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January 25, 2013

Steve Huber Mark Vaselkiv Hugh McGuirk Steve Huber, T. Rowe Price Strategic Income Fund,   Mark Vaselkiv, T. Rowe Price High Yield Fund and Hugh McGuirk, head of the Municipal Bond Division and manager of several muni bond portfolios.

Bond markets turned in another year of solid returns in 2012 but may pose more risks now than at any time since the financial crisis four years ago. A panel of three senior bond managers discusses what's ahead for credit markets: Steve Huber, T. Rowe Price Strategic Income Fund manager; Mark Vaselkiv, T. Rowe Price High Yield Fund manager; and Hugh McGuirk, head of the Municipal Bond Division and manager of several muni bond portfolios.

Coming Debt Fight Looms Over Fixed Income

While a year-end agreement averted the fiscal cliff, debt ceiling negotiations are just getting started. Will we see a replay of 2011? A debt ceiling controversy triggered a broad sell-off across fixed income assets and a corresponding rush into Treasuries. Huber anticipates volatility over the next couple of months, and the strategy for investment-grade portfolios will be to build in more liquidity, as volatility can create buying opportunities.

For municipal bonds, the issue of tax reform is a double-edged sword. Although municipal bonds typically generate tax-free returns, and income tax increases make them more attractive, the current mood of tax reform may threaten the exemption for municipal bond income altogether.

Improved Corporate Balance Sheets Are a Mixed Blessing

Healthy corporate balance sheets and improved fundamentals are part of what allowed corporate and high yield bond funds to perform well in 2012, but they have also contributed to companies shifting focus from shoring up balance sheets to driving shareholder value. Among investment-grade corporates, many companies now offer stock dividends that are higher than the yields on their bonds. Some high yield companies are issuing debt and using the proceeds to pay one-time dividends. These trends muddy the picture for potential corporate bond investors.

Fate of Interest Rates in 2013 Hangs on Fed

McGuirk notes that the economy still has a long way to go to get healthy, and imminent interest rate hikes are not likely. Yet, minutes from the Fed's December meeting suggest that the Fed may be open to raising interest rates earlier than anticipated. Even if a rise is a long way off, markets will price in tightening well before unemployment hits 6.5%, the Fed's current milestone for changing course. The Fed could also end its policy of purchasing mortgage-backed securities and Treasuries as early as this year, a possibility that could hamper these markets well before any actual action.

Early phases of a rising interest rate cycle will affect the government and investment-grade markets first, particularly for the bonds in those markets that have longer maturities. High yield issues will not be affected too much in the short term, especially if rising interest rates are due to a stronger, improving economy.

More Modest Returns Expected Across Fixed Income Markets

In the high yield arena, Vaselkiv suggests that investors may want to take some profits and harvest gains, although an improving economy and productive action in Washington could keep high yield issues favorable for a couple more years. McGuirk states that the municipal bond tax exemption still has not been directly threatened, and revenue issues for special projects like hospitals and airports generate higher yields than obligation issues. All three managers predict more modest returns in the coming year in an environment where stock markets seem to have the upper hand. Huber encourages investors to rethink their balance of fixed income and equity assets. Fixed income has had a long successful run, but all three managers agree that is likely coming to an end.

The views are as of January 8, 2013 and may have changed since that time. This is provided for informational purposes only and is not intended to reflect a current or past recommendation, or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Stocks and sectors may not perform in line with the managers' expectations. All funds are subject to market risk, including possible loss of principal. Investing overseas generally carries more risk than investing strictly in U.S. assets, due to factors such as currency, geographic, and emerging markets risk. Investing in emerging markets involves a high degree of risk. Emerging markets local currency bonds are particularly susceptible to currency risk in addition to the other risks of investing in emerging markets. Bonds are subject to credit risk and interest rate risk. High yield bonds have a greater risk of default than higher quality bonds. Unlike many fixed-income securities, Treasury bonds are guaranteed as to the timely payment of principal and interest. Investors should note that if interest rates rise significantly from current levels, bond fund total returns are likely to decline. Diversification cannot assure a profit or protect against loss in a declining market.

Copyright 2014, T. Rowe Price Investment Services, Inc., Distributor. All rights reserved.