Is it time to hire a professional to manage your bonds?

Is it time to hire a professional to manage your bonds?

Today s bond markets are more complex Finding the right bonds can be difficult. The bond markets are large and complex, and it takes a lot of homework to find bonds to invest in that fit your needs. With headlines of bankruptcies and defaults and volatility in interest rates, the complexity in the bond markets creates challenges even for the most seasoned investors. There was a time when investing in bonds was more straightforward than it is today. For example, in the past, building a portfolio of AAA rated, insured municipal bonds nearly guaranteed income that you could count on. One of the outcomes of the financial crisis in 2008 was the collapse of the muni bond insurance industry. Companies that insured investors munis also insured much more speculative things like residential mortgagebacked securities, collateralized debt obligations and other derivatives, many based on mortgage loans. The collapse of this market resulted in many of the main muni insurance companies losing their AAA rating and caused some to fall below investment grade. As you can see below, the AAA-rated muni market shrunk considerably, and now it is increasingly difficult for investors to find the highest quality bonds. Change in high quality municipal bonds since 2007 80% Percent of Index (by market value) 60% 40% 20% 0% 69% AAA 13% 49% 33% 19% 7% 5% 5% AA A BAA Credit Rating 12/31/2007 10/30/2014 Source: Barclays Municipal Bond Index, as of 10/30/14. Note, the Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax exempt bond market. To be included in the index, bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody s, S&P, or Fitch. Is it time to hire a professional to manage your bonds? 2

In addition, many investors have lost faith in the ratings agencies to accurately evaluate the credit risk. We suggest that investors use ratings as just one important part of a comprehensive risk evaluation. And we think credit analysis should not only be done prior to investing, but needs to be an ongoing process to ensure nothing has changed. Even if your strategy is to buy and hold to maturity, you cannot forget about the bonds you own. Ongoing monitoring is very important to help ensure you stay within your risk tolerance and remain on track to meet your goals. All of this takes time. Finding the right bond investments in this environment is one problem; keeping up with a bond portfolio can be an even greater challenge. Many investors find that even if they have the time to do the analysis in the beginning, they don t want to spend the time to keep up with it all. And many find that they don t have the expertise to stay on track. If you have the time and expertise, Schwab has resources to help you manage your own bond portfolio. This includes access to online tools and a team of dedicated bond specialists you can call when you need help. If you don t, that s where a professional asset manager can help. However, before turning your hard-earned money over to someone else to manage, you deserve a clear and complete picture of how your assets will be managed, the risks involved, and what you re paying. As you read on, we ll help answer many of your questions and help you decide if professional bond portfolio management is right for you. 3

Why consider professional bond management When it comes to managing a bond portfolio, there are some questions you should ask yourself: How involved do you want to be with managing your portfolio? Do you have the time and knowledge required to implement and monitor an investing strategy? Do you have a process to determine what securities to buy and sell and when to do so? Many investors value the disciplined approach that a professional asset manager can bring to oversight of their portfolios. Some of the ways asset managers can apply their insights and investment expertise to help keep your portfolio on track are outlined below. Specialized investing strategies Because of the expertise professional managers bring, some employ more sophisticated investing strategies with the goal of managing risk and getting you a better return. Examples include: Active asset managers execute trades in order to manage interest rate exposure according to their market outlooks and investment styles. Some managers may actively shorten or lengthen their portfolio duration in anticipation of future interest rate movements while others may work to maintain consistent portfolio duration. Sector rotation Many broad bond indices tend to be heavily weighted to Treasury bonds or government-related bonds. For example, the Barclay s U.S. Aggregate Bond Index is made up of Treasury bonds (36%); securitized bonds (32%), such as mortgage-backed securities issued by entities such as Fannie Mae and Freddie Mac; corporate bonds (22%); and bonds issued by other government entities (10%). 1 This type of index may not provide the level of diversification or exposure to the markets necessary to meet an investor s goals. Therefore, rather than follow an index, investors may want exposure to other sectors of the bond market that the index does not provide, such as high yield bonds. Duration management Duration estimates how a change in interest rates will affect a bond s price. Generally speaking, bonds with a longer time to maturity or lower coupon rate are more sensitive to interest rate changes, and have a higher duration. 1 Barclays, as of December 17, 2014 Is it time to hire a professional to manage your bonds? 4

