Diversifying a Fixed-Income Portfolio in Today s Low-Yield Environment

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1 leadership series investment insights November 2011 Diversifying a Fixed-Income Portfolio in Today s Low-Yield Environment The current environment is tremendously challenging for fixed-income investors. With the baby boom generation beginning to enter retirement and equity markets generating extreme volatility, investors now more than ever before are looking to fixed-income instruments to provide both income and capital preservation. However, these characteristics have become scarcer as government bonds and other high-quality fixed-income instruments are offering historically low yields. This combination of factors warrants a re-evaluation of the approach to fixed-income investing, with a particular focus on understanding the sources of risk inherent in different asset categories and how they may be combined within a portfolio to conform to an investor s risk-return objectives. To simplify the approach, we will make two significant assumptions. First, we ignore tax implications, and therefore leave aside the discussion of municipal bonds, which otherwise can be considered highquality fixed-income assets but whose return potential would be understated without the benefit of their tax-advantaged status. Second, we will focus on total return as opposed to targeting a particular level of income generation, although the discussion of yield-to-maturity provides some approximation of relative income opportunities among the categories. Evaluating the sources of risk and return across fixed-income categories Different categories of fixed income possess varying degrees of exposure to different risks, including changes in interest rates, inflation rates, economic and credit conditions, or foreign exchange rates. (A complete list of the benchmarks for these fixed-income categories is provided in the endnotes. 1 For a review of their key characteristics and risk profiles, see Exhibit 1, below, and the inset on page 2.) Exhibit 1: Fixed-income asset prices have different vulnerabilities to changes in risk factors. Fixed-Income Asset Category Real Interest Rates (U.S.) Inflation (U.S.) Economic/ Credit Exchange Rate (U.S. Dollar) U.S. Investment-Grade* U.S. Government U.S. TIPS U.S. High-Yield Corporate Real Estate Debt Leveraged Loans Emerging-Markets Debt Asian High-Yield Bonds Foreign Developed-Country Debt European High-Yield Bonds Dirk Hofschire, CFA VP, Asset Allocation Research George Fischer Portfolio Manager key takeaways The current environment, with historically low yields on high-quality bonds and a potentially volatile macroeconomic backdrop, presents different challenges to investors than those experienced over the past decade. Diversifying beyond traditional, high-quality U.S. bonds is more important than ever before, with a multisector approach providing the foundation for tailoring the allocation to the risk-return objectives of the investor. Focusing on the sources of risk that are inherent within various fixed-income categories is critical, with a particular emphasis on using complementary exposures to hedge against the risk of inflation and other factors. * Includes both government and non-government. Dots represent increasing vulnerability to risk factors. Source: Fidelity Asset Management (Asset Allocation Research Team).

2 Key Characteristics of Fixed-Income Categories U.S. investment-grade bonds U.S. government securities are issued by the U.S. Treasury or by government-sponsored entities (GSEs). Treasury bills, notes, and bonds have almost no credit risk because they are backed by the full faith and credit of the U.S. government, but they are highly sensitive to inflation and real interest rates. U.S. non-government bonds include investment-grade corporate bonds and securities backed by assets such as mortgages (MBS). As high-quality instruments, these securities are most sensitive to interest rates and inflation, though they are also influenced by business and credit conditions. U.S. TIPS U.S. Treasury Inflation-Protected Securities (TIPS) are Treasury bonds whose principal value is adjusted semiannually based on changes in the Consumer Price Index (CPI), resulting in higher interest payments that help to protect against inflation. As government securities, TIPS are highly sensitive to real interest rates, but not to credit risk. U.S. high-yield corporate bonds High-yield bonds are debt securities of companies deemed to have low credit quality, so they carry significant credit risk, which includes the risk of default. High-yield bonds tend to be less sensitive to inflation and real interest-rate movements than investment-grade bonds, but much more sensitive to economic growth and credit conditions. Real estate debt Real estate debt investments include commercial mortgage-backed securities (CMBS) and bonds issued by real estate operating companies (REOCs) and real estate investment trusts (REITs). Investment-graderated real estate bonds generally have less credit risk than lower-rated, higher-yielding debt, although they have somewhat higher credit risk than traditional high-quality U.S. bonds. Credit risk is centered on fundamentals and business conditions in the real estate market, and the hard-asset characteristics of real estate tend to limit inflation