Will Floating-Rate Bonds Sink Your Bond Portfolio?

Transcription

1 Schwab Center for Financial Research Will Floating-Rate Bonds Sink Your Bond Portfolio? A white paper by: Kathy A. Jones Vice President, Fixed Income Strategist Collin Martin Senior Research Analyst for Fixed Income

2 Floating-rate bonds and bond funds are popular due to expectations that the Federal Reserve (the Fed ) will soon cut back on its asset-purchase program and spark a rise in interest rates. The coupons on so-called floaters adjust with rates and tend to perform well when rates are rising. But the income on floaters only rises when shortterm interest rates rise and the Fed is not likely to raise short-term interest rates anytime soon. So we believe it s too early to invest in floating-rate bonds and bond funds, and that investors are better off buying short-term fixed-rate securities than floating-rate securities. Kathy A. Jones and Collin Martin share their investing outlook here. Kathy A. Jones Vice President, Fixed Income Strategist Schwab Center for Financial Research Kathy Jones is responsible for credit-market and interest-rate analysis, as well as fixed income education for investors at Schwab. Jones has studied global credit markets extensively throughout her career as a fixed income investment strategist, working with both institutional and retail clients. Collin Martin CFA, Senior Research Analyst, Fixed Income Schwab Center for Financial Research Collin Martin is responsible for providing analysis and investor education in fixed income and income planning. Martin has published fixed income model portfolios for individual investors and has also contributed to monthly fixed income strategy publications. 2

3 Executive Summary Floating-rate bonds, known as floaters, tend to perform well amid rising interest rates because the income increases as rates move up. The income increases only when short-term interest rates rise, however, not when long-term rates move higher. Currently, the Fed is discussing reducing the pace of its bond purchases, not raising short-term interest rates. Consequently, we believe it is too early to invest in floating-rate bonds and bond funds. We don t anticipate that the Fed will raise short-term interest rates until 2015, at the earliest. Therefore, we believe investors are better off buying short-term fixed-rate securities than floating-rate securities. We believe investors are better off buying short-term fixed-rate securities than floatingrate securities. 3

4 What is the gist of this idea? Predictions that the Fed is ready to taper its bond purchases and eventually end its Large Scale Asset Purchase (quantitative easing) program have sent investors piling into floating-rate bonds and bond funds. Floaters, as they are often called, are designed to track changes in interest rates because their coupons adjust with interest rates and tend to perform well when interest rates are rising. The income from floaters only rises when short-term interest rates rise, however, not when long-term rates increase. And the Fed is only talking about reducing the pace of its bond purchases not about raising short-term interest rates for another year. Consequently, we believe it s too early to invest in floating-rate bonds and bond funds. Since we don t anticipate the Fed will be raising short-term interest rates until 2015 at the earliest, we think investors are better off in short-term fixed-rate securities than in floating-rate securities. But interest rates have been going up, so doesn t that mean floaters are still a good idea? It s true that interest rates have gone up sharply ever since Federal Reserve Chairman Ben Bernanke indicated in May that the Fed would most likely taper its bond purchases later in the year. But as you can see in the chart to the right, only long-term interest rates have gone up not the short-term interest rates that are largely controlled by Fed policy. Ten-year Treasury bond yields, which represent long-term rates, have gone up by over 1% from the lows, but threemonth Treasury bill rates, representative of short-term rates, have actually declined slightly and are still very close to the Fed funds rate, which is set near zero. While intermediate- and longer-term Treasury yields have retreated since then, short-term interest rates have remained relatively flat as the prospects for Fed tapering have been delayed. Only long-term interest rates have gone up not short-term rates. 4

5 4 Short-term interest rates have remained essentially unchanged since Yield (%) Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11 Jan 12 U.S. Generic Govt 10 Year Yield U.S. Generic Govt 3 Month Yield May 12 Sep 12 Jan 13 May 13 Sep 13 Source: Bloomberg. Monthly data as of September 30, U.S. Generic Govt 10 Year Yield (USGG10YR) and U.S. Generic Govt 3 Month Yield (USGG3M). We believe that tapering may be the first step toward normalizing interest rates, i.e., reducing the Fed s influence on long-term rates. We believe, however, that investor expectations for the timing of the first rate increase are well ahead of reality. Three-month forward rates implied by the futures market indicate that investors have pulled forward expectations for the timing and pace of rate increases significantly. The market now appears priced for short-term interest rates to move up in mid We believe it is more likely that there will be a significant interval between reducing the pace of bond purchases and boosting short-term interest rates, and 2015 is the most likely time for the first rate increase by the Fed. The Eurodollar futures curve is an indication of where the futures market expects three-month interest rates to be in the future. Eurodollars are U.S. dollar-denominated deposits in banks outside the U.S. primarily in Europe. Eurodollars track U.S. three-month Treasury bills very closely. We use the Eurodollar futures curve because it is a very liquid market. As the chart on the next page illustrates, the market s expectations for the timing and pace of interest rate increases has shifted substantially since May when the Fed first hinted at tapering its bond purchases. 5

