Surviving the Fed’s next move By Leonard Aplet, CFA, Head of Short Duration and Stable Value Strategies Since the December 2008 meeting of the Federal Open Market Committee (FOMC), the Fed has maintained shortterm interest rates in a range between 0.00% and 0.25%. For much of the three-plus years since then, investors have tried to predict when the FOMC would start to raise interest rates again. The policymakers have thrown a few kinks into the Fed-watching machinery, including the purchase of substantial amounts of U.S. Treasuries and agency mortgage-backed securities (quantitative easing), a lengthening of the duration of U.S. Treasuries held by the Fed (Operation Twist) and their estimation that they would not need to raise interest rates until the end of 2014. The timing of the next interest-rate hikes are by no means certain — and there remains some disagreement among the voting members of the FOMC about how long rates need to stay this low — but what is certain is the intent of the Fed to keep interest rates as low as possible for as long as is practical. As the adage goes, timing is everything. The prospect of rising rates tends to make bond investors jittery and more likely to seek refuge in cash equivalents like money market funds. But with money market yields near zero and better yield prospects available when moving modestly out the yield curve, an extended flat interest-rate environment has its costs too. Indeed, fixedincome investors are likely to find the foreseeable future challenging. Active sector and duration management — in the context of portfolio objectives and risk parameters — can help investors successfully position their portfolios without even knowing precisely when interest rates will head higher.
Performance and yields Following strong performance during the past three years, bond yields in some sectors have reached levels that are actually lower than their durations or the average time-toreceipt of expected cash flows. This is significant because current yields tend to be predictive of the returns that can be expected on a portfolio of bonds over the medium-tolong term. Simply put, while prices may rise and fall, over the long term the largest component of bond returns tends to be income or yield.
To illustrate this, a bond’s duration can be used to roughly estimate price return when interest rates change. For example, a bond with a three-year duration would be expected to gain about 3.0% in price for a 1.0% decline in interest rates. Likewise, for a 1.0% increase in rates, the same bond would be expected to decline in price by 3.0%. When a bond’s duration is meaningfully greater than its yield, it implies that an increase in rates of more than 1.0% over a one-year holding could completely offset the bond’s income or yield and result in a negative return to the investor. There are, of course, other variables involved, but with yields at very low levels in general, a rise in rates for many types of bonds could completely subsume their income over a year.
Going short One of the ways investors traditionally protect themselves during periods of rising interest rates is by investing in shorter duration assets. Duration measures price sensitivity to changes in interest rates, so shorter bonds are less sensitive to rate changes than longer ones. Interest rates don’t always move in lockstep with each other, however, as the bond market demonstrated during the last rising-rate cycle, which started in 2004. In that period, short-term rates rose more than longer term rates, resulting in an inverted yield curve for a time. As noted above, the income component of a fixedincome investment — not changes in its price — tends to dominate total return over the long term. A shorter duration portfolio experiences smaller price changes and also allows for faster reinvestment of cash flows. As cash is reinvested in higher yielding securities, the portfolio’s total return improves. Furthermore, Treasuries tend to react more sharply to a rise in interest rates, while other securities — corporates or mortgages, for example — tend to experience more gradual price movements, with their yields rising nominally less than Treasuries.
SURVIVING THE FED’S NEXT MOVE
The cost of cash Although it can be tempting to play it safe with cash or money market investments — which often have durations of 90 days or less — it’s important to consider the opportunity cost of keeping a portfolio too short. In fact, some fixed-income portfolios with short durations may actually perform as well as cash when interest rates rise modestly, as has been the case in previous cycles where rates rose modestly. With money market rates at yields close to zero, investors are paying for the lack of volatility in cash by earning effectively no yield. Investors seldom know the exact timing of future interest rate movements. If an expected increase in rates doesn’t happen according to the investor’s expectation, then the foregone income that was lost by being in cash is an opportunity cost that may never be recouped. The performance difference between being in cash or in a short-duration portfolio should be measured over the investor’s potential holding period, not just the period of time during which rates might actually increase. Even if the investor is correct and rates do rise, the potential difference in performance may be very modest and not worth giving up yield to obtain — especially when including a period of time leading up to the rate increase.
The table below contains historical performance on various potential investments during the last period of Fed tightening, which occurred between June 30, 2004 and June 30, 2006. During that two-year period, the Fed raised the level of short-term interest rates 17 times. The fed funds rate was raised a total of 4.25%, from 1.00% to 5.25%. During that time, cash investments benefited from the increase in rates, but so did some securities that were held in short-duration bond portfolios. Floatingrate securities also benefited from the increase in shortterm yields. Because of this fact, during this period when interest rates were actually rising, it was possible to have a short-term bond fund with positive performance close to the returns from Treasuries. After interest rates had risen, those same funds could have also enjoyed the benefits of the new higher interest rates. While short-duration portfolios have clearly provided an advantage in some rising rate environments, there will be times when a cash position may prove more advantageous. Much depends on the relative yields between money market rates and short-term bonds, how quickly interest rates rise and the magnitude of interest rate change within a given period.
