Look beyond core fixed income before rates rise

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1 INCOME Diversify your income options EATON VANCE AUGUST 2015 CORNERSTONES OF INCOME INVESTING Look beyond core fixed income before rates rise The case for a short-duration, multisector approach to fixed income. David Michaud, CFA, CFP Director DCIO and Sub-Advisory Sales Brad Godfrey, CFA Director of Alternative Strategies Product and Portfolio Strategy Group EXECUTIVE SUMMARY 401(k) plan participants may be vulnerable to rising interest rates due to a limited offering of fixed-income options. We think that plan participants should have the ability to invest in nimble, opportunistic fixed-income strategies that provide more flexibility than traditional strategies. A short-duration, multisector bond strategy may provide potential diversification benefits and a way to guard against interest-rate risk.

2 AUGUST 2015 WHITE PAPER LOOK BEYOND CORE FIXED INCOME BEFORE RATES RISE 2 The need for flexibility The math is not in favor of traditional bond investors when interest rates rise. This presents a major challenge to 401(k) plans, as many offer a limited set of fixed-income options to plan participants usually a combination of stable value and core bond strategies. These core bond strategies are more vulnerable to interest rates than many investors may expect. Simply put, many plan participants do not have access to fixed-income strategies that may help mitigate the effects of rising rates. Eaton Vance believes that plan participants could benefit from diversifying their exposure to different sources of risk. In particular, we think it s time to look beyond core fixed income and participate in strategies that maintain a short duration and a nimble, multisector approach to navigate the changing market and interest-rate cycle. David A. Michaud, CFA, CFP Director, Sub-Advisory and Defined Contribution Investment Only (DCIO) Services Joined Eaton Vance in 1994 Education B.S. from Syracuse University s Whitman School of Management MBA from Babson College s F.W. Olin Graduate School of Business Brad Godfrey, CFA Director of Alternative Strategies, Product and Portfolio Strategy Group Joined Eaton Vance in 2002 Education B.S. from the University of Richmond

3 AUGUST 2015 WHITE PAPER LOOK BEYOND CORE FIXED INCOME BEFORE RATES RISE 3 Traditional fixed income s outsized exposure to interest-rate risk In our view, bond investors will soon be facing a more challenging environment than at any time in three decades. U.S. interest rates have been in a secular decline, providing a tail wind that has particularly benefited investors in U.S. Treasurys and corporate debt. That may soon change: Positive underpinnings to the U.S. economy could lead to interest rates rising in the near future. Regardless of the timing, it is likely investors can no longer depend on declining interest rates to drive returns on their fixed-income portfolios. Unfortunately, bond investors may have taken on far more interest-rate risk than is necessary, particularly those in traditional fixed-income strategies that are benchmarked against the Aggregate Bond Index (the Barclays Agg). With three quarters of the benchmark composed of government-related bonds (Exhibit A), the Barclays Agg is highly correlated with the price of U.S. Treasurys, leaving investors with little protection against declining values during a rising rate environment. This is reflected in the fact that over the past 10 years ended December 31, 2014, performance of the Barclays Agg has been 85% correlated with U.S. Treasurys. On the flip side, less than a quarter of the Barclays Agg s composition is tied to credit risk. A related risk is that investors expectations of what they can earn from traditional bonds are too high. The fixed-income options available to most plan participants offer relatively modest yields. Many investors are assuming the future will look just like the past, but according to simple bond math, it can t. Given the low absolute starting level of yields, traditional bonds are unlikely to match the returns they ve delivered in recent years. Exhibit A Government and government-related debt dominate the Barclays Agg. Government-related 10% 77% of the Barclays Agg is composed of government-related debt U.S. Treasury 36% Corporate 23% Securitized 31% Source: Barclays as of 12/31/2014. The Aggregate Bond Index is an unmanaged index of domestic investment-grade bonds, including corporate, government and mortgage-backed securities.

