Time to Invest in Short-Term Bonds?

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1 First Quarter 2010 Time to Invest in Short-Term Bonds? Executive Summary This paper outlines why now may be an opportune time to invest in short-term bonds. We believe short-term bonds offer: Less downside risk relative to longer term bonds since 1976 short-term bonds worst one-year performance was -0.2%, while long-term bonds worst one-year performance was -8.6% (see graph below) Solid long-term performance captured more than 75% of the return of their longterm counterparts Attractive risk/reward trade-off the Sharpe Ratio far exceeds that of long-term bonds over all time periods Compelling investment opportunity created by current market environment current low rates and uncertainty about future rates should shift short-term bonds to investors consideration set Incremental yield for investors with excess cash for investors with excess cash reserves and greater than a one-year investment horizon, short-term bonds offer increased yield with a minimal degree of volatility Comparison of the Best and Worst One-Year Returns Since 1976 S&P 500 Stock Index U.S. Aggregate Bond Index U.S. Govt/Cred Index -43.3% -9.2% -8.6% 10.7% 35.2% 33.5% 61.2% Inter Govt/Cred Index 1-5yr Govt/Corp Index -2.3% -0.7% 7.7% 28.6% 25.8% Best One-Year Return Annualized Total Return Worst One-Year Return 1-3yr Govt/Corp Index -0.2% 7.4% 23.6% Merrill Lynch/Bank of America 6.2% U.S. Treasury Bills (3 Month)* 0.2% *T-bill returns start 1978 Source:, Merrill Lynch/Bank of America and Bloomberg 12/31/09 PG %

2 Introduction Short-term bonds, best defined as fixed-income products that mature within one to three years, can be an attractive solution given today s historically low yields and potential for rising interest rates. On the maturity/ duration spectrum, they fall just beyond money markets and well short of long-term bonds. Short-term bonds maintain a relatively conservative investment posture and have typically had less price fluctuation than longer term bonds. Solid Long-Term Performance EXHIBIT 1: Historical Yield Curve Averages July December 2009 Yield 6.50% 6.25% 6.00% 5.75% 5.50% 5.25% Low Duration/ Short-Term Fixed Income Fed 1 Year 3 Year Funds Source: Federal Reserve and Bloomberg 12/31/09 Average ( ) 5 Year 10 Year The historical shape of the yield curve illustrates that, all things being equal, as the term of a bond increased so did its yield (see Exhibit 1). This risk premium is due to the fact that the price of a bond in changing interest rate environments is directly related to the duration of the bond, with the exception of money market funds which have a stable net asset value. Historically, moving out the yield curve has allowed investors to capture more income and have a higher total return than investors closer in on the yield curve. Short-term bonds, however, did provide 75% or more of the returns of long-term bonds over most time periods (see Exhibit 2). Over the 3- and 5-year periods, short-term bonds captured nearly 90% of the returns of long-term bonds. Exhibit 2 Comparison of Returns of Select Bond Indices Since 1976 Total Return 10.0% U.S. Government/Credit U.S. Aggregate Government & Credit (1-3 year) 6.0% 4.0% 4.5% 3.8% 5.8% 5.2% 4.7% 4.3% 6.3% 4.9% 6.8% 5.4% 7.0% 5.8% 6.5% 8.7% 7.6% 2.0% 0.0% 1 Year 3 Year 5 Year 10 Year 15 Year 20 Year 25 Year 30 Year Source: and FactSet 12/31/09 PG 2

