epo ricert · 2015. 4. 24. · issue no. 110 winter 2011 promising recovery, persistent risks stock...

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Issue No. 110 Winter 2011

Promising Recovery, Persistent RisksStock investors certainly became familiar with volatility over the last 10 years. The decade saw two of the worst bear markets in modern history—and strong recoveries from each. It was a rare period in which bonds outperformed U.S. large-capitalization stocks.

In the coming decade, market vola-tility may well continue. But Brian Rogers, T. Rowe Price chairman and chief investment officer, believes equity returns will be “much better than what we’ve seen over the last decade.” Conversely, bonds are unlikely to repeat the last decade’s outperformance, with the 30-year decline in interest rates showing signs of ending.

Expecting stocks will advance at roughly the pace of economic growth—2% to 4%—plus the long-term inflation rate of 1% to 3% and additional gains from dividends and operating efficiencies, Mr. Rogers says, “Equity returns over the next 10 years could well average in the 7% to 10% range again.”

On the following pages, T. Rowe Price equity managers detail a wide range of opportunities for 2011—from reasonably valued stocks in developed markets to the growth potential of emerging market equities. Fixed income managers are looking for more modest returns but continued good performance in riskier sectors.

In line with that, Bill Stromberg, director of global equity, cites some encouraging corporate trends: exceptional levels of productivity from global blue chips, surprisingly strong corporate earnings and cash flow, record cash on balance sheets, and the positive impact of emerging economies on global growth.

“Two years ago, few would have forecast that profit margins, earn-ings, and cash flow would recover so strongly,” he says.

At the same time, he acknowledges the challenging macroeconomic envi-ronment, including fiscal imbalances in the developed world, diverging policy responses (European austerity versus the U.S. stimulus), increased regulation (in the health care, energy, and financials sectors), and persistent risk aversion among investors.

“We think the headlines will con-tinue to be scary from time to time, particularly because fiscal imbalances have put us in uncharted territory,” Mr. Stromberg says. “Developed market recoveries seem sustainable but are still vulnerable to shocks. Emerging economies have terrific long-term prospects but, true to their past, will likely remain cyclical.”

InsIde ThIs Issue

2 Economic Rebound Gaining Momentum in 2011

4 U.S. Stocks: Recovery Continues Despite Headwinds

6 International Stocks: Riding Emerging Market Growth

8 Bond Outlook: More Modest Returns Expected in 2011

10 Performance Spotlight: Latin American Stocks and Emerging Market Bonds Are the Decade’s Leaders

12 Investment Viewpoint: Despite Recent Sell-Off, Municipal Bonds Offer Value

14 Reflections as the Equity Income Fund Marks 25 Years

15 Market Timing, Emotions, and Asset Allocation

16 Personal Finance: Dismal Decade Offers Cautionary Lessons for Retirees

19 Performance Update • Equity Market Review • Fixed Income Market Review • Fund Performance Tables

2 www.troweprice.com

Perspectives

As Economic Growth Accelerates...

Sources: Bureau of Economic Analysis, Haver Analytics, and T. Rowe Price.

- - Q4’10–Q4’11 Are T. Rowe Price Forecasts— Real GDP

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Economic Rebound Gaining Momentum in 2011By Alan Levenson, T. Rowe Price Chief Economist

With wounds sustained during the 2008–2009 crisis healing and aggres-sive fiscal and monetary policy action gaining traction, the U.S. economic recovery appeared to be gaining momentum as 2010 came to a close. That should continue this year.

We expect a 3.5% advance in real gross domestic product (GDP) growth over the four quarters of 2011 after an estimated 2.8% rise in 2010.

Moreover, the economic landscape this year should feature a sustained decline in the unemployment rate and a turn toward higher inflation, albeit at a gradual pace and from a low starting point.

The aftereffects of the housing bust will still be evident: The overhang of vacant housing units, though declining, will be a lingering drag on new construction, which will contribute little to economic growth. In contrast, the consumer outlook is markedly brighter than a year ago.

Repair of household sector finances is well advanced. Household debt fell to less than 110% of disposable income at the end of 2010 from a cycle-high 123% at the end of 2007. More significantly, periodic principal and interest payments—the burden of servicing that debt—fell to less than 12% of disposable income, down from a 13.9% peak in 2007. Less money spent paying for past purchases leaves more money to finance current consumption or to boost saving flows.

Meanwhile, the personal saving rate stabilized last year at 5.8%, a level sufficient to foster meaningful balance sheet repair. A stable or only gradually rising saving rate in 2011 means that household sector

deleveraging will not slow spending relative to the growth in disposable income.

In addition, the income trend is improving, even before taking into account tax relief measures enacted in December. A healing labor market added 1.3 million private sector jobs last year, and private industry wage and salary income expanded at a 4.1% annual rate. (In 2009, private industry employment lost 4.7 million jobs, and wage and salary income fell 2.5%.)

Overall, real consumer spending should grow by 3.4% in 2011, a full percentage point faster than in 2010.

Fundamental underpinnings are strongest in the outlook for business capital spending. Business outlays for plants and equipment rose by about 10% last year and should continue at near that pace this year. The spending pace has ample upside as businesses move to expand operations in the wake of deep cutbacks during the recession.

Following are some other

observations on how the 2011 economy may unfold on several important fronts:• Unemployment: As the pace of growth quickens, and with produc-tivity gains limited after an earlier surge, job growth will gain strength. We expect nonfarm payroll employ-ment to rise by 1.9 million in 2011—sufficient to start a sustained decline in the unemployment rate to 8.6%.

This outlook falls short of previous labor market recoveries following deep recessions, as the economy is still contending with right-sizing in construction, retailing, and financial services to lower, less-leveraged levels of demand. Also, debt-containing cutbacks by state and local govern-ments will continue to hamper the overall employment rebound. • Inflation: Core inflation measures are near all-time lows: For the first time in 50 years, the consumer price index (CPI), excluding food and energy, posted sub-1% year-to-year readings in the final months of 2010.

www.troweprice.com 3

...Unemployment Rate Should Trend Down

Sources: Bureau of Labor Statistics, Haver Analytics, and T. Rowe Price.

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- - Q4’10–Q4’11 Are T. Rowe Price Forecasts— Unemployment Rate

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Nonetheless, the underlying inflation trend is likely near a cycle trough.

We expect 1.25% core inflation this year and a 1.8% gain in the “head-line” CPI (including food and energy) compared with a 1.2% rise in 2010.

Unit labor cost inflation—a key driver of output price trends—turned up last year as productivity gains moderated and wage growth stabi-lized. A declining unemployment rate will reinforce this development. In addition, a weaker dollar—par-ticularly relative to the currencies of less-developed economies, where inflation pressures are greater—has import prices on simmer.

Finally, housing costs—accounting for roughly 40% of core CPI—have begun to rise, reflecting a downturn in residential vacancy rates. • Policy Response: The Fed’s decision to implement an additional $600 billion increase in its securi-ties portfolio—dubbed QE2—contributed to a financial market rally that lifted household wealth and bolstered business confidence in last year’s final months. In addition, a bipartisan compromise to delay scheduled increases in marginal tax rates and to extend income support provisions of last year’s stimulus

programs will add significantly to consumer wherewithal in 2011.

We do not expect active tighten-ing of current policy stances during 2011. The Fed is unlikely to raise the federal funds rate until late this year or early 2012.

As for fiscal policy, we do not expect a sharp turn from stimulus to restraint. At the same time, we are hopeful that policymakers’ greater willingness to discuss U.S. long-term fiscal challenges will evolve to bring the federal budget onto a sustainable path.• Potential Risks: Risks to this growth outlook include the possibil-ity that policymakers will not engage constructively and credibly to address U.S. fiscal challenges. A solution, in our view, must include entitlement reform (both Social Security and Medicare) as well as revenue enhance-ment. A loss of confidence in financial markets could result in higher interest rates, a weaker dollar, and lower share prices.

In addition, a banking crisis in the euro area could reverberate into the U.S. economy. A funding squeeze on European banks could pressure the assets of U.S. money market funds, which hold a significant

share of their assets in short-term European bank debt.

Other downside risks include a resumption of downward pressure on house prices in the absence of homebuyer incentives, which would pinch consumer spending. Finally, ongoing fiscal consolidation among state and local governments could be more severe than expected.• Upside Surprises?: At the same time, the economy has some upside potential. Perhaps the most immedi-ate is that the lift to consumer and business confidence from the latest stimulus measures could release pent-up demand. For example, vehicle sales are 20% below our estimate of long-term demand. Similarly, the allowance of a 100% write-off of capital outlays in 2011 could stimulate greater capital spending.

In addition, the 2009 productiv-ity surge and a weaker dollar have improved the competitiveness of U.S. products in world markets. A stronger export performance than expected could contribute to growth.

Finally, as heretical as this may sound, there is scope for an upside surprise in housing. The current pace of housing starts is roughly half of what will be required over time to meet the needs of a growing population. Over some period of time, the rate of new construction is going to double. We are forecasting a very gradual, four-year path to this long-run equilibrium, but a faster recovery is possible.

All in all, a more confidence-inspiring economic picture should emerge this year.


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Returns are based on performance of the S&P 500, Russell 2000, Russell Midcap, Nasdaq Composite, and Wilshire Real Estate Securities Indexes. The Wilshire index consists of publicly traded real estate investment trusts and real estate operating companies.The Nasdaq Composite is composed mostly of technology companies.

U.S. Markets Continue Recovery in 2010Total Return for Various Stock Indexes

Nasdaq

29.1

26.825.5

16.915.0

The rate of the U.S. economic recov-ery is modest. As this year opened, the unemployment rate persisted near 10%. And there are growing concerns about the U.S. fiscal condition.

Still, U.S. stocks advanced last year, and T. Rowe Price portfolio managers see these gains extending into 2011, particularly for large-capitalization growth stocks.

“We’re facing challenges now that I’ve never seen in almost 18 years of managing this fund—like 10% unemployment—but the outlook could continue to be favorable,” says Larry Puglia, portfolio manager of the Blue Chip Growth Fund.

“This is a volatile market in which it pays to be nimble. There’s a lot of divergent performance within sectors and industries, and that creates invest-ment opportunities.”

Over the last decade, international stocks outperformed those in the U.S., value stocks beat growth stocks, and small- and mid-cap stocks trounced large-caps.

“If you bake that all together, we may have an environment in which domestic large-cap stocks are poised for additional recovery,” Mr. Puglia says. “And typically when cycles of

U.S. Stocks: Recovery Continues Despite Headwindsoutperformance begin transitioning, they can persist for some time.”

Reasonable Valuations

A key factor for large-cap U.S. stocks is that their valuations are reasonable. The forward 12-month price-to-earnings ratio for the S&P 500 Index began 2011 at 13.6x versus the mean of about 14.4x since 1950.

“The market is reasonably valued,” says Brian Rogers, T. Rowe Price chairman, chief investment officer, and manager of the Equity Income Fund.

Rob Bartolo, manager of the Growth Stock Fund, notes that U.S. equities also are “cheap relative to other asset classes.” For example, the S&P 500’s earnings yield is significantly higher than the 10-year Treasury bond yield.

Mr. Puglia lists other positives:• Large-cap stock profitability has

grown, with the share of stocks with improving pretax margins rising from about 35% in the early 2009 market trough to more than 71% as 2011 opened.

•Atthesametime,withcapitalspending having been restrained so far, there is potential for more gains.

• Investorsentered2011withbuyingpower, holding almost 50% of their discretionary financial assets in cash or bonds, similar to the highs of the 1980s.

• S&P500gainsfrombearmarketbottoms have averaged 176% since 1947, but the index rose just 93% from March 9, 2009, through 2010.

Accessing Global Growth

In the current rally, S&P 500 sectors that declined the most in the 2007–2009 market crash—financials, industrials, materials, consumer discretionary, and information technology—have been leaders. And pretax margin expansion has been most notable in such sectors as consumer durables, capital goods, and technology.

T. Rowe Price managers believe these sector trends will persist in 2011.

But Mr. Rogers also notes that the gains to date have been driven to a great degree by “massive cost-cutting, so real questions remain about top-line revenue growth.”