6 3 Forward Eurodollar curve implied interest rates Percent (%) Sep 13 Sep 14 Sep 15 Sep 16 Sep 17 September 30, 2013 May 1, 2013 Source: Bloomberg. Eurodollar Synthetic Rate Forecast (EDSF). Can you describe floating-rate bonds in more detail? Floating-rate bonds are a type of bond without a fixed-coupon rate. The coupon on a floating-rate bond is usually based on a benchmark or reference rate, such as the 3-month London Interbank Offered Rate (Libor), plus a quoted spread. For example, the rate might be quoted as Libor plus 100 basis points (1%). A reference rate, such as Libor, tends to move with the policy rate set by the Fed. As a result, the coupon payment of a floater will rise and fall based on the fluctuations in short-term rates set by the Fed. The quoted spread above the reference rate is usually based on factors such as the issuer s credit quality and time to maturity. The spread is an indication of risk: Investors earn a higher rate than the reference rate to compensate for the risk of holding a corporate bond, such as default risk. Can t the reference rate for floaters go up even if the Fed doesn t raise rates? It s highly unlikely. While it s possible for the Fed to lose its influence over long-term rates, short-term rates are set by the Fed and the reference rates follow the Fed funds rate. Over the past 30 years, the Libor rate and the Fed funds rate have tended to move together. Libor and most short-term rates tend to follow the trend in the Fed funds rate and are currently anchored by the Fed s zero interest rate policy. 6

7 That s why the most important rate for floating-rate notes is the reference rate, which is usually Libor. Other interest rates, especially long-term interest rates, have little or no impact on floaters. Once the Fed starts raising rates, will the income from floaters go up? Not necessarily right away. Floaters sometimes have a floor or a cap. A floor is a minimum coupon rate it will pay regardless of where the reference rate is trading, while a cap is the maximum coupon rate that will be paid. Take a floater with a 3% floor for example. If at the time the coupon is reset Libor is at 1% and the quoted spread is 1%, then the floating coupon should be 2%. But since the floater has a floor of 3%, it will actually pay an annualized 3% coupon rate for that period. If the reference rate (Libor) moves up, the coupon rate will only rise once the floor has been exceeded. Therefore, floaters trading at their floor levels may not give investors the exposure to rising interest rates that they are expecting. Only when the reference rate plus spread crosses the floor threshold will the investor benefit from higher coupon rates. Floors are more common in the sub-investment grade market, so it would likely take longer for bank loans to benefit from rising short-term rates than it would for investment grade floaters. A cap, on the other hand, is the maximum coupon rate a floater will pay. 12 LIBOR tracks the Fed funds rate Yield (%) LIBOR U.S. Federal Funds Target Rate 3-Month LIBOR Source: Bloomberg. Monthly data as of September 30, U.S. Federal Funds Target Rate (FDTR) and BBA LIBOR USD 3 Month (US0003M). 7

8 6 Coupons on floating-rate notes also follow the Fed funds rate. 5 4 Yield (%) U.S. Floating-Rate Note Index Average U.S. Federal Funds Target Rate Source: Bloomberg and Barclays. Monthly data as of September 30, Barclays U.S. Floating Rate Note Index and U.S. Federal Funds Target Rate (FDTR). Anything else I need to know about floaters? Unlike traditional bonds that make semiannual payments, floaters may pay out on a quarterly basis. In the case of quarterly payments, the coupon rate is refreshed (increased or decreased) quarterly, whereas traditional bonds carry the same coupon rate for their entire life. Also, floaters tend to have short- to intermediate-term maturities, often of less than five years. These features help keep the duration, which is a measure of interest rate sensitivity, close to zero for floaters. With low duration, prices tend to be less volatile than longer duration bonds. Finally, floating-rate securities may be investment grade or sub-investment grade and generally are aimed at the institutional investor market. For the average investor, accessing floating-rate notes is done through a mutual fund. All that makes floaters sound pretty attractive. What s the issue with holding floaters until the Fed does raise short-term rates? Fixed-coupon securities currently offer higher yields than floaters, on average. Floaters do have attractive qualities, and allocating some portion of your fixed income portfolio to floaters can make sense if you anticipate a rise in short-term interest rates. However, our concern is that investors may be over allocating to 8

