FIXED INCOME STRATEGY MAY 2013

U.S. Trust Fixed Income Investment Team U.S. Trust, Bank of America Private Wealth Management

Fixed-Income Investing in a Rising Rate Environment A Shift in Management Strategies Can Help Lower the Risk of Negative Returns The bond market rally experienced for the last 30+ years is most likely near its end. We expect bond yields to rise over the next few years as the Federal Reserve and other central banks begin to withdraw stimulus from the markets. This means returns will likely be lower than those of recent years. While we do not believe we are in a bond market bubble, there will likely be some fixed-income sectors that experience negative real returns. Active fixed-income management and other strategies in our “crossover” solution can help mitigate such risks. Fixed-Income’s Challenging Environment With global interest rates near record lows and central banks around the world providing record amounts of stimulus, investing in fixed-income assets is challenging. Low yields combined with increased volatility have reduced the appeal of bonds relative to other asset classes. The potential for higher interest rates compounds the concern many investors have about fixed-income. We share these concerns and in fact, our view within the context of asset allocation is to underweight fixed-income relative to equities and certain other asset classes. Bonds should still be considered as part of an investor’s overall allocation, however. The challenge is to provide an acceptable level of return, within the proper risk framework. We believe this can be achieved through a more active strategy, considering all fixed-income sectors on an after-tax basis. This is the basis for the U.S. Trust Fixed-Income Crossover Strategy. Not a Bond Bubble…a Balloon Exhibit 1: Historical 10 Year US Treasury Yields

% Yield to Maturity

15%

10%

5%

Source: Bloomberg

0% 1962

1967

1972

1977

1982

1987

1992

1997

2002

2007

2012

Data as of March 29, 2013.

Global interest rates have been in a secular bull market since 1981, when 10-year Treasuries reached 16% (Exhibit 1). With rates now near historic lows, we believe this run is near its end. However, despite talk in the Investment products:

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financial media about a bond bubble, we believe it is unlikely that interest rates will rise explosively and cause bond prices to plummet. Rather, we believe interest rates will rise slowly and steadily, causing bond prices to deflate over time more in the manner of a leaking balloon. Negative Real Interest Rates Global interest rates in some sectors have dropped to below the rate of inflation. Therefore, investors in these securities may expect negative real returns (Exhibit 2). Exhibit 2: Inflation and Bond Yields % Yield to Maturity 9% 7% 5%

3% 1%

-1%2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 -3%

Source: Bloomberg, Federal Reserve

CPI YOY Index

Barclays 1-5 Year Treasury Index

Data as of March 31, 2013

Barclays 1-5 Year Municipal Index

Barclays 1-5 Year Corporate Index

Treasury yields are exhibiting the lowest (most negative) real rates, but other investment-grade sectors are also yielding less than inflation. A buy-and-hold strategy essentially locks in this negative real return. It is now more important than ever to employ an active approach to bond investing, taking advantage of market volatility, sector rotation, and security selection. Fed Unwind – Not If but When The unprecedented monetary stimulus initiated by the Federal Reserve and other central banks will eventually need to be unwound. Recent actions by the Bank of Japan, the European Central Bank, and the Royal Bank of Australia have pushed out our initial forecast as to when such action may begin, as highlighted in our May 6, 2013 Capital Markets Outlook. The Fed’s current Quantitative Easing (QE) strategy has called for maintaining the Federal Funds rate at less than 25 basis points and purchasing $85 billion in fixed-income securities each month, with no announced end date, in order to reduce interest rates. We believe labor dynamics are improving in the U.S. and the debate to scale back the level of asset purchases will strengthen in the next few months. The Fed may begin to reduce the pace of its purchase program (“Quantitative Deceleration” or “QD”) toward the end of this year, ahead of current market expectations. QD would mean the Fed’s balance sheet is still expanding, just at a slower pace, and private sector rates should remain well anchored by the near-zero Federal Funds rate. After slowing purchases initially, the Fed has indicated it will use an outcome-based purchase program (“Quantitative Maintenance” or “QM”), adjusting the rate of purchases periodically based on incoming data and projections for future job growth and inflation. Expect Market Reaction to Quantitative Deceleration We expect that the market will begin to move rates higher before any Fed action, with the longer end of the bond market leading the way. Typically, when the market expects interest rates to increase, bond managers will sell longer duration assets, as these are the most sensitive to changes in interest rates. This will cause longerterm rates to increase at a faster rate than shorter-term rates (see Exhibit 3). With this type of shift in the yield curve (known as “Bear Steepening”), price declines on longer assets are substantially greater than on shorterdated maturities.

