Alternative Fixed Income A Total Return Approach To Bond Funds

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1 Introduction Alternative Fixed Income A Total Return Approach To Bond Funds Arrow Dynamic Income Fund ASFFX ASFTX ASFNX TM TARGETING PORTFOLIO SOLUTIONS

2 Fixed Income: Is Hisry Deceiving? Fixed income investments are often used as part of a diversified portfolio because they typically provide a source of returns that is not directly linked other investments, such as scks or commodities. Bonds tend be less volatile than some other asset classes, often providing a sense of safety from sck market volatility. But fixed income investments typically have an inverse relationship with interest rates. When new bonds are being issued with higher interest rates, then lower yielding bonds often become less valuable because they pay less income. This hasn t been a major long-term facr in the bond markets for years. So, many invesrs continue rely heavily on traditional bond funds as a safe haven for their portfolio. The interest rate environment of the past 30 years may have caused some invesrs feel that bond mutual funds are a riskless investment. Although bonds are generally less volatile than some other investments, there is considerable downside risk. The graph below shows that there has been an inverse relationship between interest rates and bond fund returns. After more than 30 years of generally declining rates, are bond funds as reliable as invesrs have come expect or is there potential for a different result in the future? Interest 10 Year U.S. Treasury Notes Declining, Increasing Bond Fund Returns Bond Fund Returns Lipper Intermediate U.S. Govt. 8% 7% 6% 5% 4% 3% 2% 1% 0% $3,000 $2,800 $2,600 $2,400 $2,200 $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 Past performance does not guarantee future results. Index returns assume reinvestment of dividends, but do not reflect any management fees, transaction costs or expenses. Indexes are generally unmanaged and are not available for direct investment. Source: FactSet and Bloomberg. 2 Introduction Alternative Fixed Income

3 An Alternative Approach Fixed Income With interest rates near hisric lows, and the future being unknown, it is important for invesrs consider an alternative approach fixed income investing. There are now many new investment options known as unconstrained or nontraditional bond funds. The strategies vary from long-only methods long/short and inverse strategies. Each approach has its own merits and attempts address the shortcomings of traditional bond funds. Long-Only: These strategies generally act like traditional bond funds. Sometimes called unconstrained bond funds, the manager has flexibility use various kinds of bonds reduce or increase the portfolio s sensitivity interest rates. When the interest rate environment seems risky, the manager may increase the bond quality or use bonds with shorter maturities, which tend be less volatile. They may also have the flexibility use different types of bonds, such as U.S. Treasuries, corporate bonds, or agency bonds (i.e., Fannie Mae). Unconstrained bond strategies offer some diversification benefits and the potential for greater yield, but are generally still subject significant interest rate risk. Inverse (short): This strategy is fairly straight forward. These funds are designed move in the inverse, or opposite, direction from traditional bonds. In essence, they are a bet against the bond market. When invesrs feel that the bond market is subject a loss, they may tactically use these funds as a way profit from a market decline. Unfortunately, these funds often carry a higher fee structure and can lead significant losses if the market goes up instead. Generally, they are not intended as a long-term investment for a strategic asset allocation strategy. Long/Short: These funds offer the most flexibility, but also carry the risks and benefits of the other two strategies combined. The managers generally have the ability use bonds that they feel may suit the market environment and can also take short positions that may profit from market downturns. Long/short funds are subject strategy risk, meaning that the fund s approach may not work all the time. Because long/short strategies can vary so much, and gains or losses can occur in any market environment, fund selection becomes critical. When deciding which nontraditional bond strategy use, invesrs may want consider one that has the most flexibility adapt changing market environments. Using an inverse fund is really just a short-term ol intended for situational investing and is not typically used as part of a long-term portfolio strategy. For invesrs with a long-term investment time horizon, it may make more sense use either a long-only fund or a long/short fund. Of the three choices, only a long/short approach is specifically designed seek profits in times of both rising and declining interest rates. Of course, the level of success or failure depends largely on the fund s investment strategy. Introduction Alternative Fixed Income 3

