The Risk of Fixed Income Indexing vs. Active Multi-Sector Management

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1 Pioneer Perspectives TM May 2012 The Risk of Fixed Income Indexing vs. Active Multi-Sector Management A Different Future for Fixed Income Investors? Tepid economic growth coupled with volatile equity markets over the past few years have driven U.S. investors to the perceived safe haven of fixed income, as well as to cash. In most investors minds, fixed income might not offer significant capital appreciation that is the role for equities but at least it can protect principal as well as provide a modest income stream. Often, that core fixed income investment has taken the form of an indexed or index-like portfolio based on the Barclays Capital U.S. Aggregate Index (the Index ). Ken Taubes Chief Investment Officer, U.S. Pioneer Investments Ken Taubes is Chief Investment Officer, U.S. of Pioneer Investments and is Portfolio Manager of Pioneer Investments U.S. Core and U.S. Core Plus strategies. He has over 25 years of investment experience, including more than 10 with Pioneer Investments. We believe that fixed income indices may be appropriate as benchmarks, but not as investment strategies. Even broad market indices like the Barclays Capital U.S. Aggregate Index close off a large part of the opportunity set within the fixed income universe, including floating rate sectors, Treasury Inflation Protected Securities (TIPS), convertible bonds, municipals, non- U.S. dollar bonds and non-investment grade issues that can play a key role in adding return and diversifying risk within a fixed income portfolio. Particularly at this time with over 70% of Index exposure to U.S. government-related issues, increasing U.S. debt levels and a 60-year low in interest rates the broad market U.S. investment grade index exposes investors to greater potential downside interest rate risk than ever before in its thirty year history. We think an active, value-based multi-sector approach to fixed income investing is a better way to invest in fixed income. The Consensus View: Income and Principle Protection The broad market U.S. investment grade index exposes investors to greater potential downside interest rate risk than ever before in its thirty year history. To read more Pioneer Perspectives, visit us.pioneerinvestments.com or Pioneer's blog followpioneer.com Most investors expect fixed income to act primarily as a stabilizer for their portfolios; its role is to protect principal, offer reasonable income with modest volatility and serve as a diversifier of the more volatile equity allocation. Ancillary benefits may include providing liquidity, enhancing total return or, in the case of TIPS, providing an inflation hedge. The broad market s move away from equities into fixed income reflects three factors: 1) the poor relative performance of equities over the last decade, particularly in 2008; 2) the increasingly conservative demographic profile of investors, as the baby boom population ages; 3) the asset/liability focus among companies to incorporate more liability-driven fixed income solutions. As U.S. investors have moved into fixed income, however, they have invested in passive as well as actively-managed strategies. Some passive investors were driven by the gross underperformance of active managers in 2008; some have become enamored with fixed income ETFs. In the institutional universe, the market share of active vs. passive U.S. bond allocations has declined as well. Consultants believe that adding value for active domestic The views expressed in this outlook are those of Pioneer Investments, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of Pioneer.

