp below its historical average, spreads are 10bp wide of its pre-crisis average. Index yields remain around 4.0%, where they’ve traded for the last 4 to 5 months.

• Performance on the short-end has been the lone bright spot, where 1-3 year maturities have posted positive returns (0.7% YTD). This is due to short-end yields reaching their highest levels in 10-years (3.2%), and providing investors an attractive alternative to cash. Conversely, yields on IG corporates maturing in 10-year or greater are only marginally above the lows reached this cycle. As a result, flatter credit curves have created better values in shorter-dated IG bonds (Fig. 10). This was what led the CPB’s Global Investment Committee to raise their overweight to short-dated IG at their July meeting.

• We also favor short-term corporate floaters. With the Federal Reserve (see US rates section) likely to raise interest rates between 3-5 more times through the end of next year, LIBOR rates should continue to trend higher. Spread off LIBOR rates, corporate floaters provide an attractive alternative to play both a view on rising rates and our conviction in US credit markets.

• The strong US economy and active lending environment keeps us overweight IG financials. Despite the flatter US yield curve, financials have outperformed industrials and utilities YTD. Higher oil prices and attractive spreads continue to support our favorable view on the energy sector. As a whole, energy has outperformed the IG benchmark by 60bp YTD. See page 9 for a summary of our latest sectors views, or our latest US corporate sector report for a more in-depth review. European investment grade corporates • Summary: Euro IG has been supported by dovish ECB, though spreads have moved wider in anticipation of the end of QE. Supply has been robust, while fund outflows creates a negative technical environment. Absolute yields are low and spread pressures are likely to mount. We remain underweight. Similar to the US, we favor financial and energy sectors

• Supported by accommodative central bank policy, euro IG corporates have managed to outperform US markets all year (in local currency terms). However, August performance was weak, as investors needed to digest significant supply and discount the anticipation of the ECB’s next taper. Indeed, the ECB intends to reduce monthly asset purchases to €15bn/month from €30bn/month in October, before halting purchase in January 2019.

• As expected, index spreads continue to widen and currently stand at 120bp. Supply has been a significant factor, as August saw roughly €40 billion of new issuance. This was the largest volume recorded for the month of August, during a period where liquidity and volumes are seasonally low. We remain cautious euro IG, as we anticipate the end of QE. Its possible issuers may look to front-load new deals while the ECB remains a buyer. This could further weigh on spreads for the remainder of the year. Nevertheless, when private buyers need to replace the ECB in January, it’s likely the market will demand larger premiums.

• While supply has been robust, demand continues to fade. Bond fund continue to see outflows, with cumulative flows reaching -€5 billion on the year (Fig. 11). For context, US IG bond funds have cumulated $6 billion of inflows this year. With euro IG benchmark yields around 1.0% (or ¼ the US IG yield) and spread pressures likely to mount, we remain underweight

• Similar to our US recommendations, we continue to favor financial and energy sectors. Despite Italian concerns, financials should benefit from the euro area recovery, as well as improving balance sheets. Energy should also benefit from higher oil, and improved fundamentals. See page 10 for a summary of our latest sector views, or our latest European Corporate Sector report.

Figure 10. Credit curves are historically tight Figure 11. Euro corporate fund flows are discounting end of QE 500 3

400 2

1 300 0 200 US IG credit curve -1 Spread(bp) 100 (€) Billions -2 Europe ex-UK IG cumulative bond fund 0 -3 flows

-100 -4 Jan-17 Apr-17 Jul-17 Nov-17 Feb-18 May-18 Sep-18 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 Source: Bloomberg Barclays Indices as of September 6, 2018. Source: EPFR as of September 6, 2018. Past performance is no guarantee of future events. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  6

Asset class update: Corporate credit

US high yield (HY) bonds and bank loans • Summary: Remain overweight has US HY remain supported by an improving US economy. Default rates are declining, which reaffirms the underlying fundamental strength. Spreads are historically tight, but could remain that way for some time. We favor US bank loans versus high quality HY bonds. Loans should continue to benefit from tighter Fed policy and higher LIBOR rates.

• Despite a rough start to the year, US HY bonds have recovered nicely and are now up 2.0% YTD. While cash-flows were expected to dominate total YTD performance, the sharp rise in HY price returns since July has coincided with the rebound in US equity share prices. While we have seen some recent weakness in the CCC-rated quality segment, HY benchmark performance has been driven largely by the higher beta, lower quality issuers. CCC-rated corporates have gained 4.6% this year, while B-rated is up around 2.5%. Higher quality BB-rated issuers have gained a modest 20bp.

• An improving earnings outlook in the US (supported by tax cuts), continues to create a constructive fundamental backdrop for US corporates, particularly in high yield bonds. Default rates continue to fall, reaffirming the solid fundamental backdrop. Indeed, default rates have fallen from 5% in 2016 to 2.8% currently (Fig. 12) and 2.1% excluding the energy sector. With limited maturities coming due over the next 12 months, and US growth expected to remain robust, we expect default rates to fall further.

• Current benchmark spreads at +345bp are nearly where we were at the beginning of the year, trading within a 30bp range. Though spreads remain below historical averages, this should not imply we will see some immediate mean reversion. Indeed, it’s not uncommon for spreads to remain tight during economic expansions for an extended period of time. Between 1994-1997 and 2004-2007, HY spreads averaged 300bp, with real GDP averaged ~3.5%. Considering our positive outlook on the US economy and US equity markets, we remain overweight HY bonds.

• Specific sub-components within energy, pharmaceuticals, supermarkets and telecom have gained between 5-7%. These remain some of our favorite sectors. See page 9 for a summary of our latest sectors views, or our US corporate sector report for a more in-depth review on the HY bond market.

• We maintain our high conviction in HY bank loans, especially when compared to higher quality HY bonds. Bank loans have benefitted from tighter Fed policy and higher LIBOR rates, as well as the increasing demand for floating rate assets. Mutual fund flows remain exceptionally strong, with 26 of the past 27 weeks showing positive inflows. HY bank loan fund flows have now accumulated over $9.2 billion in new assets this year. The demand for floating-rate assets, as well as higher short-term rates has helped HY bank loans generate 3.5% returns YTD.

• In our view, HY bank loans should continue to benefit from rising short-rates and an improving US economy. While valuations are not necessarily “cheap”, HY loans do offer attractive carry and relatively lower price sensitivity. Especially when compared to HY bonds (Fig. 13). For example, all-in yields on BB-rated HY loans at 5% are roughly the same as similarly rated HY bonds. We recognize that new issuance has shifted toward lower quality and covenant-lite deals. While this should be watched, this change in asset mix is not concerning today. However, uneasy investors may look to increase credit quality, or invest in CLO’s (collateralized loan obligations) as a way to diversify and lower default risk. European high yield

• Euro HY spreads have been trending wider for most for most of the year, as the end of ECB QE and political volatility in Italy have been discounted by investors. Fund flows are largely negative, with €4.7 billion cumulative outflows reported since the start of the year. Total returns for the year stand at -0.6%. To no surprise, BB-rated bonds have underperformed, as “tourist” investors (or investors being squeeze by ECB bond purchases) unwind positions.

