Changing interest rates THE IMPACT ON YOUR PORTFOLIO

Transcription

1 Changing interest rates THE IMPACT ON YOUR PORTFOLIO

2 PGIM Investments helping investors participate in global market opportunities At PGIM Investments, we consider it a great privilege and responsibility to help meet the financial needs of investors by offering strategies that invest across the global markets. We are part of PGIM, the global investment management business of Prudential Financial, Inc. (PFI) 1 the 9th-largest asset manager globally 2 with over $1 trillion in assets under management, and a company that individuals and businesses have trusted with their financial future for over 140 years. This scale and investment expertise allow us to deliver Prudential Funds a diversified suite of actively managed strategies across a broad spectrum of asset classes and investment styles. 1 Pensions & Investments Top Money Managers list, 5/29/17. Represents assets managed by Prudential Financial as of 12/31/ PGIM data as of 12/31/2016.

3 Navigating the fixed income market can be daunting for the average investor. Understanding how changes in interest rates impact a portfolio is critical. We seek to demystify the mechanics around how bond prices are affected by interest rate risk and what factors make a portfolio more or less sensitive to it. How do interest rate changes affect bond investments? What factors influence U.S. interest rates? Where are long-term U.S. interest rates headed? What asset classes performed well during rising rate periods? Interest rates and bond prices are inversely related Historically, bond prices and interest rates move in opposite directions. This happens because as interest rates rise, newly issued bonds carry a higher coupon than previously issued bonds, causing prices of older bonds to drop as they become relatively less attractive to investors. Conversely, older bonds become relatively more attractive than newer bonds issued after interest rates decline. INTEREST RATES BOND PRICE INTEREST RATES BOND PRICE Represents conceptual depiction of bond price and interest rate relationship. For illustrative purposes only.

4 How do interest rate changes affect bond investments? Total return is comprised of yield (the bond s coupon payment) plus market movements (the bond price increase or decrease). The following examples show how the movement of interest rates affects a bond portfolio s returns. RISING Interest (Price DECLINE) No Change in Interest (No Price Change) Declining Interest (Price Increase) 7% 5% 5% 5% 5% 5% 3% 2% 2% 0% Bond Bond Price Decrease Investor Total Return Bond Bond Price Change Investor Total Return Bond Bond Price Increase Investor Total Return The above charts are hypothetical examples and are intended for illustrative purposes only. They do not depict a specific investment. 4

5 How does the magnitude of interest rate movements affect a bond s total return? The greater the magnitude of change in interest rates, the larger the impact to a bond s price. The example below illustrates the impact of a 1% increase versus a 2% increase in interest rates for a hypothetical Bond XYZ. 1 BOND XYZ BOND XYZ CHARACTERISTICS ONE YEAR LATER: 1% Increase 2% Increase 5-year maturity Issued at par ($1,000) rate 3% Bond 3.0% 3.0% Bond Price Decrease 3.7% 8.1% Investor Total Return ( + Price Decline) 0.7% 5.1% 1 rate assumes an annual payment. The above charts are hypothetical examples and are intended for illustrative purposes only. They do not depict a specific investment. The greater the magnitude of change in interest rates, the larger the impact to a bond s price. 5

6 How do interest rate changes affect bond investments? How does a bond s maturity affect its interest rate risk? Longer maturity bonds are more sensitive to interest rate risk than shorter maturity bonds because they have a longer time before the principal is paid back to the investor. 2 Bond maturing in 5 years Bond s Final Principal A shorter maturity bond will provide investors with their principal earlier, which results in lower interest rate risk Years Last Bond maturing in 10 years Bond s Final Principal A longer maturity bond will provide investors with their principal later, which results in higher interest rate risk Years Last 2 The example assumes no options. The above charts are hypothetical examples and are intended for illustrative purposes only. They do not depict a specific investment. The hypothetical assumes both bonds are from the same issuer. 6