2 fixed income managers has become more difficult in the current environment. 1 We believe this recent emphasis on passive fixed income may prove extremely ill-timed. U.S. government monetary and fiscal policies over the past decade and particularly in the face of the 2008 financial crisis, have driven risk exposures within the Index to extreme levels. Issuers with the most debt (and therefore possibly the least creditworthy ones) have the largest index weights. Passive Risk Exposures Are Growing The construction of the Barclays U.S. Aggregate Index reflects the market capitalization of fixed-rate investment grade sectors. Any market capitalization-based index subjects investors to potentially undesirable and unstable risk exposures. U.S. government monetary and fiscal policies over the past decade, and particularly in response to the 2008 financial crisis, have driven risk exposures within the Index to extreme levels. Issuer and sector risk The historical objection to fixed income indices, particularly to credit indices, was the greater bums argument. Issuers with the most debt, and therefore possibly the least creditworthy ones, have the largest index weights. That is why broad market indices are more attractive than credit-only indices. With their diversified exposures to government, agency, mortgage-backed securities, corporates and asset-backed securities, broad market investment grade indices are not supposed to expose investors to issuer concentration risk, at least not to higher risk issuers. The trend of rising U.S. and developed market sovereign risk could turn that assumption on its head. With U.S. gross debt to GDP levels currently at 100% and predicted by the Congressional Budget Office under current trends to increase to 195% by 2035, the United States may no longer claim its former high level of creditworthiness. 2 Default is implausible because the Fed can print money; but the value and status of the U.S. dollar could easily decline. As indicated in the chart below, over 70% of the Barclays U.S. Aggregate Index represents U.S. government exposure, including 35% Treasuries (up from 22% at the end of 2007); 32% in agency mortgage-backed securities (MBS) (up from 5% in 1976); and approximately 6% agency/government-related debt. Sector History of the Barclays Capital U.S. Aggregate Bond Index 100% 80% 60% Agency/Govt Related 40% 10 Year Yield U.S. Treasury Agency MBS 35% 6% 32% 2011 U.S. Government Sector: 73% 1 Pensions and Investments, Top 200 Pension Funds Actively Moving to Passive Strategies, February 6, 2012). 2 It is important to note as well that while debt of Fannie Mae and Freddie Mac is excluded in the above 100% debt/gdp calculation, their debt is now viewed more as an explicit obligation of the U.S. government, following their being placed into conservatorship in % 0% Mar Yr Ave Return: 3.04% Avg CPI: 4.44% Corporate Investment Grade Mar-80 Mar-84 Mar-88 Mar Yr Avg Return: 8.95% Avg CPI: 3.01% Yankee ABS/CMBS Mar-00 Mar-04 Mar-08 Source: Barclays Capital U.S. Aggregate Bond Index, December 31, Data runs from March 31, December 31, The Barclays U.S. Aggregate Bond Index is a measure of the U.S. bond market. Indices are unmanaged and their returns assume reinvestment of dividends and, unlike mutual fund returns, do not reflect any fees or expenses associated with a mutual fund. It is not possible to invest directly in an index. Mar-96 17% 8% 2% Dec-11 2 Pioneer Perspectives TM The Risk of Fixed Income Indexing vs. Active Multi-Sector Management

3 The increased share and rising valuations of U.S. Treasuries and agency MBS in the Index are directly attributable to U.S. monetary and fiscal policies. Indexed portfolios only reflect changes in prices. Unlike actively managed portfolios, they don t distinguish why prices change, or whether sectors offer value to investors. The increased share and rising valuations of U.S. Treasuries and agency MBS in the Index are directly attributable to U.S. monetary and fiscal policies. U.S. Treasury issuance rose to help fund the budget deficits; yields reached record post-ww II lows as a result of the Fed s % Fed Funds target rate as well as its on-going purchases of government securities. Growth in agency MBS issuance reflects the benefit of public policy encouraging home ownership and the low rates of the Greenspan era. More recently, agency MBS spreads have compressed in response to the Fed s 2009 $1.25 trillion mortgage purchase program and its ongoing reinvestment programs, as well as from demand from the banking sector. With the Fed keeping funding costs low, banks found the MBS carry trade attractive, although their purchases may decline in light of recent rising demand for loans. In addition, U.S. Treasury prices may continue to be driven by government policies, which have included the Fed s 2010 $600 billion Treasury purchase program, known as QE2, as well as its 2011 Operation Twist program, in which the Fed sought to reduce long-term Treasury yields by purchasing long-dated Treasuries instead of short-term Treasuries. Indexed portfolios only reflect changes in prices. Unlike actively managed portfolios, they don t distinguish why prices change, or whether sectors offer value to investors. Duration risk The most important risk in a core fixed income portfolio is duration, defined as the sensitivity of price to changes in interest rates. The duration of agency MBS, a sector that has accounted for approximately 30% of the Index over the past decade, is based on prepayment models. As prepayment models are updated with new information, the duration of mortgages will change accordingly. In the aftermath of the housing bubble which was aided and abetted by government policy homeowners have faced a new landscape in which previously wellunderstood relationships between mortgage rates and refinancing activity have not applied. Different prepayment behavior drove the largest single model-driven duration change in the history of the index in September, The duration of agency MBS rose by 1.22, which in turn changed the duration of the U.S. Aggregate Index by 0.39 from 4.2 to 4.6. Ironically, strategies mimicking the Index had greater interest rate exposure even as interest rates breached record lows. Active managers, on the other hand, have the ability to adjust their duration positioning relative to the Index. In the aftermath of the housing bubble which was aided and abetted by government policy homeowners face a new landscape, in which previously well-understood relationships between mortgage rates and refinancing activity do not apply. Different prepayment behavior drove the largest single model-driven duration change in the history of the index. The Highest Risk of Rising Interest Rates in 60 Years The over 70% government exposure and low agency MBS spreads have increased the interest rate sensitivity and potential volatility of the U.S. Bond Aggregate Index. With interest rates at 60-year lows, the risk of rising rates and falling prices stands at generational highs. The following chart depicts 10-year Treasury yields over the past 60 years. Pioneer Perspectives TM The Risk of Fixed Income Indexing vs. Active Multi-Sector Management 3

