Download Changing Interest Rates: The Impact on Your Portfolio

PRUDENTIAL INVESTMENTS, A PGIM BUSINESS | MUTUAL FUNDS
Changing interest rates
THE IMPACT ON YOUR PORTFOLIO
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
What factors influence
U.S. interest rates?
here are long-term
W
U.S. interest rates
headed?
What asset classes
performed well during
rising rate periods?
changes affect bond
investments?
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.
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 Rates
(Price Decline)
No Change in Interest Rates
(No Price Change)
Declining Interest Rates
(Price Increase)
7%
5%
5%
5%
5%
3%
2%
0%
–2%
Bond
Coupon
Payment
Bond
Price
Decrease
Investor
Total
Return
Bond
Coupon
Payment
No Bond
Price
Change
Investor
Total
Return
Bond
Coupon
Payment
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.
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
•5-year maturity
•Issued at par ($1,000)
•Coupon rate 3%
BOND XYZ
CHARACTERISTICS
ONE YEAR LATER:
1% Increase
2% Increase
3.0%
3.0%
Bond Price Decrease
–3.7%
–8.1%
Investor Total Return
–0.7%
–5.1%
Bond Coupon Payment
(Coupon + Price Decline)
+
+
Coupon 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.
1
visit prudentialfunds.com
3
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
Final
Coupon
Payment
Bond
Coupon
Bond Coupon
Payments
A shorter maturity
Final bond
Coupon
will provide investors
Payment
with their principal
earlier, which results in
lower interest rate
risk.
Principal
Payments
Principal
0
1
2
3
4
5
Last
0
1
2
3
Payment
Years
Years
4
5
Last
Payment
Bond maturing in 10 years
Bond Coupon
Payments
Bond Coupon
Payments
Final
Coupon
Payment
Final
Coupon
Payment
Principal
Principal
3
4
5
Years
0
6
1
7
2
8
3
9
4
10
Last
5
6
7
Payment
Years
8
9
10
Last
Payment
A longer maturity
bond will provide
investors with their
principal later, which
results in higher
interest rate risk.
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.
2
4
CHANGING INTEREST RATES
Final
Coupon
Payment
Bond Coupon
Payments
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 Principal
because they have a lower “yield cushion”— meaning they have a smaller percentage of total cash flows
that come from income payments.3
0
1
2
3
4
5
lower coupon Bond = Higher interest rate risk
Years
Last
Payment rate risk
higher coupon Bond = lower interest
Final
Coupon
Payment
Bond Coupon
Payments
Final
Coupon
Payment
Bond Coupon
Payments
Principal
Principal
0
1
2
3
Years
4
0
1
Cash flow 1
Cash flow 2
1
2
3
Years
4
5
Last
Payment
Final
Coupon
Payment
Bond Coupon
Payments
Lower
Coupon
2
3 Bond 4
Years
0
5
Last
Payment
Investors receive
a smaller
Principalportion
of their total cash
flows prior to
5
maturity.
Last
Payment
Cash flow 3
Principal and final cash flow
Cash flow 4
Investors receive
a larger portion
of their total cash
flows prior to
maturity.
Higher
Coupon
Bond
Cash flow 1
Cash flow 2
Cash flow 3
Cash flow 4
Principal and final cash flow
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.
3
visit prudentialfunds.com
5
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 Rates
•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.
SHORT-TERM RATES
Driver
• U .S. GDP
• Federal Reserve
• Monetary Policy
Key
Factors
•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 RATES
• Short-Term U.S.
Inflation Expectations
• Long-Term U.S.
Inflation Expectations
• U.S. Unemployment
Rate (%)
• Long-Term U.S. GDP
Growth Expectations
• Short-Term U.S. GDP
Growth Expectations
External
Factors
Long-Term Rates
•Long-term interest rates are primarily influenced by
long-term expectations for U.S. economic growth
and inflation.
• Short-Term Global
Inflation Expectations
• Long-Term Global
Inflation Expectations
• Short-Term Global
GDP Growth
Expectations
• Long-Term Global
GDP Growth Expectations
• Current Long-Term Global
Market Rates
•They may also be affected by current long-term global
market rates.
Do short- and long-term interest rates
always move in the same direction
and by the same magnitude?
PARALLEL SHIFT IN RATES
HIGH
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:
LOW Short-Term
Rates
Source: Prudential 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.
Intermediate-Term
Rates
Long-Term
Rates
•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.
6
CHANGING INTEREST RATES
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,
long-term 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%
1.2%
1.7%
1.8%
Canada
Italy
2.0%
2.5%
2.1%
1.4%
0.7%
0.0%
–0.2%
Switzerland Japan
0.2%
0.4%
Germany Netherlands France
Britain
Spain
Hong
Kong
South
Korea
United Singapore Australia New
Portugal
States
Zealand
Source: 10-year government yields: Bloomberg as of 12/31/2016.
