October 2014

Bond Market Outlook

Page 2

The Pause that Refreshes

If investors looked no further than the 0.2% return on the

aggregate index or the rounding error 4 basis point drop in

the yield of the 10-year U.S. Treasury note from 2.53% to

2.49%, they might be inclined to dismiss the third quarter

as a non-event. In fact, the quarter was rife with significant

events likely to impact markets in the quarters—and

perhaps years—to come. One clue about the shifts below

the surface could be seen in the dramatic differences in

inter-market performance as observed in the following

table.

Performance by Sector (Sorted by Q3 2014 Total Returns)

Total Return (%)

Q3 2014 YTD

European IG Corporate Bonds 1.81 6.77

Municipal Bonds 1.49 7.58

S&P 500 Index 1.13 8.34

U.S. Treasuries 0.34 3.06

European Leveraged Loans 0.32 2.21

Mortgage-Backed (Agency) 0.18 4.22

U.S. Aggregate 0.17 4.10

U.S. IG Corporate Bonds -0.08 5.60

Comm. Mortgage-Backed Securities -0.23 2.38

U.S. Leveraged Loans -0.33 2.43

Emerging Markets Debt Hard Currency -0.59 8.02

Emerging Markets Local hedged -0.66 2.10

European High Yield Bonds -0.73 4.71

U.S. High Yield Bonds -1.92 3.61

Sources: Barclays except EMD (J.P. Morgan), HY (Merrill Lynch), Senior Secured Loans (Credit Suisse), Euro Corp (iBoxx, USD-denominated). Performance is for representative indices as of September 30, 2014. See Notice for full index names. Past performance is not a guarantee or a reliable indicator of future results. An investment cannot be made directly in an index.

Events of the quarter sent a shudder of risk aversion

through the fixed income markets, causing spread

products, such as investment grade and high yield

corporate debt as well as emerging markets debt, to

underperform. Setback for the quarter notwithstanding,

year-to-date returns remained respectable considering the

low-yield environment.

Current Events

In the more or less “unchanged” category for the quarter

would be the economic question marks surrounding the

China slowdown, the ultimate success or failure of

Abenomics, and whether U.S. growth can continue

accelerating, (for more on the U.S. economy, see our

following Global Outlook section). Geopolitical events were

also on the front burner during the quarter, with western

and middle-eastern countries coming to Iraq's aid with air

strikes on Islamic State (IS). Hostilities continued in the

Ukraine/Russia crisis as well amidst rising sanctions from

the West and signs of capital flight from Russia. Another

important event at quarter end was a management

disjunction that cropped up at a major U.S. fixed income

shop, which caused, a sudden increase in outflows from its

funds and added to uncertainty in the fixed income

markets.

Europe: Into the Void

As the third quarter progressed, it became apparent that

growth in the eurozone economies had stalled. And to

make matters worse, inflation, and inflation expectations,

also fell further below target, setting off alarm bells at the

European Central Bank (ECB). By quarter end, the ECB

had cut interest rates and was hard at work designing an

asset backed and covered bond purchase program to

ease credit conditions, boost growth, and help move

inflation back up to target (for more on this program, see

our following Global Outlook section).

The eurozone bond market took the dismal growth story to

heart, and decisively pushed down core European

government bond yields. At this point, much of the German

curve—which previously occupied the same zip code as

the U.S. curve for decades—moved to levels comparable

to Japanese government bonds. Meanwhile, perhaps

attesting to the power of the ECB’s easy monetary

conditions, peripheral countries such as Spain and Italy

rallied even more than the core countries, bucking a

general spread widening trend during the quarter.

Given the likely continuation of very sluggish growth, well

below target inflation, and the resulting aggressive ECB

accommodation—replete with ultra low money market

rates, and bond financing and buying programs—eurozone

yields appear likely to remain depressed for some time to

come (for more on the European situation, see our soon to

be released white paper, “Europe: Into the Void,” October

2014). To some extent, the eurozone’s economic drop off

and the associated drop in European yields may have

suppressed, and may continue to suppress, U.S. yields.

Bond Market Outlook

Page 3

The Fed: All by Ourselves

As the global recovery has maintained its sluggish status,

growth in the U.S. has bumped along at a pace of roughly

2% or so. Perhaps more important for the Federal

Reserve, the unemployment rate has continued to decline,

bringing it to the upper edge of the Fed's long-term normal

range of 5-6%. As a result, the Fed has continued to taper

their purchase program, moving closer toward their

forecast horizon for rate hikes, which would appear likely

to begin around mid-2015. In fact, at each meeting this

year, the Fed meeting participants have modestly pulled

forward their anticipated rate hike schedule.

Fed Tightening on the Horizon—Impact #1: Dollar Gets

a Boost

U.S. Dollar Hits Multi-Year Highs

Source: Bloomberg.

With the Fed headed towards tightening policy while the

other G-3 central banks are in the midst of unprecedented

easing programs, the dollar broke out of its year-long

doldrums in the third quarter, quickly moving to multi-year

highs as depicted in the preceding chart. Whether the

stark differences in growth and policy will result in a

onetime move higher in the dollar, or alternatively keep the

wind in the dollar’s sail for some time to come, is difficult to

say at this point. Going forward, key drivers of the dollar’s

performance may be the likely speed of expected rate

hikes as well as the impact of the stronger dollar on the

U.S. trade deficit.

Fed Tightening on the Horizon—Impact #2: Get out of

Bonds? Not so Fast …

At the end of 2013, we noted that the sell-offs that occur

ahead of Fed rate hikes often mark the top of the yield

range for some time to come. In this case, the roughly 3%

level that the 10-year note hit around the turn of the year

looked like it could be the high-water mark for much of the

rate hike cycle to come. As of mid-year, the prospects for

low and range bound long rates appear as solid as they

did at the beginning of the year. Whatever improvement

we’ve seen in the U.S. economic picture is probably more

than offset by the economic deterioration on the

international front, which has left 10-year yields in the

other two G-3 countries below 1%.