9 floaters and giving up too much current income in exchange for the potential for higher coupon payments down the road. When we look at the trade-off between fixed-rate bonds with short-term maturities and floaters, we believe the total return from fixed-rate bonds is likely to be higher than in comparable floaters, whether we re looking at investment grade bonds or sub-investment grade. Why do you think short-term rates aren t going up soon? Since short-term interest rates are set by the Fed, we are taking our cue from it. According to the Fed, exceptionally low rates will be appropriate as long as the unemployment rate remains above 6.5%, inflation between one and two years ahead is projected to be no more than half a percentage point above the Committee s 2% longer-run goal, and longer-term inflation expectations continue to be well anchored (September Federal Open Market Committee Statement). The unemployment rate was 7.2% as of September 30, 2013, and while it is trending down at a faster rate than the Fed has anticipated in its projections, it s largely due to a sharp decline in the labor force participation rate. In other words, fewer people are looking for work. Moreover, Fed Chairman Bernanke has emphasized that 6.5% is not a trigger and that the Fed will take into consideration additional measures of labor market conditions, such as the number of people working part-time because they are unable to find full-time work, and the percentage of those unemployed who have been out of work for over six months. These measures still indicate that there is enough slack in the labor markets to keep short-term rates near zero even if the unemployment rate drops below 6.5% next year. Moreover, the statement from the September Federal Open Market Committee (FOMC) meeting indicated that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset-purchase program ends and the economic recovery strengthens. (Note: Emphasis is ours.) Inflation readings also indicate that the Fed is likely to keep short-term rates low for a while longer. The Fed s preferred inflation indicator is the price index for personal consumption expenditures (PCE) excluding food and energy. The yearover-year rate of increase in that indicator was only 1.2% in August, well below the Fed s target of 2%, and it has been trending downward. Moreover, as the chart on the next page shows, most indicators of inflation are falling, suggesting little reason for the Fed to shift policy in the near term. 9

10 10 Civilian unemployment rate remains above the Fed s target number. Percent (%) 8 Fed Target Unemployment Rate: 6.5% Aug. 2013: 7.3% 6 4 Jan 07 Aug 07 Mar 08 Oct 08 May 09 Dec 09 Jul 10 Feb 11 Sep 11 Apr 12 Nov 12 Jan 13 Source: Federal Reserve Bank of St. Louis, Civilian Unemployment Rate (UNRATE), percent, monthly, seasonally adjusted as of August 1, Shaded area represents recession. 4.0 Inflation indicators are still below the Fed s target number Fed s target: 2% Aug 11 Oct 11 Dec 11 Feb 12 Apr 12 Jun 12 Aug 12 Oct 12 Dec 12 Feb 13 Apr 13 Jun 13 Aug 13 U.S. CPI Urban Consumers YoY NSA Fed Target Rate U.S. Personal Consumption Expenditure Core Price Index YoY SA U.S. Personal Consumption Expenditure Chain Type Price Index YoY SA Source: Bloomberg, monthly data as of August 31, U.S. CPI Urban Consumers YoY NSA (CPI YOY), U.S. Personal Consumption Expenditure Core Price Index YoY SA (PCE CYOY), U.S. Personal Consumption Expenditures Chain Type Price Index YoY SA (PCE DEFY). 10

