Fixed Income Outlook for 2013

"Won't Get Fooled Again"...and More of My Favorite Theme (songs) for 2013

• Won't Get Fooled Again…and More of My Favorite Theme (Songs) for 2013. In the first of our "greatest hits" themes for 2013, over the long run today's low interest rates lock in negative returns after inflation, "fooling" investors expecting fair returns in fixed income. However, the short-run return outlook depends critically on the next phase of debt ceiling-induced uncertainty. Whether that outcome derails the economic recovery will determine whether rates end up higher or lower by year's end, and whether our expectations for modest increases in interest rates in 2013—targeting 2.25% for the 10-year Treasury—means we end up fooled again.
• Like a Rolling Loan. "How does it feel?" The double-digit returns of the high yield market over the past year felt pretty good. But lower starting yields means lowering asset class return projections in 2013 to mid to high single digits. We stay "overweight" high yield as those returns, while lower than in past years, are still attractive for the default risk that ample global liquidity keeps at bay in 2013.
• The Way We Were. "What's too painful to remember, we simply choose to forget..." At the root of the last credit crisis stood overly accommodative monetary policy fueling asset price bubbles. Have policymakers learned any lessons? Persistent accommodative monetary policy remains the key determinant of risk asset price performance in 2013. That should make risk assets–stocks and the most credit-sensitive bonds–the best performing asset classes in 2013.
• Movin' Out. Of the basement, that is; representing our housing recovery theme and a source of optimism to the economic outlook in 2013. The trouble is that optimism is shared by everyone else. Housing recovery-themed investment strategies already outperformed in 2012; we look for lower returns in 2013 and underperformance of homebuilders vs. banks stocks as banks remain a standout beneficiary not fully priced. We also look for outperformance from bank bonds and mortgage credit, albeit to a lower degree than last year.
• How Will I Know? "Just trust your feelings..." When it comes to the impact China has on the global economic outlook, probably better to dig deeper. The longer run China outlook depends critically on the ability of the new leadership to implement key structural reforms. For 2013 however, China likely supports the global growth outlook, fueling continued strong emerging market performance.
• Turning Japanese. Or should we say "Turning Bernankese?" Japan takes a page out of the Fed playbook and may finally successfully reflate. Though now consensus viewpoints, a weaker yen fuels a stronger Japan equity market in 2013.

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The sector performance and yields listed are represented by, respectively: Barclays US High Yield Index, S&P Leveraged Loan Index, Barclays US Securitized Ex-MBS Index, Barclays US Mortgage Backed Securities Index, Barclays US Corporate Investment Grade Index, Barclays Global Aggregate ex-USD Index, JP Morgan EMBI Global Diversified Index, Barclays US Inflation Protected Securities Index and Barclays US Treasury Index. The reference indices are represented by the Barclays US Aggregate and the Barclays Municipal Bond Index.

Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in non-investment-grade debt securities ("high yield" or "junk" bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories. International investing involves additional 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/developing markets or smaller capital markets. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

The opinions expressed are those of BlackRock® as of January 11, 2013, and may change as subsequent conditions vary. Information and opinions are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable. The information contained in this report is not necessarily all-inclusive and is not guaranteed as to accuracy. Past performance does not guarantee future results. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Investment involves risk. Reliance upon information in this report is at the sole discretion of the reader.

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Prepared by BlackRock Investments, LLC, member FINRA.