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Exhibit 3: Bear Steepening Illustration 4%

3%

2%

1%

0% 0

5

10

15

20

25

30

Source: U.S. Trust Fixed Income Estimates

Starting Yield Curve

Data as of May 15, 2013.

Ending Yield Curve

Do Higher Interest Rates lead to Negative Bond Returns? As of April 30, 2013, the benchmark 10-year U.S. Treasury yielded 1.67%. We believe this will rise by the end of 2013 to between 2.0% and 2.5%. Rising interest rates have a depressing effect on bond prices, but we believe it is still possible to garner positive, albeit low returns in such an environment. While some fixed-income sectors will likely show negative price returns, we do not believe this will be true for all of them. We have analyzed a number of scenarios in which rates increase, and believe some fixed-income sectors will experience tighter spreads, thereby mitigating the effects of the higher rates. Sectors we feel are most at risk include maturities greater than 10 years in the investment grade market and U.S. Treasuries and Agencies with maturities greater than five years. However, short-to-intermediate term assets and certain non-Treasury bonds are expected to perform significantly better (See Exhibits 4 and 5). Exhibit 4: Total Return Scenario Analysis – Bond Sectors

2.5%

2.0%

1.5%

1.0%

0.5%

0.0% 2.0% 10 Year US Treasury

Source: U.S. Trust, BondEdge (see scenario definitions and assumptions) Data as of May 15, 2013.

FIXED INCOME STRATEGY

2.5% 10 Year US Treasury

3.0% 10 Year US Treasury

-0.5% Merril Lynch 1-10 Year Corporate Index

Merril Lynch 1-10 Year Municipal Index

Barclays Mortgage-Backed Securties Index

Barclays 1-10 Year Treasury Index

3

Exhibit 5: Total Return Scenario Analysis – U.S. Treasuries

2.0% 10 Year US Treasury

2.5% 10 Year US Treasury

3.0% 10 Year US Treasury

0.0%

-5.0%

-10.0%

-15.0%

Source: U.S. Trust, BondEdge (see scenario definitions and assumptions)

-20.0%

Data as of May 15, 2013.