sensitivity. Leveraged loans Leveraged loans are the bank debt of below-investment-grade companies, making them highly sensitive to economic and credit conditions. Their floating-rate coupons adjust regularly to changes in short-term interest rates, which makes them less vulnerable to movements in inflation and interest rates than traditional fixed-coupon bonds. Emerging-market debt Our discussion of emerging-market debt (EMD) includes U.S. dollardenominated bonds issued by sovereign governments and quasi-sovereign entities in developing countries. Over half are considered investment grade, while the others are high yield. EMD securities are sensitive to the credit and economic environment, including the issuers fiscal policies; they may also be influenced by changes in U.S. interest rates and inflation expectations. Although these securities carry little direct currency risk for U.S. investors, exchange-rate movements may indirectly impact the perception of issuer creditworthiness. Asian high-yield bonds issued by corporations are also typically denominated in U.S. dollars, providing only indirect currency exposure. Although issuers tend to have higher credit ratings than issuers in the U.S. highyield market, Asian high yield is still more sensitive to credit conditions than to U.S. inflation and real interest rates. Foreign developed-country debt Foreign bonds issued in local currencies by sovereign governments in developed countries are especially sensitive to changes in exchange rates relative to the U.S. dollar. These investment-grade securities are traditionally high quality, though they have become more credit sensitive due to sovereign risk concerns. Their prices are more directly influenced by foreign (not U.S.) inflation and real interest rates. European high-yield bonds issued by non-u.s. corporations are driven by company-specific credit factors as well as local economic conditions. European high yield is less sensitive to U.S. inflation and real interest rates, but more sensitive to currency movements since most issuance is denominated in European currencies. Return correlations can reflect fixed-income risk sensitivities The returns of securities with similar sensitivities to the risk factors described above tend to be more highly correlated with each other than the returns of securities with different risk exposures (see Exhibit 2). During , for example, U.S. investment- grade bonds were highly sensitive to real interest rates and inflation and, as a result, had low correlations with the prices of more credit-sensitive debt securities, including high-yield corporate bonds and leveraged loans. Similarly, securities with direct foreign Exhibit 2: Correlations of fixed-income returns are lower among categories with different sensitivities to risk factors. Monthly Return Correlations ( ) U.S. U.S. Investment- Government Grade Bonds Bonds U.S. TIPS U.S. High- Yield Bonds Real Estate Debt Leveraged Loans Emerging- Market Bonds Asian High-Yield Bonds Foreign Developed- Country Debt European High-Yield Bonds U.S. Investment-Grade Bonds U.S. Government Bonds U.S. TIPS U.S. High-Yield Bonds Real Estate Debt Leveraged Loans Emerging-Market Bonds Asian High-Yield Bonds Foreign Developed-Country Debt European High-Yield Bonds Past performance is not a guarantee of future results. Source: Bloomberg, FactSet, Morningstar EnCorr, FAM (AART) as of 9/30/11. 2

3 currency risk such as foreign developed-country bonds or that derive their credit risk from outside the U.S. such as EMD had relatively low correlations with many U.S. fixed-income categories. While correlations tend to change over time, assets with different risk sensitivities provide the potential for diversification benefits. Fixed-income performance under various conditions Due to the varying risk and return characteristics inherent in different fixed-income categories, changing economic conditions have historically driven rotations in relative performance. To illustrate how the U.S. economy has tended to influence the relative returns of different fixed-income assets, below we explore four different scenarios for the interplay of economic growth which generally affects the perceived creditworthiness of fixed-income securities and inflation which generally affects the prices of fixed-income securities through changes in interest rates (see Exhibit 3). Stagflation Stagflation involves weak economic and income growth with relatively high inflation, a combination that presents a difficult backdrop for the performance of most fixed-income asset categories. Returns on high-quality especially long duration bonds tend to struggle to keep up with inflation, while more credit-sensitive, higher-yielding securities may be held back by the weak economic environment. Inflation-resistant securities tend to perform relatively well, with TIPS benefiting from their indexation to CPI movements and leveraged loans from their short duration. A recent example of stagflation occurred during the first half of 2008, when the U.S. economy was in recession and inflation rose to 5% on a year-over-year basis. 