Investing in the New Age of Fixed Income
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- Cleopatra Montgomery
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1 Investing in the New Age of Fixed Income 1
2 Rates May Not Be on the Rise Everywhere Global Opportunities Abound Further Rationale for a Non-U.S. Approach Other Securities to Consider in a Rising- Rate Environment Fixed-Income Investing with BNY Mellon/Dreyfus 2
3 The New Age of Fixed Income Investors stand at the threshold of a new era of fixed-income investing. After a multi-decade period of declining U.S. interest rates, improving economic conditions in this country seem to be pointing to a hike in the U.S. federal funds rate. Yet the expected timing, pace and magnitude of increases by the Federal Reserve remain a hotly debated topic. The prospect of rising interest rates is a concern for investors because bond prices have an inverse relationship with interest rates. As interest rates rise, bond prices generally decline. However, rising rates do not necessarily pose a dilemma for investors willing to take a broad approach toward fixed-income investing. Let s take a look at why. 3
4 Rates May Not Be on the Rise Everywhere First, some observers believe the European Central Bank, the Bank of Japan and other central banks are likely to be slower than the U.S. to remove accommodative monetary policies, as their respective economies remain stagnant. So with U.S. interest rates apparently set to go in the opposite direction, it may be time to explore international opportunities, particularly in areas of the world where rates are not forecast to rise in the near term. The European Central Bank has committed to quantitative easing until September 2016.* Growth in China is slowing and the central bank continues to cut rates; this affects the entire Asia-Pacific region (including Australia). Japan is still working through both quantitative easing and qualitative easing. * The government purchases securities in order to reduce interest rates. The government provides affordable financing to select business sectors. 4
5 Global Opportunities Abound Second, the world bond market is extremely large, with significant opportunities to be found outside our own country. Against the backdrop of potentially rising rates, there is growing appeal and justification for international diversification through investments in sovereign and corporate debt from highly rated developed countries and higher-yielding emerging markets. Returns from U.S. fixed income are often in the middle of the pack. In fact, the U.S. has not been the best-performing bond market in the past 12 years, and was the worst performer in Moreover, as the chart below shows, the U.S. bond market has not had a stellar track record over the past 12 years, so it may make sense to explore other opportunities in the wide world of fixed income. Why limit your core fixed income exposure to U.S. bonds? Look outside the U.S. for additional sources of return potential THE BEST-PERFORMING FIXED-INCOME MARKETS HAVE HISTORICALLY BEEN FOUND OUTSIDE THE U.S., AND PERFORMANCE RESULTS HAVE VARIED FROM COUNTRY TO COUNTRY $ Hedged Total Return (%) South Korea United States U.S. Fixed Income Market Return Mexico Japan Poland South Africa Canada Taiwan Japan United Kingdom Australia Japan South Africa Greece United Kingdom Portugal Hungary Japan Spain Philippines Indonesia Russia Russia Turkey 2015 Source: Barclays. Best- and worst-performing bond markets in U.S. dollars, based on 25 largest countries in Barclays Global Aggregate Index. Past performance is no guarantee of future results. This example is for illustrative purposes only. It is intended to illustrate the changing country leadership in terms of bond-market performance over time, the divergence in performance from year to year, and the potential benefits of a diversified investment approach. It is not intended to promote investment in any single country or market. Returns from emerging-market countries have been historically more volatile than those of the U.S. and other developed countries. Investors cannot invest directly in any index. Actual results will vary. 5
6 Further Rationale for a Non-U.S. Approach Traditional domestic approaches to bond investing those that emphasize U.S. government securities, agency debentures, mortgage-backed securities and high-grade corporate bonds, which comprise the Barclays U.S. Aggregate Bond Index have performed well during the past 35 years, as U.S. interest rates steadily declined. In fact, falling interest rates were the primary source of bond returns for that benchmark since the early 1980s. Don t get stuck with narrow interest-rate exposure, an overweight to lower-yielding securities and a limited opportunity set. 6 But with U.S. rates already near historic lows and likely poised to ratchet higher, the returns of a portfolio concentrated in U.S. high-grade bonds may be limited during this time period. In an era of rising rates, these traditional one-size-fits-all approaches aren t expected to be as successful as they have been. Investors who don t take a proactive approach that encompasses global bonds may be left with narrow interest-rate exposure, an overweight to lower-yielding securities and a limited opportunity set.