3 Attractive Risk/Reward Trade-Off As with all investments, bond returns should be evaluated in combination with the potential risks associated with achieving those returns. When volatility was introduced into the equation, short-term bonds excelled. For periods ranging from one to 30 years, the Sharpe Ratio for short-term bonds far exceeded those of long-term bonds. In the most recent time periods, the Sharpe Ratio for the 1-3 year strategy is more than double the longer term bond. Short-term bonds captured over 80% of the returns of long-term bonds with only about a third of the volatility for the 1-, 3- and 5-year periods ending 12/31/09 1. (see Exhibit 3) Exhibit 3: Sharpe Ratio Comparison of Select Indices Since 1976 Sharpe Ratio U.S. Government/Credit U.S. Aggregate Government & Credit (1-3 year) 0.0 YTD 1 Year 3 Year 5 Year 7 Year 10 Year 15 Year 20 Year 25 Year 30 Year Entire Period Source: and FactSet 12/31/09 Another way to evaluate the risk/reward trade-off in the bond market is to analyze rolling one-year periods. Exhibit 4 shows the range of rolling one-year returns of various fixed income indices relative to the S&P 500 index, illustrating past extremes in the markets. Between 1976 and 2009, shortterm bonds had an average annualized total return of 7.4%, with a high of more than 23.0% and a low of only -0.2%. In contrast, long-term bonds had an average total return of with its best 12-month period generating 33.5% and its worst 12-month period generating -8.6%. This data suggests that short-term bonds offer less downside risk relative to longer-term bonds. Exhibit 4: Comparison of the Best and Worst One-Year Returns Since 1976 S&P 500 Stock Index U.S. Aggregate Bond Index U.S. Govt/Cred Index Inter Govt/Cred Index 1-5yr Govt/Corp Index 1-3yr Govt/Corp Index -43.3% Best One-Year Return Annualized Total Return Worst One-Year Return Merrill Lynch/Bank of America 6.2% U.S. Treasury Bills (3 Month)* 0.2% *T-bill returns start 1978 Source:, Merrill Lynch/Bank of America and Bloomberg 12/31/09-9.2% -8.6% -2.3% -0.7% -0.2% 10.7% 7.7% 7.4% 17.1% 35.2% 33.5% 28.6% 25.8% 23.6% 61.2% 1 FactSet PG 3

4 Exhibit 5: Ratio of 1-3 Year Index/3-month T-bill Returns 10.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% % Dec-77 Ratio of 1-3 Year Index /3-Month T-Bills Rolling 12-Month Total Returns Since 1977 Dec-79 Dec-81 Dec-83 Dec-85 Dec Year Index outperforms 3-month T-Bills (69%) 3-month T-Bills outperforms 1-3 Year Index (31%) While attractive total return is a great benefit of short-term bonds, investors should be aware that these returns fluctuate with the market. Exhibit 5 shows the difference between the rolling 12-month total return of the 1-3 year strategy and 3-month T-bills. On average, the 1-3 year strategy has outperformed 3-month T-bills by 1.29%. This wasn t without short periods of underperformance and even, in some cases, negative performance. But, over the entire 30+ year period, the low duration strategy outperformed 3-month T-bills 69% of rolling 12-month periods. Compelling Investment Opportunity Created By Current Market Environment Interest rates are at historic lows - a level last seen in the 1950s (see Exhibit 6). Economists and market participants have differing opinions on the timing and magnitude of interest rate changes as many uncertainties exist. However, some expect interest rates to stay low for an extended period of time in order to heal and reinvigorate the U.S. economy. Others are concerned that higher inflation expectations as a result of big deficits and a weak dollar could push interest rates higher in the near term. These are all valid concerns. Investors decisions, however, should be shaped by their investment goals and tolerance for risk. If interest rates stay low for an extended period, short-term bonds may be an appropriate investment for those who have excess cash reserves. If interest rates begin to rise, short-term bonds may be a good choice for investors who have the majority of their fixed-income allocation in longer term bonds. Exhibit 6: Comparison of One-Year and 10-Year Treasury Yields Since % % 1-Year Treasury 10-Year Treasury 14.0% 12.0% 10.0% 6.0% 4.0% 2.0% 0.0% Dec-54 Dec-59 Dec-64 Dec-69 Yield Dec-74 Dec-79 Dec-84 Dec-89 Dec-94 Dec-99 Dec-04 Dec-09 Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Average +129bp Source:, Merrill Lynch/Bank of America, Bloomberg and FactSet 12/31/09 Comparison of rolling 12-month return of 1-3 U.S. Aggregate Government Credit Index minus Merrill Lynch/Bank of America 3-month T-bill. Shaded areas represent recession periods. Source: FactSet 12/31/09 PG 4