As you can see below, just like with stocks, sectors of the bond market perform differently each year. Some active managers may rotate among market sectors depending on the current economic environment. They may want to overweight the sectors that typically perform well in a particular environment, such as when interest rates are rising, and stay away from those that typically underperform. As the economic cycle changes, they can begin to move into the other sectors. Access to resources Asset managers often have teams of experts to select bonds on your behalf. They re able to do in-depth research on each security and fully evaluate the potential risks and relative value before making an investment decision. In addition, they may have access to software and financial modeling tools that can further inform their investing decisions. Portfolio monitoring Some managers actively monitor market developments and volatility, to determine if portfolio adjustments are needed. For individual bonds, this might include ongoing review of financial trends of the issuer, cash flow, liquidity, as well as qualitative items such as the company s customer relationships. In addition, they can stay apprised on any regulatory or market-related concerns that may impact the issuer. 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 12.6% 4.9% 15.8% 11.6% 13.7% 58.2% 15.1% 13.6% 16.0% 32.4% 11.1% 2.8% 11.8% 11.0% 8.3% 26.5% 15.1% 9.8% 15.8% 7.4% 10.9% 2.8% 8.2% 9.0% 5.2% 18.7% 9.0% 8.1% 9.8% -1.4% 8.5% 2.7% 5.2% 7.0% 4.4% 11.4% 6.5% 7.8% 7.0% -1.5% 5.4% 2.6% 4.3% 6.9% -2.4% 7.5% 6.3% 6.2% 4.2% -2.0% 4.7% 2.4% 4.3% 5.5% -4.9% 5.9% 5.9% 5.0% 4.1% -2.7% 4.3% 1.7% 3.1% 4.6% -26.2% 5.9% 5.4% 4.4% 2.6% -3.1% 3.5% -8.6% 0.4% 1.9% -37.0% -3.6% 4.9% 2.1% 2.0% -8.6% Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. Asset class and sector performance is represented by total annual returns of the following indices: Index, Barclays U.S. Aggregate Index (), Barclays Global Aggregate ex U.S. Index (Int l Bonds), Barclays U.S. Treasury Index (), Barclays U.S. Treasury Inflation-Protected Securities Index (), Barclays U.S. Mortgage- Backed Securities (), Barclays Investment Grade Bond Index (), and Barclays U.S. Index (). Returns assume reinvestment of interest and capital gains. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results. 5

Passive and Active bond management As an investor considering professional management of a portfolio, you may also want to consider whether to rely on a passive approach, or turn to active management to make security selections. Passive strategies include buying and holding bonds to maturity or building a portfolio to track a particular index. In contrast, active strategies attempt to outperform an index, often by buying and selling bonds in an attempt to capture price movements or capitalize on interest rate changes. There is not necessarily one right way to invest, and you may choose to rely on passive management for part of your portfolio and active management for another. However, it is important to have an understanding of the types of strategies and the pros and cons of each approach when making your investing decisions. Active bond management Passive bond management Benefits Active bond portfolio managers are attempting to outperform the bond indexes. They do this by buying and selling securities to take advantage of the credit, interest rate, or overall market environment. In addition to attempting to maximize returns, many also seek to manage risk through security selection and sector rotation. Passive bond management can help investors keep costs low. With indexing, bond managers are seeking to replicate the makeup and closely track with the returns of a particular index, such as the Barclays U.S. Aggregate Bond Index. This can be a low-cost way for investors to get exposure to certain sectors of the bond markets. Downsides Active bond portfolio management may not be right for everyone. It usually comes at a higher cost. In addition to the management fees, actively managed strategies will generally have higher turnover with the securities they hold, which may increase the cost and potentially reduce the total return to investors. In addition, managers may fail to outperform their benchmark or effectively manage risk in the portfolio. With a passive bond strategy, investors have very little opportunity to outperform the index or to align their portfolio to capitalize on changing market conditions. When returns are strong in the broad market, these strategies are generally more attractive to investors. However, in challenging market environments, investors may find that their portfolio is not well positioned to weather the downturns by simply tracking an index. Is it time to hire a professional to manage your bonds? 6