7 Most U.S. Investors Have Low Exposures to International Fixed Income As seen in the chart below, the average individual U.S. investor has only around a 2% exposure to international fixed income. If you re one of these investors, there may be benefits to expanding your portfolio to include global bonds, such as: Broader geographic exposure More opportunities around the globe to take advantage of divergent interest rates and policies Flexibility to move where opportunities are and capitalize on higher return potential Safety due to high credit quality available in developed nations The ability to seek higher income-producing opportunities on a global basis Potential for less volatility than other fixed-income diversification methods, such as adding credit risk 2.3% Domestic Cash U.S. Fixed Income International Fixed Income U.S. Equities International Equities 9.3% 14.1% 19.0% 55.4% Source: ICI as of 12/31/15. 7
8 Other Securities to Consider in a Rising-Rate Environment Clearly, investors need to consider adopting a new approach to fixed-income investing and view the advent of rising rates as an opportunity to update their bond holdings. Besides going global, you can consider select domestic fixed-income security types that may respond differently to rising rates, and help your portfolio weather the coming new environment. High-Yield Bonds A bond s coupon is an important defense against a moderately rising rate environment. Bonds with higher yields tend to be cushioned against rising interest rates, as the income they produce helps mitigate bond price declines. However, it s important to remember that high-yield bonds are rated below investment grade, so their higher credit risk may make them appropriate only if your risk tolerance allows for such investments. Municipal Bonds Municipals may be an attractive fixed-income alternative for investors who can benefit from taxexempt income. For example, consider a California resident at the highest combined effective federal and state income tax rate of 50.36%. If this person is considering a California municipal fund with a 30-day yield of 1.65%, he or she would need to find a taxable fund with a 30-day yield of 3.32% to match the yield on the municipal fund, due to the effects of federal and state taxes.* Municipal bonds generally have low levels of credit risk, notwithstanding the isolated problems of a handful of troubled issuers such as the Commonwealth of Puerto Rico and City of Detroit. * Results would be different for lower combined tax rates. Represents highest composite federal and California income tax brackets and an additional 3.8% Medicare income tax, as applicable by law. Please consult your tax advisor on any tax-related matters. 8
9 Consider select domestic fixedincome security types that may respond differently to rising rates, and help your portfolio weather the coming new environment. Floating-Rate Bank Loans This security type can pull double duty in a rising interest-rate environment. Funds that invest in these securities can offer high current yields and lower duration, which help lessen an investor s exposure to interest-rate risk. Floating-rate bank loans are arranged by banks and other financial institutions to help companies finance restructurings, acquisitions or other highly leveraged transactions. Companies that access capital through these loans typically have credit ratings below investment grade, so, similar to high-yield bonds, these types of securities must be appropriate for your individual risk tolerance. The interest rates of floating-rate loans reset periodically (typically every several months) relative to an underlying benchmark rate, such as the prime rate or the London Interbank Offered Rate (LIBOR). Due to the floating-rate nature of the interest rates on these investments, they tend to be less price-sensitive to changes in market interest rates, which can reduce volatility over time. 9
10 Fixed-Income Investing with BNY Mellon/Dreyfus Dreyfus is part of BNY Mellon, one of the world s leading investment-management organizations and one of the top U.S. wealth managers, with $1.6 trillion under management. Encompassing 13 individual investment boutiques, BNY Mellon brings institutional-quality investment management to a range of fixed-income funds designed to meet your needs. To learn more about these fixed-income mutual fund solutions, please speak with your financial advisor. BNY Mellon offers a range of mutual funds and strategies devoted to bonds that may play well in a rising-rate environment, including: FUND (CLASS A TICKER) OVERVIEW Dreyfus/Standish Global Fixed Income Fund DHGAX Globally diversified core fixed-income alternative Dreyfus Opportunistic Fixed Income Fund DSTAX Smart, unconstrained bond investing for every environment Dreyfus Floating Rate Income Fund DFLAX An alternative to traditional fixed income that may reduce interest-rate risk while seeking to provide attractive, high current income Dreyfus AMT-Free Municipal Bond Fund DMUAX A desirable solution that seeks federally tax-free income for tax-conscious investors Dreyfus Municipal Bond Fund DRTAX Pursuing the best risk-adjusted values across the municipal market 10
11 Learn More Advisors: Call or visit dreyfus.com Mutual Fund Investors: Contact your financial advisor or visit dreyfus.com 11
12 Investors should consider the investment objectives, risks, charges and expenses of a mutual fund carefully before investing. To obtain a prospectus, or a summary prospectus, if available, that contains this and other information about a Dreyfus fund, contact your financial advisor or visit dreyfus.com. Read the prospectus carefully before investing. Main Risks Bond funds are subject generally to interest rate, credit, liquidity, prepayment and extension, derivative and market risks, to varying degrees, all of which are more fully described in the fund s prospectus. Generally, all other factors being equal, bond prices move in the opposite direction of interest-rate changes. High-yield bonds are subject to increased credit risk and are considered speculative in terms of the issuer s perceived ability to continue making interest payments on a timely basis and to repay principal upon maturity. Floating-rate loans (or bank loans) include special risks related to irregular trading activity, wide bid/ask spreads and extended trade settlement periods. In addition, the value of collateral, if any, securing a floating-rate loan can decline, and may be insufficient to meet the issuer s obligations in the event of nonpayment of scheduled interest or principal, or may be difficult to readily liquidate. The lack of an active trading market for certain floating-rate loans may impair the ability of the fund to realize full value in the event of the need to sell a floating rate loan and may make it difficult to value such loans. The floating rate loans in which the fund invests typically will be below-investment-grade quality and, like other below-investment-grade securities, are inherently speculative. To the extent a fund invests in foreign securities, the fund s performance will be influenced by political, social and economic factors affecting investments in foreign issuers. Special risks associated with investments in foreign issuers include exposure to currency fluctuations, less liquidity, less developed or less efficient trading markets, lack of comprehensive company information, political and economic instability and differing auditing and legal standards. Investments denominated in foreign currencies are subject to the risk that such currencies will decline in value relative to the U.S. dollar and affect the value of these investments held by the fund. The use of derivative instruments, such as options, futures and options on futures, forward contracts, swaps, options on swaps, and other credit derivatives, involves risks different from, or possibly greater than, the risks associated with investing directly in the underlying assets. A small investment in derivatives could have a potentially large impact on the fund s performance. Income for national municipal funds may be subject to state and local taxes. Income may be subject to state and local taxes for out-of-state residents. Some income from non-amt-free funds may be subject to the federal alternative minimum tax for certain investors. Capital gains, if any, are taxable. Asset allocation and diversification cannot ensure a profit or protect against loss in declining markets. Not all funds may be available at all firms. BNY Mellon Investment Management is one of the world s leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon s affiliated investment management firms, wealth management services and global distribution companies MBSC Securities Corporation, Distributor DRY-FIBRO-0216
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