Where s the Beef? Finding Value in Fixed Income

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1 CIO REPORTS Monthly Outlook Where s the Beef? Finding Value in Fixed Income It is understandable that, in the near-decade that the Federal Reserve (Fed) did not raise interest rates, savers were penalized and forced to search further out on the credit spectrum for higher returns. The search paid off: For years, investors were rewarded with almost equity-like returns in High Yield (HY) credit annualized returns of 12.6%, close to the annualized 14.8% return of the S&P 5 Index, from 29 to 215. As the credit cycle is further along and market dynamics have shifted, however, investors need to think twice about their HY positions. The risk from deteriorating bond market liquidity, particularly for lower-quality credit, is increasing; the price impact of liquidity disruptions during periods of stress has become greater; recent episodes of market volatility demonstrate that many fixed income investments are not behaving as expected and can lead to increased volatility within portfolios; and default risk is growing in lower-rated portions of the fixed income market. APRIL 216 Chief Investment Office John Veit Vice President John Lieberkind Vice President Chris Wolfe Managing Director Recent Publications Weekly Letter Will Earnings Blossom With Spring? Rollercoaster Ride REITs Enter Adolescence Shopping for Yield and Growth Monthly Letter Forget Jack, Focus on Charlie-in-the-Box CIO Outlook The Forces Shaping Our World Despite this, we believe that fixed income still plays an important role in a balanced portfolio and that relative value exists as investors ask where they can find value and yield in fixed income. On the back of higher-growth expectations, most strategists expected the yield on the 1-year U.S. Treasury to be higher in 216; however, at the end of the first quarter of the year, it was 1.75%, down from 2.27% at the end of 215. That is low relative to history, but attractive relative to the yields on other Developed Market government bonds, which are close to zero (e.g. Germany and Japan), though we recognize that it may be insufficient for investors with greater income needs to meet their long-term goals. The Wealth Allocation Framework LIFE PRIORITIES The Wealth Allocation Framework helps you put your goals and aspirations at the center of decisions about allocating your financial resources. Asset categories within the framework include: Personal: Individual investors have a desire for safety and personal financial obligations they want to meet regardless of market conditions. To safeguard essential goals, investors can hold lower-risk assets but they have to accept lower returns in exchange. Market: When we invest, we strive to capture market growth most efficiently. Today, access to a broadening array of asset classes and types makes diversifying beyond stocks and bonds easier than ever before. Aspirational: Investors seek significant wealth mobility. To pursue goals that require higher-than-market returns, investors often need to take higher and concentrated risks. To learn more, read the whitepaper, Investing in a Transforming World: The Wealth Allocation Framework Merrill Lynch makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and other subsidiaries of Bank of America Corporation. Investment products offered through MLPF&S: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value 216 Bank of America Corporation. All rights reserved.

2 In our view, there is relative value in U.S. Investment Grade (IG) and municipal bonds, especially on a taxable equivalent yield basis. We think now is the right time for investors to consider reducing concentration in lower-quality fixed income, diversifying income sources within their portfolios, and getting back to basics using fixed income to help manage total portfolio risk. Value in the fixed income market defined We define value in a fixed income investment relative to three factors: Inflation: The yield of a fixed income investment adjusted for inflation. Its own history: The current spread relative to history, except in the municipal market, where we use the Treasuryto-municipal ratio. U.S. Treasuries: Since the U.S. Treasury bond is commonly seen as a riskless asset that is liquid, we take the difference in yields of the fixed income asset class relative to those of U.S. Treasuries. In our view, the combination of these three factors provides a framework to help guide investors looking for value in the fixed income market. Where does value exist now? Most investors think there is no value in the fixed income market but, in reality, there are pockets of it in various fixed income sub-asset classes. It is true that investors looking for real yield in U.S. Treasury bonds are not finding much. The yield on the 1-Year Treasury (which we use as a proxy for the market) is 1.75% 1. After subtracting 1.7% for the U.S. Personal Consumption Expenditure (PCE), the Fed s preferred measure of inflation, the real yield on the 1-Year Treasury is.5% almost zero. IG, however, is a different story. The IG yield is 3.13% 2. After subtracting 1.7% for the PCE, an investor receives almost 1.5%, much more than what a U.S. Treasury offers, though with slightly more risk. Investors looking for value in the fixed income market need to look beyond the index and to specific fixed income asset classes. Taxable vs. Tax-Exempt When investors invest in fixed income, they have the option of doing it in the taxable or tax-exempt portion of the market. The majority of bonds are taxable, meaning that investors must pay taxes on any receipts from them, reducing investment returns. Some examples of taxable bonds are IG or HY bonds. Smaller, less discussed, is the tax-exempt portion of the fixed income market. It includes municipal bonds, which are exempt from federal taxes