4 Yield on the 10-Year Treasury at 60-Year Lows With interest rates at 60-year lows, the risk of rising rates and falling prices stands at generational highs. 18% 15% Current 10-Year Yield: 1.92% (as of April 30, 2012) 10-Yr Avg Return: 2.74% Avg CPI: 4.22% 10-Yr Avg Return: 9.13% Avg CPI: 3.14% 12% 9% 6% 3% 0% 60-Year Low Source: U.S. Federal Reserve Bank, Latest Data Point: April 30, Return periods: ; For over three decades (a period of falling interest rates), investors seemed to believe that investing in a broad-market, investment-grade indexed portfolio, or with a benchmarkdriven manager, assures them of positive returns and low volatility. For over three decades (a period of falling interest rates), investors seemed to believe that investing in a broad-market, investment-grade indexed portfolio, or with a benchmark-driven manager, assures them of positive returns and low volatility. Indeed, the Index and the 10-year Treasury have both delivered approximately 9% annualized returns since 1981, as 10-year yields declined from peak levels of 15.3% to 1.9%, reflecting a drop in inflation from the high of 14.4% to 2.7% today. For Over Three Decades Investors Enjoyed Strong Returns as Yields and Inflation Declined % U.S. Aggregate Index Return CPI YOY 10-Year Treasury Yield 16% 12% Index and 10-Year Treasuries: 9% Average Annual Returns 8% 4% 0% Source: Federal Reserve Bank, St. Louis, Barclays Capital, Bloomberg. Reflects average annualized returns for Barclays U.S. Aggregate Index and CPI; and average monthly 10-year Treasury yields over indicated periods. Last data point 12/31/ Pioneer Perspectives TM The Risk of Fixed Income Indexing vs. Active Multi-Sector Management

5 The only reason that average nominal 10-year Treasury returns were positive in the late 1970s was due to the high average 9% yield. What investors don t remember is the performance of fixed income during a period of rising rates, reflected in 10-year Treasury returns from Fixed income investors rarely outperformed inflation, i.e. real returns were rarely positive, and turned significantly negative in the high inflation period of the late 1970s. The only reason that average nominal 10-year Treasury returns were positive in the late 1970s was due to the high average 9% yield. Conditions today appear more comparable to the low yield environment of the early 1950s. Over the Prior 30 Years Real Returns were Negative Amidst High Inflation and Rising Yields % 9% 10-Year Treasury Returns CPI YOY 10-Year Treasury Yield (Proxy for the Barclays Aggregate Bond Index) 1 8% 7% 6% 5% 4% 3% 2% 1% 0% If the 10-year Treasury merely adjusted to a normalized 5% rate (2.5% to 3.0% real rate with a 2% inflation assumption and some term premium), given its 9+ duration, it could suffer a price decline of over 25%. Unlike indexed managers, active multi-sector managers have the ability to construct portfolios with a view to absolute as well as relative risk. 1 While the Index didn t exist during this period, the 10-year Treasury returns are used as a proxy for the Barclays Aggregate Bond Index returns. Source: Federal Reserve Bank, St. Louis, Barclays Capital, Bloomberg. Reflects average annualized returns for Barclays U.S. Aggregate Index and CPI; and average monthly 10 year Treasury yields over indicated periods. Last data point 12/31/1980. If the 10-year Treasury merely adjusted to a normalized 4.5% rate (2% to 2.5% real rate with a 2% inflation assumption and some term premium), given its 9+ duration, it could suffer a price decline of almost 25%. Under these conditions, the Index, with its 5.1 duration, might fall by almost 14%. Multi-year low yields exacerbate downside risk, since there is little income to offset price depreciation. With the Fed committed to continued low interest rates into 2014, inflation could rise should the economic recovery accelerate. If inflation rises significantly, Index investors will not enjoy the benefit of the 9% yield that prevailed in the late 1970s to offset price declines. Active Multi-Sector Management: A Better Way We believe active multi-sector management is a better way to invest in fixed income markets. An active multi-sector management style can help mitigate both income and interest rate risk by investing in fixed income sectors less correlated with interest rates. Unlike indexed managers, active multi-sector managers have the ability to construct portfolios with a view to absolute as well as relative risk. They consider the interactions and correlations of all risk factors, including interest rate, credit, country, (currency, if permitted), sector, industry and issuer, in building portfolios, rather than passively accepting the changing (and increasingly risky) profile of the Index. Pioneer Perspectives TM The Risk of Fixed Income Indexing vs. Active Multi-Sector Management 5

