Interest Rates & Your Portfolio:

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1 Interest Rates & Your Portfolio: The Impact of Rising Rates 2015 Edition June, 2015 Sharon Stark Managing Director, Fixed Income Strategist Jim Rice Senior Vice President, Taxable Fixed Income Trading Manager Dustin Brumbaugh, CFA Senior Vice President, Director of Research Scott Haigh Senior Vice President, Portfolio Manager, Director of Managed Assets Research Interest Rates: Past and Present In April of 2013, as the economy approached its fourth year of expansion, we issued a whitepaper to begin the discussion about the inevitable rise of interest rates. Now two years later, interest rates in the U.S. have remained historically low due in part to aggressive easing in credit conditions by the Fed, moderate economic growth, and mild inflation pressures. The U.S. equity markets rebounded strongly from the recent recession, and also reached record highs as corporations repaired their balance sheets and improved profitability. The rebound was also partially aided by strong policies that have been implemented by the Fed, which established a target short-term borrowing rate of zero and mandated the purchase of Treasury and agency mortgage-backed securities (MBS) in the open market for the Fed s securities portfolio. The purchasing of Treasury and agency mortgagebacked securities in the market (known as quantitative easing; QE) by the Fed in November 2008 was established to help bring the U.S. housing market out of its deepest slump in decades. In October 2014, the Fed agreed to end its QE activity but continue to reinvest the proceeds from the portfolio in Treasury securities. Are You Prepared for Rising Interest Rates? Ideas to Consider: Measures that have been taken by the Federal Reserve (Fed) to stem the financial crises have driven interest rates to historically low levels. The economic and financial market recovery suggests that rates may be poised to rise in the near future. Rising interest rates generally cause bond prices to fall, and may lead to greater price volatility. Non-traditional income products (including but not limited to preferred stock, closed-end funds, REITs, and bond funds) may be significantly impacted by an increase in interest rates. Investors who are sensitive to principal risk may need to sacrifice cash flow in the short term to protect principal. A review of one s portfolio with your Financial Advisor in light of potential higher interest rates is warranted.

2 10-year U.S. Treasury Yield ( ) Looking forward we anticipate continued progress in wage growth, which we believe could be a direct result of advances in new home sales. However, deflation from Europe could have ramifications on U.S. exports, which comprise roughly 14 percent of GDP (gross domestic product), as well as stem gains in business expansion in the U.S. Additionally, the Fed has a dual mandate prescribed by Congress. One is to use monetary policy to achieve and maintain a full level of employment, and the second is to maintain stable prices. As economic growth approaches three percent on a consistent basis and the unemployment rate falls toward five percent, the Fed is contemplating increasing its Fed Funds rate in late 2015 for the first time since Labor conditions have improved markedly since the recession. Jobs are essential to economic growth in the U.S., as two-thirds of overall GDP is propelled by consumer spending. Increased hiring, lower unemployment and advancement in wages, and greater overall consumption all contribute to higher GDP which we estimate could push the pace of GDP toward 3.0 to 3.6 percent over the next two years. Positioning Portfolios for Rising Rates Sector Analysis-Bonds We believe that a combination of rising rates and a stronger economy will affect valuations and creditworthiness on various sectors of the fixed income market. Investors should consider the following fixed income instruments and how each could be affected by interest rate changes: Municipal Bonds: increased economic activity tends to be positive for municipal debt securities. Increased income, spending, and homeowner mobility help to generate additional revenue for states and cities through increased tax receipts. We continue to like general obligation and essential service revenue bonds of well-managed issuers, but advise investors to avoid credits that have large unfunded pension obligations. Government-Sponsored Enterprises (including FNMA, FHLMC, FHLB, and FFCB): we like defensive structures, such as step-coupon bonds and premium bonds. We do not see any credit concerns within this sector. Corporate Bonds: a stronger economy typically bodes well for corporate bonds. However, investors should keep in mind that credit spreads are already tight, so the potential upside is limited. We believe that the yield curve will flatten and financial issuers may underperform cyclical credits. Issuers who generate a significant portion of their revenues from exports should be examined closely, as it is likely that a stronger dollar will affect profitability. Mortgage-Backed Securities: rising rates and a flatter yield curve tend to have a negative effect on these securities. We recommend that investors consider purchasing securities with limited extension risk (when the maturity, or expiration, date for a security is extended), or consider alternatives, including stepcoupon agencies.

