SOVEREIGN BOND YIELDS: WHERE HAS THE VALUE GONE?

Legg Mason Thought Leadership SOVEREIGN BOND YIELDS: WHERE HAS THE VALUE GONE? Prashant Chandran Portfolio Manager for Western Asset Yields in developed markets have plunged to record lows, in some cases even reaching negative levels, leaving little value for investors. In a market where rates may stay lower for longer, where economic growth is still ailing and inflation subdued, unconstrained fixed income strategies will be especially important when seeking investment opportunities, or to tactically profit from the current uncertain environment. Past performance is no guarantee of future results. All investments involve risk, including possible loss of principal This material is only for distribution in those countries and to those recipients listed. Please refer to the disclosure information on the final page. MAR 2015 IN THE U.S. INVESTMENT PRODUCTS: NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

Q. Why is an unconstrained strategy so relevant, especially now? A. Uncertainty has never been higher. Anybody who s followed U.S. fixed income markets for several decades can only be incredulous about today s incomprehensibly low rates. In other regions, as well, we see 10-year bond yields below 1%, and even countries that were on the verge of a bail-out only three years ago, now face borrowing costs that are lower than those in the U.S. To make matters even more incredible in some countries investors even need to pay to lend, as rates have gone negative. This can t be sustainable for long. The key will likely be to have the flexibility to diversify when seeking to find suitable opportunities. Q. So, if interest rates are likely to rise in due course, do you see opportunity in fixed income markets this year? A. We expect to see opportunity in sectors that offer investors attractive compensation for underlying fundamental credit, sovereign or macro risks. Specifically we see value in selected investment-grade and high yield corporate bond markets where default rates are likely to stay lower than what is being implied by markets. We also see value in debt of selected emerging markets that are underpinned by strong fundamentals; or in markets that have been beaten up and offer great value. We also see opportunities to trade tactically as we may experience volatility bouts some of which may be exacerbated by policy uncertainty and ongoing geopolitical risks. In general terms, we are most likely going to see improved global growth this year, relative to last, although of course the bar is not very high. It may be a case of two steps forward and one backwards because plenty of challenges still remain: from the weak growth in the Eurozone to geopolitical tensions. Graphic 1: Rates have plunged after the financial crisis 10-year benchmark yields (%) 8 U.S. UK Germany Japan Spain 6 4 2 0 MAR 2010 MAR 2011 MAR 2012 MAR 2013 MAR 2014 MAR 2015 Source: Barclays Capital as of March 3, 2015. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. 2

Q. The U.S. is ahead of other regions in terms of growth. Should this help the corporate bond sector? A. Yes, the U.S. is backed by positive fundamentals that albeit not convincingly strong, at least are improving. Companies are expected to profit from a better environment, giving the U.S. credit sector the potential to outperform. Particularly, the banking industry seems well-positioned to profit from a new regulatory framework that has encouraged more capital building and limited additional leverage on balance sheets. In the U.S. energy sector we could see some opportunity as, following the recent sell-off, most companies trade at the same level, regardless of their business model. Also, we expect oil prices to stabilise in the $60 $65 per barrel range, improving the sector s profitability, and we might also see some merger & acquisitions activity. Finally, U.S. mortgages may also reflect this year improving housing fundamentals they aren t overly exciting, but they point towards a potential price appreciation. Mortgage default rates are also decreasing. Q. Which other sectors are attractive in the U.S.? A. Opportunities may also surface in the High Yield sector, which traditionally does well in a 2% 4% economic growth environment. This level allows companies to benefit from demand at the same time that financing costs remain relatively low, reducing default risk. Graphic 2: Non-energy High Yield spreads have fallen more than energy ones Overnight Adjusted Spread (OAS, in basis points) 525 Spread (righ axis) U.S. Corporate High Yield OAS (left axis) U.S. High Yield ex Energy OAS (left axis) 45 475 35 425 25 375 15 325 5 0 275 MAR 2014 MAY 2014 JUL 2014 SEP 2014 NOV 2014 JAN 2015 MAR 2015-5 Source: Barclays Capital as of March 3, 2015. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. 3

The majority of central banks will continue to be accommodative as they aim to reignite growth Q. Do you expect the U.S. corporate bond sector to perform better than U.S. Treasuries? A. In general, yes, although we are in front of an interest rate conundrum: U.S. rates seem overvalued when they trade at a yield under 2%, given the country s improving economic fundamentals: economic growth may reach 2.5% this year, which is a bit below the Federal Reserve s (Fed) 3% forecast, but still positive, moderate growth. But on the other hand, U.S. rates seem good value relative to other regions yields were at 0.28% in Germany very recently. Japanese yields are also at a floor, so in some cases U.S. Treasuries may look like an interesting opportunity. The front end of the curve may offer opportunity as that part of the curve may flatten to reflect the protracted low inflation prospects. But overall, if we look at the fundamentals and the macro situation lower than expected growth, falling inflation and a dovish Fed we feel that U.S. treasuries have already all those factors priced in, leaving little value in them. Q. Do you expect U.S. rates to go up? A. The Fed is willing to finalise its five-year monetary stimulus programme in June, although this may not be possible if growth is weaker than they expect or if inflation is still below their targets. This could well happen, given the low energy prices and still some slack in the labour market. And let s not forget that the Fed not only follows the unemployment rate, but also labour market statistics. If by June the data is still not pointing towards a strong improvement in those criteria, the Fed may choose to delay any interest rate hike to later this year in order to avoid derailing the recovery. The Fed minutes released on Feb. 18 validated this thinking, as many members of the rate-setting committee were said to be very worried about a sudden rate rise as that could shock markets. For the time being, the Fed continues to be patient before taking any action. Low energy prices are obviously dragging inflation down we have also been surprised about the cap they ve put on inflation. This tells us that long-term rates may stay lower for longer. 4