11 And we re not the only ones who believe the first rate increase is more likely in 2015 than The Fed s most recent forward guidance, released in September, indicated that 14 out of 17 members expect the first rate increase to occur in 2015 or later. 12 FOMC members vote on appropriate timing of first rate increase Number of Participants Note: The height of each bar denotes the number of FOMC participants who judge that, under appropriate monetary policy, the first increase in the target federal funds rate from its current range of 0 to ¼ percent will occur in the specified calendar year. In September 2013, the number of FOMC participants who judged that the first increase in the target federal funds rate would occur in 2014, 2015, and 2016 were, respectively, 3, 12, and 2. Source: Federal Reserve Board, September 18, Consensus estimates by economists also point to no Fed rate increase until According to Bloomberg, 66 out of 71 economists who publish 2014 year-end forecasts believe that the Fed funds rate will remain at its current level of 0 to 25 basis points until the end of 2014 (Bloomberg survey as of October 8, 2013). At such low interest rates, how much difference does it make if I switch to a traditional, fixed-rate bond? The difference is mostly related to how much current income you receive on a bond versus a floater. It s essentially the lost opportunity to earn a higher coupon and yield and compound the interest that you re receiving. For investment grade bonds versus floaters, the difference is relatively small but it adds up over time. For sub-investment grade or high yield bonds versus bank 11

12 loans, the difference can be greater. Bank loans are sub-investment grade securities with floating-coupon rates. For this article, we will discuss bank loans when discussing the sub-investment grade, floating-rate market. On average, fixed-coupon bonds currently offer higher coupons and yields than floating-rate bonds of similar credit quality. That s not too surprising, as floating-rate bonds can be thought of as a hedge, or insurance, in case shortterm interest rates do begin to rise. Since we think short-term benchmarks won t rise for at least another year, we also think floating-rate bonds will effectively be playing catch-up to make up for the lower yield sustained while the Fed is on hold. To illustrate this, we compared the Barclays U.S. Corporate Bond 1 3 Year Index versus the Barclays U.S. Floating Rate Note Index. Each has an average maturity of about two years, but the difference in coupon is wide, and fixedcoupon bonds have higher yield-to-worsts, on average. Assuming that the Fed keeps interest rates on hold, it would mean a higher return for the fixed-rate notes than the floating-rate notes over the next few years. Investment Grade Comparison Average Coupon Average Yield-to-Worst Average Maturity (years) Short-Term Corporate Bonds 3.56% 1.19% 2.04 Floating-Rate Notes 0.89% 0.62% 1.96 Source: Barclays. As of September 30, Barclays U.S. Corporate Bond 1-3 Year Index and Barclays U.S. Floating Rate Note Index. Yield-to-worst indicates the lowest potential realized return on a bond without an actual issuer default. On the next page we demonstrate how high rates would need to rise to effectively break even with the higher yields that fixed-coupon bonds offer. The longer the Fed remains on hold and benchmark rates remain low, the higher they would need to rise to make up for the sustained period of lower rates. The illustration below assumes a three-year investment horizon. We use the average yield-to-worst (YTW) of the Barclays U.S. Corporate Bond 1-3 Year Index as our proxy for fixed-coupon securities, at 1.2% as of September 30, For floating-rate notes, we use the average yield-to-worst of the Barclays U.S. Floating Rate Note Index, at 0.6%. (Yield-to-worst indicates the lowest potential realized return on a bond without an actual issuer default.) 12

13 The chart below illustrates how much of an increase in short-term rates would be needed for the floating-rate notes to produce the same return as fixed-rate notes, over the course of three years. We assume that an investor starts with $50,000. If he or she invests for three years at a fixed rate of 1.2%, which is the current yield-to-worst for bonds of that maturity, the ending value will be $51,827. In comparison, the current YTW for floating-rate notes is 0.6%. In order to catch up to earn that same $51,827 at the end of three years, the yield on the floating-rate notes would have to rise very quickly. If our investor holds the floating-rate notes for one year, then the yield needs to rise to 1.5% for each of the next two years to break even with the return on the fixed-rate notes. If rates remain unchanged for two years, then the yield needs to jump to 2.4% to break even. And if it takes even longer for rates to go up which is a possibility the difference in the income earned will continue to accumulate. The longer the Fed funds rate remains on hold, the harder it is to catch up. $50,000 initial investment Three-year value of $51,827 Fully invested in investment grade, fixed-coupon bonds Floating-rate bond for one year at 0.6% Floating-rate bond for two years at 0.6% Invest for three years at 1.2% then invest for two years at 1.5% then invest for one year at 2.4% Year 1 Year 2 Year 3 Source: Barclays and the Schwab Center for Financial Research. Assumes semiannual compounding and reinvestment of coupons at the prevailing interest rate. Assumes the Barclays U.S. Corporate Bond 1 3 Year Index YTW of 1.2% and the Barclays U.S. Floating Rate Note Index YTW of 0.6%. Assumes a three-year holding period, and only cash flows are taken into account, not appreciation or depreciation of price. For illustrative purposes only. Do high yield bonds offer a similar advantage over bank loans? Fixed-rate high yield, or sub-investment grade, bonds tend to have an even greater advantage than comparable floaters. Bank loans and high yield bonds both have sub-investment grade ratings. However, the nature of their coupons differentiates them. High yield bonds have fixed-coupon rates, bank loans have floating-coupon rates. Stripping out the credit risk, we can compare them on the basis of the advantages of having fixed-rate vs. floating-rate coupons. 13

