May *EU Periphery Sovereigns include bonds from countries such as Greece, Ireland, Italy, Portugal and Spain.

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1 May 2014 Rates are stuck in a holding pattern - US and UK 10-year yields have been range bound since late January, while euro-area rates have drifted lower. While technical factors may have contributed to the rally, the main culprit for stubbornly low rates still centers on growth. This is reflected in real yields, which imply broad scepticism about potential economic activity. Citi analysts believe - improving prospects in the developed world are sustainable, and that greater potential exists for bond yields to rise than to move lower from here. Recent releases have been relatively upbeat, economic surprise indexes have rebounded and inflation expectations are anchored around long term norms. Citi analysts retain a defensive stance on duration and recommend taking advantage of the rally to lighten exposures to zero coupon debt and rate-sensitive sectors. High quality corporate credit has outperformed - largely due to the decline in risk-free rates. Citi anlysts continue to recommend investors ratchet down in quality (or in the capital structure) to pick up yield, given strong fundamentals and low default rates. Citi analysts favour Euro denominated credit over USD, financials over non-financials and remain constructive on high yield bonds and bank loans. Sectors 12 Months View Investment Rationale Dev. Market (Core) Sovereigns EU Periphery Sovereigns* Emerging Market Sovereigns High Grade Corporates High Yield Corporates Underperform Outperform Underperform Market perform Outperform Favour short duration strategies as intermittently higher bond yields are expected in 2014; Bunds poised to outperform UST and UK Gilts as ECB policy remains accommodative Risks are ring-fenced, for now; Growth and banking concerns persist, but have marginally improved; Financial conditions to remain resilient and further spread compression likely Modest outperformance likely to continue near term; Favour short duration and lighten exposure to fragile credits; external (sov. & corp.) vs. local debt given FX volatility; Citi analysts favour 3- to 7-year maturities; Euro over USD, Financials over non-financials and prefer BBB-rated credits versus higher quality Carry (not spreads) are likely to drive future performance; Remain constructive; Value in Single-B rated issuers *EU Periphery Sovereigns include bonds from countries such as Greece, Ireland, Italy, Portugal and Spain.

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3 Developed Markets Government Bonds Rates are stuck in a holding pattern. Indeed, US and UK 10-year yields have been range bound since late January, while euro-area rates have drifted lower (at nearly 120bp, the 10-yr UST/Bund spread is historically wide). It s notable that 10-year UST rates have traded in a 25bp range for the past few months (the longest such period in at least two decades) and have been in a 50bp range since last June (Fig. 1). Yields have been sticky even though the term premium (which began normalizing in May 13) has been grinding higher since February. What gives? After all, economic activity and leading indicators have been fairly upbeat after a disappointing first quarter. Surprise indexes have rebounded from recent lows, and inflation expectations which have softened since January (especially in the Eurozone) are still anchored around long term norms. Yet, shorting the bond market has been the pain trade this year (Fig. 2). Figure 1: UST Treasury rates are stuck in a tight trading range Figure 2: Shorting the bond market has been the pain trade YTD We could blame it on the weather, or we could blame it on geopolitical risks. We could even blame the bullflattening of the US curve (despite tapering from the Fed) on pension fund demand and China purchases (i.e., given larger USD reserves due to weaker RMB). While it s possible that these have contributed to the rally, the main culprit for stubbornly low rates still centers on growth. This is reflected in real yields, which imply broad scepticism about potential activity. Indeed, the decline in forward real yields suggests that investors are second-guessing Fed projections as terminal policy rates and long-dated yield forecasts are reprised lower. Markets are even discounting a slower pace of rate hikes than the FOMC expects despite official guidance that reflects the slowest potential pace of tightening (100bp to 125bp per year) that has ever transpired in any prior hiking cycle. The dearth of long positioning suggests that weak data could easily drive rates even lower. But, if you believe (as Citi analysts do) that improving growth prospects are sustainable, then a greater potential exists for yields to rise than to move lower from here. Citi analysts retain a defensive stance on duration and recommend lightening exposures to zero coupon debt and rate-sensitive sectors, particularly in the US and UK.

