Bond Investing in a Rising Rate Environment

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1 September 3 W H I T E PA P E R Bond Investing in a Rising Rate Environment Contents Yields Past, Present and Future Allocation and Mandate Revisited Benchmark Comparisons Investment Options to Consider For a Rising Rate Environment Conclusion The sharp rise in US Treasury bond yields in June and July has caused many investors to consider either strategic or tactical changes to their fixed income portfolios. Although the recent rise in interest rates was record setting, rates are still likely to continue to rise over the next few years. While we would not recommend large strategic changes in fixed income allocations based on a market move, there are a number of tactical approaches available to investors who wish to reduce portfolio risk in a rising rate environment. In this paper we put the recent rise in yields into context, review historical risk/ return features of various US fixed income portfolio approaches, and discuss tactical opportunities for reducing risk in the current environment. Yields Past, Present and Future The 137 basis point rise in 1-year US Treasury bond yields, from 3.1% in early June to.5% as of August 1, was the largest percentage move for any two-month period in the last fifty years, representing a five standard deviation event. In absolute terms, the 137 basis point rise was less pronounced, representing just over a two standard deviation event. This recent rise in US yields followed an acute rally earlier this year, perhaps only correcting a short-term misvaluation. The degree of the initial market overshoot that sent 1-year yields down to 3.1% in the first place is illustrated by the fact that the returns of most bond market indices for the year through August remain in positive territory. History does tell us that once bond yields begin to rise, they tend to move fast and they tend to rise a lot (see Figure 1). In the twelve major interest rate lows of the last fifty years, 1-year US Treasury yields rose on average by 11 basis points in the twelve months following the bottom. This compares to a rise of 137 basis points for the two-month period ending August 1 of this year. As illustrated in Figure, rising bond yields have historically signaled an acceleration in nominal GDP growth. Figure 1 Twelve Major Yield Lows in Last Fifty Years 1-Year US Treasury Yield Figure Percent Interest Rates Follow Growth Rolling 3-year nominal growth 1-year Treasury Yield Source: Federal Reserve Source: Haver

2 Bond Investing in a Rising Rate Environment Wellington Management Company, llp At present, we believe that we are at an important inflection point for the US economy. Monetary and fiscal stimulus should boost sequential real GDP growth to above % in the second half of 3 (annual rate). This will be a marked acceleration from the % sequential growth of the first two quarters of the year. Fears of deflation should gradually subside we forecast the CPI to be about % for both 3 and. Key fundamental drivers of long-term interest rates include the pace of economic growth, the outlook for inflation, monetary policy, and the US fiscal position. While there were technical factors that exacerbated the recent bond market sell-off, much of the rise can be attributed to four factors: expectations of stronger economic growth; reduced concerns of deflation; a widening belief that the Federal Reserve has finished easing for this cycle; and burgeoning federal budget deficits. These factors could continue to place upward pressure on bond yields over the next few years, however, the rapid rise in bond yields has already priced in a relatively robust economic recovery. With inflationary pressures remaining low, and the Federal Reserve s statement that policy accommodation can be maintained for a considerable period, the rise in bond yields from current levels may be a relatively modest one. Allocation and Mandate Revisited Bonds are most often included in a portfolio primarily to dampen the volatility of common stocks (See Exhibit 1). Long-term total return is typically a secondary consideration. Given the longer time frame in which strategic asset allocation decisions are made, the risk/return profile of bonds remains attractive even in a rising rate environment when viewed in historical context. In setting investment policy, most investors look at the broad US bond market, as represented by the Lehman Aggregate Index. The Lehman Aggregate Index has experienced 13 calendar years with negative principal returns as illustrated in Figure 3. However, the Lehman Aggregate has had only two negative calendar year returns (199 and 1999) as income returns have offset most negative price movements due to rising rates. Furthermore, in the past years, there have been no negative returns for the Lehman Aggregate over any rolling -year period. Exhibit 1 The Role of Bonds Rolling One-Year Correlation of Stock and Bond Returns The primary role of bonds in most diversified portfolios is to dampen the volatility of common stocks. As illustrated in the graph above by the rolling one-year correlations of stock and bond returns for the period 197, bonds have done what they were intended to do offer diversification benefits and dampen overall portfolio volatility. During this period, the average one-year correlation was.35. Recently, the correlation has turned negative, largely due to a decline in inflation. In periods of inflation, stocks and bonds tend to be positively correlated. One could argue that in an environment where inflation is drifting higher, TIPS (Treasury Inflation Protected Securities) could serve as an effective hedge against inflation risk in a portfolio. TIPS have a defined relationship with inflation, and will behave differently than other fixed income securities, such as nominal Treasuries, corporate bonds, or mortgages, during various interest rate environments. Figure 3 Percent Total Returns from Bonds Lehman Aggregate Index * Source: Standard & Poors, Lehman Brothers, Ibbotson Total Return Principal *Returns through August 3 Source: Lehman Brothers

