Fixed Income: The Hidden Risk of Indexing

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1 MANNING & NAPIER ADVISORS, INC. Fixed Income: The Hidden Risk of Indexing Unless otherwise noted, all figures are based in USD.

2 Fixed income markets in the U.S. are vast. At roughly twice the size of domestic equity markets, investment options within the fixed income realm provide investors with a wide variety of income generating and capital preservation opportunities. While fixed income investments are generally considered more conservative than equities, they do contain certain risks that need to be understood and evaluated. Capital risk is perhaps the most obvious example. When a corporate issuer declares bankruptcy, bond investors are senior to equity holders and are therefore among the first investors to be repaid as assets are liquidated. Bond holders may still lose money in such cases, but often times much less than equity holders who stand to lose everything. Though fixed income investors may have some protection against capital risk, reinvestment risk and inflation risk are also important factors to consider when analyzing fixed income investments. Because fixed income investments have defined maturity schedules and because prices and yields are influenced by interest rates, understanding reinvestment risk is imperative to making sound fixed income investment decisions. Similarly, the risk that fixed income investment returns do not keep pace with rising prices means that monitoring the inflationary environment is vital. All three of these distinct risks are influenced by prevailing market and economic conditions. Economic conditions do not follow a perfectly circular path from expansion to recession and back again. Instead, they ebb and flow as expectations shift and sentiment changes. As these adjustments occur, different sectors of the fixed income market become more attractive than others. For example, when interest rates, GDP, and inflation are at certain levels, corporate bonds might present an attractive option. In a different environment, U.S. Treasury securities may be the best choice. In this regard, it is important for a fixed income investment manager to have the flexibility to analyze risks and choose which areas of the market are presenting the best opportunities. This ability to adjust to evolving conditions and pursue opportunities where they arise is generally referred to as active management. While active management has many benefits, passive management or indexing has been gaining in popularity in recent years. In a passive approach, fixed income sector selection is based on the current composition and issuance of a particular index. That means exposure to different parts of the fixed income markets is based on what an index holds, not on what areas may have the most favorable fundamentals. Manning & Napier Advisors, Inc. ( Manning & Napier ) believes this passive approach has many limitations, particularly in regards to security selection, sector allocation, and risk management. As such, we remain committed to our active and flexible investment approach, which allows us to take what the market gives and capitalize on opportunities as they unfold.

3 Fixed Income Indexing Broad fixed income benchmarks such as the Barclays Capital U.S. Aggregate Bond Index 1 ( BCA ) appear to provide investors with easy access to a diversified portfolio of high quality fixed income investments, while also offering returns that have historically been competitive with those of active fixed income investment strategies. However, indexing within the fixed income asset class may expose investors to potential hidden risks, particularly in today s market environment. In what follows, we discuss the implications of the BCA s increasing allocation to U.S. Treasury securities, today s historically low yield levels, the potential impact of rising interest rates on Treasury prices, and the general sensitivity of Treasury securities to changes in interest rates. Changes in the U.S. Treasury Allocation of Fixed Income Benchmarks BCA, which measures performance of the broad investmentgrade fixed income market, provides exposure to a variety of fixed income sectors. However, the majority of the BCA s assets are allocated to U.S. Treasury securities, corporate bonds, and mortgage-backed securities. Similar to many fixed income indices, the relative allocation of each sector within BCA largely depends on the current composition of the fixed income market and particularly on new issuance within each sector. For example, if more corporate bonds are being issued relative to Treasuries and mortgage-backed securities, BCA s allocation to corporate bonds will likely increase over time. U.S. Treasury securities currently account for approximately 33% of BCA. Treasury securities are direct obligations of the U.S. government and are thus considered to be virtually free of default risk. As expected, during the credit turmoil of 2008, U.S. Treasury securities appeared to provide a safe haven for investors, contrasting with the losses suffered by the nonagency mortgage and corporate bond sectors. In fact, while investment-grade corporate bonds (as represented by the Barclays Capital U.S. Credit Index 2 ) declined just over 3% in 2008, the broad U.S. Treasury market (as represented by the Barclays Capital U.S. Treasury Index 3 ) returned nearly 14%. Consequently, BCA outperformed the majority of active fixed income managers during the year, in part as a result of its higher allocation to U.S. Treasuries relative to the average active fixed income manager. As Chart 1 illustrates, the BCA s allocation to U.S. Treasury securities has risen materially over the past several years. The increase can be attributed to both an increase in supply (new issuance) of Treasuries by the U.S. Government and a general decrease in issuance by other fixed income sectors. Issuing Treasury securities is a primary method of funding federal spending. Therefore, as the government increased spending to provide support during the recession and credit crisis, Treasury issuance rose as well. Meanwhile, turmoil in the credit markets led to a meaningful reduction in issuance within the corporate and securitized (i.e., mortgage-backed securities) sectors, as corporations found it difficult to borrow money and demand for these types of fixed income instruments essentially disappeared. While corporate bond issuance and demand has rebounded over the past year, the allocation to U.S. Treasuries within the BCA remains near its highest level in over ten years. Chart 1 Barclays Capital U.S. Aggregate Bond Index: % Allocation to U.S. Treasuries (January 29, March 31, 2011) Source: Barclays Capital