7 How does a bond s coupon rate affect its interest rate risk? Lower coupon bonds have greater interest rate risk than higher coupon bonds with the same maturity because they have a lower yield cushion meaning they have a smaller percentage of total cash flows that come from income payments. 3 lower coupon Bond = Higher interest rate risk higher coupon Bond = lower interest rate risk Bond s Final Bond s Final Principal Principal Years Last Years Last Lower Bond Cash flow 1 Cash flow 2 Cash flow 3 Cash flow 4 Principal and final cash flow Higher Bond Cash flow 1 Cash flow 2 Cash flow 3 Cash flow 4 Principal and final cash flow Investors receive a smaller portion of their total cash flows prior to maturity. Investors receive a larger portion of their total cash flows prior to maturity. 3 Assumes both bonds are from the same issuer. The above charts are hypothetical examples and are intended for illustrative purposes only. They do not depict a specific investment. 7

8 What factors influence U.S. interest rates? In general, changes in short-term interest rates have a greater impact on short-term bonds and changes in long-term interest rates have more impact on long-term bonds. Short-Term In the U.S., short-term interest rates are strongly influenced by the Federal Reserve, which was created by Congress to provide a flexible and stable financial system. The Federal Reserve implements monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices. During a period of slowing economic growth, the Federal Reserve may decide to lower short-term interest rates (fed funds rate) to help stimulate the economy. The Federal Reserve may decide to raise short-term rates in an effort to slow down the economy, which may be growing too fast and result in high inflation. Long-Term Long-term interest rates are primarily influenced by long-term expectations for U.S. economic growth and inflation. They may also be affected by current long-term global market rates. Driver Key Factors External Factors Federal Reserve Monetary Policy SHORT-TERM RATES Short-Term U.S. Inflation Expectations U.S. Unemployment Rate (%) Short-Term U.S. GDP Growth Expectations Short-Term Global Inflation Expectations Short-Term Global GDP Growth Expectations U.S. GDP LONG-TERM RATES Long-Term U.S. Inflation Expectations Long-Term U.S. GDP Growth Expectations Long-Term Global Inflation Expectations Long-Term Global GDP Growth Expectations Current Long-Term Global Market 8

9 Do short- and long-term interest rates always move in the same direction and by the same magnitude? Short- and long-term interest rates are influenced by different factors, and as a result, they may not always move in tandem. Consider three possible rising rate scenarios: PARALLEL SHIFT IN RATES HIGH Short-term rates are rising as the Federal Reserve tightens monetary policy to help slow a growing economy. Long-term rates rise as the market anticipates an increase in economic growth and inflation. LOW Short-Term Intermediate-Term Long-Term YIELD CURVE STEEPENER HIGH Short-term rates don t move since the Federal Reserve is not making adjustments to monetary policy. Long-term rates are rising as the market anticipates an increase in economic growth and inflation. LOW Short-Term Intermediate-Term Long-Term YIELD CURVE FLATTENER HIGH Short-term rates rise as the Federal Reserve tightens monetary policy to help slow a growing economy. Long-term rates are not moving as the market does not anticipate a substantial increase in economic growth or inflation. LOW Short-Term Intermediate-Term Long-Term Source: PGIM Investments. These three scenarios represent conceptual depictions of future potential movement of short-term and long-term U.S. interest rates. For illustrative purposes only. 9

10 How do global interest rates influence U.S. interest rates? While U.S. short-term interest rates are strongly influenced by Federal Reserve monetary policy, longterm U.S. interest rates are affected by what is happening outside the U.S. U.S. long-term rates are currently well above other developed market interest rates, leading many market participants to conclude that, even if U.S. long-term rates move higher, there are limits as to how much they can diverge from the current low rate global landscape. 3.8% 3.4% 2.8% 2.4% 2.5% 1.2% 1.4% 1.7% 1.8% 2.0% 2.1% 0.7% 0.0% 0.2% 0.4% 0.2% Switzerland Japan Germany Netherlands France Source: 10-year government yields: Bloomberg as of 12/31/2016. Britain Spain Canada Italy Hong Kong South Korea United States Singapore Australia New Zealand Portugal 10