on interest income. This taxexempt status can be valuable to investors who are in higher tax brackets or are tax-sensitive. For example, the yield on municipal bonds is 2.8% 3 but, when converted to a taxableequivalent yield (based on the top marginal tax rate 43.4%), the yield an investor receives is 3.61% and, after adjusting for inflation, the real yield is 1.91%, which looks very attractive relative to U.S. Treasuries. Municipals: Decent yield without indecent risk We maintain a positive view on the municipal market along with a relatively neutral duration. Strong year-to-date performance has been driven by lower supply, healthy demand and a Fed that appears willing to be patient in raising rates. Our positive municipal view is anchored on: 1. attractive yield in a low-rate world, particularly as taxes continue to increase while rates fall 2. attractive valuation as compared to Treasuries 3. ability to mitigate portfolio volatility and act as a ballast to equity risk The BofA Merrill Lynch (BofAML) Global Research Municipal Strategy team sees fundamentals such as supply/demand dynamics and higher tax revenues remaining favorable for municipals in 216, and they should remain supportive as Treasury rates remain low, in line with our view that rates in general will remain lower for longer. While municipal yields may appear low on an absolute basis, munis still represent good value versus many taxable bond alternatives. Municipal-to-Treasury yield ratios, commonly used to value municipals, indicate fair value (see Exhibit 1). (Keep in mind, Treasuries are U.S. government-guaranteed for the timely payment of principal and interest.) 1 Bloomberg. As of April 15, BofA Merrill Lynch U.S. Corporate Index. As of April 15, BofA Merrill Lynch U.S. Municipal Master Index. As of April 15, 216. CIO REPORTS The Monthly Letter 2

3 Yield (%) Exhibit 1: Valuations relative to Treasuries remain attractive Municipal/Treasury AAA Ratio (taxable)-rhs Tax-Equivalent Yield of BofAML U.S. Municipal Master Index BofAML U.S. Treasury Index Source: Bloomberg and Merrill Lynch Chief Investment Office. Data as of April 15, 216. Please see Appendix for index definitions. Past performance is no guarantee of future results. Supply/demand outlook favorable One factor supporting municipals is the supply/demand balance. In each of the past two years, over $3 billion in issuance has been eagerly absorbed by the market. In fact, municipal bond fund net inflows continue to be supportive of the asset class (see Exhibit 2). Inflows continue to support the asset class in 216, and we see demand remaining strong throughout the year as rates remain low. Exhibit 2: Flows into municipal bond funds have been positive for most of 2H year-to-date $ Billion $4 $2 $ -$2 -$4 -$6 Weekly Municipal Flows BofAML U.S. Muni Master Price Return Index Value (RHS) $13 $125 $12 $115 $11 $15 -$8 $1 Jan 1 Jan 11 Jan 12 Jan 13 Jan 14 Jan 15 Jan 16 Source: Bloomberg, Haver Analytics, Investment Company Institute and Merrill Lynch Chief Investment Office. Data as of April 6, 216. Please see Appendix for index definitions. Past performance is no guarantee of future results. The BofAML Global Research Municipal Strategy team expects issuance of municipals to pick up slightly, reaching $44 billion this year. The low-rate environment continues to encourage state and local governments to refund or call existing debt and refinance at lower rates. The low-rate environment also remains favorable for new borrowing, as issuers have better balance sheets than they have had in several years. Municipal finances on the mend The U.S. macroeconomic outlook continues to improve, with more jobs, greater consumer spending, and growth at low but sustainable rates. An improving economy has been positive for state and local governments, as tax collections have increased, allowing them to rebuild their balance sheets. Tax revenue is the main source of payment for municipal bond interest, and the improvement in government budget balances improves the credit quality of their bonds. According to the Rockefeller Institute of Government, major sources of state and local government revenue continue to grow, but at a slower rate compared to a year ago (see Exhibit 3). At the local government level, property tax collections rose 3.4% during the period. Exhibit 3: A slow but steady path of fundamental improvement in fiscal revenues Year-over-Year Percent Change Personal Income Tax Sales Tax Revenue Total State Tax Sources: U.S. Census Bureau, Quarterly Summary of State & Local Government Tax Revenue, Rockefeller Institute of Government, Haver Analytics and Merrill Lynch Chief Investment Office. Data as of 3Q 215. Data for the most recent quarter reflect adjustments by the Rockefeller Institute to include information released after initial publication. Challenges facing municipalities While many short- and intermediate-term trends are favorable, one long-term issue, state pensions, is not. The combination of an older workforce retiring sooner and lower discount rates has led to a rise in pension liabilities. The BofAML Global Research Municipal Strategy team expects growth of unfunded liabilities, CIO REPORTS The Monthly Letter 3

