3rd QUARTER OUTLOOK July 2016

The Fixed Income Review Market Outlook

Spotlight: The Rationale for Underweighting HY Energy

In this edition of PGIM Fixed Income’s Quarterly Outlook, Robert Tipp, Chief Investment Strategist, takes a big-picture look at the factors that have influenced recent events and contributed to the historic decline in global yields (page 3, click here to read). Jürgen Odenius, Chief Economist and Head of Macroeconomic Research, examines a global economic stabilization that was largely overshadowed by developments in China and Europe (page 5). He also provides our latest economic views on Brexit (page 7).

While the advertised spread and yield on the energy sector looks attractive, there are few opportunities due to a considerable amount of noise from broken capital structures and companies that will default even if crude oil prices are materially higher (page 10, click here to read).

EM Volatility—Traders’ Nightmare, Investors’ Friend The long-term benefits of being an emerging markets debt investor rather than a trader are clear. Volatility within the sector often leads to selloffs that overshoot fundamental value, providing patient investors with sound buying opportunities (page 12).

Sector Views Corporate Debt (page 8; click here to read): Our positive view is based on wide spread levels, steady U.S. economic growth, and quantitative easing effects, although global headwinds could keep risk premia high.

Recent White Papers and Videos

Global Leveraged Finance (page 9): We hold a constructive

The following material is also available at PGIMFixedIncome.com.

view of the leveraged finance markets. In U.S. high yield, we favor intermediate duration, BB-rated, non-commodity credits. European high yield spreads remain attractive amid investors’ search for yield, the ECB’s corporate debt purchases, and low default and loss expectations.

Michael Collins, CFA, Managing Director and Senior Investment Officer, looks at how the current credit cycle “rhymes” with those in the past, while also presenting distinct nuances in a white paper entitled, The Global Credit Cycle: What Inning Are We In (Or, What Game Are We Even Playing)?

Emerging Markets Debt (page 11): The sector’s resiliency in the wake of the Brexit vote underscores its attraction to investors seeking yield and spread, particularly in markets with less exposure to the situation in the UK. Bouts of volatility remain opportune times to increase exposure.

Municipal Bonds (page 12): Attractive taxable equivalent yields and a favorable technical environment support our modestly positive view.

Ellen Gaske, PhD, CFA, Lead Economist for the G10 Economies, examines the outlook for upcoming Fed action following some mixed messages from the U.S. economy in the white paper, The Fed’s Moving Targets.

Global Rates (page 13): Many of our fundamental views remain in place—i.e. U.S. risk premia appears high on a global context—yet the magnitude of the post-vote move led us to reduce duration in the U.S. Uncertainty has become a market fixture that could lead to volatile swings, which supports our selective view based on the opportunities that may arise .

Mortgages (page 14): Our outlook on the mortgage sector has changed as we now maintain an overweight in mortgages vs. swap spreads.

Structured Product (page 14): We maintain a very positive outlook on top-of-the-capital structure bonds. Negative yields in Japan and Europe could tighten AAA CMBS and CLO spreads as investors seek more yield on high quality bonds. We remain positive on GSE credit risk mezzanine cashflows. And we are negative on CMBS and CLO mezzanine tranches .

Page 2

Giancarlo Perasso, Senior Economist for the CEEMA Region, and Todd Petersen, Emerging Markets Debt Portfolio Manager, discuss how African countries are reacting to recent volatility in the commodities markets in a video entitled Africa’s Commodity Response.

Bond Market Outlook It Ain't Pretty Out There, But It's Not Bad For Bonds Compared with others, this introduction to our Quarterly Outlook may be a bit short on detail, but that is by design: there are too many intersecting big picture trends to dive into, any one of which would be a rabbit's hole labyrinth unto itself. There's plenty of that in the economics and individual sector coverage that follows. At the end of the day, however, our overall prognosis for the bond market hasn't changed: don't let the low yields fool you. In these troubled times, a fixed income investment strategy that searches for safe yield should result in respectable returns over the intermediate to long run. The backdrop is ugly; but the bond market still has opportunity written all over it.

Not A Bad Quarter As shown in the following returns table and the “Quarter in Pictures,” after bottoming midway through Q1, commodities continued to rally and the U.S. dollar was relatively contained as the Federal Reserve's rate hike trajectory fell further. As the negative interest-rate policies (NIRP) and aggressive bond buying programs of the Bank of Japan and the European Central Bank powered ahead, JGBs and Bunds staged spectacular QE-driven rallies, as did long UK gilts, thanks to economic slowdown fears brought on by the referendum’s historic “leave” outcome. While a laggard, U.S. yields also declined with the general global trend along with some evidence of moderating U.S. growth.

While this year’s equity market returns have generally been range bound, trading patterns in Europe and Japan continue to suggest that the NIRP and the aggressive bond buying programs of the ECB and BoJ may be negatively impacting their financial institutions.

Brexit: One Manifestation of a Global Phenomenon While we could go on endlessly with the detailed causes and possible implications of the Brexit vote, we would be at risk of diving into the details while missing the big picture: globally, not just in the UK, there is not enough growth, voters are dissatisfied with its distribution, and policy makers are at a loss to fix the situation. The result: voter protest and political fragmentation that is causing strains within and across national boundaries. Intra-country, we’ve witnessed the rise of The Donald in the States, the emergence of nationalist/populist parties across Europe, and intensifying breakaway situations, i.e. the Catalans and Scots. Inter-country, a host of EU countries will undoubtedly muse about following the UK's lead (so far only the President of the Czech Republic has gone public that a referendum, in his view, should be held). While the economic and sector discussions that follow will touch upon the macro- and micro-economic impacts, the big picture view of the economic and policy backdrop we face is stark. Characterized by muted growth and inflation, widespread high debt and deficits, as well as various structural impairments to boot, the situation hardly seems to be improving despite the aggressive response from key central banks featuring negative rates and aggressive bond buying. There are simply too many structural headwinds.

Performance by Sector What’s Next? More of the Same

Total Return (%)

Global Aggregate U.S. Aggregate U.S. Treasuries Municipal Bonds Mortgage-Backed (Agency) CMBS U.S. IG Corporate Bonds Long IG Corporates U.S. Leveraged Loans U.S. High Yield Bonds EM Debt Hard Currency EM Local (Hedged) EM Currencies European IG Corporate European Leveraged Loans European High Yield Bonds

Q2 2016 2.89 2.21 2.10 2.61

YTD 2016 8.96 5.31 5.37 4.33

2015

2014

2013

2012

-3.15 0.6 0.8 3.3

0.59 6.0 5.1 9.1

-2.60 -2.0 -2.8 -2.6

4.32 4.2 2.0 6.8

1.11

3.10

1.5

6.2

-1.5

2.6

2.24 3.57 5.52 2.86 5.88 5.02 2.06 0.34 1.57

5.92 7.68 9.06 4.23 9.32 10.31 6.01 5.81 4.08

1.0 -0.7 -4.61 -0.4 -4.6 1.2 -2.2 -7.61 -0.6

3.9 7.5 15.73 2.1 2.5 7.4 3.2 -7.03 8.4

0.2 -1.5 -5.68 6.2 7.4 -5.3 -4.2 -2.04 2.4

9.7 9.8 12.41 9.4 15.6 17.4 8.9 7.45 13.6

1.63

2.60

3.6

2.1

9.0

10.8

1.90

4.00

1.3

9.1

24.8

5.1

As we've pointed out in our previous outlooks (click here to view the Q2 2016 Outlook) and thought pieces focusing on the interest-rate outlook (click here to view The Totally Mad World of Low Rates), the feedback from the global economy remains the same: hold your disbelief in abeyance—despite all the stimulus, the world economy remains soft, suggesting NIRP and aggressive QE will be with us for some time. Against that backdrop, yields seem fated to remain quite low, and there will undoubtedly be bouts of volatility—perhaps especially so over the less liquid summer months. But over the long haul, investors that take a long-term view in their bond market positioning should continue to reap the benefits.

