Bond Fund Investing in a Rising Rate Environment

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1 MUTUAL FUND RESEARCH Danette Szakaly Ext Date Issued: 1/14/11 Fund Investing in a Rising Rate Environment The recent rise in U.S. Treasury bond yields has some investors wondering how to manage their fixed income portfolios. While we do not recommend dramatic strategic changes in fixed income allocations based upon market movements, there are a few tactical strategies available that may help reduce risk in a rising rate environment. Fixed Income Trends The mutual fund industry experienced a record $376 billion of net new cash flows into fixed income bond funds in calendar year As of November 30, 2010, fixed income bond funds had seen an additional $266 billion of new flows, 90% of which had been going into taxable bond funds. (Source: Investment Company Institute) Raymond James as a firm has been seeing similar trends. In 2010, Raymond James s top sales by category had been the intermediate-term bond category followed by the world allocation and shortterm bond categories. (Funds in these categories can be found on the ly Recommended list produced by Raymond James Mutual Fund Research.) There have recently been some signs that these trends have been reversing. According to the Investment Company Institute, the cyclical demand for fixed income securities may be slowing, and the large positive returns in bond mutual funds may be nearing the end stage of this cycle. Additionally, Morningstar data showed mildly negative outflows from the intermediate-term bond category in November, followed by a huge outflow in December of about $8 billion. (Source: Morningstar Direct.) With that being said, there are other opinions that support a continued interest in fixed income as an asset class despite the one month sell-off experienced in November. Such supporting arguments have stemmed from changes in both U.S. demographics and overall investor risk appetites. As the U.S. population ages, retiring investors will have a greater need for bonds as a way to provide income and protect their nest egg going forward. As for risk appetites, investors across all age groups have experienced essentially two of the worst bear markets in a decade. Research has proven that investor appetites are heavily influenced by past experiences, which may result in heavier allocations to bonds in investors portfolios for several years to come. What Does It All Mean? As we came into year-end, the announcement of a second round of quantitative easing along with the extension of Bush s tax cuts all had an impact on fixed income securities. Looking ahead longer-term, inflation is expected to creep back up and interest rates will eventually have to rise, all of which is thought of as being bad news for bond holders. While these concerns are certainly warranted, and this paper will later provide ways to hedge that interest rate risk, many portfolio managers feel there is no cliff on the horizon where rates suddenly spike. With the Fed policy currently keeping rates between 0.00% and 0.25% most managers believe we may be in this low interest rate environment for some time due to various headwinds. The sustained high unemployment, where we have seen lost jobs and displaced workers, will have an impact on wage growth, income growth, spending, and overall growth rates of the economy, not to mention that the U.S. is still deleveraging.

2 Looking ahead, financial advisors and investors alike will have to think beyond duration as the interest rate environment changes. Generally, fixed income should serve as an anchor in any portfolio to dampen the volatility of common stocks (recall the flash crash in May), and a well diversified portfolio will include some bonds; however, keeping a fixed income portfolio risk diversified will matter more moving forward. With a $90 trillion global marketplace, there are many segments of the fixed income markets that will not be as dependent on the movements in the U.S. Treasury market, which may provide an added layer of diversification. Getting Risk Diversified! The Raymond James Taxable Fixed Income Trading Desk recommends strategies, such as rolling down the curve to provide investors with unique opportunities for varying interest rate scenarios. There is a continued emphasis to know what you own" by understanding each individual issuer s unique characteristics and how concerns over increasing longer-term rates and potential inflationary pressures would call for shorter-term duration portfolios overall. Unlike an individual bond, which returns full principal if held to maturity (assuming the issuer remains credit worthy), bond funds typically do not hold bonds until maturity. Portfolio managers will cycle through bonds, in part to maintain a certain yield, to take advantage of better opportunities, or to maintain cash for flows in and out of the fund. Many portfolio managers are taking action to prepare their portfolios for a rising rate environment, granted, different managers will be limited by what they can do depending on the investment mandates and strategies of the mutual fund. The figure below provides just a few of the strategies that have the potential to protect in a rising interest rate environment. Strategies for Hedging Interest Rate Risk What? Why? How? Manage Duration As interest rates rise, bond pr ices decline. Look at a fund's effective duration, which is a measure of overall sensitivity to interest rate movements. Fund managers have been making slight adjustments, taking duration to either neutral relative to a benchmark or slightly lower. Position a bond portfolio to profit the most Curve curve positioning may help vary interest from an expected change in the yield curve. Positioning 1 rate scenarios. "Roll down the curve." Advantage 2 Sector Allocation 3 Invest Globally 4 Maintaining a yield advantage may counter rising rates as some credits may offer protection against a rise in yields resulting in positive total returns. Other fixed income asset classes may either be weakly or negatively correlated to rising U.S. Treasury yields. Not every country will be experiencing the same monetary tightening policy as here in the U.S. And, this recovery cycle is different as the U.S. is not the engine driving growth. Look for core bond funds with allocations to lower quality, investment-grade corporate credit. Invest in non-government and corporate-type bond funds, inclusive of high-yield bonds and bank loans. Take advantage of the global opportunity set seeking sovereign and corporate debt in both developed and emerging countries. 1 Monitoring the yield curve is part of the day-to-day responsibility of being a fixed income manager. While most managers rely on bottom-up fundamental research, and most do not anticipate interest rate changes, opinions about the Fed policy and business cycle are all incorporated into yield curve positioning, sector, and security selection. 2 s do not lie! The benefits of a yield advantage must be weighed against the risks. One of the benefits of owning a mutual fund is that you can rely on professional bond management to manage credit risk through credit analysis and research. 3 yield bonds and bank loans have had historically higher correlations to the equity markets than interest rate sensitive areas of the credit market 4 Investing internationally may involve currency fluctuations, political and economic risks. 2

