October *EU Periphery Sovereigns include bonds from countries such as Greece, Ireland, Italy, Portugal and Spain.

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1 October 2012 Despite open-ended commitments by the European Central Bank and the Federal Reserve -it is doubtful that monetary stimulus will reflate economic activity any time soon or drive interest rates higher. Instead, Citi analysts expect slowing growth and heightened event risks (especially in Europe) to anchor bond yields and foster safe haven demand for developed market government securities. Fed and ECB policy - also suggests potentially greater tolerance for inflation. Our analysts expect steady demand for inflation protection as central bank asset purchases depress the real component of bond yields. High grade corporate bonds and mortgage-backed securities (MBS), are favoured convictions. MBS will remain supported by open-ended quantitative easing, while corporate debt issuers will continue to benefit from the low interest rate environment, resulting in enhanced liquidity, stronger balance sheets, and massive bond fund inflows. Sectors 12 Months View Investment Rationale Dev. Market (Core) Sovereigns EU Periphery Sovereigns* Emerging Market Sovereigns High Grade Corporates High Yield Corporates Market Perform Underperform Outperform Outperform Outperform Underweight; Favor intermediate part of the term structure; Long end maturities to be volatile as inflation expectations stay elevated. Despite ECB backstop, fiscal challenges remain unresolved and capital flight risks persist; Spain bailout is imminent External debt supported by USD fund inflows and low Treasury rates; Favour Indonesian and Peru (USD-denominated) debt; Local markets to benefit from slower growth and easier policy; Favour long-dated Mexican government debt. Remains our analysts favourite asset class, despite low absolute yields; Financials and BBB issuers are expected to outperform. Record-low absolute yields suggest caution is warranted should a risk-off move occur; Our analysts remain constructive given easy policy *EU Periphery Sovereigns include bonds from countries such as Greece, Ireland, Italy, Portugal and Spain.

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3 Developed Markets Government Bonds Yield curves steepened modestly over the past month as open-ended commitments by the European Central Bank and the Federal Reserve substantially diluted tail risks and elevated inflation expectations. Despite these good intentions, it is doubtful that monetary stimulus will reflate economic activity any time soon or drive interest rates higher. Instead, our analysts expect slowing growth and heightened event risks (especially in Europe) to anchor bond yields and foster safe haven demand for developed market government securities, which should keep interest rates low. Central bankers are still battling the impaired feedback loop between improved financial conditions and genuine growth in the real economy (Fig. 1). In theory (and often, in history), improved financial conditions (i.e., asset market rallies) and lower costs of capital translate to greater risk-taking, which in turn promotes spending, investments, and hiring. But instead of resurgence in economic activity, the current climate resembles a liquidity trap as a global slowdown persists. Indeed, in the developed world the private sector continues to delever and government spending is contracting, while the fastest-growing economies in the emerging world are reporting a substantial downtick in growth. It s true that risk-free rates in the developed markets backed up during the last two quantitative easing efforts by the Fed, and after the two LTROs from the ECB (Fig. 2). But lower growth expectations and continued event risks suggest any rise in government yields will be less pronounced this time around. Indeed, a material backup is unlikely because markets have learned that the handoff from improved financial conditions to the real economy is unlikely to occur in the near term. Forward guidance has also become even more explicit from the ECB and the Federal Reserve, which anchors forward rate expectations in the term structure. Figure 1: Improved conditions fail to trigger strong growth Source: Bloomberg, Citi, IMF Figure 2: New QE has not caused a spike in long-term rates Source: The Yield Book Past quantitative easing efforts have resulted in a weaker dollar and stronger emerging market exchange rates as higher EM interest rates and solid growth prospects attracted capital inflows. Given lower growth prospects in EM now relative to past QE periods, these countries are likely to intervene to weaken their currencies should material strengthening occur. This would imply more demand for the safest haven bond markets and would act as a buffer to rising G4 market yields. The current climate remains positive for carry trades. While our analysts are reluctant to add exposure at the longest end of the yield curve where inflation worries are likely to keep bond yields volatile they retain a long duration view since the fundamental backdrop (i.e., economic activity) is simply not supportive of a substantial selloff. Citi analysts expect that intermediate-range maturities should be well supported as growth remains subpar and the appetite for yield persists. This is especially true in the credit markets, where curves are relatively steep and opportunities exist for investors to add duration (see Corporates on page 5).