• We remain neutral euro HY. We favor Single-B rated issuers where yields (5.35%) are nearly twice that of BB-rated bonds (2.9%). If core rates rise (as expected), lower quality bonds would likely be better insulated. Despite some slowing in fundamental improvements, credit fundamentals remain strong. Indeed, default rates just above 2.0% are indicative of the economic improvement in the region.

Figure 12. Strong fundamentals push default rates lower Figure 13. HY bonds are catching up, though loans less volatile 14 1990 Oil price shock Global 4.0 & Recession Financial US HY bond total return Dot-com Crisis 12 US HY bank loan total return bubble 3.0

10 2.0 Collapse of 8 OPEC 1.0

6 Oil recession 0.0 Total Return (%) Default Rate (%) 4 -1.0 2 US HY default rate -2.0 0 Jan-18 Mar-18 May-18 Jul-18 Sep-18 '82 '86 '90 '94 '98 '02 '06 '10 '14 '18 Source: S&P as of September 6, 2018. Source: Bloomberg Barclays Indices, S&P as of September 6, 2018. Past performance is no guarantee of future events. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  7

Asset class update: US municipals

US municipals • Summary: US municipals continue to benefit from supportive supply/demand dynamics. Short-end valuations have improved some, after yield ratios reached historically low levels. As expected, intermediate maturities have outperformed. With the muni curve still steep versus US Treasury debt, we still prefer opportunities in longer durations. We continue to take a barbell approach to portfolio construction, where we favor a combination of fixed and floating-rate securities.

• The narrative for US municipal bonds remains relatively unchanged. Positive YTD performance continues to be supported by limited net supply, strong demand and long-term US rates that have been relatively contained for most of the year (see US rates section). Attractive short-term yields have fueled inflows, however pushing muni yield ratios (vs. US Treasury yields) to historically low levels. Still, higher yields have helped generate 50bp of performance over the last several months, bringing YTD returns to 0.15%. Though minimal, this is still meaningful, especially when considering that all other high quality US fixed income markets are in negative territory. • Short-end muni yield ratios have begun to trend upward, after reaching a historical low of 60.5% in late July. This is a result of several factors. One, short-dated yields dropped 30bp between April and July on significant investor demand, after reaching their highest level in 10-years. Two, with muni yields falling, the relative value proposition for variable-rate demand notes became attractive, prompting some investors to switch into floating-rate debt. Three, 2-year Treasury yields have remained relatively unchanged, as the market is fully priced for a September rate hike (Fig. 14). • Supply constraints and the relative value proposition versus floating-rate debt will likely continue to dictate short-end ratios for some time. That said, net supply is expected to be positive in September. Though the lack of new issuance has been a significant technical driver of muni performance all year, any loosening of these dynamics may soften yield ratios further. Still, valuations in munis offer value relative to taxable bonds. However, we would advise an active approach, or diversifying in a portfolio of both fixed and floating-rate securities. Moreover, moving down in quality can also enhance taxable-equivalent yields. • As we’ve highlighted in our last several monthlies, the steepening in the US muni curve was offering opportunities to extend duration. Despite contradicting our view on taxable markets, this has turned into a fruitful proposition for investors. Indeed, over the last 3-months, 10-15yr muni maturities have outperformed (+1%). Though muni curves have flattened some, the yield difference between 2 and 30-year munis is still an attractive 130bp. This is also still 90bp steep to the US Treasury curve, and reflected through much higher (and still attractive) yield ratios. • With opportunities in both short and long-term municipals, we continue to favor a barbell approach to portfolio construction. Of course, investing in 30-year debt entails a significant amount of interest rate risk. Instead, we’d consider opportunities between the 10 to 15-year part of the muni curve, where you can pick up 80% of the curve steepness, with 50% less duration risk (when compared to 30-year debt) (Fig. 15).

Figure 14. Short-dated muni yields have risen relative to UST Figure 15. 10-15-year maturities capture 80% of muni curve

2yr US Treasury yield 2yr Muni yield 2.7 1.90 3.2 3.0 1.85 2.6 2.8 1.80 2.6 2.5 28bps 1.75 2.4

1.70 2.2 Yield (%) Yield (%) 2.4 Yield (%) 2.0 1.65 135bps 2.3 1.8 1.60 1.6 US AAA-rated Muni yield curve 2.2 1.55 1.4 Mar Apr May Jun Jul Aug Sep 0 5 10 15 20 25 30 Tenor Source: Bloomberg as of September 7, 2018. Source: Bloomberg as of September 7, 2018. Past performance is no guarantee of future events. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  8

Corporate sector views – US markets

Figure 16. US Investment Grade Corporates – Summary of sector views

Source: Citi Private Bank Global Fixed Income Strategy, Bloomberg Barclays US Intermediate Corporate Bond Index as of September 2018. The expressions of opinion are not intended to be a forecast of future events or a guarantee of future results. Arrows imply our expectations of sector performance versus the Bloomberg Barclays US Intermediate Corporate Bond Index. Up arrow = outperform, Sideways arrow = market perform, Down arrow = underperform

Figure 17. US High Yield Corporates – Summary of sector views

Source: Citi Private Bank Global Fixed Income Strategy, Bloomberg Barclays US Corporate High Yield Bond Index as of September 2018. The expressions of opinion are not intended to be a forecast of future events or a guarantee of future results. Arrows imply our expectations of sector performance versus the Bloomberg Barclays US Corporate High Yield Bond Index. Up arrow = outperform, Sideways arrow = market perform, Down arrow = underperform

Global Strategy: Bond Market Monthly  September 2018  9

Corporate sector views – European markets

Figure 18. EMEA Investment Grade Corporates – Summary of sector views

Source: Citi Private Bank Global Fixed Income Strategy, Bloomberg Barclays Euro-Aggregate Corporate Statistics Index as of September 2018. The expressions of opinion are not intended to be a forecast of future events or a guarantee of future results. Arrows imply our expectations of sector performance versus the Bloomberg Barclays Euro-Aggregate Corporate Statistics Index. Up arrow = outperform, Sideways arrow = market perform, Down arrow = underperform

Figure 19. EMEA High Yield Corporates – Summary of sector views

Source: Citi Private Bank Global Fixed Income Strategy, Bloomberg Barclays Euro High Yield Corporate Bond Index as of September 2018. The expressions of opinion are not intended to be a forecast of future events or a guarantee of future results. Arrows imply our expectations of sector performance versus the Bloomberg Barclays Euro High Yield Corporate Bond Index. Up arrow = outperform, Sideways arrow = market perform, Down arrow = underperform

Global Strategy: Bond Market Monthly  September 2018  10

Fixed income tactical asset allocations

Figure 20. Fixed income allocation – Risk Level 1* Core Positions

Developed Emerging Developed government debt has an underweight position of market market equities equities -3.7% driven by underweights in Japan and Europe. Developed (0.6%), 0.6% (0.1%), 0.1% corporate investment grade fixed income has the largest Emerging Cash market debt (0.0%), 6.0% overweight at +1.5% driven by an overweight in US. (1.2%), 7.7%

Developed high yield (0.4%), 6.9% EM fixed income has an overweight position of +1.2% driven by allocations to both Latin America and Asia debt.