After a Tough Quarter, Spread Product Once Again Well

Positioned for Long-Term Outperformance

Between the geopolitical risk, prospects for rate hikes, and

concerns about a major money manager’s succession

event, the spread sectors were pelted by mutual fund

redemptions and risk aversion in the third quarter. In our

view, this represents a long-term buying opportunity.

While we can’t be sure how these situations will pan out

over the near term, we do have confidence that there are a

range of individual issuers across a range of sectors that,

subject to a rigorous credit process, appear to offer

excellent long-term value at these levels. And with U.S.

Treasury yields having declined, these spreads look all the

more attractive. In short, after widening back out to levels

where they started the year, many of the spread sectors

look, once again, poised for significant outperformance

versus U.S. Treasuries given their substantial yield

advantage and the potential for capital gains from spread

tightening.

The Bottom Line: Although the continued economic

progress in the U.S. is keeping the prospects for 2015 rate

hikes front and center, the overall muted global growth

picture is likely to keep long-term interest rates low and

range bound for some time to come. While the likely

duration of the current correction in spread product is

difficult to estimate, given investors’ desire for income and

the relative stability of fixed income products, the search

for yield is likely to resume in due time, leading to

significant outperformance by spread product, particularly

the higher-yielding sectors, such as high yield corporate

and hard currency emerging markets.

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90

100

110

120

130

Trade Weighted U.S. $ Index

Global Economic Outlook

Page 4

And Now For Something Completely Different?

The global economy enters the quarter amid

expectations of major policy changes ahead. In the

U.S., the end of asset purchases by the Fed has been long

telegraphed and markets are expecting rate hikes to follow

in 2015; in the euro zone, ECB president Draghi

announced plans for a substantial balance sheet

expansion going forward; in Japan, expectations for further

monetary policy easing are rising again as broad-based

progress on structural reforms has so far been wanting;

while in China, policy makers are telegraphing more

comfort with slower growth and implementing more

nuanced macroeconomic stimulus.

Global Growth—Firing on One Cylinder?

Source: Haver and Prudential Fixed Income.

However, each and every one of these premises can

be expected to be tested, as the global economy is

essentially only firing on one cylinder, and policy

implementation challenges abound. While the U.S.

economy—now in its sixth year of recovery—has nicely

bounced back from the first-quarter contraction, growth is

running not much faster than over past years; Europe and

Japan are once more falling short of expectations; and EM

is only consolidating but not booming, with China

unfortunately decelerating closer towards our admittedly

bearish growth expectations. In addition to these globally

lackluster trends, the current juncture is also marked by a

new phase in the quantitative easing monetary policy

experiment: central banks either come to enter a

normalization cycle (U.S.), expand their policy arsenal

(ECB), or face the limits of prior monetary policy activism

(China). While we see little reason to change our global

forecasts in a material fashion, we see scope for potential

volatility as monetary policy enters these uncharted

waters.

Against this global backdrop, the timing and

modalities of U.S. policy normalization remain

somewhat uncertain. While we expect growth to clock in

at an annual pace of about 3% during the second half of

2014 and the labor market to normalize further, an overall

weak global backdrop could well result in lower-than-

expected inflation. Moreover, the Fed’s intentions to keep

its balance sheet at elevated levels will require the use of

new tools to control the Fed funds rate once lift off begins.

Although the Fed has been test driving these tools, they

cannot know at this point how effective they will be under

various conditions. Furthermore, it has implications for the

conduct of policy normalization, as monetary policy may

have to target quantities (the balance sheet) rather than

price (the interest rate)—objectives that may well not align.

The new modalities and policy framework are thus not yet

fully understood, raising the specter of volatility as markets

and monetary policy makers adjust to the new

environment.

Persistent low inflation in Europe is a reminder of the

still unfinished adjustment agenda. More than

elsewhere, low inflation in the eurozone is a structural

phenomenon, brought about by the need of some member

countries to rebuild competitiveness vis-à-vis others,

which, in the absence of further material productivity gains,

can only be brought about by additional cost cuts. Indeed,

while progress has been recorded in this regard, it has

been slow and uneven, with critical reform measures still

facing push back, especially in Italy and France, and

reflected by these countries’ disappointing growth

trajectories. However, given stubbornly high fiscal deficits,

low growth and inflation are a noxious mix for public debt

dynamics. After years of adjustment and with elections

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65 Global Manufacturing PMI

Eurozone US China Japan

Global Economic Outlook

Page 5

ahead in some of the major countries, the political will to

undertake required structural and fiscal reforms again

appears to be flagging.

Eurozone Inflation (%YoY)

Source: Haver and Prudential Fixed Income.

Euro Area CPI (August 2014) (%YoY)

Source: Haver and Prudential Fixed Income.

The extent to which monetary policy can help is

limited in Europe, except for a much needed boost to

export sectors in the periphery. While recent

depreciation has undoubtedly eased monetary conditions,

interest rates are already low. Moreover, the ECB may find

it hard to meet its balance sheet target given its limited

implementation tools as well as the penal (negative) rates

it now charges on excess bank reserves. Thus, short of a

major expansion in credit—which we view as more

demand than supply constrained—the ECB may find it

hard to deliver on its balance sheet target.

In Japan, the sluggish recovery in activity following

the earlier consumption tax increase serves to

highlight the importance of structural reforms for a

sustainable outlook. While inflation is now running at the

highest level within the G3, much of its acceleration to date

owes to temporary factors—e.g. last April’s consumption

tax hike and the inflationary impact of the yen’s decline

over the last year and a half. The temporary nature of

these increases underscores the difficulties ahead in

achieving lasting reflation. Moreover, government efforts to

encourage companies to raise wages in tandem with the

rise in inflation have been met so far with only limited

success; real disposable household income has thus been

declining, and a positive wage/price spiral has yet to take

hold. Similarly, the substantial yen depreciation to date has

already delivered significantly easier monetary conditions,

but further aggressive moves could actually serve to

dampen consumer and (non-exporter) business sentiment

and activity. It is thus not evident that an upsizing of the

Bank of Japan’s asset purchases would be helpful,

especially if it were to lead to another large yen

depreciation. In this environment, structural reforms may

become politically more difficult, but they remain key to

raising potential growth.

