ING Investment Office Publication date: 16 November 2017, 13.00 a.m.

What will the central banks do? And when will interest rates rise? These are the most important questions concerning bond investors.

Capital market rates virtually unchanged

Before we look ahead, first a brief look back. Contrary to our expectations for this year, as discussed in Investment Outlook 2017 and the previous update of our Fixed Income Outlook, capital market rates (bond yields) have not increased. At the time of writing (3 November), both the US 10-year rate (2.35%) and the German 10-year rate (0.37%) are at almost the same level as in January.

Development of the German and US 10-year interest rate (%)

Source: Thomson Reuters Datastream, ING Investment Office

10- jaarsrente Duitsland en VS

Dec 16 Mar 17 Jun 17 Sep 17 Dec 17 Mar 18 Jun 180.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

VS verwachting ING Duitsland verwachting ING

2.32%

0.33%

2.4%

3%

0.4%

1%

Sources: Thomson Reuters Datastream, ING Investment Office (expectations), 3 November 2017.

Simon Wiersma has been Investment Manager at the ING Investment Office since 2009. He previously worked as an asset manager, portfolio manager and investment strategist. Simon has completed various investment courses and studied Business Economics at Hogeschool

Fixed Income Outlook November 2017

ING Investment Office Publication date: 16 November 2017 12:46:37

Interest rate hike in June was short-lived

Higher interest rates following Draghi’s speech at the end of June... If interest rates remain at the same level, you could say that you haven’t missed much. That is not entirely true, however, because in the intervening period there has been some movement in the bond markets. For example, the interest rate suddenly jumped up at the end of June (see chart). During a meeting of central bankers in the Portuguese Sintra, President Mario Draghi of the European Central Bank (ECB) unexpectedly hinted at a scaling back of monetary stimulus (the purchase of bonds by the ECB). Investors concluded that this might signal the start of the long-predicted upturn in the bond yield. In the last week of June and the first two weeks of July, the German 10-year rate, the benchmark for capital market rates in the eurozone, rose from 0.25% to 0.60%. ... were only temporary However, this sharp rise in interest rates was only short-lived because eurozone inflation figures, despite the surprisingly strong economic growth, were still too low and below the ECB’s target level. The fear of rapidly rising interest rates proved to be unfounded. Economic growth of (more than) 2% in the eurozone during the past two quarters and falling unemployment is not yet resulting in rising inflation. Inflation in the eurozone has fluctuated around 1.5% in recent months. Core inflation (inflation excluding the prices of energy and food) is a further 0.5% below this. Both are thus still well below the 2% aimed for by the ECB. Bond yields also hardly increasing in the US, despite growth The US 10-year yield has also hardly moved since the beginning of this year. And that is rather striking, given the positive economic developments. Although the massive incentive measures promised by President Trump, including tax cuts and investments in infrastructure, have failed to materialise, growth in the US economy nevertheless increased to 3% (converted to an annual basis) in the second and third quarters, following a weak first quarter (+ 1.2%). The growth of gross domestic product (GDP) is above the long-term average in the US and is partly reflected in a strong housing and labour market. US unemployment has now fallen to 4.1%, the lowest level since December 2000.

For a long time simultaneous growth worldwide The economy is not only doing well in the eurozone and in the US, but that is also the case in the other important economic blocs. It has been a long time since we have seen simultaneous healthy economic growth all over the world. The Chinese economy is likely to grow around 7% this year and this also stimulates growth in other emerging markets. The fear of a ‘hard landing’ (too rapid cooling down) for the Chinese economy has now sharply diminished. And even the Japanese economy has seen a sharp upswing following years of very moderate growth. GDP growth in the second quarter was 2.5% (calculated on an annual basis), well over double the 1.2% over the first quarter. No wonder that the economy is growing worldwide. After the disappointing growth of 3.1% in 2017, we expect global growth of 3.6% for this year and slightly higher for 2018: 3.7%.