Investment products that offer professional bond management Mutual funds, exchange-traded funds (ETFs), and separately managed accounts (SMAs) provide investors access to professional bond management. The considerations for each are below. As you review the differences, it s important to note that a well-constructed fixed income portfolio may combine a mix of products and securities. For example, you may combine a portfolio of individual bonds with a diversified high yield bond mutual fund, or combine a separately managed account for core bond exposure and use ETFs to get exposure to the international bond markets. Bond SMAs You may prefer a separately managed account if you want professional management along with the ability to invest in individual bonds in your account. A managed account is a portfolio of individual securities managed on a discretionary basis by an asset management firm with distinctive expertise in a specific asset class or investment style. Managed accounts are typically for higher net-worth investors, usually with at least $250,000 to invest in the account, which should be considered as a component of a larger, more diversified investment portfolio. Unlike a mutual fund, you can see the specific securities you own in a SMA. You also have direct ownership in these securities unlike owning shares of a mutual fund. In addition, you may request that the asset manager avoid investing in a particular sector or security, within reason. For example, you may have a concentrated position in your company s stock. ETFs Mutual Funds Management Are primarily passive ETFs generally aim to track an index Can be active or passive Active mutual funds offer the chance to beat an index, but can also trail it How they trade Shares trade at market price throughout the trading day, including ability to place stop orders and limit orders Share purchases and redemptions happen only once a day at the close of trading How they are priced ETFs trade at market price, which may be at a premium or a discount to the net asset value (NAV) The price is based on the NAV 7

Professional bond management at Schwab Schwab s wide selection of professionally managed bond investment products is designed to provide you with the right choices to help meet your goals. Schwab offers wide access to mutual funds, including over 700 bond mutual funds with no loads and no transaction fees 1 through Schwab Mutual Fund OneSource. For bond mutual funds, the Mutual Fund OneSource Select List offers a cost effective and convenient way to invest in mutual funds. Charles Schwab Investment Advisory, Inc (CSIA), an affiliate of Charles Schwab & Co., Inc., conducts extensive research on the full range of actively-managed funds available through Schwab s Mutual Fund OneSource service. In addition, Schwab offers over 40 bond ETFs that trade commission-free on Schwab ETF OneSource. 2 Schwab s quarterly-updated ETF Select List is designed to inform and support investors searching for the right ETFs to fit individual investment needs and goals. Developed by the experts at CSIA, the ETF Select List provides you with prescreened, low-cost ETFs to make it easier for you to find ETFs for particular market segments. We also have a selection of 31 separately managed account strategies. These span the range of fixed income investments, from high quality municipal and corporate bonds to preferred securities and riskier high yield bonds. Whether you re looking for a municipal bond ladder or a more specialized strategy, your Schwab consultant has access to a number of choices to meet your needs. 1 Schwab s short-term redemption fee of $49.95 will be charged on redemption of funds purchased through Schwab s Mutual Fund OneSource service (and certain other funds with no transaction fee) and held for 90 days or less. Schwab reserves the right to exempt certain funds from this fee, including Schwab Funds, which may charge a separate redemption fee, and funds that accommodate short-term trading. Funds are also subject to management fees and expenses. For each of these trade orders placed through a broker, a $25 service charge applies. Schwab reserves the right to change the funds we make available without transaction fees and to reinstate fees on any funds. 2 Conditions Apply: Trades in ETFs available through Schwab ETF OneSource ( including Schwab ETFs ) are available without commissions when placed online in a Schwab account. Service charges apply for trade orders placed through a broker ($25) or by automated phone ($5). An exchange processing fee applies to sell transactions. Certain types of Schwab ETF OneSource transactions are not eligible for the commission waiver, such as short sells and buys to cover (not including Schwab ETFs). Schwab reserves the right to change the ETFs we make available without commissions. All ETFs are subject to management fees and expenses. Please see Charles Schwab Pricing Guide for additional information. Is it time to hire a professional to manage your bonds? 8