2 Reflation/Inflation In an environment of high or accelerating inflation with at least moderate economic growth, more inflation-resistant categories tend to do better, while high-quality assets suffer amid rising Exhibit 3: Varying economic and inflation conditions have affected the relative performance of fixed-income categories. INFLATION / INTEREST RATES + - Index Level Nov = 100 Index Level Aug. 08 = Stagflation Favors short duration, inflation resistant TIPS U.S. High-Yield Nov- 07 Dec - 07 Jan- 08 Feb- 08 Mar - 08 Apr - 08 Recession / Deflation May- 08 Favors long duration, high quality Jun- 08 Reflation / Inflation Favors credit sensitive, inflation resistant 140 TIPS 130 U.S. High-Yield U.S. Government 120 Late 2007 Mid TIPS U.S. High-Yield U.S. Government Aug -08 Sep- 08 Oct- 08 Nov -08 Jul - 08 Goldilocks Growth Good for all, favors credit sensitive Late Index Level Feb. 09 = 100 Index Level May 96 = May- 96 Feb- 09 Mar- 09 Apr- 09 U.S. High-Yield U.S. Government Jul- 96 Sep- 96 Nov- 96 Jan- 97 Mar- 97 May- 97 May- 09 Jul- 97 Jun- 09 Sep- 97 Nov- 97 Jul- 09 Jan- 98 Mar- 98 Aug- 09 May GROWTH / PERCEIVED CREDIT OUTLOOK + Past performance is not a guarantee of future results. Source: Morningstar EnCorr, FAM (AART) as of 9/30/11. 3

4 interest rates. Credit-sensitive areas such as high-yield corporate bonds, commercial real estate debt, and leveraged loans benefit from the combination of both growth and inflation, while TIPS hold up best among high-quality categories. During a truly inflationary period in , with both solid real GDP growth and inflation that accelerated from 6% to 9%, average returns were 6.5% for investment-grade bonds and 9.0% for high-yield bonds. 3 An example of reflation occurred in an environment of accelerating growth during 2009, when inflation remained low but increased enough to drive credit-sensitive categories to large gains. Deflation/Recession Economic recession generally involves a deceleration in inflation, while a more extreme version would be outright deflation or falling prices. High-quality bonds tend to perform relatively well as interest rates decline, while credit-sensitive bonds suffer as the weak economic environment triggers a flight to quality. TIPS limit the impact of deflation by paying the larger of the original principal or the inflation-adjusted principal at the time of maturity. When the financial crisis in late 2008 led to an extreme recession with deflationary pressures (exacerbated by technical factors including deleveraging), high-quality bonds were one of the few areas of the market that registered positive gains. Goldilocks Growth Most asset categories tend to do well in an environment of solid economic growth with mild or decelerating inflation. High quality performs reasonably well amid stable interest rates, while credit-sensitive bonds tend to outperform, thanks to the boost from the robust economy. The two-year period from mid-1996 to mid-1998 experienced both solid economic growth and stable or falling inflation. Exhibit 4: Multi-sector bond portfolios include riskier assets. Illustrative Multi-Sector Bond Portfolios Portfolio Description Allocation #1 #2 #3 #4 #5 High-quality portfolio with limited risk Mix of high-yield, government, and foreign U.S.-centered mix of riskier and high-quality Riskier profile with limited high-quality Global high-yield with no high-quality 80% U.S. Investment-Grade 5% U.S. High-Yield 5% Real Estate Debt 5% Leveraged Loans 5% Emerging Market 40% U.S. High-Yield 30% U.S. Government 15% Foreign Developed 15% Emerging Market 45% U.S. High-Yield 40% U.S. Investment-Grade 15% Real Estate Debt 80% U.S. High-Yield 13% U.S. Investment-Grade 7% Emerging Market 60% U.S. High-Yield 20% Emerging Market 15% European High-Yield 5% Asian High-Yield Past performance is not a guarantee of future results. Source: FAM (AART). Global Investing/Foreign Exchange Movement in the value of the dollar against foreign currencies can also be a significant driver of relative performance, primarily for bonds issued in foreign currencies. While U.S. economic conditions and inflation affect the value of the dollar, other factors also influence exchange rates including foreign economic cycles, trade balances, and relative interest-rate differentials among countries. For instance, when the dollar declined 12% in , it helped boost foreign developed-country debt to a 27% return, compared with 12% for U.S. government bonds. In contrast, a rising dollar has sometimes coincided with weaker foreign debt performance, as in when foreign debt declined 8%, while U.S. government bonds gained 4%. 4 Allocating to fixed income: A multi-sector approach In any environment, traditional mean-variance optimization analysis (MVO) provides a useful starting point to evaluate the benefits of portfolio diversification among various fixed-income categories. The overall objective is to maximize risk-adjusted returns for any given level of risk, with the standard Sharpe ratio providing a barometer of risk-adjusted performance. 5 The following sections will demonstrate the return and risk characteristics of the fixedincome categories described above, while presenting various illustrative examples of multi-sector bond portfolios (see Exhibit 4). These portfolios hold different combinations of the fixed-income categories, and their risk profiles range from a mostly high-quality U.S.