The Fixed Income Conundrum What s your next move?

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1 What s your next move?

2 For some time, low yields have been a reality in the bond market, leading many investors to hail a new normal that is both persistent and uncharted. Government bond yields in North America are at their lowest level in more than 60 years, with 10-year Government of Canada bonds yielding around 2%. Against this backdrop, traditional fixed income portfolios are under pressure in terms of income generation and total return prospects going forward. Meanwhile, other segments of the bond market, such as highyield and emerging market debt, have continued to grow in both size and importance. Attractive yields and robust returns have made these asset classes important tools for fixed income investors, but their specialty nature requires investors to carefully assess and manage the associated risks. With fixed income investing more complex than ever, many investors are asking themselves, What s my next move? The following considerations are a helpful starting point for addressing this Fixed Income Conundrum : How does an investor: Evaluate the role of core fixed income in a low-yield environment Incorporate investment options that can boost overall yield and protect against the volatility associated with yields potentially moving higher Strike a balance between higher yields and higher risks A New Fixed Income Toolkit Today s bond market is notably different than it was even 10 years ago. While core fixed income holdings remain the key building blocks for bond allocations, today s low-yield environment highlights the importance of using a broader range of solutions that have become accessible to investors. Without using a more diversified toolkit, bond portfolios face the dual reality of lower yields and the potential downside risk of yields moving higher. The role of more complex fixed income solutions ones that can complement traditional fixed income vehicles becomes more prominent in this type of environment as investors seek to boost yield and achieve a more attractive total return. Specialty Fixed Income Maximizing current income and total return 4 Higher yields 4 Lower interest rate risk 8 Higher credit risk High Yield Emerging Markets Core Fixed Income Lower volatility and diversification benefits 4 Portfolio stability 4 Lower credit risk and variability in returns 8 Lower yields and greater sensitivity to rising interest rates Investment-Grade Corporate Provincial Federal RBC Global Asset Management 01

3 Anchoring Your Portfolio: The Role of Core Fixed Income Even When Bond Returns Are Low, Core Fixed Income Provides Excellent Portfolio Stability The combination of lower yields and modest total return prospects has tempted some investors to consider abandoning core fixed income altogether. That would be a mistake. While core fixed income holdings provide the potential for modest capital growth and interest income, their primary role within a portfolio is to dampen volatility relative to riskier asset classes, such as equities. 1.4% 2.5% -6.7% -15.1% -7.5% -17.0% 4.1% -19.1% Even during periods when core fixed income delivers modest returns, the diversification benefits within a portfolio that includes equities can be significant. This trend is particularly evident during periods in history when equity markets have experienced sharp corrections. Core bonds provide effective downside buffer -38.2% Oct Oct Aug Sept Mar Feb % /50% Equities Equities Source: Morningstar. : DEX Universe Bond Index; Equities: S&P/TSX Comp. TR Index. All returns in CAD. Warning: don t Leave the Core Unattended While the role of core fixed income is primarily that of a portfolio anchor, there are several important tools that active managers can incorporate to appropriately position portfolios depending on economic and interest rate environments. Three key strategies that active managers have at their disposal include: Credit: Compared to government bonds, corporate bonds typically provide higher yields and have less sensitivity to rising interest rates. As a result, when rates are expected to move higher, it is normal for core bond portfolios to be tilted in favour of corporate bonds over government bonds. Active Management Appropriately Positions Core Fixed Income PH&N Total Return Bond Fund Current Positioning Cash & Equivalents Corporate Government UNDERWEIGHT -33.9% Other 0.3% OVERWEIGHT 16.8% 16.8% Liquidity: that are less frequently traded than federal bonds can offer what is known as a liquidity premium, which compensates investors with greater yield for the liquidity disparity. Common examples are provincial bonds and mortgage-backed securities. Favouring these securities over federal government bonds is another strategy to add yield to the portfolio without significantly impacting its risk profile. Interest rate: Fixed income managers can adjust the sensitivity of a bond fund to movements in interest rates by changing its duration. In periods when rates are expected to rise, we would expect a fund to have a shorter duration, which would reduce the negative impact of rates moving higher. RBC Bond Fund Current Positioning Cash & Equivalents Corporate Government Other -29.1% UNDERWEIGHT OVERWEIGHT 6.6% 20.1% 2.3% Source: RBC GAM, as of March 31, Overweight and underweight relative to the DEX Universe Bond Index. RBC Global Asset Management 02