11 Where are long-term U.S. interest rates headed? Predicting the future path of interest rates is difficult because they are influenced by many factors, including Federal Reserve policies, economic sentiment, foreign central bank policies, and geopolitical events. There are many different ways rates can go in the coming years. 10-year U.S. Treasury yields are at nearrecord lows Future path of U.S. interest rates? Long-term U.S. interest rates where could they be headed? EXTREME AND ACCELERATED Strong Growth High Inflation MODERATE AND GRADUAL Moderate Growth Moderate Inflation FLAT AND RANGE-BOUND Weak Growth Low Inflation Source of 10-year U.S. Treasury yield data: Bloomberg as of 12/31/2016. Source of scenarios: PGIM Investments. Scenarios 1, 2, and 3 represent conceptual depictions of future potential movement of long-term U.S. interest rates. For illustrative purposes only. 11

12 What asset classes performed well during rising rate periods? How often do interest rates rise? Since 1995, there have been nine periods where the 10-Year U.S. Treasury yield rose by 75 basis points or more (a basis point is 1/100 of a percent). 7 P1 P2 P3 P4 P5 P6 P7 P8 P /95 12/97 12/99 12/01 12/03 12/05 12/07 12/09 12/11 12/13 12/16 10 Year Treasury 10-year U.S. Treasury yield movement during rising rate periods (1995 to 2016) 4 12

13 As rates rise, certain asset classes have historically outperformed Investments such as Global Real Estate, Master Limited Partnerships, High Yield Bonds, and Bank Loans have delivered strong historical returns during rising rate periods. These investments tend to perform in line with the business cycle. As the economy grows or experiences higher inflation, these investments have outperformed more conservative investments like U.S. Government Bonds. Duration-neutral strategies are another alternative that may perform well in a rising rate environment. Categorized within the Non-Traditional Bond category, they are constructed to have little to no interest rate sensitivity. These strategies may underpeform, however, when interest rates decline. 19.7% 16.1% 13.3% 9.6% 6.9% 3.5% 2.7% Average historical performance during rising rate periods 5 (as shown in the chart on p.12) 0.9% MLP's Global Real Estate Short Duration High Yield Bonds Bank Loans Non-Traditional Bonds Short Duration Short-Term High Income Corporate Bonds Municipal Bonds U.S. Treasury 4 Source: Morningstar Direct as of 12/31/16. Calculated by PGIM Investments using data presented in Morningstar software products. All rights reserved. Used with permission. Rising interest rate periods are defined by the monthly movement of the 10-year Treasury yield, using a threshold of 75+ basis points or greater. The 10-year Treasury yield is a commonly used reference point for tracking the general movement of U.S. interest rates. The decision to use a 75+ basis point threshold to define a rising rate period was done so that an investor could see multiple instances of rising rate periods to better assess how different asset classes performed during these types of periods. 5 Source: Morningstar Direct as of 12/31/16. Calculated by PGIM Investments using data presented in Morningstar software products. All rights reserved. Used with permission. All indices are unmanaged. An investment cannot be made in an index. Please see page 14 for asset class breakdowns and corresponding indices. 13