In line with that, T. Rowe Price managers say that large-cap multi-national companies with easier access to capital and to emerging market growth—companies able to benefit from global consumer and industrial growth and take market share—are relatively well positioned.

As a result, the Growth Stock Fund, for example, is overweight consumer discretionary and indus-trial stocks with international expo-sure. These investments range from such premium global brands with strong emerging market exposure as Nike and Starwood (hotels) to such export firms with a high level of technology as John Deere, Emerson Electric, and 3M.


Playbook for the Rally: The Last Shall Be FirstTotal Return for S&P 500 by Sector

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Sources: Wilshire and T. Rowe Price.

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� Market Peak to Trough (10/3/2007–3/9/2009) � Market Trough to 12/31/2010

Peak to Trough (10/3/2Financials -81.7 1Industrials -63.5 136.2Materials -58 1Consumer Disc. -56.6 1IT -52.4 106.3Telecom -47.7 62.1Energy -45.4 6Utilities -42.9 5Health Care -38 49.6Consumer Staples -28.8 6

Also, a third of the fund is invested in such global consumer technology stocks as Apple and Google and in such payment processing companies as Visa and MasterCard. “I’m buying stocks that can ride with the economy and take advantage of this stage of the business cycle,” Mr. Bartolo says.

One cyclical sector that has out-performed the S&P 500 for nine of the last 11 years is natural resources. Tim Parker, manager of the New Era Fund, which focuses on natural resources and invests primarily in U.S.-based firms, sees the potential for this long-term record continuing.

The sector already has bounced back from last year’s downturn due to economic concerns and the Gulf of Mexico oil spill, with some commodi-ties at new highs. Natural resource prospects, Mr. Parker says, are grounded in “tight supply from sys-tematic underinvestment the last few years facing strong demand growth from emerging market economies.”

The global financial crisis “was a pause, not an end, to the commodity cycle,” he adds. “These are long cycles in which a persistent wave of demand catches supply unaware. We’ve seen this before, and we’ve got some years to go in the current cycle.”

Risk Aware

In contrast to investors in large-caps, investors in pricier small-cap U.S. stocks may face some valuation risks, Greg McCrickard, manager of the Small-Cap Stock Fund, acknowledges.

“It’s time to be careful with small- caps,” he says. “They’ve had a long run of outperformance at premium valuations that’s likely coming to an end. They’re not going to fall off a cliff, but my guess is they will under-perform large-caps in 2011.”

Still, he sees promising recovery-oriented small-cap plays in trucking, energy (as an inflation hedge), and such late-cycle industrials as Valmont Industries and General Cable, both of which make power transmission products.

“This market may surprise us because the economic underpinnings are improving day by day,” Mr. McCrickard says. “But the wild card is that economic growth is at not much more than 2%. If something bad happens or if inflation picks up strongly, there’s not much cushion.”

Indeed, S&P 500 earnings growth— which fueled 2010’s positive returns by rocketing to a surprising degree—is expected to slow.

Joe Milano, portfolio manager of the New America Growth Fund, worries that the current economic recovery could turn out weaker than anticipated. “Every country in the world except for China and a few others has too much debt,” he says. “That’s kind of like driving your car with the emergency brake on.

“The recovery has been rapid on the corporate level, but the slope of that improvement is not going to be as steep in 2011 and 2012. I feel like the fundamentals are good—and they’re probably going to stay good—but they’re not going to accelerate.”

Mr. Bartolo is more optimistic: “We could be still in the relatively early stages of an economic recovery. I see slow but gradual growth and contin-ued reduction of fears of a double dip, bringing risk appetites back as people feel more confident we are not on the precipice of another crisis.”

Even if that’s the case, T. Rowe Price managers, citing the recent European debt crisis and the Gulf oil spill, all note the persisting risks from global debt imbalances and unpredict-able exogenous shocks.

“The stock market is going to be a good place to be, but this isn’t a year to get complacent,” Mr. Milano says. “There’s still a lot of fragility out there.”

Adds Mr. Rogers, “There is never a time when something can’t go wrong. It’s virtually impossible to predict some events. You just have to be prepared to deal with them.”

As of 12/31/10, companies men-tioned in this article by Mr. Bartolo made up 19.9% of the Growth Stock Fund. Those mentioned by Mr. McCrickard made up 1.6% of the Small-Cap Stock Fund.


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Relative Stock Valuations in International MarketsPrice/Earnings Ratio Based on Estimated 12-Month Earnings

JapanAsia Pacific ex Japan

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The bars show the price/earnings ratio (a measure of stock valuation) for various regions as of December 31, 2010. The lines on each bar show the high, low, and average (the square) based on the prior 10 years. On average, developed markets in North America and Europe are selling at below-average valuations, while emerging market valuations are generally above average but still less than those of developed markets.Source: FactSet.

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The good news for U.S. investors, who have been increasingly looking abroad for returns, is that emerging market consumers are expected to continue driving healthy stock gains over the long term—for companies in both developing and developed markets around the world.

But the caution is that emerging markets likely will continue to be volatile, face political and policy risks, and contend with the threat of infla-tion, despite the rapid and pervasive improvements in their fiscal health.

And even with this focus on emerg-ing market opportunities, T. Rowe Price managers stress that there is a wide range of attractively priced opportunities in developed markets.

Nonetheless, the emerging market growth story—accelerating over the last 15 years on the strength of indus-trialization, urbanization, and rising middle classes—is deepening.

“We think this is a great 10-year investment opportunity,” says Bob Smith, manager of the International Stock Fund. “You’re paying up for it right now, but we think it’s worth

International Stocks: Riding Emerging Market Growthit. If you talk to companies around the world, many of them are putting almost all their resources toward emerging markets.”

While the World Bank predicts that global economic growth will slow from 4.8% to 4.2% in 2011, emerging market economies, though also slow-ing, will still expand at 6.4%—almost double the anticipated U.S. growth rate.

And while companies exposed mainly to U.S. consumers face headwinds, incremental consump-tion spending growth in the BRIC countries (Brazil, Russia, India, and China) has exceeded that in the U.S. in absolute terms each of the last three years.

“Emerging market consumers have become a powerful and real force,” says Gonzalo Pangaro, manager of the Emerging Markets Stock Fund. “You have huge numbers of people whose wages are rising, who are buy-ing their first TVs or refrigerators.”

Moreover, while emerging market stock values have more than doubled off their bottom since early 2009, they

entered 2011 about 20% off their ear-lier highs. “We’re still in the 5th or 6th inning of their recovery,” Mr. Pangaro says. “There’s more room to run.”

Diverse Plays

T. Rowe Price managers are finding multiple ways to profit from the emerging market consumer—directly and indirectly—all over the world.

In 2010, consumer, mining, and financial stocks drove performance for the Emerging Markets Stock Fund, Mr. Pangaro says.

Going into 2011, the fund’s most overweight sectors were consumer discretionary and staples, but its larg-est sector was financials. Emerging market financials, less leveraged and more consumer oriented than their developed world counterparts, were largely unaffected by the global finan-cial crisis, he notes.

On a regional basis, Mr. Pangaro is overweight China, India, and Latin America outside of Brazil, which dominates its regional index.

He likes such diverse companies as Wal-Mart de Mexico, Korea’s LG Household and Health Care, Russian food retailer Magnit, Chilean copper producer Antofagasta, and certain Brazilian and Chinese banks and other financials.

“We’re still finding good opportu-nities where valuations remain reason-able,” Mr. Pangaro says. “Companies may look expensive in the next quarter, but, with 20% or more earn-ings growth, their earnings can double in just a few years.”

Justin Thomson, manager of the International Discovery Fund, which focuses on small-cap stocks, is finding emerging market plays in both devel-oping and developed markets—from Brazilian shopping mall developer Iguatemi to German chemical pro-ducer Wacker Chemie.


Performance of each country is based on its respective MSCI index. The emerging markets average reflects the return for the MSCI Emerging Markets Index.Source: T. Rowe Price Associates, based on RIMES Technologies data.

2010 Emerging Stock Market PerformanceTotal Return in U.S. Dollars

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Brazil ChinaRussiaTaiwan EmergingMarketsAverage

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“The growth of emerging market consumption and infrastructure needs plays right into what Germany does well: producing premium, productivity-enhancing products,” Mr. Thomson says.

Adds Dean Tenerelli, manager of the European Stock Fund, “Europe has really benefited from growth in China and the rest of emerging Asia.”

He also likes German and Scandinavian engineering, machinery, and automation companies capital-izing on emerging market indus-trialization, as well as such direct consumer stocks as Richemont, a Swiss luxury goods holding company with brands (Cartier, Piaget, Alfred Dunhill) that have strong appeal in the developing world.

T. Rowe Price managers are concerned that the favorable scenario for emerging market stocks could be disrupted if the recent U.S. expansion of liquidity—the second quantitative easing by the Federal Reserve—ends up exporting inflation to emerging markets. But some developing nations already have put in place capital con-trols to protect their financial markets.

Developed World

With booming emerging markets, it may be tempting for U.S. investors to shy away from debt-laden developed markets. After all, Japanese growth-driving export stocks have been held back by the strength of the yen, and Europe, of course, has been afflicted with sovereign debt crises and result-ing risk aversion.

But Mr. Smith notes that the price-to-earnings ratios in Europe and Japan, as with U.S. large-cap stocks, are below their 10-year averages, meaning that valuations generally are not extended.

He attributes this to a long list of global political, monetary, regulatory, and tax policy uncertainties, includ-ing: “Will U.S. quantitative easing be successful? Will China bring down inflation without taking that economy to a grinding halt? How will Europe deal with austerity? Will Spain and Portugal need assistance?”

Adds Ray Mills, manager of the Overseas Stock Fund: “The key for the developed world is how it comes to terms with its fiscal situation because what it is doing now is unsustainable. How it deals with that politically is

going to impact economies, and that’s going to affect markets.”

But Mr. Tenerelli says that, when it comes to dealing with its fiscal prob-lems, “the euro zone is a solid block acting as one. It will backstop Ireland and Greece.”

He also notes that “most of Europe is doing very well” because the European debt crisis only has affected nations where the combined gross domestic product accounts for less than 2% of the European Union’s total.

Meanwhile, he says, risk aversion has driven the prices of European stocks to just 11 times estimated 12-month earnings, the cheapest they have been in 20 years.

“This is too cheap when you con-sider that the whole of Europe is, in many ways, doing better than the United States,” Mr. Tenerelli says. “You have very good companies that are very disciplined with their capital and should be trading much higher.

“The market may surprise on the upside. The 2011 wild card is whether the United States and Europe will recover more than people expect. Right now, companies are firing on the 20% of their sales from emerging markets. What happens if the other 80% recov-ers in any significant way?”

As of 12/31/10, the stocks mentioned by Mr. Pangaro made up 6.8% of the Emerging Markets Stock Fund, those mentioned by Mr. Thomson made up 1.0% of the International Discovery Fund, and those mentioned by Mr. Tenerelli made up 2.0% of the European Stock Fund.

International investing is subject to market risk and risks associated with unfavorable currency exchange rates and political or economic uncertainty abroad. Investments in emerging mar-kets are subject to the risk of abrupt and severe price declines.


After back-to-back stellar years, bond markets are likely to take a breather in 2011 as the 30-year secular decline in interest rates may have finally come to an end.

For the two-year period ended December 31, 2010, investment-grade corporate bonds in the U.S. provided a total return of 29.4% as credit conditions and liquidity recovered following the financial crisis and after interest rates hit rock bottom at the end of 2008.

The high yield or “junk” bond market rebounded with a record- setting two-year stretch, returning 76.5%, and emerging market bonds gained 43.6% over the period. (For more perspective on the outlook for emerging market bonds, see page 11.)

Looking ahead, T. Rowe Price bond managers expect more modest returns this year, perhaps less than coupon yields. While Federal Reserve policy should keep short-term rates anchored near zero until 2012, manag-ers expect longer-term interest rates to trend somewhat higher, putting pressure on bond prices.