Bond Mutual Funds Bond ETFs Bond SMAs More than 700 bond mutual funds through Mutual Fund OneSource Over 40 bond ETFs through Schwab ETF OneSource that trade commission free online in a Schwab account Selection of 26 separately managed accounts with strategies to meet income needs using a broad range of products, including REITs, municipal bonds, taxable bonds, and preferreds As of January 2015 We believe in keeping fees low so that you have more money to invest. Our asset-based fees for fixed income managed account strategies are on a tiered scale, ranging from 0.25 to 0.65% per year. In addition to funds and separately managed accounts, Schwab also offers a number of other portfolio management services that offer ongoing investment advice and draw on a wealth of expertise. 9

Is professional bond management right for you? How involved do you want to be with managing your portfolio? If you would prefer to limit your day-to-day involvement, professional bond management may be right for you. Do you have the time and knowledge required to implement and monitor an investing strategy? If you do not, you may want to consider using an asset manager. Do you have a process to determine what securities to buy and sell and when to do so? If you don t have the time or ability to utilize a disciplined approach, it may be appropriate to turn to professional bond management. Before making investment decisions, developing a good financial plan and a solid understanding of what you need from your portfolio will help you avoid some serious mistakes. Part of that plan will be determining the role of bonds in your portfolio. Your Schwab Financial Consultant can help you develop your plan and will partner with a Schwab bond specialist, to develop your personalized asset allocation, and recommend strategies that are right for you. Your consultant stays actively involved, reviewing your portfolio with you on a regular basis to help you stay on track. Your Financial Consultant can help you decide. If professional management is appropriate to help you meet your needs, they can help you choose the right level of advice: professionally managed portfolios, specialized strategies, or customized investment advice. Contact us today to discuss whether professional investment management is right for you. Call a Fixed Income specialist at 1-877-908-3495 Hear from our experts at schwab.com/bondinvestors Is it time to hire a professional to manage your bonds? 10

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges, and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment returns will fluctuate and are subject to market volatility, so that an investor s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV). Charles Schwab & Co., Inc. receives remuneration from third-party ETF companies participating in Schwab ETF OneSource for record keeping, shareholder services and other administrative services, including program development and maintenance. Charles Schwab & Co., Inc. (member SIPC) receives remuneration from fund companies in the Mutual Fund OneSource program for recordkeeping and shareholder services, and other administrative services. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Diversification does not eliminate the risk of investment losses. Charles Schwab Investment Advisory, Inc. ( CSIA ) is an affiliate of Charles Schwab & Co., Inc. ( Schwab ). CSIA began providing asset manager evaluation and research services for Managed Account Select on January 1, 2010. From 2008 until the end of 2009, asset manager evaluation and research services were provided by the Schwab Center for Financial Research, a division of Schwab. Charles Schwab & Co., Inc. ( Schwab ) is the sponsor of Managed Account Select ( Select ) and Managed Account Connection programs. The asset managers in Select are unaffiliated with Schwab. Please read Schwab s Disclosure Brochure for important information and disclosures relating to Schwab Managed Portfolios and Schwab Managed Account Services. 2015 Charles Schwab & Co., Inc. (Member SIPC). All rights reserved. IAN (0115-0481) MKT84732-00 (01/15) 00134235