Positioning portfolios for today’s interest rate environment...portfolio in today’s market. 1. Sources: Bond allocations—Ned Davis Research, Inc., bonds as a percentage of financial

Positioning portfolios for today’s interest rate environment

INVESTING FOR INCOME

During the height of the credit crisis in 2008, and in subsequent periods of

extreme market volatility, investors have fled to the safety of high-quality, fixed-

income investments. In fact, data from Ned Davis Research indicates that bond

allocations are still near an all-time high in investors’ portfolios.1 While periodic

“flights to quality” are understandable and even predictable, it is prudent that

income-oriented investors diversify their sources of cash flow to help maximize their

income potential so that their portfolios are positioned properly for today’s environ-

ment, and when interest rates inevitably rise.2 In this paper we will provide investors

seeking steady cash flow with strategies for building and preserving their income

portfolio in today’s market.

1. Sources: Bond allocations—Ned Davis Research, Inc., bonds as a percentage of financial assets from 3/31/52-9/30/11. Treasury and corporate bond data—Strategic Insight/SimFunds net flow data as of 12/31/11.

2. Diversification does not guarantee a profit or ensure against loss.3. Source: Crestmont Research Copyright 2012, www.CrestmontResearch.com.

The forecasts contained in this document are opinion and are not intended to predict the performance of any specific investment.


1

Interest Rates—What Goes Down Must Go Up?

As a result of sluggish economic growth and elevated unemployment, the Federal Reserve Board (the

“Fed”) has repeatedly stated that it intends to keep the target range for the Federal Funds Rate (Fed

Funds Rate) at a historically low rate for an extended period. As a result, the current low rate environ-

ment presents two challenges for income-oriented investors: 1) finding income opportunities in today’s

market; and 2) positioning portfolios for an eventual increase in rates.

No one knows when interest rates will rise, but history tells us that they will rise at some point; it’s simply a

matter of when. Over the past 40 years, interest rates have moved more than 50 basis points (+/-) at some

point across the yield curve during every six-month period, with a few brief exceptions in 1998 and 2006.

Interest rates are at their lowest levels in decades. So in order to believe that they will go lower, one would

need to assume that the U.S. is headed for long-term deflation, and that the economy is severely broken

and will not recover in the foreseeable future—a scenario that even the most pessimistic economists are

not predicting.

Most investors understand that as interest rates rise, bond prices decrease. The longer a bond’s

maturity period, the steeper the price drop in the event of interest rate increases, all else being equal.

Yet, it seems in their efforts to generate incremental income in the low interest rate environment,

investors are exposing themselves to another kind of risk—interest rate risk. The higher interest rates

go, the more devastating potential losses become. For example, let’s look at both a one-year bond

and a 30-year bond. If interest rates go up three percentage points, the one-year bond will immedi-

ately lose approximately three percent of its value. But, if investors wait a year, they will receive the

principal plus the promised yield. However, with a 30-year bond, a three percentage point increase in

interest rates results in the loss of over 40 percent of the bond’s value. That’s a lot to lose on a “safe”

investment. Figure 1 below illustrates this point and includes the price change for bonds with varying

durations in both a rising and falling interest rate environment. Even a very modest rate increase will

negatively impact the price of longer duration bonds.

FIGURE 1: BOND PRICES AND INTEREST RATES

$500

$800

$1,100

$1,400

$1,700

$2,000

-3.0% -2.5% -2.0% -1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0%Interest Rate Movements

Bond

Pric

es

2-year5-year10-year20-year30-year

Source: Department of Treasury, using proprietary calculations of bond duration and price in relation to interest rate movements, see appendix for further details.


2

Figure 2 looks at interest rate levels since 1989. As illustrated below, interest

rates are at their lowest levels in the past 20 years. Another important point is

uncovered by looking at the gray shaded areas. The dark gray areas are time

periods where the Fed was in an easing cycle (or lowering interest rates), the

blue areas indicate periods during which the Fed tightened (or raised interest

rates). Generally, each easing cycle has been followed by a period of tight-

ening. With interest rates at or near all-time lows, and if history is any guide,

the Fed will raise interest rates at some point in the future, putting income-

oriented bond investors at risk of loss.

FIGURE 2: INTEREST RATE CYCLES

Fed Funds Target Rate* ■ Tightening Cycle ■ Easing Cycle

02/02/20120.12%

Fed Funds Target Rate and Interest Rate Cycles109876543210

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2012

Treasury Bonds Gain/Annum When:

MONETARY POLICY IS: GAIN/ANNUM % OF TIME

Easing 3.1 44.3

Neutral 3.6 37.4

Tightening –5.0 18.3

Source: Ned Davis Research, Inc.

* Prior to 7/6/1989, the Fed used a range rather than a target rate. This is our estimate of what the target rate would have been.

“ At some point interest

rates will go up and the

most significant negative

impact will probably be for

those who have extended

duration in their portfolios.”

— Rob Dial, Managing Director, New York Life Investments Fixed Income Investors


3

Diversification Abandoned Yet Again

The “Great Recession” proved to be one of the worst recessions in U.S. history. With the possibility of

prolonged uncertainty regarding the economy, it’s not surprising that investors were highly risk averse

and have either flocked to the safety of high-quality bonds or are holding high levels of cash earning

very little, if any, income. While it’s understandable for investors to want a “safe” place for their money,

investors who lost money because they were overweight in the stock market during the last major

downturn are now at risk of future declines because their portfolios are overweight in bonds.

The problem when any one asset class or sub asset class becomes flooded with investor dollars is

that, sooner or later, these investments become overvalued—this is often referred to as a “bubble.”