3 Historical Perspectives With the anticipation of a rising interest rate environment threatening to punish bond prices, investors have good reason to be wary of bonds regardless of the past 25 year history of bond fund performance. Irrespective of 1994 and 1995, the last 25 years overall has been a period of steadily declining interest rates, translating into rising bond prices. During rising rate periods, however, bond funds generally decrease in value. Between 1994 and 1995, the Federal Reserve ratcheted up short term interest rates and intermediateand long-term interest rates also increased. Most bond funds had negative returns in 1994 as the Fed had six rate hikes in 1994 totaling 2.50%. Over the last 20 years, the U.S. has seen four tightening cycles. Tables 1 4 in the appendix reveal average category returns for all major fixed income asset classes for each calendar year before, during, and after the rising rate cycle. While it is evident that no one fixed income asset class dominates performance year over year, historically, bank loans, high-yield, and multi-sector strategies have done better in calendar years when rates were rising. With that being said, some asset classes have gone from being a top performing asset class in one year, to being one of the worst performing asset classes the following year depending on interest rate movements and the credit environment. For these reasons, we do not recommend making large strategic changes to your fixed income portfolios; however, implementing some of the aforementioned tactical strategies may help reduce risk in a rising rate environment. Conclusion Because it is impossible to time when and to what extent the Fed might make its next move, or exactly what the impacts will be on bonds, leaving your fixed income portfolios in the hands of experienced professionals through a managed mutual fund can minimize some of the concerns of going it alone in these uncertain times. Fixed income securities can be quite complex and we could be entering an interesting time period for bonds. Maintaining a diversified fixed income portfolio by investing in other areas of the fixed income markets may help diversify risk in your overall portfolio. (Diversification does not ensure a gain or protect against a loss.) For additional information or investment ideas contact your financial advisor. Past performance does not guarantee future results. There is no assurance these trends will be repeated in the future. These strategies are not suitable for all investors. Investing involves risk and you may incur a profit or a loss. Investing in fixed income securities is subject to interest rate risk. When interest rates rise, bond prices and the value may decline. In general, securities with longer maturities are more sensitive to this price decline. Treasury securities are backed by the full faith and credit of the U.S. government as to the prompt payment of principal and interest. Guarantees of repayment of principal and interest do not apply to the market prices and yields of the Treasury securities. Investing in high-yield bonds ("junk bonds"), which are speculative, may not be suitable for all investors. -yield bonds or "junk bonds" generally entail greater market, credit, and liquidity risks than investment-grade securities. The risk of default may increase due to changes in the issuer's credit quality. Price changes may occur due to changes in interest rates and the liquidity of the fixed income securities. When appropriate, fixed income securities should only comprise a modest portion of your portfolio. 3

4 APPENDIX TABLE 1 TABLE 2 Rising Rate Cycle #1 S&L bailout Rising Rate Cycle #2 Mexican peso crisis March February 1989 February February 1995 Fed Funds Rate Hike 3.25% Fed Funds Rate Hike 3.00% % 12.73% 21.71% 13.76% 37.19% 18.59% 6.59% 25.92% 13.48% 13.26% Ultra 6.48% 12.56% 16.60% 9.60% 27.15% 15.15% Ultra 1.97% 22.07% 11.29% 12.99% 3.28% 11.46% 12.42% 9.14% 17.57% 15.24% -0.18% 17.70% 10.85% 10.67% 2.88% 8.44% 12.18% 8.67% 16.93% 14.58% -0.64% 17.30% 6.75% 9.24% 2.82% 8.42% 11.73% Ultra 8.09% 16.66% 14.08% -1.01% 17.06% Ultra 5.80% 9.11% 2.40% 8.39% 11.34% 6.98% 14.57% 13.06% -3.03% 16.99% 5.49% 8.81% 1.99% 7.90% Ultra 9.99% 6.95% 14.09% 12.43% -3.22% 16.63% 4.56% 8.67% 1.31% 7.68% 9.69% 6.39% 12.56% 10.44% -3.78% 16.45% 3.97% 7.96% 1.10% Ultra 6.96% 9.43% 6.28% 12.24% 9.92% -4.00% 16.23% 3.76% 7.50% 0.62% 6.92% 8.37% 6.04% 11.88% 8.15% -4.09% 12.80% 3.65% 7.20% 0.57% 6.62% 7.40% 5.74% 10.04% 6.96% -4.53% 11.29% 3.48% 6.73% -0.88% 6.50% 6.80% 5.29% Ultra 8.48% 6.69% -4.72% 11.03% 3.47% 6.59% -3.08% 5.93% 4.35% -3.54% 8.29% 5.81% -5.97% 7.94% 2.90% Ultra 6.10% -0.44% -7.10% 8.02% 5.70% -6.32% 7.83% 2.87% 5.13% % -1.08% Ultra 4.48% -6.44% Ultra 7.54% -0.47% 3.63% Source: Morningstar Direct 4

