Gibson Smith
Co-Chief Investment Officer
and Co-Portfolio Manager


Lindsay Bernum
U.S. Macro Analyst


Colleen Denzler, CFA
Global Head of Fixed Income Strategy


Rising Rates: Challenge and Opportunity

Investors have flocked to bond markets in recent years, sending yields to record lows. However, an improving economy may give the Federal Reserve (Fed) the support it needs to change its accommodative monetary policy, leading to higher interest rates. We don’t view this as a crisis. In our opinion, periods of rising rates are normal and can create opportunities for active bond managers.

Since 1970, there have been 21 periods in which rates rose significantly. While each period is unique, it’s worth noting that over the past 40 years equities were more likely to rally, not decline, when rates rose. In the 1990s-2000s, the S&P 500 Index rose in all such periods, while in the 1970s-1980s the index rallied roughly half the time (partly because Fed policy was less effective in containing inflation during those years). Historically, strong equity markets have supported corporate credit prices even when rates were rising.

Interest rate moves also have not been linear—there were spikes and pullbacks, allowing active bond managers to buy securities at attractive valuations, reposition at different points along the yield curve and reallocate between asset classes, sectors and securities. All of this can be good for investors in terms of capital preservation and positioning for the next market cycle.

Lastly, while passive investors may experience a rocky ride, active bond managers typically have more flexibility to manage duration and to benefit from market dislocations through security selection. After absorbing the Fed’s new direction, we believe market attention will shift to company fundamentals, and that companies undergoing positive structural change and balance sheet enhancement will be rewarded. In our view, managers experienced in managing duration risk and employing fundamental, bottom-up security selection will be well-positioned to maximize risk-adjusted returns and preserve client capital.
See our corporate profile and important disclosure information on page 112.

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Douglas M. Hodge, CFA
Managing Director, Chief Operating Officer

Inflection Points: Why Demand For Bonds Will Rebound

One of the keys to successful investing is the ability to identify inflection points and predict whether underlying trends will accelerate, reverse or level off.

Federal Reserve Chairman Ben Bernanke’s talk of tapering triggered an inflection point. His comments dramatically boosted interest rates, increased equity price volatility and influenced investors’ risk and asset preferences.

The jump to higher interest rates has, of course, resulted in losses for most bond investors and encouraged outflows from the asset class. It also has raised concerns about further rate hikes. Yet there are reasons to believe that over the secular horizon, flows into bond funds will turn positive.

• First, bonds are less risky than stocks over the long term. Not only are stocks sensitive to rising interest rates, if less directly than bonds, their sensitivity is likely to increase over time. What’s more, bonds are higher up in the capital structure, a high priority corporate obligation to pay interest and principal on a timely basis and confer a claim on assets of the company.

• Second, many of America’s largest corporate pension funds and insurance companies continue to buy long-dated bonds to cover liabilities that can extend decades into the future, potentially helping to de-risk portfolios long-term. We expect individual investors will eventually follow suit.

• Finally, secular forces point to increasing demand for the steady income bonds can provide, from the rapidly increasing numbers of cash-hungry retirees in developed countries and the burgeoning numbers of wealthy individuals in emerging economies. These trends will only be enhanced by the ongoing redefinition of the social contract over who will be responsible for the financial security of individuals in their old age.

As rates reset at higher levels, yields will likely increase, enhancing the opportunity for bonds to provide even more attractive return and income. In the meantime, investors should remind themselves that the journey to financial security is a long one. It is full of bumps, turns … and the occasional inflection point.

See our corporate profile on page 112.

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Eric Taylor
National Sales Manager for Annuities
Genworth Financial

Reduce Portfolio Volatility—Index Annuities

For decades, consumers have relied on bond mutual funds as a way to create current income and diversify their portfolio from the higher volatility associated with equities. In fact, as interest rates have generally declined since the early 1980s, many bond funds have provided solid long-term returns.

Today, the need for income and diversification hasn’t changed, but the interest rate environment most certainly has.  As bond funds work to manage risk from historically low yields, now may be the time for consumers to consider expanding their horizons when thinking about additional options for their fixed-income portfolio.

With yields on the rise, and three consecutive months of losses as of August, 2013, bond funds have seen significant outflows.

Consumers exiting bond funds may be looking for financial products that can create:
• A source of interest income for their retirement portfolio.
• Diversification to help reduce risk, including interest rate risk.
• A better yield opportunity than other conservative financial products.
There are alternatives available to a bond fund that can help accomplish the consumer’s financial goals. Although not a security, many fixed-index annuities provide financial benefits consumers are looking for:
• Guaranteed growth (if held for a specific period),
• Protection of principal from the impact of interest rate spikes and equity market declines
• The opportunity to credit interest rates similar to or higher than many fixed-income products.

To access a consumer-use tool you can customize with your contact information and give directly to clients, visit 

See our corporate profile and important disclosure information on page 111.

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Tony Rodriguez
Co-Head Fixed Income
Nuveen Asset Management

Taxable Fixed Income Outlook: Income May Calm Rate Worries

The mid-year rise in interest rates increased investors’ concerns about fixed-income positions.  Focusing on a bond’s most distinguishing feature—payment of income on a predetermined schedule—may offer a measure of reassurance in a rate environment that remains uncertain.  Few other investments can offer this regular cash flow.  Stocks pay dividends, but these can be cut or skipped.  Cash investments may offer some income in a higher interest rate world, but today they pay nearly zero. 

