Fixed Income Review. Second Quarter 2015

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1 Second Quarter 2015 As of June 30, 2015 Total Return Performance Calendar Year Performance Index MTD QTD YTD Barclays US Aggregate -1.1% -1.7% -0.1% 6.0% -2.0% 4.2% BAML US Agency Index -0.4% -0.7% 0.6% 4.0% -1.8% 2.4% BAML US Municipal Index -0.1% -1.0% 0.1% 9.8% -2.9% 7.3% BAML US Corporate Index -1.6% -2.7% -0.5% 7.5% -1.5% 10.4% BAML US High Yield Index -1.5% 0.0% 2.5% 2.5% 7.4% 15.6% BAML US Floating Rate High Yield -0.9% 1.8% 3.1% 1.1% 5.6% - BAML US EM Sovereign & Credit Plus -1.5% 0.8% 3.1% 4.2% -3.3% 18.2% Source: Bloomberg Reduced fear of deflationary pressures in Europe sent European yields higher, which reverberated into sharply higher yields domestically. Treasuries experienced their first quarterly loss in over a year as rates rose across all maturities. Summary Interest rates moved fast and fierce during the second quarter of 2015, sending volatility through any financial asset tied to interest rates. While the everimpending rate hike by the U.S. Federal Reserve is still on hold, a reduced fear of deflationary pressures in Europe sent European yields higher, which reverberated into sharply higher yields domestically. The broad domestic fixed income market, measured by the Barclays U.S. Aggregate Index, returned -1.7% for the quarter, erasing all gains for the year. Generally speaking, more credit sensitive investments with lower durations outperformed like high yield and floating rate loans. Higher quality investments like U.S. Treasuries, municipals and investment grade corporates underperformed due to their higher sensitivity to rates. International developed bonds were also negatively impacted by higher rates but reduced fear within emerging market countries led to outperformance for the quarter of emerging market debt. U.S. Treasuries U.S. Treasuries experienced their first quarterly loss in over a year as rates rose across all maturities. Long-dated bonds rose significantly more than shortdated bonds resulting in a steepening of the yield curve (also referred to a "bear steepener"). Moving across the curve the 2 Year, 5 Year, 10 Year and 30 Year yields rose by 9 bps, 28 bps, 43 bps, and 59 bps, respectively. U.S. Treasury yields were set to close the quarter near year-to-date highs until debt negotiations broke down between Greece and the Troika 1 in the last few days of the quarter. Prior to negotiations falling apart, yields on the 10 Year Treasury increased to almost 2.5% but fell sharply due to the safe haven bid to close the quarter at 2.35%. Year-to-date, the 10 Year yield is up 0.18%, which is similar to the level it closed at the end of the second quarter in While the focus of rates is almost always centered around the 10 Year Treasury, the 30 Year yield is not to be ignored and is more telling of long-term growth and inflation expectations. Given the negative performance of fixed income during the quarter it is easy to forget that just a handful of months prior, the 30 Year Treasury actually hit its all-time record low yield on January 30, 2015 when it 1 Comprised of the European Central Bank, the European Commission and the International Monetary Fund Fixed Income index data presented - Source BofA Merrill Lynch, used with permission. BofA Merrill Lynch is licensing the BofA Merrill Lynch Indices as is, makes no warranties regarding same, does not guarantee the suitability, quality, accuracy, timeliness, and/or completeness of the BofA Merrill Lynch Indices or any data included in, related to, or derived therefrom, assumes no liability in connection with their use, and does not sponsor, endorse, or recommend RTWM, or any of its products or services.

