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Rising Interest Rates and the Fed “Taper Tantrum”

Volatility has returned to the financial markets with a vengeance! The fixed income (bond) market as well as the equity markets have experienced extreme price swings and declines these past few weeks; sparked by fear that we have entered a rising interest rate environment much sooner than many expected. Although it has been obvious to many that with interest rates being so low for so long, that a reversal would have to take place at some point. However, the speed of the recent bond market decline and corresponding rise in the yields on 10-year U.S. Treasury Notes has been historic. Yields have risen by 86 basis points or nearly 52% (from 1.66% to 2.52%) during the time period of May 1, 2013 – June 21, 2013.

The primary cause for this rapid rise in yields can be attributed to comments from the Federal Reserve suggesting that they may be able to start winding down (“Tapering”) their stimulus-oriented bond buying program if the U.S. economy continues to shows signs of improvement. As a result, many fixed income traders and investors have been selling bonds to get ahead of any reductions in bond purchases by the Fed. The activity has spilled over to equity markets, currencies and all interest sensitive investments.

This bond market trading activity is reflective of fear driven, indiscriminate panic selling and the long awaited rotational shift out of bonds. It should be noted however that the Fed is still on record as saying that they intend to keep interest rates at historical lows through at least the middle of 2015 unless they see material improvements with respect to economic growth and unemployment. While it is true there have been signs that the economy is improving, it is still a significant distance away from the Federal Reserve’s GDP and unemployment targets. In my opinion, there is nothing in the recent string of economic reports to suggest that they will begin raising interest rates anytime soon and the indiscriminate selling is an overreaction.

10 Year US Treasury Yield in 2013 (05/01/2013 through June 21, 2013)

Preparing your portfolio for a rising interest rate  environment

At Premier Wealth Advisors we are advising our clients to brace their portfolios for an upcoming environment of rising interest rates and have been taking this into consideration with our custom managed portfolio strategies. While asset allocation remains critical with respect to long term portfolio performance and portfolio strategies may vary based upon each investor’s objective, investment time-frame and tolerance for risk, we would like to note that aside from reducing exposure to long term fixed income investments; there are certain security types that have historically performed well in previous periods of rising interest rates and may be worthy of consideration for diversified portfolios. These security types include, but are not limited to; Senior Floating Rate Loans, Common Stocks and Convertible Securities.

Senior Loans – 

Senior loans are generally floating-rate secured debt extended to companies and typically sit at the top of the capital structure while being secured by company assets. Floating rates of senior loans typically involve a credit spread over a benchmark credit rate, such as 3-month LIBOR or the Prime Rate.

As a result, when the benchmark credit rate rises or falls, the interest rate on the senior loan will move in a similar fashion. In a rising rate environment, senior loans will see coupon payments increase while the loan value remains relatively stable. Conversely, in a declining rate environment, coupon payments on senior loans will typically decrease while the loan value remains relatively stable. Additionally, senior loans have historically maintained a relatively low correlation to other fixed income (i.e. bond) asset classes, based on certain representative benchmark indices, as illustrated in the chart below:

Correlation Matrix:  January 1992 – December 2012

Fixed Income Benchmark Index
Credit Suisse Leveraged Loan Index9
Barclays U.S. Intermediate Government Index2

-0.32

Barclays U.S. Long Term Government Index3

-0.31

Bank of America Merrill Lynch Mortgage Master Index4

-0.13

Bank of America Merrill Lynch Corporate Master Index5

0.31

Barclays U.S. Aggregate Index6

-0.03

JP Morgan Emerging Markets Bond Index7

0.22

Credit Suisse High Yield Index8

0.76

Source:  State Street Global Advisors, “Active ETF Investing in the Senior Loan Market”:  Credit Suisse, Bloomberg, Ibbotson Associates, Data Stream, as of 12/31/2012.    Past performance is not a guarantee of future results.

Common Stocks-

Common stocks are securities that represent equity ownership in a corporation.

Historically rising interest rate environments have typically been associated with periods of economic growth and positive performance for common stocks. As such, common stocks may stand to benefit from rising interest rates, and bond price declines, as investors seek investments with greater total return potential.

Convertible Securities-

Convertible securities are bonds issued by a corporation which are convertible into common stock at a specified ratio. Because of this, convertible securities have some characteristics of both common stocks and bonds. Similar to stocks, convertible securities offer capital appreciation potential. In addition, the hybrid nature of convertible securities makes them tend to be less sensitive to interest rate changes than bonds of comparable credit quality and maturity.

 

Bringing together the final two security types listed above, the chart below shows the historical performance of U.S. Treasuries, Convertible Securities and U.S. Common Stocks, based on certain representative benchmark indices, during market cycles when interest rates were rising.

Correlation Matrix:  January 1992 – December 2012

Fixed Income Benchmark Index

Credit Suisse Leveraged Loan Index9

Barclays U.S. Intermediate Government Index2

-0.32

Barclays U.S. Long Term Government Index3

-0.31

Bank of America Merrill Lynch Mortgage Master Index4

-0.13

Bank of America Merrill Lynch Corporate Master Index5

0.31

Barclays U.S. Aggregate Index6

-0.03

JP Morgan Emerging Markets Bond Index7

0.22

Credit Suisse High Yield Index8

0.76

Source:  State Street Global Advisors, “Active ETF Investing in the Senior Loan Market”:  Credit Suisse, Bloomberg, Ibbotson Associates, Data Stream, as of 12/31/2012.    Past performance is not a guarantee of future results.