While markets appear to be getting used to lower

growth ahead in China, the adjustment is still far from

complete. The recent Chinese slowdown has so far

coincided with still buoyant employment prospects;

however in the event that labor market conditions were to

worsen—a risk flagged by recent PMI data—Chinese

policy makers may once again be pushed into more

aggressive stimulus. Yet, given the already over-levered

state of the economy, financial stability risks would further

-1%

0%

1%

2%

3%

4%

5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

ECB Target

Global Economic Outlook

Page 6

increase following such stimulus. The Chinese authorities

have correctly identified the need for structural reforms to

make their growth model more sustainable, and after some

delays, we see some momentum building to press ahead

with reforms more vigorously, and given the potential near-

term economic costs of reforms (e.g., related to eliminating

over capacity), we stick with our below-consensus growth

call.

Although growth in EM has held up, DM monetary

policy normalization could well deliver another stress

test of the sustainability of EM growth models. May

2013’s “taper tantrum” sell-off has served as a reminder of

the importance of capital inflows for major EMs, with the

so-called “Fragile Five” (Brazil, India, Indonesia, South

Africa, and Turkey) having been especially affected. While

some of these have made progress in boosting their

resilience, South Africa and Turkey, in particular, have

lagged, while other EM and frontier markets have let their

guard slip since.

Finally, geopolitics remains the wild card. In addition to

hot spots in Ukraine and the Middle East, popular

discontent with the Chinese authorities’ plans regarding

future Hong Kong elections has brought the potential for

political uncertainty into sharper focus. Moreover, political

uncertainty is not constrained to EMs, as highlighted by

the recent Scottish independence referendum and ongoing

disagreements on Catalonia’s future path. Markets,

perhaps helped by very easy global monetary conditions,

have so far taken a very benign view of these risks, but

that could change.

Q4 2014 Sector Outlook

Page 7

Sources of data on this page: U.S. corporate bond returns, Barclays U.S. Corporate Bond Index; European corporate bonds, Markit iBoxx.

U.S. and European Corporate Bonds U.S. investment grade corporate bonds posted a flat return

in Q3 as heavy new issuance and event risk weighed on

the market, while European corporate bonds advanced as

interest rates trended lower across the eurozone. U.S.

corporate bond spreads widened by 12 bps in Q3 to 112

bps over similar-maturity U.S. Treasuries—just shy of

year-end 2013 levels—while European spreads tightened

by 2 bps to 81 bps over swaps.

Total Return Spread Change OAS

Q3 YTD Q3 YTD 9/30/14

U.S. Corporate

-0.08% 5.60% +12 bps -2 bps 112

European Corporate

1.81% 6.77% -2 bps -17 bps 81

Represents data for the Barclays U.S. Corporate Bond Index and IBoxx Euro Corporate Bond Index. Sources: Barclays and IBoxx Markit, as of September 30, 2014. Past performance is not a guarantee or reliable indicator of results. An investment cannot be made directly in an index.

U.S. Corporate Bonds

Fundamentals in the U.S. corporate bond market held

steady at decade-high levels in Q3 despite a noticeable

pick up in mergers and acquisitions (M&As) and

shareholder-friendly activities. Corporate revenues rose,

earnings growth accelerated, and free cash flow remained

high. Corporate management appeared more optimistic

with many firms projecting an increase in second half 2014

earnings.

On a more challenging note, new issuance remained

heavy, on track to post a record for the third consecutive

year. Capitalizing on the low-rate environment, a majority

of new issue proceeds were used to refinance existing

debt or to finance shareholder dividends and share

buybacks. Some proceeds are being held as cash for

future use. New issuance earmarked for capital

expenditures trended higher, but remained below the pace

of prior economic recoveries and credit cycles.

Also unlike prior cycles, leveraged buyout volume has so

far been minimal. Instead, event risk has centered on

shareholder-friendly activities and M&As, which continued

to build in Q3 and resulted in sharply higher spreads for

some issuers, including Medtronic and Lorillard (M&A

related) and Walgreens and Kinder Morgan (shareholder

activist initiatives). Thus far, however, leverage for

industrial companies as a whole has risen only modestly,

and most announced M&As have used financing

structures designed to maintain investment grade ratings.

Going forward, we expect M&As to become more

aggressive. For example, some companies have been

forming REITs and Master Limited Partnerships, which

generally involve more leverage, to financially engineer

higher equity valuations.

Likewise, we expect activist investors to remain focused

on unlocking value for shareholders, including splitting or

spinning off business divisions, which could potentially

weaken credit profiles. As a result, we remain underweight

industrials in favor of the financial sector, particularly

money center banks, which trade about 20 bps wider than

industrial bonds and are generally a safe haven from event

risk. Importantly, most money center banks appear to be

on solid footing and remain focused on maintaining or

improving their credit ratings in light of new government

capital requirements and regulations.

Within the industrial sector, we are finding value in select

chemical, auto, and pipeline companies, but are more

cautious on energy companies given lower oil prices. We

continue to favor BBB-rated bonds in shorter maturities as

well as longer-maturity bonds that should benefit from

increased demand from insurance companies and pension

plans that are implementing a derisking path. We favor

taxable municipals, which have performed well this year

and are less vulnerable to event risk, but acknowledge

reduced liquidity in the sector.

We remain modestly constructive on U.S. corporate bonds

in the current environment, especially given the recent

back-up in spreads to year-end 2013 levels and the

prospect that spreads should tighten again given the

strong fundamental backdrop and improving U.S.

economy. Although spreads may be at risk if interest rates

rise suddenly, we believe today’s market is similar to the

mid-1990s and 2003 to 2006 period when spreads held at

lower levels for an extended time period.