A good example of this was the tech bubble of 2000. When

valuations become extremely high, it usually means the tide is

changing, and that the end is near in terms of an investment’s

upside potential. Regardless of whether or not investors believe

bonds are in a bubble, data suggests that high-quality corpo-

rate bonds and Treasury bonds are significantly overvalued

right now. One way to determine if bonds are overvalued is to

compare their yield to the S&P 500 Index earnings yield.

Figure 3 illustrates valuations for both high-quality corporate

bonds (top chart) and long-term Treasurys (bottom chart); the

green circles highlight today’s valuations. Despite common

wisdom, it seems investors don’t diversify until it’s too late,

often setting themselves up for failure, or at the very least

missing out on opportunities.

“If 10-year interest rates

were to rise just four percent

from today’s level, holders of

bonds would suffer a capital

loss of more than three

times the current yield.”

— Bill Priest, CEO and Co-CIO, Epoch Investment Partners


4

FIGURE 3: HIGH-QUALITY CORPORATE AND TREASURY BOND VALUATIONS

2.4

2.2

2.0

1.8

1.6

1.4

1.2

1.0

0.8 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

2.0

1.8

1.6

1.4

1.2

1.0

0.8

0.6

0.4 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Bonds Relatively Undervalued

Mean = 1.5x

Bonds Relatively Overvalued

1/31/2012 = 0.7x

Bonds Relatively Undervalued

Mean = 1.1x

Bonds Relatively Overvalued

1/31/2012 = 0.4x

Moody’s Baa Corporate Bond Yield/S&P 500 Operating Earnings Yield 2/28/85-1/31/2012

Long-Term Treasury Bond Yield/S&P Operating Earnings Yield

Source: Ned Davis Research, Inc.

While views are currently mixed regarding the prospects for inflation, history has shown that it has

a detrimental effect on the “real” returns of investments over longer time periods. Investors seeking

to invest in a “safe” asset fail to realize that at current rates a long-term bond guarantees neither

return of capital nor return on capital when you factor in inflation. Consider that the interest rate on

a standard non-inflation adjusted Treasury bond due in four years has fallen to roughly one percent.

The Treasury bond holder is focused solely on lack of credit risk in government bonds, while not

considering interest rate or duration risk. This is a significant oversight. There is little compensation

for taking on the duration risk of a long-term bond today. Even if one does obtain the return of

principal, there is a good chance that inflation may erode an investor’s return.


5

Where Can Investors Find Income Now and Later?

With short duration assets such as Treasurys and ultra-short bonds providing very low yields, and

intermediate and long-term bonds highly vulnerable to rising interest rates, where can investors

seeking steady cash flow turn for income? There are several viable options for today’s income-oriented

investors. Some of these strategies do require investors to assume a greater level of risk. Of course,

risk tolerance, time horizon, and long-term investment objectives play a factor in determining the

proper allocations to various income-generating investments.

Building a portfolio with independent and uncorrelated sources of income provides several benefits,

including diversification, the potential for higher yields, and a hedge against inflation. Correlation

coefficients indicate the strength and direction of the relationship between the movements of two

investments. A correlation of 1.00 means that investments move in lock-step with one another. Generally,

a correlation of 0.70 or less would indicate that the two investments are not highly correlated. If a

correlation is negative, the two investments will move in opposite directions of one another. Building

a portfolio of uncorrelated assets means investors can help offset market swings since uncorrelated

investments will not have the same reaction to market fluctuations. There are a number of investments

that work well in a portfolio together due to their low correlation to one another. Figure 4 below shows

the correlation between the various income options we’ll discuss in this paper.

FIGURE 4: 10-YEAR CORRELATION MATRIX

NameU.S.

EquityWorld Equity

Intl. Equity

Floating Rate

Loans

Short-Term

Treasury Bonds

High Yield Corporate

Bonds

Intermediate- Term

Treasury Bonds

U.S. Investment

Grade Corporate

Bonds

Emerging Market Debt

Municipal Bonds T-Bills

U.S. Equity 1.00 0.97 0.89 0.55 -0.39 0.70 -0.33 -0.05 0.57 -0.02 -0.11

World Equity 0.97 1.00 0.97 0.58 -0.37 0.73 -0.32 -0.01 0.62 0.00 -0.10

International Equity 0.89 0.97 1.00 0.56 -0.32 0.71 -0.27 0.04 0.63 0.03 -0.08

Floating Rate Loans 0.55 0.58 0.56 1.00 -0.42 0.82 -0.38 -0.01 0.52 0.25 -0.03

Short-Term Treasury Bonds -0.39 -0.37 -0.32 -0.42 1.00 -0.30 0.82 0.69 0.05 0.29 0.17

High Yield Corporate Bonds 0.70 0.73 0.71 0.82 -0.30 1.00 -0.22 0.19 0.75 0.30 -0.04

Intermediate-Term Treasury Bonds -0.33 -0.32 -0.27 -0.38 0.82 -0.22 1.00 0.89 0.24 0.48 0.11

U.S. Investment Grade Corporate Bonds -0.05 -0.01 0.04 -0.01 0.69 0.19 0.89 1.00 0.58 0.65 0.08

Emerging Market Debt 0.57 0.62 0.63 0.52 0.05 0.75 0.24 0.58 1.00 0.45 -0.02

Municipal Bonds -0.02 0.00 0.03 0.25 0.29 0.30 0.48 0.65 0.45 1.00 0.03

T-Bills -0.11 -0.10 -0.08 -0.03 0.17 -0.04 0.11 0.08 -0.02 0.03 1.00

Source: Morningstar for the 10-year time period ending 12/31/11.


