After The Dust Settles: Fixed Income in a Rising Rate Environment

After The Dust Settles: Fixed Income in a Rising Rate Environment BY DAVID B. MAZZA, HEAD OF ETF INVESTMENT STRATEGY, AMERICAS, STATE STREET GLOBAL ADVISORS With abnormally low yields over the last few years, investors have been on high alert to the potential impact that an unpleasant end to a 0-plus year bull-run in bonds could have on their portfolios. With US 0-Year Treasury yields rising over 80bps since the end of April, many investors are now feeling the pain. While other asset classes may offer greater potential for risk-adjusted returns in today s market, fixed income can and should remain core to investment portfolios due to its potential for income generation, diversification and capital preservation. Fortunately, there are opportunities available for savvy investors to create resilient portfolios regardless of how far and fast rates may rise over the rest of the year. FIGURE : FIXED INCOME SOLD OFF DURING THE TAPER TANTRUM (%) 0,00 0,000 9,600 9,00 BONDS UNDER PRESSURE As the economy continues to recover from the Great Recession and the lingering impacts of the European sovereign debt crisis subside, it comes as no surpsrise to see rates on the rise. What seems to have caught investors by surprise however, is the speed at which rates moved after Fed Chairman Ben Bernanke suggested that QE may be tapered off sooner than consensus expected. As highlighted in Figure, US 0-year yields rose in leading to greater volatility into the FI market. This move lead to a sell off during that same period. 8,800 Nov 0 Apr Barclays US Aggregate Sep Barclays Global Inflation-Linked US TIPS Barclays US Aggregate Government Treasury Feb Barclays US Aggregate Credit Non-Corporate Investment Grade Source: FactSet, State Street Global Advisors, as of 6/0/. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. For investors looking for core exposure to the fixed income market, the Barclays US Aggregate Index (Agg) has been the traditional vehicle of choice. Even after not faring well year-to-date, the Agg offers investors a relatively low yield with increased interest rate risks relative to history, as illustrated by the divergence in yield and duration shown in Figure. What is driving this potentially detrimental change? One factor is that the weight of Treasuries in the Agg has increased over the past five years. In isolation, this is not necessarily bad. However, what is disconcerting is that the Agg s increase in duration can be attributed to the rise in Treasury exposure. FIGURE : TREASURY YIELDS AND VOLATILITY ROSE SHARPLY IN (%) (%).00 0.0 FIGURE : THE AGG OFFERS LOW YIELD AND INCREASED INTEREST RATE RISK (%) Years 7 7 6 6.00 0..00 0.0.00 0.0 0.00 0 Oct 0 US 0-Year Treasury Yield (LHS) Oct Rolling -Month Volatility (RHS) Source: FactSet, State Street Global Advisors, as of 6/0/. 0.00 0 00 00 007 009 0 Jul Yield to Worst (LHS) Duration (Mod. Adj.) (RHS) Source: Barclays, State Street Global Advisors, as of 6/0/. 0 spdrs.com

Skeptics may counter with so what? The Agg is simply reflecting the US investment grade market as it always has. Exposures will ebb and flow over time. While technically correct, this thinking may add to the risk inherent in today s market. Fortunately, investors no longer need to think simply about core exposure or core plus to meet their investment needs. Many have already begun to integrate the next generation of fixed income into portfolios on a more consistent basis. Taking this a step further with greater control over exposures will allow for further precision. In other words, investors no longer need to think of allocations across bond market sectors as merely a bolt-on approach. SOLUTIONS FOR RISING RATES IN TODAY S MARKET With corporations maintaining a focus on balance sheet management, firms remain generally healthy today. Leverage ratios are moderate and interest coverage is strong as highlighted in Figure. While global economic risks remain slightly skewed to the downside, corporations are benefitting from an environment of improving economic growth with low inflationary pressures. At the same time, a rising US dollar in the near-term may help drive increased consumption, adding further