Indeed, rates already moved sharply higher toward year-end as the extension of the current income tax rates raised concerns that potentially stronger economic growth and the bulge in the budget deficit might affect Treasury supply and inflation expectations.

Overseas, the sovereign debt crisis in Europe could undermine the euro and confidence in European econo-mies and markets. And if the crisis is not contained, it could cause investors to broadly shun riskier assets.

“The ECB [European Central Bank] may be capable of orchestrat-ing a soft landing long term, but its challenge is potentially more difficult to navigate than the one the Fed faced here in 2008 and 2009,” says Mike Gitlin, director of the

Bond Outlook: More Modest Returns Expected in 2011firm’s Fixed Income Division. “The problems in Europe are likely to last years—not quarters—but if managed appropriately, the impact on the U.S. and global economy could be somewhat muted.”

Temper Expectations

In the United States, David Tiberii, manager of the Corporate Income Fund, advises investors to “temper their expectations. We’re starting the year at much lower rate levels, so it will be difficult to have the total returns that we saw last year or the year before.”

Steven Huber, manager of the Strategic Income Fund, which invests across various global bond sectors, notes that not only are interest rates relatively low, but the yield differ-ences of riskier sectors over Treasuries have narrowed considerably over the past couple of years, so investors are paid less for taking credit risk.

Average yields on investment-grade corporate bonds at the start of 2011 were about 4%, or 1.6 percentage points over comparable Treasuries, compared with a spread of six per-centage points two years earlier as the financial crisis was in full swing. Over the past decade, the average spread has been 1.75 percentage points.

High yield bonds started 2011 with yields of about 7% to 8%, and the average spread over comparable Treasuries was six percentage points—in line with the historical average but very narrow compared with two years ago.

Mark Vaselkiv, manager of the High Yield Fund, also worries that with new bond issues reaching record levels, “the quality of new issues has declined. We’re seeing some of the speculative behavior and excesses of 2007 that led to the downfall in 2008. Fundamentally, the companies are doing extraordinarily well, but the market is losing some of its discipline.”

While Mr. Vaselkiv says junk bond returns will be more “muted,” he expects this sector to outperform again—unless the U.S. economy deteriorates—because of its relatively higher yields and improving credit quality.

He also notes that high yield bonds pose less risk to principal in a rising rate environment because of their extra yield cushion and relatively short duration. (Long-term bonds, particularly Treasuries, typically suffer greater principal loss when interest rates rise.)

In addition, Mr. Vaselkiv expects the average default rate on junk bonds

Two Good Years for BondsTotal Returns by Sector, 2009 and 2010

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-3.6

Sources: Barclays Capital and J.P. Morgan.

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InternationalBonds

U.S. MunicipalBonds

U.S. Mortgage-Backed Securities

U.S. Treasury

U.S. CorporateInvestment Grade

EmergingMarkets

U.S. CorporateHigh Yield

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7.55.9 5.45.9

28.2

16.0

2.4

name ’09 YTD 2010U.S. Corporate High Yield 58.2 15.1Emerging Markets 28.2 12U.S. Corporate Investment Grade 16.1 9U.S. Treasury -3.6 5.9U.S. Mortgage-Backed Securities 5.9 5.4U.S. Municipal Bond 12.9 2.4International Bonds 7.5 5

� 2009 � 2010


to fall to just 1% this year—well below the 4.55% average since 1985 and the 11% rate two years ago. Junk bond upgrades have been exceeding downgrades for the first time in a while, and Mr. Vaselkiv says many bonds have upgrade potential, which could boost gains.

Credit quality is much less of a concern across the U.S. bond market as corporate balance sheets have improved substantially since the financial crisis.

“Corporations have been able to raise a lot of cash in the new issue market, and they’ve improved their debt profile by extending maturi-ties,” Mr. Huber says. “Liquidity is also less of a concern, so we expect many fewer defaults in the corpo-rate market now.”

Event Risk

However, managers say bond inves-tors may face greater “event risk,” or the likelihood that some firms will use the record-high cash on their balance sheets to pursue more acquisitions, stock buybacks, and dividend increases to enhance equity returns.

“So far this use of cash reserves has been done with a cautious eye to the balance sheet, so we have not seen credit quality diminish,” Mr. Tiberii says. “But we would rather see them use that cash to build out their businesses than just paying it out to shareholders through dividends or stock buybacks.”

While managers expect high yield and investment-grade corporate bonds to outperform Treasuries again this year, they also say that agency-issued mortgage-backed securities such as GNMAs, which have direct or implicit government guarantees and offer a modest yield advantage over Treasuries, are attractive for investors concerned about credit risk.

Although foreign bonds have been under pressure recently due to the fiscal problems facing Europe, Ian Kelson, head of Global Fixed Income for T. Rowe Price, says international bonds offer U.S. investors diversi-fication benefits, both in currencies and countries, as well as “a lot of value” now.

“We believe the long-term trend is for further dollar weakness, and foreign currencies, including the euro, should benefit,” Mr. Kelson says.

He also says longer-term bonds in Europe and Canada offer attractive yields, and he sees opportunities in new foreign markets, such as Asian currencies, European high yield debt, and corporate bonds issued in emerg-ing markets.

Rising Rates?

Perhaps the biggest risk that bond investors face over the next couple of years is potentially higher interest rates than expected—a scenario that Mr. Huber says could unfold even if economic growth remains sluggish.

He points out that the Fed’s mas-sive buying of Treasury securities is temporary, so rates could rise due to a supply/demand imbalance in Treasury debt as the Fed exits the market.

He also notes that the more liquidity the Fed pumps into the market, the more inflation expectations become a concern.

Mr. Tiberii worries that if the U.S. does not take steps toward resolving its huge fiscal challenges, foreign investors could look elsewhere. “If we lose the confidence of the global economy, you could see selling of Treasuries rather than buying by for-eign investors. It’s a low probability event but one with potentially great impact.”

“It’s really important in this uncertain economic environment to diversify in fixed income, both across the yield curve in terms of maturities and across different sectors,” Mr. Huber says.

He also cautions that periodic bouts of volatility may continue “as we work our way through the economic crisis and the unwinding of policy measures.”

0

4

8

12

16

20%

10 Year U.S. Treasury

U.S. Corporate Investment Grade - Yield to Worst

Emerging Markets (U.S. Dollar) - Yield to Worst

U.S. Corporate High Yield - Yield to Worst

12/1009/1006/1003/1012/0909/0906/0903/0912/0809/0806/08

Yield Spreads Over Treasuries Fall From Record Highs 10-Year Treasury Rates and Credit Yields From June 30, 2008, to December 31, 2010

Yiel

d

Source: Barclays Capital.

12/109/106/103/1012/099/096/093/0912/089/086/08

— U.S. Corporate High Yield— Emerging Markets (U.S. Dollar)— U.S. Corporate Investment Grade— 10-Year U.S. Treasury


Latin American Stocks and Emerging Market Bonds . . .

Performance Spotlight

During the past decade, the top-performing global equity asset class, by far, was Latin American stocks.

For the 10-year period, the sector’s annualized return was an astounding 21.4%, based on the MSCI EM (Emerging Markets) Latin America Index.

This far outpaced U.S. equities at 1.4%, as measured by the S&P 500 Index, as well as global emerging mar-ket stocks, which had a 16.2% average annualized return for the decade, per the MSCI Emerging Markets Index.

With the region’s considerable nat-ural resources, Latin America’s surge was fueled by the global commodity boom, largely driven by demand from China and India. Over the period, the Goldman Sachs Commodity Index soared 156% in value.

But Jose Costa Buck, manager of the Latin America Fund, also attributes the gains to a tremendous improvement in the overall invest-ing environment in the region. Governments generally implemented “very reasonable policies, stabilized their internal situations, and reduced political uncertainties,” he says. This was particularly the case in Brazil—almost 70% of the regional index.

Moreover, with Latin America’s commodity boom and growing foreign investments, the consumer economy has become more significant with growing opportunities in various sectors, including finance, education, health care, and homebuilders.

Rise of Consumer Class

Entering 2011, Mr. Costa Buck believes that Latin American con-sumer stocks—rather than natural resource and other materials stocks—“is the play going forward.

“The consumer story is really attractive,” he says. “It is less cyclical than commodities, and commodity prices are much more difficult to forecast than consumer stocks.”

So the Latin America Fund is underweight materials versus the index and overweight such stocks as Lojas Renner, a Brazilian department store chain.

“This is a bet on the Brazilian consumer,” Mr. Costa Buck explains. “Real wages are rising in Brazil, interest rates are low, and people are spending money. The company has been growing its sales space by 10% to 15% a year for the last five years.”

Latin American stocks may not be the leading global asset class in the new decade, but Mr. Costa Buck believes the case for investing in the region remains relatively strong. At the same time, he says, investors should be aware of the risks.

Chief among these are the poten-tially volatile global demand for Latin America’s commodities (though the region’s exports only account for less than 15% of its gross domestic

product) and the continuing potential for political instability or uncertainties (despite recent gains on that front).

Also the region’s opportunity set is highly concentrated, with Brazil and Mexico accounting for almost 80% of its index in market capitalization.

“Investors shouldn’t lose sight of the fact that this is a risky region,” Mr. Costa Buck says. “It’s highly con-centrated, it’s politically more volatile than developed markets, and there’s a degree of commodity dependence. Things can change very rapidly.

“But Latin America has performed extremely well, and its outlook remains very bright.”

The stocks mentioned in this article made up 3.2% of the Latin America Fund as of December 31, 2010. Because of its focus on a single region, the Latin America Fund involves higher risk than a more geographically diverse international fund. Share prices also are subject to market risk, as well as risks related to unfavorable currency exchange rates and political or economic uncertainty abroad.

0

100

200

300

400

500

600

700

800

Latin America Sets the Pace for Emerging and Developed MarketsTotal Return Indexed to 100 on December 31, 2000

Performance is based on the MSCI EM (Emerging Markets) Latin America Index, MSCI Emerging Markets Index, and MSCI All Country World Index.Source: T. Rowe Price Associates. Data provided by RIMES Technologies.


0

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800AC WORLD INDEX

EMERGING MARKETS

LATIN AMERICA

'10’09’08’07’06’05’04’03’02’01’00

— Emerging Markets— Global Developed Markets

— Latin America

’10’09’08’07’06’05’04’03’02’01’00


With emerging market stocks leading equities in performance over the past decade, it is no coincidence that emerging market bonds outdis-tanced other fixed income sectors over that period.

Emerging market bonds provided an annualized return of 10.3% in U.S. dollars during the decade ended December 31, 2010—far superior to the returns of investment-grade and even high yield bonds in the U.S. and abroad.

While this can still be a volatile asset class, its profile and appeal have changed dramatically since the crush-ing Asian and Russian currency crises in the late 1990s.

“Emerging countries have gone through some transformational crises, but they have learned lessons and fixed problems,” says Mike Conelius, manager of the Emerging Markets Bond Fund.

“In the past, some countries carried too much debt and suffered currency devaluations and defaults, but this led to fiscal policy and exchange rate reforms. They have restructured their debt and, over time, reined in their deficits and borrowing costs.”

. . . Are Asset Class Leaders for the Past DecadeWith such countries as Brazil

and Russia rich in natural resources, emerging market nations also ben-efited from the rise in commodity prices. That tailwind, along with greater fiscal discipline, enabled them to accumulate large stores of hard currency reserves that helped them weather the financial crisis over the past two years.

“While many developed nations have had to increase their debt loads through the recent credit crisis, emerging countries had tons of cash in the bank,” Mr. Conelius says.

In a twist on the past, several emerging market countries have become net creditors instead of debtors. In a stunning credit reversal, about 56% of the emerging market debt today is rated investment grade compared with just 30% a decade ago.

Mr. Conelius also credits improved political stability for helping spawn a growing corporate debt market. Corporate bonds now account for about a quarter of the fund’s assets, compared with only 10% five years ago.

Increasingly, the focus is on consumer-oriented companies riding

the growth in domestic demand spurred by developing middle classes.

