Fortunately, there are strategies that investors can utilize to help address extension risk:
- Awareness – Familiarize yourself with the extension risk in your portfolio. The most obvious indicator can be a gap between a security’s call date and its maturity date. A gap of two or three years may not translate into meaningful extension, but gaps of 10 years or more may mean higher volatility as rates rise.
- Bullets over calls – If you’re concerned about extension risk, consider looking to more bulleted type securities, which can’t be called, or securities with smaller gaps between call dates and maturity dates.
- Variable rates – Debt securities with floating or variable rates may help protect investors from a rising rate environment. Even if maturities extend beyond a call date, interest rate risk can be much lower and is limited to the time until the next rate reset.
Regardless of the path you choose, it’s essential to understand how extension risk can affect a fixed-income allocation – particularly in a volatile rate environment.
Investors concerned about extension risk may wish to consider the PowerShares VRDO Tax-Free Weekly Portfolio (PVI), the PowerShares Senior Loan Portfolio (BKLN), or the PowerShares Variable Rate Preferred Portfolio (VRP) – all of which feature variable rate structures.
Duration, which measures the price sensitivity of a fixed income investment to interest rate changes, is the number of years it will take a bond’s cash flow to repay an investor the bond’s purchase price.
Floating rates are interest rates that are allowed to move up and down with the rest of the market or with an index.
A credit spread is the difference in yield between bonds of similar maturity, but different credit quality.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating. Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/ or interest. Income may be subject to state and local taxes and to the alternative minimum tax (AMT).
If interest rates fall, it is possible that issuers of callable securities will call or prepay their securities before maturity, causing the Fund to reinvest proceeds in securities bearing lower interest rates and reducing the Fund’s income and distributions.
Variable- and floating-rate securities may be subject to liquidity risk, there may be limitations on the Fund’s ability to sell securities. Due to the features of these securities, there can be no guarantee they will pay a certain level of a dividend and such securities will pay lower levels of income in falling interest rate environment.
Underlying investments may appreciate or decrease significantly in value over short periods of time and cause share values to experience significant volatility over short periods of time.
There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The Fund’s return may not match the return of the Underlying Index.
Investments focused in a particular industry are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
The Funds are subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the Fund.
Shares are not individually redeemable and owners of the Shares may acquire those Shares from the Funds and tender those shares for redemption to the Funds in Creation Unit aggregations only, typically consisting of 50,000, 75,000, 100,000 or 200,000 Shares.