4 Play Offense While You Play Defense The tide has shifted: federal government bonds should no longer represent the majority of most fixed income portfolios. Today, whether an investor is focused on capital preservation or total return, fixed income holdings need to include many components of the bond market. This case is further supported by the fact that different types of bonds outperform at different times. Holding a mixture of different fixed income asset classes provides a portfolio with both offense and defense. This strategy enables investors to participate in segments that are performing well and be cushioned against those segments that are performing poorly. A Mix of Different Can Provide a Better Investment Experience Q % 11.3% 9.4% 3.9% 4.4% -6.2% -10.0% -13.3% 10.0% 9.0% -7.9% -9.4% 33.8% 10.2% 7.9% 1.6% 9.2% 6.5% 6.4% 3.3% 10.2% 10.0% 7.0% -2.4% 14.8% 13.0% 8.2% 2.6% 4.9% 4.1% 0.4% -0.3% Source: RBC GAM, Bloomberg, Morningstar. Government : DEX Government Index; : UBS Global Focus Bond Index; : JPM BI Global Diversified Index; : BofAML US Master II Index. All returns in CAD. Reduce the Impact of Rising Rates With yields poised to rise from their current lows at some point, adding specialty fixed income to bond portfolios can provide much-needed downside protection. Looking at over 20 years of data, we have observed that holding high-yield bonds, emerging market debt and convertible bonds has had a positive impact on investment returns during periods of rising interest rates. Due to a variety of factors, these securities have historically performed well in rising rate environments. It all comes back to the general relationship between rising interest rates, inflation and economic growth. A growing global economy is generally supportive of corporate bonds and emerging market debt. Corporate bonds, including high-yield bonds, benefit from a stronger economy as the prospects for their underlying business are strengthened alongside their credit profile. Similarly, convertible bonds, which are a hybrid security with both equity- and bond-like features, also tend to perform well during periods of economic growth and rising interest rates. Finally, emerging markets, particularly those with export-oriented economies, also benefit from global growth as there is a direct correlation between a more robust global economy and higher exports. 5.9% Government 6.8% Investment Grade 7.8% High-Yield Entire Period Protecting Bond Portfolios in a Rising Rate Environment Fixed Income Diversification Reduces the Impact of Yields Moving Higher 5.2% 10.5% Emerging Markets Government -0.3% 6.3% 0.4% Investment Grade High-Yield 8.6% Rising Rate Environment 11.0% Emerging Markets 9.3% Government 10.3% Investment Grade 8.5% High-Yield Falling Rate Environment 10.3% 3.5% Emerging Markets Source: RBC GAM, Bloomberg. Annualized returns based on monthly data. Fixed income performance represented by the following indices from Jan 1994 Dec 2012 : (1) Government : BoA ML US Treasury Master Index (2) Investment Grade: BoA ML US Corporate Master Index (3) High Yield: Citigroup US High Yield Market Index (4) : UBS Global Focus Bond Index (5) Emerging Markets : JP Morgan BI Global. Rising (falling) rate environments are defined as periods of sustained upward (downward) trends in the US 10-Year Treasury yield. RBC Global Asset Management 03

