How to manage your fixed-income investments when interest rates rise

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1 How to manage your fixed-income investments when interest rates rise April 2015 Begin by taking a thoughtful approach. Consider total return and not just current yields. Make sure you maintain portfolio-wide diversification. When market interest rates surged in 2013, many said it was the beginning of a reversal in the general interest rate decline that began in However, those predictions haven t panned out, as economic growth disappointed and rates declined once again in Nonetheless, the professionals at Merrill Lynch Investment Management & Guidance foresee a measured return to higher levels. We anticipate that rates will follow the path of economic growth, which we expect to move higher, says John Manetta, senior portfolio manager, Investment Management & Guidance. Fixed-income investors, operating from a position of strength after a 30-year-plus bull market in rates, would be prudent to plan ahead. Changing interest rates can be a concern to bond investors because as rates rise, the price of existing bonds declines. So how should you manage your fixed-income investments in light of possible rate changes? Fixed-income investors, operating from a position of strength after a 30-year-plus bull market in rates, would be prudent to plan ahead. John Manetta, senior portfolio manager, Investment Management & Guidance Historically low rates will go up eventually Since December 2008, the U.S. Federal Reserve has held its key short-term interest rate, the federal funds rate, at 0% to 0.25%, its lowest level ever. As a result, interest rates on fixed-income securities, from 30- day U.S. Treasury bills to 10-year Treasury notes and 30-year government bonds, sunk to historic lows and have risen only modestly since. But the Fed s policy of Quantitative Easing ended in 2014, and as an improved economy allows the Fed to raise its short-term rate target, rates are likely to work their way higher. This paper addresses the effect of interest rate increases on fixed-income investments and suggests how to position your portfolio in light of those changes. Whether you already own bonds individually, or through mutual funds or exchange-traded funds (ETFs) or you are getting ready to purchase them, it s essential to understand the key principles that underlie fixed-income investing so you can react appropriately. Merrill Edge is available through Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S), and consists of the Merrill Edge Advisory Center (investment guidance) and self-directed online investing. MLPF&S is a registered broker-dealer, Member SIPC and a wholly owned subsidiary of Bank of America Corporation. Banking products are provided by Bank of America, N.A., member FDIC and a wholly owned subsidiary of Bank of America Corporation. Investment products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value

2 Bond fundamentals and rising rates Interest rates drive bond prices A basic principle of bond investing is that interest rates drive prices: when rates rise, bond prices go down. More specifically, as rates go up, the price of existing bonds must fall in order to make their lower interest payments more attractive to potential buyers. If you own those loweryielding/lower-coupon bonds and you try to sell them, you ll find they ve lost some value. For example, let s say you purchased a bond for $1,000 at an annual yield of 4% (its coupon rate), but yields on bonds of that maturity and quality have now risen to 5%. When you try to sell the bond, no one will pay the $1,000 that you paid to earn a 4% yield when they can receive a yield that is 25% higher. To make your bond equally attractive, you must lower the price. While this inverse relationship between interest rates and bond prices is a basic principle of fixed-income investing, the effect of changing rates varies according to the type of securities involved. For example: Bonds that have fewer years before they are repaid (shorter maturities) are less affected by interest rate changes than longer-term bonds because holders will get their money back sooner to reinvest at the new interest rate. Lower-quality bonds issued by companies with lower credit ratings are more exposed to credit risk. Their price is affected by changing economic conditions as well as interest rate movements. Maturity matters As noted above, the prices of bonds with more time before they are repaid (longer maturities) are more sensitive to rising rates because the new, higher rate applies over a longer period. Bonds due to mature in only a few months or years are less affected by higher rates. The duration measurement calculated by bond specialists shows a bond or bond fund s sensitivity to interest rate movements in either direction. It provides a rough estimate at a specific point in time of how a bond or bond fund s price will change for a one percentage point change in yields. The higher the average duration, the more the price falls when rates rise. Conversely, the lower the duration, the less a bond is affected by a rate increase. Bond terminology Coupon rate The rate of interest to be paid on a bond from the time it is issued until its maturity date. Current yield The ratio of the annual interest payment to the actual market price of a bond, stated as a percentage. As a bond s price falls, its yield rises, and vice versa. Duration The average time for the bond to pay out, including all the individual interest payments and the payment of principal at maturity. The duration measure provides a rough approximation of the percentage change in the price of a bond or bond fund for a one percentage point change in yields. Fixed-income security A type of investment that regularly pays a set amount of income. This includes corporate and government bonds, Treasury bills and notes, money market instruments and certificates of deposit. Interest rate The annual rate that is paid for using borrowed money. Maturity/maturity date The date when the principal amount of a bond becomes due and payable. Total return Return on an investment, including its capital gain or loss, dividends and/or interest paid. 2