4 Why Focus on High Yield Bonds? Scks and high yield bonds are very different investments. Hisrically, scks tend be more volatile than bonds and are treated differently regarding taxation. Scks represent equity ownership of a company, whereas, high yield bonds are less liquid fixed income instruments and a form of debt issued by a company with a return of principal upon maturity. Different types of bonds have a wide range of risk differences. Generally speaking, high yield bonds represent lower credit quality with higher risk of default than other forms of corporate and government bonds. Despite being very different investments, high yield bonds do share some characteristics with scks because their prices have a tendency show trends. This makes high yield bonds a particularly good ol for use within nontraditional bond strategies. The chart and table below illustrate the hisrical performance of high yield bonds versus the U.S. sck market. Despite being fixed income securities, high yield bonds often display traits similar scks, while still providing some portfolio diversification. 60% 40% High Yield Bonds Scks High Yield Bonds vs. Scks Risk/Return Characteristics Since % 0% - 20% - 40% Average Return (Annualized) Standard Deviation (Monthly Data) Correlation (vs. S&P 500) High Yield Bonds BOA ML US High Yield Index 6.51% 9.72% 0.65% Scks S&P 500 TR Index 4.06% 15.09% 1.00% Past performance does not guarantee future results. Index returns assume reinvestment of dividends, but do not reflect any management fees, transaction costs or expenses. Indexes are generally unmanaged and are not available for direct investment. Scks (equity) and high yield bonds (lower quality fixed income) are different types of investments and carry risks that are specific each asset class. Data source: FactSet. 4 Introduction Alternative Fixed Income

5 : High Yield and Government Bonds High yield bonds are fixed income securities, but they often act differently than other bonds. As the name indicates, high yield bonds typically have yields above prevailing government bond rates. Since the credit ratings of high yield bonds are generally on the lower end of the spectrum, the companies issuing the bonds tend offer higher interest rates as a premium attract invesrs. When the prevailing market interest rates rise for investment grade bonds and U.S. Treasuries, high yield bonds have a built-in yield cushion due their higher yields. This cushion may allow some high yield bonds feel less turbulence from rate changes that are occurring with lower yielding investment grade bonds. The chart below shows high yield bonds compared long-term U.S. Treasury government bonds during various rising and declining rate environments. This illustrates the difference between high yield and government bonds and identifies a potential opportunity for tactical managers use both high yield bonds and long-term U.S. Treasuries in tandem. High Yield Bonds vs. Long Government Bonds Interest Rate Periods Since % 40% High Yield Bonds Long Government Bonds 30% 20% 10% 0% -10% -20% 4/1/1996 8/31/1996 9/1/1996 9/30/ /1/1998 3/31/2002 4/1/2002 5/31/2003 6/1/2003 6/30/2006 7/1/ /31/2008 1/1/2009 3/31/2010 4/1/2010 8/31/2010 9/1/2010 3/31/2011 4/1/2011 6/30/2012 7/1/ /31/2013 1/1/2014 6/30/2016 Past performance does not guarantee future results. Index returns assume reinvestment of dividends, but do not reflect any management fees, transaction costs or expenses. Indexes are generally unmanaged and are not available for direct investment. High yield bonds and government bonds are fixed income securities with very different risk characteristics. High yield bonds are generally issued with lower credit ratings and are subject greater risk of default. Data: High Yield Bond (BofA ML U.S. High Yield Index) and Long Government (Barclays Long-Term U.S. Treasury Index). Source: Morningstar. Introduction Alternative Fixed Income 5

6 The Components of Yield Bond yields are made up of two primary components: the risk free rate and the credit default premium. The interest rate offered by the U.S. Treasury for bonds and notes is considered risk free from the chance of default (although all investments have the risk of loss). In order for an invesr buy a bond from a private issuer, the interest rate offered generally must be above the risk free rate. Without a higher interest rate, why would anyone buy corporate bonds instead of Treasuries? The higher interest rate is due a credit default premium extra interest paid compensate for taking on additional risks, including the business risk that a company won t be able make the interest payments. Credit Default Risk Premium XYZ Bond Certificate Capital Sample X% Dividend Per 1000 Past performance is not indicative of future returns. High yield bonds are issued in various denominations and credit quality. This is not a real bond and is intended as a hypothetical illustration only. Any similarity an existing company or security is unintentional. Total Yield { Additional yield for assuming corporate risk + Risk Free Rate U.S. Treasury rates serve as a base rate The yield of a high yield bond is comprised of two primary components: the Risk Free rate of U.S. Treasuries, plus a Credit Default Risk Premium. Obviously, there are well known markets for high yield bonds and U.S. Treasuries, but many invesrs don t realize that there is also a robust credit default market trade just the additional risk premium portion of bond yields. High yield bonds, U.S. Treasuries and credit default markets can be traded individually, or they can be used in unison within a portfolio. Keep in mind, the potential for price appreciation may not be the only facr for choosing one over another. For example, some invesrs may choose focus on U.S. Treasuries specifically because of their lower chance of default. They each also have strengths and weaknesses depending on the economic environment. The table below illustrates the favorable and less favorable economic environments for each of the three investment types. For example, green is favorable and red is less favorable, yet the can still go up or down in any economic environment. Economic Environment Growing Stagnant Weakening High Yield Bonds Favorable Favorable Less Favorable Credit Default (CDX) Favorable Favorable Less Favorable U.S. Treasuries Less Favorable Favorable Favorable Past performance is no guarantee of future results. The hypothetical illustration above is based on general hisrical market performance, but results may vary depending on unique market conditions. 6 Introduction Alternative Fixed Income