-oriented portfolio (#1) all the way to a global high-yield portfolio made up of riskier securities (#5). Historical perspective: Falling rates boosted high quality Looking at the historical performance of fixed-income categories since 1998, we see that traditional, high-quality U.S. fixed-income assets have provided robust risk-adjusted returns (see Exhibit 5, page 5). Investors enjoyed 6% average annualized returns from the investment-grade Barclay s Aggregate Index during the period, far outpacing the rate of inflation, and these returns were delivered with a low level of volatility. From 1998 to 2011, a high-quality portfolio (#1) that maintained an 80% allocation to investment-grade bonds while adding a 20% mix of riskier securities, such as high-yield corporate bonds, achieved a slightly higher return with almost no additional volatility, providing an improved risk-adjusted return. In addition, a mixed portfolio (#2) that increased the allocation to high-yield debt and added a global-bond exposure achieved higher returns due in large part to the strong performance of EMD with a still-reasonable level of volatility, though its risk-adjusted performance was not as strong as that of the more high-quality-oriented portfolio. Adding higher exposures outside the core U.S. high-quality area largely failed to improve the risk-return profile of the portfolio. For instance, allocating at least 40% of assets to high-yield corporate bonds in the three other portfolios (#3, #4, #5) was unable to add much return but increased the volatility of the portfolios meaning- 4

5 Exhibit 5: Historical risk-return profiles are evidence of the high-quality bond portfolio s strong risk-adjusted performance in Risk-return profiles using historical returns 12-Month Annualized Trailing Total Return Efficient Frontier U.S. Investment Grade #1 #2 TIPS #3 U.S. Government Real Estate Debt ( ) #4 Foreign Developed Leveraged Loans #5 U.S. High Yield Emerging Market Asian High Yield Portfolio Sharpe Ratio # U.S. Investment Grade 0.90 # # # # European High Yield Volatility of Returns All references to volatility are represented by the annualized standard deviation of monthly total returns. Past performance is not a guarantee of future results. Diversification does not ensure a profit or guarantee against loss. Source: Morningstar EnCorr, FAM (AART) as of 9/30/11. fully, resulting in inferior risk-adjusted performance. The declining interest-rate environment from 1998 to 2011 boosted the risk-adjusted performance of high-quality core U.S. fixed-income assets to such an extent that the benefits of diversifying broadly across categories were largely minimized during this period. Today s perspective: Low yields reduce high-quality return expectations With yields on high-quality bonds at or near historical lows, the expected return among different fixed-income categories looks different today. Most notably, the yield-to-maturity on U.S. investment-grade bonds is just above 2%, which presents a number of challenges. First, with the long-term average inflation rate of 3%, realizing positive real returns on an absolute basis may be difficult. 6 Second, there is a limited yield cushion to protect against a rise in interest rates or inflation, which could cause bond income to be quickly overwhelmed by the price decline. Third, investor income objectives, which may have been predicated on assumptions of higher returns that were easily achievable from 1998 to 2011, could be difficult to fulfill at low yield levels. In this environment, revisiting the case for multi-sector diversification takes on added importance. To simplify the analysis, we assume fixed-income performance volatility will be similar to the recent past, but we use current yieldsto-maturity in an attempt to better estimate expected returns. Evaluating various illustrative portfolio mixes using MVO Using yield-to-maturity as a proxy for expected returns, the illustrative multi-sector bond portfolios demonstrate the ability to enhance risk-adjusted return by incorporating asset categories beyond the traditional high-quality U.S. sectors (see Exhibit 6, page 6). For instance, the 20% allocation to higher-yield sectors in the #1 portfolio boosts the expected return above the high-quality-only index while adding almost no additional volatility, resulting in a sizeable increase in expected risk-adjusted returns. In this portfolio, the exposure to high-yield bonds and leveraged loans adds categories with low correlations and high expected risk-adjusted return properties, while allocations to emerging-market and commercial real estate debt provide additional diversification. Similarly, higher expected Sharpe ratios may be achieved through other multi-sector allocations. For instance, the mix in portfolio #2 includes a 40% allocation to high-yield corporate bonds that pushes up the expected returns and enhances the diversification benefits given the negative correlation with the U.S. government bond exposure. Additional diversification is achieved through allocations to emerging-market and developed-country debt, which possess low to moderate correlations with the other components. The allocation in portfolio #3 has a similar risk-return profile as portfolio #2, but instead uses a more concentrated approach. With 85% of the portfolio divided between high-yield corporate bonds and high-quality U.S. bonds, this allocation lowers volatility through the combination of these low-correlation assets, while adding expected return through the hefty high-yield exposure. The lower-quality portfolio #4 achieves a similar expected riskreturn profile, largely due to the 80% allocation to high-yield corporate bonds. The diversification benefits are more limited and the volatility level rises significantly above the other portfolios, but 5