4 AUGUST 2015 WHITE PAPER LOOK BEYOND CORE FIXED INCOME BEFORE RATES RISE 4 The diversification dilemma for plan participants By staying narrowly invested and tethered to the Barclays Agg, investors may have a majority of their fixed-income portfolio invested in areas very closely tied to interest-rate risk. The pain is more acute for plan participants with 401(k) plans that offer no access to investment strategies that go beyond traditional fixed income. In our view, investors should consider tilting their portfolios toward credit sectors and more globally, while reducing exposure to more interest-rate sensitive areas of the market. That means venturing out of traditional areas into asset classes typically underrepresented in investor portfolios such as mortgage-backed securities, floating-rate loans, high-yield bonds, currency instruments, foreign bonds and absolute return strategies. While we do recognize that some plan sponsors may have concerns about adding too many options to the plan, we argue that an expanded menu of fixed-income options may be beneficial not only today but also for long-term diversification. We believe that the most attractive opportunities in the fixed-income market today lie outside of traditional benchmarks like the Barclays Agg. Exhibit B Traditional fixed-income asset classes are highly sensitive to movements in interest rates Duration (in years) Agency Index Mortgage Backed Securities Index Corp. High Yield Index Treasury Index Agg. Bond Index Muni Bond Index Corporate Index JPMorgan EM Bond Index Plus (EMBI+) Source: Morningstar, 12/31/2014. See end of this white paper for index definitions.

5 AUGUST 2015 WHITE PAPER LOOK BEYOND CORE FIXED INCOME BEFORE RATES RISE 5 Stay flexible to find opportunities In our view, there s very little room left for traditional bond strategies to earn returns much above zero going forward. So, many investors may need to do something different. But that doesn t just mean avoiding interest-rate risk and trying to mitigate losses. To us, it also means treating rising rates as an opportunity, rather than just a threat. Having a broad-based, flexible approach to exploit compelling investing opportunities is a hallmark of multisector bond strategies. Institutional investors have long employed a core plus strategy that permits managers to add instruments from outside the benchmark with greater risk and greater potential return to core portfolios of investment-grade bonds. A multisector approach takes this concept further by allowing managers to position their portfolios further away from the index, applied across a broader set of fixed-income asset classes. The multisector manager s arsenal contains a mix of novel and familiar approaches, which we believe can be deployed together in ways that amplify the impact, both positive and negative. We think a short-duration strategy makes sense as a long-term, strategic portfolio allocation in any market environment. In one of Eaton Vance s short-duration, multisector strategies, for example, the investment team favors sectors and asset classes that have historically tended to benefit from a rising rate environment. Specifically, high-yield corporate bonds and floating-rate loans may perform relatively well against the backdrop of an improving U.S. economy and moderately rising rates. Negative-duration assets are also worth considering for instance, mortgage-backed securities that would benefit from slowing mortgage refinancing as interest rates rise. In terms of currencies, with the Fed set to hike, the strategy has been long the U.S. dollar versus other major developed-market currencies. We also think it s important to take a very active approach to duration management and to have broad, diversified duration exposure. By that, we mean exposure to different parts of the yield curve and across different parts of the globe, including select positions in emerging and frontier markets. Shorten a portfolio s duration We think a short-duration strategy makes sense as a long-term, strategic portfolio allocation in any market environment. Among other things, such a strategy may provide a reliable source of income and important diversification benefits for investors. It can also be an excellent way to guard against interest-rate risk because, by definition, shorter-duration bonds are less sensitive to rising rates than longer-duration bonds in some cases, much less sensitive. In a rate-hiking cycle, the yield curve has historically flattened essentially, short-term rates rise as longer-term rates remain flat or decline. In anticipation of this, a short-duration strategy can prepare for it by careful positioning along the yield curve and even shorting specific parts of the curve to benefit (i.e., betting that those rates will rise). We expect the yield curve to keep flattening as the U.S. economic recovery continues.