YIELD CURVE “STEEPENER”
YIELD CURVE “FLATTENER”
HIGH
HIGH
LOW Short-Term
Rates
Intermediate-Term
Rates
Long-Term
Rates
LOW Short-Term
Rates
Intermediate-Term
Rates
Long-Term
Rates
•Short-term rates don’t move since the Federal Reserve
is not making adjustments to monetary policy.
•Short-term rates rise as the Federal Reserve tightens
monetary policy to help slow a growing economy.
•Long-term rates are rising as the market anticipates an
increase in economic growth and inflation.
•Long-term rates are not moving as the market does not
anticipate a substantial increase in economic growth
or inflation.
visit prudentialfunds.com
7
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
16
Future path of
U.S. interest rates
?
12
8
4
0
Long-term U.S.
interest rates …
where could
they be headed?
1980
1990
EXTREME AND
ACCELERATED
Strong
Growth
MODERATE AND
GRADUAL
FLAT AND
RANGE-BOUND
Moderate
Growth
Weak
Growth
2000
2010
2016
2020
High
Inflation
2010
2016
2020
2010
2016
2020
2010
2016
2020
Moderate
Inflation
Low
Inflation
Source of 10-year U.S. Treasury yield data: Bloomberg as of 12/31/2016.
Source of scenarios: Prudential Investments. Scenarios 1, 2, and 3 represent conceptual depictions of future potential movement of long-term U.S. interest rates.
For illustrative purposes only.
8
CHANGING INTEREST RATES
2010
2015
2020
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).
Rising rate periods
10-year U.S. Treasury
yield movement
(1995 to 2016)4
7
1 2
3
4
5
6
7
8
9
6
5
4
3
2
1
0
12/95
12/97
12/99
12/01
12/03
12/05
12/07
12/09
12/11
12/13
12/16
10 Year Treasury
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.
Average historical
performance during
rising rate periods5
19.7%
16.1%
13.3%
(as shown in the
chart above)
9.6%
6.9%
3.5%
2.7%
–0.9%
MLP's
Global
Real Estate
Short Duration
High Yield Bonds
Bank Loans
Non-Traditional
Short Term
Short Duration U.S. Treasury Index
Bonds
Corporate Bonds High Inc Muni
Source: Morningstar Direct as of 12/31/16. Calculated by Prudential Investments LLC 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.
4
Source: Morningstar Direct as of 12/31/16. Calculated by Prudential Investments LLC 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 10 for asset class breakdowns and corresponding indices.
5
visit prudentialfunds.com
9
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 (MLP) 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
Coupon Rate: The stated interest rate associated with a bond.
Duration measures the sensitivity of a bond’s price to a change in
interest rates.
GDP: The gross domestic product of a nation is the monetary value of
all the finished goods and services produced within a country’s borders
in a specific time period.
Inflation: The level of increase in prices and fall in the purchasing value
of money.
Market Interest Rate: 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: 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.
10
CHANGING INTEREST RATES
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 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 nonrated 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.
About
Prudential
Investments
Prudential Investments is dedicated to helping you solve your
toughest investment challenges—whether it’s capital growth,
reliable income, or protection from market volatility and other
risks. Through ever-changing markets, we strive to be a leader
in a broad range of investments to help you stay on course
to the future you envision. Our investment professionals also
manage money for major corporations and pension funds
around the world, which means you benefit from the same
expertise, innovation, and attention to risk demanded by
today’s most sophisticated investors. Together they manage
more than $963 billion in assets (through 12/31/2015).
We believe the knowledge and experience of a financial
professional provides a valuable advantage, so we make our
products available through financial advisors. We are part of
Prudential Financial, a company America has been bringing
its challenges to for 140 years.
Bring us yours.
FOR MORE INFORMATION, contact your financial professional or visit our website at prudentialfunds.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.
These materials are for informational or educational purposes only. The information is not intended as investment advice and is not a recommendation about managing or investing your retirement savings. In providing these materials Prudential Investments is not acting as your fiduciary as
defined by the Department of Labor. Please consult with a qualified investment professional if you wish to obtain investment advice.
Mutual funds are distributed by Prudential Investment Management Services LLC, a Prudential Financial company, member SIPC. © 2017 Prudential Financial, Inc. and its related
entities. The Prudential logo and the Rock symbol are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.
Mutual Funds • Are not insured by the FDIC or any federal government agency • May lose value • Are not a deposit of or guaranteed by any bank or any bank affiliate
0274000-00003-00 PI4128 Expiration: 07/31/2018