Q4 2014 Sector Outlook

Page 8

Sources of data on this page: European corporate bonds, Markit iBoxx; All high yield, BofA Merrill Lynch, all leveraged loans, Credit Suisse

European Corporate Bonds

European corporate bonds outperformed most other fixed

income sectors in Q3, up +1.81%, as the European

Central Bank took further steps to revive the region’s

stalling economies and derail a deflationary spiral.

Economic growth ebbed to near recessionary levels during

the period, spurring the ECB to cut interest rates further

and initiate its first quantitative easing program, targeting

covered bonds, beginning in mid-October.

Market technicals for European corporate bonds remained

strong throughout the period as issuers sought to lock-in

historically low funding rates and investors sought

securities that pay more than ultra-low-yielding

government bonds. In this “search of yield” environment,

many higher-yielding sectors, including bonds from

peripheral issuers and select banks, performed best.

In Q4, we look for central bank policy to remain a key

driver of market sentiment. Despite slower economic

growth, corporate earnings have generally been favorable

given managements’ efforts to trim costs and repair

balance sheets in recent years. Additionally, many

European corporate issuers have a global rather than

Euro-specific focus, which reduces risks associated with a

further slowdown. That said, some companies have grown

more cautious in their forward outlooks.

Heading into Q4, we continue to focus on issuers in the

UK and Northern European regions rather than bonds in

peripheral countries where spreads have compressed

sharply. We favor European industrials, including

regulated companies with solid balance sheets, such as

electrical grid, and toll road and airport operators, over

financial issuers. In the banking sector, we prefer issuers

outside of the eurozone, especially now that many French

and Spanish bank issues are trading near their highs for

the year.

We remain cognizant of geopolitical and event risks that

may buffet the European market in Q4, including the pace

of economic growth, ongoing conflict in Russia/Ukraine,

and a pick-up in event risk and M&As, which are still below

U.S. levels and have not appeared to have a negative

effect on bond holders.

In global portfolios, we are implementing our most

attractive ideas from the U.S. and Europe: an overweight

in U.S. issuers, favoring financials over industrials; as well

as select European issuers, favoring industrials over

financials. We continue to focus on BBB-rated shorter

maturities, U.S. taxable municipals, and are taking

advantage of temporary yield discrepancies between U.S.

and European issues. For example, shorter-maturity

European corporate spreads are considerably more

attractive now than similar-maturity U.S. spreads.

OUTLOOK: Mildly positive given higher spread levels,

healthy fundamentals, and the potential for spreads to

tighten again. Still favor select U.S. money center banks

and financials.

Global Leveraged Finance Despite periods of volatility in Q3, fundamentals in the

global leveraged finance sector remained relatively solid,

and, looking ahead, default expectations remain

historically low. Recent spread widening, particularly in the

U.S. high yield market, has been mostly technical and the

result of mutual fund outflows.

While concerns about tightening monetary policy in the

U.S. could spark subsequent rounds of outflows, we

believe that the continuation of solid fundamentals and

investors’ ongoing search for yield could lead to positive

total returns in Q4 amid renewed spread tightening and the

income from relatively attractive yields.

Total Return Spread Change OAS

Q3 YTD Q3 YTD 9/30/14

U.S. High Yield -1.92% 3.61% +31 bps -16 bps 384 bps+

European High Yield

-0.73% 4.71% +33 bps -2 bps 359 bps

U.S. Leveraged Loans

-0.33% 2.43% +41 bps +16 bps 497 bps*

European Leveraged Loans

0.32% 2.21% +35 bps -7 bps 486 bps

*Represents discount margin assuming a four-year life

Q4 2014 Sector Outlook

Page 9

Sources of data on this page: Loans, Credit Suisse. U.S. and European high yield, BofA Merrill Lynch. Default information from Moody’s Investors Service.

U.S. High Yield

Flows into the U.S. high yield market wavered throughout

Q3 and largely dictated the direction of spreads. The

quarter started with $18 billion of outflows through the first

week of August, which pushed spreads nearly 100 bps

wide of the year-to-date tights that were reached in late

June. After a rally in the latter half of August, a heavy new

issuance calendar also contributed in pushing spreads

wider in September.

Overall, high yield mutual funds experienced outflows of

$18 billion during the quarter, bringing their year-to-date

outflows to $13 billion, well above the $4.7 billion in

outflows in all of 2013.

The flow and spread volatility carried over to the supply

side as well with the primary market’s 15 deals in August

totaling $4.9 billion, which was the lowest monthly dollar

volume in three years. After volume rebounded in

September, year-to-date volume stood at $286 billion,

slightly behind the 2013’s record pace.

With periodic market volatility, the higher-quality BB sector

outperformed in Q3 with a return of -1.4%. It’s a similar

picture year-to-date as the 4.5% return for the BB segment

has outpaced the B and CCC segments by 150 bps and

226 bps, respectively.

From a fundamental perspective, there was little to

indicate the sector’s volatility during the quarter. Corporate

profits remained strong as aggregate revenue and

earnings within the S&P 500 Index rose 4.4% and 9.3% in

Q2. In addition, the issuer weighted upgrade/downgrade

ratio for the high yield sector ended at 1.42, marking a full

year above the 1.0 level, according to Bank of America.

Despite concerns of companies re-levering due to their

relatively easy access to the market, fundamentals have

remained solid in 2014 as net leverage ratios fell to 3.5

times in Q2, which was the lowest level since Q4 2012,

and net interest coverage rose slightly in Q2 to 4.0 times

from 3.9 times. Although the U.S. high yield default rate is

expected to tick higher to 2.7% over the next year, led by

the consumer services sector, that level remains well

below the long-term historical average, according to

Moody’s Investors Service.