In addition, the emergence of such new “frontier” markets as Iraq and Serbia—markets with less eco-nomic stability but greater upside potential—also has created attractive opportunities. Iraq was among the best-performing bond markets in 2010.

Risks Remain

While emerging markets have made great strides in improving their creditworthiness, that also has made their bonds less compelling. Average yields at the end of December 2010 were about 6%—a relatively narrow three-percentage-point spread over 10-year Treasury bonds.

Another recent concern is that, partly due to very accommodative U.S. monetary policy, emerging economies are attracting such strong capital inflows that it could stimulate too-rapid growth and higher inflation.

Some countries have responded by implementing capital controls and raising interest rates and bank reserve requirements.

There is also potential currency risk in emerging market bonds issued in local currencies if the dollar strength-ens, though Mr. Conelius says only 10% of the Emerging Markets Bond Fund is exposed to currency risk.

Considering the uncertain U.S. interest rate environment and poten-tial for higher rates, Mr. Conelius says returns in the 6% to 8% range in 2011 “would be a good showing” for emerging market bonds.

“Longer term, though, I am very confident in the fundamentals of the countries and the companies, so this asset class should continue to provide attractive returns.”

75

100

125

150

175

200

225

250

275

300

Emerging Market Bonds Lead Over Past DecadeTotal Return Indexed to 100 as of December 31, 2000

Source: T. Rowe Price Associates. Data provided by Barclays Capital and J.P. Morgan.


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275

300

U.S. High Yield

U.S. Investment Grade

Global ex-U.S.

Emerging Markets

'10’09’08’07’06’05’04’03’02’01’00

— Emerging Markets

— Global High Yield

— Global ex-U.S.

— U.S. Investment Grade Emerging Markets

Global ex-U.S.

U.S. Investment Grade

Global High Yield

’10’09’08’07’06’05’04’03’02’01’00


yielding more than comparable Treasuries. The historical average has been about 85% of Treasury yields.

Q. What precipitated the sudden sell-off in the muni market toward the end of last year?

A. That sell-off was not driven by defaults or credit-related events but rather by a sudden change in the supply/demand balance. Demand weakened in part because absolute yields had reached such low levels and because of uncertainty over the taxable Build America Bond program, which allowed municipalities to issue taxable bonds subsidized by the federal government. That program, which absorbed about $185 billion of muni bond issuance since April 2009, was not extended. As a result, tax- exempt supply will be significantly greater in 2011, which could put upward pressure on rates.

Meanwhile, issuers attempted to take advantage of the extremely low rates, which boosted supply. Another factor in the market weakness was the unexpected rise in Treasury yields, as muni yields tend to follow the

State Tax Collections Reverse Course

Source: Nelson A. Rockefeller Institute of Government, June 2010.

-30

-25

-20

-15

-10

-5

0

5

10 Total Tax

Sales Tax

Personal Income Tax

Q210Q110Q409Q309Q209Q109Q408Q308Q208Q108Q407Q307Q207Q107


— Sales Tax

— Total Tax

— Personal Income Tax

Year

-Ove

r-Ye

ar C

hang

e

-30

-25

-20

-15

-10

-5

0

5

10%

Q2’10Q4’09Q2’09Q4’08Q2’08Q4’07Q2’07

Investment Viewpoint

Despite Recent Sell-Off, Municipal Bonds Offer ValueAfter providing exceptional returns in 2009, the municipal bond market succumbed to a sell-off toward the end of last year as investors worried about ris-ing rates and budget gaps facing states and cities across the country. Hugh McGuirk, head of the firm’s municipal bond group, discusses the outlook for investing in tax-free municipal bonds.

Q. Before spiking toward the end of last year, municipal bond yields had reached historically low levels. How do you view muni yields relative to taxable alternatives?

A. For most of last year there was a surplus of demand and lack of supply that drove yields of all maturities to historically low levels last fall. By the start of this year, the yield on a 10-year AAA rated muni had risen to 3.16% and on a 30-year AAA muni to 4.68%—very attractive compared with Treasuries. So 30-year AAA rated munis were

Treasury market. We could hit more air pockets as conditions change.

Q. Credit concerns have risen given

the shaky finances of some government

entities. Is this a threat to the market?

A. Certainly that’s cause for concern, particularly for such states as California and Illinois and such cities and municipalities as Harrisburg, Pennsylvania; Jefferson County, Alabama; or Vallejo, California. Over-all, state revenues are up modestly, but we’re a long way from being out of the woods.

However, this is a $2.8 trillion market with 40,000 to 50,000 issuers. The biggest issuers in our market are state general obligation credits, which are backed by the full faith and credit of the states. Historically, the default rate for munis has been extremely low.

While the credit environment could remain challenging for some time because of the weak economy, we do not see a near-term threat to the states’ ability to continue servicing their outstanding debts, and many munici-pal securities offer good long-term value. Keep in mind that states must balance their budgets annually.

Q. Yes, but many states are also bur-

dened by unfunded pension liabilities,

and that doesn’t include the post-

employment benefits, such as health

care, that states are on the hook for. How

is this affecting the muni market?

A. Some estimates put the funded gap between the assets in state pension plans and their liabilities at $2 trillion to even $3 trillion. So this is definitely a long-term problem for the states, and rates do adjust in the market to reflect these concerns.


Municipal vs. Taxable Bond ReturnsTotal Return: Five Years Ended December 31, 2010

3.894.184.09

■ Barclays Capital U.S. Aggregate Index■ Barclays Capital Municipal Bond Index

Tax Bracket:

After-Tax Return of Taxable Bond Index

28% 33% 35%

0

1

2

3

4

5

6%

4.094.84.183.893.77

5.80

3.77

AAA Municipal YieldU.S. Treasury YieldMuni Taxable-Equivalent Yield*

Municipal vs. Taxable Bond YieldsAs of December 31, 2010

Maturities

Yiel

d

0

1

2

3

4

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6

7

8% AAA Municipal Yield

US Treasury Yield

Muni Taxable Equivalent Yield*

30yr

25yr

20yr

15yr

10yr

7yr

5yr

4yr

3yr

2yr

1yr

*Based on a 35% tax rate.

The after-tax returns of the Barclays Capital U.S. Aggregate Index, composed of taxable corporate and government bonds, are based on taxing the income generated by the index each year by the tax rate shown. It does not take into account state income taxes. Capital gains taxes also are not figured in because the example assumes no shares in the index are sold over the five-year period. Since only interest is being taxed in this example, the pretax and post-tax returns for the municipal bond index are the same.

For the chart comparing current muni and taxable bond yields at various maturities (at right), the taxable-equivalent yield for munis (top line) assumes a 35% federal tax rate and no state taxes. (The taxable-equivalent yield of a tax-free security is calculated by dividing the tax-free yield by one minus the investor’s marginal tax rate, which might combine the investor’s federal/state tax rates.) State taxes could apply to out-of-state issued municipal bonds. Interest earned on U.S. Treasury bonds is exempt from state taxation.

Sources: T. Rowe Price Associates, Federal Reserve Bank of New York, and Municipal Market Data.

States are contractually obligated to meet these pension obligations, and unlike the federal government, they can’t just print money.

Many state legislatures across the country are making tough decisions, and significant budget cuts have been made. Some pension reforms are under way, so some progress is being made.

Q. As a result of the financial crisis,

bond insurers have fled the market.

What has been the impact of that?

A. Prior to 2008, half the issuance was insured, and 85% of our market was rated either AA or AAA. Now, less than 10% of our market is insured, and the amount of AAA issuance is at very low levels. I don’t think the underlying quality of most issuers has changed a lot, but you certainly have to understand what you are buying.

Fundamental, independent credit research is critical. It’s the single most important factor that gives us an edge in the market. We always looked through the insurer to analyze the underlying issuer. We do our own work in terms of figuring out what the quality of that issuer is. We have never relied on rating agencies or insurers.

Investment Strategy

Q. How have the fiscal problems facing

many states and municipal bond issuers

affected your investment strategy?

A. We’re avoiding Illinois state bonds. We do invest in California issues if the valuation is attractive. We invest in all 50 states because there are many choices that go beyond state general obligation bonds, which overall account for only about one-third of the supply. Revenue bonds, which are funded by specific projects, account for most of the other two-thirds.

We have been focusing more on revenue bonds, particularly essential service revenue bonds for such things as water and utilities and even airport bonds. Hospital bonds also offer real value, although it remains uncertain how health care reform will affect them. We continue to underweight tobacco bonds because the funda-mentals are poor.

In terms of duration, we have favored longer-term bonds lately. But we manage our overall interest rate risk very carefully.

Q. How do you see the municipal

market shaping up for 2011?

A. I think muni yields could end the year about where they started

it. Yields rose significantly toward the end of 2010, erasing much of the gains from earlier last year. So if investors basically earn the coupon in 2011, total returns could be roughly the same as in 2010.

In the long run, most of our returns come from income, and the average income of portfolios now is probably in the 3.5% to 4.25% range, which is historically low.

But investors should evaluate munis on an after-tax basis relative to fixed income alternatives. On that score, despite the recent volatility, munis still look pretty good.


Brian Rogers wears three hats at T. Rowe Price. He is the firm’s chairman. He is its chief invest-ment officer. And he serves as the portfolio manager of one of the company’s largest and best- known mutual funds, the Equity Income Fund.

Indeed, last October, the fund—which takes a value approach to investing by largely focusing on undervalued, large-capitalization U.S. stocks—marked its 25th anniversary, and Mr. Rogers has been at the helm that entire time.

His tenure has been notably successful: Since the Equity Income Fund’s inception on October 31, 1985, through the 25 years to the end of October last year, its performance net of fees has exceeded that of the S&P 500 Index.

The fund is among 25 T. Rowe Price funds named “Analyst Picks” by Morningstar, an independent research firm, as of December 31, 2010—a distinction it has been awarded since May 2002. It has also frequently appeared on lists of recom-mended funds published by several personal finance magazines.

That record has been forged during an eventful quarter century, to say the least.

Looking back over the last 25 years, Mr. Rogers notes several key lessons he has gleaned—first and foremost that, despite many chal-lenging periods, “the world is a very resilient place.”

He cites four such periods in par-ticular that shook market foundations and really rattled investors’ nerves:

• The market crash of 1987. “It was over so quickly that it hardly mat-tered in the long run, but that was as scary a couple of days as I have ever seen.”

• The credit crisis of the early 1990s. “That was really, really difficult, exacerbated by Saddam Hussein invading Kuwait, causing oil prices to spike dramatically,” Mr. Rogers says.

• The 2000–2002 bear market. “To me,” he says, “that wasn’t quite as frightening because it wasn’t as systemically challenging. It was more the result of several overval-ued market sectors coming back to reality.”

• The crash of 2008. “This was a terrifying time because of the household name institutions that collapsed due to imprudent use of leverage and poor management decisions.”After each of these crises, however,

equilibrium returned to global markets and the financial world moved forward. “So we’ve seen a lot of things over 25 years, but what you realize over time is how resilient the system is,” Mr. Rogers says. “I some-times think we forget that in periods of market dislocations.”

The second lesson, harkening back to the technology stock bubble of the late 1990s, “is that trees don’t grow to the sky,” he says. “And so if it seems too good to be true, it may be. Very few companies grow at 20% to 25%

on a sustainable basis, and you have to be sensitive to what you what pay for an investment. And at times, when valuations become extended, you have to be willing to walk away and sell something when it looks too richly valued.

“I think that’s something that’s very hard for investors to do, because in periods of high valuation everything looks good.”

Accordingly, Mr. Rogers says, “The third lesson—and this is really hard—is that you have to force yourself to be a bit of a contrarian and avoid investing in something simply because it has recently done well.

“We work very hard to educate our shareholders, but it’s still a hard message to convey: Trying to avoid fads and avoid investing in what has done the best recently is a hard thing to do. I’ve seen investors get into more trouble chasing strong recent performance than by doing almost anything else.”

