Floating rate: Hedging the interest rate risk in your fixed-income portfolio

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1 Floating rate: Hedging the interest rate risk in your fixed-income portfolio Highlights > > The interest rate environment: an expiring tailwind > > Floating rate loans: a primer > > Key portfolio benefits of leveraged loan investment Following the Great Recession of 2008, many investors aggressively moved to cash and fixed-income securities in a classic flight to safety. In early 2009, we could point to a historic opportunity spanning across various sectors of the bond market to capture significant total return, as yield premiums corrected and the market s perception of credit risk normalized. The correction appears to be complete, as valuations across the fixed-income market have contracted to historical averages. At this juncture in the business cycle, credit risk has declined dramatically, as evidenced by defaults that are running well below long-term averages, robust new issuance and demand for bonds, and healthy corporate balance sheets. Today, interest rate risk is a greater threat to fixed-income portfolios. With that in mind, a unique asset class to consider is the floating rate or bank loan market. > Solid performance in a rising rate environment: Bank loans have a history of generating consistently positive total returns in periods of rising rates, unlike many of their fixed-income counterparts (see Figure 1). 1 > Diversification: Floating rate loans have historically had low correlation to investment-grade bonds, including Treasuries over the long term (See Figure 4). > Income that keeps pace with the general trend in interest rates: Because the interest income generated by floating rate loans is tied to a market rate of interest, such as London Interbank Offered Rate (LIBOR), income generally keeps pace with changes in market interest rates. > Senior and secured: Bank loans are unique in that they are generally the most senior source of capital in a company s capital structure and typically come with a lien on most, if not all, assets of the issuer. Both of these features differ from the generally unsecured nature of the high-yield bond market (see Figure 5). > Compelling yield and duration: Because floating rate loans reset frequently, they essentially have no duration risk a measure of the sensitivity of the price of an investment to a change in interest rates. This enables the investor to reduce interest rate risk without sacrificing income. 1 Floating rate loans (aka leveraged loans, bank 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.

2 FLOATING RATE LOAN INVESTING The interest rate environment: an expiring tailwind Over the last 30 years, the overall interest rate trend has greatly rewarded bondholders. Since September 1981, fixed-income investors witnessed 10-year U.S. Treasury rates fall from 15.32% to an all-time low of 1.40% in July of This backdrop represented a significant tailwind, boosting portfolio performance. To put things into context, from 1981 to 2012, Treasury bonds returned an annualized 8.57%, and during that stretch there were only four years during which performance was negative. 2 Overall, not a bad environment to be a buy-and-hold fixed-income investor. Having experienced an unprecedented level of monetary easing by the Federal Reserve (the Fed) since 2008, investors are now bracing for increased interest rate volatility as the economy strengthens and the Fed gradually begins to unwind its support. Since 1994, we have seen the 10-year U.S. Treasury increase more than 100 basis points (bps) on several occasions. During each of those periods, leveraged loans provided consistently solid total returns (see Figure 1). Importantly, however, the 10-year Treasury rate and the federal funds rate do not necessarily move in tandem. With the fed funds rate near 0%, it s appropriate to study distinct periods of Fed tightening and the impact Fed action has had on various sectors of the bond market. The results are interesting (see Figure 1). Again, the leveraged loan market as represented by the Credit Suisse Leveraged Loan Index provided investors with consistently positive performance, as compared with other sectors of the bond market. Figure 1: Leveraged loan performance in a rising rate environment In periods of 10-year U.S. Treasury increases of 100 bps or more 12 months ending 10-Year U.S. Treasury Yield (bps) Credit Suisse Leveraged Loan Index (%) Credit Suisse High-Yield Bond Index (%) Barclays U.S. Aggregate Index (%) S&P 500 Index (%) Barclays U.S. Treasury Index (%) October January May June December October 6, 2010 February 6, 2011 Sources: Credit Suisse and Barclays, as of December 2012 During Fed tightening cycles (%) Date 01/94 01/95 06/99 06/00 06/04 06/05 Fed funds rate Credit Suisse Leveraged Loan Index Credit Suisse High Yield Bond Index Barclays Aggregate Bond Index Barclays Treasury Index Sources: Credit Suisse and Barclays Past performance does not guarantee future results. Performance shown is not indicative of the performance of any particular product. 2 Based on Barclays 10-Year U.S. Treasury Bellwethers Index. Treasury bond return includes coupon and price appreciation. It will not match the Treasury bond rate each period.

