With interest rates at historically low levels, and the U.S. economy showing continued strength,
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1 Managing Interest Rate Risk in Your Bond Holdings THE RIGHT STRATEGY MAY HELP FIXED INCOME PORTFOLIOS DURING PERIODS OF RISING INTEREST RATES. With interest rates at historically low levels, and the U.S. economy showing continued strength, it was just a matter of time until the Fed moved to raise interest rates. They took the first step at their regularly scheduled December 16, 2015 meeting, voting to raise the benchmark federal funds rate 0.25% the first rate hike in nearly a decade. The Fed cited improving economic data, including healthy employment numbers (the current unemployment rate is a low 5.0%), as the rationale for its decision. THE EFFECT OF RISING RATES ON BOND INVESTORS Rising interest rates generally hurt existing bond prices because they make new, higher-yielding bond issues more attractive, reducing the amount investors are willing to pay for outstanding issues. Conversely, the yield the interest paid by new bonds to investors generally rises along with prevailing rates. The total return for a bond is measured by the yield plus any price appreciation or depreciation if investors sell the bond before it matures. Returns of various types of bonds can vary widely during periods of climbing interest rates, and certain bonds tend to fare better than others. High-quality U.S. Treasury bonds, for example, tend to be particularly sensitive to rising rates because few factors other than interest rate movements affect their yields. Corporate bond prices, on the other hand, typically decline less than Treasury bonds when rates rise because their yields are determined by market demand and are influenced by, among other things, the creditworthiness of the company issuing the bonds. With the Fed s expressed desire to control inflation, the likelihood that we could be entering an extended period of gradually rising interest rates seems a strong possibility, says Mike Loewengart, VP of Investment Strategy for E*TRADE. Over the past 30 years, bonds have had an incredible run, and rates are now sitting near historic lows, Loewengart says. That s not to say that the Fed couldn t ease off at some point. But a look at the numbers certainly suggests a general tightening of monetary policy might be in order. Source: U.S. Treasury Given today s low yields and solid economic fundamentals, investors should make sure that their fixed income holdings are positioned in attempt to keep pace with rising rates. It may be more cost effective, Loewengart says, to position a portfolio at the beginning of a rising interest rate cycle, rather than to wait until after rate hikes begin in earnest. Once rates do begin to rise, however, investors can still take steps in an effort to reduce their portfolio s sensitivity to rate increases. 1
2 UNDERSTANDING THE IMPACT OF RISING RATES Two key bond metrics can help investors understand the relationship between rising interest rates and bond performance: Duration. Interest rates on bonds are typically locked in until the bond matures. So when rates rise, investors holding bonds with longer maturities can t take advantage of that increase because they must wait until their current holdings mature before they can reinvest those assets in a higher-yielding bond. Credit spread. The spread is the difference in yields between lower-risk and higher-risk bonds. Higher-risk bonds generally have lower credit ratings, so they pay more interest in exchange for the investor assuming more risk of default. When interest rates rise, that higher yield can help offset potential price declines. It s important to remember, however, that investing in higheryielding bonds often means taking on more risk that the issuer might not be able to make principal and interest payments as promised. WAYS TO MANAGE INTEREST RATE RISK With the concepts of duration and credit spread in mind, there are two basic strategies that may help certain investors better prepare their fixed income investments for rising interest rates: Choose bonds with shorter durations. Given the risks of locking in longer maturities in a rising rate environment, holding bonds with shorter maturities generally those that mature within five years may help minimize interest rate risks. As an alternative to individual bonds, certain exchange-traded funds (ETFs) and mutual funds focus on short- and ultrashort-term bonds, providing exposure to a diversified basket of bonds with shorter maturities. While risks may differ between individual bonds and bond funds, duration impacts both in a similar manner: the shorter the duration (or average duration in the case of funds), the less price sensitivity an investor would expect. Moreover, an investor might consider building a bond ladder. This entails holding fixed income securities with a wide range of maturities. As the shorter-term bonds mature, the principal can be reinvested in new bonds with yields reflecting the higher prevailing interest rates, thereby cushioning the investor against interest rate risk and providing greater liquidity. Additional benefits can be gained by adding diversity across issuers and credit ratings. Assume more risk. Including bonds in your portfolio with higher yields (and correspondingly lower credit ratings) than Treasury bonds, such as corporate bonds, may help offset the negative effects of rising interest rates. Bonds receive credit ratings based on the market s confidence in the issuer s ability to make timely principal and interest payments as promised. Corporate bonds generally range from investment grade to high yield based on their credit ratings. Given the greater market risks associated with higher-yielding bonds, it s important to diversify across many different issuers and industries. For example, an investor might spread his or her bond portfolio across various long- and short-term corporate and government bonds or for convenience, they might select a broadly diversified bond mutual fund or ETF. Reading the prospectus will give an investor a better idea of a fund s objectives, costs, and holdings. 2