The Bottom Line: We expect fixed income returns to continue to surprise on the upside—especially those of the higher yielding sectors. Additionally, market volatility should provide above-average opportunities for active management.

Sources: Barclays except EMD (J.P. Morgan), HY (Merrill Lynch), Senior Secured Loans (Credit Suisse). Performance is for representative indices as of June 30, 2016. 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.

Page 3

Bond Market Outlook The Quarter in Pictures

Adjusted for currency changes, equity indices have been relatively range bound. European and Japanese financials, however, have suffered as their yield curves have bull flattened.

Yield curves continued their impressive trend of bull flattening. While the U.S. 30-year yield has declined roughly 74 bps this year, the even bigger winners were UK Gilts thanks to Brexit (30-year Gilt yields dropped by just over 1 percentage point) and, perhaps even more implausibly given their lower starting yields, the 76 and 113 bps respective declines in the 30-year Bund and JGB (end yields of 40 bps and 14 bps, respectively).

120 110 100 90 80 70 60 50 40

3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0%

S&P 500 Index MSCI EM Equity Index TOPIX Bank Index 30-yr Bund Yield 30-yr JGB Yield

TOPIX Index Euro STOXX 50 Index Euro STOXX Bank Index Source: Bloomberg

30-yr U.S. Treasury Yield 30-yr Gilt Yield Source: Bloomberg

After bottoming midway through Q1, commodities continued to rally and the U.S. dollar was relatively range bound as the Federal Reserve's rate hike trajectory continued to fall.

High yielders, such as below investment grade corporates and emerging markets debt, were the big winners thanks to a “good enough” economic picture and an aggressive bid for yield in the market. bps 950

110 100 90 80 70 60 50 40

800 650 500 350 200

U.S. Dollar Trade Weighted Index West Texas Intermediate Crude Spot Price

BofA ML High Yield Spread J.P. Morgan EMBI Global Diversified Spread

Source: Bloomberg 4.5 3.5 2.5 1.5 0.5 2016

2017 2018 Fed Funds Forecast September '15 Fed Funds Forecast December '15 Fed Funds Forecast March '16 Fed Funds Forecast June '16

Longer Run

Source: Federal Reserve

Page 4

Source: Bloomberg.

Global Economic Outlook Macro Stabilization Overshadowed by Brexit and China Risks For most of Q2, until the Brexit surprise in late June, fears over the global economy receded, amidst considerable credit stimulus from China, a stronger-than-expected Q1 GDP print from Europe, and signs that the Japanese economy is doing somewhat better than expected. As the Federal Reserve continued to sit on its hands and an apparent truce in currency wars took hold, dollar strength and currency market volatility eased. This backdrop facilitated risk taking and a rebound in financial markets after the pronounced selloff in the first quarter. Nevertheless, the Brexit surprise—discussed in detail in the following box—has served to highlight political complexities in Europe and dampen the European Union’s growth outlook. Furthermore, the likely tapering of stimulus in China would also curtail growth. Brexit-related bouts of risk aversion are a prominent reminder that the global financial system’s excess liquidity tends to boost volatility.

U.S.—Late Cycle Recovery In the U.S., May’s disappointing non-farm payrolls report rekindled recession fears. However, private sector leverage, be it among households or non-financial corporations, does not show signs of strain, although corporate leverage has been rising. Likewise, private sector fixed investments also remain low relative to history. The apparent absence of excess capacity and leverage suggests that the odds of a recession 1 over the near term remain low. As the labor market continues to tighten, hiring, as captured by non-farm payrolls, has begun to slow. However, wage pressures have so far remained muted. The Phillips curve—the relationship between wage growth and the unemployment rate—has remained flat. While falling unemployment has not yet had a discernible impact on wages, it is conceivable that this relationship will change, especially in the context of continued dismal productivity growth and attendant upward pressures on unit labor costs. Firms may have found it difficult to cut nominal wages during the height of the Global Financial Crisis (GFC). This may explain why wages have been slow to rise in its aftermath. However, as the market clearing wage begins to exceed wages paid, the nominal wage rate may yet rise. In this context, an inflation surprise cannot be ruled out, although admittedly it may seem unlikely.

Sticky CPI Vs Headline CPI 6 5 4 3 2 1 0 -1 -2 -3

Sticky CPI

Source: Federal Reserve Bank of Atlanta, Haver Analytics

Euro Area—Monetary Policy Effectiveness Reaching Its Limits Some eight years after the onset of the GFC, the euro area economy finally recovered the output losses that occurred during the crisis. However, there remains a considerable dispersion in performance. While output in Ireland and, to a lesser extent, in Germany at this point are substantially above their respective pre-crisis levels, Spain remains moderately below this level. Italy and Portugal still have to recoup 10 and 5% of their pre-crisis output, indicative of the continued rigidities in these economies. With output hovering more than one quarter below its pre-crisis level, Greece’s fate is illustrative of the difficulties that ensue when policies are not geared towards the constraints imposed by the currency union. The sluggishness of the recovery reflects in part the slow and uneven progress with deleveraging. The euro area’s output gap is unlikely to close before 2018. Combined with the low dynamism of the economy, excess capacity has continued to impede the efforts of the ECB to raise inflation closer to its de 2 facto 2% headline rate target. With both growth and inflation thus far having remained subdued, the effectiveness of the extraordinary measures taken by the ECB—most notably the combination of negative deposit rates and quantitative easing—remains in question. That said, amid steady bond purchases, 10-year Bund yields turned negative in Q2 and corporate bonds have rallied. Nevertheless, as government bond yields in core countries tended to edge lower during the quarter, they were little changed in the periphery, despite the ECB’s sizeable bond purchases. As the inflation target remains out of reach, it seems likely that the ECB will extend its purchase program beyond March 2017, the current expiration date.

As energy prices are seemingly stabilizing, the drag from their earlier collapse is soon to drop out of the CPI. However, core inflation hovers below 1% and any marked increase is likely to require a prolonged period of time. 2

Incidentally, a model run by the Federal Reserve Bank of New York estimates a probability of barely 7% as of May 2016. 1

Headline CPI

Global Economic Outlook Although liquidity and other concerns may convince the authorities to hold off from accelerating its government bond purchase program, further policy easing seems to be in the cards, given the difficulties in rekindling inflation.