3 In every market environment, portfolio duration, credit exposure and yield are all considerations in setting an appropriate asset allocation to fixed income. As investors prepare for rising rates, however, principal stability becomes a heightened concern and shortening duration can keep volatility in check. In most cases, shortening a portfolio s duration will decrease an investor s ability to generate yield. Bank loans are the exception. With their regularly resetting coupon features, bank loan yields tend to maintain pace with the current market environment and are higher than many of their short-duration counterparts because of the underlying credit quality of the issuers, which is below investment grade. (Generally speaking, an issuer with a lower credit quality rating will need to pay a higher interest rate to attract investors due to increased default risk.) Because the frequent rate resets reduce interest rate risk, the price of bank loans tends to fluctuate more with the market s appetite for risk than with shifts in the yield curve. A more thorough understanding of the asset class and the risks and benefits of adding it to an investment portfolio will help determine if it s an appropriate choice. Floating rate loans: a primer Leveraged loans (also known as floating rate loans, bank loans or high-yield loans) are loans extended to companies with higher levels of debt relative to their cash flows. Companies typically borrow in the loan market to refinance existing debt, recapitalize their balance sheet or finance leveraged buyouts. Money center banks and other financial institutions are the primary arrangers of these loans, which are then syndicated (i.e. sold) to investors. The loans are below-investment-grade credit quality and are secured by assets of the borrower. As the most senior source of capital in a company s capital structure, these secured, leveraged loans are paid down first in the event of a bankruptcy or liquidation (see Figure 5). The interest rate paid on the loan is based on an index, typically LIBOR, plus a predetermined spread. The total coupon moves as the index fluctuates. Typically, LIBOR resets every 30, 60 or 90 days. This floating rate nature of leveraged loans may protect investors from interest rate risk during rising rate environments and result in a portfolio with extremely short duration : A historic period for the loan market The leveraged loan market has grown significantly since the mid-1980s. Importantly, a broader swath of institutional investors, including hedge funds, mutual funds and CLO managers, gradually began to enter the asset class and facilitated the creation of an active secondary market. It has also enabled loans to trade relatively close to par outside of the recession of 2002 and credit crunch in Figure 2: Average price (excluding defaults) Source: Credit Suisse, as of December 2012 Growth in the bank loan market was driven primarily by demand from investors such as collateralized loan obligations (CLOs) and hedge funds, which accounted for approximately 60% of the buyer base. 3 Both types of investors used leverage to purchase loans, but hedge funds used the equivalent of up to 95% margin credit. In 2008, the market landscape became overshadowed with concerns of rising defaults, lower corporate earnings and a freeze in bank lending. In addition, the contagion of the subprime crisis spread to all structured products, including CLOs, and starting in late 2007, the CLO market essentially shut down. Institutions began to deleverage and were forced to sell risky assets in an attempt to avoid credit downgrades. In addition, hedge funds levered up to 20 times through the large banks were also forced to sell their loan holdings to meet margin calls. Magnifying the supply of loans on the market was new issuance. By that point in time, large banks had already underwritten more than $250 billion in loan commitments backing leveraged buyouts and refinancings. The market was flooded with these large scale sales, demand was weak and loan prices in the secondary market collapsed from an average bid of approximately $95 at the end 2007 to approximately $62 by the end of As a result, the bank loan market witnessed its worst one-year performance in history the Credit Suisse Leveraged Loan Index fell 28.75%. The leveraged loan asset class, which had historically displayed minimal volatility and a low correlation with other indices, was now performing in line with both equities and other traditional high-yield fixedincome investments S&P Leveraged Commentary & Data, January 2009

4 FLOATING RATE LOAN INVESTING Since the credit crunch, investors have recognized that falling prices were largely due to technical factors. Prices rebounded sharply in 2009, as the leverage in the market unwound and an appetite for bank loans resumed. Returns on the Credit Suisse Leveraged Loan Index rebounded, up 44.88% in 2009 and another 9.97% in More than $14 billion of investor capital flowed into leveraged loan funds in On the supply side, new issuance recovered, and in 2010 new loan volume was four times the 2009 level. The recovery of loan market technicals continued through 2012, supported by several factors including the re-emergence of the CLO market, strong retail demand, and near-record institutional loan issuance. Fundamentals at the issuer level also steadily improved, resulting in lower than average defaults. As shown in Figure 3, after spiking at an all-time high of 14.18% in 2009, defaults have declined to well below the long-term average of 4% and, as J.P. Morgan states below, are expected to stay low over the next few years. Companies aggressively refinanced pending maturities and reduced leverage levels following the financial crisis. While postrecession operational efficiencies have likely been exhausted, leveraged issuers retain a great deal of financial flexibility and should be well-positioned to effectively maneuver through a period of decelerating earnings growth. Figure 3: Default rates are expected to remain low through 2013 Par-weighted default rate (%) Dec 98 Jun % Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Nov % Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec % Source: J.P. Morgan; S&P Leveraged Commentary and Data (LCD), as of December Dec 10 Dec 11 Dec 12 Key portfolio benefits of leveraged loan investment 1 Diversification historically low correlation 5 Historically, leveraged loans have displayed low correlations to more traditional asset classes, which can help reduce volatility in an investor s portfolio. 6 The correlation between high-yield bonds and leveraged loans is worth noting, however, and is largely due to the underlying issuer in both markets being below investment grade. 7 Still, there are several important distinctions between the two asset classes. Figure 4: Correlation of the Credit Suisse Leveraged Loan Index with other asset classes Measured monthly from January 1, 1992 through December 31, Barclays U.S. Intermediate Government Index Barclays U.S. 3 Month Treasury Index Barclays U.S. Aggregate Index Barclays U.S. Municipals Index S&P 500 Index Barclays U.S. High Yield Index Source: Barclays, Credit Suisse and Standard & Poor s, as of December AMG/Lipper data as cited in a December 16, 2011 Bank of America report. 5 Diversification does not assure a profit or protect against loss. 6 Correlation measures how asset classes perform in relation to each other. Perfect positive correlation (+1.0) indicates that the asset classes move together up or down. Perfect negative correlation (-1.0) indicates that the asset classes move opposite each other, when one goes up, the other goes down. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random. 7 Non-investment grade securities, commonly called high-yield or junk bonds, have more volatile prices and carry more risk to principal and income than investment grade securities.