The Equity Income Fund’s annual-ized returns for the 1-, 5-, and 10-year and since-inception periods, as of December 31, 2010, were 15.1%, 2.7%, 4.3%, and 10.9%, respectively. From its inception on October 31, 1985, through October 31, 2010, the fund’s annualized return was 10.65% compared with 10.16% for the S&P 500 Index. Past performance cannot guarantee future results.

Reflections as the Equity Income Fund Marks 25 Years

[ “Trying to avoid fads and avoid investing in what has done the best recently is a hard thing to do. I’ve seen investors get into more trouble chasing strong recent performance than by doing almost anything else.”

]


More than two years ago—as global stock markets were in what surely felt like a free fall to many investors—a well-known TV stock commentator sounded a strikingly strong alarm, warning viewers to take any money out of the stock market that they might need within five years and put it only in absolutely safe investments. That sentiment was shared by some other market pundits as well.

Of course, it has not yet been five years, but how has that advice played out since that day, October 6, 2008, through 2010?

Short-term Treasury bills—a risk-free investment in terms of principal value—had a total return of 0.4%. Although U.S. stocks continued falling sharply for six months after that alarm was sounded, they have returned 25.3% since then. (See chart.)

And a portfolio of 20% stocks, 50% bonds, and 30% cash—T. Rowe Price’s recommended allocation for those who may need their assets in five years—returned 13.4%.

The point is not that investors shouldn’t have an allocation to cash for emergencies or to anchor a diversified portfolio. But making knee-jerk investment decisions in the midst of a market crisis can backfire and undermine a sound long-term investment strategy.

Stuart Ritter, a T. Rowe Price financial planner, acknowledges that 2008 was a scary time for many stock investors and, as a result, the temptation to take action—partic-ularly by fleeing stocks entirely for cash—was strong.

Nonetheless, subsequent market movements underscore precisely why it is so difficult to make such sweeping predictions with much accuracy.

Market Timing, Emotions, and Asset Allocation“Taking one element and making

predictions based on it is not an appropriate approach to investing,” Mr. Ritter says.

For one reason, he says, prognos-ticators’ views are often biased by recent events. “After a big slide in stocks, pronouncements to ‘get out’ become loudest,” he says. “And we tend to give them credence because it’s easy—in hindsight—to find all sorts of advance warnings of the cri-sis that we feel we should have seen. We ignore that there almost always is great uncertainty about what will happen next.”

For another reason, changing your asset allocation in response to market events actually requires two decisions and two actions—what to sell and what to buy.

“In this case, we were told to sell stocks,” Mr. Ritter notes. “But what to buy? The implication was to go to cash.”

And in just a little more than two years, the performance differential of stocks over cash has totaled almost 25 percentage points.

With a sudden shift in asset allo-cation, he says, “you could be right, but the consequences of not being right could be huge.”

In this case, investors may have ended up selling after much of the downturn and missing out on a significant stock rebound.

Such failed efforts at market timing underlie national studies that show mutual fund investors’ average returns often lag those of the indi-vidual funds they are invested in.

The best course, Mr. Ritter advises, is for investors to use the time hori-zons of their goals as a guide to their asset allocation strategy.

T. Rowe Price’s framework sug-gests that those saving for specific goals more than 16 years away would start out virtually 100% invested in stocks and reduce that allocation over time in favor of more bonds and cash as they get closer to their goal.

The key is sticking with the strategy, Mr. Ritter says, even in the face of significant shorter-term challenges.

*The diversified portfolio is composed of 20% stocks, as represented by the S&P 500 Index; 50% bonds, as represented by the Barclays Capital U.S. Aggregate Index; and 30% cash, as represented by the Barclays Capital 1–3 Month T-Bill Index. It is not possible to invest directly in an index. Past performance cannot guarantee future results.

Source: T. Rowe Price.

A Snapshot of Market Returns After the “Panic” Performance October 6, 2008, Through December 31, 2010

Diversified Portfolio* CashBondsStocks

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30%

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0.4


Those who initially may have felt fortunate were now faced with the misfortune of watching the market decimate the nest eggs it had helped them create.

How could retirees have coped better with such a dismal decade?

T. Rowe Price has conducted a new study to examine various strategies for coping with such challenges. The study illustrates the importance of retirees:

Personal Finance

Dismal Decade Offers Cautionary Lessons for Retirees

Retirees should have a sound financial strategy for sustaining their income throughout retirement. But as the last decade has shown, the stock market is capable of upending even the best-laid plans.

Those who retired in 2000 appeared to have perfect timing. Over the prior two decades, the stock market had achieved an annualized return of 17.8%, including double-digit gains in

excess of 20% each year from 1995 through 1999.

While more modest returns were expected for the next decade, few could have predicted an actual loss in value—it’s only occurred about 5% of the time over rolling 10-year periods since 1926. However, that rarity became reality when 2000–2010 proved one of the worst decades in history, featuring two ferocious bear markets.

Options When Retiring Into Bear Markets

The chart below outlines four options for handling a 30-year retirement account, starting January 1, 2000, with an account balance of $500,000 invested in a 55% equity, 45% bond portfolio. In this hypothetical example, the retiree withdraws 4% (or $20,000) the first year and increases the annual withdrawal amount by 3% each year to keep up with inflation. Actual returns for stocks and bonds are used for the period January 1, 2000, through December 31, 2010, and projections thereafter are based on 10,000 simulations of possible future market scenarios. (See explanation on page 18.)

The four options below assume the investor retired on January 1, 2000. The table reflects the impact of the two major bear markets over the past decade on the investor’s chance of not running out of money over a 30-year retirement—as well as the impact of marking certain adjustments to compensate for the misfortune of retiring into a dismal decade for equity investing. Past performance cannot guarantee future results. This chart is for illustrative purposes only and does not represent the perfor-mance of any specific security.

Account Status

Portfolio

Value

Monthly Withdrawal

Amount

Odds of Success*

Odds of Success After Bear Market Ended March 2009

At retirement on January 1, 2000 $500,000 $1,667 89%

Results as of December 31, 2010, Assuming Four Different Strategies:

OPTION 1: Continue withdrawals as planned

$334,578

$2,307

29%

6%

OPTION 2: Best Outcome Reduced withdrawals by 25% for three years after each bear market bottom

386,113

1,493

84

43

OPTION 3: Take no annual inflation adjustments for three years after each bear market bottom

352,367

1,990

69

26

OPTION 4: Worst Outcome Switched to 100% bond portfolio after first bear market bottom on October 1, 2002

270,669

2,307

0

0

Source: T. Rowe Price Associates.

*Represents the percentage of total simulations in which the investor does not run out of money during a 30-year retirement period. The odds of success on January 1, 2000, reflect the initial investment and withdrawal assumptions. The odds of success at the various stages of the options reflect historical return data and any changes in the investment or withdrawal assumptions and projections thereafter. For historical returns, the S&P 500 Index is used for stocks and the Barclays Capital U.S. Aggregate Index is used for bonds. For simulations, stocks are expected to return 10% overall with a standard deviation of 15% and fees of 1.211%; bonds are expected to return 6.5% with a standard deviation of 5% and fees of 0.726%. Portfolios are rebalanced monthly, and withdrawals are made monthly. This example does not take into account taxes or required minimum distributions from retirement plans.


•Periodicallyrevisitingtheirstrategy and making adjustments when market downturns significantly increase their odds of outliving their savings.

•Focusingonwhattheycancontrol—mainly how much they spend each year and how they allocate their investments.

“Our research shows that retirees who take a ‘set it and forget it’ approach to their retirement income strategy do so at their own peril, particularly when hit by a bear market,” says Christine Fahlund, a senior financial planner with T. Rowe Price. “The last decade has shown that they must remain engaged and sometimes temporarily reduce their expenses in order to maintain a successful withdrawal strategy.”

Options for Bear Markets

The new study tracked the portfolios of four hypothetical retirees from 2000–2010 and their odds of not outliving their assets over 30 years, based on actual market returns for the first decade and on projected returns thereafter using a sophisticated methodology of 10,000 simulated portfolio outcomes. (See page 18 for an explanation of this analysis.)

The study assumed that each investor retired on January 1, 2000, with a $500,000 portfolio invested 55% in equities and 45% in bonds and withdrew 4% of portfolio assets ($20,000) the first year, with that amount increasing 3% annually for inflation.

Based on the initial probability analysis, these investors had an 89% chance of sustaining these withdrawals over 30 years. However, the 2000–2002 and 2007–2009 bear markets wreaked havoc on their potential success.

By the end of the first bear market in September 2002, for example, the odds of sustaining withdrawals over the balance of the retirement period had fallen to just 46%.

Those odds were largely restored by the five-year bull market that followed but then fell again to only 6% after the financial crisis inflicted another severe bear market from October 2007 to March 2009.

As shown in the table on page 16, this analysis examined four different strategies:

1) Continue withdrawals as planned throughout the decade.

2) Temporarily reduce withdrawals by 25% for three years after each bear market bottom (from 2002–2005 and again from 2009–2012).

3) Take no inflation increases for three years after each bear market bottom (from 2002–2005 and again from 2009–2012).

4) Switch to a 100% bond portfolio at the end of the first bear market in September 2002.

The disciplined retiree able to tighten her belt when times got tough (Option 2) fared the best. By the end of 2010, her odds of sustaining withdrawals over the remainder of the retirement period had reached 84%.

Taking no inflation adjustment for three years after each bear market (Option 3) was perhaps a more achievable option for some retirees. This restored the odds of sustaining withdrawals to 69% by the end of the decade.

Switching to 100% bonds produced the worst outcome, leaving this investor with a virtual certainty of running out of money in retirement.

The complacent retiree who ignored both bear markets now only has a 29% chance of not running out of money. Perhaps favorable markets

will bail her out in the coming years, as they did temporarily after the five-year bull market from 2002–2007.

“But passively allowing the markets to whipsaw your chances of having a successful retirement is not advisable,” Ms. Fahlund says. “And fleeing to bonds was certainly no panacea. Those investors, who locked in their equity losses, missed the ensuing market rebounds.”

No Silver BulletAdmittedly, there was no foolproof strategy for getting completely back on track while enduring such an unusually poor decade for equity investing, especially right after retiring. Even the retiree who was able to substantially reduce income for a few years has a ways to go before restoring her odds of success at the start of retirement.

“The past decade really shows the importance of revisiting your retirement income strategy regularly and making adjustments if necessary,” Ms. Fahlund says.

Retirement Checkup

Investors interested in seeing if their retirement plans are on track can use the T. Rowe Price Retirement Income Calculator, available at troweprice.com/ric. The free calculator estimates how much income investors will have in retirement.

Users can immediately see the effect on retirement income of changing various factors, such as: the amount being saved; retirement age; number of years in retirement; asset allocation strategy; and, for retirees, their monthly spending amount.

New features let users personalize the experience by offering the option to log in and save their information.

Additionally, T. Rowe Price custom-ers can now use their account logins to automatically enter their invest-ments in the calculator.


The following is an explanation of the Monte Carlo simulation analysis used in the retirement article on pages 16 and 17. Information in brackets applies only to the Retirement Income Calculator sidebar on page 17.

Monte Carlo SimulationMonte Carlo simulations model future uncertainty. In contrast to tools generating average outcomes, Monte Carlo analyses produce outcome ranges based on probability—thus incorporat-ing future uncertainty. In the study, savings data are based on average outcomes and retirement income data on Monte Carlo analysis.

Material Assumptions Include:• Underlying long-term expected

annual returns for the asset classes are not based on historical returns, but on estimates, which include reinvested dividends and capital gains.

• Expected returns—plus assumptions about asset class volatility and correlations with other classes—are used to generate random monthly returns for each class over specified periods.

• These monthly returns are then used to generate 10,000 scenarios, representing a spectrum of possible performance for the modeled asset classes. Success rates are based on these scenarios. [Success rate is defined as the percent of market simulations that result in a positive balance at the end of the time horizon.]

• Taxes aren’t taken into account, nor are early withdrawal penalties. But fees—average expense ratios for typi-cal actively managed funds within each asset class—are subtracted from the expected annual returns.