6

Naturally, these uncorrelated asset classes have varying levels of income potential and respond differ-

ently to interest rate movements. Figure 5 below looks at several asset classes (as represented by

their respective benchmarks) and compares their yield and correlation to Treasury bonds. Fixed-income

asset classes vary widely in terms of their yield potential and movement versus Treasury bonds and

one another. By constructing a diversified income portfolio, investors may build in a buffer to weather

different interest rate environments, while at the same time achieving a higher level of income than a

non-diversified portfolio consisting of only Treasury and high-quality corporate bonds.

FIGURE 5: YIELD & SENSITIVITY TO TREASURY BONDS

US Equity

T-Bills

Short Treasury

Treasury

Muni Bonds

Corporate Bonds

Emerging Market BondsHigh Yield Bonds

Intl. Equity

Floating Rate Loans

World Equity

Yield

Sens

itivi

ty to

Tre

asur

y Bo

nds

High

Low

0.00 9.00

S&P 500MSCI WorldMSCI EAFECS Leveraged Loan

BarCap 1-3 US TreasuryBarCap High Yield BarCap TreasuryBarCap US Credit

JPM EMBI Global Diversified BarCap Muni 3-Month T-Bill

Source: MainStay Investments, as of 12/31/11. Government bonds and Treasury bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and fixed principal value. For full index disclosures, please refer to the footnotes section of the paper. Investors cannot make an investment in an index. Past performance is no guarantee of future results.

The following is a brief description of the asset classes that we believe when blended in a portfolio

together, will offer investors the potential for steady cash flow now, provide opportunities for long-

term capital appreciation, and help position investors going forward, should there be a change in

the interest rate environment.

Floating Rate Loans

Floating rate loans may provide investors with an attractive yield compared with other short-duration

products. The near zero duration of floating rate loans helps to limit price depreciation in a rising

interest rate environment since their rates adjust, or float, with the market.

Floating rate loans pay a spread over a pre-determined reference rate, generally the U.S. Dollar

London Interbank Offered Rate (LIBOR), and interest rates on floating rate loans reset periodically to

reflect the current market rate. The rate paid by the borrower typically resets every 30, 60, or 90

days, so that the aggregate rate “floats” and is highly correlated with the reference rate. Consider

this example: if a floating rate loan of ABC Company has a coupon of 5.0% (3.0% higher than its

benchmark (LIBOR), which in this example is 2.0%) and LIBOR moves to 3.0%, as of the next reset

date, the coupon of the floating rate loan of ABC Company is changed to 6.0%.


7

Also, the low correlation with other broad fixed-income asset classes can provide investors with

additional portfolio diversification. It’s important to note that floating rate funds are generally

considered to have speculative characteristics that involve default risk of principal and interest,

collateral impairment, borrower industry concentration, and limited liquidity.

In an environment in which dividend income is a key driver of performance, positioning a fixed-

income portfolio with higher-yielding instruments and lower duration can be beneficial to investors.

Floating rate bank loans are an ideal combination of these elements. Figure 6 shows returns for

floating rate loans over the past 19 years. The blue shaded areas represent times when the Fed raised

rates. As you can see, floating rate loans did well during these time periods. In fact, floating rate loans

had positive returns for every time period except during the credit crisis of 2008, during which most

asset classes underperformed.

FIGURE 6: FLOATING RATE LOANS & INTEREST RATES

FLOATING RATE LOANS (Annual Total Return)FED ACTION: YEAR

Fed lowered rates 3 times 1992 6.75%

Fed made no changes 1993 11.17

Fed raised rates 6 times 1994 10.32

Fed raised rates 1 time then lowered rates 2 times 1995 8.91

Fed lowered rates 1 time 1996 7.48

Fed raised rates 1 time 1997 8.30

Fed lowered rates 3 times 1998 5.31










Fed lowered rates 7 times 2008 –28.75




Source: Morningstar and Federal Reserve Bank of New York, 12/31/11. Floating rate loans are represented by the Credit Suisse Leveraged Loan Index, a representative index of tradable, senior secured, U.S. dollar denominated non-investment-grade loans. An investment cannot be made directly into an index. Past performance is no guarantee of future results. Returns do not reflect the deduction of the fees and charges that are normally associated with these investments. Performance may be lower once fees and charges are taken into account.

Investing in floating rate loans is one way to get enhanced yield over a Treasury or a high-grade corporate fixed income option without extending duration.


8

High-Yield Bonds

High-yield bonds historically provide higher income when compared with investment-grade bonds,

while also offering investors the potential for capital appreciation. In addition, with moderate duration

and greater spreads, high-yield bonds are typically less sensitive to changes in interest rates than

investment-grade bonds, making them less susceptible to price declines when interest rates rise.

Historically, high yield has performed better than investment grade and Treasury bonds in a rising

interest rate environment.

The chart for Figure 7 depicts the monthly effective Fed Funds Rate from January 1990 to July 2010.

The table below illustrates the performance of broad fixed-income alternatives during periods of flat

to rising rates as indicated by the circles shown on the “Effective Fed Funds Rate” graph. In two of

the past three rising interest rate cycles, high yield outpaced intermediate investment-grade bonds,

Treasury bonds, and short-term government bonds. It’s worth mentioning that the one period in which

high yield did not outperform, was not only the shortest period, but also the period during which rates

were rising from the highest base.