4 a credit negative. Despite that, with revenues steadily increasing at the state and local levels, we expect that governments, for the most part, will be better positioned to fund their annual required contributions, easing the pain of growing unfunded liabilities. For now, we think there is time to address pension reforms and, therefore, consider it a secondary issue when assessing municipal securities. Distressed situations in Puerto Rico and Detroit, as well as in certain Michigan municipalities, highlight the headline risk that has affected some investors perceptions of municipal bonds. While they show that investing in municipal securities is not without risks, it is important to keep in mind that the problems relating to those localities developed over time and were welldocumented. We believe it is misleading to view certain municipal bond distressed situations as representative of the overall municipal bond market. Most state and local governments stand on solid footing, having made significant progress in pension reform and closing budget gaps. Investment Grade: One of the last pockets of yield The highly volatile start to the year in financial markets, given concerns over oil, China and global growth, has spurred investors to sell risk assets and seek shelter in safe-haven assets and cash. In this environment, bonds have proven resilient: Year-to-date, through April 18, bonds (as measured by the Barclays U.S. Aggregate Bond Index) have total returns of 3.4%, while U.S. Investment Grade corporate bonds are up 4.8% Within a diversified bond portfolio, U.S. Investment Grade corporate bonds and high-quality municipal bonds remain our preferred exposures. We are bullish on U.S. IG for three key reasons: 1. Big foreign inflows, as investors reach for yield in the U.S. corporate bond market the only game in town (see Exhibit 4) 2. Improving fundamentals as M&A and share buyback volumes taper, and upside surprises to earnings 3. Still fairly attractive valuations acknowledging that most of the spread tightening is already behind us Exhibit 4: U.S. Investment Grade (IG) yield income as % of global IG yield income vs. foreign investor flow Dec 9 Jun 1 Dec 1 Jun 11 Foreign Investor Buying of U.S. IG ($bn, LHS) U.S. IG Yield as % of Global IG Yield (RHS) Dec 11 Jun 12 Source: BofAML Credit Research and Merrill Lynch Chief Investment Office. Data as of 4Q 215. Past performance is no guarantee of future results. Dec 12 We live in a yield-hungry world The demand for U.S. IG credit has been fueled in part by the meaningful amount of negative-yielding debt globally. Thirteen European countries have negative-yielding sovereign debt, and the Bank of Japan introduced negative interest rates recently (see the February 4 Investment Insights, Whatever It Takes). In the eurozone, the negative rate experiment is already more than a year old. Roughly 2.5 trillion euros of sovereign debt and 6 billion euros of corporate debt carry negative rates, according to BofAML Global Research. Lower for longer The zero interest-rate policy (ZIRP) that the Fed held from December 28 to December 215 created a significant hunger for yield, and U.S. IG and HY bonds benefited tremendously from it. By the same token, it has been widely believed that the beneficiaries of ZIRP would suffer as the Fed started to tighten monetary policy. However, U.S. Treasury bond yields are still stubbornly low, with the 1-year yielding just 1.89% as of April 22 and, as mentioned earlier, there is a significant amount of negative-yielding debt globally. Furthermore, BofAML Global Research now expects the Fed to hike rates only twice (rather than three or four times) in 216. Jun 13 Dec 13 Jun 14 Dec 14 Jun 15 Dec 15 8% 75% 7% 65% 6% 55% 5% 45% CIO REPORTS The Monthly Letter 4

5 Attractive valuations We believe that investors appetite for income and relatively higher-quality income assets will remain in place. IG spreads are trading at the 7 th percentile, indicating that spreads are wide relative to history (see Exhibit 5). Spreads (bp) Exhibit 5: Investment grade spreads are trading at recession-like levels Recession Periods Investment Grade Spreads 1 IG-7 th Percentile Source: Bloomberg and Merrill Lynch Chief Investment Office. Data as of March 31, 216. Investment Grade index = BofA Merrill Lynch U.S. Corporate Index. Please see Appendix for index definition. Past performance is no guarantee of future results. IG credit metrics and fundamentals remain stable despite the higher volatility in the credit markets. Over the last year, the difference between the yields on U.S. Treasuries and U.S. IG widened by 3 basis points (bps), from 133bps to 163bps. BofAML Global Research forecasts a 216 U.S. IG spread of 15bps, implying a potential for 13bps of spread tightening from current levels. Thus, valuations still look fairly attractive. Chasing High Yield tread lightly As investors have stretched for yield, one area of the bond market that has gotten much attention is High Yield. A quick glance shows why, as the yield on the BofA Merrill Lynch U.S. High Yield Master Index was 8.4% at the end of the first quarter of the year. While the yield in HY looks attractive, HY bonds come with additional risks, as well as a higher correlation with the equity market. We do not believe that all HY is bad; however, investors need to know what they own and, for most investors, the allocation to HY should be low. The elephant in the High Yield market: Energy What s given us pause in the HY market recently? The HY market contains a greater sensitivity to Energy companies, as approximately 13% of the BofA Merrill Lynch U.S. High Yield Master Index consists of Energy companies. The decline in oil prices over the past 18 months has put pressure on Energy company profits. The large Energy exposure in the HY index is one reason we believe investors should use an active manager when investing in HY. In addition to the fact that HY is historically more volatile than other fixed income asset classes, there is even greater volatility in the Energy sector from the underlying volatility in oil prices. The pressure of lower oil prices on the Energy sector has resulted in default rates much higher than in the broad HY universe, as well as in deteriorating revenues (see Exhibit 6). Revenue declines for the Energy sector are much more severe when compared to the broad HY market. This concerns us, as declining revenues raise concerns about Energy companies ability to service their debt (see Exhibit 7). While we have not seen contagion in the HY