1 Year US Treasury

2 Year US Treasury

10 Year US Treasury

30 Year US Treasury

5 Year US Treasury

Five Investment Strategies to Maximize Returns Given the challenging rate environment, we believe investors should not simply invest in the most common bond indices. The bond market is getting longer and the percentage of Treasuries within the bond market is increasing. In taking an active, absolute-return approach to investing, we purposefully avoid these two sectors, despite their greater weighting in the indices. To maximize fixed-income returns in today’s market, we recommend five specific strategies (as discussed in our January 2013 report, “Fixed Income Strategies for 2013”). 1. Reduce Portfolio Maturities and Duration In a rising rate environment, bonds that have short-dated maturities will outperform long-dated bonds. Therefore, fixed-income portfolios should be managed to a shorter average maturity or duration. For example, if the yield on the current U.S. Treasury 10-year note rises by 50 basis points, the price of that security will decline by about 4.5%. However, if the yield on the current three-year note rises by 50 basis points, the price will decline by only 1.5%. Therefore, given our interest rate forecast, we are seeking greater exposure to the shorter end of the maturity spectrum. 2. Active Management versus Buy-and-Hold We believe the traditional buy-and-hold strategy or laddered approach is not the optimal solution in this volatile market. Systematically buying long maturity bonds at record-low yields adds duration risk and locks in low yields for extended periods. However, by actively managing fixed-income portfolios we can take advantage of market volatility, potentially enhancing the portfolio’s return. Opportunities to buy low and sell high occur more frequently in volatile markets than in stable ones. There is currently an abundance of market-moving news to consider, such as potential changes to the tax code impacting municipal bonds, debt ceiling negotiations, and geopolitical unrest impacting overall price levels. We take a long-range approach to portfolio investing and use these opportunities to adjust positions and capitalize on the price volatility. 3. Expanding the Investable Fixed-Income Universe The benefits of active management are greater if the universe of investable asset classes is large. Given the current interest rate environment, the need to reevaluate traditional views of fixed-income investing is important, specifically as they pertain to tax-exempt investing. Historically, investors in a high income tax bracket sought municipal securities because they offered the best after-tax return. Recently however, this relative valuation has varied from historical norms. Given market volatility, it sometimes makes sense to invest in taxable securities because of higher relative after-tax yields. Additionally, by including other fixed-income asset classes such as mortgage-backed securities, high yield, preferred securities, leveraged loans, Treasury

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Inflation-Protected Securities (TIPS), and structured products, the potential exists for higher returns along with additional diversification. We also view investments in non-U.S. dollar-denominated bonds as an attractive investment for various reasons. They can offer benefits such as diversification, higher yields, and potential currency appreciation, advantages not available if investing exclusively in domestic securities. However, currency exchange rates can be quite volatile at times and may outweigh contributions to fixed-income returns from coupon payments and changes in yield. As such, this asset class requires an added level of diligence and tactical responsiveness to manage effectively. 4. Selectively Increase Exposure to Lower Quality Credits Although not a bubble, we believe Treasury securities offer poor value at current pricing levels. Treasury yields are at record lows, and if we consider inflation, real rates for most of the Treasury curve are negative. For the balance of 2013, we believe that securities with lower credit ratings will perform better than those with the highest credit ratings. The universe of available AAA-rated securities has been dramatically shrinking since the 2008 fiscal collapse. Those few that remain are very expensive and in some cases have lower yields than comparable Treasuries. Our current strategy focuses on selectively increasing exposure to bonds with lower credit ratings, particularly in the corporate bond market. For some clients with the appropriate risk profile, this would include BBB and lower rated bonds, preferred securities, and leveraged loans. This focus on lower-quality securities requires more in-depth research by experienced analysts to find those credits that are less susceptible to downgrades. Though credit spreads have compressed in recent months, providing superior returns, we believe there is still some room to outperform. A systematic approach to corporate and municipal bond selection by a dedicated credit team is crucial, as we believe this is a bond picker’s market. In a low-yielding environment, the quest for yield will continue to favor these asset classes over U.S. Treasuries and AAA-rated bonds. 5. Plan for Higher Inflation While there is currently little inflation concern in the market, we do believe this will change as we move through 2013 and beyond. Therefore, we are interested in fixed-income securities that offer some inflation protection. For example, we will look to increase our exposure to TIPS on signs of weakening valuations. Floating-rate securities in mortgages, corporate bonds, and leveraged loans should also be considered, as their underlying valuations will float higher if inflation begins to accelerate. There is also a new proposal by the U.S. Treasury to issue floating-rate securities. The details are still being determined, but these could also offer value in a higherinflation environment. The U.S. Trust Crossover Strategy Given the difficult fixed-income environment, we believe the U.S. Trust Crossover Strategy, which employs the five tactics discussed above, has the potential to provide stronger after-tax yields and returns. The U.S. Trust Crossover strategy is currently positioned for a rise in interest rates over the near term. A scenario analysis with the same parameters and assumptions as previously illustrated shows the defensive positioning (See Exhibit 6).

