Bond Outlook. Third Quarter Waiting on the Fed. 10-Year Treasury Yields. Treasury Bonds. Break-even Inflation Rate

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1 Third Quarter 21 Waiting on the Fed Despite a strong rebound in domestic economic activity with gross domestic production accelerating toward %, persistent low inflationary pressures and dramatically lower global sovereign rates kept Treasury yields well contained during the third quarter. By the end of October, the Federal Reserve (Fed) will have completed its year-long tapering of its asset purchase program of longer dated Treasuries and mortgaged-backed securities, otherwise known as quantitative easing. With tapering behind us, the focus will shift to changes in the federal funds policy. The Fed has indicated that, should economic activity continue on its recent trajectory, it could begin to increase the rate as early as mid-215. However, the Fed has clearly telegraphed that any change in policy will be data dependent as economic information unfolds. Treasury Bonds Concerns about an eventual move away from the zero interest rate environment helped push up yields on shorter dated Treasury securities during the third quarter. The yield on the 5-year Treasury note increased 16 basis points (bps) to end at 1.78%. Contrastingly, yields on longer dated securities fell, particularly on 3-year Treasury bonds. The benchmark 1-year note was essentially unchanged ending the quarter at 2.52%; whereas the yield on the 3-year Treasury declined 13 bps to 3.21%. Treasury Inflationary Protected Securities (TIPS) had a difficult quarter as a significant drop in oil prices, coupled with weaker global growth, dampened inflation expectations. The implied breakeven rate on 1-year TIPS remained steady during July and August, but collapsed in September. The implied breakeven rate on the 1-year TIPS fell from 2.25% down to 1.92%, causing TIPS to underperform nominal coupon Treasury securities by roughly 2%. 1-Year Treasury Yields Break-even Inflation Rate As of 9/3/1. Source: Bloomberg 1

2 Corporate Bonds Corporate bonds underperformed Treasury securities during the third quarter, which was the first such underperformance in many quarters. A heavy new issue supply calendar, especially in September, helped push out credit spreads. Investment grade corporate spreads widened 12 bps to end the period at 112 bps. The supply of corporate bonds totaled $3 billion, with a substantial $18 billion issued during September alone. Energy-related corporate debt experienced the most widening of all the subsectors, increasing 25 bps. High yield corporate bonds uncharacteristically underperformed Treasury securities as spreads on high yield securities widened 87 bps during the quarter, eliminating all of the tightening which occurred during the first half of the year. High yield spreads ended the reporting period at approximately 25 bps after tightening to 325 bps in early July. The spread widening was largely a result of approximately $5 billion in outflows from open-end high yield bond mutual funds, the largest quarterly outflow since 28. Supply of high yield bonds continued to be relatively heavy with more than $8 billion issued during the third quarter. The Barclays High Yield Index delivered a total return of over -2% for September and -1.8% for the quarter. High yield bonds lost ground to the Barclays Aggregate Index during the period, delivering 5 bps less in total return for the quarter after returning in excess of 2% greater than the index in early July. Emerging market bonds also had a tough quarter, with bonds denominated in local currency experiencing the steepest losses as many emerging market currencies fell against the U.S. dollar. Local currency emerging market debt declined by over 5% for the quarter, whereas, dollar denominated emerging market debt declined only 6 bps. Year-to-date, both profiles have produced total positive returns; however, the returns on dollar denominated debt have exceeded the returns of local currency by more than %. Fixed Income Sector Returns As of 9/3/1. Source: Barclays Capital. High Yield Spreads As of 9/3/1. Source: U.S. Census Bureau/Bloomberg L.P. 7. Treasury Agency Corporate TIPS MBS High Yield 213 Year End 21 YTD Emerging Municipal Markets Bond Index BofA Merrill Lynch High Yield Corporate Master II 1-Year U.S. Treasury Note 2

