Protecting Bond Portfolios from Rising Rates

As the U.S. economy continues to strengthen and the prospect of inflation rises, investors are concerned the U.S. may potentially face a sustained period of rising interest rates. This matters to bond owners because changes in interest rates directly impact the market value of bonds and bond portfolios. Bond investors should be aware of the implications that rising rates pose to individual bonds and bond funds, and that there are ways to protect a portfolio from higher rates.

With todays fixed income markets now implying an increase in interest rates and higher volatility in credit spreads, a traditional buy-and-hold bond portfolio or a more traditional fixed income mutual fund strategy may not be as attractive to investors. Rising rates can cause a significant loss of value in fixed income holdings if not anticipated. While the Neuberger Berman Fixed Income team believes that interest rates will eventually increase, a substantial rise in the near term is not expected, in the teams opinion. Nonetheless, bond investors should still be aware of the implications that rising rates pose to individual bonds and bond funds and that there are ways to protect a portfolio from higher rates while also potentially benefiting from interest rate volatility.
H o w C H a n g i n g i n t e r e s t r at e s a f f e C t B o n d P r i C e s

Interest rate change presents both risks and opportunities in todays low interest rate environment. Both individual bonds and bond funds share interest rate risk, which can be described as the risk of locking up a bond at a given rate, only to see rates rise in a subsequent time period. The impact of this interest rate risk to bond or bond mutual fund prices depends on the maturity or duration of the investment: the longer the maturity or duration of a bond or bond fund, the more the price will drop due to rising rates. Duration, which is measured in years, is the primary gauge of a bond or bond funds sensitivity to interest rate changes and indicates approximately how much the price of a bond or bond fund will change in the opposite direction given a shift in interest rates. For instance, a bond with an average duration of five years will fall in value approximately 5% if rates rise by 1% and the opposite is true as well.
its aBout tHe inCome

Returns from bonds and bond funds come from two sources: interest payments and changes in price. Over time, interest payments typically dominate the contribution to long-term returns. It is estimated that over 95% of the total return generated from a bond comes from interest payments versus price change. Consequently, short-term returns are more influenced by interest rates while long-term returns are driven by income earned.

ProteCting Bond Portfolios from rising rates

When bond prices rise, total return increases, and vice versa. Over time, this tends to be balanced out. Income is always positive (and is the most reliable part of bond returns) and drives bond returns over time.
figure 1: inCome CusHion Has Played a Key role in fixed inCome total return
20 15 10 5 0 -5 -10 Coupon Return Price Return Total Return

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Source: Barclays as of 12/31/10.

reCovering tHe loss of PrinCiPal and tHe Power of ComPounding A rising rate environment will eventually help bond fund investors. As yield or expected future returns rise, principal can be reinvested at those higher yields.

As previously mentioned, during a rising-rate environment bond investors will experience a short-term drop in the price of their investment. If the investment is sold before it matures, it will be sold at a discounted price. This is where the holding period is key in bond investing: barring a default, bond investors should expect to receive the face value of their bonds if they hold them until maturity.
figure 2 : HyPotHetiCal growtH of a $1,000 Bond witH a 4% CouPon
$1,300 $1,200 $1,100 $1,000

1990 $900 $800 0 1 Constant Rate Rates up 1% annually Source: Neuberger Berman. 2 3 4 Holding Period (years) Rates up 6% during year 1 Rates up 2% annually 5

ProteCting Bond Portfolios from rising rates

A rising rate environment will eventually help bond fund investors. As yield or expected future returns rise, the fund manager is able to reinvest principal at those higher yields, so that interest is earned on interest from that moment on. These higher rates increase income returns and eventually offset the drop in price. It is important to know that interest rate changes do not affect all bonds equally. A bond mutual fund may be affected differently than an individual bond as a bond funds manager can change the funds holdings to minimize the impact of rate changes.
H o w r at e s H av e m o v e d i n t H e Pa s t

Bond performance during past interest rate cycles may offer valuable context for investors today. Over the past 25 years, the 1994 tightening cycle resulted in the largest rate increase 2.50% while the median and average increases have been much lower.
rising rate Periods
Aug. 1986 to Oct. 1987 Oct.1993 to Nov. 1994 Jan. 1996 to Apr. 1997 Oct. 1998 to Jan. 2000 June 2003 to May 2004 June 2005 to June 2006 Dec. 2008 to Jan. 2010 Median Average

fed funds change (b.p.)