• [Required minimum distributions (RMDs) are included in the calculator. In the simulations, if the RMD is greater than the planned withdrawal, the excess amount is reinvested in a taxable account.]

Material Limitations Include:• Extreme market movements may

occur more often than in the model.• Some asset classes have relatively

short histories. Expected results for each asset class may differ from our

Explaining Monte Carlo Analysis Used in Retirement Studyassumptions—with those for classes with limited histories potentially diverging more.

• Market crises can cause asset classes to perform similarly, lowering the accuracy of projected portfolio volatility and returns. Correlation assumptions are less reliable for short periods.

• The model assumes no month-to-month correlations among asset class returns. It does not reflect the average periods of “bull” and “bear” markets, which can be longer than those modeled.

• Inflation is assumed constant, so variations are not reflected in our calculations.

• The analysis does not use all asset classes. Other asset classes may be similar or superior to those used. [The analysis assumes a diversified portfolio, which is rebalanced monthly.]

Model Portfolio Construction and Initial Withdrawal AmountIn the study, we used two hypothetical portfolios for illustrative purposes only. One was composed of 55% large-cap stocks and 45% investment-grade bonds. The other was composed of investment-grade bonds only. The underlying long-term expected annual return assumptions (without fees) are 10% for large-cap stocks and 6.5% for investment-grade bonds. Net-of-fee expected returns use these expense ratios: 1.211% for large-cap stocks and 0.726% for investment-grade bonds.

[In the Retirement Income Calculator, the underlying long-term expected annual return assumptions (without fees) are 10% for stocks, 6.5% for bonds, and 4.75% for short-term bonds. Net-of-fee expected returns use these expense ratios: 1.211% for stocks, 0.726% for bonds, and 0.648% for short-term bonds. The portfolio is either determined by the user or based on preconstructed allocations that shift in 5% increments throughout the retirement horizon (as displayed in the calculator graphic “Why should I consider this” in the Asset Allocation section of the Web tool).]

The initial withdrawal amount is the percentage of the initial value of the investments withdrawn on the first day of the first year. In subsequent years, the amount withdrawn grows by a 3% annual

rate of inflation. Success rates are based on simulating 10,000 market scenarios and various asset allocation strategies. [Success rates for the calculator are based on simulating 1,000 market scenarios and various asset allocation strategies.]

IMPORTANT: The projections or other information generated by the T. Rowe Price Investment Analysis Tool and the T. Rowe Price Retirement Income Calculator regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. The simula-tions are based on assumptions. There can be no assurance that the projected or simulated results will be achieved or sustained. The results present only a range of possible outcomes. Actual results will vary with each use and over time, and such results may be better or worse than the simulated scenarios. Clients should be aware that the potential for loss (or gain) may be greater than demonstrated in the simulations.

The results are not predictions, but they should be viewed as reason-able estimates. Source: T. Rowe Price Associates, Inc.

U.S. stocks rose briskly in the fourth quarter of 2010, closing near their highest levels of the year and capping a second consecutive year of strong gains. Equities advanced as the econ-omy showed signs of improvement and the Federal Reserve signaled that it would purchase more Treasury securities in an attempt to keep long-term interest rates low. The rally was supported by late-year bipartisan legislation to extend for two years the Bush-era tax cuts that were set to expire at the end of 2010.

Stronger Economic Growth and New Stimulus Measures Lift U.S. Equities

Domestic Small-Cap, Growth, and Natural Resource Shares Outperform

Small- and mid-cap shares outper-formed large-caps during the quar-ter. As measured by various Russell indexes, growth stocks fared better than value across all market capitaliza-tions. Despite a sharp pullback from late April through early July, most major indexes closed the year more than 85% above their March 2009 bottom.

In the U.S. equity market, as measured by the Wilshire 5000 Total Market Index, energy and materials stocks fared best amid rising commod-ity prices. The financials and informa-tion technology sectors performed mostly in line with the broad market, but consumer discretionary and indus-trials and business services outper-formed. Sectors with lower sensitivity to the health of the economy lagged as investors favored riskier investments.

Non-U.S. equity markets produced moderate gains in the fourth quarter. Emerging markets narrowly outper-formed developed markets, led by stocks in the emerging Europe, Middle East, and Africa region. Among devel-oped markets, equities in the Pacific Rim—especially Japan, New Zealand, and Australia—produced strong returns. Select European markets also did well, but the European debt crisis weighed on others, especially Greece and Spain.

December 31, 2010T. Rowe Price Quarterly Performance Update

Equity Review


U.S. Stock Market Performance

Total Returns for Periods EndedDecember 31, 2010


S&P 500 Stock IndexS&P MidCap 400 IndexNasdaq Composite IndexRussell 2000 Index

0%

4%

8%

12%

16%

20%

24%

28%

Russell 2000 Index

Nasdaq Composite Index (Principal Return)

S & P Midcap 400 Index

S & P 500 Stock Index

1 Year3 Months

10.7

6 13.5

0

12.0

0

16.2

5

15.0

6

26.6

4

16.9

1

26.8

5

5.67

5.67

3 Months 1 YearS & P 500 Stock Index 11.29 10.16 S & P Midcap 400 Index 13.12 17.78Nasdaq Composite Index (Principal Return) 12.3 11.6Russell 2000 Index 11.29 13.35

1 Year3 Months0

4

8

12

16

20

24

28%

International Stock Market Performance



MSCI EAFE Index(Europe, Australasia, Far East)MSCI Emerging Markets Index

1 Year3 Months

5.67

5.67

3 Months 1 YearMSCI EAFE Index -13.75 6.38MSCI Emerging Markets Index -8.29 23.480.94 2.45

55.2 81.55

8.21

0

4

8

12

16

20

24%

7.36

6.65

19.2

0

Performance of Wilshire 5000 Series

Total Returns for Periods Ended December 31, 2010,Ranked by Highest to Lowest Quarterly Return

1 Year3 Months

0 4 8 12 16 20 24 28 32 36

1 Year

3 Months

Utilities

Health Care

Telecomm Services

Consumer Staples

Financials

Information Technology

Industrials and Business Services

Consumer Discretionary

Materials

Energy

-50 -45 -40 -35 -30 -25 -20 -15 -10 -5 0% 10

Performance of Wilshire 5000 Series 3 Months 1 YearInformation Technology 10.51 61.91Materials 8.90 55.73Consumer Discretionary 7.87 48.61Health Care 7.86 23.31Telecomm Services 7.54 12.78Utilities 6.85 13.12Energy 6.55 22.92Industrials and Business Services 5.53 22.55Consumer Staples 5.35 15.08Financials -2.30 14.68

0 4 8 12 16 20 24 28 32 36%

20.89

20.71

13.98

13.41

11.28

11.17

6.29

6.26

5.34

2.36

23.50

27.75

31.31

27.31

13.07

15.42

14.38

17.54

6.58

7.68Utilities

Health Care

Telecommunication Services

Consumer Staples

Financials

Information Technology

Industrials and Business Services

Consumer Discretionary

Materials

Energy


Fixed Income Review

Most Global Bond Sectors Decline as Long-Term Interest Rates Jump

U.S. bond prices generally declined in the fourth quarter. Signs of economic improvement and expectations for stronger growth in 2011 caused longer-term Treasury yields to rise sharply. Treasury bond prices fell despite the Federal Reserve’s early November decision to purchase an additional $600 billion in Treasuries by mid-2011—its second round of quantitative easing since the 2008 financial crisis.

High yield bonds bucked the negative trend and significantly outperformed investment-grade issues, as investors continued to favor securities with a yield advantage. In the investment-grade universe, long-term Treasuries fared worst. Municipal bonds also fell sharply due to heavy issuance, reduced demand, and rising Treasury rates. Corporate bonds and asset-backed securities held up somewhat better, while agency mortgage-backed securities were flat.

Non-U.S. bond returns were negative, as rising long-term interest rates in the U.S. and other developed nations and concerns about economic overheating in some emerging countries weighed on global bond markets.

-5

0

5

10

15

20%

1 Year3 Months

U.S. Bond Market Performance



Barclays Capital U.S. Aggregate IndexBarclays Capital Municipal Bond IndexCredit Suisse High Yield Index

-5%

0%

5%

10%

15%

20%Credit Suisse High Yield Index

Barclays Capital Municipal Bond Index

Barclays Capital U.S. Aggregate Index

1 Year3 Months

-4.1

7 3.15

6.54

2.38

14.4

2

5.67

5.67

3 Months 1 YearBarclays Capital U.S. Aggregate Index 3.49 9.5Barclays Capital Municipal Bond Index 2.03 9.61Credit Suisse High Yield Index 0.21 26.91

-1.3

0

International Bond Market Performance



J.P. Morgan Emerging Markets Bond Index–Global

Barclays Capital Global Aggregate ex U.S. Dollar Bond Index

-3%

0%

3%

6%

9%

12%

15%JP Morgan Emerging Markets Bond Index-Global

Barclays Capital Global Aggregate Ex-USD Index

1 Year3 Months

1 Year3 Months

5.67

5.67

-1.3

4

4.95

Barclays Capital Global Aggregate Ex-USD Index JP Morgan Emerging Markets Bond Index-Global3 Months -2.43 1.161 Year 1.89 17.9

12.0

4

-3

0

3

6

9

12

15%

-1.8

5

-1.65 4.1611.84 29.15

Trends in Interest Rates


Credit Suisse High Yield Index*

Barclays Capital Municipal Bond Index*

90-Day Treasury Bills

Barclays Capital U.S. Aggregate Index*

7.45%

0.12%

2.96%3.78%

* Yield-to-worst

0%

3%

6%

9%

12%

15%

18%

21% Credit Suisse High Yield Index*

Barclays Capital Muni Bond*


90-day Treasury Bill

12/1012/0912/0812/0712/0612/0512/0412/0312/0212/01

0

3

6

9

12

15

18

21%

Credit Suisse High Yield Index*

Barclays Capital Muni Bond*


90-day Treasury Bill

12/1012/0912/0812/0712/0612/0512/0412/0312/0212/01

-7%

0%

7%

14%

21%

28%Credit Suisse High Yield Index



MSCI EAFE Index

Russell 2000 Index

Nasdaq Composite Index (Principal Return)

S & P Midcap 400 Index

S & P 500 Stock Index1 Year3 Months

Stock and Bond Market Performance

Total Returns for Periods Ended December 31, 2010Unlike stocks, U.S. government bonds are guaranteed as to the timely payment of interest and principal.


S&P MidCap 400 Index

S&P 500 Stock Index

Russell 2000 Index

Nasdaq Composite Index


MSCI EAFE Index

Credit Suisse High Yield Index


1 Year3 Months

5.67

10.7613.50

12.00

16.25

-1.30-4.17

26.64

16.91

8.216.54

3.15

6.65

2.38

26.85

15.06

-7

0

7

14

21

28%

14.42

T. Rowe Price Mutual FundsPerformance Summary

The performance information presented here includes changes in principal value, reinvested dividends, and capital gain distributions. Current performance may be higher or lower than the quoted past performance, which cannot guarantee future results. Share price, principal value, yield, and return will vary, and you may have a gain or loss when you sell your shares. To obtain the most recent month-end performance, call us at 1-800-225-5132 or visit our website. The performance information shown does not reflect the deduction of redemption fees (if applicable); if it did, the performance would be lower. Call 1-800-225-5132 to request a prospectus or summary prospectus; each includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. Funds are placed in alphabetical order in each category. To learn more about each fund’s objective and risk/reward potential, visit troweprice.com/mutualfunds.