Historical performance during the last tightening cycle June 30, 2004 –June 30, 2006 (%) Change in fed funds rate
4.25
Total return of 3-month Treasury bills (annualized)
3.07
Lipper Money Market Mutual Fund average (annualized)*
2.38
Morningstar Taxable Money Market Mutual Fund average return (annualized)*
2.61
Barclays Conventional 15 year MBS (annualized)
2.91
Barclays AAA ABS Index (annualized)
2.52
Barclays 0–3.5 year CMBS Index (annualized)
2.68
Barclays 1–3 year Credit Index (annualized)
2.35
Barclays 1–3 year Government/Credit Index (annualized)
2.08
Barclays 1–3 year Treasury Index (annualized)
1.82
*The Lipper Money Market Mutual Fund Average does not include institutional money market share classes (I, R and W) as they have their own Lipper Institutional Money Market Funds category. Morningstar Taxable Money Market Fund Average Return includes all share classes. Past performance does not guarantee future results. It is not possible to invest directly in an index.
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The short-duration menu While all interest rates may rise equally across maturities and security types, more often interest rates adjust in an uneven fashion. Structuring your bond portfolio more heavily at both ends of the duration range of the portfolio, i.e., barbell, may help you take advantage of relatively low duration securities on the short end and higher yielding securities at the upper end. Barbelled portfolio structure. When interest rates change, often bonds with different maturities will perform quite differently because interest rates typically do not change in a parallel manner. The shape of the yield curve gets steeper or flatter as interest rates change. The term structure of a portfolio’s overall duration and average maturity plays a big role in determining total return performance as rates change. The degree to which a short-term portfolio is barbelled measures how much of the overall average duration comes from a combination of very-short- and intermediate-term bonds rather than bonds with durations closer to the overall average. In an environment where the yield curve is flattening, i.e., the difference between longer term and shorter term rates is shrinking, a more barbelled portfolio will perform better. There are also several security types that tend to offer higher yields and the potential for different return patterns than U.S. Treasuries as interest rates change. These include: >>Treasury Inflation-Protected Securities (TIPS). TIPS are Treasury issues with a constant coupon and a principal value that is indexed to inflation. Rising inflation expectations result in an upward revaluation of the principal amount — and additional interest earned on higher principal thus offsets the effects of inflation. In the event of deflation, investors are paid the original face value of the security. During periods of rising inflation expectations, TIPS generally outperform similar maturity Treasuries. As with any security that offers an added level of safety, however, TIPS typically offer lower coupon rates than their Treasury counterparts.
>>Floating-rate securities. Certain corporate and assetbacked securities offer variable coupon rates that are regularly adjusted according to the movement of a specific index. Because their interest rates rise and fall in line with market interest rates, floaters can help a portfolio keep pace in a rising-rate environment. We think securities backed by nonmortgage consumer assets — which are less sensitive to interest rates — may provide some of the best results in a rising-rate environment. For example, bonds backed by auto and guaranteed student loans. >>Mortgage-backed securities (MBS). Commercial and residential MBS offer high credit quality and higher yields than Treasuries. However, they are more sensitive to changes in interest rates, which, in turn, may accelerate or slow the pace of principal payments. Rising mortgage rates typically result in an extension of the average maturity of these bonds, which can both help and hurt bondholders. When rates rise, structures that are less sensitive to rate changes are favored, such as 10- or 15-year mortgage-backed bonds (versus 30-year issues) and well-structured securities, like planned amortization class collateralized mortgage obligations. >>Corporate bonds. Corporate debt-holders benefited over the past three years, earning a hefty yield advantage relative to other sectors amid increased investor demand. With the yield advantage of corporate bonds still at or above historic averages, we expect this sector to perform well going forward, although with some volatility in performance.
Finding relief Fixed-income investors may be concerned about the likelihood that interest rates are headed higher. However, with a well-constructed, well-diversified short duration bond portfolio, bondholders can potentially feel less concerned about the impact of rising interest rates. Active sector and duration management — in the context of portfolio objectives and risk parameters — can help investors successfully position their portfolios in rising-interest-rate environments.