FIGURE 7: HIGH-YIELD PERFORMANCE IN A RISING INTEREST RATE ENVIRONMENT

9.00

8.00

7.00

6.00

5.00

4.00

3.00

2.00

1.00

0.00 1/90 1/92 1/94 1/96 1/98 1/00 1/02 1/04 1/06 1/08 1/10

Effective Fed Funds Rate

Effective Fed Funds Rate*

Annualized Returns**

NAME: 12/1/92 to 4/30/95 1/1/99 to 9/30/00 12/1/03 to 8/31/07

Credit Suisse HY Index 10.56% 1.77% 7.90%

Bar Cap U.S. Agg Bond Index 6.06 3.52 4.06

Bar Cap U.S. Treasury Index 6.08 3.02 3.90

Bar Cap U.S. Govt/Credit 1-3 Yr Index 4.70 4.85 3.13

* Source: St. Louis Federal Reserve, monthly effective federal funds rate from January 1990 to July 2010. Past performance is no guarantee of future results.

** Source: Morningstar Direct 8/23/10. Returns do not reflect the deduction of the fees and charges that are normally associated with these investments. Performance may be lower once fees and charges are taken into account.

With the current low interest rate environment and lower level of default rates in the market, the poten-

tial for higher income that high-yield bonds offer over investment-grade bonds, as well as their lower

sensitivity to interest rates, the asset class is an attractive option for today’s income-oriented investors.


9

However, it is important to note that high-yield bonds are considered speculative and are subject to

greater default, or credit risk (when compared with high-quality bonds). Investment manager selection

is crucial in determining which high-yield investment or fund to choose and investors should look for

managers who have a historically lower default rate in their portfolio.

Municipal Bonds

Municipal bonds have historically generated solid returns

with less default risk than many other types of fixed-income

vehicles. In addition, they offer a steady stream of tax-free

income and currently offer a yield advantage over U.S. Treasury

bonds. It’s important to note that interest income on Treasury

bonds is exempt from state and local taxes.

Given the budget challenges in many states, some people may

be wary of investing in the municipal bond market. However,

despite periodic and sometimes severe economic downturns,

municipal bond defaults have historically been rare. As shown

in Figure 8, municipal bond defaults have been significantly

lower than their corporate bond counterparts. In fact, the total

number of defaults of the entire municipal investment grade universe does not equal the defaults of

AAA corporate bonds alone.

FIGURE 8: MUNICIPAL BOND VS. CORPORATE BOND DEFAULT HISTORY (by credit quality)

Municipal Bonds Corporate Bonds

AAA 0.00% 0.50%

AA 0.03% 0.54%

A 0.03% 2.05%

BBB 0.16% 4.85%

Source: Moody’s cumulative default rates within 10-years of original issue, by rating category, from 1970-2009.

From a relative value perspective, municipal bonds are currently cheap. In many cases, they are also

yielding more than Treasury bonds. Historically, the average municipal bond yields about 14% lower

than a comparable Treasury bond. Yet today, municipal yields are materially higher than Treasurys

(Figure 9 top chart). As illustrated in the bottom chart in Figure 9, the average of municipal yields as

a percentage of Treasurys was 87.2%, indicating that municipal bonds are undervalued relative to

Treasurys.

“When you factor in the

historically low default rates

and the tax-equivalent yield

municipal bonds offer, the

case for this asset class is

very compelling.”

— John Loffredo, Sr. Managing Director, MacKay Shields Municipal Managers


10

FIGURE 9: MUNICIPAL BOND & TREASURY YIELDS

16151413121110

9876543

180

160

140

120

100

80

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2012

20-Year Treasury Bond Yields1/31/2012 = 2.69%

20-Year Municipal Bond Yields1/31/2012 = 3.68%

Munis, Treasurys and the Implied Tax Rate Monthly Data 4/30/53 – 1/31/2012

Mean = 87.2% Munis Undervalued

Munis Overvalued 1/31/2012- = 136.5%

Muni Yields as a % of Treasury Yields

Source: Ned Davis Research, Inc. Past performance is no guarantee of future results.

As well as offering a potentially higher current yield, municipal bonds (as represented by Barclays

Capital Municipal Index) have historically tended to outperform Treasury bonds (represented by

Barclays Capital U.S. Treasury Index) in rising interest rate environments (from 1980-2009).4

Past performance is no guarantee of future results.

After factoring in the tax benefits offered by municipal bonds, they are even more compelling.

Consider that as of December 31, 2011, the average municipal bond was generating a 6.08%

taxable equivalent yield—an attractive yield in any environment. This is calculated by taking the

20-year municipal bond yield of 3.95% and dividing it by one minus the tax rate. For the purposes

of this example, the highest federal tax rate of 35% was used. The table in Figure 10 shows the

tax equivalent yield for other tax brackets as well. It is important to note that a portion of income

from municipal bonds may be subject to state and local taxes or the alternative minimum tax.

4. Source: Barclays Capital Municipal and U.S. Treasury Indices tax-adjusted monthly returns from 1980-2009, taking into account interest rate changes and the top marginal tax rate each calendar year. The Barclays Capital Municipal Index is a market-weighted index designed to measure the performance of the broad tax-exempt market. The Barclays Capital U.S. Treasury Index represents public obligations of the U.S. Treasury with a remaining maturity of one year or more. An investment cannot be made directly into an index.