market from the Energy sector, we are cautious and continue to monitor credit fundamentals for signs of decline. We also believe that the pessimism relating to oil prices and their impact on the Energy sector of HY is priced into the market. The decline in lower-rated HY Energy bond prices (Energy companies that are more likely to default) is significant, implying that the market has already taken the risk of lower oil prices and is reflected in the lower price. LTM Issuer Default Rate (%) Exhibit 6: Defaults remain concentrated in the HY Energy sector BofAML U.S. HY Default Rate Energy Source: BofAML Credit Strategy and Merrill Lynch Chief Investment Office. Data as of March 31, 216. High Yield index = BofA Merrill Lynch U.S. High Yield Master Index. Please see Appendix for index definition. Past performance is no guarantee of future results. CIO REPORTS The Monthly Letter 5

6 Revenue, YoY% Change Exhibit 7: Revenues in the HY space remain stable excluding the Energy sector Energy BofAML U.S. High Yield Master Index Source: BofAML Credit Strategy and Merrill Lynch Chief Investment Office. Data as of 4Q 215. Please see Appendix for index definition. Past performance is no guarantee of future results. Macro headwinds tighten For the first time since 28, the Fed s Commercial & Industrial lending survey showed a net higher number of regional banks tightening their lending standards versus loosening them. This is the second quarter in a row where we have seen tightening of lending standards. This is a concerning trend for High Yield because it indicates that we are in the later stages of the credit cycle and access to credit is declining. Historically, the tightening of lending standards is a leading indicator of increasing HY default rates months ahead (see Exhibit 8). So, while we have seen two consecutive quarters of tightening, we are still in the early stages of the default cycle. The relationship between lending standards and defaults is one we are watching closely as a signpost that High Yield is set for another leg down. Exhibit 8: Tightening lending standards indicate that we are moving into the final stages of the credit cycle, reducing credit availability to issuers Net Percent of Banks Tightening Standards Net Percent of Banks Tightening Standards U.S. HY LTM Issuer Default Rate (RHS) Source: BofAML Credit Strategy and Merrill Lynch Chief Investment Office. Quarterly data as of 4Q 215. High Yield index = BofA Merrill Lynch U.S. High Yield Master Index. Please see Appendix for index definition. Past performance is no guarantee of future results LTM Issuer Default Rate Portfolio Strategy: See Page 7. CIO REPORTS The Monthly Letter 6

7 Portfolio Strategy: It is easy to see why investors, in a yield-starved environment, have stretched for income into riskier parts of the bond market. In this hunt for yield, investors have taken unintended risks in their portfolios. Recent bouts of episodic volatility have demonstrated that many of these investments aren t behaving as expected and can lead to increased volatility within portfolios. Despite this, fixed income continues to have an important role managing total risk in balanced portfolios, and investors can find relative yield by asking Where s the beef? Using the relative value framework, investors can find yield as well as diversifying sources of income within their portfolio. We advocate a core/satellite approach for fixed income portfolio construction (see Exhibit 9). The core of the portfolio is intended to provide broad exposure to a diverse set of highquality fixed income asset classes. The core of the portfolio is higher-quality fixed income, expected to provide capital preservation and dampen total portfolio volatility. Municipals and U.S. Investment Grade can provide effective diversification from equities. During the last five equity market drawdowns, when total returns fell by more than 1%, total returns from high-quality municipal bonds (as measured by the BofAML U.S. Municipal Master Index) were, in fact, positive (see Exhibit 1). Meanwhile, U.S. Investment Grade total returns were positive in four of the five equity market drawdowns. Exhibit 9: A core/satellite approach to fixed income Core Investment Grade Corporates Core U.S. Treasuries and High-Quality Municipals Satellite TIPS* Senior Loans** * Treasury Inflation-Protected Securities. **May be subject to significant credit, valuation and liquidity risk. Source: Merrill Lynch Chief Investment Office. For illustrative purposes only. U.S. Treasury inflation-indexed securities are subject to interest rate risk. If interest rates rise, the market value of your Treasury investment will decline. While you may be able to liquidate your investment in the secondary market, you may receive less than the face value of your investment. Percent Change Exhibit 1: Historically, U.S. municipal and Investment Grade total returns have risen as U.S. equities have fallen S&P 5 Index Drawdown BofAML U.S. Corporate Index Jun 9 to Oct 9 Jul 98 to Aug 98 BofAML Municipal Master Index Total Return Sep to Sep 2 Nov 7 to Feb 9 May 11 to Sep 11 Source: Bloomberg, MPI and Merrill Lynch Chief Investment Office. Drawdown is defined as the maximum peak-to-trough percentage decline in value experienced during the given period. Please see Appendix for index definition. Past performance is no guarantee of future results. The satellite portion of the fixed income portfolio is intended to augment portfolio income. The satellite piece of the portfolio, while designed to generate income, may take on additional duration or credit risk. That additional risk is why the satellite allocation as a percentage of the total fixed income portfolio is small. For the satellite portion of the portfolio, investors may look to senior loans, TIPS or High Yield. Ultimately, an investor s goal, risk tolerance and time horizon drive the asset allocation decision. Longer-term investors should look past short-term volatility and focus on the fundamentals that drive longer-term returns. The fundamentals for IG bonds and municipals remain intact for long-term investors. Investors looking for capital preservation should consider keeping their investments primarily in high-quality fixed income to mitigate drawdown risk. Investors who need a portion of their portfolio for disbursements or other spending needs in the near term should consider keeping that portion of their portfolio in cash or cash-like products to ensure liquidity. CIO REPORTS The Monthly Letter 7