Developed investment Developed grade national, (1.5%), 22.1% suprational and regional (-3.7), 56.6%

Figures in brackets are the difference versus the strategic benchmark * Risk level 1 is designed for investors who have a preference for  Cash capital preservation and relative safety over the potential for a return  Global fixed income on investment. These investors prefer to hold cash, time deposits  and/or lower risk fixed income instruments. Global equities

Strategic = benchmark; tactical = the Citi Private Bank Global Investment Committee’s current view; and active = the difference between strategic and tactical. Source: Citi Private Bank Global Investment Committee, August 22, 2018.

Figure 21. Fixed income sovereign tactical allocation Figure 22. Fixed income credit tactical allocation (Level 3)** (Level 3)**

12 8 7.2 Strategic 9.9 7 Strategic 10 Tactical Tactical 8.2 6 8.0 5.3 8 5

6 5.5 4 4.8 2.8 3.5 3 4 2.2 1.8 2.4 2.2 2

GIC Level 3 Asset Allocation 1.5 1.8 GIC Level 3 Asset Allocation 2 1.3 1.31.1 1 0.5 0.5 0.20.2 0.20.1 0 0 EM Japan Asia Nordic UK Cont. Canada US Europe US Europe US ex. JP Europe high yield high yield IG Corp IG Corp Source: Citi Private Bank Global Investment Committee, August 22, 2018. Source: Citi Private Bank Global Investment Committee, August 22, 2018.

**Risk Level 3 is designed for investors with a blended objective who require a mix of assets and seek a balance between investments that offer income and those positioned for a potentially higher return on investment. Risk Level 3 may be appropriate for investors willing to subject their portfolio to additional risk for potential growth in addition to a level of income reflective of his/her stated risk tolerance. Strategic = benchmark; tactical = the Citi Private Bank Global Investment Committee’s current view; and active = the difference between strategic and tactical. Opinions expressed herein may differ from the opinions expressed by other businesses or affiliates of Citigroup, Inc., and are not intended to be a forecast of future events, a guarantee of future results or investment advice, and are subject to change based on market and other conditions. In any case, past performance is no guarantee of future results, and future results may not meet our expectations due to a variety of economic, market and other factors. Further, any projections of potential risk or return are illustrative and should not be taken as limitations of the maximum possible loss or gain.

Global Strategy: Bond Market Monthly  September 2018  11

Government bond benchmark yield curves

Figure 23. Germany, Japan, UK, US government yield curves Figure 24. US government bond yield curve

4 US 3.5 UK Japan Germany 3.0 3

2.5 2 2.0

Yield (%) 1 Yield (%) 1.5 Current One Year Ago 0 12mo Forecast (3Q '19) 1.0 Fo rwards (1 Year)

-1 0.5 0 5 10 15 20 25 30 0 5 10 15 20 25 30 Year to Maturity Years to Maturity Source: Bloomberg. Source: Bloomberg.

Figure 25. German government bond yield curve Figure 26. UK government bond yield curve

1.5 2.0

1.0 1.5

0.5 1.0 Yield (%)

Yield (%) 0.0 Current 0.5 One Year Ago -0.5 Current 12mo Forecast (3Q '19) One Year Ago Fo rwards (1 Year) 12mo Forecast (3Q '19) Fo rwards (1 Year) 0.0 -1.0 0 5 10 15 20 25 30 0 5 10 15 20 25 30 Years to Maturity Years to Maturity Source: Bloomberg. Source: Bloomberg.

Figure 27. Japan government bond yield curve Figure 28. Australia government bond yield curve

1.25 4.0 Current One Year Ago 1.00 3.5 12mo Forecast (3Q '19) 0.75 Fo rwards (1 Year) 3.0 0.50 2.5 0.25 Yield (%) Yield (%) 2.0 0.00 Current -0.25 1.5 One Year Ago 12mo Forecast (3Q '19) Fo rwards (1 Year) -0.50 1.0 0 5 10 15 20 25 30 0 5 10 15 Years to Maturity Years to Maturity Source: Bloomberg. Source: Bloomberg.

Figures as of September 6, 2018. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events.

Past performance is no guarantee of future events. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  12

Long-term historical government bond yields

Figure 29. US government bond yield Figure 30. German government bond yield

10yr German Bund yield (current: 0.33%) 18 10yr US Treasury yield 10 (current: 2.86%) Long-term average (4.23%) STD+1 15 Long-term average (6.2%) 8 STD-1 STD+1 12 6 STD-1

9 4 Yield (%) Yield (%) 6 2

3 0

0 -2 '62 '67 '72 '77 '82 '87 '92 '97 '02 '07 '12 '18 '89 '91 '94 '97 '99 '02 '04 '07 '10 '12 '15 '18

Source: Bloomberg. Source: Bloomberg.

Figure 31. UK government bond yield Figure 32. Japan government bond yield

14 10 10yr UK Gilt yield (current: 1.43%) 10yr Japan JGB yield (current: 0.11%) Long-term average (5.2%) Long-term average (2.27%) 12 8 STD+1 STD+1 10 STD-1 STD-1 6

8 4

6 Yield (%) Yield (%) 2 4 0 2 -2 0 '87 '90 '93 '96 '98 '01 '04 '07 '09 '12 '15 '18 '89 '91 '94 '97 '99 '02 '04 '07 '10 '12 '15 '18

Source: Bloomberg. Source: Bloomberg.

Figure 33. 10yr US Treasury spread to German Bunds Figure 34. 10yr UK Gilt spread to German Bunds

300 10yr US Treasury spread to German Bunds (current: 253bp) 450 10yr UK Gilt spread to German Bunds (current: 110bp) Long-term average (47bp) 400 250 Long-term average (97bp) STD+1 350 STD+1 200 STD-1 300 STD-1 150 250 100 200 50 150 Spread(bp) Spread(bp) 0 100 -50 50 -100 0

-150 -50 '89 '91 '94 '97 '99 '02 '04 '07 '10 '12 '15 '18 '89 '91 '94 '97 '99 '02 '04 '07 '10 '12 '15 '18

Source: Bloomberg. Source: Bloomberg.

