DURATION, LIQUIDITY AND DEFAULTS, OH MY! BY COLIN LUNDGREN, CFA AND GENE TANNUZZO, CFA 2016 GLOBAL PERSPECTIVES

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1 DURATION, LIQUIDITY AND DEFAULTS, OH MY! BY COLIN LUNDGREN, CFA AND GENE TANNUZZO, CFA 216 GLOBAL PERSPECTIVES

2 DURATION, LIQUIDITY AND DEFAULTS, OH MY! Duration-bitten portfolio managers may be capitulating on U.S. interest rates at just the wrong time. Positioning surveys suggest professional investors are less afraid of higher rates than retail investors. Also, the market is priced well below the Federal Reserve s current guidance for the path of the federal funds rate. In other words, the interest rate market is not well set up for a stronger economy, higher inflation or anything more than a few Fed rate hikes. The market is priced below the Fed s interest rate projections 4 Short-term interest rate (%) Longer term Projected SEP median* Market expectations Source: Bloomberg, 12/15 *Median based on the Fed s Summary of Economic Projections (SEP), 12/15 COLIN LUNDGREN, CFA Head of U.S. Fixed Income GENE TANNUZZO, CFA Senior Portfolio Manager for Strategic Income and Multi-sector Fixed Income Colin is responsible for investment oversight of managed and owned fixed-income portfolios, leading a team of experienced investment professionals. Gene manages the strategic income and income builder strategies, as well as certain institutional accounts.

3 Dealer inventories of corporate bonds Dealer inventory slump threatens bond market liquidity 2, 18, 16, 14, 12, 1, 8, 6, 4, 2, Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Nov Investment grade money market High yield money market Source: Federal Reserve Bank of New York, 11/15 Beyond the headlines Defaults are on the rise, but the headline number masks the real story. High-yield spreads are currently compensating investors for a 5% default rate, well above the current rate and slightly higher than the long-term average. Our internal default forecast is 5.5% in 216 and 6.4% in 217. But the increase in defaults is expected to be largely concentrated in energy, metals and mining. We expect energy defaults to exceed 2% in 216 and be close to that level in 217. Excluding those troubled areas, we think defaults will be less than 3% in 216 and under 5% in 217. Therefore, higher defaults should warrant some caution and careful security selection, but a broad repricing of the high yield market may provide more than enough yield compensation to produce attractive risk-adjusted returns in 216. Indeed, based on our proprietary model of default rates, current credit spreads already price in rising defaults throughout 216 and 217. Default rates expected to rise in Bond market liquidity: From bad to worse? Liquidity will continue to nag the bond market, and not just in risk-off environments. Regulatory changes help explain why dealer inventories are at or near all-time lows, and they are no longer the source of liquidity they once were. Also, we can t necessarily take comfort in size. Mega funds may be especially challenged to navigate changing market conditions, respond to large flows or invest in cash bonds. Morningstar s non-traditional and multi-sector fixed-income categories include six mutual funds with more than $15 billion in assets, and two funds that exceed $3 billion as of November 3, 215. Unfortunately, the surprise may be bond market liquidity going from bad to worse. High yield may produce some of the most attractive returns in fixed income, despite higher defaults. Default rate (%) Moody s global speculative-grade default rate Model default rate Sources: Moody s, Columbia Threadneedle Investments proprietary research, 11/15

4 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. Investing involves risk including the risk of loss of principal. The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate. Securities referenced should not be construed as a recommendation to buy or sell.

5 About Columbia Threadneedle Investments Columbia Threadneedle Investments is a leading global asset management group that provides a broad range of actively managed investment strategies and solutions for individual, institutional and corporate clients around the world. With more than 2, people, including over 45 investment professionals based in North America, Europe and Asia, we manage $471 billion* of assets across developed and emerging market equities, fixed income, asset allocation solutions and alternatives. We are the 13th largest manager of long-term mutual fund assets in the U.S.** and the 4th largest manager of retail funds in the U.K.*** Our priority is the investment success of our clients. We aim to deliver the investment outcomes they expect through an investment approach that is team-based, performance-driven and risk-aware. Our culture is dynamic and interactive. By sharing our insights across asset classes and geographies, we generate richer perspectives on global, regional and local investment landscapes. The ability to exchange and debate investment ideas in a collaborative environment enriches our teams investment processes. More importantly, it results in better informed investment decisions for our clients. To find out more, call or visit columbiathreadneedle.com/us * In U.S. dollars as of September 3, 215. Source: Ameriprise Q3 Earnings Release. Includes all assets managed by entities in the Columbia and Threadneedle groups of companies. Contact us for more current data. ** Source: ICI as of September 3, 215 for Columbia Management Investment Advisers, LLC. *** Source: Investment Association as of September 215 for Threadneedle. Securities products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC. Columbia Threadneedle Investments (Columbia Threadneedle) is the global brand name of the Columbia and Threadneedle group of companies. Columbia Management Investment Distributors, Inc., 225 Franklin Street, Boston, MA Columbia Management Investment Advisers, LLC. All rights reserved. 11W2 (1/16)