6 We believe investors should seek out an active bond manager who understands and adds value by investing in a variety of sectors and regions, and has proven credit research expertise in security selection. Active managers can exploit the full range of the fixed income universe, investing in a variety of higher yielding sectors, floating rate sectors and other less correlated assets to offset rising rates. In the increasingly uncertain environment that may characterize the next several years of fixed income markets, we believe it makes most sense to select an active manager whose strategy derives the majority of its excess returns from sector and industry allocation and from security selection, rather than from focusing on government bond markets. We believe investors should seek out an active bond manager who understands and adds value by investing in a variety of sectors and regions, and has proven credit research expertise in security selection. Finally, investors should consider active managers who have been able to perform strongly by being different from the benchmark. If active managers incur tracking error, they should exhibit high information ratios: when they take risk different from the benchmark, they are rewarded for that risk. Such an active manager can mitigate the primary risk for a fixed income investor: rising interest rates. Active managers can exploit the full range of the fixed income universe, investing in a variety of higher yielding sectors, floating rate sectors and other less correlated assets to offset rising rates. Yield Higher yielding assets produce higher income to cushion any price decline resulting from rising rates. Yield is particularly important in the current low yield environment. A multi-sector portfolio might offer a higher yield than that of the Index. In addition, all other things being equal, these higher income assets will have shorter duration than a government issue of comparable maturity, further muting their interest rate sensitivity. Spread The higher spreads of these higher yielding sectors may also hedge against rising rates. Credit spreads tend to compress in a rising interest rate environment, if rates are rising due to in an improving economic climate. As the outlook for earnings improves, credit risk declines and credit spreads tend to narrow. Floating Rate Sectors The floating rate nature of bank loans, certain non-agency MBS/ ABS and shorter maturity floating rate corporates, and even event-linked (catastrophe) bonds can act to hedge interest rate risk. Rising rates can be driven by increased rates in the short end of the yield curve. Because floating rate securities have little interest rate duration, their coupons will reset to reflect rising rates, offering protection against the reshaping of the yield curve. Active managers can also consider investing in TIPS, which adjust to compensate investors for actual CPI. Sectors with Lower Correlation Active managers can seek out other sectors less correlated to U.S. interest rates and yield curves, investing in non-dollar sovereigns with different yield curves. Should valuations dictate, they might choose to invest in emerging market corporates, convertible bonds or preferred stock. Security Selection The active multi-sector manager can focus on security selection, mitigating the over 70% broad U.S. government exposure of the U.S. Aggregate Index. Active bond managers can invest in issues that offer diversification, but that are also inefficiently priced and offer the potential opportunity for additional returns. 6 Pioneer Perspectives TM The Risk of Fixed Income Indexing vs. Active Multi-Sector Management

