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    Monthly Outlook

    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:

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    © 2016 Bank of America Corporation. All rights reserved.

    The Wealth Allocation Framework

    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


    APRIL 2016

    Chief Investment Office

    John Veit Vice President

    John Lieberkind Vice President

    Chris Wolfe Managing Director

    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 500 Index, from 2009 to 2015.

    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.

    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 10-year U.S. Treasury to be higher in 2016; however, at the end of the first

    quarter of the year, it was 1.75%, down from 2.27% at the end of 2015. 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.

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  • CIO REPORTS • The Monthly Letter 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 Treasury-

    to-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 10-Year Treasury (which we use as a proxy for

    the market) is 1.75%1. After subtracting 1.70% for the U.S.

    Personal Consumption Expenditure (PCE), the Fed’s preferred

    measure of inflation, the real yield on the 10-Year Treasury

    is 0.05% — almost zero. IG, however, is a different story. The

    IG yield is 3.13%2. After subtracting 1.70% for the PCE, an

    investor receives almost 1.50%, 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 tax-

    exempt status can be valuable to investors who are in higher

    tax brackets or are tax-sensitive. For example, the yield on

    municipal bonds is 2.08%3 but, when converted to a taxable-

    equivalent 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 2016, 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, 2016. 2 BofA Merrill Lynch U.S. Corporate Index. As of April 15, 2016. 3 BofA Merrill Lynch U.S. Municipal Master Index. As of April 15, 2016.

  • CIO REPORTS • The Monthly Letter 3

    Exhibit 1: Valuations relative to Treasuries remain attractive

    0.0 2010 2013 2014 201520122011 2003 2016














    Yi el

    d (%







    Tax-Equivalent Yield of BofAML U.S. Municipal Master