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About the Columbia Management Short Duration and Stable Value Team The Columbia Management Short Duration and Stable Value Team believes that yield is the most significant and predictable component of return and that a higher yielding, high-quality portfolio (AA or better) with low volatility relative to its benchmark can outperform over time. We also believe we can minimize credit and structure risk through portfolio diversification and disciplined, fundamental and quantitative analysis.
Investment approach The investment process, developed by Leonard Aplet in 1987, begins with a top-down assessment of the current economic conditions and financial markets, leveraging the full fixed-income investment team to understand the macroeconomic environment. This process helps identify relative value opportunities within the bond sectors used by the fund. The team then leverages the Investment Grade Credit and Structure Assets research teams to identify candidates for purchase as the use of investment-grade corporate bonds and mortgage- and asset-backed securities offer investors the opportunity to pick up yield over Treasuries and cash. The team adds value and increases yield in the fund by using a number of strategies, including sector rotation, yield-curve positioning, security selection and making small adjustments in duration versus the benchmark.
Columbia Short Term Bond Fund >>We strive for performance that is consistently good, not occasionally great, by using a consistently applied, disciplined investment process. >>We take a multi-sector approach that seeks to add value through strategic sector rotation, quality and structure shifts, yield-curve positioning and duration management. >>The lead manager developed the Short Duration strategy more than 20 years ago. >>This fund may potentially offer shareholders a real benefit in the form of added income and an increase in total return while keeping price volatility low. Class A NSTRX Class Z NSTMX
About Columbia Management Columbia Management is committed to delivering insight on subjects of critical importance, including insight on financial markets, global and economic issues and investor needs and trends. Our investment team examines the issues from multiple perspectives and we’re not afraid to take a strong stand or point out opportunities, even when there is no clear consensus. By turning knowledge into insight, Columbia Management thought leadership can provide: >>A deeper understanding of investment themes, trends and opportunities. >>A framework for more informed financial decision-making. Access the insight, intellectual strength and practical wisdom of our experienced team. Find more white papers and commentaries in the market insights section of our website columbiamanagement.com/market-insights
There are risks associated with an investment in a bond fund, including credit risk, interest rate risk, and prepayment and extension risk. See the fund’s prospectus for information on these and other risks associated with the fund. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer term securities. There are risks associated with fixed-income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer term securities.
Generally, when interest rates rise, the prices of fixedincome securities fall; however, securities or loans with floating interest rates can be less sensitive to interest rate changes, but they may decline in value if their interest rates do not rise as much as interest rates in general. The market value of securities may fall, fail to rise or fluctuate, sometimes rapidly and unpredictably. Market risk may affect a single issuer, sector of the economy, industry, or the market as a whole. Limited liquidity will affect the ability to purchase or sell floating rate loans and have a negative impact on performance. The floating rate loans and securities are lower rated (non-investment grade) and are more likely to experience a default, which results in more volatile prices and more risk to principal and income than investment-grade loans or securities.
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The Barclays MBS Conventional 15-Year Index is a subset of the Barclays U.S. MBA Index, which measures agency mortgagebacked pass-through securities (both fixed-rate and hybrid ARM) issued by Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC). The Barclays Asset-Backed Securities Index is the ABS component of the Barclays U.S. Aggregate Index. The ABS Index has three subsectors: credit and charge cards, autos, and utilities. The index includes pass-through, bullet and controlled amortization structures. The Barclays 0–3.5 Year Collateralized Mortgage-Backed Index measures the performance of investment-grade, fixed-rate, mortgage-backed pass-through securities with durations less than 3.5 years.
The Barclays 1-3 Year Credit Index measures the performance of investment-grade corporate debt and sovereign, supranational, local authority and non-U.S. agency bonds that are U.S. dollar denominated. The index includes investment-grade U.S. credit securities that have a remaining maturity of greater than or equal to one year and less than three years and have more than $250 million or more of outstanding face value. The Barclays 1-3 Year Government/Credit Bond Index consists of Treasury or government agency securities and investment-grade corporate debt securities with maturities of one to three years. The Barclays 1–3 Year Treasury Index measures the performance of U.S. Treasury securities that have a remaining maturity of at least one year and less than three years.
If you would like more information about investment solutions at Columbia Management, please contact your financial professional or visit columbiamanagement.com.
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Investors should consider the investment objectives, risks, charges and expenses of a mutual fund carefully before investing. For a free prospectus, which contains this and other important information about the funds, visit columbiamanagement.com. The prospectus should be read carefully before investing. Columbia Funds are distributed by Columbia Management Investment Distributors, Inc., member FINRA, and managed by Columbia Management Investment Advisers, LLC. © 2012 Columbia Management Investment Advisers, LLC. All rights reserved. CM-TL/246961 A (08/12) 3280/138618