3 A rule of thumb is that for every 1% change in interest rates, a bond gains or loses 1% in value for every year of duration, explains Manetta. So a 1% increase in market interest rates would cause a bond with a duration of 5 years to fall in value by 5%. Conversely, a 1% decrease in interest rates would cause the bond s value to go up by 5%. That also means that the larger the duration number, the greater the impact an interest rate move will have on that bond or bond fund s price, and therefore the higher its interest rate risk. For example, says Manetta, If the interest rate increases by 1%, a bond with a one-year duration would fall in price by 1%, while the price of a bond with a five-year duration would drop by 5%. Total return is paramount Interest rates and bond yields are key factors to consider when buying and selling fixed-income investments. But the most important number to watch is your bond or bond fund s total return. Total return includes what the bond has paid you in interest over time (its yield) plus any capital gain or loss resulting from a rise or fall in a bond s price when it is sold. Essentially, it shows the full amount you will have earned or lost on a bond or bond fund when you finally sell it. Credit quality also affects risk While a bond s ongoing yield and total return are important, you want to weigh your desire for higher yields against the relative safety provided by bonds that may have lower coupon rates but higher credit quality and lower risk of default. Below-investment grade ( junk ) bonds may pay a higher yield than government bonds, for example, but you must be willing to accept a higher risk of default on these bonds. What this means for your investments How you manage your fixed-income investments when interest rates rise depends in large part on what types of fixed-income securities you own and why you own them. Diversification is key Remember that fixed-income investments are a core component of a diversified portfolio. Because they respond differently to the market than equities, an allocation to bonds and bond funds can deliver incremental income while moderating overall portfolio risk. If you seek the greatest diversification benefits, U.S. Treasury securities are ideal because they truly react differently to the market with little or even negative Pay attention to total return While interest rates can affect bond prices, it s the amount you make when you eventually sell your securities plus all the interest you have earned the total return that really matters. The explanation and chart below approximates how a 1% rise in market interest rates could affect the total return for two hypothetical bond investments when they are sold after one year. Keep in mind that the duration measure is a rough estimate at a specific point in time of how a bond or bond fund s price will change for a one percentage point change in yields. Plus, an increase in the interest rate will negatively affect the bond s price based on its duration, so the result is a negative number. How a 1% rise in market interest rates could affect the total return for two bond investments Duration (years) Capital gain or loss (duration x 1% rate increase) Coupon (yield) Total return Gain or loss + coupon BOND A BOND B 5-5% 2% -3% 10-10% 3% -7% Bond A (with a shorter duration) earned 2% in coupon interest, but lost 5% in value when it was sold a year after the rate increase. Here s how that bond s total return was calculated: Loss in value when sold after rate increase = Duration (in years) X rate increase = 5 x 1% = -5%. Total return = Capital gain or loss + amount of coupon interest received = -5% + 2% = -3%. Bond B (with a longer duration) earned 3% in interest, but lost 10% in value when it was sold a year later. In this case: Loss in value when sold after rate increase = Duration (in years) X rate increase = 10 x 1% = -10%. Total return = Capital gain or loss + amount of coupon interest received = -10% + 3% = -7%. 3