6 Exhibit 6: Risk-return profiles using yields-to-maturity show that adding riskier asset categories can enhance risk-adjusted return. 12 Risk-return profiles using current yield-to-maturity ( ) Yield-to-Maturity Efficient Frontier U.S. High Yield #5 #4 Leveraged Loans #3 #2 Real Estate Debt #1 U.S. Investment Grade TIPS Foreign Developed U.S. Government Emerging Market Asian High Yield European High Yield Portfolio Sharpe Ratio # # # # # U.S. Investment Grade Volatility of Returns 25 Yield-to-maturity is represented by the three-month average ended 9/30/11. Past performance is not a guarantee of future results. Diversification does not ensure a profit or guarantee against loss. Source: Bloomberg, FactSet, Morningstar EnCorr, FAM (AART) as of 9/30/11. the high return expectations offset the added risk and result in a solid risk-adjusted return profile. The global high-yield portfolio #5 is even more tilted toward riskier credit categories, with no exposure to high-quality U.S. bonds. Diversification is achieved through the addition of geographic, credit, and currency risk from U.S., European, and Asian highyield bonds. However, the result is a significant increase in expected risk, since this portfolio s geographical diversification does not completely offset the added volatility as much as the exposure to high-quality bonds maintained in the other portfolios. To summarize, in an environment where the yield gaps between credit-sensitive and high-quality categories are large, portfolio riskreturn profiles can be improved significantly by diversifying across a broad variety of fixed-income categories, with an assortment of options for any given risk-level objective. Considerations for adding credit risk MVO analysis using yield-to-maturity as the expected return assumption provides a framework for understanding how fixedincome diversification opportunities have changed in today s lowyield environment, but this approach also has limitations, which require additional layers of analysis. For instance, the mean-variance analysis alone may exaggerate the benefits of lower credit-quality sectors such as high-yield corporate bonds. One reason is that these sectors may expect a certain number of defaults, which necessarily would lower the expected return below the yield-to-maturity, whereas in the higher-quality areas, defaults are less likely. Another consideration is that smaller, less established markets have liquidity risk. The U.S. Treasury market is the largest, most liquid debt market in the world, but at the other extreme, many of the higher-yield categories are smaller and more thinly traded. While historical return volatility somewhat captures the increased price volatility that this implies, liquidity in bond markets has generally become more constrained since the 2008 financial crisis and the subsequent changes in U.S. and global financial systems. Low-credit-quality sectors also tend to have higher correlations with equity performance. As a result, a higher allocation to lowercredit-quality instruments within a fixed-income portfolio will tend to reduce the diversification benefit that this fixed-income portfolio would provide when added to an overall investment portfolio including stocks. For instance, when each of the illustrative fixedincome portfolio mixes is combined with equities to make a fully diversified portfolio (50% fixed income, 50% equities), the more high-quality portfolio #1 achieves the highest expected Sharpe ratio (see Exhibit 7, page 7). This occurs because portfolio #1 has the largest allocation to high-quality bonds, which possess the lowest correlation with stocks. The high-quality diversification of portfolios #2 and #3 provided lower but still solid risk-adjusted return expectations, while the high-yield-focused portfolios #4 and #5 had far inferior risk-return profiles when combined with equities. This suggests that maintaining a substantial anchor position in 6

7 Exhibit 7: Sharpe ratios decline as risk is added to bond/equity mix. Multi-Sector Bond Portfolio Sharpe Ratio with 50% Equity* # # # # # * Equity = 70% DJ U.S. Total Stock Market Index and 30% MSCI EAFE. Source: Fidelity Asset Management. high-quality bonds may continue to be important for fully diversified equity-bond portfolios. Layering additional risk considerations (inflation, currency) Expected returns may also differ from yield-to-maturity because they can be influenced by movements in the various risk characteristics discussed above. For instance, the yield-to-maturity on TIPS is calculated using today s market expectations for future inflation. Because these expectations, at 2%, are relatively low, the expected returns and Sharpe ratio of TIPS are well below those of many other categories. If inflation were to rise well above the current expected level, however, TIPS returns would increase accordingly (assuming no changes in real interest rates). The positive correlations of leveraged loan and real estate debt performance with inflation rates imply they also may perform relatively well in an environment of higher inflation. Similarly, if the dollar loses value against foreign