Figures as of September 6, 2018. Note: STD+1= Plus one standard deviation from the average, STD-1= Minus one standard deviation from the average. Past performance is no guarantee of future returns. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  13

Long-term historical corporate bond yields

Figure 35. US investment grade corporate yield Figure 36. US high yield corporate yield

US HY corp yield (current: 6.27%) 18 US IG corp yield (current: 3.95%) 24 Long-term average (10.08%) Long-term average (7.5%) 22 STD+1 15 STD+1 20 STD-1 STD-1 18 12 16

9 14 Yield (%)

Yield (%) 12 6 10 8 3 6 4 0 '87 '89 '92 '95 '98 '01 '03 '06 '09 '12 '15 '18 '73 '78 '83 '88 '93 '98 '03 '08 '13 '18 Source: Bloomberg Barclays Indices. Source: Bloomberg Barclays Indices.

Figure 37. European investment grade corporate yield Figure 38. European high yield corporate yield

Euro HY corp yield (current: 3.8%) Euro IG corp yield (current: 1%) 28 8 Long-term average (3.6%) Long-term average (9.06%) STD+1 STD+1 24 STD-1 STD-1

6 20

16

4 12 Yield (%) Yield (%) 8 2 4

0 0 '98 '02 '05 '08 '12 '15 '18 '99 '02 '05 '08 '11 '14 '18

Source: Bloomberg Barclays Indices. Source: Bloomberg Barclays Indices.

Figure 39. EM (USD) sovereign yield Figure 40. EM (USD) corporate yield

EM (USD) sovereign yield (current: 6.61%) 12 25 EM (USD) corporate yield (current: 6.11%) Long-term average (6.22%) Long-term average (6.71%) STD+1 STD+1 20 STD-1 STD-1 10

15

8 Yield (%)

Yield (%) 10

6 5

4 0 '03 '05 '07 '09 '11 '13 '15 '18 '03 '05 '07 '09 '11 '13 '15 '18

Source: Bloomberg Barclays Indices. Source: Bloomberg Barclays Indices.

Figures as of September 6, 2018. Note: STD+1= Plus one standard deviation from the average, STD-1= Minus one standard deviation from the average. Past performance is no guarantee of future returns. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  14

Long-term historical corporate bond spreads

Figure 41. US investment grade corporate spread Figure 42. US high yield corporate spread

700 2000 US HY corp spread (current: 338bp) US IG corp spread (current: 114bp) 1800 Long-term average (509bp) Long-term average (132bp) 600 STD+1 1600 STD+1 STD-1 500 STD-1 1400 1200 400 1000 300 800 Spread(bp) Spread(bp) 600 200 400 100 200 0 0 '94 '96 '98 '01 '03 '06 '08 '10 '13 '15 '18 '89 '92 '95 '98 '00 '03 '06 '09 '12 '15 '18 Source: Bloomberg Barclays Indices. Source: Bloomberg Barclays Indices.

Figure 43. European investment grade corporate spread Figure 44. European high yield corporate spread

Euro IG corp spread (current: 119bp) 2500 Euro HY corp spread (current: 348bp) 500 Long-term average (130bp) Long-term average (603bp) 450 STD+1 STD+1 2000 400 STD-1 STD-1 350 1500 300 250 1000 200 Spread(bp) Spread(bp) 150 100 500 50 0 0 '00 '03 '06 '09 '12 '15 '18 '00 '03 '06 '09 '12 '15 '18 Source: Bloomberg Barclays Indices. Source: Bloomberg Barclays Indices.

Figure 45. EM (USD) sovereign spread Figure 46. EM (USD) corporate spread

EM (USD) corporate spread (current: 337bp) 1000 EM (USD) sovereign spread (current: 378bp) 2000 Long-term average (406bp) 900 Long-term average (322bp) 1750 STD+1 STD+1 800 STD-1 1500 STD-1 700 1250 600 1000 500

Spread(bp) 750 Spread(bp) 400 500 300 250 200 0 100 '03 '05 '07 '09 '11 '13 '15 '18 '03 '05 '07 '09 '11 '13 '15 '18 Source: Bloomberg Barclays Indices. Source: Bloomberg Barclays Indices.

Figures as of September 6, 2018. Note: STD+1= Plus one standard deviation from the average, STD-1= Minus one standard deviation from the average. Past performance is no guarantee of future returns. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  15

Long-term historical corporate bond spread comparisons

Figure 47. US BB corp spread to BBB corp Figure 48. Euro BB corp spread to BBB corp

1200 600 US BB corp spread to BBB corp (current: 78bp) Euro BB corp spread to BBB corp (current: 134bp) Long-term average (162bp) Long-term average (242bp) 500 STD+1 1000 STD+1 STD-1 STD-1 400 800

300 600 Spread(bp) Spread(bp) 200 400

100 200

0 0 '00 '03 '05 '08 '10 '13 '15 '18 '94 '97 '00 '03 '06 '09 '12 '15 '18 Source: Bloomberg Barclays Indices. Source: Bloomberg Barclays Indices.

Figure 49. EM Asia (USD) IG credit spread to US Gov/Credit Figure 50. EM Asia (USD) HY credit spread to US HY

250 EM Asia (USD) IG credit spread less US 350 EM Asia (USD) HY credit spread less US gov/credit spread (current: 97bp) HY spread (current: 192bp) Long-term average (120bp) Long-term average (-8bp) 225 250

200 STD+1 STD+1 150 STD-1 175 STD-1 50 150 -50 Spread(bp) Spread(bp) 125 -150 100 -250 75

50 -350 '10 '11 '12 '14 '15 '16 '18 '10 '11 '12 '14 '15 '16 '18 Source: Bloomberg Barclays Indices. Source: Bloomberg Barclays Indices.

Figures as of September 6, 2018. Note: STD+1= Plus one standard deviation from the average, STD-1= Minus one standard deviation from the average. Past performance is no guarantee of future returns. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  16

Long-term historical municipal bond yield ratios vs US Treasuries

Figure 51. US AAA-rated 2yr muni yield ratio Figure 52. US AAA-rated 5yr muni yield ratio

350 US AAA 2yr muni yield ratio (current: 65bp) 220 US AAA 5yr muni yield ratio (current: 74bp) Long-term average (103bp) Long-term average (103bp) 200 300 STD+1 Series3 180 STD-1 Series4 250 160

200 140

120 150 100 100 80 Ratio (as % Treasury of Yield) Ratio (as % Treasury of Yield) 50 60

40 0 '01 '04 '06 '09 '12 '15 '18 '01 '04 '06 '09 '12 '15 '18 Source: Bloomberg. Source: Bloomberg.

