Citi analysts expect long-term US rates may rise further than markets are currently discounting. The US is showing signs of a sustainable recovery

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1 Citi analysts expect long-term US rates may rise further than markets are currently discounting The US is showing signs of a sustainable recovery Improving fundamentals are expected to drive US interest rates even higher by later this year Citi analysts believe now is the right time for investors to position their portfolios Portfolio analysis is a crucial starting point in order to determine the risks inherent in your portfolio and set a clear investment objective Investors can either look to capitalize on a rising rate environment or manage their exposure to interest rate risk our analysts highlight strategies for both Why Now? Interest rates in the developed world are near record lows given slow growth and benign inflation pressures. That said, the macro underpinnings of a sustainable US recovery have become more evident. While timing is uncertain, our analysts believe that rates may rise further than the markets are currently discounting. Although Citi analysts expect inflation to remain subdued and soft economic data to persist near term, improving fundamentals are likely to drive US interest rates higher by later this year. The window of opportunity to prepare portfolios will narrow once markets build consensus around this view. Citi analysts believe that now is the right time for investors to be thinking about the implications of higher interest rates. In their view, the risks of not preparing portfolios for a higher rate climate currently outweigh the costs. In this paper, our analysts explain their views on where interest rates are headed and the implications this may have on fixed income portfolios. They also outline the various options available to investors looking to either capitalize on or protect their portfolios from a rising rate environment. Concerns about higher interest rates have prompted many investors to re-evaluate their holdings. After all, with short-term rates in the developed world near zero and longer-term rates around historic lows, it s safe to presume that interest rates will rise eventually. While rising interest rates naturally correlate to improving economic activity, many investors have simply hedged portfolios too early. Lackluster growth has persisted across the developed world, broadly keeping rates low and postponing the day of reckoning for many bond investors. Growth prospects remain fairly benign, suggesting that central banks will remain on hold and that a sharp rise in bond yields is unlikely near term.

2 That said, the macro underpinnings of a sustainable US recovery have become more evident. Citi economists expect fourth quarter 2013 GDP to be around 2.4% (year-over-year), and improving activity into While inflation will probably remain subdued, fundamentals are likely to drive US interest rates higher later this year. Business and consumer credit demand is rising, and the housing market has broadly stabilized. Although labour markets have only modestly improved, our analysts expect a more constructive trend to resume during the second half of the year as the US economy gathers momentum and uncertainties about fiscal drag (government spending cuts and tax increases) begin to fade. In short, the current level of rates does not appear consistent with improving fundamentals. Lest anyone accuse us of ignoring any weakness in US economic data clearly, the economy is still healing. Our analysts acknowledge that the path to higher rates will not be linear, and that soft activity may continue. US interest rates may be constrained by disappointments to growth, low inflation, and safe haven flows (which bolster the demand for Treasury debt) as European periphery concerns and other global risks persist. But if you believe, as our analysts do, that the healing process in the US is underway, and is further advanced than in other major markets, then now is a good time to assess your USD fixed income holdings. Unless you expect another recession to occur, then US interest rates will (at best) move sideways in the near term or trend higher from here. Our analysts suggest preparing for the latter eventuality. Which Rates will likely be impacted? Of course, investors have been speculating about the possibility of higher interest rates in the US since the conclusion of the Great Recession (which officially ended in June 2009). Bond bears have been foiled every time. Indeed, this year we have witnessed a similar pattern to 2010, 11, and 12: Interest rates rose during the first quarter, and subsequently swooned during the second quarter. In the last few years, bond yields mostly stayed lower for the remainder of the year (Figure 1). Figure 1: Treasury rates have swooned in the second quarter of the last four years Source: Bloomberg, as of 20 May Past performance is no indication of future results Substantially reduced tail risks in Europe and a stronger US economy suggest that the decline in rates this time around will be more transitory. Indeed, we have already seen evidence of this reflected in the sharp backup in rates that occurred in May. The fundamental backdrop in the US stands in stark contrast to its largest developed market counterparts. In Europe, recessionary conditions are apt to persist, and further policy rate cuts are likely. In Japan, where growth prospects have improved, policymakers have pulled out all the stops in an attempt to defeat the deflationary demon once and for all. Citi analysts don t expect interest rates to rise equally across the yield curve (sometimes referred to as a parallel shift ). Indeed, short-term rates are unlikely to move much near term. That s because the Federal Reserve s overnight rate (Fed funds) is likely to be anchored near zero for at least the next two years. The central bank