ECB Bond Purchases Vs Fiscal Deficits 12 10

% of GDP

8

China—Near-Term Recovery Versus Long-term Challenges

6 4 2 0

ECB Govt Bond Purchases (annualized) Fiscal Deficit (2016) Source: IMF, PGIM Fixed Income

Japan—Struggling Abenomics Just as in Europe, Japan is struggling to rekindle inflation and stimulate growth. Consumer prices (excluding fresh food), as targeted by the BoJ, again turned in the second quarter, while core inflation continued to hover just below 1%. Also just as in Europe, leverage remains elevated across key sectors of the economy, thus overshadowing the growth outlook. The appreciation of the yen, that unexpectedly set in late January when the BoJ moved—albeit half-heartedly with a “tiering” scheme—to negative deposit rates, partly emulating what the ECB had done some eighteen months prior, strongly suggests that the “exchange rate channel of monetary policy is muted when several monetary authorities are reducing interest rates 3 at the same time.”

In the second quarter, China’s economy stabilized and, as the dollar reversed some of its earlier gains, fears of a pronounced devaluation of the yuan subsided. While these developments are undoubtedly positive near term, they mask underlying challenges. The apparent stabilization of growth was largely achieved through an oversized credit stimulus. During the first quarter, the authorities injected 10% of annual GDP in various forms of credit stimulus, commonly referred to as total social financing (TSF). This credit stimulus is on par with the size of the economy of the Netherlands and, if it were to be sustained throughout the year, it would be on par with that of Italy. These magnitudes illustrate that this pace is unsustainable. Similarly, the exchange rate has continued to depreciate—though in a steady and orderly fashion—against the dollar as well as, more importantly, by some 5% in effective, trade weighted terms.

Total TSF (% GDP, 3MMA) 70% 60% 50% 40% 30% 20% 10%

The BoJ’s quantitative easing program has been proceeding apace. By now, the BoJ holds more than one third of all government bonds. While the size of the program already exceeds 35% of GDP, the sizeable debt stock of Japan’s general government suggests scope for additional quantitative easing.

RMB + FX Local Government Off-Balance Credit Corporate Bond Total TSF

Size of QE Programs Relative to GDP

Source: China National Statistics, Haver Analytics, PGIM Fixed Income:

40% 35% 30% 25% 20% 15% 10% 5% 0%

It is noteworthy, however, that notwithstanding this substantial policy support, growth barely stabilized. This suggests that a large share of the stimulus may have been allocated as refinancing and possibly as loss- financing. Ultimately, these observations underscore the need for comprehensive structural reforms, especially among state-owned enterprises that operate in sectors with large excess capacity. The authorities are finalizing a reform strategy and its implementation will be key. Source: OECD

3

See OECD Economic Outlook, Volume 2016 Issue 1. Page 6

Global Economic Outlook Brexit—Although Clouding the Outlook, Its Macroeconomic Impact Seems Manageable The fateful Brexit decision on June 23rd has generated considerable uncertainty and thereby, once again, clouded the global outlook. Rather than falling prey to popular doomsday scenarios, this synopsis attempts to provide some structure to the debate. It concludes that the macroeconomic fallout should be manageable, if not limited. Our base-case scenario envisages that the uncertainties emanating from the Brexit decision will push the UK economy into a downturn in short order, if not outright recession. However, the attendant spillover effects are likely to remain overall contained. The UK downturn will undoubtedly spillover to the euro area in the near term, while less favorable access to EU markets would hamper trade, at the margin, over the medium term. In another clear indication that the Bank of England is prepared to stand by as the British pound finds its new equilibrium in the foreign exchange markets, Governor Carney indicated that policy easing was likely. Against the background of a near-historic current account deficit of about 7% of GDP, a likely slowdown of foreign direct investment (FDI) inflows and a possible repatriation of capital, the GBP is likely to weaken on a trend line. Nevertheless, the magnitude of the overall depreciation of the pound seems unlikely, a least in a base case, to be of such large magnitudes that it would unleash large-scale financial sector dislocations and a systemic credit event. That said, banking system exposure to the UK is large in Switzerland, Spain and Ireland.

% of Own GDP

The potential for further departures from the EU poses another prominent risk to our benign outlook. Concerns about such possibility have heightened as anti-EU parties in several countries called for referenda on their continued EU membership immediately after the Brexit vote. Although Largest Foreign Bank Claims on UK further departures cannot be ruled out, the 40% probability of such an event seems low, at least in the near term. 30% 20%

Gross exposures Net exposures

10% 0% -10%

The eastern economies in the EU, whether it is the Baltic states, central Europe, or southern eastern Europe, are all united in their desire for geopolitical stability. Furthermore, the annexation of the Crimea and the invasion of the eastern parts of the Ukraine have placed a premium on stability in the eyes of many. The desire for geopolitical stability is likely to trump the desire for optimizing the workings of the EU and regaining sovereignty in these countries.

In Europe’s periphery, any quest to leave the EU would simultaneously lead to the abandonment of the euro and the introduction of a new, national currency. Such a move would undoubtedly end the ECB bond purchase program and counteract the recent bond rally that has driven yields to near historic lows. Besides, any move to a new currency by any of the periphery states would likely result in a considerable recession and, therefore, seems unlikely, despite considerable public debate. Source: BIS, Haver Analytics

That said, European politics have become divisive and political risks—independently of the Brexit referendum—have risen both in the periphery and the core of Europe. In the core, including in Austria, Germany and the Netherlands, anti-EU parties are gaining prominence. In the periphery, the June 26th repeat elections in Spain seem to have once more resulted in a hung parliament. In Italy, Prime Minister Renzi has staked his career on the passage of his political reforms and related constitutional changes designed to enhance political stability. A referendum on these reforms is scheduled for this autumn. Should PM Renzi be forced to resign, there is a risk of early elections and of a possible electoral win of the anti-EU Five-Star Movement.

Page 7

Q3 2016 Sector Outlook U.S. and European Corporate Bonds

U.S.-based banks passed the Fed’s most recent stress tests and were approved for capital return plans, while the U.S. arms of two European-based banks did not.

U.S. corporate bonds delivered a strong return in Q2, up +3.57%, as investors’ demand for yield against a backdrop of steady, albeit modest, U.S. economic growth outweighed global headwinds. U.S. corporate index spreads tightened 10 bps during the quarter with the sector posting 99 bps in excess return to U.S. Treasuries.

Against this backdrop, we currently favor issuers in the auto, chemical, health insurance, paper, and select pharmaceutical industries. We remain focused on U.S.-centric issuers over multinationals or exporters that are vulnerable to a strong U.S. dollar. We also favor financials, primarily money center banks, given their generous spread levels and relative immunity to the event risk that is weighing on the industrial sector. We continue to look for select opportunities in the energy and metals/mining sectors. We continue to overweight lower-quality issues in shorter maturities and favor taxable revenue municipal bonds given their low credit migration risk, although this sector has generally low liquidity.

European corporate bonds also posted a positive quarterly return (+1.57%) with the European Central Bank's bond buying program providing a strong technical backdrop despite uncertainty and volatility surrounding the Brexit vote. Total Return

Spread Change

OAS

Q2

YTD

Q2

YTD

6/30/16

U.S. Corporate

3.57

7.68

-9

-10

155

European Corporate

1.57

4.08

7

3

136

Represents data for the Barclays U.S. Corporate Bond Index and Barclays European Corporate Bond Index (unhedged). Sources: Barclays as of June 30, 2016. Past performance is not a guarantee or reliable indicator of results. An investment cannot be made directly in an index.