1 The LIBOR or the London Inter-Bank Offered Rate is an interest rate that banks can borrow funds from other banks in the London inter-bank market. It is fixed on a daily basis by the British Bankers’ Association. The LIBOR is derived from a filtered average of the banks’ interbank deposit rates for larger loans with various maturities in multiple currencies. The 3 Month LIBOR is the LIBOR for a three month deposit in US dollars.

2 The Barclays U.S. Intermediate Government Index tracks the performance of intermediate-term US government securities. The US Government Index is comprised of the US Treasury and US Agency Indices. The US Government Index includes Treasuries (public obligations of the US Treasury that have remaining maturities of more than one year) and US agency debentures (publicly issued debt of US Government agencies, quasi-federal corporations and corporate or foreign debt guaranteed by the US Government).

3 The Barclays U.S. Long Term Government Index tracks the performance of long-term US government securities. The US Government Index is comprised of the US Treasury and US Agency Indices. The US Government Index includes Treasuries (public obligations of the US Treasury that have remaining maturities of more than one year) and US agency debentures (publicly issued debt of US Government agencies, quasi-federal corporations and corporate or foreign debt guaranteed by the US Government).

4 The Bank of America Merrill Lynch Mortgage Master Index tracks the performance of US dollar-denominated fixed rate and hybrid residential mortgage pass-through securities issued by US agencies in the US domestics market having at least $5 billion per generic coupon and $250 million outstanding per generic production year.

5 The Bank of America Merrill Lynch Corporate Master Index is a market value weighted index comprised of domestic corporate (BBB/Baa rated or better) debt issues.

6 The Barclays U.S. Aggregate Index represents the securities of the US dollar-denominated, investment grade bond market. The Index provides a measure of the performance of the US dollar-denominated, investment grade bond market, which includes investment grade (must be Baa3/ BBB-or higher using the middle rating of Moody’s Investor Service, Inc., Standard & Poor’s, and Fitch Rating) government bonds, investment grade corporate bonds, mortgage pass through securities, commercial mortgage backed securities and asset backed securities that are publicly offered for sale in the United States.

7 The JPMorgan Emerging Markets Bond Index measures total returns of external currency-denominated debt instruments.

8 The Credit Suisse High Yield Index is designed to mirror the investable universe of the US dollar-denominated high yield debt market.

9 The Credit Suisse Leveraged Loan is an index designed to mirror the investable universe of the US dollar-denominated leveraged loan market.

10  The Bank of America Merrill Lynch 10-Year U.S. Treasury Index is a one-security index comprising the most recently issued 10-year U.S. Treasury note. The index is re-balanced monthly.

11 The Bank of America Merrill Lynch All Convertibles, All Qualities Index contains issues that have a greater than $50 million aggregate value. The issues are U.S. dollar-denominated, sold into the U.S. market, and publicly traded in the United States.
12  The S&P 500 Index is widely recognized as the standard for measuring large cap U.S. stock market performance and includes a sampling of leading companies in leading industries.

The following provides a deeper discussion of the primary risks associated with Senior loans:

Interest Rate Risk: When interest rates decline, the value of fixed-rate securities can be expected to rise. Conversely, when interest rates rise, the value of fixed-rate portfolio securities can be expected to decline. The rate on bank loans periodically adjusts with changes in interest rates. Consequently, exposure to fluctuations in interest rates will generally be limited until the interest rate on the loan is reset. To the extent that changes in market rates of interest are reflected – not in a base rate such as LIBOR, but in a change in the spread over the base rate – the loan’s value could be adversely affected. This is because the value of a loan asset is partially a function of whether it is paying what the market perceives to be a market rate of interest for the particular loan, given its individual credit and other characteristics.

Reinvestment Risk: Income from investing in loans will decline if the proceeds, repayment or sale of loans are invested into a lower yielding instrument with a lower spread of the base-lending rate. A decline in income could affect the yield and overall return.

Credit Risk and Junk Bond Risk: Credit risk is the risk that an issuer of a loan will become unable to meet its obligation to make interest and principal payments. Bank loans are typically debt securities that are rated below investment-grade. Investment in loans below investment grade quality involves substantial risk of loss. Junk debt is considered predominantly speculative with respect to the issuer’s ability to pay interest and repay principal and is susceptible to default or decline in market value due to adverse economic and business developments. The market values for fixed income securities of below investment-grade quality tend to be more volatile, and these securities are less liquid than investment grade debt securities. Adverse changes in economic conditions are more likely to lead to a weakened capacity of a high yield issuer to make principal payments and interest payments than an investment grade issuer.

Economic downturns could severely affect the ability of highly leveraged issuers to service their debt obligations or to repay their obligations upon maturity.

Issuer Risk: The value of bank loans may decline for a number of reasons, which directly relate to the issuer, such as management performance, financial leverage, and reduced demand for the issuer’s goods and services. More broadly, there is industry risk, in so far as it could affect a group of similar companies.

Liquidity Risk: Adverse market conditions may result in markets where there is no readily available trading or that are otherwise illiquid, which can lead to sales at prices below those at which the investor could sell such securities if they were more widely traded. In addition, the limited liquidity could affect the market price of the securities, thereby adversely affecting the bank loan’s value. Most loans are valued by an independent pricing service that uses market quotations of investors and traders in bank loans.

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