4 correlation to equities, says Martin Mauro, fixed-income strategist for BofA Merrill Lynch Global Research. But they also deliver the lowest yields. Because their yields are so low, he says, investors seeking diversification often add other fixed-income investments to try to boost returns. In addition to their potential for higher returns, other fixed-income investments also may be less sensitive to changes in the Fed s policy and rising rates, says Chris Vale, senior vice president, products and solutions, Merrill Edge. That s why creating a mix of bond maturities and types of bonds (corporate, municipal and government; domestic and international) can be a good strategy for reducing portfolio risk and minimizing the effect of rising rates, he says. For more about bond diversification, read our The Vital Role Bonds Play in a Diversified Portfolio topic paper. You might also consider adding international 1 bonds or bond funds because they won t react in the same way to U.S. interest rate changes, he says. If you own individual bonds If you own or plan to purchase individual bonds primarily to provide a regular stream of income for example, in retirement you still receive your anticipated income payments plus your principal at maturity, even if interest rates rise. The loss of value only comes into play if you don t hold the bonds to maturity. Ideas for managing your bond investments when interest rates increase Here s a summary of some strategies you can use to manage your bond investments when interest rates rise, with the pros and cons of each. ACTIONS YOU CAN TAKE IF YOU OWN INDIVIDUAL BONDS Diversify among types of bonds Hold to maturity Buy short-duration bonds Pursue laddering strategy PROS Mitigates credit and interest rate risk Receive income plus principal Potential to avoid losses and achieve higher return Potential for better risk/return CONS Missed opportunities to invest at higher rates IF YOU OWN MUTUAL FUNDS Diversify among types of funds Stay in fund Move to lower-duration fund Consider loan participation (floating rate/bank loan) funds (see page 7) PROS Mitigates credit and interest rate risk Professional management seeks to adapt to evolving risks and opportunities (for actively managed funds); avoid transaction costs of selling; maintain diversification Potential for better returns Potential for better returns CONS Limited by fund guidelines, which may not allow manager to optimally position fund Transaction/sales load costs ; lower credit quality means more risk IF YOU OWN ETFs Diversify among types of ETFs Stay in fund Move to lower-duration fund Consider fixed-maturity ETFs (see page 7) PROS Mitigates credit and interest rate risk Maintain diversification; avoid transaction costs of selling Potential for better returns Potential for better risk/return by laddering CONS Limited by need to match index ; lower income 4

5 But if you stay with your original, lower-yield bonds until they mature, you may miss the opportunity to receive more income from a higher-yielding bond along the way, says Mauro. That s why weighing the transaction and opportunity costs for the change is so critical. If your holding period is shorter (and you don t intend to keep your individual bonds to maturity), then interest rate risk becomes more important, because the bonds you own when interest rates rise may fall in price when you try to sell them. You can mitigate this risk by using a bond laddering strategy that creates a portfolio of bonds with staggered maturities. Then as each bond matures, you can reinvest the proceeds to seek higher yields as rates rise (see page 6). If you own bond mutual funds In a rising interest rate environment, owning shares in an actively managed, fixed-income mutual fund rather than individual bonds can provide an advantage because the fund manager monitors interest rates and can make appropriate buy and sell decisions on behalf of the fund s shareholders. But the fund s investing guidelines may also limit the types and maturities of the bonds the manager can purchase. And that, in turn, can affect the fund manager s flexibility because he or she must have cash on hand to deal with increasing shareholder redemptions. That s why you need to understand the fund s investing guidelines too. You also have little control over the decisions the fund manager makes about whether bonds are sold, held to maturity, or laddered and reinvested. You can t use hold How to check interest rate sensitivity for the bond mutual funds you own You can see the effect interest rates may have on your portfolio of bond mutual funds by looking at the fund s duration (shown in the fund s prospectus or online information). The higher the number, the more a rise (or fall) in interest rates impacts the price of the underlying bonds and the mutual fund s value. to maturity or bond laddering strategies using mutual funds like you can with individual bonds, says Vale. Even if the fund manager uses a laddering strategy, those transactions are made within the fund. You won t get a periodic maturity (and return of cash) from the fund to reinvest, he says. Owning shares in a passively managed mutual fund that tracks a particular bond index can save you money because of its lower expenses. But unlike an actively managed fund that gives the manager some investment flexibility, your returns are tied to the fortunes of the securities in the index. That can leave you more vulnerable to the effects of interest rates. If you own bond ETFs Because most ETFs are also passively managed against a particular index, they don t give you access to the expertise of a portfolio manager. When interest rates move, your fixed-income ETF simply follows the market up and down. So if your bond ETF is invested primarily in longer-maturity bonds and you want to mitigate the risk of a rate increase, you can t rely on the expertise of a fund manager to make portfolio decisions for you. You ll need to weigh the transaction costs and the missed opportunity to invest at higher rates, and decide whether to sell the fund and look for another one with shorter maturities. Strategies for a rising rate environment Here are three strategies you can use that are designed to ease the effect of rising rates on the value of bonds and bond funds in your investment portfolio: 1. Reduce maturities/manage duration. Individual bondholders and bond fund shareholders can lessen the effect of rising rates by reducing the maturities of the bonds and bond funds they own. Because the duration of a bond mutual fund or ETF is related to the average maturity of the bonds it holds, that figure can help you evaluate how sensitive a fund is to rising rates. (Mutual funds and ETFs typically include this information in their prospectuses, annual fund reports and online performance information.) 5