14 HELPING INVESTORS PARTICIPATE IN GLOBAL MARKET OPPORTUNITIES At PGIM Investments, we consider it a great privilege and responsibility to help investors participate in opportunities across global markets while meeting their toughest investment challenges. We re part of PGIM, the 9th-largest investment manager globally 1 with more than $1 trillion in assets under management. 2 This scale and investment experience allow us to deliver Prudential Funds actively managed investment solutions that meet the needs of investors around the globe. 1 Pensions & Investments Top Money Managers list, 5/29/2017. Represents assets managed by Prudential Financial as of 12/31/ PGIM data as of 12/31/2016. Risk Information Mutual fund investing involves risk. Some mutual funds have more risk than others. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost, and it is possible to lose money. There is no guarantee a fund s objectives will be achieved. Fixed income investments are subject to interest rate risk, where their value will decline as interest rates rise. Diversification does not assure a profit or protect against loss in declining markets. Global Real Estate Investing in real estate poses certain risks related to overall and specific economic conditions as well as risks related to individual property, credit, and interest rate fluctuations. Real estate companies and REITs may be leveraged, which increases risk. Master Limited Partnerships (MLPs) are subject to complicated and in some cases unsettled accounting, tax, and valuation issues as well as risks related to limited control and limited rights to vote, potential conflicts of interest, cash flow, dilution, and limited liquidity, and risks related to the general partner s right to force sales at undesirable times or prices. MLPs are also subject to risks relating to their complex tax structure, including losing its tax status as a partnership, resulting in a reduction in the value of the MLP investment. Definitions and Indices Rate is the stated interest rate associated with a bond. Duration measures the sensitivity of a bond s price to a change in interest rates. Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country s borders in a specific time period. Inflation is the level of increase in prices and fall in the purchasing value of money. Market Interest Rate is the current prevailing interest for a bond of similar maturity and credit quality. Maturity is the average time to maturity for a bond. Yield-to-Maturity (YTM) reflects the internal annual rate of return an investor would realize by purchasing a bond, holding it to maturity, and reinvesting all coupon interest received at the same YTM. Another way to think about YTM is as the interest rate that will make the present value of the bond s cash flows equal to its purchase price. Yield Curve is a line that plots bond yields from the shortest maturity issues to the longest maturity, all other characteristics being equal. Bank Loans: Credit Suisse Leveraged Loan Index is unmanaged and represents the investable universe of the dollar-denominated leveraged loan market. U.S. Treasury: Bloomberg Barclays U.S. Treasury Index represents the public obligations of the U.S. Treasury with a remaining maturity of one year or more. Global Real Estate: FTSE NAREIT All Equity REITs Index is an unmanaged index which measures the performance of all U.S. real estate investment trusts. Master Limited Partnerships (MLPs): Alerian MLP Index is a composite of the 50 most prominent energy MLPs that provides investors with an unbiased, comprehensive benchmark for this emerging asset class. The index is calculated using a float-adjusted, capitalization-weighted methodology. Non-Traditional Bonds: Morningstar Non-Traditional Bond Category contains funds that pursue strategies divergent in one or more ways from conventional practice in the broader bond-fund universe. Short Duration High Income Municipal Bonds: Bloomberg Barclays Short Duration Muni 50% HG / 50% HY Index consists of the Bloomberg Barclays Municipal Bond 1 8 Year Index (50%), which is an unmanaged index that includes all benchmark-eligible, investment-grade municipal bonds with maturities from 1 to 8 years, and the Bloomberg Barclays Municipal High Yield 1 8 Year Index (50%), which is an unmanaged index that includes all benchmark-eligible, Ba1 or lower rated and non-rated municipal bonds with maturities from 1 to 8 years. Short Duration High Yield Bonds: Bloomberg Barclays BB/B 1 5 Year 1% Constrained High Yield Index is an unmanaged index that covers the universe of fixed rate, non-investment-grade debt. Issuers are capped at 1% of the Index. Index holdings must have at least one year to final maturity, at least $150 million par amount outstanding, and be publicly issued with a rating of Ba1 or lower and maturities from one to five years. Short-Term Corporate Bonds: Bloomberg Barclays 1 5 Year U.S. Credit Index is an unmanaged index of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet specific maturity (between one and five years), liquidity, and quality requirements. It gives a broad look at how short- and intermediate-term bonds have performed. Indices are unmanaged, and an investment cannot be made directly into an index. 14

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16 For more information, contact your financial professional or visit our website at pgiminvestments.com. Consider a fund s investment objectives, risks, charges, and expenses carefully before investing. The prospectus and summary prospectus contain this and other information about the fund. Contact your financial professional for a prospectus and summary prospectus. Read them carefully before investing. This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation about managing or investing your retirement savings. Clients seeking information regarding their particular investment needs should contact a financial professional Prudential Financial, Inc. and its related entities. PGIM and the PGIM logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide PI4128 Expiration: 10/31/2018