Lately the media has been focused on the end of the bull market for bond price appreciation, but historically the total return of bonds has mainly stemmed from income. Even in the period since the credit crisis—when greatly depressed bond prices staged a remarkable recovery—we calculate that more than 80% of the total return was due to income.  Examining the past 30 years reveals that bonds have typically generated returns through income rather than price appreciation. 

It is important to mention that rising interest rates may actually increase the income that a fixed-income portfolio may generate.  As rates increase, cash flow can be used to add newer bonds to an actively managed portfolio at higher yields.  Rising rates may be bad for bond prices, but they may be very good for income generation. 

It was once common to complement a stock portfolio with a plain-Jane government bond fund, but today’s investor may need a more diversified mix of income-generating fixed-income assets that likely mixes both high and low-quality corporate bonds with market segments considered exotic just a few years ago.  This multi-sector combination is clearly not your grandmother’s government bond portfolio, and this increasing complexity has created a greater need for portfolios with an active allocation style to navigate the markets.

See our corporate profile on page 112.

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Dan Fuss
Vice Chairman
Loomis, Sayles & Company, L.P.

Managing Fixed Income In A Rising Interest Rate Environment

Our team’s view on positioning funds at this time is to prepare for a secular rise in interest rates that should run at least 20 years with four or five intervening cycles. The very obvious first thing to do is to try to limit the overall sensitivity to the base rate of interest as exhibited along the U.S. Treasury yield curve. A big part of this is to bring in the maturities. However, in doing so, it is very important not to reduce the current level of income too much. The fine balance between protecting income and protecting principal must be achieved. This takes careful study and implementation of the yield curve and various yield spreads versus the base yield curve. As rates rise, coupon levels versus par value of bonds also come into play.

The next most important thing in fixed-income portfolio construction is quality and quality spreads versus the Treasury market. In general, the rising interest rate environment tends to favor stronger companies with leading market shares. As time progresses, upward and downward pressures on individual credits will surface and what used to look like reasonable value will no longer appear that way and vice versa.

Rising rates make it even more important to examine the individual differences between issues as well as the differences between issuers. The various explicit and implicit options that both investors and issuers have become more and more important as interest rates rise. Examples of this are many and include sinking funds, investors’ puts and indenture provisions that normally give the issuer more latitude under certain circumstances. However, a rising interest rate environment also can improve the position of the investor in regard to the issuer’s incentive to circumvent various call protection features.
Other factors that come into play as rates go higher are country of issue and currency. While, a rising interest rate environment impacts countries and their currencies, it also provides both more opportunity and more risk. This may or may not be appropriate for individual portfolios.

In short, the best way to deal with rising market risk is, to the degree possible, substitute specific risk. A rising interest rate environment can create many more opportunities to add meaningful value through good item selection—as long as you have a strong analytical team.

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Jeffrey Sherman
Portfolio Manager
DoubleLine Capital LP

Handling With Care, Up Yield Vs. Duration

Biomimicry, to quote design guru Janine Benyus, is the art of the “apprentice of nature.” The apprentice imitates the engineering found in living organisms to solve complex problems. Likewise, study of passive asset classes during periods of rising interest rates can reveal active strategies for such environments. This study also yields a bonus discovery: Fixed-income portfolios often have delivered positive returns in the face of rising rates, though not always.

Since inception, the Barclays U.S. Aggregate Bond Index has logged 439 rolling 12-month periods, 42.6% of which ended in a higher yield on the 10-year Treasury. Interestingly, the Aggregate posted rolling 12-month losses only 6.4% of the time. In another analysis at DoubleLine, we identified 17 episodes in which the 10-year yield rose more than 100 basis points, trough to peak. The Agg managed positive returns in eight episodes.

So rising rates don’t doom all bond portfolios. Even passive investments of intermediate-term duration can overcome rising rates, sometimes. Active management can improve those odds. The key is to maximize income relative to duration while practicing prudent risk management.

Personally, I doubt a rising-rate spiral lurks around the near-term corner. Where’s the catalyst? Disinflation? Stagnant household income? Homeownership affordability? Bank deleveraging? Curtailed federal spending? Growth looks vulnerable if the 10-year were to yield above 3%. That said, the world can always surprise, and regardless of my macro opinion, managing portfolio yield to duration is common sense.

How to implement that common sense? Diversify income streams across the global bond market. Consider adding to floating-rate debt like bank loans, CLOs and certain MBS. Own fixed-rate streams with higher yield than duration. Higher income dampens portfolio volatility and buffers interest rate volatility. At this writing, the Aggregate yields 2% with duration of 5½ years. So that index would lose more than 3% if rates rise 1% over a year. A hypothetical portfolio yielding 5% with duration of 2 would return 3%.

Finally, remember loathing of asset classes begets discounted income streams—such as in certain mortgage REITs and emerging market debt at the end of August. The prepared manager seizes these opportunities.

See our corporate profile on page 111.

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