4 Current Yield Levels and Implications for Future Treasury Returns Given U.S. Treasury securities strong relative performance during the recent credit contraction and their minimal default risk, investors may view the benchmark s increasing allocation to Treasuries as advantageous. In fact, even over longer time periods, U.S. Government bonds appear to provide competitive returns. For example, Long-Term Government Bond* returns over the ten-year period from 1/01 12/10 were approximately 7.9% annualized. This is superior to equity performance (as represented by the S&P 500 Index 4 ), which achieved annualized returns of only 1.4% over the same period. However, achieving similar fixed income results going forward, for the Treasury sector and the benchmark as a whole, may be difficult. In particular, current low yield levels and the inverse relationship between fixed income prices and yield movements could present potential headwinds. Chart 2 Yield on 10-Year U.S. Treasury Bond The total return of a fixed income security over a given period is generally calculated using a coupon payment and any changes in the security s price. While coupon payments are generally fixed in nature (i.e., represent a fixed dollar amount and occur at designated intervals), the price of a fixed income security varies over time and moves inversely with changes in interest rates (yields). Accordingly, periods of rising (falling) interest rates are generally associated with a decline (increase) in the price of fixed income securities. Depending on the magnitude and direction of interest rate movements over a given period, a fixed income security may generate total returns above or below its fixed coupon payment. While U.S. Treasury returns from 1/01 12/10 were competitive, it should be noted that the yield on the ten-year U.S. Treasury Bond decreased from approximately 5.1% to 3.4% during that time. Over this period, Treasury coupon* returns amounted to approximately 4.9% annualized, while the price appreciation component (a result of falling yields) boosted total returns to 7.9%. The environment today is noticeably different. As Chart 2 shows, government bond yields are currently between 3% and 4%. Source: FactSet As Chart 3 on the next page illustrates, with yields near 40- year lows, the future ten-year returns for government bonds could be as low as 2%-3%. Moreover, in today s low yield environment, further yield declines appear less likely (although possible in the near term), thereby reducing the potential for bond price appreciation in response to falling interest rates. As a result, total returns for government bonds may be closer to their coupon returns going forward. With regards to BCA, about 90% of the index s total returns have been attributable to coupon payments since it s inception in Therefore, the current low level of yields may have additional adverse implications for future returns as lower coupon bonds are incorporated into the benchmark. Given this environment, a passive approach that follows the benchmark may be limited. In contrast, an active investment approach may be able to manage market risks and identify opportunities across all areas of the fixed income markets.

5 Chart 3 Low Yields Have Historically Led to Lower Fixed Income Returns in the Future (July December 2010) Sources: Morningstar, FactSet