11

FIGURE 10: TAXABLE EQUIVALENT YIELDS TABLE

If your federal marginal income tax rate is equal to a taxable yield of:

A Tax-Free Yield of:

3.50% 4.00% 4.50% 5.00% 5.50% 6.00% 6.50% 7.00%

would equal a taxable yield of:

15.00% 4.1% 4.71% 5.29% 5.88% 6.47% 7.06% 7.65% 8.24%

27.00% 4.79% 5.48% 6.16% 6.85% 7.53% 8.22% 8.90% 9.59%

30.00% 5.00% 5.71% 6.43% 7.15% 7.86% 8.57% 9.29% 10.00%

35.00% 5.38% 6.15% 6.92% 7.69% 8.46% 9.23% 10.00% 10.77%

This table reflects application of the regular federal income tax only; other taxes may be applicable with respect to a particular shareholder. Such taxes could change the information shown. Tax rates are subject to change.

This table is for illustrative purposes only; investors should consult their tax advisers with respect to the tax implications of an investment in a Fund that invests primarily in securities the interest on which is exempt from regular federal income tax.

Emerging Market Bonds

In recent years, emerging market bonds have evolved from an asset class utilized primarily by ultra-

high net worth individuals and institutions, to one that is now more of a complementary component

to most investors’ fixed-income portfolios. The inclusion of emerging market bonds in an investor’s

portfolio can provide several distinct advantages as compared to other, traditional fixed-income securities.

Emerging market bonds have a low correlation to other fixed-income investments such as domestic

sovereign and corporate debt. They can also provide broader country exposure to a portfolio comprised

of domestic and developed international securities. Their low correlation to other asset classes and

geographic diversification benefits have the potential to provide enhanced returns while helping to

manage risk in an investor’s portfolio by providing additional diversification.

While global economic growth has moderated, the demand for certain commodities will likely remain

robust as countries invest in manufacturing and infrastructure projects. There are a number of emerging

market countries that are rich in natural resources, such as crude oil (Russia and Venezuela) and iron

ore (Brazil). Should export earnings in these emerging market countries rise, it will allow them to inflate

their current account surplus or reduce their current account deficits, increase their national currency

reserves, etc., all of which leads to stronger economic growth. In addition, there are some very strong

companies in these regions and it is worth mentioning that much of the emerging market debt is now

investment grade, approximately 55% currently and that number is expected to rise.5

Also, while risks still exist in this market, they have been reduced as qualifying emerging market

countries now have the benefit of being able to access the International Monetary Fund’s (IMF)

“Flexible Credit Line (FCL)” program. When a country faces the prospects of an economic crisis, it

may have trouble accessing funds in the capital markets. Short-term funding is often needed in order

to weather the crisis and reassure financial markets and investors. The FCL was designed to provide

5. Source: JPM EMBI Global Diversified Index make-up as of 12/31/11.


12

these qualifying countries large and up-front access to IMF resources with no ongoing conditions.

By giving emerging market countries access to these resources, future economic crisis within these

countries can potentially be mitigated and/or prevented.

Finally, emerging market bonds have the potential to provide an additional layer of return to an investor’s

portfolio while reducing interest rate risk. As shown in Figure 11, during the last two periods of rising

interest rates, emerging market bonds (as represented by the JP Morgan EMBI Global Index) have

significantly outperformed traditional domestic fixed-income securities such as corporate bonds

and Treasurys (as represented by BarCap U.S. Aggregate Index and BarCap U.S. Treasury Index, respec-

tively). Foreign securities can be subject to greater risks than U.S. investments, including

currency fluctuations, greater price volatility, and political and economic instability. These risks are

likely to be greater for emerging markets than in developed markets.

FIGURE 11: EMERGING MARKET BONDS PERFORMANCE IN RISING INTEREST RATE ENVIRONMENTS

Annu

aliz

ed R

etur

n, %

1/1/99-9/30/00

■ JPM EMBI Global Index ■ BarCap U.S. Aggregate Bond Index ■ BarCap U.S. Treasury Index

12/1/03-9/31/070

5

10

15

20

25

3.52 3.02

20.92

9.73

4.06 3.90

Source: Morningstar. Past performance is no guarantee of future results.

Dividend-Paying Stocks

Investors may not think of equities when they think of income, but dividend-paying stocks can be a

very attractive source of cash flow. Dividends are a portion of profits that are paid by a corporation to

its shareholders. When a corporation earns a profit or surplus, that money can be put to several uses:

it can be re-invested in the business, used to pay down debt, for stock buybacks, or it can be paid

to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the

remainder as a dividend.

Income-oriented investors seeking a conservative approach to equities and who may not be comfortable

with the volatility of more aggressive equity products, may want to consider dividend-paying equity

funds. They provide investors with both current income and the potential for long-term capital growth

to help preserve purchasing power.

Independent research shows that dividend-paying stocks have historically outperformed stocks that

do not pay dividends. The chart in Figure 12 shows historical performance for those S&P 500 Index

stocks that paid dividends versus those stocks that did not. As you can see from Figure 12, a $100


13

initial investment made 25 years ago on December 31,1986, would have grown to $608 if invested

in the dividend-payers versus only $134 if the investment was made in the non-payers. Stocks are

subject to market fluctuations and may lose value.

FIGURE 12: DIVIDEND-PAYING STOCKS VS. NON-DIVIDEND-PAYING STOCKS IN S&P 500 INDEX

12/31/86

12/31/87

12/31/88

12/31/89

12/31/90

12/31/91

12/31/92

12/31/93

12/31/94

12/31/95

12/31/96

12/31/97

12/31/98

12/31/99

12/31/00

12/31/01

12/31/02

12/31/03

12/31/04

12/31/05

12/31/06

12/31/07

12/31/08

12/31/09

12/31/10

12/31/11

$1,000900800700600500400300200100

0Valu

e of

$10

0 In

vest

men

t

Non Dividend-Paying Stocks

All Dividend-Paying Stocks$608

$134

Last 25 years ending December 31, 2011

Source: Ned Davis Research. The S&P 500® Index is widely regarded as the standard for measuring large-cap U.S. stock market performance. Past performance is no guarantee of future results.

