t. rowe price fixed income company sector strategy views

Company NamePresentation To:

T. Rowe Price Fixed Income Sector Strategy Views

January 2015

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2015-GL-1238

1

As of 12 January 2015

T. Rowe Price Fixed Income Sector Views

See next page for Fixed Income Sector Strategy Drivers.This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are as of 12 January 2015 and may have changed since that time.Source: T. Rowe Price.

• A continued decline in commodity prices, falling inflation expectations, and the attractiveness of U.S. rates relative to most other developed sovereign markets have driven 10-year Treasury yields back below 2%. With the domestic economy maintaining strong momentum, a Federal Reserve rate hike remains on track around mid-year. But given a weak global backdrop, the Fed will be patient with the pace of tightening.

• Amid weak economic growth and sub-zero inflation, the European Central Bank is widely expected to soon launch sovereign bond purchases. Although the outlook for euro area growth has brightened this year, ECB policy will remain highly accommodative for the foreseeable future.

• The Bank of Japan’s recently expanded quantitative and qualitative easing program has further compressed an already flat JGB yield curve despite concerns about the country’s long-term debt sustainability.

• Plummeting commodities have pressured corporate credit spreads wider, with U.S. high yield bearing the brunt. High yield defaults are expected to remain low in 2015 but will rise next year if oil prices persist at depressed levels. With a growing percentage of bonds trading at distressed prices, high yield valuations are increasingly compelling.

• Less exposed to energy, securitized credit has been resilient to market volatility. Agency MBS spreads have recently ticked wider amid concerns around volatility and increased prepayments in addition to uncertainty stemming from new government housing initiatives.

• In emerging markets, external sovereigns and corporates remain attractive versus similarly rated developed market credit, though low liquidity and weak commodity prices remain risks. Local EM rates have rallied with global rates, while the strong dollar trend has weighed on currency performance; at current valuations, certain currencies look enticing.

2This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.Source: T. Rowe Price.

Fixed Income Sector Strategy Drivers and Outlook

As of 12 January 2015

SectorLevel/ Spread Drivers

Sector Outlook

Relative Value Rationale

Treasury (10-year) 1.97% Inflation expectations continue to move lower, and global economic conditions are holding term premiums low. The persistent decline in oil prices has kept global inflation expectations a moving (downward) target for the past several months. Risk asset underperformance and rallying global yields, particularly as the U.S. continues to appear relatively attractive versus other developed markets, all serve to hold U.S. yields low, even as domestic growth and employment remain firm.

3 4

The labor market continues to maintain strong momentum, and the Fed’s communications indicate a mid-2015 liftoff to the hiking cycle. The Fed also continues to look through energy-related headline inflation weakness, keeping the liftoff in rates on track. Relatively strong growth conditions would suggest higher yields, but the market’s focus on inflation expectations and global weakness continues to hold yields down. Until those conditions change, any rise in yields will be limited.

TIPS (10-year breakeven) 162 basis points (bps)

TIPS continue to face headwinds from weak energy prices, particularly as the Fed remains on track to raise rates around mid-year. Global macro conditions, including the strong dollar, are keeping breakevens on the defensive. 3 3

TIPS breakevens remain attractively valued toward the long end of the curve, but the global macro environment is a strong counterbalance (weak energy, strong dollar, and, recently, skittish risk assets). Until energy weakness abates, TIPS will likely have difficulty performing, particularly the energy-sensitive front-end of the curve.

Municipals (10-year) Ratio at 95%

The 10-year Municipal to Treasury yield ratio has moved 3% higher since last month and is now at 95%. Valuations are more compelling, but we remain neutral on the sector.

3 4

On net, valuations are not compelling enough for a crossover buyer, and we remain neutral on munis. January is typically a strong month for the market given lower supply and heavy redemption activity. This year has followed that pattern thus far with strong month-to-date performance, particularly given the rally in Treasuries. In addition, cash flows into munis have remained strong in recent weeks. Going forward, low rates make higher levels of refunding issuance likely in coming months, which may pressure intermediate yields. Along with the potential for Fed tightening and the typically weak spring period for the asset class, there will likely be a better time for crossover investors to buy munis.