6 The Sensitivity of the U.S. Treasury Sector to Interest Rate Movements Among the various sectors of the fixed income markets, the Treasury sector is considered to have the greatest sensitivity to interest rate movements. As Chart 4 shows, the price level of the Bank of America Merrill Lynch U.S. Treasuries Master Index 5 nearly mirrors the changes in yield of the ten-year U.S. Treasury Bond. As such, an increase (decline) in yields is almost always associated with a decline (increase) in the price level of the index. Moreover, we note that the duration (i.e., interest rates sensitivity) of the U.S. Treasury sector has increased since the middle of 2007 from approximately 4.9 years to 5.3 years. Given this heightened interest rate sensitivity, BCA s increasing allocation to Treasuries may provide an additional performance headwind during a period of expected rising interest rates. Chart 4 (January March 2011) While the inverse relationship between prices and interest rate movements generally holds across fixed income sectors, certain sectors of the fixed income market trade at yields above that of Treasury securities. Without the perceived backing of the U.S. government, many sectors demand a higher premium (or higher yield) for the additional risk. These sectors include corporate bonds and mortgage-backed securities and are sometimes collectively referred to as spread sectors. The relative performance of these sectors depends not only on the absolute trend in interest rate movements, but also on how their yields move in relation to that of U.S. Treasuries. For example, if overall interest rates rise, but yields on U.S. Treasuries increase by a greater amount than those of corporate bonds, the spread between Treasuries and corporate bonds should decrease. This spread tightening can help boost the relative performance of corporate bonds. (If corporate bond yields rise by less than Treasury yields, their prices typically fall by less than Treasuries). As Chart 5 illustrates, the current spread between investment-grade corporate bonds and Treasuries remains relatively attractive. A further tightening of the spread could partly mitigate the effects of rising interest rates. Source: FactSet Chart 5 (January January 2011) Source: FactSet (Right) (Left) *Represents the spread between the yield on long-term corporate AA rated bonds and the yield on the constant maturity 10-year U.S. Treasury Bond

7 Conclusion While index-based fixed income strategies may provide investors with exposure to a broad range of investment-grade fixed income securities, the current composition of BCA may be a source of potential risks in today s market environment. Most notably, the benchmark s increasing allocation to U.S. Treasury securities could represent a performance headwind in light of current low yield levels and the general sensitivity of Treasury prices to rising interest rates. With an investment strategy based on the benchmark, a passive approach would be restricted to this current composition of the index. In contrast, given the dynamic nature of fixed income markets, an active strategy allows for the ability to adjust to changing market conditions. More specifically, active management provides the flexibility to adjust a portfolio s overall duration in response to interest rate movements, as well as allocate assets to the most attractive fixed income sectors and securities depending on the market environment. Perhaps most importantly, an active approach to fixed income management can also take into account an investor s long-term goals, objectives, and risk tolerance in implementing the most appropriate fixed income investment strategy. 1 The Barclays Capital U.S. Aggregate Bond Index ( BCA ) is an unmanaged index that represents the U.S. domestic investment-grade bond market. It is a market value-weighted index of investmentgrade debt issues, including government, corporate, asset-backed and mortgage-backed securities, with maturities of one year or more. The Index returns do not reflect any fees or expenses. Index returns provided by Interactive Data. 2 The Barclays Capital U.S. Credit Index is an unmanaged index considered representative of publicly issued, fixed-rate, nonconvertible, dollar-denominated, SEC-registered, investment-grade corporate debt. The Index returns reflect total returns, which include reinvestment of dividends. Index returns provided by Morningstar. 3 The Barclays Capital U.S. Treasury Index is an unmanaged index of U.S Treasuries, agency bonds, and 1-3 Year U.S. government obligations. The Index returns reflect total returns, which include reinvestment of dividends. Index returns provided by Morningstar. 4 The S&P 500 Total Return Index is an unmanaged, capitalization-weighted measure of 500 widely held common stocks listed on the New York Stock Exchange, American Stock Exchange, and the Over-the-Counter market. The Index returns assume daily reinvestment of dividends and do not reflect any fees or expenses. Index returns provided by Bloomberg. 5 The Bank of America ( BofA ) Merrill Lynch U.S. Treasury Master Index is an unmanaged index of sovereign debt publicly issued by the U.S. government in its domestic market. The securities must have at least one year remaining term to final maturity, a fixed coupon schedule, and a minimum amount outstanding of $1 billion. The Index is denominated in U.S. Dollars. Index returns provided by Bloomberg. *Representative of Ibbotson Associates Stocks, Bonds, Bills, and Inflation as of 12/31/10. Manning & Napier Advisors, Inc. ( Manning & Napier ) is governed under the regulations of the U.S. Securities and Exchange Commission (SEC). Analysis: Manning & Napier. Sources: FINRA, Wilshire Associates, U.S. Securities and Exchange Commission, Investopedia, BlackRock Investments LLC, Northern Trust, Morningstar, Ned Davis Research, Inc. J.P. Morgan, Standard & Poors, Board of Governors of the Federal Reserve System, FactSet, Barclays Capital. All investments contain risk and may lose value. This material contains the opinions of Manning & Napier Advisors, Inc., which are subject to change based on evolving market and economic conditions. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. SMA-PUB012 USCDN (5/11)