5 Interest income that paces with the rate environment The coupon on bank loans resets regularly to mirror a market interest rate (typically LIBOR, which resets every days). As a result, bank loans generate income that reflects the overall rate environment plus a premium that is set at origination. The premium or spread reflects the underlying credit quality of the issuer as well as technical factors in the market at the time of issuance: the market s appetite for risk, liquidity, the default environment, etc. Capital structure senior and secured Bank loans are generally the most senior source of capital in a company s capital structure and are paid down first in the event of a bankruptcy or liquidation. They offer collateral protection with a first lien on most, if not all, assets of the issuer, have more robust documentation and have financial covenants that are regularly monitored by the lenders. As a result, bank loans have experienced a much higher recovery rate in default situations (historically, about 80%) as compared with other types of securities. 8 Figure 5: Corporate capital structure Paid first Paid last > Senior secured debt > Senior unsecured debt > Subordinate unsecured debt > Preferred stock > Common stock Compelling yield-duration relationship Floating rate loans have near-zero duration, such that their principal value remains largely unaffected by interest rate changes. Typically, an investor has to give up yield in exchange for low interest rate risk. Floating rate loans offer a higher yield with lower duration because the underlying issuers are below-investment-grade credit quality. If investors are comfortable with the underlying credit risk which can be mitigated by the aforementioned structural features of the asset class they can achieve a yield that keeps pace with the overall trajectory of interest rates and are less likely to not suffer the price declines typically associated with other fixed-rate investments. Conclusion From a fundamental and technical viewpoint, we believe that the floating rate market is an attractive asset class for many investors. With credit risk muted and financial markets continuing to recover, investors will be focused on maximizing yield relative to duration risk in the years ahead. The structural characteristics of bank loans can act as a hedge against rising rates and diversify an otherwise fixed-rate bond portfolio. The events of 2008 and 2009 should not be totally discounted, however, and are a good reminder that the asset class does come with some risk. Understanding the drivers of that performance and reflecting on the overall financial landscape at that time can help put that underperformance into context. The historical long-term profile of the loan market suggests stability, low correlation with other fixed-income sectors and solid performance in a rising rate environment, which is why we see it as a worthy contender in an overall asset allocation strategy, especially now. Figure 6: Yield versus interest rate risk across the fixedincome landscape Yield to maturity (%) Credit Suisse Leveraged Loan Index Barclays U.S. Mortgage Backed Barclays U.S. High Yield Barclays Global Emerging Markets Barclays U.S. Corporate Barclays Municipal Barclays U.S. Aggregate 1 Barclays 3-Month Barclays U.S. Treasury Treasury Bill Duration (years) Sources: Barclays and Credit Suisse, as of December 2012 Past performance does not guarantee future results. Performance shown is not indicative of the performance of any particular product. 8 Moody s Investors Service, Moody s Ultimate Recovery Database, Based on ultimate recoveries, or the value creditors realize at the resolution of a default event.