U.S. Leveraged Loans

While U.S. leveraged loans also experienced retail

outflows in Q3, demand from collateralized loan

obligations (CLOs) continued to buoy the sector as its flat

performance outpaced U.S. high yield by 159 bps during

the quarter. Loans’ relatively flat performance is more

evident from a year-to-date perspective as the sector

continued to trail high yield by 118 bps.

After a prolonged streak of weekly inflows that lasted

nearly two years, the leveraged loan sector has put

together a new streak as the sector experienced outflows

for 22 out of 24 weeks as the quarter ended. The $7.7

billion in Q3 outflows brought the year-to-date outflow total

to $6.8 billion, compared with $63 billion of inflows in 2013.

Despite the retail outflows, demand from CLOs has

remained consistent this year as 193 U.S. issues totaling

$101 billion priced through Q3, eclipsing the $87 billion

that priced throughout all of 2013. The CLO issuance

carried over to the loan market as year-to-date issuance in

the primary market reached $409 billion.

Looking ahead, we expect CLO demand to continue

offsetting retail redemptions, thus providing further support

for the asset class.

European High Yield

Performance in the high yield sector was weaker in Q3 as

the European market posted a return of -0.73%, albeit still

ahead of the U.S. market’s return. The main

underperformance came at the lower end of the quality

spectrum as CCC's in particular underperformed. Spreads

in the European high yield market widened to 359 bps, up

from 350 bps at the end of Q2.

Whilst year-to-date issuance reached record levels at

€102.8 billion through Q3 (issuance was €67.2 billion in

2013), the pace of issuance changed markedly in Q3 and

was flat to Q3 2013 at about €18 billion. The flat pace of

issuance was attributed to more nervousness over the

underlying economic picture in Europe and the

Q4 2014 Sector Outlook

Page 10

Sources of data on this page: European loans, Credit Suisse. Emerging markets debt, JP Morgan.

underperformance of new issues that came to the market

in July.

From a sector perspective, chemicals, financials and

gaming/leisure were notable outperformers in Q3, while

retail, food, and energy underperformed. Most sectors

posted negative returns during the period.

Looking ahead, we see little risk of rising European

interest rates in the short to medium term. However,

economic data out of the eurozone were generally

disappointing in Q3 and point to increasing headwinds,

especially in the core. Also, corporate results announced

in Q3 showed increasing pressure on corporate earnings,

adding to the negative sentiment that grew towards quarter

end.

The fundamental outlook in terms of economic and

corporate data has become more challenging, but with a

backdrop of ECB asset purchases and fiscal easing,

demand for higher yielding assets should remain. The

downside risk to the outlook would be for further

disappointing economic data out of the eurozone’s core,

an unexpected peripheral sovereign shock, or broader

geopolitical issues, such as those involving Russia and

Ukraine.

Overall, we are constructive on European high yield.

Although we believe volatility could increase, there is the

capacity for spreads to tighten as the sector remains

underpinned by a search for yield in a low interest-rate

backdrop. In the medium to longer term, it will likely pay to

be selective in asset selection as pressure on

fundamentals potentially increases, especially in a low-

growth—or possibly deflationary—environment.

European Leveraged Loans

Although the European leveraged loan market

underperformed its U.S. counterpart, it remained in

positive territory with a return of +0.32% during the third

quarter. It is not uncommon to see less volatility in loan

prices relative to high yield when the underlying market is

more volatile, and indeed this was the case again in Q3.

Despite gross new issuance of €81 billion year-to-date,

there was a net contraction of €2 billion in the institutional

loan market due to a heavy flow of repayments. There is

still a generally robust level of demand for new issue

loans, partly driven by the ramping up of new CLOs.

However, with increased nervousness over the economic

outlook for the eurozone and pressure on underlying

corporate earnings, there has been some pullback,

providing improved spreads and terms as a result.

Going forward, we see default rates in the European

leveraged loan market remaining elevated compared to

bonds due to the tail effect of highly levered deals with

serial defaulters from previous years. Excluding this tail

effect, the underlying default rates will likely remain below

long-term averages. Estimates for 2015 are within the

range of 1-3% for European leveraged loans.

OUTLOOK: Positive with expectations for further spread

tightening considering minimal default concerns, limited

new issuance, constructive M&A activity, and relatively

attractive spreads compared to expected

default losses.

Emerging Markets Debt Following a strong first half of 2014 (+3.7% in 1Q, +4.8%

in 2Q), the emerging markets (EM) debt sector saw muted

returns in Q3 primarily due to EM growth concerns,

China’s specific factors, the strong dollar/commodity price

weakness, geopolitical pressures, idiosyncratic country

factors, and more recently, Fed policy expectations.

Total Return Spread Change OAS

Q3 YTD Q3 YTD 9/30/14

E.M. Hard Currency

-0.59% 8.02% +30 bps -9 bps 299 bps

E.M. Local Currency (Hedged)

-0.66% 2.10% +20 bps -11 bps 6.74%

E.M. FX -3.93% -1.71% +51 bps -76 bps

E.M. Corporates -0.09% 6.24% +16 bps -12 bps 298 bps

Source: J.P. Morgan

Q4 2014 Sector Outlook

Page 11

Sources of data on this page: Emerging markets debt, JP Morgan.

Smaller issuers that trade at relatively attractive spreads

and are less widely held performed well in Q3. Examples

include issuers in Central America and the Caribbean

(Belize +8.55%, Honduras +4.92%), Africa (Zambia

+4.04%, Ghana +4.51%) and Iraq (+2.19%). While the

credit fundamentals of these countries are not particularly

noteworthy, they offered less correlated opportunities, and

they do not face external liquidity pressures in the near

term. On the other hand, the most significant

underperformers were Venezuela (-16.46%) and Ukraine

(-9.36%). Corporate EM debt marginally outperformed in

Q3, while EM local hedged returns were impacted by

negative returns in EMFX despite a more neutral/dovish

tone from EM central banks.