7 Arrow Dynamic Income Fund The Arrow Dynamic Income Fund is designed address some of the shortcomings of traditional longonly bond funds. The fund s returns are derived from three core portfolio strategies across distinct market segments: high yield, credit default and long-term U.S. Treasury bonds. The directional long, short or flat positions are based on a series of proprietary indicars that are cusmized for each specific market segment. The strategies are meant act independently from one another, providing the ability respond various economic cycles and interest rate environments. Despite using some of the elements typically associated with high yield bonds, the fund does not focus on generating yield and income. Instead, the fund has an overall tal return goal, while also serving as a portfolio diversifier. Each strategy works independently, providing a layer of internal diversification. Tactical High Yield Dynamic Government Bond Dynamic Credit Default Tactical High Yield: Long or flat exposure global corporate high yield bond markets. Dynamic Credit Default: Long, short, or flat exposure U.S. credit default markets. Dynamic Government Bond: Long, short, or flat exposure U.S. Treasury 30-year bonds. Long/Short/Flat Directional Indicars: Proprietary market signals for each of the three strategies include price movement, volatility and market sentiment, among others. The ability be long, short or flat within its strategies provides a level of variation that is unique the fund. When markets are bad, the fund has the ability adapt and take a defensive posture: high yield exposure can be tactically flat (i.e., in cash), whereas the two dynamic strategies can be long, flat or short, depending on their specific market signals. The dynamic strategies can actually profit during negative markets and rising rate environments. Equally important the fund s ability profit during bad markets is the ability work well when bond markets are good. Not all nontraditional bond funds are adaptive both good and bad bond markets. The Arrow Dynamic Income Fund can work like a defensive nontraditional bond fund when needed, but can act like a traditional bond fund as well. All investments involve risks, including the potential for loss. See back cover for additional information, including asset class risks and strategy-specific investment risks. For more information about the Arrow Dynamic Income Fund, contact your financial professional or call Arrow at (877) Be sure visit our website: Introduction Alternative Fixed Income 7

8 Arrow Dynamic Income Fund Highlights Exposure three alternative fixed income strategies Low correlation traditional investments Core holding for alternative investment allocations Adaptive changing rate environments Available in multiple share classes CLASS Class A Class C Class I SYMBOL ASFFX ASFTX ASFNX CUSIP For more information, contact your financial professional or call Arrow Funds at (877) TM TARGETING PORTFOLIO SOLUTIONS Arrow Funds is a mutual fund company with a passion for helping invesrs meet their financial goals. We believe in offering targeted portfolio solutions for the ever-changing markets. Our vision is be the leading provider of alternative and tactical investments that seek enhance returns and mitigate risk. The Arrow Dynamic Income Fund may not be suitable for all invesrs. The fund s use of derivatives such as futures, options and swap agreements may expose the fund additional risks that it would not be subject if it invested directly in the securities underlying those derivatives. Investing in leveraged instruments will magnify any gains or losses on those instruments. The fund s use of short selling involves increased risks and additional costs. The fund may invest in fixed income securities, which are subject risks including interest rate, credit and inflation. Before investing, please read the fund s prospectus and shareholder reports learn about its investment strategy and potential risks. Mutual fund investing involves risk including loss of principal. An invesr should also consider the fund s investment objective, charges, expenses, and risk carefully before investing. This and other information about the fund is contained in the prospectus, which can be obtained by calling Please read the prospectus carefully before investing. Arrow Funds are distributed by an affiliate, Archer Distriburs, LLC (member FINRA). Arrow Funds 6100 Chevy Chase Drive, Suite 100 Laurel, MD (877) Opt. 1. Visit our website at AD