U.S. Corporate Bonds U.S. corporate bonds continued to rally in Q2 as global quantitative easing—which now includes European corporate bonds—steered investors to the higher yields and relatively stable fundamental backdrop of the U.S. corporate bond market. Record issuance during the quarter was readily digested by both U.S. and non-U.S investors with notable demand from Japanese investors. Fundamentals remained solid overall for U.S. consumeroriented sectors that are benefitting from positive U.S. economic growth, while most commodity, energy, and metals/mining issuers have gone into full repair mode to shore up their balance sheets. During the period, nearly $50 billion of debt from these sectors was downgraded from investment grade to non-investment grade status. Across other industrial sectors, leverage continued to inch higher as lower interest rates spurred debt-financed mergers and acquisitions and share buybacks, although buybacks appear to be trending lower. U.S. financial issues came under pressure during the quarter on fears that slower global growth, including a hit to European growth following the Brexit referendum, and renewed reluctance from the Federal Reserve to raise rates, may weigh on bank earnings. There is also potential for further economic and market disarray in the event other countries in the Europe were to consider leaving the European Union. From a fixed income perspective, however, the new regulations enacted to strengthen bank balance sheets have dramatically improved banks’ capital ratios and credit quality. In fact, all of the major

European Corporate Bonds The key driver of European corporate bond returns in Q2 was the ECB's new bond buying program. The ECB also provided assurances it would remain accommodative to keep economic growth on track. Although volatility rose in the run-up to, and directly following, the Brexit vote in late June, the market quickly realized the selloff was overdone and rallied across the board. The new issue market reopened within a week after Brexit and several attractive-yielding reverse yankee issuers performed exceptionally well in the reach-for-yield environment. As the quarter ended, UK spreads were well off their widest levels but remained cheap, while bank issues lagged, most notably subordinated banks and Italian banks. European corporate issuance continued at a record pace in Q2, including strong issuance from reverse yankee issuers (primarily U.S. issuers) looking to take advantage of rockbottom yields in the UK and euro markets. Investor demand for these issues was exceptionally strong. And with the ECB expected to buy 5 to 10 billion of euro corporate bonds per month, the technical picture remains on solid ground. Additionally, fundamentals are robust, supported by generally conservative management, lower energy prices, weaker FX, and limited M&A activity to date. Near term, our strategy remains broadly unchanged. We are looking for opportunities to invest in issuers we believe are oversold, as well as in new issues with attractive concessions. We are focusing on reverse yankee issues that are priced at significant discounts to where they trade in U.S. dollars and have spread levels that more than compensate for the lack of name recognition. We remain underweight European financials and prefer Northern European issuers over peripheral country debt. Within euro-area industrials, we are focusing on regulated companies with solid balance sheets such as electrical grids and airport operators. We find value in certain corporate hybrids from stable, well-rated utility issuers and are avoiding

Page 8

Q3 2016 Sector Outlook hybrids issued to uplift ratings, including those in the telecom industry. In global corporate portfolios, we continued to hold an overweight in euro spread risk but within this bucket we are now overweight reverse yankee issuers. Our decision to reduce direct European exposure is due to the fact that many credits have experienced significant spread tightening following the ECB’s corporate bond buying announcement. Within the financial sector we remain overweight U.S. money center banks and underweight European banks. We remain focused on BBB-rated shorter maturities and U.S. taxable revenue municipals. We continue to take advantage of price dislocations and yield discrepancies between U.S. and euro bonds of the same and/or similar issuers. In the U.S. and Europe, we believe spreads remain attractive and have room to tighten but expect volatility to remain high. Key risks include slowing global growth, the effectiveness of central bank policies including negative interest rates, uncertainties surrounding the Brexit referendum, heavy issuance, tighter liquidity, and, in the U.S., event risk.

OUTLOOK: Positive given wide spread levels, steady U.S. economic growth, and quantitative easing effects. Global headwinds could keep risk premia high. Still favor U.S. money center banks.

Global Leveraged Finance While the broader Brexit reaction was initially viewed as a riskoff event, the general sentiment following the vote was that the U.S. and European leveraged finance markets remained more resilient than anticipated. The uncertainty in Europe supported the relative stability in U.S. assets, and both sectors were said to be bolstered by the limited options for investors seeking attractive yields and spreads. Although buyers emerged as both markets encountered pressure following the vote, there was very little trading at lower prices given the general lack of forced sellers. Total Return

Spread Change

OAS

Q2

YTD

Q2

YTD

6/30/2016

U.S. High Yield

5.88

9.32

-84

-74

621

Euro High Yield

1.90

4.00

-8

-20

500

U.S. Leveraged Loans

2.86

4.23

-39

-61

L+581

Euro Leveraged Loans

1.63

2.60

-5

19

L+536

Sources: BofA Merrill Lynch and Credit Suisse as of June 30, 2016. Past performance is not a guarantee or reliable indicator of results. An investment cannot be made directly in an index. European returns euro hedged.

U.S. High Yield and Leveraged Loans The U.S. high yield market posted another quarter of strong returns in Q2, driven by commodity names and the CCCportion of the market.

In spite of the strong performance during the quarter, energy and metals & mining names continued to account for most of the sector’s default activity. Including distressed exchanges, the broad market posted a year-to-date default rate of 4.7% as of the end of June 2016. When the two commodity sectors are excluded, the default rate was merely 0.53% as of the end of June, according to J.P. Morgan. In terms of fallen angels, the market absorbed $161.3 billion in former-IG credits thus far in 2016, topping the mark of $150.2 billion that was set in 2009. Besides the general risk-on appetite that supported the CCC segment, it also experienced a technical benefit as the lowerrated portion of the market continued to contract as the BB portion expanded. The primary market also reflects this contraction as issuance from the lower-rated portion of the market (split B-rated and below) is at the lowest level in a decade. Broader issuance levels have increased throughout the year, but the $152 billion issued thus far remains well behind the $183 billion in issuance through mid-2015. That said, there are some indications that primary market activity may pickup in the second half of 2016 given the attractive refinancing conditions. Considering the extreme outperformance of CCC issues in Q2 and our revised outlook for slower global growth amid geopolitical risks and rising populist sentiment, we feel the fundamentals are less supportive of CCCs going forward. In addition, more dovish central banks means that market technicals will likely become even more favorable, which we believe will benefit the BB portion of the market in this low-rate environment. Therefore, at the margin, we are shifting our preference to BBs from CCC issues. Furthermore, despite 2016’s recovery in crude oil prices, we’re maintaining our underweight to the energy sector as detailed in the accompanying box. U.S. leveraged loans followed a similar pattern as high yield bonds with lower-rated loans outperforming by a wide margin in Q2. The margin increased during the quarter as investors sold higher-quality loans near or above par in order of fund purchases of those with room remaining for potential price appreciation. Primary market activity was also similar as issuance increased during the quarter with year-to-date levels of $135 billion still below the $180 billion issued through mid2015. In terms of CLOs, issuance of $24 billion was 56% lower than a year earlier. The leveraged loan default rate ended May 2016 at 3.4%, up from 2.8% at the end of Q1 and 2.0% as 2016 began.