14 For this comparison, we used the Barclays U.S. High Yield 350mm Cash Pay 0 5 Year 2% Capped Index and the PowerShares Senior Loan Portfolio (BKLN) exchange-traded fund. 1 We found that short-term, sub-investment grade bonds in this index have an average coupon of 7.54%, compared to 4.15% for bank loans in the ETF. In fact, the high yield bonds have higher coupons and yields despite a shorter average maturity. Given the higher coupons that high yield bonds generally have compared to bank loans, there could be a significant advantage to holding fixed-rate coupon bonds while short-term rates are flat. Sub-Investment Grade Comparison Average Coupon Average Yield-to-Worst Average Maturity (years) Short-Term Corporate Bonds 7.54% 6.03% 3.55 Floating-Rate Notes 4.15% 5.35% 4.86 Source: Barclays and PowerShares, as of October 7, Barclays U.S. High Yield 350mm Cash Pay 0 5 Year 2% Cap Index and PowerShares Senior Loan Portfolio (BKLN). Statistics for the PowerShares Senior Loan Portfolio are indicative of the loan portion of the holdings. Moreover, once short-term benchmark rates begin to increase, the coupon rates wouldn t just need to rise to a level equal with high yield bonds they would need to increase even more. Since bank loans are at a yield disadvantage until short-term rates rise, the coupons will need to go even higher to compensate for the time spent at lower levels. The chart below illustrates this. As we did before, we assumed our investor has $50,000 to invest and is willing to take the risk of investing in sub-investment grade bonds with a three-year investment time horizon. The longer the Fed funds rate remains on hold, the harder it is to catch up. $50,000 initial investment Three-year value of $59,703 Fully invested in sub-investment grade, fixed-coupon bonds Bank loans for one year at 5.4% Bank loans for two years at 5.4% Invest for three years at 6.0% then invest for two years at 6.3% then invest for one year at 7.2% Year 1 Year 2 Year 3 Source: Barclays and the Schwab Center for Financial Research. Assumes semiannual compounding and reinvestment of coupons at the prevailing interest rate. Assumes the Barclays U.S. High Yield 350mm Cash Pay 0 5 Year 2% Cap Index YTW of 6.0% and the PowerShares Senior Loan Fund (BKLN) YTW of 5.4%. We use the PowerShares ETF as a proxy for bank loans, as most indices don t publicize YTW. Assumes a three-year holding period, and only cash flows are taken into account, not appreciation or depreciation of price. For illustrative purposes only. 1 Data on bank loan indices often lacks key characteristics; BKLN is an exchange-traded fund whose benchmark is the S&P/LSTA U.S. Leveraged Loan 100 Index, a bank loan index. 14

15 Given where yields are today, the average coupon would need to move much higher to catch up with fixed-coupon high yield bonds. Assuming the coupon remains the same for the next 12 months, the average coupon on floaters would have to average, over the next 24 months, 90 basis points higher in order to break even with fixed-coupon sub-investment grade bonds. And if the benchmark remains unchanged for two years, the average coupon on bank loans would need to increase to 7.2%, roughly 180 basis points higher than its current level. And most bank loans have floors or a minimum coupon rate. With Libor so low, many bank loans are paying the floor coupon rate. That means that the coupon rate on many bank loans won t actually increase until the floor gets reached, making the pace and magnitude of necessary coupon increases even greater. But haven t bank loan funds performed very well recently? Although bank loans have generated positive year-to-date returns, fixedcoupon high yield bonds have still outperformed them. As of September 30, 2013, the year-to-date total return for the Barclays U.S. High Yield 350mm Cash Pay 0 5 Year 2% Cap Index was 4.87%. The Barclays U.S. High Yield Loans Index generated a total return of 3.60% over the same time period. The results are comparable when comparing investment grade securities as well. As of September 30, the YTD total return for the Barclays U.S. Corporate Bond 1 3 Year Index (a fixed-coupon index) was 1.11%, compared to 0.95% for the Barclays U.S. Floating Rate Note Index. These indices have very similar average maturities. The average price of the fixed-rate index has dropped as short-term Treasury yields (like the two-year Treasury) have risen, leading to negative price returns for the fixed-coupon index. The Barclays U.S. Corporate Bond 1 3 Year Index generated a price return of 1.56%, compared to a price return of positive 0.22% for the Barclays U.S. Floating Rate Note Index. We believe this is due to the popularity of floaters and may be an indication that investors are overpaying for the possibility of higher coupons in the future. On the sub-investment grade side, fund flows for bank loans (floating-coupon rates) have been very strong compared to high yield bonds (fixed-coupon rates), even though both types of securities are sub-investment grade. According to Morningstar, for the 12 months up to September 30, bank loan funds saw 12 straight months of positive net inflows, totaling over $57 billion. Over the same time period, high yield bond funds actually experienced over 15