currencies, foreign developed-country debt may provide better returns to U.S. investors than indicated by its current low yield-to-maturity. Other local currency bonds, including European high-yield corporate bonds, may also benefit from a weakening dollar. These examples illustrate that investors who are especially concerned with a particular risk rising inflation, falling dollar or interested in hedging against this risk may use the component asset categories to tilt their multi-sector exposure in a particular direction. In these examples, TIPS and developed-country debt do not register large positions in multi-sector portfolios using MVO analysis, although they can be incorporated to make the portfolio more resistant to rising inflation or a declining value of the dollar. Potential macroeconomic impact on fixed-income categories In the medium term over the next five years or so, the U.S. macro environment may face a higher probability of fat tail outcomes than the average investment climate during the past two or three decades, potentially making the backdrop more volatile. This is likely for two main reasons: First, the U.S. economy is still in a period of deleveraging in the aftermath of the 2008 financial crisis. Household debt levels primarily related to lower home prices and still excessive mortgage debt are constraining consumption. Progress on private sector deleveraging is being offset by the massive deterioration in the federal government budget, which will require greater fiscal austerity in the years ahead. In this context, the trend rate of the U.S. economy will likely be significantly lower for the next few years than during the past several decades. Second, the Federal Reserve is inclined toward continuing and expanding extraordinarily stimulative monetary policies in the face of these economic challenges. Above all, the Fed fears that deleveraging and falling asset prices could push the economy into a deflationary spiral similar to the 1930s. In an attempt to reflate the economy by pushing investors into riskier assets, the Fed is willing to employ measures that force interest rates on high-quality cash and bond instruments to all-time low levels. Because deleveraging creates deflationary pressures, and stimulative monetary policies are generally attempts at reflation or raising inflationary expectations, the high-level struggle between these two forces may continue to play out over the next several years. In fact, the greater the threat of deflation, the more likely that the Fed will respond with more reflationary policies, increasing the probability of continued swings between the two. As discussed previously, movements between different economic scenarios can have widely divergent impacts on the performance of the various fixed-income asset categories. During the past three years, the U.S. has swung between periods when recession and deflationary concerns dominated (late 2008 and mid-2010) and periods when reflation and rising inflationary expectations gained the upper hand (during most of 2009, with QE2 in late 2010). The state of the U.S. economy for the past year may best be described as mild stagflation, registering 1.6% real GDP growth and 3.9% headline inflation in the third quarter of While all these scenarios remain possible over the next several years, the continuing battle between deflationary deleveraging forces in the economy and reflationary policies from the Fed suggests that similar fluctuations among the different backdrops will continue to occur. This is likely to result in continued periods of sudden, divergent performance across various fixed-income categories. Looking more broadly across the fixed-income universe, the heavy levels of indebtedness throughout the world particularly among developed economies presents an additional degree of uncertainty to investors. While sovereign bonds in large industrialized economies have traditionally been considered relatively safe assets, the current turmoil in the eurozone demonstrates that even large economies and bond markets such as Italy are not risk-free assets. For instance, the low bond yields in Japan today may reflect current investor perceptions of Japanese government debt as a high-quality asset, but extreme levels of sovereign debt as well as economic and demographic challenges may change that view at some point in the future. In short, the definition of which assets are high quality is not a static calculation, but one that must be constantly reassessed during an era of elevated debt levels in a more uncertain environment. 7