European High Yield and Leveraged Loans Despite initial concerns of a dramatic post-vote selloff, the European high yield market weathered the volatility on the way to another quarter of solid returns. The post-referendum stability seemed to underscore a supportive technical backdrop amid ongoing ECB corporate IG purchases, positive year-todate inflows, and limited new issuance.

Page 9

Q3 2016 Sector Outlook As the market opened up under pressure following the referendum, investors seemingly recalled the trickle-down effect of the ECB’s corporate purchases and sought opportunistic purchases at lower prices. The general widening in spreads across the 500 bps mark also served as a reminder that defaults will likely be lower than implied, particularly given the sector’s improved financing conditions, beneficial FX rates, and limited energy exposure. The European high yield default rate ended May at 2.7%, but is expected to decline to 1.9% by the end of the year, according to Moody’s.

exchanges with 85% of YTD defaults coming from commodity credits) and is expected to be around 6% in 2016. Assuming the broad market’s recent average recovery rate of 40% and current spreads of 621 basis points, valuations appear reasonable.

HY Implied Default Rate Current Spread

While outflows were on the rise as the quarter ended, they remained in positive territory for the year, and the ECB’s purchases will likely continue to influence demand in the high yield market. Issuance also remains below the levels from mid2015, and there are few indications of a building supply pipeline going forward. Prior to the referendum, the BB, B, and CCC segments of the market had performed equally well, only for the CCCs to take the brunt of the selling following the vote. Looking forward, as risk appetites return, we expect the BBs to outperform at the outset with the lower-quality components eventually following suit. Due to a slow start to the year, European leveraged loans underperformed their U.S. counterpart through the first half, yet they seemed to find their footing in Q2 on the back of renewed demand from CLO formations.

The Rationale for Underweighting High Yield Energy

+621

– Historical Risk Premium +300 = Current Excess Spread to Compensate for +321 Default Losses (1 - Recovery Rate) (100%-40%) = Implied Default Rate

5.4%

Overall reasonable valuation When we look under the hood, however, we observe that the high yield market is materially mispriced, which presents both opportunity and risk. Looking at energy and commodities spreads, which collectively make up 20% of the overall market, we think investors are under-pricing the risk in the sector. Since February, energy spreads have rallied over 1,100 bps to 831 bps, and as seen in the following table, spreads imply a nearterm default rate of 6.6% within the energy sector. The sector’s default rate has risen to 14% (20% with distressed exchanges) and recovery rates have also fallen well below expected levels to 20% (versus 46% recovery for non-commodity credits). Therefore, considering the current default rate of 20% and our belief that a $50 crude range remains challenging for many credits, we believe that energy defaults rates will be meaningfully higher than currently implied by spreads in the sector.

While this year’s significant tightening in high yield energy spreads was accompanied by the biggest recovery in crude oil prices since 2009, we have chosen to participate in the market’s risk rally in non-commodity credits. We consider the energy sector to be fully valued given our range bound outlook for crude oil prices and the degree to which spreads have rallied in anticipation of a crude market that has started to find some balance. Simply, spreads for a large portion of the energy sector have normalized to a level better than a year earlier when crude prices were notably higher.

HY Implied Default Rate Energy Current Spread

+831

– Historical Risk Premium = Current Excess Spread to Compensate for Default Losses (1 - Recovery Rate)

+300

= Implied Default Rate

Today, nearly two thirds of the of the sector trades inside of 7% versus 44% a year ago when crude oil was over $10 higher and the average yield in the high yield index was a 150 bps lower. While the advertised spread and yield on the energy sector looks attractive, there are few opportunities due to a considerable amount of noise from broken capital structures and companies that will default even if crude oil prices are materially higher. When looking at the high yield market’s spread implied defaults and excess premium, it appears the market is accurately pricing the near-term probability for defaults, as indicated in the following table. Just prior to the end of Q2, the broad market default rate crept up to 3.8% (4.8% including distressed

+531 (100%-20%) 6.6%

Including distressed exchanges, the energy default rate is 20% and is expected to remain at that level going forward The other 80% of the market is also mispriced and presents a great opportunity. Just prior to the end of the quarter, the noncommodity high yield sectors collectively experienced a default rate of only 0.42%, according to JP Morgan, and are experiencing recovery rates of 46%, which is well above the rate for commodity credits and the market’s overall long-term average. Considering spreads have rallied only 152 bps since early February to 578 bps, the non-commodity sectors are pricing in near-term defaults of 5.1%. With recent default rate of 0.42% and our view that defaults will stay well below 2% for the foreseeable future, we believe the majority of the high yield market remains structurally cheap.

Page 10

Q3 2016 Sector Outlook current, slowly expanding trajectory and that the Brexit result will stay the Fed’s hand in terms of rate hikes.

HY Implied Default Rate Ex-Commodities Current Spread

+578

– Historical Risk Premium = Current Excess Spread to Compensate for Default Losses (1 - Recovery Rate)

+300

In terms of a Brexit impact on European EM countries, consensus seems to indicate that the initial macro impact via trade, remittances, EU funds, and foreign direct investment should be manageable over the next one to two years. While the rhetoric about political cohesion increased following the referendum, we see no strong motivation for CEE to exit the EU; if anything European EM countries are net beneficiaries of being in the EU.

+278 (100%-46%)

= Implied Default Rate

5.1%

Given our expectations for much lower default rate, ex-commodity HY remains cheap! Source for table data: J.P. Morgan

The CEE currencies would likely remain under pressure and the banking sectors in the region could face temporary liquidity disruptions but we believe CEE countries have large enough buffers to cope with these temporary issues. We see slightly higher fiscal deficits from the region if growth in the euro zone really suffers and countries use the fiscal to prop up growth. One positive is that unlike other regions, since the European debt crisis, we have seen a reduction in leverage for many countries, most notably Hungary. These countries have been able to grow with the help of monetary policy, but for the most part it hasn't been credit-fueled growth.

OUTLOOK: Constructive. In U.S. high yield, we favor intermediate duration, BB-rated, non-commodity credits. While fundamentals have weakened modestly, the technical picture amid low/negative rates, slow global growth, ECB-driven IG spread compression, and moderate issuance is supportive. In U.S. leveraged loans, we’re seeing an increase in opportunistic financings and repricings, which may limit price appreciation over the short run. European high yield spreads remain attractive amid low default and loss expectations. The ECB corporate buying provides an attractive backdrop.

Emerging Markets Debt Emerging markets debt concluded Q2 in strong fashion as the sector benefited from being one of the few offering attractive yields and spreads, but with relatively little impact from the Brexit situation. Total Return

Yield/Spread Change

OAS/Yield

Q2

YTD

Q2

YTD

6/30/2016

EM Hard Currency

5.02%

10.31%

-22

-27

388

EM Local (hedged)

2.06%

6.01%

-19

-81

6.33

EMFX

0.34%

5.81%

18

-113

3.87

EM Corporates

3.77%

7.80%

-25

-33

395

In hard currency bonds, African, Middle Eastern, and Latin American countries were the outperforming regions as commodity markets rebounded and China fears diminished. Ecuador (+10.0%), Cameroon (+8.9%), and Iraq (+12.4%) were among the top performers, while defensive oil importers such as Hungary (+1.72%) and Lithuania (+1.4%) underperformed. Argentina (+10.3%) was also a standout performer, as improving sentiment due to President Mauricio Macri’s economic policies overwhelmed the impact of over $16 billion of new issuance. The primary market opened up during the quarter, with $146 billion of new issues in sovereign and EM corporate bonds. In local bonds, Latin American and African bonds outperformed as well. Brazil-hedged local bonds returned +5.2% as inflation rolled over and the market set up for an upcoming easing cycle. The beginning of the impeachment process for President Dilma Rousseff was also perceived positively by the market. Peru-hedged local bonds returned +7.9% with declining inflation and the election of center-right leader Pedro Pablo Kuczynski as president driving returns.