In addition to providing diversity of income sources, dividend-paying stocks may also act as a hedge

against inflation due to the inherent growth potential of equities. As illustrated previously, stocks are

also less sensitive to the movement of interest rates compared with Treasury bonds. Figure 13 shows

the historical sources of returns for the S&P 500 Index. In a rising rate environment as seen in the

1970s and 1980s, dividends and earnings accounted for a larger part of equity returns, indicating

that dividend-paying equities have the potential to offer regular income in a rising rate environment.

Dividends fluctuate and are subject to change. There is no guarantee that they will be paid. While

dividends may cushion returns in down markets, investments are still subject to loss of the principal

amount invested.

FIGURE 13: COMPONENTS OF TOTAL RETURNS BY DECADE

25%

20%

15%

10%

5%

0%

–5%

–10%

–15% 1927- 1930- 1940- 1950- 1960- 1970- 1980- 1990- 2000- 1927- 1929 1939 1949 1959 1969 1979 1989 1999 2009 2009

■ Combined Effects (cross terms) ■ P/E Change ■ EPS Growth ■ Dividend Reinvestment Total Return

21.5%

0.1%–1.0%

9.7%

8.9%

18.9%

7.7%

5.8%17.2% 18.0%

S&P 500 Index 1927-2009

Source: Epoch Investment Partners, Inc.; Standard & Poor’s. The S&P 500® Index is widely regarded as the standard for measuring large-cap U.S. stock market performance. Past performance is no guarantee of future results.


14

Investing for Income: Bringing It All Together

While each of the asset classes discussed are unique in their ability to generate income and weather a

change in interest rates, the benefits of diversification also apply when constructing a portfolio designed to

generate income. To demonstrate this point, we conducted a case study using a hypothetical investment

of $100,000. Taking a look at the last time period during which interest rates were rising (2003-2007),

we analyzed the income and return potential of a portfolio consisting of only Treasurys versus a blended

income portfolio. In Portfolio A, we invested the entire $100,000 in General U.S. Treasury Funds. In

Portfolio B, we allocated equal portions of the $100,000 to Treasury bonds with different durations,

floating rate loans, high-yield bonds, municipal bonds, emerging market bonds, and dividend-paying

equities. As you can see from the illustration below, not only did the blended portfolio (Portfolio B) generate

a higher income than Portfolio A, the ending value of the investment was greater as well. The investments

in Portfolio B carry inherently higher risks than Treasurys. High-yield bonds (“junk bonds”) are considered

speculative; emerging market bonds are subject to foreign securities risks; and, as previously discussed,

payment of dividends is not guaranteed. Government bonds and Treasury bills are guaranteed by the

U.S. government and, if held to maturity, offer a fixed rate of return and fixed principal value.

FIGURE 14: INCOME AND TOTAL RETURN FOR GENERAL U.S. TREASURY FUNDS VERSUS BLENDED PORTFOLIO

Growth of $100,000 —Total Return

Blend General U.S. Treasury Funds

Blend General U.S. Treasury Funds

$126,316.25

$116,496.99

Cumulative Income 12/03–8/07

$13,030

$16,307

$135,000

$130,000

$125,000

$120,000

$115,000

$110,000

$105,000

$100,000

$95,000

$90,00012/03 4/04 8/04 12/04 4/05 8/05 12/05 4/06 8/06 12/06 4/07 8/07

$20,000

$18,000

$16,000

$14,000

$12,000

$10,000

$8,000

$6,000

$4,000

$2,000

0

Source: MainStay Investments, 12/31/03-8/31/07. Asset classes are represented by their respective Lipper mutual fund categories. For the purpose of this illustration, category averages were used to determine income and total return. This example is hypothetical in nature and does not represent an investment in a specific fund or index. Returns do not reflect the deduction of the fees and charges that are normally associated with these investments. Performance may be lower once fees and charges are taken into account. Past performance is no guarantee of future results.


15

Special Considerations for Retirees— Timing Can Be Everything When It Comes to Retirement Income

As discussed in the previous sections of this paper, it is prudent for income-oriented investors to

construct a portfolio comprised of uncorrelated sources of income. However, investors who are

entering or already in retirement may require more than a mix of stocks and bonds to secure income

for life. For retirees looking to supplement Social Security or other traditional sources of retirement

income, lifetime income annuities serve as a guaranteed source of cash flow that is uncorrelated to

the equity and fixed-income markets.

Today’s retirees face multiple financial risks, including longevity risk, withdrawal risk, inflation risk,

and perhaps most critical for people recently retired or entering retirement right now, market risk.

While average annual returns are the primary focus in the accumulation stage of investing, “order” or

“sequence” of returns can matter most in the distribution (income) phase of investing. Essentially what

this means is that the market conditions when an individual retires will play a key role in determining

whether or not retirees will have sufficient income for their lifetime. Early losses in retirement can

materially impact portfolios, leaving insufficient funds to last throughout retirement. Unfortunately,

many baby boomers have experienced this type of volatility first hand over the past decade.