From the perspective of the global backdrop and EM

specific macro factors (including slowing growth in China,

lower commodity prices, and continued tensions in

Ukraine/Russia), it is reasonable to question whether or

not we will see a repeat of the 2013 taper tantrum—a

period when EM underperformed.

We expect the global economic backdrop—characterized

by moderate GDP growth and credit demand, low inflation,

and high public and private sector leverage—to keep

developed market interest rates at levels lower than those

currently implied by the forward rate markets. More

generally, we expect this low interest-rate environment to

be accompanied by a search for yield that may not only

cap long-term interest rates, but also compress credit

spreads. However, there could be sell-offs, such as the

one that occurred during 2013’s taper tantrum. As has

happened in the past, these sell-offs often present

opportunities.

In this environment, the “Fragile Five” and some other

emerging market countries will likely carry some risk of

capital outflows and market sell-offs. While policymakers in

current account deficit countries responded to the

pressures in the market in 2013 with interest rate hikes, FX

weakness will likely be tolerated to a greater extent going

forward, and, therefore, we are more cautious on EM

currencies. The growth outlook in EM is much more

muted, and because inflation pressures are more benign,

EM central banks have a more neutral or dovish bias. After

elections in India, Indonesia, Turkey, South Africa, and

Brazil (the Fragile Five)—the latter of which will hold

elections in early October—there may be new

governments and policymakers at the central banks in

these countries. As such, there is the scope for some

tightening in fiscal policy to help address structural and

market challenges.

EM debt spreads are still elevated relative to the levels

prior to the 2013 sell-off, and while we are cautious in the

short term given the potential for a market correction, we

believe spreads have the ability to tighten as behavior over

the past year has shown that there is still demand for

assets with attractive spreads. EM investment grade

sovereign spreads traded about 80 bps wider than U.S.

investment grade corporates at quarter end, and EM high

yield sovereign spreads were even wider to U.S. high yield

corporate bonds. Historically, EM sovereigns have traded

through the U.S. corporate bond markets.

There are opportunities in countries and quasi-sovereigns

with improving fundamentals, such as those in Mexico and

Indonesia. Other opportunities include a number of storied

credits from the sovereign perspective that have the

potential to be solid performers in Q4, including Argentina,

Venezuela and Russia. While there are clearly higher risks

with these names, valuations and our understanding of

idiosyncratic factors suggest value. In spite of the default

on New York Law bonds in Argentina, returns are still

positive, reflecting expectations that a solution will be

reached over the next year, curing the default. Under such

a scenario, the upside potential is high, especially

considering the supportive technical environment and the

high probability of a change in government next year.

In Venezuela, the dramatic underperformance since July

reflects concerns about its ability to service near-term debt

maturities given the severe deterioration of the economy

and the lack of adjustment amid weak oil prices and low

reserves. While the ability to pay has been compromised,

as an oil exporting country with the willingness to pay,

valuations compensate for the risks. The conflict in the

Ukraine has clearly impact Russian assets as the imposed

sanctions have pressured spreads while the economy has

slowed. Given Russia's strong external position, however,

Q4 2014 Sector Outlook

Page 12

Sources of data on this page: Emerging markets debt, J.P. Morgan. Municipal bond returns, Barclays; Municipal bond supply, J.P. Morgan.

the sanctions imposed by the West have yet to impact the

sovereign's ability to pay.

We still hold a constructive outlook on EM corporates. We

estimate that on average, when evaluated by rating

category, EM corporates have a spread cushion relative to

similar-rated U.S. industrial corporates. For example,

single A-rated issues traded approximately 40 bps cheap,

BBB-rated and BB-rated issues traded approximately 75

bps cheap at quarter end, even after the backup in the

U.S. high yield sector. Given this cushion, we expect EM

corporate spreads to tighten. Often, the credit metrics of

EM corporates in select industries are stronger than those

in developed markets. In addition, the supply pipeline of

EM corporates has continued to grow and expand,

broadening the scope of companies and industries in

which to invest. We continue to find good value from a

bottom up fundamental and relative value assessment,

focusing on companies with a strong balance sheet and a

solid business profile. We consider low BBB- and high BB-

rated credits to be the sweet spot in the market.

We believe select EM local rate markets remain attractive.

The yield differential between EM and developed markets

is still wide, and many EM central banks have either cut

rates (Chile, Turkey, Hungary), placed them on hold

(Brazil, Mexico, Indonesia), or have neared the end of their

hiking cycle (Colombia, India, South Africa). With a muted

inflation outlook, many central banks have adopted a more

neutral or dovish bias. In particular, we see attractive

levels in Brazil, with nominal yields at 12.40%. The outlook

for rates is impacted by EMFX dynamics.

In EMFX, opportunities are limited by a strong U.S. dollar

and weak EMFX, which is expected to be under pressure

given the less robust EM economic outlook. Additionally,

commodity price weakness has continued and a number of

EM countries need a weaker currency to improve their

economic competitiveness. The lone supportive factor is

that positioning is at very low levels. We are focusing on

select currencies with strong fundamentals and balance of

payment positions such as Mexico, Philippines, and other

higher yielding countries.

OUTLOOK: Modestly positive. In spite of the uncertainty

regarding higher-risk countries, Fed policy, and isolated

geopolitical pressures, higher-yielding credits have the

potential to rebound in Q4 given their valuations and

investors’ ongoing search for yield. We find EM corporates

attractive, but have less conviction towards EMFX

considering the vulnerabilities from China, the Fed, and

broader EM growth.

Municipal Bonds AAA-rated municipal bonds outperformed U.S. Treasuries

on the long end of the curve with the 30-year

Municipal/U.S. Treasury yield ratio ending Q3 at 96%,

down from 98% at the start of the quarter. High yield

municipals outperformed high grade bonds in Q3, +4.61%

vs. +1.49%, respectively. Year-to-date (YTD), lower-quality

bonds have returned +12.48%, outperforming high-grade

municipals (+7.58%). Taxable municipals returned +0.74%

in Q3 and +13.65% YTD.