3 Yield (%) has provided guidance that a substantial drop in the unemployment rate (to at least 6.5%) is required before they would consider hiking Fed funds from their current 0% to 0.25% range. That doesn t mean short-term policy or market rates won t budge. Indeed, a majority of Federal Reserve board members currently believe that the target rate over the longer run (5-6 years) should be closer to 4%, not 0%. In the near term, Citi rate strategists project that 3-month LIBOR could roughly double and 2-year Treasury yields could triple during the next 12 months despite the expectation that Fed funds will remain unchanged. But with the Fed s overnight rate anchored for at least the next two years, yields on longer-dated maturities are likely to bear the greatest impact near term. Current Q The long end of the curve which will be affected by improving economic activity, higher inflation expectations and lower demand is poised to bear steepen (longterm rates rise faster than short-dated yields) as growth improves (Figure 2). This steepening was clearly reflected in the May sell-off triggered by news of improving economic data Figure 2: The US yield curve is poised to bear steepen Source: Bloomberg, CIRA Interest Rate Forecast as of 22/07/2013. Past performance is no indication of future results Moreover, while Federal Reserve officials are currently debating the benefits and costs of its asset purchase program, QE (quantitative easing) efforts are likely to be moderated sometime later this year. The Fed has been buying $45 billion of long duration Treasury securities each month (along with $40 billion of agency mortgage-backed bonds) in order to inhibit a rise in yields and hold down borrowing costs. Citi estimates that the cumulative effects of the Fed s easing programs have helped to artificially depress the 10-year Treasury yield by around 100 basis points. Recent minutes from the Federal Open Market Committee (FOMC) and statements by the Chairman and Fed Governors confirm that some board members favour tapering off QE purchases in the near term, which would directly dilute demand for longer-dated Treasury debt. Any further signals suggesting that purchases could be tapered off, or that the program could end, would likely drive bond yields even higher across the term structure. What Does this Mean for Investors? Potentially higher rates are a critical consideration for bondholders since the discounted value of future cash flows declines as interest rates rise. This negatively impacts the principal value and prospective returns of fixed income portfolios. Portfolios with longer effective durations are more sensitive to changes in risk-free rates. Effective duration provides investors with a way to gauge the approximate change in price given a 100 basis point (or 1.0%) change in yield. For example, the value of a fixed income portfolio with a 10-year effective duration would rise (or fall) by around 10% for every 1.0% change in yield, while a portfolio with a 5-year duration would only rise (or fall) by roughly 5.0%. Figure 3 demonstrates this rate sensitivity. Our analysts performed in May this year an interest rate analysis on the Citi US Broad Investment Grade Index (US Treasury, US agency, corporate and collateralized debt)

4 over a 12-month period for multiple yield curve scenarios. The table makes clear that longer duration securities are more susceptible to severe increases in government rates. Total returns may be positive if interest rates increase by only a modest amount since coupon returns could offset potential principal loss. Figure 3: The impact of rate changes on bond returns Source: Source: Citi Private Bank Fixed Income Strategy as of 20 May Our analysts assume a parallel shift in the US Treasury yield curve, over a 12 month time horizon, with zero reinvestment rate. Past performance is no indication of future results More specifically, we look at the impact of higher interest rates on return prospects in the US government market based upon Citi s interest rate forecasts. Clearly, we expect losses to progressively mount as yields rise during the second half of the year and beyond, and for long-duration securities to be under the greatest pressure. (Figure 4) Figure 3: Returns on US government bonds based upon Citi rate forecasts Source: Source: Citi Private Bank Fixed Income Strategy as of 20 May Our analysts assume a zero reinvestment rate. For Illustrative Purposes Only. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Actual results may differ materially from the forecasts/estimates. Strategies and Opportunities Our analysts believe now is an opportune time to consider repositioning fixed income portfolios. Investors may consider hedging existing holdings or adding exposures that could potentially outperform in a rising rate environment. There are many ways to position bond portfolios for higher interest rates. Options vary depending on an investor s level of sophistication and suitability. The alternatives range from simply shortening duration to using complex interest rate swaps to hedge or partially hedge positions. As suitable, certain derivatives and structured products can also help investors opportunistically invest for a rise in rates, both on a capitalprotected and non-capital protected basis. Our analysts provide the following as a compendium (but not exhaustive) of ways to prepare for a rising rate environment, and briefly highlight how each strategy could be impacted by a change in rates.