3 Municipal Bonds The tax-exempt fixed income market continued its strong performance through the third quarter, once again outperforming comparable taxable fixed income securities. Returns were buoyed by strong demand from retail investors seeking greater after tax returns, especially in high income tax states like California and New York. Similar to the taxable market, the total return on longer dated muni bonds significantly outperformed shorter dated securities. The total return on lower investment grade securities again exceeded higher credit quality profiles. After a much weaker supply environment during the first half of 21, total supply of new issue municipal bonds accelerated during the third quarter. Through the end of the third quarter, municipal bond supply was approximately 25% compared to the third quarter of 213. An increase in the amount of refinancings helped push supply up to $8 billion, compared to $7 billion the previous year. Despite the recent uptick in issuance, overall year-to-date supply is still approximately 15% lower than last year s levels. The overall lower supply environment has contributed to the strong total return seen year to date. Municipal Bond Suply $BILLIONS E Net* Muni Supply Build America Bonds Supply Predicted Gross Supply Net Supply *21 projected net supply is the projected gross supply less 213 maturities and estimated calls As of 12/31/13. Source: Bond Buyer, Thomson Reuter s Credit Two major stories continue to dominate municipal bond credit: Puerto Rico and Detroit. In early July, the government of the Commonwealth for Puerto Rico hurriedly passed legislation called the Puerto Rico Corporations Debt Enforcement Recovery Act. The initial market impact was quite negative, especially on authority debt (electric, aqueduct and highway), but Puerto Rico debt recovered somewhat later in the quarter. While there are some signs of economic stability, such as improving sales tax revenues, the overall economic picture of Puerto Rico continues to be dim. Declining population, high unemployment, an inability to attract new manufacturing jobs, aging population and high energy costs are the main challenges that have plagued the Commonwealth. Municipal Credit Quality Returns As of 9/3/1. Source: Barclays Capital On a brighter note, it appears Detroit should successfully emerge out of bankruptcy by year-end. Considering the city only filed bankruptcy a little over a year ago, most market participants have been surprised by the quick exit from bankruptcy. The disconcerting aspect of the Detroit bankruptcy is that bondholders, particularly the bond insurance companies, took a more significant cut compared to pension obligations. Fortunately, the agreement was executed out of court and thus does not set judicial precedence. Nevertheless, the concept that a major city could file bankruptcy then quickly exit and receive significant concessions from bondholders is alarming for general obligation debt holders across the municipal bond landscape AAA AA A BBB YTD

4 Outlook The U.S. economy is expected to improve in the quarters ahead. Employment gains, low energy costs, improving real estate markets and stronger consumer spending should help drive gross domestic production trend toward 3%. As the Fed finishes its quantitative easing program, it will begin to shift focus towards the timing of the first federal funds rate increase, which we expect will begin mid-215. A lack of inflationary pressures and the fragile global economy likely will be highlighted as reasons supporting a low federal funds rate. Yields on European sovereign bonds have plummeted over the last several quarters because of weak economic activity and muted inflation. The yield on the German 1-year bund ended the third quarter below 1%, and Italian and Spanish 1-year rates have correspondingly been dragged lower. Despite all the efforts of central banks around the globe, there are growing concerns that inflation will continue to be muted. Many bond market participants now question the United States ability to delink our economy and inflation outlook away from the global problems. As a result, intermediate- and long-term interest rates could very well decline in sympathy to the extremely low interest rates that our industrialized trading partners are experiencing. Consequently, we have lowered our previous outlook for the yield on the 1-year Treasury note. We believe the 1-year Treasury note yield could approach 2% and most likely will not exceed 2.75% before year-end. As we enter 215, our optimistic view of the U.S. should eventually result in slightly higher interest rates, but we do not anticipate a significant increase anytime during 215. Although investment grade corporate bond spreads and the high yield bond spreads have recently started to widen, we continue to expect investment grade corporate bonds to outperform Treasury securities. Steady corporate profits and strong corporate balance sheets should act as a buffer for any material widening on investment grade corporate bonds. High yield corporate bond spreads, however, are more vulnerable to significant near-term widening due to fundamental and technical reasons. Weaker bondholder covenants, on many of the recent new issues, and higher leverage, may come back to hurt high yield bondholders. Also, retail high yield bond investors may continue to redeem a material amount of money from high yield bond mutual funds. Therefore, we are more cautious on high yield than we are on investment grade corporate bonds. We reiterate our perspective about the municipal bond market: low supply and strong retail demand should keep municipal bond prices well bid. The current yield environment is extremely low and thus the potential for comparable price appreciation compared to year-to-date movements seems unlikely. We would not be surprised if prices move sideways or only slightly higher over the next several quarters. Thus, while we are not bearish on municipal bonds, we are also not overly bullish. The first three quarters of 21 have been a prudent reminder to investors that markets do not move in straight lines. After U.S. interest rates almost doubled in 213, we have seen a retracement or correction from those levels. Eventually, interest rates will again trend higher, but rates may stay low for longer than previously imagined. While the year-to-date volatility of the fixed income market has been relatively low, investors should remain guarded against the potential for an acceleration in volatility. Holding a variety of diversified fixed income strategies continues to be a prudent approach in meeting an investor s overall fixed income goals of principal protection and income. Strong risk controls also continue to be paramount.

5 About the Author John F. Flahive Director, Fixed Income Investments John is the director of fixed income for BNY Mellon Wealth Management and is responsible for all fixed income strategy, policy and management. He is chairman of the Bond Strategy Committee, and is a member of the Investment Strategy Committee, Investment Policy Committee, and Asset Review Committee. He has more than 2 years of investment experience and has been an investment manager with the firm since 199. Prior to joining the firm, he was a senior portfolio manager and vice president with Neuberger & Berman, and a vice president and associate portfolio manager with T. Rowe Price. John holds a bachelor s degree in business administration from Saint Michael s College and a master of business administration from Clarkson University, and attended New York University s Graduate School of Business Administration for Visiting Professionals. He is a CFA charterholder. This material is provided for illustrative/educational purposes only. This material is not intended to constitute investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of all of the investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation. 21 The Bank of New York Mellon Corporation. All rights reserved. 5 1/21 [96]

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