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4Q Investment Report US Long Duration Full Discretion 2 0 1 6 Interest Rate Trends Yield Curve Interest rates surged over the quarter as markets anticipated higher US growth and inflation stemming from the upcoming fiscal policy transition. While 5s-to-bonds (as depicted below) ended the quarter a few bps flatter, the overall yield curve steepened as shorter-dated bonds (0-3 years) rose much less than long-dated issues. 5-Year to 30-Year Spread Spread Between 5- and 30-Yr. UST Yield (bps) 5 Treasury Yields Yield to Maturity (%) 4 3 30-Year Treasury Yields 2 1 5-Year Treasury Yields 0 -1 2008 3-Month Treasury Yields 2009 2010 2011 2012 2013 2014 2015 300 250 200 150 100 2016 Source: Bloomberg Source: Bloomberg. As of 31 Dec 16 50 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Bloomberg Source: Bloomberg. As of 31 Dec 16 Credit Spreads Long Credit Subsector Spreads Spreads ended the quarter at tighter levels. Other than sovereigns, spreads for all subsectors finished the quarter at tighter levels. 325 300 275 Basis Points Basis Points 280 Long Credit Index Spreads 260 240 220 U.S. Long Credit 200 180 160 140 U.S. Intermediate Credit 120 100 80 60 Jan 13 May 13 Sep 13 Jan 14 May 14 Sep 14 Jan 15 May 15 Sep 15 Jan 16 May 16 Sep 16 Fed Watch: Evolution of Median FOMC Member Interest Rate Forecasts Long Sovereign 200 175 US Long Corp ex Fins 150 - Long Taxable Municipal: US Aggregate Eligible 125 100 Jan 13 May 13 Sep 13 Jan 14 May 14 Sep 14 Jan 15 May 15 Sep 15 Jan 16 May 16 Sep 16 Source: Bloomberg Barclays Source: Bloomberg Barclays. As of 31 Dec 16 IG: Financial 250 Institutions – 225 Long Source: Bloomberg Barclays Source: Bloomberg Barclays. As of 31 Dec 16 4Q16 Fixed-Income Returns Most spread sectors posted positive excess returns in 4Q16. The FOMC raised interest rates during its December meeting and moderately increased its forecast of 2017 rate hikes from two to three. 4.0 Dec '16 FOMC Meeting Predictions 3.5 Excess Return (%) 3.0 Percent 2.5 2.0 1.5 1.0 Dec '16 FOMC Meeting 0.5 0.0 End 2016 End 2017 End 2018 End 2019 Long Run Source: Federal Reserve. As of 14 Dec 16 Source: Federal Reserve. As of 14 Dec 16 Note: FOMC = Federal Open Market Committee 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 -6 4.4 1.9 Excess Return % 3.3 2.4 Total Return % (Treasuries) 4.1 2.3 1.1 0.0 -0.4 -1.8 -4.1 -4.4 Govt Corp Long Mtge TIPS Non-$ EMD Corp Hedged Sectors HY Long Govt Credit 2 5 10 Maturity (years) -3.9 30 -3.4 30 (strip) Source: Bloomberg Barclays, J.P. Morgan, Western Asset Source: Bloomberg Barclays, JPMorgan, Western Asset. As of 31 Dec 16 US Long Duration Full Discretion PERFORMANCE SCORECARD We thought that … Therefore, we … Central banks would remain highly accommodative and growth and inflation would remain subdued. Therefore, UST rates were likely to remain low. Duration also served as a useful hedge for spread product exposures. Covered the mild duration overweight fol- – Yields ended the quarter at higher lowing the election. levels. The potential changing nature of monetary policy could exert upward pressure on the long end of the yield curve. Maintained a steepener bias in the long end – The curve flattened somewhat over the quarter. of the curve. The US agencies, FNMA and FHLMC, would continue to gradually improve their finances. Maintained an overweight to long-end se- +/–The overall strategy did not have a nior debt. meaningful impact on relative performance this quarter. Although corporate earnings could weaken modestly in the near term, the technical tailwinds should remain very positive for US credit. Maintained a modest underweight in long – Long corporate spreads ended the quarter at tighter levels; however, subinvestment-grade corporate credit. sector and issue selection offset part of the drag. Non-corporate credits, primarily consisting of Canadian provincials and long educational bonds, offered value. Maintained a small overweight. Certain states within the municipal market faced pension-related fiscal challenges and overall there was better relative value elsewhere. Maintained the modest underweight to tax- +/– Municipal spreads tightened over the able municipals. quarter; however, issue selection offset most of that drag. High-yield corporate fundamentals were sound and valuations were attractive. Maintained the modest position in high- + High-yield spreads tightened. yield exposure. The housing market continued to be supported by a slow easing of the tight credit conditions in play since 2008, which limited new supply and enticed demand. Maintained the overweight to non-agency + Spreads tightened during the quarter. RMBS. Emerging market bonds were exiting a deep bear market and would benefit from improving fundamentals and favorable technical tailwinds. Maintained corporate and local currency + Spreads tightened during the quarter. exposure. Long swap spreads would widen into yearend. Reduced the duration-hedged 30-year payer + Long swap spreads widened toward positions. the end of the quarter. Short euro and Chinese yuan currency positions would serve as a macro-hedges against policy errors and volatility from those areas. Where allowed, maintained a short euro and + The US dollar strengthened following yuan position and added a long Mexican the election. peso position near quarter-end as valuations looked attractive. Western Asset And the results … 2 + Issue selection within this strategy was a small contributor to outperformance. Fourth Quarter 2016 US Long Duration Full Discretion OUTLOOK Our thesis since the financial crisis has been that the global recovery would be ongoing but very slow by historical standards. In 2016, our view remained that US and global growth were going to be steady but unspectacular and that it would be sufficient to give us some ongoing forward momentum. Combined with a backdrop of subdued global inflation, central banks would increase accommodative monetary policies and this would help provide the support for an ongoing recovery. Our working premise has been a trend growth rate of roughly 1.5% for the US and just under 3% for the global economy. In order to take advantage of the ongoing global and US recoveries, a healthy amount