5 Shorten Portfolio Duration One of the most straightforward ways to seek protection against rising rates is to eliminate fixed income allocations altogether, or to simply shorten duration. By reducing duration (or the portfolio s sensitivity to changes in interest rates), investors mitigate the price impact on bond investments as rates rise. Investors can reduce allocations to long-duration fixed income debt, or swap longer-dated positions into securities with shorter maturities. Although shorter duration bonds are characteristically less volatile when interest rates rise, these types of investments offer limited price appreciation if rates remain low (or move lower). Moreover, since short-dated bonds mature in a relatively brief time period, there is a higher risk that principal proceeds may need to be reinvested into a lower yielding security. There are also opportunity costs associated with cutting duration when the yield curve is positively sloped. With short-term rates near zero, the benefits from lower volatility may be offset by reduced portfolio income. Purchasing premium bonds with relatively higher coupons is another way to shorten overall duration and lower volatility. Premium bonds typically feature more attractive cash flows relative to current market levels. Thus, in a rising rate climate, the price of these securities would be more resilient and outperform compared to a portfolio of lower coupon debt. Moreover, high coupon bonds often feature relative value compared to par or discount bonds given the disinclination of most investors to pay a premium. Limit Exposure to Rate-sensitive Securities Investors concerned about rising rates should consider limiting exposure to fixed income asset classes that are most sensitive to changes in rates. These include US Treasury bonds, government agency securities and high quality (AAA/AA-rated) corporate bonds, which run a greater risk of principal deterioration as rates rise. This is largely due to the negligible spread (or incremental yield over the risk-free rate) currently offered by these securities, which provides a minimal buffer to rising interest rates. Zero coupon bonds are exceptionally vulnerable to higher rates since these provide no cash flow and feature higher volatility than traditional bonds. Favour credit risk over rate risk In an improving economy, we prefer credit risk over interest rate risk. As long as rising interest rates are due to strengthening fundamentals (as we expect), lower quality fixed income investments (such as BBB-rate corporates and high yield bonds) can potentially offer attractive returns with relatively higher yields. Although spread compression may be very modest, these bonds typically feature larger yield premiums (due to inherently higher credit risks), which can potentially generate more compelling interest returns compared to government-backed debt following a modest correction. Investors could consider utilizing a lower quality, short duration strategy to limit rate volatility while benefiting from the larger spread premium. Diversify Sources of Yield Fixed income investors seeking income-generating vehicles should consider diversifying their sources of yield beyond bonds. As suitable, these could include real estate investment trusts (REITs) and other high dividend paying stocks, such as utilities, where current dividend yields compare favourably to the income produced by high quality bond instruments. As economic prospects improve and rates rise, equities generally have greater potential for price appreciation than traditional fixed income instruments. Consider Floating-rate Investments Many fixed income asset classes offer floating-rate debt, such as securitized bonds (commercial mortgagebacked securities (CMBS), asset backed securities (ABS), and some non-agency residential mortgagebacked securities (RMBS), high grade corporate securities, municipal bonds, subordinated hybrids (fixed-to-