3 Wellington Management Company, llp Bond Investing in a Rising Rate Environment 3 Although some investors have compared the most recent rate rise to the bond bear market of 199, the economic profile was very different then. Economic growth and inflation were much stronger in 199 than they are today. In 199, the Federal Reserve implemented restrictive monetary policy to control inflation, whereas in the current environment the Federal Reserve has maintained an accommodative monetary policy to encourage global economic growth. Also, by comparison, the current steepness of the yield curve is at a level not seen in the past twenty years. This raises the question of how much further bond yields are likely to rise while the Fed keeps short rates anchored at 1%. As mentioned earlier, despite the recent sharp rise in bond yields, returns in 3 through August for the Lehman Aggregate Index and most other bond market indices were still positive. This is especially noteworthy considering that, as interest rates reached 5-year lows in 3, there has been less of an income cushion to offset any negative price movements than in the past. Benchmark Comparisons The risk/return profiles of the most typical bond mandates are also worth comparing in historical context (using the major US bond indices as proxies), since the selection of a benchmark is most often the primary determinant of portfolio interest rate risk. 1 The range of returns over the past years for the cash, short, intermediate, and broad bond markets (using the 3 month T-bill, Lehman Brothers 1-3 year Treasury Index, Lehman Brothers Intermediate Gov/Credit Index and Lehman Brothers Aggregate Index) Figure Benchmark Risk and Return Characteristics 1 Quarterly Returns, % Rolling Monthly Cash Short Intermediate Core Strategy Source: Lehman Brothers years ended 6/3/ Annual Returns, % Rolling Quarterly Cash Short Intermediate Core Strategy Best Median Worst is illustrated in Figure on both a quarterly and annual basis. The past twenty years captures periods of both rising and falling interest rates as well as several significant events that caused volatility in the capital markets: the Mexican peso devaluation (199); the dissolution of Long Term Capital Management and the Russian debt default (1998); Enron and other corporate governance issues (); and War with Iraq (3). As expected, Figure shows that the greater the interest rate risk taken, as measured by duration, the higher and more volatile were the returns experienced. In addition, when viewed together, the two charts illustrate that, when viewed over annual versus quarterly time periods, the median return improves and the loss severity diminishes. It is important to point out that the underlying data reflect index returns only, which approximate the returns available from a passive, buy-and-hold investment. Active portfolio management can further enhance returns. As evidence, even the median manager in the Frank Russell and William M. Mercer manager universes has consistently outperformed the broad US fixed income market over the 1, 3, 5, 7 and 1-year periods ended June 3, 3. Investment Options to Consider For a Rising Rate Environment There are several options that fixed income investors may employ to tactically hedge a portfolio against a rise in interest rates. The options outlined below are presented as alternatives for tactical asset allocation shifts, although options one and four may also reflect changes in strategic asset allocation. Tactical asset allocation moves may pose several challenges. They may be difficult to implement swiftly enough to take advantage of changes in market conditions. Also, a discussion with the portfolio manager may reveal that a short duration strategy is already being pursued tactically that may accommodate the desire to reduce interest rate risk in the near term. Finally, before making a tactical move, one needs to compare the market forecast with the forward rate structure to see what market moves have been priced into the market. Exhibit describes forward rate analysis, which would be background for a discussion with the fixed income portfolio manager about tactical opportunities.