fuel to the tailwinds of a housing recovery and better jobs numbers. Thus, investors should feel comfortable taking on credit risk to meet their income needs. In addition, default rates are expected to remain low over the coming year. By diversifying portfolios across fixed and floating rate investment-grade high-yield securities, investors will be able to construct portfolios that meet their needs in an environment of rising rates. SHORT-TERM CORPORATE BONDS In today s market, a main concern for investors is interest rate risk. Shorter durations allow for greater protection in an environment of rising rates and for reinvestment at potentially higher yields. However, many investors may not be fully harnessing the credit exposure that they wish to target. More specifically, investors may wish to avoid exposure to the government-related sector as opposed to simply owning securities in the industrial, utility and financial sectors. What further compounds the matter is that government-related sectors are either highly leveraged or low yielding. FIGURE : CORPORATIONS REMAIN HEALTHY TODAY (%) 60 0 0 0 0 0 0 Sep 997 00 006 0 0 99 Interest Coverage LTM (LHS) Debt to Assets (RHS) Source: Bloomberg, L.P., State Street Global Advisors, as of 6/0/. 8 0 6 8 SHORT-TERM HIGH YIELD BONDS Market participants have embraced the benefits of high yield bonds in a low rate environment and one conducive to credit exposure. With absolute yields compressed and option-adjusted spreads around historical averages, some are questioning how much more return the segment can provide. It may be the case that investors are correct to recalibrate their return assumptions, but the market is not yet exhibiting signs of excess froth from a credit perspective. While certain segments may be richly valued and subject to greater volatility, there are options for investors who wish to remain exposed to below investment grade credits, but with less potential for performance fluctuations. One such area is short-duration high yield. While high yield is a market segment with generally low duration, short-term higher yield offers attractive yield per unit of duration. The 0 year maturity window offers half of the interest rate risk of longer maturity bonds with the added benefit of less performance volatility. CROSSOVER BONDS By focusing on the lowest rated investment grade and the highest rated below investment grade crossover bonds, investors are able to harness inefficiencies in the corporate market. By doing so, investors can avoid the lower spreads available in higher rated AAA and AA-rated bonds while at the same time avoiding the most speculative, equity-like exposure of CCC-rated high yield bonds. In addition, what investors may not know is that BBB and BB-rated bonds have offered the highest sharpe ratios of any rating bucket over long-term periods. This market segment provides a relatively attractive yield with moderate duration, an excellent combination to combat today s challenges. SENIOR SECURED LOANS With yields that are comparable to unsecured fixed rate high yield bonds, senior secured loans are an increasingly compelling option to further evolve portfolios in today s environment. Senior loans are floating rate instruments while most high yield bonds are fixed rate. This means that loans have the ability to see their rate of income increase should rates normalize, which fixed rate bonds cannot do. More specifically, because loans reset they have minimal duration risk. Investors are increasingly recognizing that it pays to wait with loans. In addition, because loans are senior in the capital structure to bonds, they have experienced significantly greater recoveries in cases of defaults than have unsecured bonds. CONVERTIBLE SECURITIES As hybrid securities, convertible securities combine the upside potential of stocks while exhibiting some of the downside protection inherent in bonds. Convertibles tend to have low sensitivity to interest rate risks, which make them more resilient to rising rate environments. In fact, while convertibles do pay interest they can be converted into their shares of the issuing company and have exposure to underlying equity fundamentals, which often perform well when rates are increasing.