6 float preferreds), and high yield (leveraged bank loans). These have the potential to outperform traditional fixed-rate instruments during periods of rising rates. Typically, floating-rate securities are linked to very short-term interest rates (usually LIBOR), plus a spread. As short-term rates rise, these securities benefit from higher cash flows, thereby limiting volatility. Many credit and bank loan investments also contain coupon floors (or minimum coupons), which ensure a minimum cash flow if rates were to decline significantly. While floating-rate investments provide one way to hedge higher rates, they tend to be fairly illiquid compared to conventional fixed income securities. This fosters higher volatility, and can be a distinct disadvantage for investors seeking to lighten exposure if demand waned (say, if rates were to decline). Floating-rate funds have gained a significant amount of investor attention during the last six months. This is especially true of funds that feature high yield bank loans, where valuations have been comparable to spreads of fixed-rate (unsecured) high yield bonds. While high yield bank loans benefit from tighter credit spreads, it is important to keep in mind that the floating-rate component is tied to a short-term rate. This is likely to constrain performance near term if, as our analysts expect, short-term rates remain relatively low. Offset Potential Inflation Risks We don t expect US inflation pressures to be particularly onerous near term. However, as growth prospects become more sustainable, investors should consider hedging potential price pressures with inflationprotected debt. Treasury inflation protected securities (TIPS), are designed to outperform when inflation rises. Of course, this is contrary to the way inflation impacts other bonds. Typically, when accelerating, inflation causes interest rates to back up, and therefore conventional bond prices decline. The value of TIPS, however, is tied to the performance of the consumer price index (CPI-U), and even though the coupon is fixed, semi-annual interest payments would increase along with rising inflation. Investors can also add inflation protection with real return funds. These funds typically invest in inflationlinked debt, floating-rate securities, commodities and real estate. Integrate an Absolute Return Strategy For opportunistic investors, absolute return strategies featured by hedge funds or mutual funds may provide the flexibility to profit from a potential rise in interest rates. These funds seek to generate uncorrelated returns from traditional market benchmarks with reduced volatility. Since absolute return managers endeavour to produce profits in all market conditions, strategies are typically unconstrained and holdings can be quite diverse, For example, an absolute return fund may comprise active allocations to conventional spread sectors while employing hedging strategies that use derivative instruments (i.e., futures, options, and swaps). Hedge with Derivatives or Structured Products Derivatives allow both investors with bond portfolios and borrowers with floating-rate liabilities to hedge interest rate risks. Fixed income derivatives can be used to either mitigate the impact of, or used opportunistically to profit from, changes in interest rates. Most investors require guidance to properly evaluate these instruments since they tend to be more complex and less transparent than other investments. Many types of structured products are created using derivatives to benefit from changes to interest rates. Structures can be customized to specific risk parameters and may be purchased on a principal-protected or non-principal protected basis, depending on whether an investor is willing to put capital at risk.

7 Citi analysts View Bond yields in the developed markets are likely to continue trading near record lows in the near term given weak economic data and anaemic inflation pressures. Periphery challenges in Europe are far from over, and the continued use of unconventional central bank action around the world is a stark reminder that the healing process is still underway. While US rates are likely to remain low in the near term due to fiscal drag, we continue to believe that the underpinnings of a sustainable recovery have fallen into place. As such, US government yields are poised to rise further during the second half of the year as economic activity improves. There are many ways to opportunistically position for higher rates or to hedge fixed income portfolios and floating-rate liabilities. Each strategy features its own set of risks and costs that investors should carefully evaluate depending on their individual investment objectives and risk tolerance. To be sure, getting the exact timing right for a rise in interest rates has always been challenging. It is no different this time around, particularly since a number of economic and geopolitical headwinds ensure that the move to higher rates will not be linear. Indeed, investors who hedge or seek to profit from higher rates could risk being too early should economic prospects fall short of what our analysts expect. In Citi analysts view, though, the soft patch transpiring in the US is temporary, and economic momentum will accelerate later this year. The risks of not preparing portfolios for a higher rate climate currently outweigh the costs. Strategies and investments mentioned in this document may not be suitable for all investors and may have eligibility requirements that must be met prior to investing. Each investor should carefully view the risks associated with the investment and make a determination based upon the investor s own particular circumstances, that the investment is consistent with the investor s objective. Products and strategies described herein involve risk and may not perform as described. For details regarding these risks, please see disclosures.

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