7 The active multi-sector manager can focus on security selection, mitigating the over 70% broad U.S. government exposure of the U.S. Aggregate Index. The following chart illustrates diversification benefits available* from a broad range of fixed income asset classes, particularly from non-benchmark asset classes. 10-Year Correlation Among Fixed Income Asset Classes Benchmark Sectors US Treasuries Agencies Agency MBS CMBS Investment Grade Corporates Non Benchmark Sectors 6 TIPS Municipals Non Agency ABS High Yield Bonds Leveraged Bank Loans Convertibles Preferred Stock International Bonds Emerging Market Bonds Event-Linked (Catastrophe) Bonds * Diversification does not ensure a profit or protect against loss in a declining market. Source: Barclays Capital, Bank of America Merrill Lynch,JP Morgan, Morningstar. 1 BofA Merrill Lynch (BOA ML) Treasury Master, which measures the performance of the US Treasuries market. 2 Barclays Capital (BarCap) US Agency Index, which measures the performance of US Agency issues. 3 BarCap US Agency Fix Rate MBS Index, which measures performance of the mortgage-backed securities market. 4 Collateralized Mortgage Obligation is a type of mortgagedbacked security. 5 BOA ML Corporate Bond Master measures performance of the investment grade corporate bond market. 6 BarCap U.S. Treasury US TIPS Index, a measure of the performance of TIPS (Treasury Inflation Protected Securities). 7 BOA ML Municipal Master Index, measures the performance of the overall municipal bond market. 8 A type of security issued by private institutions collateralized by mortgages that do not conform to agency requirements. 9 BOA ML High Yield Master II Index, which measures performance of the U.S. high yield bond market. 10 Credit Suisse Leveraged Loan Index, a commonly used benchmark for higher yielding, higher risk loans. 11 BOA ML U.S. Convertible Bonds Index, a measure of the convertible bond market. 12 BOA ML U.S. Preferred Stock Hybrid Security Index, a measure of the fixed-rate preferred stock market. 13 Citi WGBI Non USD Index, a measure of the performance of Non-US investment grade bond issuance. 14 JP Morgan EMBI Plus Index Tracks the performance of the below- and borderline-investment-grade global debt markets denominated in the major developed currencies. 15 Barclays Event- Linked Bond Index which measures instruments, usually insurance linked, used to raise money in the event of a catastrophe. Indices are unmanaged and their returns assume reinvestment of dividends and, unlike mutual fund returns, do not reflect any fees or expenses associated with a mutual fund. It is not possible to invest directly in an index. The following copyright pertains only to the Morningstar information. The Morningstar information contained herein: (1) is proprietary to Morningstar; (2) may not be copied; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information Morningstar, Inc. All Rights Reserved. Pioneer Perspectives TM The Risk of Fixed Income Indexing vs. Active Multi-Sector Management 7

8 With interest rates at 60-year lows, we believe we are facing an important historic inflection point in fixed income markets. With interest rates at 60-year lows, we believe we are facing an important historic inflection point in fixed income markets. While declining yields over the past 30 years offered a benign historical environment for fixed income investors, and particularly for fixed income indices, we believe that the future could be very different from this past experience. Active multi-sector managers can help investors navigate in this unfamiliar environment and continue to offer investors the possibility of better returns, while controlling for risk, in their fixed income portfolios. The Barclays U.S. Aggregate Bond Index is a measure of the U.S. bond market. Indices are unmanaged and their returns assume reinvestment of dividends and, unlike mutual fund returns, do not reflect any fees or expenses associated with a mutual fund. It is not possible to invest directly in an index. The views expressed in this memorandum regarding market and economic trends are those of Pioneer Investments, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of any Pioneer investment product. There is no guarantee that market forecasts discussed will be realized. There is no guarantee that these trends will continue. No forecast is a guarantee. The performance data quoted represents past performance, which is no guarantee of future results. Neither Pioneer, nor its representatives are legal or tax advisors. In addition, Pioneer does not provide advice or recommendations. The investments you choose should correspond to your financial needs, goals, and risk tolerance. For assistance in determining your financial situation, please consult an investment professional. Investors should consider risk tolerance and time horizons prior to making investment decisions. This material is not intended to replace the advice of a qualified attorney, tax adviser, investment professional or insurance agent. Before making any financial commitment regarding any issue discussed here, consult with the appropriate professional advisor. To receive automatic notification of updates to this and other Pioneer thought leadership pieces, sign up at us.pioneerinvestments.com/enotify, or look for this icon on our website. Pioneer Investments 60 State Street, Boston, Massachusetts Pioneer Investments us.pioneerinvestments.com

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