Figure 53. US AAA-rated 10yr muni yield ratio Figure 54. US AAA-rated 30yr muni yield ratio

220 US AAA 10yr muni yield ratio (current: 86bp) US AAA 30yr muni yield ratio (current: 102bp) 230 Long-term average (94bp) Long-term average (103bp) 200 STD+1 ) 210 STD+1 180 STD-1 STD-1 190 160 170 140 150 120 130 100 110 Ratio (as % Treasury of Yield)

80 Ratio (as % Treasury of Yield 90

60 70 '01 '03 '06 '08 '11 '13 '15 '18 '01 '04 '06 '09 '12 '15 '18 Source: Bloomberg. Source: Bloomberg.

Figures as of September 6, 2018. Note: STD+1= Plus one standard deviation from the average, STD-1= Minus one standard deviation from the average. Past performance is no guarantee of future returns. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  17

Fixed income market returns

Figure 55. Fixed Income index returns (local currency, %)

Index YTD Last 12m Last 3m Last 1m Yield Duration Broad Aggregate Indices Global Agg (local currency) -0.6 -0.8 0.3 0.2 US Agg Bond -1.2 -1.6 0.7 0.3 3.34 6.05 European Agg -0.1 -0.1 0.0 -0.1 0.78 6.70 Developed Sovereign Debt Global (local currency) -0.3 -0.8 0.1 0.2 1.61 7.89 US Treasury -1.0 -2.1 0.6 0.4 2.75 6.06 US Agency -0.2 -0.9 0.5 0.4 2.88 4.02 German Bunds 1.4 0.6 0.4 0.2 -0.02 7.72 UK Gilts 0.1 -0.8 -0.2 0.0 1.39 12.91 Japan JGBs -0.3 -0.4 -0.8 -0.1 0.23 10.62 Portugal 1.6 6.9 -0.2 -0.5 8.05 3.09 Italy -5.0 -4.6 -1.7 -0.8 2.73 6.56 Ireland 0.5 0.6 0.4 0.1 0.39 7.25 Spain 2.3 2.3 0.1 -0.1 0.95 7.50 Inflation-linked Sovereign Debt Global I-Linked (local currency) 0.4 1.0 0.7 0.2 -0.58 12.21 US I-Linked -0.1 0.1 0.7 0.4 3.00 6.72 US Municipals US Municipals 0.2 0.3 0.6 0.3 2.69 6.06 Emerging Markets EM (Hard Currency) Sovereign -6.1 -5.9 -1.7 -2.5 6.73 7.05 EM LatAm -7.4 -7.6 -2.7 -3.2 8.20 7.91 EM Asia -3.2 -2.7 1.2 -0.4 4.76 7.50 EM EMEA -5.4 -5.1 -1.3 -2.3 6.11 6.59 EM (Local) Govt, hedged USD -0.3 -0.1 0.0 -0.3 5.25 5.94 EM LatAm -0.4 -0.3 -0.6 -1.7 8.81 4.03 EM Asia 1.5 0.9 0.8 -0.2 4.30 6.79 EM EMEA -3.2 -2.6 -3.0 -1.6 6.79 5.11 Securitized debt US MBS -0.7 -0.9 0.7 0.3 3.47 5.14 US CMBS -0.6 -1.5 1.0 0.7 3.46 5.28 US ABS 0.5 0.2 0.7 0.3 3.06 2.15 High Grade Corporate Debt USD Corporates -2.3 -1.7 0.9 0.0 4.00 7.27 EUR Corporates -0.7 -0.4 -0.2 -0.5 1.08 5.14 GBP Corporates -1.6 -1.5 -0.1 -0.1 2.77 8.09 High Yield Corporate Debt USD High Yield 2.0 3.3 1.9 0.6 6.28 3.78 EUR High Yield -0.6 0.6 0.1 -0.3 3.87 4.33 Asia (USD)High Yield -2.9 -1.7 0.6 0.4 8.05 3.09 S&P/LSTA Leveraged Loan 3.4 4.9 1.2 0.4 Hybrid debt S&P US Variable Rate Preferred Index (F2F) 2.4 2.8 2.1 0.9 S&P US Fixed Rate Preferred Index 2.5 2.9 2.0 0.9

Source: The Yield Book, Bloomberg Barclays Indices, S&P as of September 6, 2018. Past performance is no guarantee of future results. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  18

Interest rate forecasts

Figure 56. Major developed market rate forecasts

Citi Forecasts1 Consensus Forecasts2

US Current 2Q'18 3Q'18 4Q'18 1Q'19 2Q'19 3Q'19 2Q'18 3Q'18 4Q'18 1Q'19 2Q'19 3Q'19 Policy Rate 2.00 2.25 2.25 2.50 2.75 3.00 3.00 2.20 2.40 2.60 2.80 2.95 3.00 3m Libor 2.32 2.65 2.65 2.90 3.15 3.40 3.40 2.46 2.58 2.74 2.88 3.02 3.11 2-year 2.65 2.35 2.40 2.40 2.50 2.60 2.65 2.68 2.83 2.94 3.04 3.12 3.18 10-year 2.90 2.65 2.65 2.65 2.75 2.80 2.85 2.97 3.09 3.19 3.26 3.31 3.37 30-year 3.07 2.90 2.90 2.95 3.10 3.15 3.15 3.27 3.37 3.47 3.53 3.63 3.73 Germany Policy Rate 0.00 0.00 0.00 0.00 0.00 0.00 0.25 0.00 0.00 0.00 0.05 0.10 0.25 3m Libor (0.32) (0.30) (0.30) (0.30) (0.15) (0.15) 0.00 (0.31) (0.29) (0.22) (0.10) 0.01 0.13 2-year (0.56) (0.50) (0.45) (0.35) 0.00 0.10 0.40 (0.60) (0.51) (0.45) (0.38) (0.35) (0.18) 10-year 0.38 0.60 0.65 0.80 0.80 0.85 1.00 0.53 0.64 0.80 0.91 0.96 1.00 30-year 1.05 1.30 1.35 1.40 1.40 1.40 1.40 Japan Policy Rate (0.10) (0.10) (0.10) (0.10) (0.10) (0.10) (0.10) (0.10) 0.00 0.00 0.00 0.00 0.00 3-month (0.04) (0.06) (0.07) (0.08) (0.03) (0.03) 0.00 (0.01) (0.01) 0.00 0.01 0.01 0.01 2-year (0.11) (0.13) (0.14) (0.15) (0.12) (0.10) (0.12) (0.10) (0.08) (0.07) (0.06) (0.04) (0.03) 10-year 0.12 0.05 0.05 0.07 0.07 0.05 0.07 0.10 0.11 0.13 0.14 0.15 0.15 30-year 0.85 0.70 0.75 0.75 0.80 0.85 0.85 UK Policy Rate 0.75 0.75 0.75 0.75 0.75 1.00 1.00 0.70 0.75 0.80 0.90 1.00 1.15 3m Libor 0.80 0.80 0.80 0.80 0.90 1.05 1.05 0.76 0.85 0.92 1.01 1.14 1.16 2-year 0.74 0.85 0.95 0.95 1.05 1.15 1.25 0.85 0.95 1.07 1.16 1.26 1.42 10-year 1.44 1.40 1.45 1.45 1.50 1.55 1.70 1.45 1.60 1.67 1.84 1.89 2.09 30-year 1.81 1.80 1.80 1.80 1.85 1.85 1.95

Source: Citi Research, Bloomberg as of September 6, 2018. 1) Forecasts are quarterly average, 2) Bloomberg consensus forecasts. Note: There is no 30-year consensus forecast for Germany, Japan or UK. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Past performance is no guarantee of future events. Real results may vary.