Source: J.P. Morgan as of June 30, 2016. Past performance is not a guarantee or reliable indicator of results. An investment cannot be made directly in an index.

Similar to other spread sectors, EM encountered pressure in the immediate aftermath of the vote, but the wider spreads and higher yields soon attracted buyers. By the middle of the day after the vote, EM currencies retraced about half of their losses, and most hard currency bonds were back to unchanged in dollar price (though still wider in spread due to the rally in U.S. Treasuries).

In EM currencies, the index return masked substantial volatility between individual currencies. The Brazilian Real (+13.7%) and Russian Ruble (+7.4%) outperformed on improving trade numbers, improving investor sentiment, and upcoming rate cutting cycles. The Polish Zloty (-5.8%) and other eastern European currencies underperformed on Brexit concerns, and the Mexican Peso (-6.2%) continued its underperformance due to flows and its use as a macro hedge.

Currencies that sold off following the Brexit vote may represent a buying opportunity. This view has some underlying assumptions, including a U.S. economy that remains on its

Page 11

Q3 2016 Sector Outlook EM Volatility—A trader's nightmare, an investor's friend

increasingly clear that the 2015 elections would produce a more market-friendly government. Similarly, Brazil has been a star performer in 2016 as President Rousseff was forced from office and replaced with the more orthodox Michel Temer. Our understanding of these policy shifts translated to overweight positions, which substantially benefited our client portfolios.

The emerging markets and volatility are often seen as part and parcel. Some investors find the association particularly troublesome whether it emanates from general risk aversion affecting all risky assets, fundamental EM country risks, or derived from adverse headlines that may or may not have actual economic implications. The EM debt sector has experienced all three of these this year: Brexit, political turmoil in Brazil, and the protests in Venezuela are some events that have affected EM prices. In the post-2008 environment, price volatility has been exacerbated by the reduced willingness of the broker-dealer community to warehouse risk, leading to markets that are often one-sided with either buyers or sellers dominating without obvious takers on the other side of the trade. The bouts of price volatility have resulted in a particularly difficult environment for short-term traders, who often try to exit from or add to positions at the same time as they respond to perceived changes in risk. In these environments, bid-offer spreads widen, prices hit “air pockets,” and it is often difficult to determine the market’s new clearing level. For those who are able to take a longer term view, however, these dislocated markets present opportune times to buy fundamentally sound assets at a discount. But when is the right time to buy? Timing markets is notoriously difficult, but there are some factors that have helped us identify positive risk/reward opportunities over the years. First, higher yielding asset classes like EM tend to have strong, mean-reverting tendencies, which work to the benefit of long-term investors. If one had invested in the EMBI Global Diversified index at the peak in 2008, at one point your losses would have been close to 30%. However, if you had reinvested your coupons at lower dollar prices and higher yields during the selloff, you would have made all of your losses back in less than a year. Obviously, if you had added to your exposure during the selloff, your returns would have been substantially better. And 2008 is not an outlier—we’ve observed similar bounce-backs from all EM hard currency selloffs since the early 1990s. The mean-reverting impact is greatest in assets classes with a high ratio of carry to volatility; it works best with hard currency assets, reasonably well with local hedged bonds, but has been less effective with EM currencies. Timing of individual country calls is more difficult, as the mean reverting tendencies for individual credits is less than for the market as a whole. In these situations, it is crucial to assess the fundamental trajectory of an individual country as well as the potential for a turning point. Having a strong forwardlooking view of potential political change can be very helpful. Argentina, for example, underperformed dramatically in 2011 and 2012 due to poor macroeconomic policies and a lack of competitiveness under the Kirchner regime. In 2014 and 2015, however, it was one of the top performers as it became

In each case, market volatility led to selloffs that overshot the fundamental value, allowing patient investors to benefit. The benefits of these purchases might not have been immediately apparent, as it can take a while for markets to find their footing. But the long-term benefits of being an investor rather than a trader are clear. How is this impacting our portfolios now? We continue to believe that in a world of low G3 interest rates, the meanreverting aspect of EM will continue to dominate. This means that generalized market selloffs related to Brexit-type scenarios or Fed concerns are likely opportunities to capitalize on our judgment to time the purchases. With respect to individual countries, we will continue to lookout for potential changes in political or economic policies, which could affect fundamentals and investor sentiment. Official creditor support for countries, such as Sri Lanka (approved) and Mongolia (anticipated), could be harbingers of such a change, as could a potential change of Venezuela’s leadership.

OUTLOOK: Positive. The sector’s resiliency following the Brexit vote underscores its attraction to investors seeking yield and spread, particularly in markets with less exposure to the UK situation. While bouts of volatility will continue, they remain opportune times to increase exposure.

Municipal Bonds AAA-rated municipal bonds outperformed U.S. Treasuries across the curve with the 30-year Municipal/Treasury yield ratio dropping to 87.4% from 102.7% (at the start of Q2). Solid performance was driven by steady mutual fund inflows (almost +$19 billion Q2 and $33 billion YTD) coupled with manageable supply ($119 billion Q2 and $219 billion YTD). Positive total returns continued in Q2 for both high grade (+2.61%) and high yield (+5.10%) municipals, bringing YTD returns to 4.33% and 7.98% for high grade and high yield, respectively. Puerto Rico credits bounced back in Q2 and outperformed the broad high yield muni index, returning +7.82% in Q2 and +8.36% YTD. Long taxable municipals returned +6.56% in Q2, in-line with the long corporate index, and +12.35% YTD, lagging the long corporate index. The rally in Puerto Rico credits in Q2 was driven by the passage of the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) late in Q2. PROMESA establishes a seven-member federal control board with broad fiscal oversight over the Commonwealth. Among the key provisions of PROMESA is a temporary stay on litigation