4 Bond Investing in a Rising Rate Environment Wellington Management Company, llp Exhibit Forward Rate Analysis Percent Percent 6 Forward Interest Rate Structure as of July 31, Implied Change in US Treasury Yields Years to Maturity July 3 July July 5 YOY basis point change 3- YOY basis point change year year 3 year year 5 year 7 year 1 year year Source: Bloomberg The shape of the yield curve can often tell us a lot about market expectations for future interest rate movements. A very steep yield curve implies that market participants expect the general level of interest rates to rise, whereas expectations for lower interest rates lead to a flatter, or even inverted, yield curve. Forward rates are essentially break-even rates reflecting what future yields are priced in to the bond market. The forward interest rate can be calculated for virtually any maturity, and any investment time horizon. Active fixed income managers often use forward rates to determine which parts of the yield curve are rich or cheap relative to their forecasts. For example, on July 31, 3 the 1-year forward rate for the 1-year Treasury bond was 37 basis points higher than the current rate. If the actual 1-year rate in one years time has risen more than 37 basis points, then reducing duration would have generated better total returns (taking into account income, and yield curve roll-down). Similarly, if interest rates in one years time have risen by less than the forward rate implies, a longer duration strategy would have been more profitable. Due to the upward slope of a normal yield curve, the forward yield curve nearly always lies above the current yield curve. Holding longer maturity bonds, however, involves more return variability and therefore has a risk premium attached. 1 Shorten Duration via Mandate Change Portfolio duration can be shortened by changing the mandate in whole, or in part, to a shorter-duration benchmark. A portfolio managed against the Lehman Brothers Aggregate Index could, for example, move to the Lehman Brothers Intermediate Government/Credit Index, the Lehman Brothers 1-3 Year Treasury Index, or 1-month LIBOR. The strategy of shortening duration does effectively reduce the risk of principal loss, however the transactions costs for selling longer-duration securities can be significant, especially if the move is a tactical one that may be reversed in a short period of time. Other considerations include the income that would be sacrificed by a move down the yield curve, and the potential additional costs incurred by conducting a search for a new manager if the current portfolio manager does not manage, or specialize in, shorter-duration portfolios. Of course, there is also the opportunity cost relating to the sacrifice of enhanced returns, especially in the case that the original rate forecast were to later turn out to be incorrect. Shorten Duration Using Derivatives A second option is to modify the portfolio s duration through the use of derivatives. A futures program, for example, can often be implemented by the existing portfolio manager. Selling Treasury futures to reduce overall portfolio duration is easy to implement, flexible, and does not incur significant transactions costs, as illustrated in the example in Exhibit 3. Although some income is sacrificed when selling futures, the high degree of liquidity and flexibility for duration adjustment more than offsets this income give-up. 3 Shorten Duration by Redeployment of Income A third option is to redeploy principal and coupon payments into shorter-duration fixed income instruments. This strategy gradually shortens the duration of the overall portfolio and does not incur the transactions costs that occur when an index or mandate is changed altogether. In this option, some yield is sacrificed as shorter-duration fixed income instruments are replacing longer-duration ones.

5 Wellington Management Company, llp Bond Investing in a Rising Rate Environment 5 Diversify Mandate The last option that we explore is a strategy that, instead of reducing interest rate risk, diversifies portfolio risk by broadening the fixed income mandate to include opportunistic allocations to less-correlated asset classes such as non-dollar fixed income, emerging markets debt, and high yield bonds. This option may not change the overall portfolio duration, but reduces interest rate risk by adding fixed income sectors to the portfolio that are less correlated with interest rate movements. A portion of the portfolio is still exposed to interest rate movements because the majority of portfolio assets are still invested in governments, mortgages and investment grade corporates. Adding non-dollar fixed income, emerging markets debt, and high yield debt increases portfolio volatility, however on the positive side, there is a significant income advantage to adding these sectors to the portfolio. Figure 5 summarizes pros and cons of the four options outlined above. Figure 5 The Impact of Policy Options to Reduce Risk Source: WMC Conclusion Reduces Low Impact Ease of Duration Transaction on Implementation Costs Income Mandate and Index Change Employ Treasury Futures Redeploy Cash Flows (over time) (over time) Include Opportunistic Sectors Legend: + = positive impact; - = negative impact ; = neutral impact The sharp rise in US bond yields in 3 has been significant in historical context. We are currently at a cyclical turn in the interest rate cycle and increased volatility around this inflection point is natural. Bonds will continue to play an important role in a diversified portfolio and the policy rationale for their inclusion has not changed. Benefits include dampening the volatility in a portfolio and, even Exhibit 3 Controlling Interest Rate Risk with Futures The duration of a fixed income portfolio can be easily managed through the purchase and sale of bond futures. The calculation of the number of futures contracts required to change portfolio duration is simply: Desired Change in Portfolio Duration x Portfolio Market Value Futures Contract Duration x Futures Contract Face Value The standard face value of bond futures traded on the Chicago Board of Trade is $1,. The current duration of the cheapest-to-deliver bond for the 1- year Treasury future is approximately 7 years. Thus, the calculation of the number of contracts required to shorten the duration of a $1 million portfolio by one year would be: -1 x $1,, 7 x $1, = -13, or short 13 contracts. Selling longer-duration cash securities to shorten the duration of a portfolio that is structured like the Lehman Aggregate Index by one year would require the sale of most corporate and government bonds with a duration longer than ten years, or about 9% of the portfolio. The commissions cost for the futures trade would run about 1.6 basis points, or $,88 in our example. The transactions costs involved in trading on-the-run Treasury bonds would be similar, however, transactions costs for corporate bonds would be substantially higher, perhaps between and 5 basis points. Assuming the sale of an equal amount of Treasuries and corporate bonds, the transactions cost for the sale would be approximately 3 basis points on 9% of the portfolio, or approximately $,7. Although futures contracts are generally fairly liquid out one year or longer, contracts may need to be rolled over into longer-dated contracts, which may increase trading costs. However, credit and counterparty risk in the futures market is virtually negligible as the exchange acts as counterparty for all futures trades.

