Fixed Income Focus June 2016 FOR PROFESSIONAL INVESTORS ONLY

US rates and Danish mortgage bonds.

Even if the Fed hikes rates in June, long-term rates are likely to stay low. Margaret Steinbach Investment specialist Based in Los Angeles

• The Fed’s communications in May signalled that an interest rate increase could occur as soon as June. • US monetary policymakers have indicated that their decision will be data-dependent — and with mixed domestic and global economic conditions, a rate hike could still be delayed. • Even if the Fed does hike rates this summer, we expect US rates to remain low for an extended period.

In this issue:

• The implications of a summer Fed rate hike • How investors can find value in global niches

The US Federal Reserve surprised markets in May with what seemed like a concerted effort by its members to inform investors that it could raise interest rates as early as June should economic and financial conditions continue to improve. Nevertheless, even if the Fed follows through with a rate hike this summer, it does not change our view that US interest rates will remain low for the foreseeable future. The probability of a Fed rate hike in June has risen significantly as result of the more hawkish tone taken by some of its monetary policymakers in recent statements. Irrespective of whether or not the Fed hikes rates this summer,

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we believe overall that the Fed will continue to take a gradualist approach in tightening monetary policy. That’s because any interest rate hike by the Fed has wide-ranging domestic and global repercussions and has the potential to create a negative feedback loop. If economic and financial conditions tighten as rates increase, credit becomes more expensive. As the dollar consequently strengthens, financial conditions will grow even tighter. It’s important to remember that the Fed’s influence is greatest on short-term interest rates. The longer maturities reflect a combination of factors, including economic growth 1

Fixed Income Focus June 2016

and inflation expectations. Growth in the US remains modest by most measures. While inflation has started to inch higher, as evident in the most recent Consumer Price Index report, it is by no means excessive. Moreover, deflationary forces still persist in many parts of the world. Against this backdrop, our base case scenario is for short rates to move slightly higher, in sync with the Fed, and long-term rates to be range-bound, with 10-year US Treasuries not exceeding 2.5%. How we got here The Fed raised its benchmark federal funds rate by 25 basis points in December 2015 to a range between 0.25% and 0.50%, after leaving it near zero for seven years. At the time, officials projected they would raise rates by a full percentage point this year. In their March meeting, however, officials cut that estimate in half as worries about risks from abroad and turbulent financial markets in the early months of the year stayed the Fed’s hand on interest rate increases. Despite the Fed’s more dovish stance in March, looking at the domestic data that followed, it was clear that two important indicators for the Fed’s monetary policy mandate — employment and inflation — were showing signs of further improvement. Through the end of April, hourly wages grew at an annualised pace of 3.2%. Inflation, too, began to increase, with energy prices appearing to have bottomed. In April, the core Consumer The market doesn’t seem to believe the Fed

Price Index, which excludes energy and food, rose at an annualised rate of 2.3%, implying a 2.5% pace for the year. Despite the stronger data, the market had already priced out all interest rate increases for 2016. That string of data, along with the backdrop of improved financial conditions, appears to have triggered some Fed members to adopt a more hawkish stance. On 9 May, Federal Open Market Committee (FOMC) Vice Chair and New York Fed chief William Dudley, who typically falls on the more dovish end of the spectrum, reiterated the Fed’s forecast of raising rates in 2016 by a total of 50 basis points, in two moves. Later, in speeches on 17 May, two Fed policymakers indicated that a hike was on the table for June. The following day, the FOMC’s April meeting minutes revealed the Fed’s intended course remained intact. The minutes stated that “most participants judged that if incoming data were consistent with economic growth picking up in the second quarter” it would likely be appropriate to raise rates in June. As of late May, the Atlanta Fed’s GDPNow forecasts second-quarter growth of around 2.5%. These events meaningfully shifted market expectations for future interest rate hikes. Immediately following the release of the April minutes, the futures market suggested a 30% probability for a hike in June, up from 4% just two days prior. The probability of an increase in July rose from 19% to nearly 60%.

Federal Open Market Committee projections – target federal funds rate at year-end Mar 16 median Dec 15 median Overnight Index Swap 4.0 (%)

Sep 15 median

3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 2016f

2017f

As at 16 March 2016. Source: FOMC economic projections 2

2018f

Longer run

“If the Fed does end up hiking rates this summer, we could see the yield curve flatten further. Should the Fed decide not to raise rates by July, though, we would expect the curve to steepen.”

