Active Management IN AN UNCERTAIN FINANCIAL ENVIRONMENT, ADDING VALUE VIA ACTIVE BOND MANAGEMENT

PRICE PERSPECTIVE September 2016 In-depth analysis and insights to inform your decision-making. Active Management IN AN UNCERTAIN FINANCIAL ENVIRONMENT, ADDING VALUE VIA ACTIVE BOND MANAGEMENT EXECUTIVE SUMMARY Although actively managed bond strategies remain much larger in terms of total assets, passive bond strategies have been growing in popularity with investors who see them as a simple, low-cost means of gaining exposure to fixed income. Amid broad strength in bond performance in recent years, investors may have overlooked the benefits of active fixed income management, as well as the risks that can come with trying to replicate the performance of bond indexes, where issuers with the heaviest debt loads typically garner the largest weightings. This Price Perspective examines the potential advantages of an actively managed bond strategy versus an index-based approach to fixed income portfolio construction. In our view, active bond strategies that emphasize fundamental credit research can help mitigate downside risk and enhance returns especially in a more volatile market environment as global central banks follow different policy paths and credit fundamentals are deteriorating in some areas of the markets. The relatively calm bond market environment that investors have enjoyed in recent years may be nearing an end. Volatility has increased in the past year as the Federal Reserve embarked on its first tightening cycle in a decade, while the European Central Bank and Bank of Japan are moving in the other direction and experimenting with negative interest rates. In the U.S. credit markets, corporate leverage is increasing, earnings are plateauing, and defaults are rising for commodity-related issuers. Conditions across international markets are broadly mixed, with varied rates of growth and inflation, divergent monetary policies, and disparate credit fundamentals. SELECTIVITY IS INCREASINGLY IMPORTANT IN TODAY S MARKET ENVIRONMENT The shift in market conditions coincides with the increased popularity of passive, index-based fixed income products whose appeal has grown with investors who see them as a simple, low-cost means of gaining exposure to the asset class. While actively managed bond strategies still hold far more assets, passive bond vehicles have been gaining market share. Amid broad strength in bond performance in recent years, investors may have overlooked the benefits of active management, as well as the risks and opportunity costs that can come with indexed investing. Of course, actively managed strategies can underperform their benchmarks when managers allocation and security selection decisions fail to pay off, particularly over shorter time periods and when bond prices are broadly moving in the same direction. However, we believe that actively managed bond strategies possess

inherent advantages that can help mitigate downside risk and enhance returns, and our portfolios are designed to address this dynamic. This is especially true in less hospitable market conditions where bond performance is more varied. With the potential for rising interest rates and increased turbulence in credit markets, security selection and interest rate management are becoming even more important drivers of performance. BOND INDEX STRUCTURES CAN LEAD TO UNDUE CREDIT RISK Bond and equity indexes possess a key difference. With equity indexes, market capitalization usually determines individual stock weightings. If a company s earnings potential increases in turn, raising its share price its stock garners a larger weighting in the index. By contrast, weightings in most fixed income indexes are based on the market value of an issuer s outstanding bonds. The result is that companies and governments with the most outstanding debt have the largest weightings in bond benchmarks. Issuers possessing large debt loads often some of the leading companies in the world can be good investments if they are capable of meeting their obligations to bondholders and are working to strengthen their finances. But it is important to remember that fixed income investments have what is known as an asymmetrical risk/ reward profile: Upside is limited to the promised stream of interest and principal payments, but downside can be substantial if an issuer defaults. Credit rating downgrades triggered by deteriorating fundamentals likewise can hurt performance as default risk rises. Therefore, indiscriminately buying highly leveraged issuers simply because they are large index positions is a dubious investment approach particularly at times of rising rates, when it becomes more expensive to refinance outstanding bonds. We believe employing in-depth credit analysis to identify bond issuers with stable or improving fundamentals and attractive valuations is the most prudent means of generating reliable income streams and possibly some capital appreciation if the market has mispriced credit risk. Diligent fundamental research also helps to avoid or minimize exposure to issuers and sectors with deteriorating credit profiles in an effort to mitigate the negative impact of downgrades and defaults. ACTIVE BOND STRATEGIES ARE BETTER EQUIPPED TO DEFEND AGAINST INTEREST RATE RISK A sustained period of historically low interest costs has prompted corporations and governments to issue large quantities of new bonds and extend maturities. Lower yields and longer maturities have led to increased duration, a measure of how sensitive bond prices are to interest rate changes (see Figure 1). While longer durations have benefited bond performance in a declining interest rate environment, there is now greater risk that bond prices will fall if inflation picks up and pressures interest rates higher. Unlike indexed products that attempt to mirror the duration profile of their benchmark as closely as possible, active fixed income strategies typically have some latitude to modify duration and yield curve exposures. This can range from modest flexibility, in the case of more traditional core bond strategies that adhere more closely to benchmarks, to significant leeway for less traditional, benchmark-agnostic bond strategies that can reduce duration to zero or below. Although correctly predicting the precise timing and magnitude of interest rate moves is extremely difficult, the ability to shorten duration when rates appear likely to rise can help to protect bond portfolios against price declines. Likewise, the ability to lengthen duration in markets where yields are prone to fall and curves are steep can augment return potential. ACTIVE PORTFOLIOS CAN MORE FULLY EXPLOIT THE BROAD GLOBAL FIXED INCOME OPPORTUNITY SET The fixed income investment universe is extremely large, and even broad fixed income benchmarks represent only a portion of it. For example, nearly three-quarters of the popular Barclays U.S. Aggregate Bond Index consists of U.S. Treasuries, agency mortgage-backed securities, and other government-related bonds sectors with low yields and greater interest rate sensitivity. Notably, its Treasury FIGURE 1: Yields Lower, Interest Rate Risk Higher Since the Global Financial Crisis June 2008 to June 2016 Yield to Maturity (%) 6% 5 2 1 Yield to Maturity 2009 2010 Duration 2011 2012 201 201 Lines represent yield and duration of Barclays U.S. Aggregate Bond Index. Sources: Barclays and T. Rowe Price. 2015 2016 6 5 Duration (Years) 2

