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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SURVIVING THE FED’S NEXT MOVE
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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SURVIVING THE FED’S NEXT MOVE
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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SURVIVING THE FED’S NEXT MOVE
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.
225 Franklin Street
Boston, MA 02110 -2804
columbiamanagement.com
800.426.3750
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.
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