4 Emerging Markets Government Bonds Emerging market returns are being fuelled by slower-than-expected growth, accommodative central bank policies (in developed markets), the strong demand for yield, and relatively attractive valuations. Since the sharp sell-off in May through September 2013, EM spreads (and yields) have declined by roughly 65bp. USD EM sovereign debt has risen by about 5.5% YTD (and by 11.5% since September). Local currency bond markets have also rebounded, rising by 4.5% this year (unhedged to USD) and by 7.5% since the selloff peaked last September. While developed market growth concerns have diminished negative headlines, Citi analysts remain concerned about the (relatively unchanged) fundamental landscape in EM. Indeed, real yields have broadly risen (along with higher policy rates) but growth has not. Inflation remains elevated, export growth is weak, and credit standards are tightening (e.g., India, Brazil, Indonesia, Russia, Turkey). While low implied volatility may support further gains near term, Fed tapering and improving US data should pressure government yields higher. Typically, rising US rates correlate with a reduced appetite for EM debt. While Citi analysts do not anticipate another severe market reaction, higher Treasury yields are likely to be a principal headwind to performance. They recommend that investors retain a short duration bias in external EM markets, to favour select corporate issuers over sovereign debt (particularly in Latin America), and to avoid issuers among the more fragile (i.e., deficit-laden) EM nations. Citi analysts maintain a cautious view on local EM markets debt. In their view, growth prospects are likely to weaken further and current account deficits are likely to persist, fuelling elevated currency volatility. Citi analysts continue to prefer Mexico local currency (and external) debt, which has risen 6.1%, YTD. Mexico s economy is likely to benefit from improving US manufacturing activity, while central bank policies promote a stable MXN. Prospects of QE in the Eurozone may support local markets in high quality Eastern European countries, such as Czech Republic and Poland. Interest rates in these markets have demonstrated a high correlation to German Bunds and increased foreign inflows may lead to FX appreciation (Fig. 3). Figure 3: High quality East European rates are tracking Bunds Source: Bloomberg.

5 Investment Grade Corporate Bonds High grade corporate debt has benefitted from strong demand as core government rates remain range-bound. For example, US bond inflows have eclipsed $20 billion this year (after $12 billion of outflows in 2013). As a result, USD corporates have risen 4.2% year-to-date, outperforming both GBP and EUR securities (3.9% and 3.2%, respectively). These outsized returns have primarily been driven by the decline in interest rates, not spread compression. Indeed, when returns are adjusted for the decline in UST and German Bund yields, corporate bonds post only modest gains of 1.2% and 0.9%, respectively (Fig. 11). Although fundamentals remain solid, the expected drag from rising government rates is Citi analysts principal concern. While they expect spreads to be stable, total return investors should consider taking profits or shortening duration in the 3- to 7-year maturity range. They favour euro-denominated credits over USD and GBP, financials over nonfinancials, and BBB-rated credits versus higher quality names. Figure 4: HG corp. returns have been fuelled by lower rates ) are expected t High Yield Corporate Bonds HY markets enjoyed another month of positive performance despite weaker technicals. European and US markets gained roughly 1.0% and 0.6% in April, boosting YTD total returns to 4.2% and 3.7%, respectively. Spreads remain near post-crisis tights, and yields are at (or near) historic lows. Market demand continues to be bolstered by relatively strong fundamentals, low default rates, subdued volatility, central bank liquidity, and the eternal quest for yield. Prevailing conditions are poised to persist despite stretched valuations. That said, further gains in HY will be more dependent on coupon since substantial spread compression is unlikely, in Citi analyst s view. Citi analysts favour Europe over US credits, Single-B rated issuers, and HY unsecured debt to outperform bank loans in the near term. In bank loans, 95 straight weeks of fund inflows finally ended last month, followed by four weeks of outflows. That said, the roughly $1 billion of reported outflows comprises a mere 1.0% of the total assets invested in the loan market since January 2013 ($73+ billion). While outflows could persist in the near term, Citi analysts do not expect to see a substantial market reversal similar to Indeed, even as rates continue to fall this month, loan prices have risen. Citi analysts expect attractive valuations to further bolster demand from CLO managers, helping to stabilize flows, and for duration-sensitive investors to return as rate fears re-emerge.