allocation has grown significantly since the 2008 credit crisis as U.S. budget deficits ballooned (see Figure 2). The widely tracked Barclays index, despite having thousands of holdings and a market value of more than $18 trillion, excludes multiple sectors and securities that can offer attractive yields and compelling risk-adjusted return opportunities. High yield bonds, floating rate bank loans, Treasury inflation protected securities, and nondollar bonds are among the sectors not represented. The index also has low exposure to securitized credit sectors, such as asset-backed and commercial mortgage backed securities, and omits trillions of dollars worth of bond issues that do not meet prescribed index eligibility requirements. (See Four Ways That Bond and Equity Indexing Differ on page.) Active managers whose portfolios are measured against broad market indexes can potentially generate better returns versus their benchmarks by strategically allocating less to loweryielding government bonds and increasing their exposure to sectors with higher yields and lower interest rate risk. Active managers can often supplement index-eligible bonds with some out-of-benchmark securities, such as high yield bonds and bank loans, which offer larger coupons and are less sensitive to rate increases. Managers also may be able to add foreign bonds and currencies to improve return potential and increase diversification as global interest rates follow different paths. These securities are subject to additional risks, such as default risk and the risks of international investing. Active multi-sector bond managers can add further value by adjusting sector allocations as relative valuations and market risks change. Sector performance can vary widely from year to year, and some sectors historically have fared better than others in different interest rate and credit environments. For example, noninvestment-grade securities, or those with higher default risk, have tended to outperform in market environments where interest rates and corporate revenues are rising due to an improving economy; conversely, high-quality bonds typically perform best in environments where economic growth and inflation are weak, putting downward pressure on interest rates. FIGURE 2: Treasury Weighting in the Barclays U.S. Aggregate Index has Increased June 2006 to June 2016 60% 50 0 0 20 10 0 June 2006 U.S. Treasury Mortgage-Backed Securities Investment-Grade Corporates 2007 2008 2009 Sources: Barclays and T. Rowe Price. 2010 2011 We believe that actively managed bond strategies possess inherent advantages that can help mitigate downside risk and enhance returns. Government-Related Commercial Mortgage-Backed Securities Asset-Backed Securities 2012 201 201 2015 June 2016 WITH MANY FIXED INCOME OPTIONS AVAILABLE, ACTIVELY MANAGED FUNDS OFFER A SENSIBLE CHOICE Bonds serve important roles in portfolios, helping to diversify equity risk, generate income, dampen volatility, and preserve capital. Investors can select from a multitude of fixed income options, depending on their specific objectives and risk tolerances, with strategies ranging from the benchmark aligned to the benchmark agnostic. Regardless of the route taken, we believe that investors benefit from skilled fixed income managers, supported by robust global research and trading platforms, who are able to make judicious sector allocation, security selection, and duration decisions. We believe our active approach to fixed income investing holds distinct advantages over a highly constrained, passive approach to fixed income portfolio construction particularly in a more challenging environment with elevated interest rate risk and areas of credit concern. Even in highly benchmarkaligned portfolios, there is room to add incremental value and increase risk-adjusted returns with modest active overlays. Our disciplined fixed income investment process, with an emphasis on independent research and risk management, is designed to help our clients meet their long-term investment objectives. Of course, if the investments selected and strategies employed by a fund fail to produce the intended results, the fund could underperform in comparison to other funds with similar objectives and investment strategies.