ING Investment Office Publication date: 16 November 2017 12:46:37

Prospect of more interest rate hikes

Economic growth is widely supported

Source: Thomson Reuters Datastream, ING Investment Office

Groei BBPjaar op jaar (%)

Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q2015 2016 2017

5.6%

5.8%

6.0%

6.2%

6.4%

6.6%

6.8%

7.0%

7.2%

eurozone Japan VS China (linkeras)

Source: Thomson Reuters Datastream, 3 November 2017 Central banks slowly turning off the money tap Because economic growth is still expected to increase a little more, the most important central banks will cautiously turn off the money tap after almost ten years of enormous monetary stimulus. The aim is to prevent the economy from overheating. The US economy is growing strongly and, if Trump's incentive plans are implemented, will improve even more next year. The US central bank, the ‘Fed’, has therefore already increased its policy rate by a quarter of a percentage point on four occasions since December 2015. This occurred even though inflation in the US is still relatively low. We expect the Fed to raise interest rates once again by a quarter of a percentage point in December. We expect a further two or three interest rate hikes next year. The Fed is not the only central bank that is raising interest rates. At the beginning of this month, the Bank of England, the British central bank, raised its policy rate for the first time in ten years by 0.25% to 0.5%. The Bank of Canada also already came into action and earlier this year increased interest rates in two steps to 1%. Central banks in the eurozone, Japan and China proceeding cautiously Closer to home, the ECB indicated that although the bond buy-back programme will be extended until at least September 2018, the monthly budget will be halved to € 30 billion from January 2018. According to ECB President Mario Draghi, the policy rate in the eurozone will only be increased long after the end of the buy-back programme. This means that the interest rate on savings in the eurozone will still remain low for some time. The Japanese central bank has indicated that it will continue to pursue accommodating policies for some time still, while the Chinese central bank very carefully hinted at less stimulating policy and thus higher interest rates.

Development of average central bank policy rate

Source: Thomson Reuters Datastream, ING Investment Office

Centrale bankenrente ontwikkeling

07 08 09 10 11 12 13 14 15 16 170.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

Gemiddelde beleidsrente: eurozone, Japan, VK, VS (linkeras)

We anticipate higher capital market rates... Increasing economic growth and the less accommodating policies of central banks mean we can expect higher interest rates. And I must honestly confess that we have often expected this, but have not yet seen it happen (although our expectations for short-term interest rates were correct). Nevertheless, looking ahead, rising interest rates are currently the most likely scenario. Particularly in the US there is increasing ‘underlying’ inflationary pressure (such as the strengthening labour and housing markets and the higher oil price). That is also what the Fed is telling us. We therefore expect that Jerome Powell, the intended successor to Fed chair Janet Yellen, will continue the Fed’s gradual policy rate normalisation. In response to increasing US inflationary pressure and the FED's balance-sheet reduction, and in anticipation of less stimulation by other central banks, the US 10-year yield may rise to 3% at the end of next year. The German 10-year yield, the benchmark for the capital market interest rate in the eurozone, may increase towards 1%. Our main arguments for this are: relatively healthy economic growth (1.9%) with slightly higher inflation expectations (around 1.5%) and above all: the prospect of a less accommodating policies by the ECB.

We maintain a bandwidth of 0.4%-1% for German 10-year yields

... via underweight of government bonds and lower interest rate sensitivity Our outlook for eurozone government bonds has not changed fundamentally compared to the beginning of this year. We do not expect soaring wages, but the speculation about the further scaling back of the stimulus by the ECB will increase, with in the first instance slightly higher capital market rates as a result. We are therefore maintaining our expectation for the future German 10-year yield. We are shifting the bandwidth for this of 0.4% to 1%, which we had earlier this year, further forward in time to the middle of next year. For the time being, we are therefore sticking to the short duration (lower interest rate sensitivity) within the fixed income portion of the investment strategies. Slightly increasing interest rates, thus accompanied by falling government bond prices, will result in a negative return for the index of eurozone government bonds (Citigroup Euro Government Bond Index). We are therefore maintaining our underweight position for this class in the tactical asset allocation of our investment strategies. In addition, with the government bonds subcategory we are also investing partly in inflation-linked government bonds. An increase in interest rates due to higher inflation (expectations) will therefore have a much less negative effect. Although we anticipate negative returns on 12-month government bonds from the present levels, we are still maintaining some investments in this bond category, since such bonds are the only asset class to offer protection in times of crisis or great uncertainty in the financial markets.