5 Low Volatility Option Given Regulatory Reform As a result of the financial crisis and subsequent impact on the money market fund industry, the SEC is in the process of updating Rule 2a-7 which governs the management of money market mutual funds. These more restrictive changes to Rule 2a-7, designed to better protect investors during times of market duress, are expected to curtail the yield on money market funds while providing greater liquidity and a higher degree of safety. For the most part, these changes are positive for investors with short-term cash needs who need the security and liquidity of money market funds. The changes to Rule 2a-7, coupled with exceptionally low levels of interest rates at the very front end of the yield curve, prompted investors with an investment horizon beyond one-year to seek alternative strategies to enhance yield. A logical next step on this path to higher yields is to extend maturities beyond the money market arena to the low duration/short-term fixed-income markets. For investors with excess cash reserves, the road to higher yields may be garnered through the low duration/shortterm fixed-income markets and is accompanied with a higher degree of volatility. Investors looking to pursue a low duration strategy should evaluate options in ultra-short and short-term fixed-income categories. Conclusion The current market environment characterized by historically low interest rates and money market reform has created an opportune time to invest in short-term bonds. Investors with excess cash reserves earning near zero percent, as well as those invested in long-term bonds who may be most impacted by a rise in rates, will be well served to consider an allocation to short-term bonds as we believe they offer: Less downside risk relative to longer term bonds Solid long-term performance Attractive risk/reward trade-off Compelling investment opportunity created by current market environment Incremental yield for investors with excess cash In our opinion, investors who add an allocation of shortterm bonds to their portfolio mix will be rewarded for the effort. PG 5

6 About Ridgeworth Investments RidgeWorth serves as a money management holding company with eight style-specific institutional investment management boutiques, each with a welldefined, proven approach and all with unwavering commitments to exceptional performance. Through our multiple, style-specific boutiques, we offer a wide range of equity, alternative, fixed-income and liquidity management investment disciplines. RidgeWorth Investments, an investment adviser registered with the SEC since 1985, is headquartered in Atlanta, Georgia. Investment Considerations Bonds offer a relatively stable level of income, although bond prices will fluctuate providing the potential for principal gain or loss. Intermediate-term, higher-quality bonds generally offer less risk than longer term bonds and a lower rate of return. U.S. Government guarantees apply only to the underlying securities of a portfolio and not a Fund s shares. Mortgage-backed investments involve risk of loss due to prepayments and, like any bond, due to default. Because of the sensitivity of mortgage-related securities to changes in interest rates, a portfolio s performance may be more volatile than if it did not hold these securities. Definitions Standard & Poor s 500 Index is an unmanaged index of 500 selected common large capitalization stocks (most of which are listed on the New York Stock Exchange) that is often used as a measure of the U.S. stock market. Merrill Lynch/Bank of America 3-Month U.S. Treasury Bill Index tracks the total return performance of a 3-month Treasury bill, based on monthly average auction rates. 1-3 year Government/Credit Index is a component of the U.S. Government/Credit Index that includes Treasuries, Government-Related issues, and Corporates maturing between one and three years. Barclays 1-5 year Government/Credit Index is a component of the U.S. Government/Credit Index that includes Treasuries, Government-Related issues, and Corporates maturing between one and five years. Barclays Intermediate Government/Credit Index is an unmanaged index composed of all bonds that are investment grade rated Baa or higher by Moody s or BBB or higher by S&P, if unrated by Moody s. Issues must have at least one year to maturity. Barclays U.S. Aggregate Index is a widely recognized index of securities that are SEC-registered, taxable, and dollar denominated. The Index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage passthrough securities and asset-backed securities. Barclays U.S. Government/Credit Index is a widely recognized composite made up of the Barclays U.S. Government Index and the Barclays U.S. Credit Index, which include U.S. government, Treasury and agency securities, as well as high grade corporate bonds. Important Information This paper reflects the analysis and opinions of RidgeWorth Investments as of March Because market and economic conditions are often subject to rapid change, the analysis and opinions provided may change without notice. The analysis and opinions may not be relied upon as investment advice. Statements of fact are from sources considered reliable but no representation or warranty is made as to their completeness or accuracy. Although historical performance is no guarantee of future results, these insights may help you understand our investment management philosophy. In preparing this paper, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from reliable sources. An investor should consider the fund s investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information about the RidgeWorth Funds can be found in the fund s prospectus. To obtain more information, please call or visit Please read the prospectus carefully before investing RidgeWorth Funds. RidgeWorth Funds are distributed by RidgeWorth Distributors LLC. RidgeWorth Investments is the trade name for RidgeWorth Capital Management, Inc., the adviser to the RidgeWorth Funds, and is not affiliated with the distributor. Not FDIC Insured No Bank Guarantee May Lose Value PG 6

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