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Exhibit 6: Total Return Scenario Analysis – Crossover Strategies

2.5%

2.0%

1.5%

1.0%

0.5%

0.0% 2.0% 10 Year US Treasury

Source: US Trust, BondEdge (see scenario definitions and assumptions).

2.5% 10 Year US Treasury

3.0% 10 Year US Treasury

-0.5% 1- 5 Year Crossover Portfolio

1-10 Year Crossover Portfolio

Data as of May 15, 2013.

In all the likely scenarios presented, the shorter 1-5 Year Crossover portfolio and the longer 1-10 Year Crossover portfolio both show positive returns. Note that our scenario analysis is based on a static portfolio, as it is difficult if not impossible to model an active strategy. Details of the scenario results and assumptions used, as well as limitations to the analysis, are discussed in Appendix A. The U.S. Trust Liquidity Bond Solution Due to the decline in global interest rates, assets held in savings accounts and other bank deposit are earning near-zero returns. We expect this condition will persist for some time. In addition, when interest rates do begin to rise, short-term interest rates will be the last to increase. The U.S. Trust Liquidity Bond Solution is a strategy designed to provide more yield than traditional cash deposits. By combining a high quality institutional class money market fund with individual short-term bonds, this approach offers higher yields than cash alternatives and can be fully customized to meet an investor’s specific liquidity needs. When rates do eventually begin to rise, maturing short-term instruments can be reinvested into higher-yielding securities. Please note however that this strategy is not FDIC guaranteed.

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APPENDIX A Scenario Analysis Description and Assumptions The scenario results shown in Exhibits 4, 5, and 6 are based on a number of assumptions. For all three scenarios presented, we shift the Treasury and municipal yield curves and adjust the spreads on corporate bonds and mortgage-backed securities according to the charts in Exhibit 7 and 8 below. Exhibit 7: U.S. Treasury and Municipal Curve Assumptions Tenor

6 Month 1 Year 2 Year 3 Year 5 Year 7 Year 10 Year 20 Year 30 Year

Source: U.S. Trust

Municipal Curve

U.S. Treasury Curve Start

2.0% 10 Year UST

2.5% 10 Year UST

3.0% 10 Year UST

0.08

0.09

0.13

0.17

0.11

0.13

0.18

0.23

0.25

0.28

0.34

0.41

0.39

0.43

0.51

0.59

0.82

0.87

1.00

1.10

1.28

1.35

1.50

1.68

1.90

2.00

2.50

3.00

2.83

3.00

3.65

4.00

3.11

3.36

4.00

4.40

Exhibit 8: Corporate and Mortgage – Backed Securities Spread Change Assumptions

6 Month 1 Year 2 Year 3 Year 5 Year 7 Year 10 Year 20 Year 30 Year

Start

2.0% 10 Year UST

2.5% 10 Year UST

3.0% 10 Year UST

0.16

0.08

0.11

0.14

0.19

0.11

0.15

0.20

0.28

0.24

0.29

0.35

0.43

0.37

0.43

0.50

0.78

0.74

0.85

0.94

1.25

1.15

1.27

1.43

1.81

1.70

2.13

2.55

2.62

2.55

3.10

3.40

2.93

2.86

3.40

3.74

Spread Change Sector

Source: U.S. Trust

Tenor

Change (bps)

Aaa Aa A Baa Ba

0 -3 -5 -10 -15

B

-20

Caa

-25

Ca

-30

C

-35

D

-40

NR

-45

CMBS

-8

MBS

-12

The purpose of scenario analysis is to highlight the potential effects of rising interest rates on certain fixed income asset classes and securities. These assumptions, which we believe to be reasonable based on historical yield and spread movements, are consistent with U.S. Trust Thought Leadership expectations for 2013. However, one of the limitations of scenario analysis is the inability to quantify the effect of active management. While we do expect active management to enhance returns, it is difficult if not impossible to model such activity. Therefore, our analysis assumes a static portfolio. As with any scenario analysis, the actual results may differ substantially from the expected returns.