Global Strategy: Bond Market Monthly  September 2018  19

Broad bond market cumulative weekly fund flows, by country & region

Figure 57. Cumulative fund flows – US Figure 58. Cumulative fund flows – Germany, UK, Japan 1200 35 30 1000 Germany 25 US UK 800 20 Japan 600 15

400 10 Billions ($) Billions Billions ($) Billions 5 200 0 0 -5

-200 -10 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 Source: EPFR. Source: EPFR.

Figure 59. Cumulative fund flows – Core vs Periphery Europe Figure 60. Cumulative fund flows – Emerging market regions

50 60

40 Core Europe 50 EM Asia EM LatAm 30 Periphery Europe 40 EM CEEMEA

20 30

10 20 Billions ($) Billions Billions ($) Billions

0 10

-10 0

-20 -10 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 Source: EPFR. Source: EPFR.

Figures as of September 5, 2018.

Global Strategy: Bond Market Monthly  September 2018  20

Notes

Global Strategy: Bond Market Monthly  September 2018  21

Market definitions

Asset classes Benchmarked against Global equities MSCI All Country World Index, which represents 48 developed and emerging equity markets. Index components are weighted by market capitalization. Global bonds Bloomberg Barclays Multiverse (Hedged) Index, which contains the government -related portion of the Multiverse Index, and accounts for approximately 14% of the larger index. Hedge funds HFRX Global Hedge Fund Index, which is designed to be representative of the overall composition of the hedge fund universe. It comprises all eligible hedge fund strategies; including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage and relative value arbitrage. The strategies are asset-weighted based on the distribution of assets in the hedge fund industry. Commodities Dow Jones-UBS Commodity Index, which is composed of futures contracts on physical commodities traded on US exchanges, with the exception of aluminium, nickel and zinc, which trade on the London Metal Exchange (LME). The major commodity sectors are represented including energy, petroleum, precious metals, industrial metals, grains, livestock, softs, agriculture and ex-energy. Equities

Developed market MSCI World Large Cap Index, which is free-float adjusted and weighted by market capitalization. The index is large cap designed to measure the equity market performance of the large cap stocks in 23 developed markets. Large cap is defined as stocks representing roughly 70% of each market’s capitalization. US Standard & Poor’s 500 Index, which is a capitalization -weighted index that includes a representative sample of 500 leading companies in leading industries of the US economy. Although the S&P 500 focuses on the large cap segment of the market, with over 80% coverage of US equities, it is also an ideal proxy for the total market. Europe ex UK MSCI Europe ex UK Large Cap Index, which is free-float adjusted and weighted by market capitalization. The index is designed to measure large cap stock performance in each of Europe’s developed markets, except for the UK. UK MSCI UK Large Cap Index, which is free-float adjusted and weighted by market capitalization. The index is designed to measure large cap stock performance in the UK. Japan MSCI Japan Large Cap Index, which is free-float adjusted and weighted by market capitalization. The index is designed to measure large cap stock performance in Japan. Asia Pacific MSCI Asia Pacific ex Japan Large Cap Index, which is free-float adjusted and weighted by market capitalization. The ex Japan index is designed to measure the performance of large cap stocks in Australia, Hong Kong, New Zealand and Singapore. Developed market MSCI World Small Cap Index, which is a capitalization-weighted index that measures small cap stock performance in small and mid-cap 23 developed equity markets. Emerging market MSCI Emerging Markets Index, which is free-float adjusted and weighted by market capitalization. The index is designed to measure equity market performance of 22 emerging markets. Bonds

Global Aggregate Index Bloomberg Barclays Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. US Aggregate Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment Bond Index grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non- agency). Pan-European Bloomberg Barclays Pan-European Aggregate Index tracks fixed-rate, investment-grade securities issued in the Aggregate Index following European currencies: Euro, British pounds, Norwegian krone, Danish krone, Swedish krona, Czech koruna, Hungarian forint, Polish zloty, and Slovakian koruna. Inclusion is based on the currency of the issue, and not the domicile of the issuer. The principal asset classes in the index are Treasuries, Government-Related, Corporate and Securitised, which include Pfandbriefe, other covered bonds and asset-backed securities. Developed sovereign Citi World Government Bond Index (WGBI), which consists of the major global investment grade government bond markets and is composed of sovereign debt, denominated in the domestic currency. To join the WGBI, the market must satisfy size, credit and barriers-to-entry requirements. In order to ensure that the WGBI remains an investment grade benchmark, a minimum credit quality of BBB–/Baa3 by either S&P or Moody's is imposed. The index is rebalanced monthly. Emerging sovereign Citi Emerging Market Sovereign Bond Index (ESBI), which includes Brady bonds and US dollar -denominated emerging market sovereign debt issued in the global, Yankee and Eurodollar markets, excluding loans. It is composed of debt in Africa, Asia, Europe and Latin America. We classify an emerging market as a sovereign with a maximum foreign debt rating of BBB+/Baa1 by S&P or Moody's. Defaulted issues are excluded. Inflation-Linked Citi World Inflation-Linked Securities Index (WorldILSI) coverage includes the United States, Japan, France, Germany, Greece, Italy, Sweden, and the United Kingdom. It measures the returns of the inflation-linked bonds with fixed-rate coupon payments that are linked to an inflation index. Supranationals Citi World Broad Investment Grade Index (WBIG)—Government Related, which is a subsector of the WBIG. The index includes fixed rate investment grade agency, supranational and regional government debt, denominated in the domestic currency. The index is rebalanced monthly.