Past Quarter, Year, and Average Annual Total ReturnsPeriods Ended December 31, 2010

Ticker Symbol

3 Months 1 Year 3 Years 5 Years

10 Years or Since

InceptionInception

DateRedemp-tion Fee

Redemp-tion Fee Period

Expense Ratio

Expense Ratio

as of Date

StOCk fUNDS Domestic

Blue Chip Growth TRBCX 11.81% 16.42% -1.62% 3.38% 1.41% 6/30/93 0.81% 12/31/09Capital Appreciation PRWCX 8.80 14.07 3.39 5.77 8.54 6/30/86 0.76 12/31/09Capital Opportunity PRCOX 10.81 13.30 -2.37 2.62 1.94 11/30/94 0.79 12/31/09Diversified Mid-Cap Growth PRDMX 14.31 27.94 1.83 5.46 7.20 12/31/03 1.26 12/31/09Diversified Small-Cap Growth PRDSX 17.62 33.50 5.48 5.81 4.01 6/30/97 1.0% 90 days 1.39 12/31/09Dividend Growth PRDGX 10.87 13.26 -1.57 3.52 3.06 12/30/92 0.72 12/31/09Equity Income PRFDX 10.97 15.15 -2.41 2.72 4.31 10/31/85 0.73 12/31/09Equity Index 500 PREIX 10.68 14.71 -3.02 2.06 1.16 3/30/90 0.5 90 days 0.33 12/31/09Extended Equity Market Index PEXMX 15.48 27.45 2.33 5.24 5.92 1/30/98 0.5 90 days 0.41 12/31/09Financial Services PRISX 11.14 12.90 -4.57 -1.79 2.51 9/30/96 1.02 12/31/09Growth & Income PRGIX 10.88 13.92 -1.94 2.78 2.22 12/21/82 0.76 12/31/09Growth Stock PRGFX 11.34 16.93 -1.11 4.01 2.69 4/11/50 0.73 12/31/09Health Sciences PRHSX 9.90 16.33 3.08 7.34 5.76 12/29/95 0.87 12/31/09Media & Telecommunications PRMTX 10.69 26.79 4.59 12.37 10.76 10/13/93 0.90 12/31/09Mid-Cap Growth1 RPMGX 13.78 28.06 3.95 7.13 7.54 6/30/92 0.83 12/31/09Mid-Cap Value1 TRMCX 10.33 16.45 3.78 6.21 9.96 6/28/96 0.84 12/31/09New America Growth PRWAX 14.13 19.34 3.21 6.04 2.84 9/30/85 0.89 12/31/09New Era PRNEX 19.64 20.96 -3.45 8.18 11.56 1/20/69 0.69 12/31/09New Horizons PRNHX 17.94 34.67 5.85 6.24 6.64 6/3/60 0.85 12/31/09Real Estate TRREX 8.05 29.89 1.38 2.96 10.86 10/31/97 1.0 90 days 0.77 12/31/09Science & Technology PRSCX 13.07 21.25 4.58 6.51 -2.78 9/30/87 1.00 12/31/09Small-Cap Stock OTCFX 17.45 32.53 6.94 6.27 7.79 6/1/56 0.95 12/31/09Small-Cap Value PRSVX 15.82 25.25 4.30 5.66 11.39 6/30/88 1.0 90 days 0.97 12/31/09Tax-Efficient Equity2 PREFXReturns before taxes 13.15 21.38 -0.92 3.65 3.06 12/29/00 1.0 365 days 1.25 2/28/10Returns after taxes on distributions – 21.35 -0.92 3.65 3.06 12/29/00

Returns after taxes on distribu-tions and sale of fund shares – 13.93 -0.78 3.14 2.65 12/29/00

Total Equity Market Index POMIX 11.54 16.80 -1.86 2.81 2.31 1/30/98 0.5 90 days 0.40 12/31/09U.S. Large-Cap Core TRULX 12.03 14.38 – – 23.60 6/26/09 2.96 12/31/09Value TRVLX 11.66 15.96 -1.42 2.94 4.56 9/30/94 0.91 12/31/09

1 Closed to new investors except for a direct rollover from a retirement plan into a T. Rowe Price IRA invested in this fund.2 The returns presented reflect the return before taxes; the return after taxes on dividends and capital gain distributions; and the return after taxes on dividends, capital

gain distributions, and gains (or losses) from redemptions of shares held for 1-, 5-, and 10-year or since-inception periods, as applicable. After-tax returns reflect the highest federal income tax rate but exclude state and local taxes. The after-tax returns reflect the rates applicable to ordinary and qualified dividends and capital gains effective in 2003. During periods when a fund incurs a loss, the post-liquidation after-tax return may exceed the fund’s other returns because the loss generates a tax benefit that is factored into the result. An investor’s actual after-tax return will likely differ from those shown and depend on his or her tax situation. Past before- and after-tax returns do not necessarily indicate future performance.

BEnch- MARkS Domestic Stock

S&P 500 Index 10.76% 15.06% -2.86% 2.29% 1.41%S&P MidCap 400 Index 13.50 26.64 3.52 5.73 7.16Nasdaq Composite Index 12.00 16.91 0.01 3.76 0.71Russell 2000 Index 16.25 26.85 2.22 4.47 6.33Lipper IndexesLarge-Cap Core Funds 10.05 12.77 -3.12 1.91 0.76Equity Income Funds 9.62 14.04 -3.01 2.15 2.86Small-Cap Core Funds 15.39 25.71 2.88 4.76 6.95


T. Rowe Price Mutual FundsPerformance Summary Past Quarter, Year, and Average Annual Total ReturnsPeriods Ended December 31, 2010

Ticker Symbol


10 Years or Since

InceptionInception

DateRedemp-tion Fee


Expense Ratio

Expense Ratio

as of Date

StOCk fUNDS International/Global

Africa & Middle East TRAMX 4.99% 17.21% -12.59% — -4.38% 9/4/07 2.0% 90 days 1.62% 10/31/09Emerging Europe & Mediterranean TREMX 14.91 33.48 -10.13 4.58% 15.41 8/31/00 2.0 90 days † 10/31/09

Emerging Markets Stock PRMSX 6.25 18.75 -4.64 10.35 14.69 3/31/95 2.0 90 days 1.32 10/31/09European Stock PRESX 8.30 8.76 -6.09 4.68 3.46 2/28/90 2.0 90 days 1.08 10/31/09Global Infrastructure TRGFX 3.30 — — — 7.22 1/27/10 2.0 90 days †† 1/27/10Global Large-Cap Stock RPGEX 8.46 14.72 — — 39.98 10/27/08 2.0 90 days ‡ 10/31/09Global Real Estate TRGRX 5.93 23.17 — — 30.22 10/27/08 2.0 90 days ‡‡ 12/31/09Global Stock PRGSX 7.85 12.45 -8.97 2.15 3.14 12/29/95 2.0 90 days 0.95 10/31/09Global Technology PRGTX 14.18 22.66 7.37 9.08 2.40 9/29/00 1.22 12/31/09International Discovery PRIDX 8.86 20.47 -2.07 6.92 8.72 12/30/88 2.0 90 days 1.29 10/31/09International Equity Index PIEQX 6.45 8.84 -6.57 2.86 3.64 11/30/00 2.0 90 days 0.50 10/31/09International Growth & Income TRIGX 6.94 10.49 -6.47 2.93 5.28 12/21/98 2.0 90 days 0.94 10/31/09International Stock PRITX 7.24 14.48 -3.25 4.15 3.11 5/9/80 2.0 90 days 0.91 10/31/09Japan PRJPX 10.19 14.22 -7.56 -6.78 -0.67 12/30/91 2.0 90 days 1.15 10/31/09Latin America PRLAX 7.86 18.49 4.01 20.44 21.89 12/29/93 2.0 90 days 1.29 10/31/09New Asia PRASX 1.28 20.35 -1.63 16.61 15.01 9/28/90 2.0 90 days 1.01 10/31/09Overseas Stock TROSX 7.35 10.57 -6.01 — -2.36 12/29/06 2.0 90 days 0.97 10/31/09

BEnch- MARkS International/Global Stock

MSCI EAFE Index 6.65% 8.21% -6.55% 2.94% 3.94%Lipper AveragesEmerging Markets Funds 6.97 19.54 -2.61 10.81 15.26International Large-Cap Core Funds 6.76 8.05 -7.72 2.01 2.68International Large-Cap Growth Funds 7.98 12.30 -5.52 3.90 3.92International Small-/Mid-Cap Growth Funds 10.92 23.43 -2.90 5.65 8.29

BOND fUNDS Domestic Tax-Free3

California Tax-Free Bond PRXCX -4.63% 2.18% 3.26% 3.40% 4.16% 9/15/86 0.51% 2/28/10Georgia Tax-Free Bond GTFBX -5.03 1.09 3.13 3.14 4.15 3/31/93 0.57 2/28/10Maryland Short-Term Tax-Free Bond PRMDX -0.41 0.76 2.62 2.89 2.77 1/29/93 0.52 2/28/10

Maryland Tax-Free Bond MDXBX -4.36 1.99 3.95 3.65 4.43 3/31/87 0.47 2/28/10New Jersey Tax-Free Bond NJTFX -4.48 1.95 3.40 3.36 4.36 4/30/91 0.53 2/28/10New York Tax-Free Bond PRNYX -4.52 1.64 3.21 3.38 4.27 8/28/86 0.52 2/28/10Summit Municipal Income PRINX -4.84 2.37 3.77 3.68 4.81 10/29/93 0.50 10/31/09Summit Municipal Intermediate PRSMX -3.34 2.23 4.29 4.15 4.47 10/29/93 0.50 10/31/09

Tax-Free High Yield PRFHX -4.89 3.91 2.34 2.52 4.35 3/1/85 0.68 2/28/10Tax-Free Income PRTAX -4.82 1.73 3.61 3.63 4.48 10/26/76 0.53 2/28/10Tax-Free Short-Intermediate PRFSX -1.20 2.09 4.08 3.87 3.66 12/23/83 0.50 2/28/10Virginia Tax-Free Bond PRVAX -4.88 1.14 3.63 3.54 4.44 4/30/91 0.48 2/28/10

† As of its fiscal year ended 10/31/09, the Emerging Europe & Mediterranean Fund’s gross expense ratio was 1.64%. However, the fund operates under a 2.00% contractual expense limitation that expires on 2/28/11.

††As of its inception on 1/27/10, the Global Infrastructure Fund’s gross and net expense ratios were 1.31% and 1.10%, respectively. The fund operates under a 1.10% contractual expense limitation that expires on 2/29/12.

‡As of its fiscal year ended 10/31/09, the Global Large-Cap Stock Fund’s gross and net expense ratios were 2.40% and 1.00%, respectively. The fund operates under a 1.00% contractual expense limitation that expires on 2/28/11.

‡‡As of its fiscal year ended 12/31/09, the Global Real Estate Fund’s gross and net expense ratios were 4.41% and 1.05%, respectively. The fund operates under a 1.05% contractual expense limitation that expires on 4/30/11.

3 Some income from the tax-free funds may be subject to state and local taxes and the federal alternative minimum tax.All mutual funds are subject to market risk, including possible loss of principal. Funds that invest overseas generally carry more risk than funds that invest strictly in U.S. assets due to factors such as currency risk, geographic risk, and emerging markets risk. Funds that invest in fixed income securities are subject to credit risk and liquidity risk, with high yield securities having a greater risk of default than higher-quality securities.