6 6 Bond Investing in a Rising Rate Environment Wellington Management Company, llp in a rising rate environment, bonds have an overall income advantage, and that increases as coupon income is reinvested at higher prevailing interest rates. Important also is that strategic asset allocation decisions are usually made with a long time horizon in mind. However, on a tactical basis, the portfolio strategies outlined in this paper can be implemented to mitigate potential losses that may be caused by further yield rises. Maryann E. Carroll Director, US Macroanalysis Diana L. Kaschub Fixed Income Product Manager Christopher B. Steward, CFA Portfolio Advisor September 3 1We recognize that many fixed income investors look to hedge against inflation. Others may use fixed income for liquidity, as a deflation hedge, as a liability-matching strategy, or have other constraints placed upon their portfolios. For the purposes of this discussion, the analysis will be limited to total return-oriented fixed income investors. The large weight of mortgage-backed securities in broad market indices also can lead to duration volatility, simply because of the negative convexity property of mortgages. The shift to an index such as the Lehman Brothers Intermediate Government/Credit Index may be more suitable, as this index does not include mortgages. In fact, the duration of the Lehman Aggregate tends to lengthen in a rising rate environment. This brochure is prepared for and authorized for internal use by designated institutional clients of Wellington Management Company, llp and its affiliates ( Wellington Management ) only, and is not intended to convey investment advice. The brochure and/or its contents may not be used, reproduced or distributed, in whole or in part, for any purpose, without the express written consent of Wellington Management. Wellington Management International Ltd is regulated in the UK by the Financial Services Authority (FSA). This communication is directed only at persons (Relevant Persons) who are classified as market counterparties or intermediate customers under the rules of the FSA. This communication must not be acted on or relied on by persons who are not Relevant Persons. Any investment or investment service to which this communication relates is available only to Relevant Persons and will be engaged in only with Relevant Persons. 1169_6 3 Wellington Management Company, llp. All rights reserved.

7 Wellington Management Company, llp Bond Investing in a Rising Rate Environment 7

8 8 Bond Investing in a Rising Rate Environment Wellington Management Company, llp This brochure is prepared for and authorized for internal use by designated institutional clients of Wellington Management Company, llp and its affiliates ( Wellington Management ) only, and is not intended to convey investment advice. The brochure and/or its contents may not be used, reproduced or distributed, in whole or in part, for any purpose, without the express written consent of Wellington Management. Wellington Management International Ltd is regulated in the UK by the Financial Services Authority (FSA). This communication is directed only at persons (Relevant Persons) who are classified as market counterparties or intermediate customers under the rules of the FSA. This communication must not be acted on or relied on by persons who are not Relevant Persons. Any investment or investment service to which this communication relates is available only to Relevant Persons and will be engaged in only with Relevant Persons. 1169_6 3 Wellington Management Company, llp. All rights reserved.

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