5 The Diversified Total Fixed Income Portfolio: More Than the Sum of Its Parts In a more stratified and increasingly global fixed income market, the case for fixed income diversification has become more important. In examining fixed income portfolio construction and risk-return over a meaningful period of time, we are able to illustrate how specialty fixed income asset classes can work together to build better portfolios. When examined in isolation, specialized asset classes, such as highyield bonds, emerging market bonds and convertible bonds, can carry a fair amount of risk as stand-alone investments. However, by combining these asset classes with more traditional core holdings and other specialty asset classes, the benefits of diversification begin to apply, resulting in lower volatility overall without having to give up too much upside return potential. Annualized Total Returns 12% 10% 8% 6% 4% 2% 0% TOTAL Portfolio 60% Core Fixed Income Mix 40% Specialty Fixed Income Mix CORE FIXED Income Mix 100% Canadian Blending Asset Classes Can Improve Risk-adjusted Returns Specialty Fixed Income Mix 15% 42.5% High Yield 42.5% Emerging Markets 3% 6% 9% 12% Risk (Standard Deviation) Total Portfolio Specialty Fixed Income Mix Core Fixed Income Mix High-Yield Emerging Markets Source: RBC GAM, Bloomberg, Morningstar; Data from March 2003 March 2013 Canadian : DEX Universe Bond Index; High Yield: BofAML Global Constrained Index; s: UBS Global Focus Bond Index; : JPM BI Global Diversified Index; All returns are in USD except for Canadian which are in CAD. Conclusion: Fixed Income Diversification is a Prudent Strategy Fixed income is a critical ingredient in any well-diversified portfolio because of the regular income and stability of returns it provides over the long term. Having exposure to fixed income asset classes outside of those that are deemed traditional has been shown to add value and the benefits of active management. Active management can also play a key role in defending a portfolio against the prospect of rising rates. Incorporating high-yield bonds, emerging market debt and convertible bonds with a core fixed income solution is a good strategy to enhance yield while adding defensive portfolio characteristics. This is a prudent strategy in an environment of continued uncertainty and persistently low yields. RBC Global Asset Management 04

6 A FIXED INCOME FRAMEWORK FOR TODAY High Yield Emerging Markets Investment-Grade Corporate Provincial Federal CORE FUNDS PH&N Total Return Bond Fund A core bond fund with the ability to invest in high yield bonds Uses a multi-strategy approach to enhance overall yield and take advantage of market dynamics to position the portfolio A strong emphasis on risk management through the use of a proprietary risk management system allows the team to identify, measure and manage risks that impact the value of the portfolio on a daily basis RBC Bond Fund A well diversified core bond fund with the ability to invest in foreign bonds, emerging markets bonds and high yield bonds to enhance yield and provide diversification benefits Minimizing portfolio volatility is a key objective in the investment process Managed by a team of investment professionals that employs a multi-layer approach to investing: 1) a bottom-up, value-oriented buy-and-hold process; 2) extensive fundamental and technical credit analysis; 3) diligent portfolio monitoring; and 4) measured risk taking Specialty FUNDS BlueBay Global Monthly Income Bond Fund All-in-one specialty fixed income fund, which taps into high yield, emerging market and convertible bond markets Provides a monthly stream of interest income, which, when combined with a core bond fund, enhances overall yield and protects against rising rates BlueBay Global Bond Fund Pure global convertible bond portfolio hedged to Canadian dollars A hybrid asset class that offers a bridge between bonds and equities, giving investors the downside protection of bonds while participating in the upside of equities particularly when rates are rising RBC High Yield Bond Fund Invests in a portfolio of high-yield and investment-grade corporate bonds issued primarily in the U.S. market and hedged to Canadian dollars Looks to take advantage of appealing valuations to provide attractive yield characteristics, good return potential and downside protection relative to peers RBC Emerging Markets Bond Fund High quality emerging market sovereign bond portfolio positioned to take advantage of structural trends in these markets, which is now considered two-thirds investment grade Provides an attractive spread over U.S. Treasuries and in doing so, serves as a beneficial tool in protecting against rising rates RBC Global Asset Management 05

7 For more information about RBC Global Asset Management investment solutions, please contact your financial advisor. This information has been provided by RBC Global Asset Management Inc. (RBC GAM) and is for informational purposes only. It is not intended to provide legal, accounting, tax, investment, financial or other advice and such information should not be relied upon for providing such advice. RBC GAM takes reasonable steps to provide up-to-date, accurate and reliable information, and believes the information to be so when printed. Due to the possibility of human and mechanical error as well as other factors, including but not limited to technical or other inaccuracies or typographical errors or omissions, RBC GAM is not responsible for any errors or omissions contained herein. RBC GAM reserves the right at any time and without notice to change, amend or cease publication of the information. Please consult your advisor and read the prospectus before investing. There may be commissions, trailing commissions, management fees and expenses associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. The indicated rates of return are the historical annual compounded total returns for the periods ended December 31, 2012, including changes in unit value and reinvestment of all distributions, and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns RBC Funds and PH&N Funds are offered by RBC Global Asset Management Inc. and distributed through authorized dealers. / TM Trademark(s) of Royal Bank of Canada. Used under licence. RBC Global Asset Management Inc (05/2013)