MBS MBS Index +67 bps zero volatility spread

An eventful start to the new year with a sharp move lower in yields, continued flattening in the Treasury curve, and new housing initiatives from the Obama administration weighing on the agency MBS sector. Valuations across the mortgage curve have widened 1 to 10 bps with the back end of the curve now approaching its cheapest levels in the last two years. An environment of a sub 2% 10-year Treasury yields and elevated levels of market volatility have led to a higher degree of directionality in spread movement than during previous months.

3 3

Spreads across the sector have cheapened considerably, but the moves appear warranted given the greater uncertainty in the market. The fundamental backdrop for MBS is becoming more challenged with increasing prepayment concerns, as well as new policy efforts to ease credit standards to support housing.

ABS +58 A strengthening U.S. economy (and consumer) will be supportive, and this low-duration sector should remain well-bid.

3 3

High-quality ABS spreads are at the wider end of their range and attractive for those seeking a low-risk (and relatively low-return) place to put cash to work. The esoteric parts of the market, for example timeshare and whole business ABS, continue to offer the best opportunity for higher returns.

Sector Outlook and Relative Value Key

Upgrade from the prior month

Downgrade from the prior month

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Positive Neutral Negative

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This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.Source: T. Rowe Price.




1 2 3 4 5

Positive Neutral NegativeAs of 12 January 2015


Sector Outlook


CMBS +119 Supportive backdrop of improving real estate values and lower odds of a downside economic scenario.

3 3

CMBS have remained resilient even as volatility has picked up over the last several months. The sector as a whole looks fairly valued relative to competing spread product. Supply estimates for 2015 are moderately higher than 2014, but given the amount of legacy paper rolling off, the technical backdrop will continue to be a supporting factor.

US Investment Grade Corporate

+131 The market’s focus remains on higher-beta commodity- and energy-related sectors, contributing to increased volatility and wider spreads. 4 4

Non-financial credit fundamentals have arguably peaked for this cycle, leaving technicals as the primary support for valuations. We continue to find opportunity in select financials and lower-beta sectors.

Euro Corporate +89 Spreads remain very stable and close to seven-year tights, benefitting from low government bond yields and rising expectations of increased European Central Bank (ECB) monetary stimulus.

3 3

Speculation of ECB bond buying dominates the medium-term outlook. Direct corporate bond purchases could further squeeze spreads. However, it’s not all about the ECB, as the European economic environment of low growth, low inflation, and low rates remain supportive of credit even if valuations are stretched.

US High Yield +625 The overall fundamental picture remains intact—outside of the commodities space. A muted default rate is expected in 2015, with the 2016 default outlook dependent on energy prices. The main driver of the market is commodity prices given the size of the energy sector and the impact on the market of oil price deterioration. Low dealer inventories have been contributing to increased volatility.

3 3

We continue to see a relatively muted default outlook through 2015. Overall valuations and market yields are getting more interesting now as they start to approach 7.5%, albeit likely with some volatility still to come from the energy sector. Spread levels are starting to imply a higher default rate than we are currently expecting. If oil prices remain low for a more extended period of time, we will evaluate the impact to our 2016 default outlook.

Euro High Yield +495 Fundamentally little has changed over the quiet year-end period. New issuance is yet to get underway and market cash balances are reported as high. Risk appetite is expected to be driven by the extent of ECB accommodative action but may be tempered by concerns over periods of volatility (Greek elections are an example of a possible trigger).

4 4

In relative terms, Euro high yield spreads are 130 bps inside the U.S. market following the U.S. energy sell-off. Despite appearing less attractive, Euro high yield was less volatile over 2014. Focusing on Europe, risk aversion remains apparent, with the ratio of Euro high yield to Euro investment-grade spreads at the highest level since 2006 at 5.6x.

Bank Loans +458 The fundamental backdrop remains intact with low forward default expectations and a minimal near-term maturity profile. The asset class continues to experience retail outflows, but overall net demand has still been solid given strong offsetting collateralized loan obligation (CLO) issuance. 2014 registered as the largest year ever for CLO issuance. Looking forward, risk retention rules and lending standards are starting to garner more headlines.