Q. Europe and Japan are still immersed in monetary stimulus do you expect them to recover? A. Both remain fragile, and this will pressure their respective currencies, leading some to believe that the euro and the yen could underperform in 2015. Japan may need further monetary stimulus to kick-start its economy, while the situation in Europe is highly concerning, with weak growth increasing the deflation threat. The progress of the Greek talks is positive, but one should not rule out that this may not end well and that the country may be abruptly forced out of the Eurozone an unlikely scenario, but not impossible. We also have the uncertainty of as many as seven national elections in Europe this year, and in some cases, such as in Greece and Spain, we have seen the ascent of more radical political parties. However, the European Central Bank has finally adopted very aggressive monetary policy, with its January announcement of a Quantitative Easing programme. This could support peripheral bond yields, such as Italy s, and is also supportive of the banking sector. Q. Do you expect central banks to still play a key role in 2015? A. Yes. The majority of central banks will continue to be accommodative as they aim to reignite growth. In the U.S., growth is better, but deflationary factors from Europe and China still weigh on growth, so rates may stay lower for longer. In Emerging Markets (EM), inflation is low enough for many central banks to cut rates, as we have already seen in India, Turkey and Indonesia. Thus we should also be very careful as central banks, immersed in all this action, could still make policy mistakes tightening or loosening policy too soon, or too late. We have entered a more volatile period for many asset classes. Q. Do you think China is facing a hard-landing? A. The world s second-largest economy may not suffer from a hard-landing, as some expect, since its authorities have engaged in big stimulus programmes to steer the economy towards consumption, rather than exports. The Chinese government seems to be handling the deceleration of growth well. Q. The ECB has said it will start buying bonds in the market from March where will that money go? A. We believe investors selling to the ECB at these high prices may be attracted by the higher yields in the U.S. and the UK. 5

Q. Do you think Emerging Markets may offer opportunity this year? A. EMs are still expected to contribute more to global growth than developed markets. Some valuations are also attractive, following the substantial drop that the asset class suffered in November and December, when plunging oil prices made some believe prospects of improving global growth had reversed. Very few people saw that coming and it was a disappointment that it hit until-then well-performing countries such as Mexico. Still, Mexico is expected to be positively transformed in the long run, boosted by reforms and improving fundamentals. Mexico is an oil exporter, but much less dependent on oil than Brazil or Russia, yet, it now trades at a similar risk premium as it did at the height of the financial crisis in 2008. India is another case of a country improving its fundamentals - and we have seen an example of that in the recent removal of certain subsidies. Opportunities in Emerging Markets may also come from countries with a bit of a distressed story, such as Brazil or Russia, as they may be attractively valued and they offer a high yield. But the currency risk is there, hasn t abated, and this is why we favour local instead of U.S. dollar-denominated EM bonds. Local bonds also usually offer a very attractive yield and in selected countries they are backed by strong fundamentals: let s not forget that EM s external debt as a percentage of Gross Domestic Product is just over 30%, well below the levels in developed markets, which sometimes is above 100%. Graphic 3: Rising dollar ($) 100 USD vs major currencies 95 90 85 80 75 70 65 FEB 2010 FEB 2011 FEB 2012 FEB 2013 FEB 2014 FEB 2015 Source: Bloomberg as of March 3, 2015. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. 6

Investment risks The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. Common stocks generally provide an opportunity for more capital appreciation than fixed-income investments but are subject to greater market fluctuations. Fixed income securities involve interest rate, credit, inflation, and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors. U.S. Treasuries are direct debt obligations issued and backed by the full faith and credit of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities. Yields represent past performance and there is no guarantee they will continue to be paid. High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues. Asset-backed, mortgage-backed or mortgage related securities are subject to additional risks such as prepayment and extension risks. Outperformance does not imply positive results. Definitions The Barclays U.S. Corporate High-Yield Index provides a broad-based measure of the U.S. high-yield fixed income markets. The Barclays U.S. Corporate High-Yield Index ex-energy provides a broad-based measure of the U.S. high-yield fixed income markets, excluding the energy sector. The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro currency. The U.S. Federal Reserve, or Fed, is responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments. The Bank of Japan (BoJ) is the central bank of Japan and is responsible for the yen currency. Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities. Yield to worst (YTW) is the lowest potential yield that can be received on a bond without the issuer actually defaulting. A spread is the difference in yield between two different types of fixed income securities. An Asset-Backed Security (ABS) is a financial security backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities. A basis point is one-hundredth (1/100, or 0.01) of one percent. High Yield securities are those securities with a below investment-grade credit rating. Developed markets refers to countries that have sound, well-established economies and are therefore thought to offer safer, more stable investment opportunities than developing markets. Gross Domestic Product ( GDP ) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time. Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries. An Option-Adjusted Spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options. A credit spread is the difference in yield between two different types of fixed income securities with similar maturities. 7

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