3 We believe the Fed will be cautious to reduce the level of credit accommodation in the system and may begin raising the target Fed Funds rate in the second half of A steady beat of subsequent rate hikes are expected to push the borrowing rate to 1.50 percent by the third quarter of The return of inflation? Inflation Slows Inflation Slows PCE* PCE Deflator Deflator YoY YoY % Change Change Source: Bloomberg L.P. 0 6/1/07 12/1/07 6/1/08 12/1/08 6/1/09 12/1/09 6/1/10 12/1/10 6/1/11 12/1/11 6/1/12 12/1/12 6/1/13 12/1/13 6/1/14 12/1/14 (*PCE=Personal Consumption Expenditures) Another point of interest illustrated above is inflation. Prices have been slow to rise, moving from just 2 percent to 1.5 percent in the last two years. The 58 percent drop in oil prices from June 2014 to January 2015 was certainly a contributor to the disinflation that the economy has seen, but weakening foreign economies have also resulted in less global demand for goods, falling prices, and the strength of the U.S. dollar has contributed to lowered costs of imported goods. There are measures currently in place to stimulate overall economic growth, which we believe may allow prices to accelerate. Several economists forecast a rebound in U.S. inflation this year and have projected an increase in the Fed Funds rate to begin in the second half of Sector Analysis-Mutual funds, ETFs and CEFs (Closed-End Funds): We believe that bond funds, ETFs and CEFs allow for greater diversification for investors. Bond funds offer a diversified portfolio, thereby reducing the exposure that any one individual holding or sector could possibly inflict on their overall portfolio. Another characteristic of actively managed funds is that, as interest rates move prior to the maturity of the bonds within the fund, funds have the ability to easily and efficiently swap in newer, higher-yielding bonds an advantage that holders of individual bonds may not have. Even though bonds may decline in price as yields rise, the bond fund investor may be able to make up at least part of that drop by obtaining higher interest payments to the investors from the newly purchased bonds. Additionally, active management keeps a keen eye to issuers creditworthiness. Investors should also assess the potential risks associated with a popular type of security, the closed-end fund. As the name implies, this type of security differs from traditional mutual funds in that there are a finite number of shares issued by the creditor. Secondary market supply and demand is also a feature that may affect CEFs. A CEF has both a NAV, and a market price, but these two values may and often do differ. Changes in demand for a particular CEF may cause the fund to trade at a price that differs from the NAV. Periods of rising interest rates historically have been accompanied by widening discounts to fund NAVs, further reducing the returns to CEF investors. Additionally, some CEF s employ leverage. Leveraging, (or borrowing additional assets) can also exacerbate the impact rising rates could have on the funds price. This is not to say that investors should sell their leveraged CEF s; rather, investors are encouraged to fully understand the components of total return in the funds within their portfolio, as well as assess both their investment objective and risk tolerance.

4 The real impact to returns As a basic tenet, investors must be aware that as interest rates fluctuate, so do the prices of their bonds. The table below illustrates the effect that up to a 100 basis point rise in interest rates would have on various fixed income investments. While some sectors would be more negatively impacted than others, notice that all listed fixed income sectors would experience price declines. The following table shows the potential effect of interest rate hikes of up to 1% on various sectors of the bond market. Weighted Avg. Price Return from Increase in Interest Rates Coupon Duration* 25bps 50bps 75bps 100bps Treasuries 1.86% % - 2.2% - 3.2% - 4.3% TIPS 0.96% % - 3.8% - 5.6% - 7.5% Municipals 4.52% % - 2.4% - 3.5% - 4.7% Investment Grade Corporate 4.28% % - 3.3% - 4.9% - 6.6% High Yield Corporate 6.79% % - 2.1% - 3.1% - 4.1% Mortgage Backed Securities 3.78% % - 1.7% - 2.5% - 3.4% *modified duration for Treasuries & TIPS; effective duration for the remaining Source: *D.A. Davidson & Co., S&P Dow Jones Indexes used to represent various sectors of the bond market. As of April 30, This table is a hypothetical example meant for illustrative purposes only. Strategic allocations are hypothetical and are not intended to indicate specific investment recommendation or advice. Investors should also be aware of credit risk (also referred to as default risk), which represents the borrower s ability or potential failure to repay a loan to its buyers and is the second most common risk in bond investing. And finally, investors should be mindful of duration, which is a measure of a bond s price sensitivity to a change in interest rates. In general, the longer the amount of time until maturity, the greater the price changes when interest rates move. It is a complicated calculation and, for investors, it may serve as an indicator of the potential risk in a bond or bond fund. In our view, higher interest rates are a challenge for fixed income investments especially those with high sensitivity to interest rate fluctuations. However, there are several fixed income alternatives with lower correlation to interest rate changes that may be considered by investors. Assuming equal duration, prices on credit securities, such as investment-grade corporate bonds and municipal bonds, are less-correlated to interest rate fluctuations and offer higher coupons to compensate investors for non-u.s. government-guaranteed investments. This does not mean that the prices of the credit securities will not decline as rates increase, but investors can reduce potential decline of the investment by diversifying the maturities and credit quality of the bonds that they purchase within their portfolio. Sector Analysis-Stocks The level and direction of interest rates are also powerful drivers for stocks. Valuation measures, including common price multiples (e.g. P/Es), have an underpinning in the level and direction of base (or risk-free) interest rates and as such may be influenced by changes in the rate environment. All else being held constant, a lower and/or falling interest rate environment generally supports higher P/E multiples for stocks and higher and/or rising interest rates generally portend lower P/E multiples for stocks. Of course P/E multiples are influenced by a number of factors, including corporate earnings growth expectations, which may result in deviations from the general rule. We believe that actions by the Fed to drive down longterm interest rates through a zero-bound Fed Funds rate, as well as quantitative easing (QE), or bond-buying in the market by central banks, have been a significant driver of the recovery in the stock market since the global financial crisis low in March We should also note that earnings growth has been a key driving factor of the current bull market, as we have seen a strong rebound in corporate profits since the recession, driven by economic recovery and improving company margins.