FIGURE 15: MARKET RISK AND RETIREMENT INCOME

$1,400,000

1,200,000

1,000,000

800,000

600,000

400,000

200,000

01959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989

Value of Assets if Investor Had Retired in a Good Year (1959) — 50% equity, 50% bonds

4% Withdrawal Rate

5% Withdrawal Rate

6% Withdrawal Rate

Asse

t Val

ue

Year

$1,400,000

1,200,000

1,000,000

800,000

600,000

400,000

200,000

01966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996

Value of Assets if Investor Had Retired in a Bad Year (1966) — 50% equity, 50% bonds

4% Withdrawal Rate

5% Withdrawal Rate6% Withdrawal Rate

Asse

t Val

ue

Source: New York Life, 2008. Hypothetical value of assets held in an untaxed account of $1,000,000 invested in a portfolio of 50% stocks and 50% bonds. The illustration uses historical annual performance from 1959-1989 and from 1966-1996 obtained from Ibbotson Associates. Past performance is no guarantee of future results. Stocks are represented by S&P 500 Index and bonds by Morningstar U.S. Intermediate Government Bond Index. Each withdrawal rate is adjusted annually for inflation using historical rates. The portfolio is rebalanced annually and assumes an annual deduction of 125 and 75 basis points for management fees for stocks and bonds, respectively. This example does not take into account taxes, if any. This example is for illustrative purposes only and does not represent the performance of an actual investment. Note: an investor cannot invest directly in an index.


16

In Figure 15, the top chart depicts an individual retiring in the bear market of 1966, looking at three

different withdrawal rates. As illustrated, there’s a good chance that an investor retiring during a down

market will outlive their assets even if they have a substantial nest egg at the time of retirement.

Furthermore, as the bottom chart in Figure 15 illustrates, retiring in a bull market may still result in

failure with a withdrawal rate higher than 4%.

Withdrawal rate is a significant factor in determining retirement income success. For decades, finance

experts and academics have put forth great efforts to determine the ideal withdrawal rate for retirees.

Part of the reason why this exercise is so difficult is because it is impossible to know with certainty how

long one will live. Today, most experts have settled on a recommended withdrawal rate of approximately

4%, with many retirees requiring a higher rate in order to achieve their desired lifestyle. On the other

hand, withdrawal rates of two or three percent may succeed but may not provide sufficient income for

retirees to live their desired lifestyle or even cover basic expenses.

With life expectancies becoming progressively longer, and financial markets increasingly more

unpredictable, outliving their income is one of retirees’ greatest concerns. Individuals who are

supplementing retirement income from retirement plans and Social Security, or who want to establish

a higher withdrawal rate, should consider guaranteed lifetime income annuities, which are fixed

immediate annuities. With a single premium fixed immediate annuity, individuals pay a single premium

to an insurance company, and in return the insurance company makes monthly payments to the client

for their lifetime. These payments are fixed, do not fluctuate with market performance, and are guaran-

teed. However, the guarantees are subject to the claims-paying ability of the issuer. By allocating

a percentage of their assets to lifetime income annuities, investors are able to construct an income

stream like a “personal pension.” Retirees can diversify their income sources with the confidence that

a portion of that income does not change with the market, and is also guaranteed for life. Investors also

have the ability to customize an income stream that meets their individual needs and circumstances,

including securing income for a spouse or legacy planning. There are also options that allow investors

to protect against inflation, whereby income starts out lower and increases over time.

Retirees may be hesitant to lock in a lifetime annuity while interest rates are low, believing that the

payout will be higher when interest rates rise. While there is some element of truth to this notion,

payout rates may not fluctuate as much as investors think.


17

While interest rates fluctuated significantly from 2005-2010,6 Figure 16 shows that the payout rates

for sample lifetime income annuity portfolios remained very consistent. Of course, the General Account

of an insurance company, which backs the payout of a fixed annuity, can also be negatively affected by

fluctuating interest rates, and one of the purposes of an annuity is to deplete the principal, in contrast

to how a bond works, where principal is returned to the investor when he or she holds the bond to

maturity.

Some providers have options, often referred to as an “income enhancement” option, which enables

clients to lock in guaranteed income now, while still taking advantage of rising interest rates. The

option works in conjunction with a benchmark interest rate index so that if interest rates rise within a

certain time frame, the payout will adjust. For investors requiring guaranteed income for life, there’s no

reason to delay purchasing a lifetime income annuity due to low interest rates.

FIGURE 16: NEW YORK LIFE INCOME ANNUITY PAYOUT RATES

12%

10

8

6

4

2

0 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 1/10

2005-2010 by Quarter (includes both interest and return of premium)

LIA Male 75

Year

LIA Male 65

VERY IMPORTANT NOTE RE THIS CHART:Chris Mauer asked that the data points for the LIA Male 75 be �guredout from the existing chart (which did NOT include data points). I established the values for this points using measurements and used themfor the Male 75.I then took each of these values and tracked them 1.4% lower. I used thesenumbers for the Male 65 line as per Chris’ e-mail and phone discussionof March 25, 2011.

Source: New York Life Insurance Company. Lifetime income annuity (LIA) payout rates are for the New York Life Lifetime Income Annuity and are based on the rates that are in effect on the first calendar day of each quarter and include interest and return of principal. They represent the annualized payouts as a percent of total premium. LIA rates are based on rates in effect on the first calendar day of each quarter, using a “Life with Cash Refund Payout Option” for a male ages 65 and 75 years old. Note that LIA payout rates may be lower than shown based on age, gender, and payout option selected. Issued by New York Life Insurance and Annuity Corporation (a Delaware Corporation), a wholly owned subsidiary of New York Life Insurance Company. All charges related to the insurance features and options of the annuity, such as mortality and expense charges, are applied in the payout made to the client.

Incorporating a lifetime income annuity into a portfolio takes the pressure off of withdrawals, leading

to greater certainty that retirees won’t outlast their portfolios, and the potential to leave a legacy.

6. Source: Ned Davis Research. Based on two-year Treasury note yields, which closely track the Federal Funds Rate, 2005-2010.