3 REDUCING INTEREST RATE RISK THROUGH DIVERSIFICATION As with all investment strategies, one effective way to help mitigate interest rate risk is to diversify fixed income portfolios across a wide range of different types of bonds and other securities especially those that are traditionally less responsive to interest rate increases. Diversification in a fixed income portfolio may help hedge against rising rates while potentially minimizing the risks of a portfolio that is concentrated in one particular bond issuer or type of security, Loewengart says. Below are several types of fixed income investments that may outperform in a period of rising interest rates: Treasury Inflation-Protected Securities. Often called TIPS, these are bonds that are adjusted semi-annually to the U.S. Consumer Price Index the federal government s key inflation measure. For example, if you buy a $10,000 bond with a yield of 2% but inflation equals 3%, the face value of the bond will be increased by $300 to $10,300. The 2% yield will be paid based on the new, higher value of the bond. While inflation and interest rates aren t directly linked, they tend to rise at the same time, given macroeconomic factors such as a strengthening U.S. economy and more consumer demand for loans. Given the typical relationship between inflation and interest rates, TIPS tend to perform better in rising rate environments. Premium bonds. A premium bond has a coupon that is higher than the prevailing market rate and will trade at a price above par. Premium bonds may return cash at a faster rate than par or discount bonds and thus have shorter durations. In a rising interest rate environment, the investor may reinvest these larger coupon payments at a higher rate. Premium bonds tend to have lower sensitivity to rising interest rates. As a result, they offer additional downside protection by limiting principal erosion. Short-term government bond funds. These mutual funds and ETFs generally keep at least 90% of their holdings in U.S. Treasury bonds with durations of between one and three-and-a-half years. Shorter maturity periods allow their rates to reset more frequently to better keep up with rising rates. They can provide the best of two worlds: offering low credit risk as the securities held by the fund are backed by the full faith and credit of U.S. government while also being very responsive to rising rates. Short-term corporate bond funds. These funds typically invest in a broad range of corporate bonds with durations of one to three-and-a-half years. They may be especially attractive to fairly conservative investors because they tend to be less sensitive to interest rates than portfolios with longer durations. Ultrashort bond funds. These funds focus on bonds with very short durations, generally less than one year. They may include a broad range of fixed income investments, such as corporate or government bonds with very short maturities. However, they typically do not include international, convertible, and high-yield bonds meaning exposure to those sectors must be gained through other funds or ETFs. The focus on very short durations means these funds aim to have reduced interest rate sensitivity, potentially lowering risk and boosting return potential in a rising rate environment. 3
4 High-yield bond funds. These bond funds invest in bonds that are riskier than standard investment-grade corporate bonds because they are issued by companies with lower credit ratings. However, their higher yields may help offset the general underperformance and lagging rates of Treasury bonds when interest rates rise. Mutual funds and ETFs that focus on highyield bonds tend to invest in a broadly diversified portfolio of issues to offset company and sector risk. Though not guaranteed, the prospect of better returns is often an attractive feature for investors willing to take on additional risk in their fixed income holdings. THE BENEFITS OF A PROACTIVE APPROACH Even with the threat of rising interest rates seemingly on the horizon, many fixed income investors can benefit from maintaining an allocation to bonds and other fixed income securities because they may help manage long-term risk in any interest rate environment. Bonds can help reduce overall volatility in a diversified portfolio because their prices historically have moved inversely to stock prices and fluctuated within a narrower range of highs and lows. That said, diversification within a bond allocation and incorporating bonds and other fixed income investments that tend to rise along with interest rates may help fixed income investments better keep pace with rate increases and attempt to take advantage of U.S. and international economic growth. INVESTOR INSIGHT RECAP Investors shouldn t necessarily sell bonds simply because of price declines. Selling a bond after its price drop means that loss may be realized; waiting until maturity means the investor will receive the promised return. Investors shouldn t try to predict interest rates movements. Instead, they may wish to consider a bond-laddering strategy, including intermediate and long-term bonds, in an effort to reduce the impact of interest-rate risk and help provide more consistent income and better price stability. Investors can use ETFs and mutual funds to gain exposure to a broad diversification of different types of bonds from different issuers, including government, corporate, high-yield and foreign bonds. Investors should review their entire fixed income portfolio to help ensure that they have a properly balanced portfolio based on their income needs, investment objectives, financial circumstances, and risk preferences. To learn more about strategies that seek to protect your portfolio against inflation using bond funds, click here (login required). Visit the Fixed Income Solutions Center to learn more about individual bonds (login required). 4