High yield municipal bond outperformance was driven by

Puerto Rico credits which returned +10% in Q3 and

comprise over 30% of the high yield index. Yields and

volatility peaked in late June/early July following the

passage of the Recovery Act and subsequent downgrades

of the general obligation and other credits. In August, the

Puerto Rico Electric and Power Authority (PREPA)

reached an agreement with banks to extend bank lines to

March 2015, providing much needed liquidity. PREPA also

appointed a chief restructuring officer in September. Unlike

2013, volatility in Puerto Rico was largely contained and

did not spread to the broader municipal market.

Manageable supply ($226 billion YTD) combined with

steady demand provided a supportive technical

environment.

Solid outperformance relative to U.S. Treasuries leaves

municipal bonds at the richest levels in a year. Despite this

outperformance, we anticipate favorable technicals to

remain intact into year end. Therefore, any near-term

underperformance due to supply pressures should be

viewed as a buying opportunity. From a credit perspective,

there are several ongoing bankruptcy trials (Detroit, San

Q4 2014 Sector Outlook

Page 13

Sources of data on this page: U.S. Governments, Bloomberg.

Bernardino, and Stockton), which will garner attention and

headlines in Q4. While long-term implications regarding

the treatment of bondholders versus pensioners could be

significant, we don’t anticipate near-term trading volatility

related to these court decisions. Additionally, we anticipate

a court ruling regarding the legal challenges to Illinois’

pension reform. However, a definitive resolution is unlikely

in the short term, as the losing party is likely to appeal.

Unfunded pension liabilities remain the greatest credit risk

for certain states and localities.

As we enter Q4, we expect taxable municipal bonds to

continue to perform in line with corporate bonds.

OUTLOOK: Modestly positive. Despite the relative richness

of tax-exempts, positive technicals provide support as they

remain attractive to investors who can benefit from the tax-

exemption.

Government Related With Europe’s economy stagnating and the ECB taking

additional steps to revive growth, the notable decline in

long-term Bund yields in Q3 likely limited the increase in

other high-quality developed rate markets. Despite the

anticipation that some central banks, such as the Federal

Reserve and Bank of England, may be nearing a

tightening of monetary policy, long-term interest rates were

stable to lower throughout the quarter.

The 10-year Bund yield fell 30 bps during the quarter to

0.90% amid speculation that the ECB would eventually

adopt some form of quantitative easing to stem the threat

of deflation across the European economy. As a result of

the recent rally, we believe Bunds offer less value

compared to other high-quality, government-related

markets, although we do see some value in the 15-year

segment of the curve.

The notable decline in long-term Bund yields contributed to

the 10 bps decline in the 10-year U.S. Treasury yield to

2.50%. The decline came even with the presumed October

conclusion of the Fed’s asset purchases and the mounting

anticipation that the Fed may raise short-term rates in

2015. While long-term yields declined modestly, front-end

yields rose during the quarter, and the U.S. Treasury yield

curve flattened by 30 bps. Looking ahead, we see a

terminal fed funds rate of 2.5%-3.5% being priced into the

market over the near term and believe a significant

increase in rate hike expectations is unlikely. As a result,

most of the curve flattening observed year to date is likely

behind us. We view U.S. Treasuries as attractive versus

other high-quality, global markets, and, in particular, we

believe that the value in the five-year segment of the curve

may have reached the best level since just prior to the

Fed’s policy tightening in 2004.

Yields on Japanese Government Bonds (JGBs) remained

stable in Q3, and we see a 15-year bullet position as

attractive from a carry and rolldown perspective. We do

not see much value in the UK Gilt market as the curve

remains much flatter than comparable curves in the U.S.

or Europe, and long-term forward rates on Gilts appear

very rich.

In terms of interest rate swaps, we expect spreads relative

to Treasuries to widen with the added benefit of positive

carry.

OUTLOOK: Although we favor the more attractive spread

sectors, we see areas of opportunity within the

government-related sectors, such as the five-year segment

of the U.S. curve and the 15-year segments of JGB and

Bund curves. We expect interest-rate swap spreads to

widen.

Mortgages Agency mortgage-backed securities (MBS) posted a total

return of +0.18% in Q3, bringing year-to-date return to

+4.22%. Agency mortgages underperformed U.S.

Treasuries by -27 bps in Q3, but outperformed U.S.

Treasuries by +40 bps year-to-date.

Agency mortgages initially weakened in Q3 due to a

modest pickup in net supply, then resumed a tightening

trend as net supply declined and higher yields attracted

MBS buyers. Mortgage applications and origination

Q4 2014 Sector Outlook

Page 14

Sources of data on this page: Mortgages, Barclays.

remained light, leading investment firms to sharply reduce

their full-year net MBS supply estimates.

During the period, the Federal Reserve continued to taper

its MBS purchase program, reducing purchases to just $5

billion per month (down from $40 billion at the start of the

year). In light of recent statements from the Federal Open

Market Committee (FOMC), market participants anticipate

that the Fed will announce the end of its MBS purchase

program at the October 29th FOMC meeting. In an effort to

support the MBS market, however, the Fed plans to

continue reinvesting principal and interest payments from

its agency debt and agency MBS holdings back into the

agency MBS market. We believe this reinvestment

program will continue until the Fed begins to raise short-

term rates, most likely in mid-2015.

In Q4, we look for MBS technicals to remain challenging

given low origination levels and the potential for yield-

based buyers to increase purchases should interest rates

rise. Although overall demand will decline if the Fed fully

tapers in Q4, the ongoing reinvestment of principal and

interest into MBS is expected to remove about $20 billion

of MBS per month given the size of the Fed's $1.7 trillion

MBS portfolio. In addition, banks may need to add MBS

exposure now that the Fed's Liquidity Coverage Ratio

(LCR) rules have been finalized. Lastly, overseas buyers

may increase MBS purchases if interest rates rise.