Ticker Symbol


10 Years or Since

InceptionInception

DateRedemp-tion Fee


Expense Ratio

Expense Ratio

as of Date

BOND fUNDS Domestic Taxable

Corporate Income PRPIX -1.57% 9.61% 6.40% 5.56% 6.41% 10/31/95 0.65% 5/31/10GNMA4 PRGMX 0.84 6.49 6.15 5.77 5.43 11/26/85 0.66 5/31/10High Yield PRHYX 3.44 14.37 8.82 7.85 8.35 12/31/84 1.0% 90 days 0.76 5/31/10Inflation Protected Bond PRIPX -0.78 6.29 4.84 5.07 5.61 10/31/02 0.63 5/31/10New Income PRCIX -0.95 7.16 6.87 6.21 5.97 8/31/73 0.72 5/31/10Short-Term Bond PRWBX -0.16 3.13 4.40 4.61 4.36 3/2/84 0.59 5/31/10Strategic Income PRSNX 1.30 10.42 – – 16.52 12/15/08 1.04 5/31/10Summit GNMA4 PRSUX 0.63 6.56 6.22 5.86 5.45 10/29/93 0.60 10/31/09U.S. Bond Index PBDIX -1.19 6.35 6.14 5.81 5.66 11/30/00 0.5 90 days 0.30 10/31/09U.S. Treasury Intermediate4 PRTIX -3.09 7.04 6.40 6.30 5.51 9/29/89 0.52 5/31/10U.S. Treasury Long-Term4 PRULX -8.19 8.91 6.15 5.86 6.09 9/29/89 0.59 5/31/10

4 The market value of shares is not guaranteed by the U.S. government.

BEnch- MARkS Domestic Bond

Barclays Capital U.S. Aggregate Index -1.30% 6.54% 5.90% 5.80% 5.84%Barclays Capital Municipal Bond Index -4.17 2.38 4.08 4.09 4.83Credit Suisse High Yield Index 3.15 14.42 9.22 8.40 9.11Lipper AveragesShort Investment-Grade Debt -0.06 3.90 3.06 3.61 3.65Corporate Debt Funds A Rated -1.09 7.51 5.19 4.78 5.24GNMA 0.29 6.16 6.36 5.86 5.26High Current Yield 3.50 14.24 7.07 6.60 7.02Short Municipal Debt -0.54 1.22 2.18 2.55 2.73Intermediate Municipal Debt -3.20 2.31 3.63 3.49 3.92General Municipal Debt -4.71 1.72 2.49 2.59 3.69

BOND fUNDS International/Global

Emerging Markets Bond PREMX -0.21% 13.29% 7.94% 8.20% 11.67% 12/30/94 2.0% 90 days 0.97% 12/31/09International Bond RPIBX -1.35 5.17 5.07 6.55 6.97 9/10/86 2.0 90 days 0.82 12/31/09

BEnch- MARkS International/Global Bond

Barclays Capital Global Aggregate ex U.S. Dollar Bond Index -1.34% 4.95% 5.62% 7.19% 7.42%

J.P. Morgan Emerging Markets Bond Index–Global -1.85 12.04 8.56 8.36 10.29

Lipper AveragesEmerging Markets Debt Funds -0.69 12.35 7.50 7.62 11.27International Income Funds -1.30 6.58 6.25 6.51 6.59

Ticker Symbol

7-Day Yield

7-Day Yield Without Waiver


10 Years or Since

InceptionInception

DateExpense

Ratio

Expense Ratio

as of Date

MONEy MaRkEt Tax-Free5

California Tax-Free Money PCTXX 0.01% -0.19% 0.00% 0.01% 0.60% 1.54% 1.37% 9/15/86 0.60% 2/28/10Maryland Tax-Free Money TMDXX 0.01 -0.19 0.00 0.01 0.66 1.60 1.41 3/30/01 0.53 2/28/10New York Tax-Free Money NYTXX 0.01 -0.19 0.00 0.01 0.63 1.57 1.42 8/28/86 0.58 2/28/10Summit Municipal Money Market TRSXX 0.01 -0.07 0.00 0.01 0.74 1.70 1.59 10/29/93 0.45 10/31/09

Tax-Exempt Money PTEXX 0.01 -0.12 0.01 0.03 0.70 1.66 1.51 4/8/81 0.49 2/28/10

Taxable5

Prime Reserve PRRXX 0.01% -0.21% 0.00% 0.01% 0.91% 2.42% 2.15% 1/26/76 0.58% 5/31/10Summit Cash Reserves TSCXX 0.01 -0.10 0.00 0.01 0.99 2.51 2.28 10/29/93 0.45 10/31/09U.S. Treasury Money PRTXX 0.01 -0.26 0.00 0.01 0.53 1.99 1.88 6/28/82 0.45 5/31/10

An investment in the money market funds is not insured or guaranteed by the FDIC or any other government agency. Although the funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the funds. Money fund yields more closely reflect current earnings than do total returns. 5 In an effort to maintain a zero or positive net yield for the fund, T. Rowe Price has voluntarily waived all or a portion of the management fee it is entitled to

receive from the fund. A fee waiver has the effect of increasing the fund’s net yield. The 7-day yield without waiver represents what the yield would have been if we were not waiving our management fee. This voluntary waiver is in addition to any contractual expense ratio limitation in effect for the fund and may be amended or terminated at any time without prior notice. Please see the prospectus for more details.



Editor: Steven E. norwitz Associate Editor: Robert BenjaminStaff Writers: Brian Lewbart and heather McDonoldEditorial Board: christine Fahlund, Alan Levenson, Brian Brennan, Darrell Riley, Tom Siedell, Brian Sullam, Jerome Tuccille

charts and examples in this issue showing investment performance (excluding those in the Performance Update section) are for illustrative purposes only and do not reflect the performance of any T. Rowe Price fund or security. A manager’s view of the attractiveness of a company may change, and the fund could sell the holding at any time. This material should not be deemed a recommendation to buy or sell shares of any of the securities discussed. Past performance cannot guarantee future results.

T. Rowe Price Investment Services, Inc., Distributor. copyright © 2010 by T. Rowe Price Associates, Inc. All Rights Reserved.

04779_UD 101669M00-065 1/11

Ticker Symbol

7-Day Yield


10 Years or Since

InceptionInception

DateRedemp-tion Fee


Expense Ratio

Expense Ratio

as of Date

aSSEt aLLOCatION

Balanced RPBAX 6.74% 12.51% 1.09% 4.72% 4.59% 12/31/39 0.73% 12/31/09Personal Strategy Balanced TRPBX 7.05 13.79 2.17 5.15 5.59 7/29/94 0.86 5/31/10Personal Strategy Growth TRSGX 9.37 15.38 -0.33 4.03 4.85 7/29/94 0.91 5/31/10Personal Strategy Income PRSIX 4.87 11.68 3.71 5.58 5.79 7/29/94 0.77 5/31/10Retirement 2005 TRRFX 4.78 11.51 2.60 5.13 5.62 2/27/04 0.61 5/31/10Retirement 2010 TRRAX 5.80 12.70 1.86 4.93 8.57 9/30/02 0.64 5/31/10Retirement 2015 TRRGX 6.88 13.79 1.41 4.83 5.78 2/27/04 0.68 5/31/10Retirement 2020 TRRBX 7.87 14.74 0.80 4.62 9.25 9/30/02 0.71 5/31/10Retirement 2025 TRRHX 8.61 15.37 0.26 4.44 5.79 2/27/04 0.74 5/31/10Retirement 2030 TRRCX 9.36 16.01 -0.14 4.32 9.66 9/30/02 0.76 5/31/10Retirement 2035 TRRJX 9.94 16.34 -0.38 4.18 5.71 2/27/04 0.77 5/31/10Retirement 2040 TRRDX 10.04 16.51 -0.31 4.22 9.64 9/30/02 0.77 5/31/10Retirement 2045 TRRKX 10.02 16.44 -0.31 4.22 5.48 5/31/05 0.77 5/31/10Retirement 2050 TRRMX 9.93 16.41 -0.35 — 1.40 12/29/06 0.77 5/31/10Retirement 2055 TRRNX 9.98 16.41 -0.38 — 1.37 12/29/06 0.77 5/31/10Retirement Income TRRIX 4.17 10.10 3.13 5.06 7.06 9/30/02 0.59 5/31/10Spectrum Growth PRSGX 10.86 16.88 -1.24 4.02 4.31 6/29/90 0.83 12/31/09Spectrum Income RPSIX 1.56 9.68 6.12 6.58 6.90 6/29/90 0.72 12/31/09Spectrum International PSILX 6.86 13.52 -4.09 4.60 4.83 12/31/96 2.0% 90 days 1.01 12/31/09

t. ROwE PRICE NO-LOaD VaRIaBLE aNNUIty6

Blue Chip Growth Portfolio 11.55% 15.72% -2.18% 2.72% 0.61% 12/29/00 0.85% 12/31/09Equity Income Portfolio 10.82 14.37 -3.17 1.98 3.55 3/31/94 0.85 12/31/09Equity Index 500 Portfolio 10.47 13.93 -3.83 1.30 0.13 12/29/00 0.40 12/31/09Health Sciences Portfolio 9.47 15.03 2.05 6.17 5.21 12/29/00 0.95 12/31/09International Stock Portfolio 7.03 13.78 -4.17 3.21 2.24 3/31/94 1.05 12/31/09Limited-Term Bond Portfolio -0.41 2.53 3.70 3.89 3.74 5/13/94 0.70 12/31/09Mid-Cap Growth Portfolio 13.66 27.42 3.40 6.50 6.93 12/31/96 0.85 12/31/09New America Growth Portfolio 14.33 18.99 2.87 5.62 2.38 3/31/94 0.85 12/31/09Personal Strategy Balanced Portfolio 6.91 13.07 1.19 4.29 4.93 12/30/94 0.98 12/31/09Prime Reserve Portfolio7 -0.55% -0.14 -0.42 0.50 1.95 1.67 12/31/96 0.55 12/31/09


An investment in the money market funds is not insured or guaranteed by the FDIC or any other government agency. Although the funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the funds. Money fund yields more closely reflect current earnings than do total returns.6 �A prospectus is available to existing clients who are considering an exchange into a new portfolio. The prospectus includes investment objectives, risks, fees,

expenses, and other information that you should read and consider carefully before investing. The T. Rowe Price No-Load Variable Annuity (Variable Annuity) is issued by Security Benefit Life Insurance Company (Form V6021). In New York, it is issued by First Security Benefit Life Insurance and Annuity Company of New York, White Plains, New York (FSB201(11-96)). (Security Benefit Life is not licensed in New York and does not solicit business in New York.) The yields and performance figures are based on the accumulation unit value (AUM) of the Variable Annuity subaccounts. Variable Annuity subaccount performance reflects a hypothetical contract and includes the effects of a mortality and expense risk charge of 0.55% on an annualized basis. The inception date relates to the date the portfolios were available as investment options in the Variable Annuity. The Variable Annuity, which has been available since April 1995 and in New York since November 1995, has limitations; contact your representative. It is distributed by T. Rowe Price Investment Services, Inc.; T. Rowe Price Insurance Agency, Inc.; and T. Rowe Price Insurance Agency of Texas, Inc. The underlying portfolios are managed by T. Rowe Price Associates, Inc. The Security Benefit Group of companies and the T. Rowe Price companies are not affiliated. The Variable Annuity may not be available in all states.

7 The 7-day unsubsidized simple yield for the Prime Reserve Portfolio was -0.73% as of December 31, 2010. In an effort to maintain a zero or positive net yield for the underlying portfolio of the variable annuity subaccount, T. Rowe Price has voluntarily waived all or a portion of the management fee it is entitled to receive from the underlying portfolio. This voluntary waiver is in addition to any contractual expense ratio limitation in effect for the underlying portfolio and may be amended or terminated at any time without prior notice. A fee waiver has the effect of increasing the underlying portfolio’s and subaccount’s net yield; without it, the underlying portfolio’s and subaccount’s 7-day yield would have been lower.

Indexes included in this update track the following: S&P 500—500 large-company U.S. stocks; S&P MidCap 400—stocks of 400 mid-size U.S. companies; Nasdaq Composite (principal only)—U.S. stocks traded in the over-the-counter market; Russell 2000—stocks of 2,000 small U.S. companies; MSCI EAFE—the stocks of about 1,000 companies in Europe, Australasia, and the Far East; MSCI Emerging Markets—more than 850 stocks traded in over 20 emerging markets; Barclays Capital U.S. Aggregate—investment-grade corporate and government bonds; Barclays Capital Municipal Bond—tax-free investment-grade U.S. bonds; Credit Suisse High Yield—noninvestment-grade corporate U.S. bonds; Barclays Capital Global Aggregate ex U.S. Dollar Bond—tracks investment-grade government, corporate, agency, and mortgage-related bonds in markets outside the U.S.; J.P. Morgan Emerging Markets Bond–Global—U.S. dollar-denominated Brady Bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities; Lipper averages—all funds in each investment objective category; and Lipper indexes—equally weighted indexes of typically the 30 largest mutual funds within their respective investment objective categories.

epo ricert · 2015. 4. 24. · issue no. 110 winter 2011 promising recovery, persistent risks stock...

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