BOND FUNDS TO CONSIDER For investors seeking to diversify their equity exposures with high-quality bonds, the T. Rowe Price New Income Fund (PRCIX) may be a good option. The fund s objective is to generate attractive income, while aiming to preserve capital, by investing primarily in U.S. investmentgrade bonds, including corporate debt, mortgage-backed securities, and Treasuries. It also has some flexibility to allocate to noninvestment-grade securities, emerging markets bonds, and nondollar-denominated bonds and currencies to enhance return potential. Many investors want to diversify equity exposures but are concerned about the interest rate risk of conventional highquality bond portfolios. The T. Rowe Price Global Unconstrained Bond Fund (RPIEX) seeks to defend against both equity volatility and rising rates while generating consistent returns across market cycles. The fund has significant flexibility to adjust duration and is not bound to a market-based index. It emphasizes liquid global government bonds but can access the full universe of credit and currency instruments to build a balanced portfolio that combines returnseeking and defensive investments. For those seeking higher income, more potential for capital appreciation, and greater global diversification, the T. Rowe Price Global Multi-Sector Bond Fund (PRSNX) may be a suitable choice. It invests broadly across the expanding global opportunity set and has significant leeway to purchase high yield and nondollar-denominated securities. It seeks to add value by targeting multiple return sources sector allocation, credit selection, interest rate management, and currency exposures in order to navigate evolving market environments. FOUR WAYS THAT BOND AND EQUITY INDEXING DIFFER It s difficult to passively replicate the performance of a bond index. Investors cannot buy fixed income benchmarks because they are essentially hypothetical constructs. Bond indexes are also much more difficult to passively replicate than equity indexes. The reasons include: Large size As its name indicates, the S&P 500 Index the wellknown proxy for the U.S. equity market comprises 500 stocks. By contrast, the Barclays U.S. Aggregate Bond Index, a popular benchmark representing the U.S. taxable investment grade market, comprised almost 9,700 individual bond issues at the end of 2015. Global fixed income benchmarks are even larger. Buying every issue in such indexes is not feasible. High turnover Fixed income index components change much more rapidly than equity indexes. New issues are continually added, and many bonds with call features are retired early. Bond indexes are also defined by specific maturity and quality rules, which results in bonds regularly moving into and out of benchmarks as maturity dates approach and credit ratings shift. These frequent composition changes make it cost prohibitive for indexers to maintain exact clone portfolios. Supply/demand imbalances Issuers sell limited quantities of bonds in the primary market, and investor demand for attractively priced deals can be intense. In recent years, new bond offerings have often been oversubscribed. As such, portfolio managers may receive lower-than-desired allocations to popular new issues that seamlessly become part of benchmarks, and managers may have to pay a premium to build full positions in bonds that are in high demand. Liquidity challenges Unlike exchange traded stocks, bonds trade over the counter through dealer intermediaries who manually connect buyers with sellers. Individual bonds trade far less actively than the typical stock; many bonds are held to maturity and do not trade. Transaction costs for less liquid bonds can be substantial. Therefore, benchmark issues may not be available in the required size or at a reasonable price, and managers may not be able to efficiently sell bonds that exit the index. Given these challenges, even bond index portfolios require some degree of active management decisions. Most hold only a fraction of the benchmark s securities. Rather than buying every bond in the precise proportions, passive managers employ sampling techniques or use other mechanisms to build a representative portfolio that is similar to the index in such key areas as sector allocation, duration, yield, credit quality, and spread. In addition, bond index portfolios routinely experience tracking error, or performance variances between portfolios and their benchmarks. These performance discrepancies can be surprisingly large at times. Management fees, sampling error, erratic cash flows due to vacillating investor sentiment, liquidity constraints, and unrealistic index pricing are among the factors that can lead to tracking error and cause passive portfolios to underperform their benchmark.

T. Rowe Price focuses on delivering investment management excellence that investors can rely on now and over the long term. To learn more, please visit troweprice.com. Important Information This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are as of September 2016 and may have changed since then. Price Perspectives are provided for informational and educational purposes only and are not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. This Price Perspective provides opinions and commentary that do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision. Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. Past performance cannot guarantee future results. Fixed income investing involves credit risk and interest rate risk. If interest rates rise significantly from current levels, bond fund total returns will decline and may even turn negative in the short term. High yield corporate bond funds could experience greater price declines than funds that invest primarily in high-quality bonds. Investing internationally is subject to additional risks, including currency risk and political risk. Call 1-800-225-512 to request a prospectus, which includes investment objectives, risks, fees, expenses, and other information you should read and consider carefully before investing. T. Rowe Price Investment Services, Inc., distributor 2016-US-25891 9/16