Western Asset Investment Grade Income Fund : Fixed Income Market Commentary

1Q 2023

Investment Highlights

Western Asset Fixed-Income Market

Key Takeaways

• Bond yields fell and risk assets were mixed as investors shifted from a narrative of a "higher for longer" fed funds rate to significantly repricing the Fed's interest rate trajectory later in the quarter, on the back of banking sector concerns.
• US inflation reports during the quarter appeared to add to evidence of a bumpy path for inflation, while employment reports were mixed.
• The FOMC hiked the fed funds target rate by a total of 50 bps-25 bps each in February and March-to a target range of 4.75%-5.00%. There were indications that-although interest rate hikes may soon be coming to an end-the Fed is expected to keep interest rates at an elevated level for some time.

Market Review

During the first quarter of 2023, bond yields fell and risk assets were mixed as investors shifted from a narrative of a "higher for longer" fed funds rate to significantly repricing the Federal Reserve's (Fed) interest rate trajectory later in the quarter, on the back of banking sector concerns. Credit spreads were mixed while the S&P 500 rose.

Developments in the banking sector came to the forefront during the latter part of the quarter. Medium-sized regional banks-Silicon Valley Bank and Signature Bank-were shut down and taken over by the Federal Deposit Insurance Corporation (FDIC) after the banks failed to stem deposit outflows. The events triggered bank runs and financial stability concerns at similarly sized regional banks, but contagion risks were mitigated when the FDIC announced that it would guarantee uninsured deposits at the two banks. The Fed and Treasury also launched the Bank Term Funding Program, a new emergency liquidity provision tool that allowed banks to borrow in exchange for eligible collateral-atpar-to fund potential deposit outflows. At the press conference following the Federal Open Market Committee (FOMC) meeting, Fed Chair Jerome Powell emphasized that the "banking system is sound and resilient" and that the Fed is prepared to use all of its tools to keep the system "safe and sound."

In terms of US economic data, inflation reports during the quarter appeared to add to evidence of a bumpy path for inflation; although inflation moderated during the quarter in year-over-year (YoY) terms, it appeared to show a slower pace of disinflation compared to previous months. Headline Consumer Price Index (CPI) moderated to 6.0% YoY in February, from 6.5% in December. Core CPI-excluding food and energy components-decelerated from 5.7% YoY in December to 5.5% in Febru- ary. The 0.5% month-over-month (MoM) increase in February exceeded the consensus forecast of 0.4% and was the largest monthly increase in five months. Employment reports were mixed during the quarter. Non- farm payrolls were strong and exceeded expectations-rising 504,000 and 311,000 in January and February, respectively-despite anecdotal evidence of increased layoffs in certain sectors of the economy, including the tech sector. The unemployment rate, however, ticked higher to 3.6% versus the 53-year low of 3.4% at the beginning of the quarter, while the participation rate increased to 62.5%, its highest level since March 2020.

Average hourly earnings increased 4.6% YoY in February, down slightly from the 4.8% YoY increase seen at the end of last year.

Fed officials pressed on with rate hikes, but at a slower pace compared to recent months. During the quarter, the Federal Open Market Committee (FOMC) hiked the fed funds target rate by a total of 50 basis points (bps)-25 bps each in February and March, versus the 50-bp hike in December-to a target range of 4.75%-5.00%. There were indications that-although interest rate hikes may soon be coming to an end-the Fed is expected to keep interest rates at an elevated level for some time. For example, in February, Chair Jerome Powell said that "restoring price stability will likely require maintaining a restrictive stance for some time." In the March FOMC post-meeting statement, the committee softened the forward-looking part of its official statement-that previously included "ongoing [rate] increases will be appropriate"-to now say that "addi- tional policy firming may be appropriate," which signaled a potentially more cautious approach going forward. At the end of March, fed funds futures contracts were pricing in one more 25-bp rate hike by the end of the second quarter of 2023, and around two more 25-bp rate cuts during the second half of the year.

The Fed also released its March Summary of Economic Projections (SEP), which showed that the median FOMC member still expects scope for one more rate hike this year and for the fed funds rate to end the year at 5.10%, unchanged from its December forecast. No member expected a rate cut over the course of the year. The dot plot also projected a lower 2024 year-end fed funds rate of 4.3%, up from 4.1% projected in December, though the range of forecasts varied widely from 3.4% to 5.6%. By the end of 2023, the median FOMC member also expects core Personal Consumption Expenditures (PCE) inflation to decline to 3.6%, revised higher from 3.5% projected in December. That compares to the 4.4% YoY increase in core PCE inflation realized at the end of last year. The projected 2023 unemployment rate was revised lower from 4.6% to 4.5%, as was 2023 GDP growth, from 0.5% to 0.4%.