8 Investment implications The first implication of this backdrop is that multi-sector bond diversification will be more necessary than ever before to smooth out the heightened performance volatility that may occur. Some element of rebalancing and active asset allocation can also mitigate performance volatility, but the highly uncertain nature of the macro environment mandates a portfolio that is well anchored across various risk exposures. The second implication is that, on average, the risks appear skewed toward the prospect of higher inflation. The most likely form of inflation may continue to be the mild stagflation that has occurred recently, where the economy muddles along at a slow rate and inflation remains moderate but higher than the pace of income or economic growth. This combination of inflation and sub-par growth remains possible over the next few years, particularly if the Fed continues to employ extraordinary monetary policies, under-investment in the U.S. leads to capacity restraints, import prices from abroad rise amid higher inflation in China and other countries, or commodity prices rise due to supply constraints and/or monetary stimulus. This prospect ensures that some attributes of the more inflation-resistant categories such as leveraged loans and real estate bonds may be desirable, although the effectiveness of more credit-sensitive categories will depend on businesses continuing to perform well in a difficult economic environment. TIPS may provide the inflation hedge and the defensive characteristics that are needed in a weak economic environment. The third implication is that non-u.s. fixed-income exposure may become increasingly important. Direct foreign currency exposure provides some benefit if the U.S. dollar weakens in the future. But even more important, other geographic regions, governments, and businesses may provide diversification during an era when the U.S. backdrop is uncertain and potentially volatile. While other countries around the world also face a variety of challenges, their challenges are different, and may therefore provide some degree of diversification. The fourth implication is that a higher degree of active fixed-income portfolio management may be necessary to constantly monitor the changing risk factors and underlying characteristics of fixed-income categories. Traditional assumptions may be less durable in an everchanging and more complicated macro environment. In summary, our review of multi-sector allocation yields the following observations: MVO analysis shows that diversifying beyond high quality is more important now than ever before. Illustrative multisector portfolios demonstrate that different ways of combining fixedincome assets can be chosen according to risk-return objectives. Other key considerations include adding additional component exposures to hedge risks (inflation, currency) and making sure that the quality component is not overly minimized when combined with an equity portfolio. (For a review of the six key portfolio considerations for fixed-income investors, please see the inset, right.) Key Portfolio Considerations for Fixed-Income Investors 1. Diversifying beyond high-quality fixed-income categories is more important than ever before. Relatively low yields-tomaturity on high-quality bonds, in addition to an uncertain macro backdrop that may generate higher volatility, confirm the need to diversify across multiple categories. 2. Multi-sector bond portfolios offer attractive risk-reward properties. Evaluating risk-return properties by using traditional MVO analysis still provides an important framework for fixed-income allocation. Across the entire risk spectrum, there are multiple options for tailoring different bond mixes to the risk-return objectives of the investor. 3. Focusing on the sources of bond risk particularly inflation should be an important consideration. Due to the yield differentials among categories, as well as the macroeconomic environment that may tend toward higher inflation over time, it is critical to pay attention to not just the levels but also the sources of risk inherent in various fixedincome categories. Inflation-resistant properties should be an important secondary objective to the expected Sharpe ratio. 4. Using additional component exposures can hedge risks and broaden diversification opportunities. With a focus on the macro risks and the unique risk-return objectives of an investor, complementary asset categories may be used to fine-tune risk exposures. For instance, a global bond allocation may provide foreign currency exposure and greater geographic diversification. TIPS may possess properties that hold up relatively well in some challenging economic scenarios, despite their low yields. Additional diversification may be achieved through different credit sectors and structures, including some unique properties in areas such as leveraged loans and commercial real estate debt. 5. An exposure to traditional, high-quality assets should continue to anchor a portfolio. In a world with the potential for ongoing elevated macroeconomic volatility and high correlations among many asset classes, high-quality U.S. fixed-income assets continue to provide valuable diversification benefits. This is particularly true for investment strategies with shorter time horizons or greater sensitivity to near-term volatility. 6. Active management of risk exposures may become even more important amid high levels of indebtedness and macroeconomic uncertainty. Traditional assumptions about which fixed-income categories provide lower risk will need to be constantly monitored, as risk factors and market perceptions may change more rapidly and profoundly than during the recent past. 8