6 AUGUST 2015 WHITE PAPER LOOK BEYOND CORE FIXED INCOME BEFORE RATES RISE 6 Driving returns with the right risk We think plan participants need to put a great deal of thought into the specific risks they want to take in their portfolios given today s interest-rate environment. Whether it is credit risk, currency risk or duration risk, employing a professional manager who implements a strategy with out-of-index sectors may potentially generate excess returns. Increasing active risk implies more downside potential as well, which underscores the importance of manager selection. The depth of a manager s experience, credit expertise and overall skill needs to be commensurate with the greater leeway that is crucial to a short-duration, multisector model. Index Definitions Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. It is not possible to invest directly in an index. Historical performance of the index illustrates market trends and does not represent past or future performance. Treasury Index measures public debt instruments issued by the U.S. Treasury. Agency Index measures agency securities issued by U.S government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. government. Aggregate Bond Index is an unmanaged index of domestic investment-grade bonds, including corporate, government and mortgage-backed securities. Mortgage Backed Securities (MBS) Index measures agency mortgage-backed pass-through securities issued by GNMA, FNMA and FHLMC. Corporate Index is an unmanaged index that measures the performance of investment-grade corporate securities within the Aggregate Bond Index. Barclays Municipal Bond Index is an unmanaged index of municipal bonds traded in the U.S. JPMorgan Emerging Markets Bond Index Plus (EMBI+) is a market cap-weighted index that measures USD-denominated Brady Bonds, Eurobonds and traded loans issued by sovereign entities. Corporate High Yield Index measures USD-denominated, noninvestment-grade corporate securities.

7 AUGUST 2015 WHITE PAPER LOOK BEYOND CORE FIXED INCOME BEFORE RATES RISE 7 About Eaton Vance Eaton Vance Corp. is one of the oldest investment management firms in the United States, with a history dating to Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today s most discerning investors. For more information, visit eatonvance.com. About Risk Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging countries, these risks may be more significant. An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer s ability to make principal and interest payments. As interest rates rise, the value of certain income investments is likely to decline. Investments rated below investment grade (typically referred to as junk ) are generally subject to greater price volatility and illiquidity than higher-rated investments. A nondiversified fund may be subject to greater risk by investing in a smaller number of investments than a diversified fund. No Fund is a complete investment program and you may lose money investing in a Fund. The Fund may engage in other investment practices that may involve additional risks and you should review the Fund prospectus for a complete description. The views expressed in this white paper are those of the authors and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and the authors disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. This white paper may contain statements that are not historical facts, referred to as forward-looking statements. A Fund s actual future results may differ significantly from those stated in forward-looking statements, depending on factors such as changes in securities or financial markets or general economic conditions, the volume of sales and purchases of Fund shares, the continuation of investment advisory, administrative and service contracts, and other risks discussed from time to time in the Fund s filings with the Securities and Exchange Commission.

8 AUGUST 2015 WHITE PAPER LOOK BEYOND CORE FIXED INCOME BEFORE RATES RISE 8 If you like the views expressed in this white paper, you might be interested in learning more about the following strategy: Eaton Vance Short Duration Strategic Income Fund A flexible, short-duration approach to fixed-income investing Key Highlights The Fund This multi-sector, short-duration Fund provides sweeping exposure to fixed-income markets, offering investors a core holding that may complement traditional bond market investments. The Fund offers access to a broad range of typically unrepresented asset classes, with allocations directed by Fund portfolio managers. The Fund limits its duration to 3.5 years or less. Portfolio Managers Eric Stein, CFA Andrew Szczurowski, CFA A Shares Inception 01/23/1998 Investment Objective Symbols and CUSIPs A Shares C Shares I Shares R Shares ETSIX ECSIX ESIIX ERSIX Total Return The Approach A time-tested macroeconomic and political research process informs investments across a range of leading Eaton Vance fixed-income capabilities. Broad exposure to a global opportunity set, short duration and an eye toward risk-adjusted performance have helped provide a historically low volatility experience. The Features The Fund s short duration combined with its broad exposure to investment-grade bonds, mortgage-backed securities, floating-rate loans, noninvestment-grade bonds, currency instruments, foreign bonds and absolute return strategies may provide important diversification benefits for investor portfolios. For more information about Eaton Vance Short Duration Strategic Income Fund and other income strategies from Eaton Vance, please visit eatonvance.com/income. Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor. Prospective investors should read the prospectus carefully before investing Eaton Vance Distributors, Inc. Member FINRA/SIPC Two International Place, Boston, MA eatonvance.com Not FDIC Insured Not Bank Guaranteed May Lose Value