To Western Asset CIO, Uncertainty Is The Chief Bond Market Theme

In a market commentary white paper issued by Western Asset Management, CIO Ken Leech sees a common thread binding global fixed income markets: uncertainty. The current market strategy of Morningstar’s 2014 U.S. Fixed-Income Fund Manager of the Year for the Western Asset Core Plus and Western Asset Core Bond funds is predicated upon it.

“We believe there is no long-term value in current Treasury prices, but we respect the crosscurrents that underpin current yield levels,” Mr. Leech wrote. “We are underweight government securities tactically, but we have not undertaken any meaningful strategic negative duration stance, feeling there are other, better areas with the potential to add value. Our decision not to undertake a decisive negative duration position despite the overvaluation of the government bond market could be ascribed to this extensive analysis.”

“Another reason, more probable and even more powerful, is the consideration with which we began this note: too much uncertainty.”

The entire white paper is available at www.leggmason.com/westernasset and on Western Asset’s web site.

Mr. Leech and the Western Asset team believe the U.S. economy will continue to lead the way.

“Our view is that growth in the U.S. will be solid but unspectacular,” Mr. Leech wrote. “Our working premise of 2.5 percent growth is not as optimistic as the Fed’s 3 percent forecast, but this is not a huge difference. Either rate would be sufficient for the Fed to follow through on its intention to raise the federal funds rate above zero. We believe the Fed intends to start this process at mid-year, consistent with the guidance it has been communicating.”

Mr. Leech added notes of caution, however.

“The potential for error in GDP forecasting, particularly multiple quarters in the future, is very high. Actual GDP growth has consistently underperformed the Fed’s forecast over the last four years, and inflation has also remained below the Fed’s forecasts. On both counts, we are doubtful that the Fed will have sufficient confidence to tighten should core inflation meaningfully underperform its forecasts this year.”

“Market prices also reflect expectations that the first rate rise will come later in the year. We have long felt the process would be a protracted one. When we specifically compare our view with today’s market prices, we find there is an insufficient difference to take a position.”

One of the primary concerns for fixed income market participants and central banks is inflation.

“Our steadfast view has been that the downward trend in U.S. and global inflation would ultimately be arrested,” Mr. Leech wrote. “Even we have been surprised by the renewed downshift in inflation. It clearly suggests this process will take even more time and that long-term rates will stay lower for longer.”

These factors are having unexpected impacts on bond prices, in Mr. Leech’s view.

“Our views of lower-than-expected growth, declining core inflation, and a more dovish-than-previously-expected Fed would normally be pretty bullish for government bonds. However, these views look to be already fully reflected in yields on short- and intermediate-maturity government securities.

Similarly, at the long end, our view of an extended period of below 2 percent inflation would normally be constructive for long bonds, except that this view also looks to be fully reflected in Treasury bond yields under 2.5 percent.”

“Market pricing appears to have overshot optimistic scenarios across the yield curve.”

About S. Kenneth Leech

Ken Leech is Chief Investment Officer of Western Asset Management Com­pany. He joined the Firm in 1990. From 1991–2014, assets under manage­ment grew from just over $5 billion to $466 billion. Ken leads the Global Port­folio, US Broad Portfolio, and Macro Opportunity teams. From 2002–2004, Ken served as a member of the Treasury Borrowing Advisory Committee. In 2014, Ken and the Western Asset team were named Morningstar’s US Fixed-Income Fund Manager of the Year. Ken was inducted into the Fixed-Income Analyst Society Hall of Fame in 2007.

Ken is a graduate of the University of Pennsylvania’s Wharton School, where in four years, he received three degrees, graduating summa cum laude.

About Western Asset

Western Asset Management is one of the world’s leading fixed-income managers with $466 billion in assets under management as of December 31, 2014. The firm is a wholly owned, independently operated subsidiary of Legg Mason, Inc. (NYSE: LM) From offices in Pasadena, Hong Kong, London, Melbourne, New York, Sao Paulo, Singapore, Tokyo and Dubai, the company provides investment services for a wide variety of global clients, across an equally wide variety of mandates. For more information, please visit www.westernasset.com.