16 $7 billion in net outflows. Of those 12 months, HY bond funds experienced six months of net inflows and six months of net outflows. This leads us to believe that investors may be reallocating some of their money from fixed-coupon to floating-coupon securities Fund flows into various types of bond funds. 40 Net Flows ($ billions) Bank Loans High Yield Bond Intermediate Gov Intermediate-Term Bond Long Government Long-Term Bond Multisector Bond Short Government Source: Morningstar, Inc. Trailing 12-month data as of September 30, Short-Term Bond What would change the timing of the Fed s expected rate increases? A shake-up in the composition of the FOMC could mean a change in the outlook. In addition to the anticipated naming of Janet Yellen as new Fed chairperson next year, many other members are leaving, or are considering leaving, their posts. This means that the key policy makers next year could be different from the current group. Although an initial shift in Fed policy is unlikely, it is possible that the new Fed chief could push the FOMC toward an earlier shift in policy. We don t believe this is likely in the one-year time frame that we are looking at, but we can t know for sure. The other major risks are inflation and/or that the economy grows more strongly than we or the Fed anticipate, forcing it to change policy sooner than expected. The key to both factors would be employment growth. Historically, inflation has picked up when wages rise, so the unemployment rate is a key indicator. If unemployment drops rapidly to below 6.5%, then the Fed could raise rates sooner rather than later. However, Fed Chairman Bernanke has indicated that 6.5% unemployment is not a trigger and that the Fed is monitoring other labor 16

17 market indicators, such as the level of underemployed workers and the percentage of unemployed out of work for over six months. Those indicators are not showing as much improvement in trend as the unemployment rate. These are considered indicators that there is still a lot of slack in the labor market. 20 U6RATE (total unemployed, plus all marginally attached workers plus total employed part time for economic reasons). Percent (%) 15 Average % Aug. 2013: 13.7% 10 5 Jan 03 Jul 04 Jan 06 Jul 07 Jan 09 Jul 10 Jan 12 Jul 13 Source: Federal Reserve Bank of St. Louis, total unemployed, plus all marginally attached workers plus total employed part time for economic reasons (U6RATE), percent, monthly, seasonally adjusted, as of August 1, Shared area represents recession. 50 Average (mean) duration of unemployment. 40 Number of Weeks 30 Long-Term Average: 18.3 Weeks Weeks Jan 81 Jan 85 Jan 89 Jan 93 Jan 97 Jan 01 Jan 05 Jan 09 Jan 13 Source: Federal Reserve Bank of St. Louis, average (mean) duration of unemployment (UEMPMEAN), weeks, monthly, seasonally adjusted, as of August 1, Shaded areas represent recessions. 17