Page 12

Q3 2016 Sector Outlook intended to promote an environment for negotiations between the Commonwealth and creditors. There is also a collective action provision whereby a two-thirds majority within a creditor group could agree to a debt restructuring plan. There is also language in PROMESA stating that any adjustment of debts must “respect the relative lawful priorities or lawful liens, as may be applicable in the constitution”. Passage of the act is generally viewed favorably by creditors given that it provides an orderly framework for debt restructuring. Despite the first priority granted to GO bondholders under the Puerto Rican constitution, the Commonwealth defaulted on GO and Commonwealth guaranteed debt service on July 1st. Reports indicate that the Commonwealth missed a total of $911 million in debt service payments, including $780 million on GO debt. In other credit-related news, the New Jersey Supreme Court ruled in favor of the state in a case which challenged the suspension of cost of living adjustment payments as part of 2011 pension reform. According to Moody’s, a ruling against the state would have resulted in a 33% increase in unfunded pension liabilities and a drop in the funded status to 44% from 51%, which would have led to a downgrade. In Illinois, as a result of political gridlock, the credit suffered additional downgrades, with current ratings of Baa2 and BBB+ and negative outlooks. A lack of a budget for fiscal year 2016 and fiscal year 2017 has led to a continued budget imbalance and a growing backlog of bills. On the last day of fiscal year 2016, the Illinois legislature approved a stopgap budget that will fund the government through December. Looking ahead, despite the solid outperformance in Q2, demand for tax-exempts should continue to provide a supportive environment, especially in the context of the global rate environment. Supply is expected to remain manageable, with any supply-driven cheapening representing an attractive buying opportunity. The problematic credits that have dominated the municipal market headlines in recent years have not been resolved. Political gridlock will continue to weigh on Illinois and credits reliant on state funding, thus further rating downgrades cannot be ruled out. We continue to believe that these credit stories, regardless of the outcomes, do not pose a systemic risk to the broader municipal market. We expect taxable municipals to perform in line with corporate bonds, with the potential for outperformance should corporate M&A activity persist.

OUTLOOK: Modestly positive—Attractive taxable equivalent yields and a favorable technical environment through the summer should provide a supportive environment.

The evolution toward, and through, the zero bound pervaded the global rates complex. This phenomenon was best exemplified by the German rates market as the 10-year Bund rallied to negative yields after wavering around zero for much of the quarter, while the 20-year JGB rallied sharply toward zero. Although there is the potential for retracement once risk appetites return, strong technical factors remain, including sizable monetary stimulus that could further exaggerate the negative rate environment. In the U.S., the post-vote reaction produced a considerable bull flattening as the 10-year yield collapsed 31 bps, flattening the 2- to 10-year curve by 11 bps. While term premia in the U.S. remains relatively high globally, the magnitude of the post-vote move led us to reduce overall long-duration exposure, though we remain positioned for further flattening of the U.S. yield curve. Given global headwinds, we see a potential trading range in the 10-year Treasury between 1.25%-1.75%. U.S. monetary policy was already in flux given May’s surprisingly weak payroll additions of 38,000, and the referendum outcome likely tabled Fed rate hikes for the rest of 2016. Following the vote, the market implied terminal Fed funds rate fell to approximately 65 bps—indicating the potential for only one additional rate hike throughout the current cycle. While the repercussions from the Brexit vote are not yet certain, the decline in long-term rates and the weakening of the pound could soften the fallout from an EU departure. The Bank of England still has considerable easing options and could provide additional direct credit provisions to banks, initiate quantitative easing, and/or cut the policy rate. Elsewhere, the BoJ may be inclined to ease further in July. While the BoJ has tolerated USDJPY volatility between 100 and 125, intervention may prove necessary should the yen appreciate further. Commodity exporters that were biased to ease before the vote—Norges Bank, Reserve Bank of Australia, Reserve Bank of New Zealand—may now be more inclined to deliver more accommodative monetary policy. As the quarter concluded, we continued to see value in a swap spread widener in the U.S. The inverted swap spreads and positive carry profile appears out of line amid the global backdrop. We also favor U.S. curve flatteners amid relatively high term premia that is likely to be reduced. Conversely, the term premia in the JGB market appears too low, and we consequently favor steepeners in the 20-year versus 30-year portion of the curve.

Global Rates The developed rates market followed a gradual trajectory lower for much of the second quarter before accelerating to historic lows after the surprising Brexit vote.

Page 13

Q3 2016 Sector Outlook program, which may continue for longer than the market anticipated.

OUTLOOK: Selective. Many of our fundamental views remain in place—i.e. U.S. term premia appears high on a global context—yet the magnitude of the post-vote move led us to reduce duration over-weights in the U.S. While we continue to believe rates will remain low and range bound, uncertainty has become a market fixture that could lead to volatile swings in either direction, which supports our selective view based on the opportunities that may arise.

OUTLOOK: Overweight mortgages vs. swap spreads.

Structured Product

Mortgages Mortgage-backed securities underperformed U.S. Treasuries in Q2 with a total return of 1.11%, lifting the sector's year-to-date return to 3.10%. MBS initially performed well in the quarter in response to heavy, outright buying by U.S. banks and overseas investors. The Federal Reserve also increased its MBS reinvestments, given higher prepayments on its holdings. Absolute prepayment levels, although higher in Q2, came in lower than expected and remain below 2015 levels. The Home Affordable Refinance Program is expected to sunset later this year and may be replaced by a LTV-based homeowner assistance program. We expect prepays from any additional government assistance programs to have a negligible impact on prepayment speeds. During the first half of June MBS spreads widened again on a flight-to-quality trade following a soft U.S. jobs report and downshift in market expectations for a near-term Federal Reserve rate hike. In fact, some market participants believe that weaker global economic data and increased political risk may keep the Fed on hold well through 2017, which strengthens the likelihood that the Fed will continue its mortgage reinvestment program longer than anticipated. Following the Brexit referendum and subsequent spike in market volatility in late June, MBS held up well with MBS option-adjusted spreads (OAS) rising just a few basis points. The market-cap weighted LIBOR OAS was unchanged at L+52 bps as was the Treasury OAS at T+39 bps. As the quarter ended, MBS spreads remained attractive relative to swaps. Although prepays are expected to increase in the summer in response to the recent rally and seasonal home buying activity, we expect the Fed’s reinvestments to increase as well. Against this backdrop, we look for MBS performance to be directional with rates and benefit from outright buying if rates rise. We hold a more positive near-term view on MBS at current spread levels. We have continued to tactically trade Freddie Macs, reduced TBAs versus specified pools and are focused on lower coupon issues. Longer-term, we look for MBS spread performance to be driven by demand for liquid spread product in a low-rate environment and the Fed’s mortgage reinvestment

Structured products had a strong second quarter, bouncing back from a weak start to the year. That said, the sector continues to take their cue from other markets, as evidenced by spreads within the sector tightening after the stock market rally and the ECBs corporate bond purchase announcement in late Q1. The third quarter tends to be a poor quarter for spread product, so we are somewhat cautious near term, but Q1 is typically the best quarter for excess returns in spread product and this year amply showed that exceptions do happen. Negative yields in non-U.S. developed markets (especially Japan) continue to make U.S. spread product alluring, and we expect this technical environment to bode well for spread tightening on high quality assets in the intermediate term – especially for AAA CMBS and CLO bonds. Non-Agency RMBS. Non-agency RMBS had a strong rally in Q2. Spreads returned to the levels of the second half of 2015 – L+250-275 for senior ‘06/’07 legacy bonds. At current spread levels we think the rally has run its course in the near term, yet the technical underpinnings remain strong with roughly 15% of legacy non-agencies paying down every year and demand from the money manager community proving steady. Fundamentals are also improving. Housing remains a strong part of the economy and has room to improve further, which bodes well for fundamentals going forward. House price appreciation was about 5% over the last year. All things considered, we continue to hold non-agency RMBS with the expectation of earning carry rather than excess return from spread tightening. For newer issue bonds, Credit Risk Transfer securities tightened significantly in Q2. We still like the fundamental underpinnings of this market, but at current spreads we are shortening spread duration in this space to reduce exposure to market beta. CMBS. CMBS also bounced back in Q2, rallying from Q1 wides of 173 to 110 in Q2 before weakening slightly to end the quarter. The spread volatility and lack of price discipline in the market revealed how thin the sponsorship in this sector can be from deal-to-deal, even at the top of the capital structure. Nevertheless, we feel that even at 110 to 115, CMBS AAAs look attractive as a corporate and agency MBS surrogate. Mezzanine CMBS also tightened, but the credit curve remains steep. We think this steepness is appropriate given the deterioration in underwriting quality on many of the loans that find their way into the CMBS space. We are also concerned mezzanine positions (particularly BBB- bonds) held by structured products hedge funds may have to be liquidated if fund redemptions persist. The most noteworthy response to the volatility in Q1 was that CMBS origination all but shut down in Q2. Conduit issuance fell to $7 billion in Q2 from $16.5 billion a