8 CIO Insights A Conversation with Dennis Stattman* Insights and the best thinking from distinguished investors around the world. Dennis Stattman, CFA, Managing Director and portfolio manager, is head of the Global Allocation team within BlackRock s Multi-Asset Strategies Group. He serves as a member of BlackRock s Global Operating and Leadership Committees. Mr. Stattman s service with the firm dates back to 1989, including his years with Merrill Lynch Investment Managers (MLIM), which merged with BlackRock in 26. Mr. Stattman joined Merrill Lynch Investment Managers as a portfolio manager of the Merrill Lynch Global Allocation Fund at the Fund s inception in From 1989 through 1996, he was also a portfolio manager of the Merrill Lynch Special Value Fund. Prior to joining MLIM, Mr. Stattman served as the director of research for Meridian Management Company, and as pension investment officer for the World Bank, supervising the management of U.S. equities in the Bank s Retirement Plan. Mr. Stattman earned a BS degree in commerce from the University of Virginia in 1973 and an MBA degree, with honors, from the University of Chicago in 198. Mr. Stattman is a CFA Charterholder CIO Office: What s your outlook for the global economy, and what are some of the key risks you see going forward? Dennis Stattman: We expect slow but positive growth in the global economy, but acknowledge that the risks are skewed to the downside. First, secular trends, including lower productivity growth and demographic changes (e.g., aging populations), suggest that long-term growth is likely to be lower than the post-wwii average. Second, international developments represent an ongoing risk for the global economy. Chief among them is China, which is challenged to transition from an economy driven by investments and exports to one that is consumption-led, while at the same time coping with a large buildup in debt and slowing growth. In addition, political challenges are evident in several developing markets, particularly in Europe and Latin America. Dennis Stattman CFA, Managing Director and portfolio manager The market s expectations for the Fed to continue to raise rates this year have dropped precipitously. How should investors look to position across asset classes in this lower-for-longer environment and yieldhungry world? In a world characterized by slow growth and relatively tame inflation, investors expect nominal rates to remain low. This, in turn, suggests that the stretch for yield will continue, with investors willing to pay a premium for income-producing assets. The dilemma is that after seven years of zero-interest-rate policy, and with interest rates falling into negative territory in an increasing number of geographies and maturities, most income-producing assets are expensive. To address this challenge, we believe income-seeking investors should consider casting a wide net and including selective, price-sensitive exposure to investment grade and high yield corporate bonds and international dividend stocks, as well as more niche asset classes, such as preferred stocks. Investment returns may be anemic going forward. Coupling that with the trend of longevity, which means people s money has to last longer, do we need to start getting used to taking more risks? Each person is clearly unique, but it does seem fairly obvious that many investors are facing more difficult choices in planning for retirement today. If you are nearing retirement, and particularly if you had built up a significant portfolio, the good news is that bull markets in stocks and bonds have lifted many asset prices above what many could have imagined or expected after the financial crisis. On the other hand, low interest rates, increasing longevity and a decline in private defined-benefit pension plans all require you to adapt your retirement strategy. There is no single solution to this conundrum. Certainly focusing on those assets likely to produce higher real returns, such as equities, has the potential to facilitate growth in a retirement portfolio. This can be particularly advantageous for younger investors who have the time horizon to withstand the incremental risk. Overall, however, investors should be wary about increasing risk in their portfolios after a prolonged period of rising asset prices. Our favored approach is using a global multi-asset strategy in an effort to balance risk and reward. Beyond refining your investment approach, behavioral changes may play a key role in securing retirement goals. These include a higher savings rate during working years and, most powerfully, delaying retirement for a few more years. CIO REPORTS The Monthly Letter 8