3 3

Loans still appear to offer a more defensive way to play solid high yield fundamentals with lower volatility. The market remains supported by the CLO bid, which is currently more than making up for retail outflows (otherwise, the market would likely be cheaper). Loans performed more defensively than high yield in the recent selloff but were not immune. There are discounts to be had with 80% or more of the asset class trading below par. And importantly, the asset class has a materially lower exposure to the commodities sectors than U.S. high yield.

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Sector Outlook


EM Dollar Sovereign +436 1. Sovereigns are attractive versus U.S. credit (both high yield and investment grade) but are increasingly idiosyncratic (Russia, Venezuela, and other oil-driven names, in particular);

2. Following rallies in local rates, U.S. dollar-denominated debt and FX overlays offer decent relative value.

3 3

Valuations remain attractive relative to developed market assets.

EM Corporate +415 1. Valuation is attractive relative to U.S. investment grade and high yield across ratings (this now includes single Bs as well);

2. Commodity price weakness has a mixed impact but is generally a headwind to spread compression;

3. Our enthusiasm is tempered by poor liquidity, particularly in EM high yield.

3 3

Valuations are still attractive versus similarly rated U.S. credit and, increasingly, sovereign credit.

EM Local +490/ 5-year

Yield spreads are near their tights versus U.S. Treasuries. EM local market performance remains bifurcated: Bonds have been performing better, but currencies remain weak. Both trends appear more extended. Local bond valuations look relatively cheap to global sovereign bonds. However, local bonds are looking expensive versus EM dollar sovereigns now.Signposts:• EM local flows have improved modestly but remain low. They

are not expected to pick up notably until the strong U.S. dollar bid steadies.

• Valuations are relatively attractive. • Growth rates remain subdued in EM. Until they pick up, EM

currencies will remain under a cloud. • The main risk of U.S. strength has been felt via the FX

channel, not bonds.

3 2

Duration: Rates in Brazil, Mexico, Colombia, Romania, Hungary, Turkey, and South Africa are attractive. FX: Favored long positions in LatAm include Brazil, Mexico, and Colombia. In Asia, India, Indonesia, Sri Lanka, and Vietnam are attractive. In Europe and Africa, we prefer exposure to Poland, Turkey, Zambia, Egypt, and Serbia. Retaining a basket of developed market FX hedges.

Eurozone (Germany 10-year) 0.48% The ECB is likely to announce sovereign QE at its next meeting on January 22. The small size of the German bund market and zero net new supply of bunds mean that QE will probably distort the market. The growth and inflation outlook is expected to improve later this year, but monetary policy is likely to remain accommodative for the foreseeable future.

4 4

Negative yields in the front end are pushing demand further out the curve. Sovereign bond QE should constrain yields at low levels. However, valuations are extremely expensive.

Japan (10-year) 0.30% Core inflation continues to undershoot, dragged lower by energy prices.Q4 growth signs have been more encouraging after a very weak Q3. The Bank of Japan (BoJ) has implemented further qualitative and quantitative easing, raising the amount of JGB purchases by ¥30 trillion.

4 4

While longer-term debt dynamics look unsustainable and Government Pension Investment Fund rebalancing will be an offsetting outflow, the BoJ’s bond purchase program is expected to dominate and support low yields.

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Sector Outlook


UK (10-year) 1.62% Benign inflation and concern about the drag from a weak eurozone has seen market pricing push out the timing of rate hikes; the Bank of England has validated the first move coming only later in 2015. A general election in May could see a potentially messy result.

3 3

We continue to expect only a modest hiking cycle given the interest rate sensitivity of the economy.

Canada (10-year) 1.66% Growth data remains relatively resilient, and we expect Canada to benefit from the U.S. recovery and stronger export growth. Inflation has returned close to target. Downside growth risks have grown recently with the sharp decline in oil prices.

4 4The market is underpriced for a resumption of rate hikes from the Bank of Canada later this year, though the Bank could lag the Fed and have a shorter hiking cycle given the higher starting point.

Australia (10-year) 2.68% The Reserve Bank of Australia (RBA) is content to stay on hold for now but has been disappointed by the recovery in non-mining sectors of the economy. There are downside growth risks given the ongoing decline in commodity prices and terms of trade.

3 3The market views the prospect of a resumption in rate cuts as more likely than not. On balance, we expect the RBA to remain on hold for an extended period but acknowledge the door for further easing is open.

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