4 Emerging Markets Government Bonds Emerging market external (US denominated) sovereign debt remains one of Citi s top convictions in fixed income. Over the last two months, emerging market sovereigns have returned 2.7%, outperforming the US Treasury market by 250 basis points and US high grade corporate debt by over 160bp. External EM country debt has benefitted from low US Treasury rates, strong bond mutual fund inflows and encouraging economic policy objectives. Since the beginning of August, spreads have tightened by 40bp, while yields have dropped by 30bp (currently around 4.5%). With central bank easing likely to keep investors focused on risky assets, our analysts expect demand for emerging market debt to remain high. Indeed, investors have flocked into EM bond funds (with nearly $11.5 billion over the last 15 weeks) as the reach for higher yields continues. Moreover, valuations remain attractive, as current spread levels remain nearly 120bp above historical lows (Fig. 3). Figure 3: USD EM spreads are still wide versus historic low Source: The Yield Book Long-duration Indonesian and Peruvian external (USD-denominated) bonds continue to be our favoured recommendations. Both issuers feature good growth prospects and attractive valuations relative to other issuers in their regions. During the last month, both markets have gained 3.2% and 1.3%, respectively. Returns have been relatively muted in local government markets over the last month as yields took a respite from their year-long decline. Recent easing measures by the Federal Reserve have provided a boost for local investors as the US dollar declined sharply versus most EM currencies. Indeed, while local currency returns on our global EM index were barely a half of one percent during the last month, returns jump to 3.5% if an investor is converting local currency exposure into US dollars. Citi s favoured market continues to be long-dated Mexican Bonos, which has benefited from strong manufacturing, a positive election outcome, and the likelihood that the central bank will be on hold. Long dated Mexican government debt has returned 17.4% year-to-date (or 25.3%, unhedged to USD)

5 Investment Grade Corporate Bonds Global high grade corporate debt has returned 9.1% year to date and remains our analysts favourite fixed income sector. There have been only two other periods since 2000 that high grade corporate debt markets posted higher returns during the first three quarters of the year (11% and 15% in 2001 and 2009, respectively). In Citi analysts view, this year s gains are much more impressive than prior episodes since US Treasury and German Bunds yields are substantially lower today. Despite some giveback last month, corporate spreads are likely to grind tighter. Since the beginning of the year, USD and EUR denominated corporate spreads have declined by 80bp and 140bp, respectively. In our analysts view, spreads will compress further as appetite for corporates persists, notwithstanding absolute yield levels that continue to breach historical lows (Fig. 4). Figure 4: Absolute yields in corporates reaching new lows Source: The Yield Book Figure 5: Financials remain attractive vs. non-financial debt Source: The Yield Book, Bloomberg. The ECB s announcement of its sovereign backstop facility (OMT) has softened downside risks in Europe. Moreover, the Federal Reserve s open-ended qualitative easing program announced on September 13 has provided a strong tailwind for risk assets. Despite weaker earnings and profit expectations, Citi analysts expect strong inflows into investment grade credit bond funds to persist. This is exacerbating lopsided supply/demand dynamics, whereas too much cash is chasing too few bonds. Indeed, last week another $2 billion of inflows went into high grade bond funds. This boosts year-to-date total inflows to $100 billion, or about 127% higher than all inflows last year. Corporate issuers continue to benefit from the low interest rate environment, allowing them to refinance maturing debt at attractive rates while enhancing liquidity and strengthening balance sheets. Many companies are also hoarding cash given heightened uncertainties and weakening growth prospects. While accumulating large amounts of cash may be counter-productive, many of these issuers appear well-positioned should an event that disrupts capital markets occur or if a severe slowdown transpired. Broader central bank support has prompted our analysts to take another look at the bank and finance sector. Despite a sharp rally, valuations remain attractive relative to non-financials (Fig. 5). Citi analysts favour US versus European banks, as uncertainty persists over the Spanish banking system and a potential Greece exit. A yield pickup of around 100bp in the subordinated debt of some issuers is attractive, in their view. In non-financials, Citi analysts favourite sectors continue to be cable/media and tobacco, where cash flows are high and earnings are stable. Over the last 12 months, these two sectors have returned 8.1% and 8.9%, respectively (when adjusted for changes in interest rates), largely outperforming the broader index by over 100bp.

6 High Yield Corporate Bonds September was another solid month for high yield debt despite some giveback midway through the month. The 1.9% return last month boosts the sector s year-to-date total return to 14.6%. Performance was led again by European issuers, which outperformed US high yield by 86bp (or about 850bp YTD). European bonds led high yield gains despite a relatively stronger fundamental backdrop in the US, mostly due to cheaper valuations. At the beginning of the year, European high yield index spreads were nearly 870bp as fiscal concerns in the periphery intensified. US high spreads were closer to 680bp, or a spread difference of 190bp. Today, that difference has compressed to 35bp (Fig. 6). Although spreads remain attractive relative to low default rates, yield levels are near historic lows. Record-low absolute yields suggest caution is warranted should a risk-off move occur. That said, our analysts remain constructive on the sector given easy monetary policy. High yield debt remains one of the few fixed income asset classes that still presents investors with attractive (and positive) real yields. Figure 6: EUR HY valuations catch up to USD HY issuers Source: Barclays Capital Past performance is no indication of future results Spreads could tighten further as easy central bank policies and strong technical dynamics continue to support valuations. Indeed, more than $17 billion in mutual bond fund inflows were recorded during the last four months ($34 billion year-to-date). Citi analysts favour US versus European issuers as the periphery sovereign debt crisis is far from resolved, in their view. They expect lower-quality issuers to benefit the most from increased demand, as valuations are more attractive