5 All investments involve risk, including loss of principal amount invested. For more detailed discussion about the risks of investing in a mutual fund or ETF, as well as the fund s investment objectives, policies, charges, and expenses, please read the fund s prospectus. This article is distributed for informational purposes only. It contains current opinions of E*TRADE Capital Management, LLC. The investment ideas and expressions of opinion may contain forward looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell securities. E*TRADE Capital Management s statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. Each investor should consider his or her unique personal objectives, risk tolerances and time horizons when making investment decisions. Past performance is not an indication of future returns. Diversification strategies do not ensure a profit and cannot protect against losses in a declining market. All investments involve risk, including the loss of principal amount invested. Data and statistics contained in this commentary are obtained from what E*TRADE Capital Management considers to be reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed. Stocks fluctuate in response to the activities of individual companies and general market conditions, domestically and abroad. Investments in mid and small-cap stocks typically have higher risk characteristics than large cap stocks and may be subject to greater price fluctuations than large-cap stocks. 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 usually more pronounced for longer-term securities. Lower-quality fixed-income securities generally offer higher yields, but also carry more risk of default or price changes due to potential changes in the credit quality of the issuer. Municipal Bonds are subject to market and interest rate risk if sold prior to maturity. Treasury securities are guaranteed by the US government as to timely payment of principal and interest. A bond ladder is a portfolio of fixed-income securities that mature at regular, staggered intervals. You can also build a ladder with brokered CDs. Laddering is an investment technique that seeks to generate income based on an investor s unique situation, whether to support ongoing cash flow needs or plan for those expected to arise in the future. It can also reduce one s exposure to interest rate fluctuations. Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets. Indices used in this presentation are intended to provide a general measure of the market performance for a particular asset class or type. An Index is an unmanaged portfolio of predetermined securities and does not reflect any initial or ongoing expenses such as brokerage fees, commissions, principal mark-ups, management fees or taxes. The inclusion of any one of these items would reduce the performance shown. It is not possible to invest directly in an index. Full portfolio management and advisory services are offered through E*TRADE Capital Management, an investment adviser registered with the Securities and Exchange Commission. Upon request, we will send you a free copy of E*TRADE Capital Management s Form ADV Part 2A, which describes, among other things, affiliations, services offered and fees charged. Prior to investing in a managed account, E*TRADE Capital Management will obtain important information about your financial situation and risk tolerances and provide you with an account information package, which includes a detailed investment proposal, the investment advisory agreement, and wrap fee program brochure. These documents contain important information that should be read carefully before enrolling in an investment advisory managed account program. 5
6 PLEASE READ THE IMPORTANT DISCLOSURES BELOW. The fund s prospectus contains its investment objectives, risks, charges, expenses and other important information and should be read and considered carefully before investing. For a current prospectus, visit or visit the Exchange-Traded Funds Center at Investments in money market mutual funds are neither insured nor guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Although money market funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund. Exchange-traded funds [ETFs] are subject to risks similar to those of other diversified portfolios. Although ETFs are designed to provide investment results that generally correspond to the performance of their respective underlying indices, they may not be able to exactly replicate the performance of the indices because of expenses and other factors. Also, there are brokerage commissions associated with trading ETFs that may negate their low management fees. ETFs are required to distribute their portfolio gains to shareholders at year end. These gains may be generated by portfolio rebalancing or the need to meet diversification requirements. ETF trading will also generate tax consequences. Investing outside the United States involves additional risks related to currency fluctuations, economic and political differences and difference in accounting standards. There are additional risks of investing in emerging market countries. Investing in Commodities, REITS, and International or Global investments carries certain risks such as price volatility, currency risk, market risk, interest rate risk and credit risk. An investor should fully understand these risks before making an investment. All bonds are subject to interest rate risk and you may lose money. Bonds sold by issuers with lower credit ratings may offer higher yields than bonds issued by higher rated or investment grade issuers, but are usually associated with higher risks. High yield bonds, also known as junk bonds, generally have a greater risk of default, which increases the risk that an issuer may be unable to pay interest and principal on the issue. In addition, high yield bonds tend to have higher interest rate risk and liquidity risk, particularly in volatile market conditions, which makes it more difficult to sell the bonds. Before investing in high yield bonds, you should carefully consider and understand the risks associated with investing in high yield bonds. 6
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