18 Let s say I own fixed-rate bonds and rates move up faster than expected. What s the downside? If the Fed were to move short-term rates up faster and earlier than we anticipate, investors in fixed-rate securities would most likely underperform those in floating- rate securities, but we don t think the difference would be significant. Below we performed a scenario analysis of the fixed-coupon indices. The low durations of these investments result in low price declines when interest rates rise, and the higher coupons help offset some of that decline. As seen above, a 100-basis-point increase in the average yield of each of these indices should still generate a positive 12-month total return. A 200-basis-point increase in the average yield would generate a negative total return for fixed-rate investment grade bonds, however. Short-term high yield bonds would have generated positive returns in both hypothetical scenarios. Scenario analysis of various interest rate assumptions Barclays U.S. Corporate 1 3 Year Bond Index Barclays U.S. High Yield 350mm Cash Pay 0 5 Yr. 2% Cap Index Potential Total Return If Interest Rates Rise By: 100 Basis Points (1%) 200 Basis Points (2%) 3.56% 1.19% 0.89% 0.62% Source: Barclays and the Schwab Center for Financial Research. Illustration assumes a one-year time horizon and a one-time, instantaneous interest rate shift. Also assumes semiannual compounding and reinvestment of coupons at the prevailing interest rate. Assumes the Barclays U.S. Corporate Bond 1 3 Year Index modified adjusted duration of 1.97, an average coupon of 3.6% and a YTW of 1.2%. Assumes the Barclays U.S. High Yield 350mm Cash Pay 0 5 Yr 2% Cap Index modified adjusted duration of 2.22, an average coupon of 7.6% and a YTW of 5.3%. For illustrative purposes only. There are too many assumptions to be made for a scenario analysis for floating-rate bonds, and bank loans don t even have a stated duration. However, rising rates will likely have less of an impact on the price floaters than they would on fixed-coupon bonds over a short time horizon because most floaters have floors, so the current income rate may not change. An investor would need a price decrease to see a significant impact on the return. 18

19 This seems to be just the opposite of what I ve heard elsewhere. Why is that? The topic of rising interest rates is everywhere, and we are all concerned about the potential impact that higher rates can have on an investor s bond portfolio. Although we agree that bond yields will continue to move higher going forward, we believe the pace will be slow, and the magnitude of the rise may be lower than many expect. Fund flow data, as well as anecdotal evidence, leads us to believe that many investors have been moving money to floating-rate notes and funds to take advantage of higher rates, but may not have taken the time to calculate what they are giving up relative to the potential gain. We believe it s too early to invest in floaters, based on our outlook for the timing of the Fed s first rate increase. The magnitude of the rise in bond yields may be lower than many expect. How can an investor implement this idea at Schwab? We advise that all investing should be done with a longer-term time frame in mind, and that tactical moves such as this should be considered within the context of each investor s long-term goals and desired asset allocations. This idea is based on our current preference for fixed-rate corporate bonds over floating-rate corporate bonds. You can talk with a Schwab fixed income specialist for ways to implement this idea based on your particular situation. 19

20 Important Disclosures Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges, and expenses. You can request a prospectus by visiting Schwab.com or calling Please read the prospectus carefully before investing. Investment returns will fluctuate and are subject to market volatility, so that an investor s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV). Past performance is no guarantee of future results. Examples and comparisons are hypothetical and provided for illustrative purposes only. They are not intended to represent a specific investment product or results you can expect to achieve. Dividends and interest are assumed to have been reinvested, and the examples do not reflect the effects of taxes or fees. The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data here is obtained from what are considered reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Lowerrated securities are subject to greater credit risk, default risk, and liquidity risk. Indices are unmanaged; do not incur management fees, costs, or expenses; and cannot be invested in directly. The Barclays U.S. Corporate High-Yield Bond Index covers the U.S. dollardenominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high yield if the middle rating of Moody s, Fitch, and S&P is Ba1/BB+/BB+ or below. The Barclays U.S. High Yield 350mm Cash Pay 0 5 Yr 2% Cap Index is a subset of the index. The Barclays U.S. Corporate Bond Index covers the U.S. dollar-denominated, investment grade, fixed-rate, taxable corporate bond market. Securities are included if they re rated investment grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody s, S&P, and Fitch. This index is part of the U.S. Aggregate. The Barclays U.S. Corporate Bond 1 3 Year Index is a subset of the index that focuses on securities with between one and three years to maturity. The Barclays U.S. Dollar Floating Rate Note Index provides a measure of the U.S. dollar-denominated floating-rate note market. The index measures the performance of floating-rate notes across sector, credit quality, maturity, and asset class sectors. The index includes both corporate and non-corporate sectors. Securities are included if they re rated investment grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody s, S&P, and Fitch, and must have at least one month to final maturity and an issue date of 1998 or later. The Barclays High Yield Loans Index, also known as the Bank Loan Index, covers the universe of syndicated term loans. To be included in the index, a bank loan must be U.S. dollar-denominated, have at least a $150 million funded loan, a minimum term of one year, and a minimum initial spread of LIBOR+125. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc Charles Schwab & Co., Inc. All rights reserved. Member SIPC. CS ( ) PLC77732FM-00 (11/13)