6 You can reduce your portfolio s exposure to interest rate risk by shifting the mix to bonds and funds with shorter durations, Mauro says. That would be especially important if your portfolio consists largely of long-term bonds, he notes. 2. Balance risk and return with bond laddering and reinvestment. Bond laddering may be an effective technique that individual bond owners can use to help diversify their exposure to interest rate risk. Essentially bond laddering involves creating a portfolio of bonds with staggered maturities. Then as each bond matures, you can reinvest the proceeds at higher yields should rates rise. A laddered bond portfolio helps take advantage of rising rates Creating a bond ladder with staggered maturities and reinvesting the proceeds as each bond matures can help you moderate the effect of rising interest rates on your bond portfolio. As shorter-term, lower-yield bonds mature, the proceeds are reinvested at the top of the ladder where longer maturity bonds could potentially offer higher yields. This can increase the total return for the portfolio as interest rates rise. The diagram below illustrates the laddering concept, using hypothetical bonds with maturities of one, three and five years and increasing yields. Higher Yielding Bond Lower Yielding Bond 5 YR 5 YR 5 YR REINVEST REINVEST 3 YR 4 YR 3 YR 1 YR 2 YR 2 YR YEAR 1 YEAR 2 YEAR 4 A bond ladder, depending on the types and amount of securities within the ladder, may not ensure adequate diversification of your investment portfolio. While diversification does not ensure a profit or guarantee against loss, a lack of diversification may result in heightened volatility of the value of your portfolio. You must perform your own evaluation of whether a bond ladder and the securities held within it are consistent with your investment objective, risk tolerance, liquidity needs and financial circumstances. Just as with dollar-cost averaging for stocks, bond laddering means more gradual adjustments to your portfolio, so the effect is less severe as interest rates rise. Of course there are still transaction costs associated with trading individual bonds, and the minimum investment you need to build a diversified bond portfolio is much greater than it would be if you bought shares in a mutual fund or ETF. For a rising rate environment, Mauro suggests a ladder composed of bonds that range in maturity from one to ten years: This way, when your one-year bond matures and pays its coupons, you would reinvest the proceeds into the longer end of the ladder in this case, a ten-year bond. By reinvesting the proceeds at the current interest rate, your portfolio s yields would increase as rates rise, leading to the potential for higher total returns. If your investment horizon is five years or less, you should consider a five-year ladder. Your decision on whether to invest in a single five-year bond vs. a bond ladder depends on how soon you expect interest rates to rise, Mauro says. His analysis shows that if bond yields stay the same for a year or more, investors may be better off with the single security. But if yields were to rise substantially over a few years by one percentage for example they may be better off using a laddering approach. The ladder also has the advantage of providing more liquidity the investor would have the flexibility to redirect the maturing funds to another purpose, he explains. 3. Consider securities that can help protect against changing rates. There are a number of fixed-income securities that can offer a level of protection against rising rates. Securities with short durations, such as 30-day Treasury bills or two-year Treasury notes But remember, says Mauro, before reducing portfolio duration or average maturity, consider the cost of forfeiting higher yields and weigh this against the loss of bond value expected with an increase in interest rates. If you shift to short-term securities, such as 6