FIGURE : ACTIONABLE FIXED INCOME IDEAS FOR A RISING RATE ENVIRONMENT WITH SPDR ETFS ETF TICKER INDEX GROSS EXPENSE RATIO SPDR Barclays Short Term Corporate Bond ETF SCPB Barclays U.S. Year Corporate Bond Index 0. SPDR Barclays Short Term High Yield Bond ETF SJNK Barclays U.S. High Yield 0mn Cash Pay 0 Year % Capped Index SPDR BofA Merrill Lynch Crossover Corporate Bond ETF XOVR BofA Merrill Lynch US Diversified Crossover Corporate Index 0.0 SPDR Barclays Investment Grade Floating Rate ETF FLRN Barclays U.S. Dollar Floating Rate Note < Years Index 0. SPDR Blackstone / GSO Senior Loan ETF SRLN Markit iboxx USD Liquid Leveraged Loan Index / S&P/LSTA U.S. Leveraged Loan 00 Index SPDR Barclays Convertible Securities ETF CWB Barclays U.S. Convertible Bond > $00MM Index 0.0 Source: State Street Global Advisors, as of 6/0/. The gross expense ratio is the fund s total annual operating expenses ratio. It is gross of any fee waivers or expense reimbursements. It can be found in the fund s most recent prospectus. 0.0 0.70 CONCLUSION With 0-year TIPS moving into positive territory, investors appear to be pricing in Fed tightening or at least tapering sooner than many expected. In fact, yields could move up more if economic growth surprises to the upside or the market continues pricing in Fed policy changes earlier than expected. Many are looking back to previous Fed tightening signals for clues and courses of action. With 99 and 00 potentially providing weak guidance due to the extent of extraordinary monetary policy today, investors should look beyond the core to build portfolios that behave less like return-free risk. In doing so, investors can also move beyond certain well-trodden segments that may be crowded and no longer offer their historical value propositions. Unique credit exposures through various corporate bond segments are an especially attractive solution today and allow for the development of more resilient and adaptive fixed income portfolios in a rising rate environment.

ABOUT SPDR ETFs SPDR ETFs are a comprehensive fund family of over 00 ETFs, spanning an array of international and domestic asset classes. Offered by State Street Global Advisors, SPDR ETFs provide investors with the flexibility to select investments that are precisely aligned to their investment strategy. Recognized as the industry pioneer, State Street Global Advisors created the first ETF in 99 (SPDR S&P 00 Ticker SPY). Since then, we ve sustained our place as an industry innovator through the introduction of many ground-breaking products, including first-to-market launches with gold, international real estate, international fixed income and sector ETFs. For information about our ETF family, visit spdrs.com. STATE STREET GLOBAL ADVISORS State Street Financial Center One Lincoln Street Boston, MA 0 866.787.7 spdrs.com BofA Merrill Lynch, State Street Global Advisors as of e 0,. FOR PUBLIC USE. IMPORTANT RISK INFORMATION ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns. Diversification does not ensure a profit or guarantee against loss. All investing involves risk. Investors are encouraged to seek the advice of well-qualified financial advisors, accountants, attorneys and other professionals before making any investment decision. This material is for informational purposes only and does not constitute investment advice and it should not be relied on as such. It does not take into account any investor s particular investment objectives, strategies, tax status or investment horizon. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results. The views expressed in this material are the views of David B. Mazza through the period ended e 0, and are subject to change based on market and other conditions. The information provided does not constitute investment advice and it should not be relied on as such. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise bond values and yields usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Investing in high yield fixed income securities, otherwise known as junk bonds is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Non-diversified funds that focus on a relatively small number of issuers tend to be more volatile than diversified funds and the market as a whole. Passively managed funds invest by sampling the Index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the Index. Investments in Senior Loans are subject to credit risk and general investment risk. Credit risk refers to the possibility that the borrower of a Senior Loan will be unable and/or unwilling to make timely interest payments and/or repay the principal on its obligation. Default in the payment of interest or principal on a Senior Loan will result in a reduction in the value of the Senior Loan and consequently a reduction in the value of the Portfolio s investments and a potential decrease in the net asset value ( NAV ) of the Portfolio. Actively managed ETFs do not seek to replicate the performance of a specified index. These investments may have difficulty in liquidating an investment position without taking a significant discount from current market value, which can be a significant problem with certain lightly traded securities. Actively managed funds may underperform their benchmarks. An investment in the fund is not appropriate for all investors and is not intended to be a complete investment program. Investing in the fund involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment. Convertible securities generally provide yields higher than the underlying stocks, but generally lower than comparable non-convertible securities, in exchange for limited upside potential. Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and may be more vulnerable to changes in the economy. Other risks associated with convertible bond investments include: Call risk which is the risk that bond issuers may repay securities with higher coupon or interest rates before the security s maturity date; liquidity risk which is the risk that certain types of investments may not be possible to sell the investment at any particular time or at an acceptable price; and investments in derivatives, which can be more sensitive to sudden fluctuations in interest rates or market prices, potential illiquidity of the markets, as well as potential loss of principal. The value of the debt securities may increase or decrease as a result of the following: market fluctuations, increases in interest rates, inability of issuers to repay principal and interest or illiquidity in debt securities markets; the risk of low rates of return due to reinvestment of securities during periods of falling interest rates or repayment by issuers with higher coupon or interest rates; and/or the risk of low income due to falling interest rates. To the extent that interest rates rise, certain underlying obligations may be paid off substantially slower than originally anticipated and the value of those securities may fall sharply. This may result in a reduction in income from debt securities income. continued on next page

continued Because of their narrow focus, financial sector funds tend to be more volatile. Preferred Securities are subordinated to bonds and other debt instruments, and will be subject to greater credit risk. The municipal market can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. The fund may contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; inflation risk; and issuer call risk. The Fund may invest in U.S. dollar-denominated securities of foreign issuers traded in the United States. Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable. All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment. There can be no assurance that a liquid market will be maintained for ETF shares. Because the SPDR SSgA Active Asset Allocation ETFs are actively managed, they are therefore subject to the risk that the investments selected by SSgA may cause the ETFs to underperform relative to their benchmarks or other funds with similar investment objectives. Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. Foreign investments involve greater risks than US investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets. Barclays is a trademark of Barclays, the investment banking division of Barclays Bank PLC ( Barclays ) and has been licensed for use in connection with the listing and trading of the SPDR Barclays ETFs. The products are not sponsored by, endorsed, sold or promoted by Barclays and Barclays makes no representation regarding the advisability of investing in them. Merrill Lynch, Pierce, Fenner & Smith Incorporated and its affiliates ( BofA Merrill Lynch ) indices and related information, the name BofA Merrill Lynch, and related trademarks, are intellectual property licensed from BofA Merrill Lynch, and may not be copied, used, or distributed without BofA Merrill Lynch s prior written approval. The licensee s products have not been passed on as to their legality or suitability, and are not regulated, issued, endorsed, sold, guaranteed, or promoted by BofA Merrill Lynch. BOFA MERRILL LYNCH MAKES NO WARRANTIES AND BEARS NO LIABILITY WITH RESPECT TO THE INDICES, ANY RELATED INFORMATION, ITS TRADEMARKS, OR THE PRODUCT(S) (INCLUDING WITHOUT LIMITATION, THEIR QUALITY, ACCURACY, SUITABILITY AND/OR COMPLETENESS). State Street Global Markets, LLC is the distributor for all registered products on behalf of the advisor. SSgA Funds Management has retained GSO Capital Partners as the sub-advisor. SPDR is a registered trademark of Standard & Poor s Financial Services LLC ( S&P ) and has been licensed for use by State Street Corporation. STANDARD & POOR S, S&P and S&P 00 are registered trademarks of Standard & Poor s Financial Services LLC. No financial product offered by State Street Corporation or its affiliates is sponsored, endorsed, sold or promoted by S&P or its Affiliates, and S&P and its affiliates make no representation, warranty or condition regarding the advisability of buying, selling or holding units/shares in such products. Further limitations and important information that could affect investors rights are described in the prospectus for the applicable product. Distributor: State Street Global Markets, LLC, member FINRA, SIPC, a wholly owned subsidiary of State Street Corporation. References to State Street may include State Street Corporation and its affiliates. Certain State Street affiliates provide services and receive fees from the SPDR ETFs. Before investing, consider the funds investment objectives, risks, charges and expenses. To obtain a prospectus or summary prospectus which contains this and other information, call 866.787.7 or visit spdrs.com. Read it carefully. State Street Corporation. All Rights Reserved. ID97-IBG-0 Exp. Date: 9/0/0 IBG.EDU.ADS.09