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Securitized Citi World Broad Investment Grade Index (WBIG)—Securitized, which is a subsector of the WBIG. The index includes global investment grade collateralized debt denominated in the domestic currency, including mortgage -backed securities, covered bonds (Pfandbriefe) and asset -backed securities. The index is rebalanced monthly. Corporate Citi World Broad Investment Grade Index (WBIG)—Corporate, which is a subsector of the WBIG. The index includes investment grade fixed rate global investment grade corporate debt within the finance, industrial and utility sectors, denominated in the domestic currency. The index is rebalanced monthly. Mortgage Backed Mortgage Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of Security mortgages. The mortgages are sold to a group of individuals (a government agency or investment bank) that securitizes, or packages, the loans together into a security that investors can buy Corporate Bloomberg Barclays Global High Yield Index is a multi-currency flagship measure of the global high yield debt market. high yield The index represents the union of the US High Yield, the Pan-European High Yield, and Emerging Markets (EM) Hard Currency High Yield Indices. Municipal Bloomberg Barclays Municipal Bond Index is a broad-based benchmark that measures the investment grade, US dollar-denominated, fixed tax-exempt bond market. The index includes state and local general obligation, revenue, insured, and pre-refunded bonds Preferred/Hybrid Bank of America (BofA) Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed rate US dollar denominated preferred securities issued in the US domestic market.

European Contingent Credit Suisse European Contingent Convertible Index tracks bonds known as “CoCos”. The term CoCo is used to Convertible describe a new type of convertible bond that is automatically converted into a predetermined amount of shares when a predefined trigger is breached. Since this type of bond is transformed into equity upon conversion, it would be available for further loss absorption and therefore satisfies regulatory requirements of hybrid capital instruments. CDS CDX North Markit CDX North American Investment Grade Index consists of CDS levels for the most liquid north American entities America Inv Grade with investment grade credit ratings. CDX North America Markit CDX North American High Yield Index consists of CDS levels for the most liquid north American entities with High Yield high yield credit ratings. CDX North America Markit CDX North American Investment Grade High Volatility Index consists of CDS levels for the most liquid north High Vol American entities with investment grade credit ratings and higher volatility. Markit MCDX The Markit MCDX index is a credit index consisting of municipal single name CDS. Municipal Index iTraxx Europe Index The benchmark Markit iTraxx Europe index comprises CDS levels of 125 equally-weighted European names. Inv Grade iTraxx Europe The Markit iTraxx Crossover index comprises CDS levels for the 75 most liquid sub-investment grade entities. Crossover Index iTraxx Europe The Markit iTraxx Europe Senior Financials Index consists of twenty-five (25) financial entities from the Markit iTraxx Senior Financial Europe index referencing senior debt. iTraxx SOVX The Markit iTRaxx SovX Western Europe index consists of 15 equally weighted Western European sovereign CDS Western Europe constituents. iTraxx Japan The Markit iTraxx Japan Investment Grade Index consists of fifty (50) of the most liquid Japanese entities with Inv Grade investment grade credit ratings as published by Markit iTraxx Asia ex-Japan The Markit iTraxx Asia ex-Japan Investment Grade Index consists of forty (40) of the most liquid Asian entities with Inv Grade investment grade credit ratings as published by Markit CDX Emerging The Markit CDX Emerging Markets Index is composed of 14 sovereign CDS issuers. All entities are domiciled in three Markets regions: (i) Latin America, (ii) Eastern Europe, the Middle East and Africa, and (iii) Asia.

Other miscellaneous definitions Citi Economic The Citigroup Economic Surprise Index are objective and quantitative measures of economic news, covering all G10 Surprise Index economies. They are defined as weighted historical standard deviations of data surprises (actual releases vs Bloomberg survey median).

S&P/LSTA Leveraged The S&P/LSTA (Loan Syndication and Trading Association) Leveraged Loan Index is a rules based index that tracks Loan Index the investable senior loan market. European Additional European Additional Tier 1 capital (or Contingent Convertibles or CoCo's) are subordinated securities that qualify as Tier 1 Tier 1 capital under Basel III capital requirements. LIBOR The London Interbank Offered Rate (LIBOR is the average of interest rates estimated by each of the leading banks in London that it would be charged were it to borrow from other banks. Libor rates are calculated for 5 currencies, including Euros, and 7 borrowing periods ranging from overnight to one year and are published each business day Barbell strategies Barbell strategies incorporate weighing two distinctively different investments in order to mitigate potential market risk AMT Bond Alternative Minimum Tax (AMT) bond is a private activity municipal bond whose interest is treated as a preference item for purposes of computing the alternative minimum tax imposed on individuals and corporations. Variable rate demand Longer-term municipal securities that feature both a periodic coupon reset and a demand feature that allows an note (VRDN) investor to periodically tender, or put, the securities at par plus accrued interest. Bond Connect Bond Connect is a new mutual market access scheme that allows investors from mainland China and overseas to trade in each other’s respective bond market

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Runoff Cap According to the US Federal Reserve, holdings of Treasuries, agency debt and agency mortgage-backed securities will be allowed to mature (or run-off) up to a pre-determined amount. This amount is considered a “cap”. Any amount of matured debt that exceeds this cap, will be reinvested back into their respective market. G7 Group of 7 (G7) is a group consisting of Canada, France, Germany, Italy, Japan, the United Kingdom and the United States. EuroCOIN Is a coincident indicator of the euro area business cycle that provides an estimate of monthly growth of euro area GDP after the removal of measurement errors, seasonal, and other short run fluctuations. Merrill Lynch Option Merrill Lynch Option Volatility Expectations or MOVE is an index measure of Treasury yield volatility. Volatility Expectations Asset Backed Security A security whose income payments and hence value are derived from and collateralized (or "backed") by a specified (ABS) pool of underlying assets such as consumer credit card debt or auto loans. Investment Grade Investment grade corporate bonds are bonds with a credit rating equal to or above BBB- (S&P) or Baa3 (Moody’s), Corporate bonds (IG) and are debt securities issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. High Yield Corporate High yield corporate bonds are bonds with a credit rating less than BBB- (S&P) or Baa3 (Moody’s), and are debt Bonds (HY) securities issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. Commercial Mortgage Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed security that is secured by Backed Securities mortgages on commercial properties, instead of residential real estate.