138 250 0 25 0 225 0 25 91

10 year change (b.p.)

235 263 124 213 140 111 131 140 174

Source: Federal Reserve 10 Year Treasury constant maturity rate, H.15 monthly average.

w H at t H e m a r K e t i s P r i C i n g t o d ay A strategy to hold cash would be advantageous if one expects rates to move up faster than currently priced into the market.

A benchmark for pricing bonds today is the current yield curve (used to capture the overall movement of interest rates), which is derived from spot interest rates for varying maturities. Interest rates generally reflect the markets forward expectations on real GDP growth and inflation. Implied future interest rates can be derived from the yield curve by applying a forward interest rate methodology. This theory as it applies to yield curve analysis states that the interest rate for a longer time period, such as 10 years, is a product of the interest rates for the total of the shorter time intervals that comprise the entire time period. Today, the market anticipates rates will move higher and, if forward rates are realized, investors should be indifferent given the choices of either locking in the current 10-year rate or rolling over short-term securities at increasingly higher rates. However, if an investor has a different view than consensus, a strategy to lock in long term rates may be appropriate if one expects rates not to rise as quickly as implied. Alternatively, a strategy to hold cash would be advantageous if one expects rates to move up faster than currently priced into the market.

ProteCting Bond Portfolios from rising rates

figure 3 : 10 -year ust: HistoriCal average, Current and imPlied future yield
8% 7% 6% 5% 4% 3% 2% 1% 0% Since 1900 Since 1970 Since 2000 Current (3/31/11) 1 year from now 3 years 5 years from now from now
4.8% Historical Average 4.4% 3.5% Forward Curve 4.2% 5.5% 5.0% 7.1%

Source: Robert Shiller long-term interest rate series, Barclays Capital and Bloomberg

m a n a g i n g i n t e r e s t r at e r i s K Actively managed fixed income portfolios can offer returns that participate in the capital appreciation process and serve to reduce the interest rate risk in bonds.

Interest rate risk can be effectively managed by adjusting the duration or sensitivity of a bond portfolio according to the expected direction of interest rates. Even during bear markets where rates move higher, there are opportunities to protect principal and there are also periods to gain price appreciation. For example, interest rates rose substantially from December 1976 to September 1981. The Barclays U.S. Treasury Index Yield rose from 6% to 16% and the principal values of bonds deteriorated. However, during this movement upwards in rates, there were many opportunities to capture price appreciation during shorter-term decreases. For example, between December 1976 and September 1981, interest rates actually went down 30% of the time based on the monthly change in yields. This bear market did not result in a straight line of higher interest rates during a period of rapidly rising inflation.

ProteCting Bond Portfolios from rising rates

Actively managed fixed income portfolios can offer returns that participate in the capital appreciation process and serve to reduce the interest rate risk in bonds. Flexible bond management can also reduce overall risk by opportunistically investing in sectors with less correlation to movements in U.S. Treasuries. Your Neuberger Berman representative can work with you to help determine which fixed income funds may provide you with options that help meet your fixed income needs.

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A bonds value may fluctuate based on interest rates, market conditions, credit quality and other factors. You may have a gain or a loss if you sell your bonds prior to maturity. Bonds are also subject to the credit risk of the issuer. The information presented herein was compiled from sources believed to be reliable. It is intended for illustrative purposes only, and is furnished without responsibility for completeness or accuracy. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Material contained in this publication should not be considered legal, tax, investment, financial or other professional advice. This material is not intended to be a research report and should not be considered as an offer to sell or the solicitation of an offer to buy any security. Neuberger Berman Fixed Income LLC is a Registered Investment Advisor. L0112 05/11 2011 Neuberger Berman Management LLC. All rights reserved.