9 CIO Insights A Conversation with Dennis Stattman* (cont d) Insights and the best thinking from distinguished investors around the world. We ve seen a reversal in U.S. equities this year with value outperforming growth. What do you see as the driver behind this, and do you expect this trend to persist? Also, are there any segments or sectors of the U.S. markets that you like? Value has benefited this year from two key factors: 1) the fact that it is relatively cheap and 2) a more recent comfort with the global economic outlook. Value typically performs best when expectations for economic growth are rising. To the extent recent economic data have alleviated recession fears, value has been a natural beneficiary. However, one reason growth was able to outperform for many years, even as the stocks became somewhat expensive, was because profitability at growth companies held up better than profitability at many value firms. For value to continue to outperform, we would need to see improvements in corporate profitability, notably improved return-on-equity, at value firms. After a seven-year bull market and with the corporate profit share of gross domestic product (GDP) near a cyclical high, we are selective in our exposure to the U.S. stock market and have only small overweights in our largest sector exposures namely, health care and energy. In health care, we see good value relative to other stable growth sectors of the market. Within energy, we believe depressed prices may offer a good entry point for long-term investors. What about international equities? It was expected that easy monetary policy and low to negative interest rates would serve as a boon to European and Japanese equities, but we ve witnessed mixed reactions in these markets. Where do you see value in these regions, and how do you expect monetary policy and the continued slowdown in Emerging Markets to impact these markets? We continue to see value in international markets, particularly Japan. That said, monetary policy is not providing the tailwind that we ve witnessed in recent years past. Part of the challenge is that after seven years of extraordinary efforts by central bankers to bolster economies and markets, monetary policy is proving less effective at lifting asset prices. This reflects several developments: Asset markets are generally more expensive, economic growth has not accelerated as expected and some of the tools currently being deployed, notably negative deposit rates, exert a cost on the financial sector. Inflation has been below expectations of investors and central bankers. Where do you see inflation headed in the U.S. and globally, and how are you positioning your allocations accordingly? How would you advise clients tackle portfolio duration in the current rate environment? The outlook for inflation is very dependent on geography. Despite strong global disinflationary forces, inflation in the U.S. appears stable, and by many measures is even rising. Core inflation, which excludes volatile food and energy prices, has been firming. This is particularly true in the service sector, where we see evidence of rising costs for housing and medical care. We do not expect inflation to become a major problem, but given relatively low expectations for future inflation, it is certainly possible that inflation could surprise to the upside. One way to address this scenario is with U.S. Treasury Inflation Protected Securities (TIPS). While inflation expectations have risen, they are still low by historical standards. This suggests that TIPS offer value relative to traditional Treasury notes and bonds. Given the TINA ( There is no alternative ) environment across asset classes, have you been looking at any non-traditional asset classes such as commodities? Also, what is your view on the U.S. dollar? Within the parameters of our investment mandate as relates to non-traditional asset classes, we have enjoyed success in private placements and distressed debt, although these investments have never represented a large portion of the portfolio. Today, we believe oil- and gas-related securities represent an area of opportunity for long-term value investors. Also, since forgone interest income is a key opportunity cost for owners of gold, the yellow metal has grown more attractive in today s environment of negative interest rates, which are evident in more than 25% of the sovereign bond universe. We have been overweight the dollar for several years, based on the strong performance of the U.S. economy relative to the rest of the developed world and the improvement in America s trade balance and current account due to greater domestic oil production. More recently, we have taken some profits on our dollar overweight given both the appreciation of the dollar and the more muted outlook for Federal Reserve interest rate hikes. What has been the biggest shift in your thinking about investing over your career? Over the course of my 36-year career, I would like to believe my thinking has become more sophisticated, broader and more objective, and that I see the investment world from a greater variety of perspectives. Certainly I now spend more time on global macro topics and non-u.s. investing given the exponential growth of economies and opportunities around the world. As the opportunity set has grown, so too have the data and analytical resources available to support our portfolio decision making. Tools matter to thinking, and today at BlackRock, our information tools are dramatically more powerful than even a few years ago. This added capability influences what we think about, as well as how we think. We see all of this as a clear benefit to our shareholders, which always have and always will remain central to our thinking as we seek to invest for optimal risk-adjusted returns. CIO REPORTS The Monthly Letter 9