2 closed at 2.22%, capping off its best monthly return in history. This, however, was short-lived and reversed quickly as yields on the 30 Year have since risen 90 bps to 3.12% as of June 30, Until there is more certainty on the path and level of rate hikes, rate volatility will likely remain in the Treasury market along with a wider band of rate possibilities. With the steepening of the yield curve year-to-date, we anticipate the pending announcement of an increase in the Fed Funds Rate would likely trigger a knee-jerk reaction higher in all rates, but for the largest impact to be on the short end of the curve. All maturities experienced an increase in yields but not in a linear fashion like their Treasury counterparts. Municipals Municipal bonds ended the quarter down 1.0%, which was in line with Treasuries. Headlines focused on debt issued from Puerto Rico in June but there was limited spillover in the municipal space from the issues surrounding the U.S. territory. All maturities experienced an increase in yields but not in a linear fashion like their Treasury counterparts. Long-dated municipals experienced a disproportionate increase in yields with the 30 year AAA G.O. municipals rising 0.82% during the quarter. AAA G.O. yields in the 10 year maturity rose about half as much as the 30 Year, which was similar to the increase in 10 Year Treasury rates. Unlike the Treasury market, the 5 Year AAA G.O. yields barely budged. In fact, while other maturities were seeing rates rise, the 5 Year AAA G.O. municipal saw rates decline slightly in June and is actually 0.21% tighter year-to-date. The strong performance at the 5 Year maturity is reflective of municipal investors that typically prefer to go down in duration as rates increase and a longer term investment horizon. This demand pushes yields lower and results in less attractive valuations within municipal bonds compared to Treasuries using the AAA Municipal/Treasury ratio. At the 5 Year maturity, the ratio closed the quarter at 88%, about 12% lower than the average ratio over the last five years. In comparison, municipals at the 10 Year maturity have a yield ratio of 101%, meaning they yield more than Treasuries despite their tax-exempt status. While this ratio can move around day to day, this level indicates little relative value in 5 Year municipals and fair value in 10 and 30 Year municipals. From a technical perspective, refundings have remained strong year-to-date despite higher rates and new issuance coming to market at a steady pace. Year-to-date a total of $220 billion of capital has been priced in the market compared to $155 billion through the same time period last year. 2 This strong issuance is being absorbed by the market in the current environment but future rate volatility in Treasuries will likely impact municipals more than other fixed income sectors if technicals shift in the coming months. Corporates Investment Grade Corporates Duration and widening spreads weighed on investment grade corporates during the quarter as the broad investment grade index declined nearly 2.7%. Generally, lower quality bonds underperformed higher quality bonds for the quarter as spreads widened across the asset class. However, year-to-date BBB bonds have outperformed as they have been the only rating bucket to see spreads tighten during the year. By duration, long dated bonds underperformed with 10+ year corporates declining 7.2% (average duration of 13.5 years). Intermediate corporates (duration of 1-10 years) fared better but still ended the 2 Securities Industry and Financial Markets Association, U.S. Municipal Bond Issuance 2 P age

3 quarter down 0.9%. Year-to-date, intermediate corporates have generated a return of 1.1% while long dated corporates are down 4.2%. Duration exposures drove sector performance as financial bonds outperformed due to their shorter duration. Duration exposures drove sector performance as financial bonds outperformed due to their shorter duration (typically 5 years). Industrials lagged and were down 3.0% due to a longer average duration of 7.2 years. However, spreads on industrials have remained fairly consistent year-to-date while spreads have widened slightly for financial bonds over the same time period. The only sector to experience spread tightening this year has been the bonds issued by energy companies, which tightened 43 bps to close the quarter at a slight premium to the industrial sector. While the broad corporate index states an average yield of 3.3%, yields of close to 4.0% can be found in communication and energy sectors. In comparison, financials have yields below 3.0% and industrials provide yields in the mid-3% range. Current spreads are about bps higher than where they were a year ago depending on industry and rating, which could mitigate the risk of higher rates through spread compression so long as fundamentals do not deteriorate. High Yield Corporates After a June sell-off, high yield ended the quarter flat but managed to post positive returns of 2.5% year-to-date. Spreads at the end of the quarter ended at 500 bps above comparable U.S. Treasuries, which is within 4 bps of where they started the year. Lower quality high yield, those rated CCC and below, continue to struggle and lost 0.4% during the quarter. Over the last one year period these bonds are down 6.9% while higher quality junk bonds rated BB/B are up 0.7%. Underperformance of CCC-rated bonds was a result of increasing spreads, which have increased almost 50 bps year-to-date. The sub-sector has seen spreads widen from 639 bps in June of 2014 to over 1,000 bps at the end of the quarter. This equates to a yield of 11.5% on the sector, nearly double that of the broad high yield index. While there is increased opportunity for high yield to absorb higher rates due to widening spreads, we see lower volatility with similar dynamics available in floating rate loans and prefer to gain our below investment grade exposure through the loan asset class. The average price within the asset class is similar to where it started the year but price dispersions have shifted. Floating Rate Loans Similar to high yield bonds, floating rate loans sold off in June resulting in a quarterly return of -0.1% and year-to-date return of 1.8%. 3 With the slight negative performance during the quarter, average prices have declined across the largest 100 loans 4 to $96.60, down from $97.00 three months ago. According to the same data, the average price within the asset class is similar to where it started the year but price dispersions have shifted. For instance, coming into 2015, only 1% of loans traded above par and 50% traded between $98.00 and $ At quarter end, 37% of loans trade above par and 26% trade between $ Stressed loans, those priced below $95, have remained relatively constant at 13.4% at the beginning of the year and 14.6% at the end of second quarter. The average spread among the largest 100 loans closed the quarter at 536 bps, which would imply a default rate of 1.6%. 5 This spread is up slightly during the 3 S&P/LSTA Leveraged Loan 100 Index 4 Represented by the holdings of the PowerShares Senior Loan ETF 5 Assumes a 70% recovery rate 3 P age