5 Strategies to consider Floating rate securities can be used as a way to minimize price depreciation as rates change. Floating rate funds may be issued with coupon rates that adjust based on a benchmark index, such as LIBOR. In other words, the interest payments change as the index that it tracks does increasing or decreasing with the benchmark. Generally, the price of a floating rate security will experience less price volatility and a higher yield than strictly purchasing fixed-rate bonds. Investors should also consider the time horizon of their investments. A laddering of maturities, or purchasing bonds with both shorter maturities (less price-sensitive, lower yield) and longer maturities (more price-sensitive, higher yield), can be an effective way to achieve a higher average yield on the portfolio. Purchasing a spectrum of bonds or bond funds with varying degrees of investment grade credit ratings (from AAA to BBB, for example) in an investment grade portfolio may also lead to less price volatility and a higher yield than strictly purchasing AAArated bonds. Bonds may also be issued with coupon rates that increase, or step-up, to pre-determined levels on specific dates. Generally, the issuer of the bond may elect to redeem the bond on the specified date, or the coupon will step-up to a pre-established rate. The structures may have a one-time step-up or multiple step-ups until the maturity date. Investors generally receive a lower initial coupon rate when purchasing this structure, but a higher coupon on the step-up date than one would receive if they purchased a fixed-rate bond. In effect, the investor forgoes some current income for the potential to receive a higher yield and income over the life of the bond. As the coupon of the bond increases as interest rates rise, the price decline of the bond may be less than a fixed-coupon bond with a similar maturity. Conclusion As stated, we expect interest rates to gradually increase over the next few years. We maintain that it is important for investors to understand how various fixed income investments may perform within a raised rate environment. We believe that securities such as bonds and bond funds generally provide a steady stream of income in portfolios, as well as supplement other investment instruments that provide more price performance and sector diversification. As interest rates rise, the value of bonds typically decline and investors that are overweight in this asset class may consider making changes to their portfolio to reduce the risk of depreciation in the holdings. This may include minimizing holdings of longer duration bonds or bond funds, or investments with limited opportunities for share buybacks or liquidation. And as always, investors should regularly assess the diversification of their portfolios. Investors are encouraged to schedule a review with their Financial Advisor to discuss specific portfolio asset allocations to determine how the overall value of the portfolio may change as interest rates rise, to ensure that the investments continue to meet individual objectives. Sector Analysis-Preferred Stocks While stock by name, preferred shares live somewhere between fixed income and common stocks and we believe warrant special mention. Like common stocks, preferred stocks generally have no set maturity date but their periodic dividends are typically fixed, which makes them behave more like fixed-rate bonds. The level of interest rate risk inherent in preferred securities depends on structure. Fixed-to-floating rate, where dividend payments may be fixed for a period of time and then adjust to market rates, and floating-rate (or adjustable) preferred stocks generally have less interest rate risk than fixed-for-life, or perpetual preferred. Due to the perpetual nature of their fixed payments, the latter tend to have a very high duration and hence elevated sensitivity to changes in interest rates. While many perpetual preferred have call features, which afford issuing companies the option to buy back the stock at par value, companies may choose not to redeem these securities if rising rates have made them an advantageous source of continued funding in the capital structure. We believe that investors who are wishing to protect their portfolio value and returns against the risk of rising rates should pay special attention to fixed-for-life preferred, which are typically exchange traded and carry a $25 par value. Your Financial Advisor can help you assess the risk specific to your particular holdings. Important Disclosure Information contained herein has been obtained by sources that we consider reliable, but it is not guaranteed and we are not soliciting any action based upon it. Any opinions expressed are based on our interpretation of the data available to us at the time of the original publication of the document. These opinions are subject to change at any time without notice. Investors must bear in mind that inherent in investments are the risk of fluctuating prices and the uncertainties of dividends, rates of return, and yield. Investors should also remember that past performance is not necessarily an indicator of future performance, and D.A. Davidson & Co. makes no guarantee, express or implied, to future performance. Investors should consult their Financial and/or Tax Advisor before implementing any investment plan.