7 those with maturities of two years or less, you might have to sacrifice a significant amount of yield. Loan participation funds These loan-based investments commonly known as floating-rate or bank loan funds tend to have lower credit quality because they are issued by belowinvestment grade companies. But they typically have less credit risk than high-yield bonds and might be worth owning when interest rate risk is a greater concern than credit risk. Fixed-maturity ETFs Fixed-maturity ETFs focus on bond investments that mature in a particular year. You can use them to build a laddered portfolio of bond ETFs with staggered maturity dates. How Merrill Edge can help For more about the role bonds play in a diversified portfolio, visit merrilledge.com/bonds to read The Vital Role Bonds Play in a Diversified Portfolio topic paper and get the Understanding Types of Bond Risks fact sheet. As a Merrill Edge client you have access to a variety of products and resources to help you address the impact of rising interest rates: Fixed-Income Investment Products A wide selection of bond mutual fund and ETF offerings A broad range of fixed-income securities including U.S. Treasuries, Municipals, Agencies, Corporations and New Issue Brokered CDs Professional management for your fixed-income portfolio with Merrill Edge Select Portfolios To learn more about Merrill Edge Select Portfolios, visit the Investing & Trading section of merrilledge.com. Fixed-Income Reports and Commentary For ongoing insights from the BofA Merrill Lynch Global Research team, including the The Fixed-Income Digest, log in to your account at merrilledge.com and visit the Research section. If you re making your own investment decisions You ll find exclusive online tools and resources at merrilledge.com: The Fixed-Income Screener to search bonds by coupon rate, type, maturity, duration, yield and price (log in required) Merrill Edge Select Funds and Merrill Edge Select ETFs simplify your investing experience by leveraging a proprietary Merrill Lynch screening process to help you take the guesswork out of selecting mutual funds and ETFs. To learn more, visit the Investing & Trading section of merrilledge.com and select Mutual Funds or Exchange Traded Funds. If you re working with a Merrill Edge Financial Solutions Advisor You can get help to determine an investment strategy suited to your personal financial situation with suggested next steps. Visit merrilledge.com/ fsalocator to find a Merrill Edge Financial Solutions Advisor at select financial centers. Or, call us at 888.ML.INVEST ( ) Monday through Friday, 8 a.m. to 10 p.m. Eastern. If you are not a Merrill Edge client, please visit merrilledge.com or call 888.MER.EDGE ( ) to learn more and get started. 7

8 1 International investing presents certain risks not associated with investing solely in the U.S. These include, for instance, risks related to fluctuations in the value of the U.S. dollar relative to the value of other currencies, custody arrangements made for a fund s foreign holdings, political risks, differences in accounting procedures and the lesser degree of public information required to be provided by non-u.s. companies. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities. Bond investing poses special risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yield and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa. GWM Investment Management & Guidance (IMG) provides industry-leading investment solutions, portfolio construction advice and wealth management guidance. Diversification and dollar cost averaging do not guarantee a profit nor protect against a loss in declining markets. Since such an investment plan involves continual investment in securities regardless of fluctuating price levels, you must consider your willingness to continue purchasing during periods of high or low price levels. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available through the Merrill Lynch family of companies. Any tax statements contained herein were not intended or written to be used, and cannot be used for the purpose of avoiding U.S. federal, state or local tax penalties. Neither Merrill Edge nor its Financial Solutions Advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors. You should carefully consider a fund s investment objectives, risks, charges and expenses before investing. This and other important information is included in the fund s prospectus, which should be read carefully before investing. Prospectuses for mutual funds can be obtained through the investor s sign-in area of merrilledge.com. Clients of the Merrill Edge Advisory Center can also call If you re not currently a Merrill Edge client, please call Mutual funds are not FDIC insured; are not deposits or obligations of, or guaranteed by, any financial institution; and are subject to investment risks, including possible loss of the principal amount invested. Investment return and principal value will fluctuate so that an investor s shares, when redeemed, may be worth more or less than their original cost. Important Note on Bond Funds: Return of principal is not guaranteed. Bond funds have the same interest rate, inflation, and credit risks that are associated with the underlying bonds owned by the fund. Generally, the value of bond funds rises when prevailing interest rates fall and falls when interest rates rise. There are ongoing fees and expenses associated with owning shares of bond funds Bank of America Corporation. All rights reserved. ARRKCGLV WP B 04/2015

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