High valuation and lower credit rating make HY less attractive Attractive investments in mortgage bonds

Weighting of high-yield corporate bonds reduced At the beginning of 2017 we still maintained a substantial overweight of high-yield corporate bonds, also known as ‘high-yield bonds’ (HY). In the meantime, we have reduced their weighting in the tactical asset allocation in two steps (April and September) to neutral. The most important reasons for this are the strong valuation and the expectation that the US economy has entered the final phase of the business cycle. Due to low yields worldwide, more and more investors have in recent years been looking for extra returns, compared with the very low (and partly negative) effective yields on government bonds. As a result, the prices of HY bonds have risen sharply, but their risk premiums have also declined substantially. The spreads, i.e. the interest rate differentials with respect to ‘safe’ government bonds, have after all fallen sharply. The average spread is now approaching the low point from before the start of the financial crisis in 2007. At the same time, the average credit rating of US companies issuing HY loans has decreased during the past year. Globally, US HY bonds represent around 70% of this bond category. Now that the Fed will pursue less accommodating monetary policy, resulting in higher expected yields, bankruptcies are increasingly likely due to higher interest charges. We therefore believe that the risk/return ratio has become less attractive at the moment and consider a neutral position in high-yield bonds to be more appropriate.

Spread development* of bond categories (%)

Source: Thomson Reuters Datastream, ING Investment Office

Credit Spreads

2004 2006 2008 2010 2012 2014 20160%

5%

10%

15%

20%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

BARCLAYS GLOBAL HIGH YIELD vs 5y TEMBI Global Diversified SpreadBARCLAYS EURO IGC vs 5y Bund (linkeras)

*) Spread: risk premium in market interest rates relative to the interest rates on ‘safe’ government bonds (such as German) with the same residual maturity. Source: Thomson Reuters Datastream, 6 November 2017. Increased weighting of corporate bonds We are more enthusiastic about bonds from first-class debtors (‘investment grade credits’, IGC). As can be seen from the chart above, the spread on IGC in absolute terms is a lot lower than HY, but a lot more attractive in historical terms. Compared to the level for 2007, there is still quite a difference of about 50 basis points (0.50%). Due to the continuation of the ECB’s purchasing programme it is not expected that the spread will rapidly increase. Within the IGC category, for our investment strategies we do not only invest in Europe but also beyond. (We are currently hedging the exchange risks in this respect.) For example, for several years we have already been investing in US and European mortgage bonds. In August, we increased the weighting of IGC from neutral to overweight.

Index returns realised per class in 2017 (until 3 November)

Source: Thomson Reuters Datastream, ING Investment Office

test

8.6%

7.4%

7.0%

2.5%

1.1%

0% 2% 4% 6% 8% 10%

Obligaties opkomende markten (USD)

High Yield eurozone (EUR)

High Yield VS (USD)

Bedrijfsobligaties (EUR)

Staatsobligaties (EUR)

performance 2017*

*Total return

Featured indices High Yield US (USD): BofA ML HY Master II Index, High Yield eurozone: BofA ML Euro High Yield, emerging market bonds: J.P. Morgan EMBI Global Diversified Composite (USD), corporate bonds: Citigroup EUROBIG Corporate Index, corporate bonds: Citigroup EMU GBI All Maturities Index (EUR). The value of your investments may fluctuate. Past performance is no guarantee of future results. No account has been taken of any service fee. This must be deducted from the return. Source: Thomson Reuters Datastream, 6 November 2017. Partial profit-taking on EMD At the same time as the increase in the position in IGC, in August we reduced the weighting of emerging market bonds (‘emerging markets debt’, EMD) from overweight to neutral in the tactical asset allocation. In doing so, we took profit on April’s tactical decision, when we increased the position in EMD from neutral to overweight. Substantiation of EMD tactical policy At the beginning of this year, investors were afraid of protectionist measures by President Trump and of rapid interest rate increases by the Fed. These could slow down economic growth in emerging markets and put pressure on local currencies. During the course of this year, it appeared that this was not happening. That fear faded even more following the publication of strong growth figures for the Chinese economy in the first quarter. Partly for this reason, we increased the tactical weighting of EMD in April. As already mentioned, in August we reduced the weighting again from overweight to neutral. Our argument for this was the increasing likelihood of higher interest rates in the US and thus a stronger US dollar. You can see from the chart below that the market has also responded in the same way. Especially EMD in local currencies has since September surrendered part of the profit already accumulated this year. The development of the return of EMD in hard currencies (such as the dollar) has been quite flat since then. As long as interest rates in the US do not rise sharply and the dollar does not become much stronger, we consider the risk premium (the ‘spread’) on EMD rather attractive. We should, however, point out that the spread is already moving quite some way towards the low levels from before the financial crisis. For the time being we are maintaining a neutral weighting for EMD.