At this time, we favor reducing TBA exposure vs.

seasoned pools as we expect dollar roll financing to

cheapen given the Fed's MBS purchase reductions.

Although some TBAs may be in demand as year end

nears, we believe positioning in seasoned pools will

improve portfolio convexity, while also offering more

attractive OAS.

OUTLOOK: Despite light MBS origination, we prefer other

fixed income spread sectors for more attractive

opportunities.

Structured Product Spreads in the structured product market were largely

unchanged in Q3, and we remain positive on top-of-the-

capital structure bonds, finding value in high-quality

segments. The absence of leverage (due to high repo

haircuts and financing levels) adds stability in this sector.

That said, collateral quality, particularly in CMBS and sub-

prime auto loans, is somewhat less pristine due to

competitive pressures on loan origination. On the

regulatory front, the SEC issued final loan-level disclosure

requirements for public CMBS, non-agency RMBS, and

auto loan and lease ABS. Loan-level disclosure will

enhance the due diligence process; however, it increases

issuer costs and potentially creates legal liability related to

privacy laws. As such, the possibility exists for a shift

toward 144a issuance, which is exempt from the new

rules. In Euro ABS, spreads tightened on the back of the

ECB’s ABS quantitative easing announcement, but ABS

bond purchases are unlikely to have an impact on credit

growth unless accompanied by ABS subordinate bond

support.

CMBS – Top-of-the-capital structure CMBS remains

attractive. Legacy 2006/2007 super senior CMBS spreads

were unchanged in Q3 and continue to trade in the swaps

(S)+75-90 bps range. New issue 10-year super senior

bonds traded several bps wider (S+ low 80s bps), and the

market is readily absorbing new issue supply, which rose

to $17 billion in Q3. Agency CMBS spreads were slightly

wider at S+37 bps. Going forward, we expect CMBS

spreads to outperform the overall fixed income market.

Commercial real estate values were up 2% and are now

only about 3% lower than their 2007 peak. The private

label conduit new issue CMBS market is projected to issue

about $70 billion in 2014, while Fannie Mae and Freddie

Mac are projected to originate approximately $45 billion

backed by multi-family properties (down about $15 billion

from 2013). Delinquencies in 2006/2007 CMBS pools

remain high, but are improving. We believe losses will be

limited to subordinate bonds, such as AM, AJ, and lower

classes.

Q4 2014 Sector Outlook

Page 15

Sources of data on this page: Structured product, Barclays; CLOs, Prudential Fixed Income.

Consumer ABS – We remain positive on consumer ABS

as a low-beta, high-quality trade as consumer credit

fundamentals are strong. Spreads on benchmark credit

cards and auto ABS were 5 bps wider in Q3 (e.g., 5 year

AAA cards were LIBOR (L)+40 bps). New issue volume is

approximately $160 billion so far this year, slightly higher

than last year’s pace.

Non-Agency Residential Mortgages – Senior RMBS prices

were generally range bound in Q3. Fundamentally,

mortgage defaults are moderating and home prices are

appreciating. We expect home price increases to slow in

2014 to roughly 4% to 6% after two years of double digit

gains. Bond technicals remain positive as annual

paydowns are approximately 15% of outstandings and the

new issue market is de minimus as bank portfolio whole

loan bids provide better execution than securitization. We

continue to favor 2005 and prior sub-prime bonds with

significant enhancement, which trade in the L+100-200

bps range. We also find value in select 2006/2007 vintage

senior bonds and re-remics of those bonds, which trade at

L+200-300 bps.

CLOs – AAA-rated U.S. collateralized loan obligation

(CLO) spreads widened marginally in the primary market

on the back of robust supply. Primary U.S. (CLO 3.0)

spreads widened 4 bps to L+149 bps, while secondary

amortizing CLOs tightened to L+70 bps. New issue

spreads widened despite the continued inflow of new

entrants into the CLO market.

In Europe, spreads on AAA-rated CLO primary deals

tightened by 15 bps on limited activity to L+125 bps. Akin

to the U.S., European new issues have been stymied by

regulations and a limited buyer base, but recently

benefitted from spread compression in other ABS markets.

We continue to believe CLOs offer outstanding relative

value in both the primary and secondary markets. In the

primary U.S. and European markets, investors in AAA

tranches continue to enjoy a favorable environment to

negotiate spreads and covenants.

OUTLOOK: Positive on ‘top of the capital structure’ bonds.

Q4 2014 Sector Outlook

Page 16

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Performance for each sector is based upon the following indices:

U.S. Investment Grade Corporate Bonds: Barclays U.S. Corporate Bond Index

European Investment Grade Corporate Bonds: iBoxx Euro Corporate Index 100% USD Hedged

U.S. High Yield Bonds: BofA Merrill Lynch U.S. High Yield Index

European High Yield Bonds: Merrill Lynch European Currency High Yield ex Finance 2% Constrained Index

U.S. Senior Secured Loans: Credit Suisse Leveraged Loan Index

European Senior Secured Loans: Credit Suisse Western European Leveraged Loan Index: All Denominations Unhedged

Emerging Markets USD Sovereign Debt: JP Morgan Emerging Markets Bond Index Global Diversified

Emerging Markets Local Debt (Hedged to USD): JPMorgan Government Bond Index-Emerging Markets Global Diversified Index

Emerging Markets Corporate Bonds: JP Morgan Corporate Emerging Markets Bond Index Broad Diversified

Emerging Markets Currencies: JP Morgan Emerging Local Markets Index Plus

Municipal Bonds: Barclays Municipal Bond Indices

U.S. U.S. Treasury Bonds: Barclays U.S. U.S. Treasury Bond Index

Mortgage Backed Securities: Barclays U.S. MBS - Agency Fixed Rate Index

Commercial Mortgage-Backed Securities: Barclays CMBS: ERISA Eligible Index

U.S. Aggregate Bond Index: Barclays U.S. Aggregate Bond Index

2014-2550