Still, these probabilities imply that most of the market still doesn’t believe that the Fed will actually raise rates at its June meeting and a significant portion remains unconvinced that the Fed will hike by July. That’s because, despite improvement in indicators like employment and inflation, headwinds remain. Corporate earnings were weak in the first quarter, and while fears concerning overseas economic turmoil have abated somewhat, global growth isn’t expected to be robust this year. Looking ahead We believe the Fed is attempting to calibrate financial conditions not just by means of actual policy actions but also through its verbal communications. The most recent spate of Fed communications may well be testing how much tightening of financial conditions the markets can absorb without creating disruption. The rates market’s repricing the odds of a summer hike resulted in a flattening of the US Treasury

yield curve, with two- and five-year yields both rising by about 20 basis points. 30-year yields remained more anchored, rising only a few basis points. If the Fed does end up hiking rates this summer, we could see the yield curve flatten further. Should the Fed decide not to raise rates by July, though, we would expect the curve to steepen. Perhaps more significant than Fed policy implications, another factor that is likely to keep US rates anchored is the cross-market valuations between US Treasuries and the sovereign debt of other developed-market nations. Government bond yields are negative in Germany for maturities out to nine years and in Japan for maturities out to 15 years. In fact, 10-year US Treasuries had a higher yield than some 87% of developed-market sovereign debt at the end of the first quarter. The crossmarket valuations, in combination with the negative feedback loop described above, lead us to believe that US rates will remain lower for longer.

Opportunities in Danish mortgage bonds for global bond investors

Jim Hurlin Investment specialist Based in London

• Danish mortgage-backed securities provide an example of a niche where a savvy portfolio manager could have found value last year, despite low rates dominating global markets.

an asset class that recently became attractive on a valuation basis as a significant part of the buyer base found themselves forced to sell for technical reasons.

• However, such opportunities can provide favourable outcomes only when all the risks associated with an unusual market and asset class are appropriately evaluated.

The Danish mortgage market Denmark has one of the largest mortgage bond markets in the world, with an equivalent value of more than $400 billion as of December 2015. Danish mortgage bonds are predominantly triple-A-rated with no record of default and denominated in Danish krone. A large part of the market is in the form of fixed-rate amortising prepayable mortgage bonds similar to US agency pass-through mortgagebacked securities.

In today’s low-yield environment, finding attractive return opportunities has become increasingly difficult. Managers with a global view can benefit from a broader opportunity set and the potential to identify interesting investments that are complementary and bring diversification benefits to investors. Sometimes opportunities arise through market segmentation, which can be a form of market inefficiency: valuations of a security or a class of securities can be driven by the actions of a subset of the buyer base who are reacting to changes in a common factor. Danish mortgages are an example of

Concentrated ownership can lead to volatility The Danish mortgage market is dominated by domestic investors, particularly banks and pension funds, who hold just over 80% of callable mortgages. Many of these investors are liability-driven, meaning that they seek to 3

Fixed Income Focus June 2016

Convexity event: In a convexity event, price losses arising from the impact of rising rates on holdings in prepayable or callable assets such as mortgage pass-through securities are amplified, as the duration (interest rate sensitivity) of the securities increases as rates rise. These assets are said to have ‘negative convexity’.

Danish mortgage bond spreads

match the interest-rate sensitivity of their liabilities with assets of a similar duration. However, as pass-through securities, the duration of Danish mortgage bonds is highly sensitive to prepayments by the underlying mortgage borrowers. When interest rates fall, those borrowers have more incentive to refinance their mortgages, and mortgage bond duration shortens; when interest rates rise, prepayment rates fall and mortgage bond duration lengthens. A change in the duration of these mortgage bonds can affect the level of demand from liability-driven investors.

Taking a broad approach An ability to identify and analyse opportunities globally can be an important source of returns for investors in the current yieldconstrained environment. For example, at the end of April, the average spread on US agency fixed-rate mortgages was 4 basis points, while triple-Arated Danish mortgage-backed bonds offered 97 basis points.

A convexity event opens up value 10-year Danish government yields fell from about 2% at the start of 2014 to a low of 0.11% in February 2015. Mortgage rates also tracked lower and led to increased prepayment rates and a significant shortening of mortgage bond duration. However, rates then rose suddenly and the 10-year government yield reached 1.15% by early June. That led to a rapid extension in mortgage bond duration as prepayment rates dropped. That phenomenon is referred to as a ‘convexity event’. Liability-driven investors became forced sellers as they sought to bring the interest rate sensitivity of their assets back in line with their liabilities. That selling led to a widening of the interest rate spread of Danish mortgages over government bonds, and spreads reached levels not seen since the 2008 financial crisis.