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U.S. TRUST FIXED INCOME INVESTMENT TEAM John W. Donovan, Head of Fixed Income and Trading Portfolio Management: Chris Gunster CFA, Senior Portfolio Manager, National & East Coast Division Lead Newlin Rankin, Senior Portfolio Manager, West Coast Division Lead Ned Costello, Senior Portfolio Manager, Central Division Lead Peter Vaream, Senior Portfolio Manager, Northeast Robert Speer, Senior Portfolio Manager Dmitri Artemiev, Portfolio Manager II, National Team Michael Perkons, Portfolio Manager II, National Team Andy Hibbert, Portfolio Manager I, National Team Benjamin Kriss, Portfolio Manager I, National Team Conor Daly, Portfolio Manager I, Central Division Sarah Dwyer, Portfolio Manager Associate, National Team Justin Nahoul, Portfolio Manager Associate, West Coast Research: David Litvack, Head of Tax-Exempt Fixed Income Research Martin Sullivan, Senior Tax-Exempt Research Analyst Marilyn Cruz, Tax-Exempt Research Analyst Jesse Harris, Head of Taxable Fixed Income Research Tim Pickett CFA, Taxable Research Analyst Brett G. Smith CFA, Taxable Research Analyst Darren Walters, Taxable Research Analyst Trading: Frank Butto, Senior Tax-Exempt Trader Carol Wilson, Senior Tax-Exempt Trader Ben Wigren, Senior Taxable Trader Jennifer Crane, Tax-Exempt Trader Philip Foronda, Tax-Exempt Trader Peter O’Neill, Tax-Exempt Trader Terry Trought, Tax-Exempt Trader Maura Halloran, Taxable Trader Matt Kelly, Taxable Trader

FIXED INCOME STRATEGY

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TAXABLE FIXED INCOME SUMMARY TABLE STRATEGY

ACTION

Duration

Underweight

Yield Curve

Tactical Barbell

Treasury/Agency

Underweight

TIPS

Market Weight

Credit

Overweight

MBS

Overweight

ABS

Underweight

Sovereign Bonds

Overweight

We are recommending portfolios move towards a shorter duration profile over the next few quarters. We believe a low interest rate environment has been framed by the Federal Reserve and recommend portfolios seek opportunities to capture roll across the curve. Our strong recommendation is to be underweight Treasury and agency securities across all points of the curve. Treasury and agency valuations are extremely rich compared to alternative fixedincome asset classes. We believe the Fed is creating an environment where long-term inflation will be a concern. We would look to purchase TIPS with maturities of five years and longer, given proper valuations. We view investment grade corporate debt as one of the best alternatives within taxable fixedincome. We recommend a neutral weighting across the financial and non-financial sectors within Investment Grade at this time. The additional yield that agency mortgages offer is very attractive both on a relative basis to other fixed-income assets types as well as historically. We believe Asset-backed securities offer little value at this time. Bonds available in the secondary market have been bid through fair value given the scarcity of supply. Investment in sovereign bonds can offer both attractive yields and diversification. We recommend investing in countries based on strength of the economy, yield levels, and favorable currency expectations. We are currently recommending: Australia, Brazil, Canada, Mexico, New Zealand, Norway, Singapore, and Sweden.

Source: U.S. Trust Fixed Income Strategy Team

TAX-EXEMPT FIXED INCOME SUMMARY TABLE STRATEGY

ACTION

Duration

Underweight

Curve Tax-Supported Debt

Tactical Barbell Overweight

Revenue Bonds

Overweight

We are recommending portfolios move towards a shorter duration profile over the next few quarters. We believe a low interest rate environment has been framed by the Federal Reserve and recommend seeking opportunities to capture roll across the curve. General obligation (full faith and credit) bonds and bonds secured by broad-based tax revenues of state and local governments with stable economies, balanced financial operations, and manageable debt and pension liabilities. Revenue bonds issued by essential service and infrastructure enterprises with strong rate-setting flexibility and that have legal provisions to protect bondholders.