10 CIO Insights A Conversation with Dennis Stattman* (cont d) Insights and the best thinking from distinguished investors around the world. DISCLOSURE: You should consider the investment objectives, risks, charges and expenses of the BlackRock Global Allocation Fund carefully before investing. The Fund s prospectus and, if available, the summary prospectus contain this and other information about the Fund and are available, along with information about other BlackRock funds, by calling or from your financial professional. The prospectus and, if available, the summary prospectus should be read carefully before investing. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments in emerging or smaller capital markets. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the portfolio manager profiled as of April 216, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that may, in certain respects, not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. The fund is actively managed, and its holdings and portfolio characteristics are subject to change. * The views and opinions expressed are those of the speaker as of April 28, 216, are subject to change without notice at any time, and may differ from views expressed by Bank of America Corporation, Merrill Lynch, Pierce, Fenner & Smith Incorporated, or any affiliates. This conversation is presented for informational purposes only and should not be used or construed as a recommendation of any service, security or sector. Before acting on the information provided, you should consider suitability for your circumstances and, if necessary, seek professional advice. CIO REPORTS The Monthly Letter 1

11 When assessing your portfolio in light of our current guidance, consider the tactical positioning around asset allocation in reference to your own individual risk tolerance, time horizon, objectives and liquidity needs. Certain investments may not be appropriate, given your specific circumstances and investment plan. Certain security types, like hedged strategies and private equity investments, are subject to eligibility and suitability criteria. Your financial advisor can help you customize your portfolio in light of your specific circumstances. ASSET CLASS Global Equities U.S. Large Cap U.S. Mid & Small Cap International Developed Emerging Markets Global Fixed Income U.S. Treasuries U.S. Municipals U.S. Investment Grade U.S. High Yield U.S. Collateralized Non-U.S. Corporates Non-U.S. Sovereigns Emerging Market Debt Alternatives* Commodities Hedged Strategies Real Estate Private Equity U.S. Dollar Cash CHIEF INVESTMENT OFFICE VIEW Negative Neutral Positive COMMENTS Further upside expected based on improving economic and earnings growth and valuations, which remain close to fair value. However, return expectations should be lower than in recent history. Full valuations and headwinds of stronger dollar, lower energy prices and weak economic activity may lead to higher volatility. Higher quality is preferred in a rising volatility environment. Valuation multiples remain extended, although the valuation gap with large caps has narrowed. Investors with a higher risk tolerance may consider select opportunities within higher-quality small caps. Extension of European Central Bank quantitative easing till March 217 and evidence of greenshoots in European economy should drive European equities higher. Japan should continue to benefit from reflationary Abenomics. Stronger dollar, weaker growth in China and downward pressure on commodity prices will challenge Emerging Markets (EM). Bonds continue to provide diversification, income and stability within total portfolios. Interest rates remaining lower for longer limit total return opportunities in bonds. Current valuations are stretched, especially on longer maturities. Consider TIPS as a highquality alternative. Valuations relative to U.S. Treasuries remain attractive, and tax-exempt status is not likely to be threatened in the near term; advise a nationally diversified approach. Risk of rates rising subsiding. Stable to improving fundamentals expected to attract high-quality foreign investors as yield differentials are supported by divergent monetary policy. We remain cautious, as defaults expected to increase; spreads to remain range-bound until further economic growth. Higher rates and Federal Reserve tapering are likely to increase spread volatility. A shortage of new issues should counter the effects of tapering. Select opportunities in European credit, including financials; however, any yield pickup likely to be hampered by a stronger dollar. Yields are unattractive after the current run-up in performance; prefer active management. Vulnerable to less accommodative Fed policy and lower global liquidity; prefer U.S. dollar-denominated EM debt. Local EM debt likely to remain volatile due to foreign exchange component; prefer active management. Select Alternative investments help broaden the investment toolkit to diversify traditional stock and bond portfolios. Medium-/long-term potential upside on stabilizing oil prices; near-term opportunities in energy equities /credits. Equity Event-Driven & Distressed gain from recent event selloff and increasing default potential. Global Macro a timely diversifier, given higher expected volatility across equity, fixed income and foreign exchange markets. Strong fundamentals driving increased investment; cap rates continue to compress; favor global opportunistic. Strong fund raising and high valuations; special situations, energy, and private credit favored. Stronger domestic growth and a less dovish Federal Reserve policy (relative to the monetary policies of other Developed Market central banks) support a stronger dollar going forward. Monetary policy by Developed Market central banks reduces the attractiveness of cash, especially on an after-inflation basis. * Many products that pursue Alternative Investment strategies, specifically Private Equity and Hedge Funds, are available only to pre-qualified clients. CIO REPORTS The Monthly Letter 11