9 Authors Dirk Hofschire VP, Asset Allocation Research Dirk Hofschire is vice president, Asset Allocation Research for Fidelity Asset Management, the investment management arm of Fidelity Investments. AART is responsible for conducting economic, fundamental, and quantitative research to develop dynamic asset allocation recommendations for the Global Asset Allocation Division of Fidelity Asset Management. George Fischer Portfolio Manager George Fischer is a portfolio manager for Fidelity Management & Research Company (FMRCo), the investment advisor for Fidelity s family of mutual funds. Mr. Fischer manages the fixed-income investments for several asset allocation funds. Portfolio Managers Matthew Conti, Ford O Neil, and Christopher Sharpe; Institutional Portfolio Managers Jim Jordan and Lisa Kasparian; Director of Asset Allocation Research Lisa Emsbo-Mattingly; Asset Allocation Research Analyst Craig Blackwell; and Research Analyst Pramod Atluri also contributed to this paper. 9

10 Before investing, consider the funds investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments. Fidelity does not assume any duty to update any of the information. Investment decisions should be based on an individual s own goals, time horizon, and tolerance for risk. Past performance is no guarantee of future results. Investing involves risk, including risk of loss. Diversification does not ensure a profit or guarantee against loss. Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible. 1 All references to the following fixed-income security asset classes and related performance and statistics are represented by the indices listed unless otherwise noted: U.S. Investment-Grade Barclays Capital (BC) Aggregate Bond Index; U.S. Government BC U.S. Government Index; U.S. High-Yield Corporate Bank of America Merrill Lynch (BofA ML) High Yield Master II Index; Real Estate Debt 50% BC CMBS Index and 50% BofA ML Corporate Real Estate Index; Treasury Inflation-Protected Bonds (TIPS) BC TIPS Index; Leveraged Loans S&P/LSTA Performing Loan Index; Emerging-Markets Debt JP Morgan (JPM) Emerging Market Bond Index Global (EMBIG) Composite; Asian High-Yield BofA ML Asian Dollar High Yield Constrained Index; Foreign Developed-Country Bonds Citigroup (CG) G-7 non-usd Bond Index; European High-Yield BofA ML European High Yield Constrained Index. 2 In July 2008, the U.S. Consumer Price Index increased 5.5% on a year-over-year basis. Source: Bureau of Labor Statistic, Haver Analytics, FAM (AART). 3 Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Haver Analytics, Morningstar EnCorr, FAM (AART). 4 The U.S. dollar is represented by the U.S. Trade-Weighted Major Currencies Index. The U.S. dollar declined 12% from Feb 2002 to Feb The dollar appreciated by 7% from Dec 2004 to Dec Source: Federal Reserve Board, Haver Analytics, FAM (AART). 5 Mean-variance optimization mathematically accounts for expected return (mean) and risk (variance) in an attempt to find optimal portfolios along the so-called efficient frontier with the maximum return for the minimum risk. The Sharpe ratio compares portfolio returns above the risk-free rate relative to overall portfolio volatility. A higher Sharpe ratio implies better risk-adjusted returns. 6 Average annualized inflation rate from Jan 1926 through Sep Source: Morningstar EnCorr, FAM (AART) as of 9/30/11. 7 Source: Bureau of Labor Statistic, Haver Analytics, FAM (AART) as of 9/30/11. The U.S. Trade-Weighted Major Currencies Index includes currencies from the following countries: Euro Area, Canada, Japan, United Kingdom, Switzerland, Australia, and Sweden. Standard deviation shows how much variation there is from the average (mean or expected value). Low standard deviation indicates that the data points tend to be very close to the mean, whereas high standard deviation indicates that the data is spread out over a large range of values. Barclays Capital (BC) Aggregate Bond Index is an unmanaged, market-value-weighted performance benchmark for investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities with maturities of at least one year. The BC U.S. Government Index is an unmanaged index considered representative of fixed-income oblgations issued by the U.S. Treasury, government agencies, and quasi-federal corporations. The BC CMBS Index is constructed to measure the market of investment-grade commercial mortgage-backed securities. The JP Morgan (JPM) Emerging Market Bond Index Global (EMBIG) Composite tracks total returns for U.S. dollardenominated debt instruments issued by emerging-market sovereign and quasi-sovereign entities. S&P/LSTA Performing Loan Index is a market value-weighted index designed to represent the performance of U.S. dollar-denominated institutional leveraged performing loan portfolios (excluding loans in payment default) using current market weightings, spreads, and interest payments. The Citigroup G-7 non-usd Bond Index tracks the performance of government bonds in developed nations including Canada, France, Germany, Italy, Japan, and the United Kingdom; measures the total principal, interest, and returns in each market; and provides a realistic measure of market performance. The Bank of America Merrill Lynch (BofA ML) High-Yield Bond Master II Index is an unmanaged index that tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. BC TIPS Index is an unmanaged market index made up of U.S. Treasury inflation-linked index securities. The BofA ML Global High Yield European Issuers Constrained Index is designed to measure the performance of high-yield bonds issued by European companies. The BofA ML Asian Dollar High Yield Constrained Index is designed to measure the performance of high-yield bonds issued by Asian companies. 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