1) Bullseye Highlights Broken Income M any investors seek professional management and diversification offered through fixed income mutual funds. But is the term “fixed income fund” actually an oxymoron? There is nothing “fixed” about a bond fund’s price, and lately, they don’t pay very much income. With interest rates near all-time lows, perhaps it’s time to question the perceived benefits of bond funds that may be largely based on several decades worth of strong performance during a highly favorable time period. In the world of fixed income investing, when interest rates rise, the value of bonds will generally decline. The real world logic to this inverse relationship is fairly basic. If a new bond is issued paying a higher interest rate, then any existing bonds with lower rates may not be worth as much to investors. Why buy an existing bond paying 3% interest when you can get a new one paying 4%? Of course, the owner of an individual bond would have the choice of simply holding their bond until it matures to get back the full face value of the bond. But traditional bond fund investors don’t have that choice because most open-ended bond mutual funds never mature. So, traditional bond fund investors are perpetually exposed to interest rate risk without a specific end date. The graph (below) shows that bond funds have clearly benefitted from a long-term decline in interest rates. This was a trend that actually began as far back as the early 1980s when rates were above 15%. During the 20-year period shown in the graph, rates did increase a few times and bond funds seemed to do fine, which may have provided a false sense of security. At the time of those brief rate increases, many bond funds were likely protected by a “yield cushion.” The yield cushion helps bond funds when the underlying portfolio’s yield is higher than current market rates. If the fund’s average interest rate is higher than current market rates. If the fund’s Declining Rates, Increasing Bond Fund Returns (1995 to 2014) average interest rate is higher than current market rates, the value of the Interest Rates Bond Fund Returns 10 Year U.S. Treasury Notes Lipper Intermediate U.S. Govt. holdings may have a tendency to be 8% $3,000 more stable. But with interest rates $2,800 near all-time lows, the average yields of 7% $2,600 many bond funds have slowly dropped 6% $2,400 to levels that are in line with current $2,200 market rates. The lower underlying 5% $2,000 portfolio yield means there may no 4% longer be a cushion. If prevailing $1,800 market rates rise, there is potential for $1,600 3% greater sensitivity to those rate changes $1,400 2% than previously experienced by some $1,200 mutual funds. 1% $1,000 Some investors own bond funds specifically for the income, while others simply own bond funds as a diversifier for their stock-based portfolio. Past performance does not guarantee future results. Index returns assume reinvestment of dividends, but do not reflect any management fees, transaction costs or expenses. Indexes are generally unmanaged and are not available for direct investment. 

2) With interest rates near all-time lows, what are fixed income investors to do? First, they need to ask themselves why they own bond funds in the first place. Do they want diversification, are they seeking income, or a combination of both? Owning a portfolio of individual bonds can be quite an expensive endeavor, and the income still may not meet the investors’ needs. Again, many investors are more comfortable with the potential diversification benefits and professional management of mutual funds. There are many other asset classes and categories of mutual fund solutions that provide diversification for stock-centric portfolios. If an investor is concerned about the low rate environment and the potential for rising rates, they may wish to consider looking beyond traditional bond funds. For investors seeking diversification, there are other asset classes with a history of low correlation to traditional stocks and bonds. For investors who are able to tolerate some levels of risk, they may want to consider alternative assets and consider looking outside of the U.S. markets. If income is the primary focus, many regions around the world have higher prevailing market interest rates than the rates found within the U.S. fixed income markets. For investors who are more risk averse, there are ways to maintain exposure to fixed income without maintaining such a high level of interest rate sensitivity. Many nontraditional bond funds have the ability to change course as the markets shift. A long/short bond fund can invest in bonds as rates are flat or falling, but have the ability to profit during rising rate environments by shorting bonds—i.e., taking the opposite side of the trade by investing against the bond market. Some nontraditional bond funds may also have the ability to put assets into cash and stay away from interest rate turbulence altogether until the markets calm down. Did 2013 provide a glimpse at the potential for a 2008-type scenario for bond markets? Many investors are aware of the 2008 global financial crisis, but paid little attention to 2013. Fueled mostly by a short-lived fear of rising rates, 2013 was a hard year for domestic bonds, which delivered negative returns for the first time in more than a decade. How will the U.S. bond market react in the event of a prolonged period of increasing rates? 2013 Performance U.S. Bonds -2.02% Nontraditional Bonds 7.16% Global Multi-Asset 9.07% Barclays U.S. Aggregate Bond Index PSAI Index (Long/Short Fixed Income) Dow Jones Global Composite Yield Index Past performance does not guarantee future results. Index returns assume reinvestment of dividends, but do not reflect any management fees, transaction costs or expenses. Indexes are generally unmanaged and are not available for direct investment. Summary: Fixed income investing makes sense for a lot of investors, and for many reasons. But investors who primarily use bond funds for diversification, income or overall stability may want to take note of the interest rate environment. Interest rates are near all-time lows, and of course the future is unknown. What direction are rates going? Technically, they could still creep lower or remain relatively flat with the chance of being outpaced by inflation. But if rising rates are a primary concern, domestic bond fund investors may want to consider nontraditional bond strategies where the fund has the ability to adapt to changing markets. For those with greater risk tolerance who are seeking diversification from other sources of return and higher yields, it may be wise to think globally and consider multiple asset classes beyond U.S. stocks and bonds. Past performance is not indicative of future returns. Historical data is used for illustration purposes only and should not be used as a predictive measure for the future return expectations of any investment. The information is subject to change (based on market fluctuation and other conditions) and should not be construed as a recommendation of any specific security or investment product, and was prepared without regard for specific circumstances and objectives of any individual investor. Traditional, nontraditional, and alternative investments involve risks, including the potential for loss of principal. Nontraditional and alternative investments may involve additional risks, including, but not limited to, shorting risks, the use of leverage, the use of derivatives, futures market speculation and regulatory changes. Before investing in any financial product, always read the prospectus and/or offering memorandum for product-specific risks. Data sources: FactSet, Bloomberg. Index returns assume reinvestment of dividends, but do not reflect any management fees, transaction costs or expenses. Indexes are generally unmanaged and are not available for direct investment. AD-050815