Source: U.S. Trust Fixed Income Strategy Team

CROSS-OVER STRATEGY SUMMARY TABLE STRATEGY

ACTION

Duration

Underweight

Curve

Tactical Barbell Active

Crossover Strategy

We are recommending portfolios move towards a shorter duration profile over the next few quarters. We believe a low interest rate environment has been framed by the Federal Reserve and recommend seeking opportunities to capture roll across the curve. Short maturity investment grade taxable securities Agency mortgage backed securities Municipal bonds

Source: U.S. Trust Fixed Income Strategy Team

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This report is provided for informational purposes only and was not issued in connection with any proposed offering of securities. It was issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and does not contain investment recommendations. Bank of America and its affiliates do not accept any liability for any direct, indirect or consequential damages or losses arising from any use of this report or its contents. The information in this report was obtained from sources believed to be accurate, but we do not guarantee that it is accurate or complete. The opinions herein are those of U.S. Trust, Bank of America Private Wealth Management, are made as of the date of this material, and are subject to change without notice. There is no guarantee the views and opinions expressed in this communication will come to pass. Other affiliates may have opinions that are different from and/or inconsistent with the opinions expressed herein and may have banking, lending and/or other commercial relationships with Bank of America and its affiliates. All charts are based on historical data for the time period indicated and are intended for illustrative purposes only. This publication is designed to provide general information about economics, asset classes and strategies. It is for discussion purposes only, since the availability and effectiveness of any strategy are dependent upon each individual’s facts and circumstances. Always consult with your independent attorney, tax advisor and investment manager for final recommendations and before changing or implementing any financial strategy.

Other Important Information Past performance is no guarantee of future results. All sector and asset allocation recommendations must be considered in the context of an individual investor’s goals, time horizon and risk tolerance. Not all recommendations will be suitable for all investors. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. Investing in fixed income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa. Tax-exempt investing offers current tax-exempt income, but it also involves special risks. Single-state municipal bonds pose additional risks due to limited geographical diversification. Interest income from certain tax-exempt bonds may be subject to certain state and local taxes and, if applicable, the alternative minimum tax. Any capital gains distributed are taxable to the investor. For investments in ABS and MBS, generally, when interest rates decline, prepayments accelerate beyond the initial pricing assumptions, which could cause the average life and expected maturity of the securities to shorten. Conversely, when interest rates rise, prepayments slow down beyond the initial pricing assumptions, and could cause the average life and expected maturity of the securities to extend, and the market value to decline. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Stocks of small and mid cap companies pose special risks, including possible illiquidity and greater price volatility than stocks of larger, more established companies. 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. 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 risks related to renting properties, such as rental defaults. An investment in a hedge fund involves a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage, and short sales which can magnify potential losses or gains. Restrictions exist on the ability to redeem units in a hedge fund. Hedge funds are speculative and involve a high degree of risk. Treasury bills are less volatile than longer term fixed-income securities and are guaranteed as to timely payment of principal and interest by the U.S. Government. The credit quality ratings represent those of Moody’s Investors Service, Inc. (“Moody’s”) or Standard & Poor’s Corporation (“S&P”) credit ratings. The ratings represent their opinions as to the quality of the securities they rate. Ratings are relative and subjective and are not absolute standards of quality. The security’s credit quality does not eliminate risk. For information regarding the methodology used to calculate the ratings, please visit Moody’s at "www.moodys.com or S&P at www.standardandpoors.com.This report may not be reproduced or distributed by any person for any purpose without prior written consent. U.S. Trust operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC. © 2013 Bank of America Corporation. All rights reserved. | AR503B05 | 05/2013

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