12 Appendix Index Definitions The S&P 5 Index is a market-capitalization weighted index that measures the market value of 5 large U.S. companies having common stock listed on the New York Stock Exchange or NASDAQ. The S&P 5 index components and weightings are determined by S&P Dow Jones Indices. The Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the Investment Grade, U.S. dollardenominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency). The BofA Merrill Lynch U.S. High Yield Master Index tracks the performance of below Investment Grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. Yankee bonds (debt of foreign issuers issued in the U.S. domestic market) are included in the index provided the issuer is domiciled in a country having an Investment Grade foreign currency long-term debt rating (based on a composite of Moody s and S&P). The BofA Merrill Lynch U.S. Municipal Masters Index tracks the performance of the Investment Grade U.S. tax-exempt bond market. The BofA Merrill Lynch U.S. Corporate Index tracks the performance of U.S. dollar-denominated Investment Grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have an Investment Grade rating (based on an average of Moody s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $25 million. The BofA Merrill Lynch U.S. Treasury Index tracks the performance of U.S. dollar-denominated sovereign debt publicly issued by the U.S. government in its domestic market. Qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $1 billion. CIO REPORTS The Monthly Letter 12

13 CHIEF INVESTMENT OFFICE Christopher Hyzy Chief Investment Officer Bank of America Global Wealth and Investment Management Christopher J. Wolfe Head of the Merrill Lynch Chief Investment Office Mary Ann Bartels Head of Merrill Lynch Wealth Management Portfolio Strategy Karin Kimbrough Head of Macro and Economic Policy Merrill Lynch Wealth Management Niladri Mukherjee Managing Director Chief Investment Office Maxwell Gold Vice President Emmanuel D. Manos Hatzakis Director Jon Lieberkind Vice President John Veit Vice President This material was prepared by the Merrill Lynch Chief Investment Office and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of the Merrill Lynch Chief Investment Officeonly and are subject to change. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available. This information and any discussion should not be construed as a personalized and individual client recommendation, which should be based on each client s investment objectives, risk tolerance, and financial situation and needs. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates, or any related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. Investments and opinions are subject to change due to market conditions and the opinions and guidance may not be profitable or realized. Any information presented in connection with BofA Merrill Lynch Global Research is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investment objectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects may not be realized. Asset allocation and diversification do not assure a profit or protect against a loss during declining markets. Alternative investments, such as hedge funds and private equity funds, are speculative and involve a high degree of risk. There generally are no readily available secondary markets, none are expected to develop and there may be restrictions on transferring fund investments. Alternative investments may engage in leverage that can increase risk of loss, performance may be volatile and funds may have high fees and expenses that reduce returns. Alternative investments are not suitable for all investors. Investors may lose all or a portion of the capital invested. The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks. Investments in high-yield bonds may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories. Income from investing in municipal bonds is generally exempt from federal and state taxes for residents of the issuing state. While the interest income is tax exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the federal alternative minimum tax (AMT). Investments in foreign securities involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets. Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risk related to renting properties, such as rental defaults. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. No investment program is risk-free, and a systematic investing plan does not ensure a profit or protect against a loss in declining markets. Any investment plan should be subject to periodic review for changes in your individual circumstances, including changes in market conditions and your financial ability to continue purchases. Reference to indices, or other measures of relative market performance over a specified period of time (each, an index ) are provided for illustrative purposes only, do not represent a benchmark or proxy for the return or volatility of any particular product, portfolio, security holding, or AI. Investors cannot invest directly in indices. Indices are unmanaged. The figures for the index reflect the reinvestment of dividends but do not reflect the deduction of any fees or expenses which would reduce returns. Merrill Lynch does not guarantee the accuracy of the index returns and does not recommend any investment or other decision based on the results presented. The Private Banking and Investment Group is a division of MLPF&S that offers a broad array of personalized wealth management products and services. Both brokerage and investment advisory services (including financial planning) are offered by the Group s Private Wealth Advisors through MLPF&S, a registered broker-dealer and registered investment adviser. The nature and degree of advice and assistance provided, the fees charged, and client rights and Merrill Lynch s obligations will differ among these services. The banking, credit and trust services sold by the Group s Private Wealth Advisors are offered by licensed banks and trust companies, including Bank of America, N.A., Member FDIC, and other affiliated banks. MLPF&S is a registered broker-dealer, registered investment adviser, member SIPC and wholly owned subsidiary of BofA Corp. 216 Bank of America Corporation. All rights reserved. ARRQTRB8