In Europe, economic data also informed the outlook for monetary policy. During the quarter, the European Central Bank (ECB) delivered two 50-bp rate hikes to raise the deposit facility rate to 3.00%, as expected. However,

Western Asset Fixed-Income Market

an initially hawkish message earlier in the quarter was counterbalanced by the ECB's removal of previous guidance from its policy statement in March, though during her March press conference, ECB President Christine Lagarde reiterated that the ECB was not "waning on our commitment to fight inflation, and we are determined to return inflation back to 2%." The Bank of England (BoE) raised its Bank Rate by a total of

75 bps-in50-bp and 25-bp in February and March, respectively-to 4.25%, though two members voted to keep the rate unchanged in March, potentially raising the threshold for additional rate hikes. In March, the Swiss government, central bank and market regulator orchestrated the state-backed takeover of Credit Suisse by UBS for 3 billion Swiss francs ($3.3 billion). In an unprecedented move, Swiss officials forced Credit Suisse's AT1 securities to be written down to zero and subordinated to equity. The Bank of Japan (BoJ) kept its monetary policy unchanged in the last meeting of Governor Haruhiko Kuroda's 10-year tenure before Kazuo Ueda takes the reins in April. In China, official Purchasing Man- agers' Index (PMI) manufacturing and services indices rebounded in February-with the manufacturing gauge rising to its highest reading since 2012-pointing to signs of a broad-based economic recovery after policymakers substantially eased COVID-19 restrictions in December.

During the quarter, credit spreads were mixed as high-yield corporate spreads tightened while investment-grade and structured product spreads widened. USD-denominated emerging market (EM) bond spreads widened, while EM local yields fell. The S&P 500 rose 7.5% while WTI oil fell 6% to just under $76/barrel. The US dollar weakened versus EM currencies but strengthened versus some developed market (DM) currencies. Over the quarter, US Treasury (UST) yields fell and the yield curve was mixed with the 2s-10s segment flattening from -53 bps to -58 bps, while the 5s-30s segment normalized and steepened from -2 bps to +7 bps. 2-year UST yields fell from 4.41% to 4.06%, 5-year yields fell from 3.99% to 3.60%, 10-year yields fell from 3.88% to 3.48% and 30-year yields fell from 3.97% to 3.67%.

Outlook

In line with our expectations, global growth appears to be downshifting and inflation is trending lower. Declining new order activity, rising inventories and improving supply chains worldwide have resulted in lower manufacturing inflation. Signs of moderating price pressures are also evident across service sectors, globally. These trends, combined with the major central banks continuing to advocate for tight monetary policy, should further temper growth and inflation. In the US, ongoing rate hikes and the Fed's intent to maintain a restrictive policy stance are weighing on inflation ex- pectations, wage growth and housing activity. That stated, our view is that the Fed is in a position to pause and that the US will avoid a recession. In Europe, the outlook is mixed as demand has improved and the labor market remains buoyant, albeit with forward-looking growth indicators pointing to additional softening. Meanwhile, macro conditions in the UK continue to deteriorate-deeply negative real wage growth and higher costs of living (e.g., energy and food prices) have crimped discretionary spending and pushed consumer confidence to all-time lows. The one bright spot in the global picture is China, where we see broad policy accommodation (to support the reopening of its economy following the end of its zero-Covid strategy) acting as a positive growth catalyst for Asia and EM as a whole. As global growth and inflation continue to moderate, and recent concern over the stability of the US and EU banking systems abates, we expect DM government bond yields to trend lower. In such an environment, we anticipate that the US dollar will weaken modestly and that EM-where central banks are at the end of their tightening cycle-will outperform. Credit markets currently offer attractive value but we acknowledge that they remain vulnerable to unanticipated shifts in macro-related sentiment, geopolitical developments and the risk of central bank overtightening.

Western Asset

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First Quarter 2023

Western Asset Fixed-Income Market

Risk Disclosures

Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. 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. International investments are subject to special risks, including currency fluctuations and 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. High yield bonds are subject to greater price volatility, liquidity, and possibility of default.

The Consumer Price Index (CPI) tracks prices for a basket of more than 80,000 goods and services.

Core Personal Consumption Expenditures (PCE) refers to the PCE Price Index excluding food and energy. The core PCE price index is closely watched by the Federal Reserve as it conducts monetary policy.

COVID-19 is the World Health Organization's official designation of the current coronavirus disease.

The Federal Open Market Committee (FOMC) consists of twelve members-the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.

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.

Gross domestic product (GDP) is an economic statistic that measures the market value of all final goods and services produced within a country in a given period of time.

A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.

Spread refers to the difference between Treasury securities and non-Treasury securities of similar maturity but different credit quality.

Summary of Economic Projections are released by the Federal Reserve four times a year. SEP features the Federal Open Market Committee (FOMC) participants' projections for GDP growth, the unemployment rate, inflation and the appropriate policy interest rate.

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

West Texas Intermediate (WTI) is a popular oil price benchmark. It is the underlying asset in the New York Mercantile Exchange's oil futures contract.

The yield curve shows the relationship between yields and maturity dates for a similar class of bonds.

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Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.

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First Quarter 2023