4 quarter and helps explain the lower dollar prices of the loans. However, with the lower prices and consistent coupons, yields on the index have become more attractive. S&P/LSTA data puts quarter-end average yields on B/BB-rated loans at their highest level in two years at nearly 5.25%. However, any increase in coupon rates seems unlikely in the coming quarters as LIBOR floors are typically 100 bps within loans. LIBOR closed the quarter at 28 bps so LIBOR would need to increase 72 bps for coupon payments to increase. Not surprisingly, the most attractive loans are those within the energy complex and there are less stressed opportunities in consumer staples, financials, and health care. Prices continue to remain attractive and allow for an active manager to find opportunities for addition total return. We do not anticipate double digit growth from the asset class but view the 4-5% coupon with another 1-2% of capital appreciation as an attractive return, especially given the low volatility. Developments in Europe dominated the global markets during the quarter and as Europe went, so did the majority of the developed world. International Bonds Developed Bonds Global government bonds excluding U.S. Treasuries generated a return of -0.8% and -5.7% for the quarter and year-to-date periods, respectively. Global corporates underperformed governments for the quarter with a return of -1.4% but have outperformed so far this year with a return of -2.7%. Developments in Europe dominated the global markets during the quarter and as Europe went, so did the majority of the developed world. European yields actually decreased going into the quarter and hit astonishing low levels by mid-april with the benchmark European bond, the German 10 Bund, yielding just 0.05%. The low levels were short lived and yields quickly reversed after data was released that eased deflationary fears. By the end of May, the Bund closed just under 0.50% (after almost hitting 0.80% in early May). June began in a similar manner as May with Bund yields skyrocketing higher by over 0.30% in just the first three trading days of the month before ultimately closing the month at 0.76% after debt negotiations between Greece and the Troika drove a safe haven bid to bonds. While the rally was welcomed by bond holders, it was not enough to undo the losses already experienced during the quarter as investors holding German Bunds were taken on a wild ride and experienced a loss of 5.4% for the quarter. Shorter-term paper within the Eurozone fared relatively better and rallied in Japan resulting in outperformance of the global high yield market. The index returned 1.4% for the quarter and is up 1.8% for the year. European high yield was a top performer for the quarter with a return of 3.2% but the index remains down for the year-to-date period. Compared to other developed market government bonds, the U.S. has relatively attractive rates. The yield-to-worst on the Bloomberg U.S. Treasury Index is 1.56%, second only to the UK Index at 1.91%. Canada, the Eurozone and Japan all have lower yields with longer durations. The unattractive yields, elevated rate volatility and exchange rate risks supports an underweight to global bonds in favor on domestic fixed income. Emerging Market Bonds Emerging market (EM) debt was one of the few fixed income indices to post positive returns for the quarter and year-to-date periods, with the broad Bloomberg Emerging Market Debt Composite up 0.31% and 2.5%, respectively. Corporate EM debt denominated in U.S. Dollars outperformed, aided by strong 4 P age

5 performance within the high yield segment. Quarter-to-date, EM high yield debt returned 4.7% while EM investment grade debt lost 0.2%. Sovereign EM debt also declined during the quarter but remains in positive territory year-todate. Spreads within the asset class generally tightened for the first two months of the quarter but began to widen in June. 6 Asian EM debt underperformed during the quarter as it was pulled lower from volatility surrounding China. Asian EM debt underperformed during the quarter as it was pulled lower from volatility surrounding China. Europe, the Middle East and Africa (EMEA) outperformed Latin America as it returned 3.1% versus 1.6%. Outperformance is a result of tightening spreads within the region, which compressed 80 bps, double that of the spread compression in Latin America. As of quarter-end, Asia continues to provide higher quality exposure with spreads of 238 bps and yields of 3.9% while EMEA and Latin America provide respective yields of 5.3% and 6.8%, albeit with higher risk. 7 Year-to-date performance across some of the largest countries within the Bloomberg Emerging Market Corporate Debt Index was mixed with Russia (a 13% weighting) posting price returns of almost 10%. Even with the strong rally this year, spreads within Russia remain the highest among debt issuers at nearly 500 bps, which is over 100 bps more than next highest country, Brazil. Brazil also happens to be the largest country exposure within the index at 24% and debt from the country experienced losses during the year as it continues to struggle with political corruption. Mexico which comprises 19% of the index was also a notable underperformer as bond prices issued from the country declined 1.7%. Market Outlook and Recommendation Fixed income markets will likely struggle with the challenges of timing the first Fed Funds rate hike since 2006 and the realized volatility year-to-date may continue into the latter half of The fixed income market enjoyed an unprecedented time of low volatility while the Fed Funds rate was set to % and an adjustment period is necessary. We feel that the Federal Reserve has been as transparent as they can be in setting expectations and that while volatility may persist, this does not guarantee losses within fixed income. With the rise in volatility it is as important as ever to focus on risk-adjusted returns. We favor spread sectors and shorter duration strategies and are avoiding longer term strategies with returns driven purely by rates. Spread sectors offer an additional component of return beside the interest rate/pricing relationship and lower duration leads to lower volatility, both of which can maximize returns in a challenging asset class going forward. 6 Bloomberg Emerging Market Index Data 7 Credit Suisse Emerging Market Index Data 5 P age

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