18

In ConclusionIncome-oriented investors want durable and dependable cash flow, and one way to achieve this is by

diversifying income sources with investments that provide independent and uncorrelated cash flows

over time. While there are a number of asset classes that are well positioned to provide income in

the current environment and looking forward, it’s important to understand that not all funds and/or

investment solutions are created equal. Product and investment manager selection is a key component

of achieving investment success. At New York Life Insurance and Annuity Corporation and MainStay

Investments, we offer a broad range of customized income solutions. New York Life received the

highest ratings for financial strength currently awarded to any life insurer by all four major independent

agencies.7

7. Third-Party Ratings Report as of 1/25/2012: A.M. Best A++, Fitch AAA, Moody’s Aaa, Standard & Poor’s AA+.


19

The information and opinions herein are for general information use only. New York Life Investments

assumes no liability for any loss that may result from the reliance by any person upon any such

information or opinions. Such information and opinions are subject to change without notice, and are

not intended as an offer or solicitation with respect to the purchase or sales of any security or as

personalized investment advice.

Appendix for Figure 1

DMac

is annual, I= is periodic rate, m = payment frequency

DMod = DMac

(1+i)DMac =

t=1 (1+i)t

N CFt t

VB

C = (1+i)21

t=1

N

(1+i)t

CFt (t2+t)[VB

]


20

Index Definitions

Emerging Market Bonds are represented by J.P. Morgan EMBI Global Diversified Index, an unmanaged, market-capitalization weighted, total-return index tracking the traded market for U.S. dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.

Municipal Bonds are represented by Barclays Capital Municipal Bond Index, an unmanaged index that includes approximately 15,000 municipal bonds, rated Baa or better by Moody’s, with a maturity of at least two years.

Floating Rate Loans are represented by Credit Suisse Leveraged Loan Index, a representative index of tradable, senior secured, U.S. dollar-denominated non-investment grade loans.

Corporate Bonds are represented by the Barclays Capital U.S. Credit Index, an unmanaged index which is unbundled into pure corporates (industrial, utility, and finance, including both U.S. and Non-U.S. corporations) and non-corporates (sovereign, supranational, foreign agencies, and foreign local governments).

Barclays Capital 1-3 Year Treasury Index is an unmanaged index that includes all publicly traded, U.S. Treasury securities that have a remaining maturity between one-three years, are non-convertible, are denominated in U.S. Dollars, are rated investment grade or better by Moody’s Investor Services, are fixed rate, and have $250 million or more of outstanding face value.

High Yield Corporate Bonds are represented by The Barclays Capital U.S. Corporate High Yield Index, a total return performance benchmark for fixed-income securities having a maximum quality rating of Ba1 (as determined by Moody’s Investors Service).

U.S. Equity is represented by the S&P 500 Index. The S&P 500 Index is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

International Equity is represented by the MSCI EAFE Index. The Morgan Stanley Capital International Europe (MSCI), Australasia, and Far East (MSCI EAFE) Index is composed of all the publicly traded stocks in developed non-U.S. Markets. The MSCI EAFE Index consisted of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.


21

Index Definitions (continued)

World Equity is represented by the MSCI World Index. The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance. The MSCI World Index consists of the following 24 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States.

The Merrill Lynch 3-Month T-Bill Index is an unmanaged index that measures returns of three-month Treasury Bills.

MainStay Investments is a registered service mark and name under which New York Life Investments does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. New York Life Investments engages the services of federally registered advisors to subadvise the Funds. Epoch Investment Partners, Inc. is unaffiliated. Fixed Income Investors Group (Fixed Income Investors) is a multi-product fixed income investment manager and a division of New York Life Investments.MacKay Shields LLC is an affiliate. Fixed annuities issued by New York Life Insurance & Annuity Corporation (NYLIAC), New York, NY, a Delaware Corporation and wholly owned subsidiary of New York Life Insurance Company (NYLIC). Guarantees relate only to fixed annuities and are based on the claims-paying ability of NYLIAC. Insurance products issued by NYLIC. NYLIAC, and NYLIC ratings based on Third Party Ratings as of January 2012 ( A.M. Best A++, Moody’s Aaa, Fitch AAA,Standard & Poor’s AA+). Ratings or guarantees do not apply to the investments offered through NYLIFE Distributors, which will fluctuate in value due to market conditions. For most jurisdictions, the policy form numbers for the New York Life Lifetime Income Annuity are 203-169 for the Life Only Annuity; 203-170 for the Primary and Secondary Joint Life Annuity; 203-171 for the Life Annuity with Percent of Premium Death Benefit; 203-172 for the Life Annuity with Cash Refund; 203-173 for the Life Annuity with Period Certain; 203-174 for the Primary and Secondary Joint Life Annuity With Period Certain; and 210-195 for the Life Annuity with Installment Refund. For most jurisdictions, rider form numbers are 205-300 for the Changing Needs Rider; 206-300 for the Income Enhancement Rider; 206-308 and 206-309 for the 30% Cash Withdrawal Rider; and 206-310 for the Up to 100% Cash Withdrawal Rider. Securities distributed by NYLIFE Distributors LLC, 169 Lackawanna Avenue, Parsippany, NJ 07054.

Not FDIC/NCUA Insured Not a Deposit May Lose Value No Bank Guarantee Not Insured by Any Government Agency

NYLIM-21197 446874 CV RIS014-12 RIS38a-03/12

Documents

Positioning portfolios for today’s interest rate environment...portfolio in today’s market. 1. Sources: Bond allocations—Ned Davis Research, Inc., bonds as a percentage of financial