Indices for emerging market bonds in hard and local currencies

Source: Thomson Reuters Datastream, ING Investment Office

JPM Emerging Market Indices(beide in USD)

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov2017

-5%

0%

5%

10%

15%

20%

JPM EMBI GLB.DIVERS COMPOSITE JPM GBI-EM GLOBAL DIV Composite($)

8.6%

10.8%

Orange line: EMD HC; grey line: EMD LC. Source: Thomson Reuters Datastream, 6 November 2017. Remain alert Our expectations for higher capital market rates have not yet materialised this year. We nevertheless assume that the yields on eurozone government bonds will increase on balance in 2018. However, we do not think that this will happen in one straight line. The markets will, as in the past, be confronted with sudden changes. It seems unlikely that the low volatility (price movement), which we have already seen on the financial markets for many months now, will still continue for a very long time. Bond investors must therefore also remain alert. Earlier this year, we mitigated the risks within investment strategies by reducing the weighting of HY and EMD. For the moment, we feel comfortable with an overweight of IGC. Low expectations for fixed-income securities For (government) bond investors, the yield forecasts for 2018 are not very high. By means of a well-diversified bond portfolio, an active duration policy and supplemented by government bonds and IGC with bond categories with a higher expected return, we seek a return on the bond investments that is slightly higher than the return on a savings account with a close eye naturally being kept on the risks. Want to know more? You can find our current tactical asset allocation in our Monthly Investment Outlook.

Disclaimer This investment recommendation was prepared by Simon Wiersma, Investment Manager, and was published and first distributed on 9 November 15.30 by the ING Investment Office, part of ING Bank N.V. For the preparation of this investment recommendation, use was made of the following substantive sources of information: S&P Capital IQ, Bloomberg, CreditSights, Oddo Securities, S&P, Moody’s, Fitch, UBS Neo. This investment recommendation was based on the following accounting principles, methods and assumptions: price/earnings ratio, price/book value ratio and NAV. No protected models were used for this investment recommendation. A description of the ING policy regarding information barriers and conflicts of interest can be found on: http://www.ing.com/About-us/Compliance/Information-Barriers-Conflicts-of-Interest.htm. Unless otherwise stated, ING Bank N.V. will not update the investment recommendation. Developments that have occurred after the preparation of this investment recommendation may affect the accuracy of the assumptions on which this investment recommendation is based. Investment recommendations are generally revised two to four times a year. This investment recommendation does not constitute individual investment advice, but only a general recommendation on which investors can also base their investment decisions and does not constitute an invitation to enter into any contract or commitment whatsoever. This investment recommendation is based on assumptions and does not represent any guarantee for a particular development or result. No rights can be derived from this investment recommendation. Decisions based on this investment recommendation are for your own account and risk. Neither ING Bank N.V., nor ING Groep N.V. nor any other legal entity belonging to the ING group, accepts liability for any damage to any extent whatsoever, arising from the use of the above investment recommendation or the information contained therein. Investing entails risks. You could lose all or part of your initial investment. The value of your investment may fluctuate. Past performance is no guarantee of future results. ING Bank N.V. is not registered as a broker dealer and investment advisor as referred to in the US Securities Exchange Act of 1934, respectively, the US Investment Advisers Act of 1940, as amended from time to time, nor within the meaning of other applicable legislation and regulations of the individual states of the United States of America (hereinafter jointly referred to as: ‘US investment law’). This investment recommendation is not addressed to and not intended for US Persons within the meaning of US investment law. Copies of this may not be sent or brought to the United States of America or provided to US Persons. ING Bank N.V. has its registered office in Amsterdam, Commercial Register no. 33031431, and is supervised by the Netherlands Authority for the Financial Markets (Stichting Autoriteit Financiële Markten) (“AFM”). ING Bank N.V. is part of ING Groep N.V. All rights reserved. This investment recommendation may not be reproduced, copied, published, stored, modified or used in any form, online or offline, without the prior written consent of ING Bank N.V. ©2017 ING Bank N.V., Amsterdam.