About Legg Mason

Legg Mason is a global asset management firm with $706 billion in assets under management as of January 31, 2014. The Company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange (symbol: LM). For more information, please visit www.leggmason.com.

All investing involves risk. Past performance is no guarantee of future results.

Western Asset Core Plus Fund

Investments in fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. An increase in interest rates will reduce the value of fixed income securities. The Fund may use derivatives, such as options and futures, which can be illiquid, may disproportionately increase losses, and have a potentially large impact on Fund performance. Leverage may increase volatility and possibility of loss. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Asset-backed, mortgage- backed or mortgage-related securities are subject to prepayment and extension risks. Risks of high-yield securities include greater price volatility, illiquidity and possibility of default. Potential active and frequent trading may result in higher transaction costs and increased investor liability. Diversification does not assure a profit or protect against market loss.

Western Asset Core Fund

Fixed-income securities involve interest rate, credit, inflation, and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed-income securities falls. Derivatives, such as options and futures, can be illiquid, may disproportionately increase losses, and have a potentially large impact on fund performance. Investing in asset-backed, mortgage-backed or mortgage-related securities subjects the Fund to additional risks such as prepayment and extension risks. The Fund may engage in active and frequent trading, resulting in higher transaction costs and increased investor liability. Diversification does not assure a profit or protect against market loss. Please see the prospectus for a more complete discussion of the Fund’s risks.

Western Asset Core Plus Fund Sector Allocation % as of December 31, 2014
Mortgage-Backed Securities 39.0
Investment Grade Corporate Bonds 25.1
Government 15.3
Emerging Market (IG) 8.1
High Yield Corporate Bonds 4.6
Asset-Backed Securities 2.4
Bank Loans 2.3
Inflation-Linked 2.1
Cash & Other Securities 1.1

Effective Duration (Years): 5.84

Western Asset Core Fund Sector Allocation % as of December 31, 2014
Mortgage-Backed Securities 44.1
Investment Grade Corporate Bonds 27.4
Government 13.2
Emerging Market (IG) 7.1
Asset-Backed Securities 3.8
Cash & Other Securities 1.9
Inflation-Linked 1.7
High Yield Corporate Bonds 0.7
Municipal 0.2

Effective Duration (Years): 5.91

Morningstar Award: Awarded to Ken Leech, Carl Eichstaedt, and Mark Lindbloom for Western Asset Core Bond Fund (WACSX) and Western Asset Core Plus Bond Fund (WAPSX) named Morningstar 2014 U.S. Fixed Income Manager of the Year, United States of America. Morningstar Awards 2015 © Morningstar, Inc.

Morningstar Fund Manager of the Year award recognizes portfolio managers who demonstrate excellent investment skill and the courage to differ from the consensus to benefit investors. To qualify for the award, managers’ funds must have not only posted impressive returns for the year, but the managers also must have a record of delivering outstanding long-term performance and of aligning their interests with shareholders’. The Fund Manager of the Year award winners are chosen based on Morningstar’s proprietary research and in-depth evaluation by its fund analysts.

U.S. Treasuries
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity.

Duration
Duration is a measurement that signals how much the price of a bond is likely to fluctuate when there is a change in interest rates. The higher the duration number, the more sensitive a bond will be to interest rate changes.

Effective Duration
Effective Duration is a duration calculation for bonds with embedded options. Effective duration takes into account that expected cash flows will fluctuate as interest rates change.

Yield Curve
Shows the relationship between yields and maturity dates for a similar class of bonds.

Investment-Grade Bonds
Are those rated Aaa, Aa, A and Baa by Moody’s Investors Service and AAA, AA, A and BBB by Standard & Poor’s Ratings Service, or that have an equivalent rating by a nationally recognized statistical rating organization or are determined by the manager to be of equivalent quality.

Basis Point
A basis point is one one-hundredth of one percent (1/100% or 0.01%).

Gross Domestic Product (GDP)
Gross Domestic Product (“GDP”) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

Federal Reserve Board
The Federal Reserve Board (“Fed”) is responsible for the formulation of policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Before investing, carefully consider a fund’s investment objectives, risks, charges and expenses. You can find this and other information in the Fund’s prospectus available at www.leggmason.com/individualinvestors