5 TABLE 3 TABLE 4 Rising Rate Cycle #3 Y2K and Dot-com Rising Rate Cycle #4 Record budget crash deficits, Hurricane Katrina June May 2000 June June 2006 Fed Funds Rate Hike 1.75% Fed Funds Rate Hike 4.25% % 9.54% 7.49% 7.36% 7.19% 6.37% 6.26% 6.13% 5.95% 5.52% 5.43% Ultra 5.10% 4.59% 1.40% -0.13% 5.86% 5.05% Ultra 4.38% 2.89% 2.21% 1.79% 1.48% 0.73% -1.34% -1.34% -2.06% -2.73% -2.86% -4.70% -8.23% 17.05% 12.35% 11.24% 10.85% 9.43% 9.35% 9.16% 8.29% 7.59% Ultra 6.81% 5.87% 5.52% 3.21% 1.73% -7.12% 7.85% 7.64% 7.27% 7.26% 7.25% 6.80% Ultra 5.52% 4.76% 4.39% 4.22% 4.09% 3.91% 2.38% 1.95% 1.64% 14.80% 14.09% 13.85% 9.22% 8.57% 8.45% 8.36% 8.03% 6.85% 6.76% 5.46% 5.39% Ultra 2.89% 0.84% -1.51% % 16.17% 13.79% 10.42% 8.78% 7.14% 5.10% 4.89% 4.09% 2.53% 2.43% 1.90% Ultra 1.75% 1.74% 1.45% 9.98% 8.97% 8.37% 7.47% 7.39% 6.47% 5.12% 3.91% 3.77% 3.01% 2.83% 1.62% 1.45% Ultra 1.26% 1.18% 6.05% 4.57% 3.09% 2.59% Ultra 2.52% 2.23% 2.11% 2.08% 1.90% 1.80% 1.79% 1.44% 1.25% 1.21% -3.32% 10.13% 6.90% 6.56% 5.41% Ultra 4.69% 4.56% 4.42% 4.14% 4.04% 3.67% 3.67% 3.46% 2.95% 0.14% 0.09% 9.86% 9.76% 7.28% 6.08% 5.86% 4.70% 4.44% 4.29% 3.30% 3.09% 2.75% Ultra 2.41% 1.47% 1.26% 1.08% Source: Morningstar Direct The Morningstar category is assigned to a mutual fund based on the underlying securities in each portfolio. A Morningstar category cannot be invested in directly. -Term ernment: A fund with at least 90% of its bond portfolio invested in government issues with a duration of greater than or equal to six years or an average effective maturity of greater than 10 years. ediate-term ernment: A fund with at least 90% of its bond portfolio invested in government issues with a duration of greater than or equal to 3.5 years and less than six years or an average effective maturity of greater than or equal to four years and less than 10 years. -Term ernment: A fund with at least 90% of its bond portfolio invested in government issues with a duration of greater than or equal to one year and less than 3.5 years, or average effective maturity of greater than or equal to one year and less than four years. -Term : A fund that focuses on corporate and other investment-grade issues with an average duration of more than six years, or an average effective maturity of more than 10 years. ediate-term : A fund that focuses on corporate, government, foreign or other issues with an average duration of greater than or equal to 3.5 years but less than or equal to six years, or an average effective maturity of more than four years but less than 10 years. -Term : A fund that focuses on corporate and other investment-grade issues with an average duration of more than one year but less than 3.5 years, or an average effective maturity of more than one year but less than four years. Ultra : Used for funds with an average duration or an average effective maturity of less than one year. This category includes general- and government-bond funds, and excludes any international, convertible, multisector, and high-yield bond funds. - : A fund with at least 65% of assets in bonds rated below BBB. : A fund that invests at least 40% of bonds in foreign markets. 5

6 or : Used for funds that seek income by diversifying their assets among several fixed-income sectors, usually U.S. government obligations, foreign bonds, and high-yield domestic debt securities. Inflation-Protected (): Inflation-protected bond portfolios invest primarily in debt securities that adjust their principal values in line with the rate of inflation. These bonds can be issued by any organization, but the U.S. Treasury is currently the largest issuer for these types of securities. : Funds that invest primarily in floating-rate bank loans instead of bonds. In exchange for their credit risk, they offer high interest payments that typically float above a common short-term benchmark. cipal National -Term: A national fund with an average duration of more than seven years, or average maturity of more than 12 years. cipal National ediate-term: A national fund with an average duration of more than 4.5 years but less than seven years, or average maturity of more than five years but less than 12 years. cipal : A fund that focuses on municipal debt/bonds with an average duration of less than 4.5 years, or an average maturity of less than five years. 6