of our risk budget was devoted to spread product, in the belief that slow growth, if sustained, would be sufficient to bring down various credit spreads. We have also utilized macro strategies, particularly overweights to duration that have helped protect the portfolio during risk-off periods, while also benefiting from the slow pace of interest-rate normalization. abroad while after many years of increasing supply, expectations are now for a deceleration in the pace of new issues as we head into 2017. Against this we remain vigilant about global issues that could come off the backburner such as Chinese growth and political events and policy errors in Europe. Overall, the base case view for credit spreads remains a tighter destination in the near to mid term, but the aggressive move tighter in spreads over the past many months have valuations nearing what can only be described as fair. The largest sector bias of the Firm’s credit portfolios, an overweight to financials, remains, but the magnitude has been reduced over the back half of the year. US and global bank regulation is well advanced and we view more regulation as generally good for bank bondholders. The incoming administration could relax the regulatory environment but Democrats are unlikely to allow wholesale changes to Dodd-Frank. Longer term, a looser regulatory environment could arguably be worse for bondholders but near term we resist the notion that changes will be dramatic enough to materially impact the domestic banking business model. US banks generated record revenues and earnings in 3Q16 and near-term bank performance will continue to be closely linked to domestic GDP performance. The market’s optimistic growth expectations since the US presidential election is based on policies that could come over the next 12-18 months, though the bond market has already raised interest rates today. Can the global and US economies fulfill those accelerated projections? It was not quite a year ago that optimism about US growth led the Federal Reserve to forecast four rate hikes in 2016, only to see China fears and global growth concerns lead to a very different outcome. While the markets appear to be pricing in an imminent uptrend for the economy, the economic releases over the past few months largely remained on trend. Overall the US economy is showing better growth than the 1.3% GDP growth pace that occurred from mid-2015 through mid-2016, but we think that improvement is less dramatic than what has become baked into market pricing. The evolution of Trump’s economic policies will be crucial. Our view is that the jury is still very much out. Igniting US growth in the context of a very weak global environment has proven exceedingly difficult. Trump’s trade policies are potentially negative for global growth. The implications of labeling China a currency manipulator and the erection of trade barriers may reinforce the global risk-off episodes we have seen intermittently over the last five years. We continue to view the overall market as being in the latter half of the credit cycle and are cautious about the potential for further M&A and shareholder-friendly activities in certain sectors. As such we are generally maintaining an underweight to technology and healthcare/pharmaceuticals. Commodity sectors such as energy and metals and mining have passed through the end of their cycles and are in deleveraging mode. We shifted to an overweight in energy earlier this year and remain comfortable holding this position as many issuers continue to take the necessary steps toward rightsizing their operations. On the margin we are reducing exposure in the telecommunications/media space on concerns over M&A activity and we are also reducing auto exposure. Overall, the strategy is still constructive on spreads and overweight beta, but given the significant improvement in valuations since the first quarter, the magnitude of this tilt has been significantly reduced. On the credit front, the fundamental backdrop for credit is mixed as there are late cycle indications (e.g., earnings growth is challenged, leverage is rising); however, new fiscal and political developments could be supportive of growth and credit friendly. The technical tailwind remains favorable as demand is expected to remain firm given investor flows from lower-yielding markets Western Asset While taking some profits on non-agency mortgages and other securitized issues, a sizable-yet-reduced allocation remains on a duration-hedged basis as we feel this sector remains attractive given the carry advantage over similar quality instruments. On the margin, emerging market fundamentals are improving and 3 Fourth Quarter 2016 US Long Duration Full Discretion we believe we have seen the bottom after a multi-year bear market. Within emerging markets we see more value in corporate and local currency exposure as opposed to dollar denominated sovereign exposure. Modest short positions in the euro and Chinese yuan also remain serving as a macro hedges against volatility emanating from those areas. The long-held underweight to taxable municipals remains. With regard to the agency sector, we believe the underlying fundamentals are still supportive. A curve-steepener bias on the long end of the US Treasury curve also remains. In addition to the positive carry feature in the current environment, the potentially changing nature of monetary policy, while still accommodative and aggressive, may exert upward pressure on the long end of the curve. © Western Asset Management Company 2017. 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Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business, investment management, and Type II Financial Instruments Dealing business with the registration number KLFB (FID) No. 427, and members of JIAA (membership number 011-01319) and JITA. Western Asset Management Company Limited (“WAMCL”) is authorized and regulated by the Financial Conduct Authority (“FCA”). In the UK this communication is a financial promotion solely intended for professional clients as defined in the FCA Handbook and has been approved by WAMCL. For more information on Western Asset visit our website at www.westernasset.com. Western Asset 4 Fourth Quarter 2016