Disclosures

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Investing in structured products is intended only for experienced and sophisticated investors who are willing and able to bear the high economic risks of such an investment. Investors should carefully review and consider potential risks before investing. OTC derivative transactions involve risk and are not suitable for all investors. Investment products are not insured, carry no bank or government guarantee and may lose value. 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This material may mention options regulated by the US Securities and Exchange Commission. Before buying or selling options you should obtain and review the current version of the Options Clearing Corporation booklet, Characteristics and Risks of Standardized Options. A copy of the booklet can be obtained upon request from Citigroup Global Markets Inc., 390 Greenwich Street, 3rd Floor, New York, NY 10013 or by clicking the following link: http://www.theocc.com/components/docs/riskstoc.pdf or http://www.theocc.com/components/docs/about/publications/november_2012_supplement.pdf. If you buy options, the maximum loss is the premium. If you sell put options, the risk is the entire notional below the strike. If you sell call options, the risk is unlimited. The actual profit or loss from any trade will depend on the price at which the trades are executed. The prices used herein are historical and may not be available when you order is entered. 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Citigroup, its affiliates and any of the officers, directors, employees, representatives or agents shall not be held liable for any direct, indirect, incidental, special, or consequential damages, including loss of profits, arising out of the use of information contained herein, including through errors whether caused by negligence or otherwise. Citi Private Bank is a business of Citigroup Inc. (“Citigroup”), which provides its clients access to a broad array of products and services available through bank and non-bank affiliates of Citigroup. Not all products and services are provided by all affiliates or are available at all locations. In the U.S., investment products and services are provided by Citigroup Global Markets Inc. (“CGMI”), member FINRA and SIPC, and Citi Private Advisory, LLC (“Citi Advisory”), member FINRA and SIPC. CGMI accounts are carried by Pershing LLC, member FINRA, NYSE, SIPC. Citi Advisory acts as distributor of certain alternative investment products to clients of Citi Private Bank. CGMI, Citi Advisory and Citibank, N.A. are affiliated companies under the common control of Citigroup. Outside the U.S., investment products and services are provided by other Citigroup affiliates. Investment Management services (including portfolio management) are available through CGMI, Citi Advisory, Citibank, N.A. and other affiliated advisory businesses. These Citigroup affiliates, including Citi Advisory, will be compensated for the respective investment management, advisory, administrative, distribution and placement services they may provide. This document is for informational purposes only and the views expressed in this document by the Global Investment Committee. Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.

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Alternative investments referenced in this report are speculative and entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in the fund, potential lack of diversification, absence of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds and advisor risk. Asset allocation does not assure a profit or protect against a loss in declining financial markets. Mortgage-backed securities (“MBS”), which include collateralized mortgage obligations (“CMOs”), also referred to as real estate mortgage investment conduits (“REMICs”), may not be suitable for all investors. There is the possibility of early return of principal due to mortgage prepayments, which can reduce expected yield and result in reinvestment risk. Conversely, return of principal may be slower than initial prepayment speed assumptions, extending the average life of the security up to its listed maturity date (also referred to as extension risk). Additionally, the underlying collateral supporting non-Agency MBS may default on principal and interest payments. In certain cases, this could cause the income stream of the security to decline and result in loss of principal. Further, an insufficient level of credit support may result in a downgrade of a mortgage bond's credit rating and lead to a higher probability of principal loss and increased price volatility. Investments in subordinated MBS involve greater credit risk of default than the senior classes of the same issue. Default risk may be pronounced in cases where the MBS security is secured by, or evidencing an interest in, a relatively small or less diverse pool of underlying mortgage loans. MBS are also sensitive to interest rate changes which can negatively impact the market value of the security. During times of heightened volatility, MBS can experience greater levels of illiquidity and larger price movements. Price volatility may also occur from other factors including, but not limited to, prepayments, future prepayment expectations, credit concerns, underlying collateral performance and technical changes in the market. Real Estate Investment Trusts (REITs) are subject to special risk considerations similar to those associated with the direct ownership of real estate. Real estate valuations may be subject to factors such as changing general and local economic, financial, competitive, and environmental conditions. REITs may not be suitable for every investor. Dividend income from REITs will generally not be treated as qualified dividend income and therefore will not be eligible for reduced rates of taxation. The indexes are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. International investing entails greater risk, as well as greater potential rewards compared to US investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economics. Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity. Factors affecting commodities generally, index components composed of futures contracts on nickel or copper, which are industrial metals, may be subject to a number of additional factors specific to industrial metals that might cause price volatility. These include changes in the level of industrial activity using industrial metals (including the availability of substitutes such as man-made or synthetic substitutes); disruptions in the supply chain, from mining to storage to smelting or refining; adjustments to inventory; variations in production costs, including storage, labor and energy costs; costs associated with regulatory compliance, including environmental regulations; and changes in industrial, government and consumer demand, both in individual consuming nations and internationally. Index components concentrated in futures contracts on agricultural products, including grains, may be subject to a number of additional factors specific to agricultural products that might cause price volatility. These include weather conditions, including floods, drought and freezing conditions; changes in government policies; planting decisions; and changes in demand for agricultural products, both with end users and as inputs into various industries. Diversification does not guarantee a profit or protect against loss. Different asset classes present different risks. The information contained herein is not intended to be an exhaustive discussion of the strategies or concepts mentioned herein or tax or legal advice. Readers interested in the strategies or concepts should consult their tax, legal, or other advisors, as appropriate.

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Asia Pacific Europe & Middle East Latin America North America HONG KONG CHANNEL ISLANDS BRAZIL UNITED STATES Orange County, CA Hong Kong St. Helier, Jersey Rio de Janeiro Beverly Hills, CA 650–329–7060 852–2868–8688 44–1534–608–010 55–21–4009–8905 213–239–1927 Palm Beach, FL Sao Paulo Boca Raton, FL 800–494–1499 INDIA ISRAEL 55–11–4009–5848 561–368–6945 Palo Alto, CA Bangalore Tel Aviv Boston, MA 415–627–6330 91–80–4144–6389 972–3–684–2522 LATAM OFFICES IN US 617–330–8944 Philadelphia, PA Mumbai Houston, TX Chicago, IL 267–597–3000 312–384–1450 91–22–4001–5282 MONACO 713–966–5102 Phoenix, AZ Dallas, TX 602–667–8920 New Delhi Monte Carlo Miami, FL 214–880–7200 91–124–418–6695 377–9797–5010 305–347–1800 San Francisco, CA Denver, CO 415–627–6330 New York, NY 212–559–9155 303–296–5800 Seattle, WA SINGAPORE SPAIN Greenville, DE 888–409–6232 Singapore Madrid 302–298–3720 Short Hills, NJ 65–6227–9188 34–91–538–4400 MEXICO Greenwich, CT 973–921–2400 Mexico City 800–279–7158 52–55–22–26–8310 Washington, DC SWITZERLAND Houston, TX High Net Worth Monterrey Geneva 832–667–0500 202–776–1500 52–81–1226–9401 41–58–750–5000 Los Angeles, CA Law Firm Zurich 213–239–1927 202-220-3636 41–58–750–5000 Miami, FL Westport, CT 866–869–8464 203–293–1922 UNITED ARAB New York, NY CANADA EMIRATES 212–559–9470 Montreal Abu Dhabi Asia 514–393–7526 971–2–494–3200 212–559–9155 Toronto Dubai Latin America 416–947–5300 971–4–604–4644 212–559–9155 Vancouver 604-739-6222 UNITED KINGDOM London 44–207–508–8000

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