• Currency risk: What is the outlook for the Danish krone, and should the currency risk be hedged?

What other factors do investors need to assess in making this investment? Some of the key factors include:

• Liquidity risk: How easy is it to trade in these securities and what are the costs of trading? Does the spread earned compensate for liquidity risks? • Interest rate risk: What is the likely direction of Danish interest rates? • Convexity risk: Are there likely to be further changes in the duration of these securities that could benefit or detract from returns? How will changes in Danish interest rates affect prepayment rates on Danish mortgages? Returns are never certain, but a broad view and careful analysis of risks can help investors uncover global opportunities and diversify their portfolios.

Long-term index option-adjusted spread to Danish government bonds

140 (bps) 120 100 80 60 40 20 0 –20 Jan 00

Jan 04

As at 12 May 2016. Source: Nordea Markets 4

Jan 08

Jan 12

Jan 16

Fixed Income Focus June 2016

Markets at a glance (as at 31 May 2016) US Treasury yields (%) 3-Month 2-Year 5-Year 10-Year 30-Year 2- to 10-Year Spread (bps) 2- to 30-Year Spread (bps)

Month end1 0.34 0.87 1.37 1.84 2.64 97 177

Quarter end2 0.21 0.73 1.21 1.78 2.61 105 188

Year end3 0.16 1.06 1.76 2.27 3.01 121 195

US Treasury yield curve (%) 31 May 16

31 Mar 16

31 Dec 15

3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

0

5

10

15

20

25

30

Sources: Datastream, Federal Reserve

Spreads (bps) Barclays US Corporate Barclays US High Yield Corporate JPM EMBIG Diversified (IG) JPM EMBIG Diversified (HY) JPM EMBIG Diversified

Month Quarter end1 end2 149 163 566 656 249 253 599 621 396 406

Year end3 165 660 271 627 409

Investment-grade spreads (bps) JPM EMBIG Diversified (IG) Barclays US Corporate 350 300 250 200 150 100 50 May 11

May 12

May 13

May 14

May 15

May 16

Sources: Barclays, RIMES

Yields (%) UK 10-year Government Bond Germany 10-year Government Bond Japan 10-year Government Bond Barclays US Corporate Exchange rates (% change vs. USD)4 British pound Swiss franc Euro Japanese yen Fixed-income index returns4 Barclays US Aggregate Barclays Global Aggregate

Month Quarter end1 end2 1.44 1.42 0.15 0.16 –0.11 –0.04 3.14 3.21 1 3 month months –0.64 –3.59 –2.80 –3.53

4.44 0.18 2.46 1.78

1 3 month months 0.03 1.33 –1.34 2.67

Year end3 1.96 0.63 0.25 3.67

US corporate spreads (bps) Barclays US Corporate (left scale) Barclays US High Yield 2% Cap (right scale) 240 220 200

900 800

180

700

YTD

160

600

–1.25 0.68 2.48 8.47

140 120

500

100 400 May 15 Jul 15 Sep 15 Nov 15 Jan 16 Mar 16 May 16 Source: Barclays

YTD 3.45 5.87

Sources: Barclays, Datastream, Federal Reserve, RIMES 1. Month-end: 31 May 2016 2. Quarter-end: 31 March 2016 3. Year-end: 31 December 2015 4. As at 31 May 2016 5

Fixed Income Focus June 2016

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. The information provided is intended to highlight issues and not to be comprehensive or to provide advice. This information has been provided solely for informational purposes and is not an offer, or solicitation of an offer, or a recommendation to buy or sell any security or instrument listed herein. Past results are not a guarantee of future results. This communication is issued by Capital International Limited (authorised and regulated by the UK Financial Conduct Authority), a subsidiary of the Capital Group Companies, Inc. (Capital Group). This communication is intended for professional investors only and should not be relied upon by retail investors. While Capital Group uses reasonable efforts to obtain information from sources which it believes to be reliable, Capital Group makes no representation or warranty as to the accuracy, reliability or completeness of the information. This communication is not intended to be comprehensive or to provide investment, tax or other advice. © 2016 Capital Group. All rights reserved. CR-291380 EMEA