Page 14

Q3 2016 Sector Outlook year prior, and Q3 CMBS issuance is likely to be similarly light. This technical factor contributed to the spread rally that took place in Q2. Nevertheless, the wall of maturity issues for ‘06/’07 CMBS start in earnest in the back half of 2016 and we expect CMB S issuance to turn back on if spreads remain somewhat stable. Overall, we expect CMBS spreads to remain stable at current levels or grind tighter as the pick-up in issuance could well be absorbed by overseas flows in to high quality structured products in response to negative/low interest rates in other developed markets.

OUTLOOK: We remain very positive on top-of-the-capital structure bonds. These bonds offer positive fundamental returns across a wide range of scenarios. Negative yields in Japan and Europe could tighten AAA CMBS and CLO spreads as investors seek more yield on high quality bonds. We remain positive on GSE credit risk mezzanine cashflows but remain negative on CMBS and CLO mezzanine tranches.

CLO. We continue to believe AAA CLO bonds (L+150-170) to be one of the most attractive investments in the fixed income sector. With credit enhancement of 35% or more, and diversification by corporate sector, AAA CLOs have robust protections to the recent credit concerns in the energy, commodity and retail sectors. ABS. An improved macro-economic environment resulted in spread tightening and credit and liquidity compression in the ABS sector. Benchmark cards/autos tightened by 5-10 bps to L+40 bps for 3yr cards and L+25 bps for 1yr Prime auto. Five year senior rental car spreads tightened by 30 bps to +140. We expect these fundamentally sound sectors to earn their carry and augment returns through average life roll-down but anticipate spreads remaining range bound at current levels. For student loans, Moody’s recently released revised rating criteria for legacy government guaranteed Federal Family Education Loan Program bonds. Fitch has stated they will do so soon as well. The issue at hand is slow loan repayment speeds that might cause bonds to not be fully repaid by the legal final date (though we believe ultimately repayment is highly likely due to a US government loan-level guarantee), which will lead to rating downgrades. There has been little trading and indicative spreads are modestly wider. We believe FFELP spread widening remains a risk due to potential forced selling from ratings-based investors should the forthcoming rating actions prove severe. In UK Non-conforming RMBS 2.0, spreads widened 25-50 bps post-Brexit before recovering 10-35 bps in subsequent days. We have been avoiding exposure to this sector due to our belief that Brexit risk was not adequately reflected in spreads. While we believe senior bonds are fundamentally sound, the outlook for UK housing, particularly in greater London, has darkened in the wake of the referendum and recent tax law changes and we believe better value exists in other structured products. Risk retention. Risk retention is becoming an urgent issue in both CLOs and CMBS. The CLO market is further along in addressing this challenge, but recent rumblings from European Members of Parliament about increasing risk retention amounts (to possibly 20%) could still further threaten European CLO issuance. In CMBS we expect to see the first risk-retention compliant structures in Q3 and current estimates are that risk retention requirements will require an additional 10-20 bps in spread from borrowers to compensate lenders for retaining risk. We view this as a borrower cost, with little impact on bond spreads.

Page 15

Q3 2016 Sector Outlook Notice Source(s) of data (unless otherwise noted): PGIM Fixed Income as of July 2016. Prudential Fixed Income (the “Firm”) operates primarily through PGIM, Inc., a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. In Europe and certain Asian countries, the Firm operates as PGIM Fixed Income. The Firm is headquartered in Newark, New Jersey and also includes the following businesses: (i) the public fixed income unit within PGIM Limited, located in London; (ii) Prudential Investment Management Japan Co., Ltd (“PIMJ”), located in Tokyo; and (iii) PGIM (Singapore) Pte. Ltd., located in Singapore. Prudential Financial, Inc. of the United States is not affiliated with Prudential plc, which is headquartered in the United Kingdom. These materials represent the views, opinions and recommendations of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of the Firm is prohibited. Certain information contained herein has been obtained from sources that the Firm believes to be reliable as of the date presented; however, the Firm cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The Firm has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services and should not be used as the basis for any investment decision. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Past performance is not a guarantee or a reliable indicator of future results and an investment could lose value. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. The Firm and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of the Firm or its affiliates. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients or prospects. No determination has been made regarding the suitability of any securities, financial instruments or strategies for particular clients or prospects. For any securities or financial instruments mentioned herein, the recipient(s) of this report must make its own independent decisions. Conflicts of Interest: The Firm and its affiliates may have investment advisory or other business relationships with the issuers of securities referenced herein. The Firm and its affiliates, officers, directors and employees may from time to time have long or short positions in and buy or sell securities or financial instruments referenced herein. The Firm and its affiliates may develop and publish research that is independent of, and different than, the recommendations contained herein. The Firm’s personnel other than the author(s), such as sales, marketing and trading personnel, may provide oral or written market commentary or ideas to the Firm’s clients or prospects or proprietary investment ideas that differ from the views expressed herein. Additional information regarding actual and potential conflicts of interest is available in Part 2A of the Firm’s Form ADV. In the United Kingdom, information is presented by PGIM Limited, an indirect subsidiary of PGIM, Inc. PGIM Limited is authorised and regulated by the Financial Conduct Authority of the United Kingdom (registration number 193418) and duly passported in various jurisdictions in the European Economic Area. These materials are issued by PGIM Limited to persons who are professional clients or eligible counterparties for the purposes of the Financial Conduct Authority’s Conduct of Business Sourcebook. In Germany, information is presented by Pramerica Real Estate International AG. In certain countries in Asia, information is presented by PGIM (Singapore) Pte. Ltd., a Singapore investment manager registered with and licensed by the Monetary Authority of Singapore. In Japan, information is presented by PIMJ., a Japanese licensed investment adviser. In South Korea, China and Australia, information is presented by PGIM, Inc. In Hong Kong, information is presented by representatives of Pramerica Asia Fund Management Limited, a regulated entity with the Securities and Futures Commission in Hong Kong to professional investors as defined in Part 1 of Schedule 1 of the Securities and Futures Ordinance. PGIM, the PGIM logo, and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide. © 2016 Prudential Financial, Inc. and its related entities.

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: Barclays European Corporate Bond Index (unhedged)



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



European High Yield Bonds: Merrill Lynch European Currency High Yield 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 (unhedged): 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. Treasury Bonds: Barclays 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

2016-2091

Page 16