6 FLOATING RATE LOAN INVESTING About the Columbia Management Leveraged Debt Group The Columbia Management Leveraged Debt Group believes strong and consistent risk-adjusted returns in the bank loan market are best achieved through the proactive management of credit risk combined with a strategy to seek out relative value opportunities. The Columbia Management Bank Loan Strategy seeks to construct a broadly diversified portfolio of bank loans that maximizes return and minimizes default risk over the long run. The team Lynn Hopton Industry experience since 1987 Yvonne Stevens Industry experience since 1987 Steven Staver, CPA Industry experience since 1994 Ronald Launsbach, CFA Industry experience since 1995 Research team 8 credit analysts Industry experience averaging 14 years Investment approach The investment process is primarily bottom-up, focusing on rigorous, in-house, fundamental credit research as the primary driver of performance. The team leverages their knowledge in the bank loan asset class and depth of resources dedicated to the strategy to establish an information advantage through which they can strive to implement their strongest conviction ideas ahead of the market. The team s experience, size and presence in the market have led to top-tier allocations in the primary origination market as well as strong secondary activity. They believe there are two critical keys to success in bank loan investing. The first is a mastery of credit skills to determine which companies will have the ability to withstand a credit cycle or other financial events. The second is employment of a proprietary rating system to help guide position sizing. Columbia Floating Rate Fund > > A broadly diversified portfolio of bank loans managed with an emphasis on risk-adjusted returns. > > Deep and stable investment team of leveraged debt specialists with active presence and longevity in the bank loan market. > > Extensive commitment to fundamental credit research and an independent, proprietary risk and relative value rating system. > > Constant focus on downside risk. Class A: RFRAX Class Z: CFRZX Class Z shares are sold at NAV, have limited eligibility and the investment minimum requirement may vary. Only eligible investors may purchase Class Z shares of the fund, directly or by exchange. Please see the fund s prospectus for eligibility and other details.

7 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. To learn more about the support and services available to you, contact your Columbia Management representative at

8 FLOATING RATE LOAN INVESTING 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, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for 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 the forecasts are accurate. Investing involves risks, including the loss of principal invested. Columbia Floating Rate Fund is designed for investors with an above-average risk tolerance. 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. Due to its active management, the fund could underperform other mutual funds with similar investment objectives. The fund invests primarily in floating rate loans, the market value of which may fluctuate, sometimes rapidly and unpredictably. Risks of investing in the fund include but are not limited to liquidity risk, interest rate risk, credit risk, counterparty risk, highly leveraged transactions risk, derivatives risk, confidential information access risk, impairment of collateral risk, and prepayment and extension risk. Generally, when interest rates rise, the prices of fixed-income 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. Limited liquidity will affect the ability of the fund to purchase or sell floating rate loans and have a negative impact on fund performance. The floating rate loans and securities in which the fund invests 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. The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. The Credit Suisse First Boston (CSFB) High Yield Index is a broad-based index that tracks the performance of high-yield bonds. The Barclays U.S. Aggregate Bond Index is a benchmark index composed of U.S. securities in Treasury, government-related, corporate and securitized sectors. It includes securities that are of investmentgrade quality or better, have at least one year to maturity and have an outstanding par value of at least $250 million. The Standard & Poor s (S&P) 500 Index is an unmanaged index that tracks the performance of 500 widely held, large-capitalization U.S. stocks. The London Interbank Offered Rate (LIBOR) is the rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to London time The Barclays Intermediate Government/Credit Bond Index is an unmanaged index that tracks the performance of intermediate-term U.S. government and corporate bonds. The Barclays Municipals Index is an unmanaged index considered representative of the tax-exempt bond market. The Barclays Credit Index is an unmanaged index composed of U.S. investment-grade corporate bonds. The Barclays High Yield Index is an unmanaged index that covers the universe of fixed-rate, non-investment-grade debt. The Barclays 10-Year U.S. Treasury Bellwethers Index is a universe of Treasury bonds and used as a benchmark against the market for longterm maturity fixed-income securities. The index assumes reinvestment of all distributions and interest payments. The Barclays U.S. Mortgage-Backed Index measures the performance of investment-grade, fixed-rate, mortgage-backed pass-through securities of the Government National Mortgage Association (GNMA or Ginnie Mae), Federal National Mortgage Association (FNMA or Fannie Mae), and Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). The Barclays Emerging Markets Index is an unmanaged index that tracks total returns for external-currency-denominated debt instruments of the emerging markets. The Barclays U.S. Corporate Index consists of publicly issued, fixed-rate, nonconvertible, investment-grade debt securities. The Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury. Treasury bills, certain special issues, U.S. Treasury TIPS and STRIPS are excluded. Securities in the Index roll up to the U.S. Aggregate, U.S. Universal and Global Aggregate indices. To learn more about the support and services available to you, contact Columbia Management at Franklin Street Boston, MA columbiamanagement.com 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. Read the prospectus carefully before investing. Columbia Funds are distributed by Columbia Management Investment Distributors, Inc., member FINRA, and managed by Columbia Management Investment Advisers, LLC Columbia Management Investment Advisers, LLC. All rights reserved. CM-TL/ D (05/13) 3885/152551