Rolling Down the Yield Curve

A SIMPLE STRATEGY FOR BOOSTING FIXED INCOME RETURNS: ROLLING DOWN THE YIELD CURVE In a low rate environment, fixed income investors naturally fear the possibility of an increase in interest rates. To minimize the risk of principal loss, many investors choose a strategy of investing in money market or other short term fixed income securities. While this does minimize the potential for unanticipated capital loss when proceeds are needed, this strategy also reduces investment income due to the low yields at the shortest end of the yield curve. Not only are these instruments generating historically low returns, but the after-tax real return may in fact be negative. Fortunately, there is an alternative strategy for fixed income investing that generates higher returns yet still minimizes the risk of principal loss. In this paper, we explore the strategy of “rolling down the yield curve” and highlight the utility of RBC Target Maturity Corporate Bond Index (TMCB) ETFs in implementing the strategy.

The Strategy: “Rolling Down the Yield Curve” One of the attractive features of bonds is the clarity they provide on cash flows, and therefore the ability to model their total investment performance under different interest rate environments. This modeling capability, along with the passage of time, can be used to the investor’s advantage. In an upward sloping yield curve and low rate environment, an opportunity exists to earn higher yields, while still minimizing the risks to principal. The strategy, known as “rolling down the yield curve”, involves the purchase of a bond with a maturity in the higher yielding section of the yield curve and selling the bond prior to maturity when it reaches a lower yielding section. The strategy can benefit investors by providing: 1. Higher incremental income: By purchasing relatively higher yielding bonds 2. Higher principal proceeds at liquidation: Depending on the characteristics of the bond, a capital gain or reduced capital loss 3. Declining bond price volatility as the bond moves close to maturity.

Implementing the Strategy with RBC Target Maturity Corporate Bond Index ETFs The table below illustrates the excess returns produced by purchasing a longer duration RBC TMCB ETF and selling it one year prior to maturity, rather than purchasing a shorter duration ETF and holding it to maturity. For example, if an investor intends to purchase RQE (maturing in 2017) the annualized return after MER would be 2.43%. Utilizing the “rolling down the yield curve” strategy, the investor would purchase RQF (maturing in 2018), sell it in 2017 and generate an annualized return of 3.00%. This provides the investor with an excess annual return of 57 Bps, enhancing total returns by 23%. For the purposes of this exhibit, we assume that interest rates remain unchanged.

Assumes No Increase/Shift in the Yield Curve (at January 31, 2012)

Security Maturity Current Purchased Yield Total Return to Total Return to Ann. Return to Annualized Excess Return from Symbol Year Yield to Maturity Maturity 1 Year Prior 1 Year Prior Buying Longer Duration and (after MER) (after MER) to Maturity to Maturity Selling 1 Year Prior to Maturity Purchasing the 2017 bond and holding it until 1 Year Bankers Acceptance 1.45% 1.45% 1.45% maturity would produce RQA 2013 4.59% 1.44% 2.90% 1.43% 1.43% -0.02% an annualized return RQB 2014 4.46% 1.89% 5.79% 4.28% 2.12% 0.68% of 2.43%. RQC 2015 3.89% 2.17% 8.95% 7.39% 2.40% 0.51% RQD 2016 4.15% 2.36% 12.37% 10.76% 2.59% 0.42% Purchasing the 2018 RQE 2017 4.17% 2.43% 15.47% 13.82% 2.62% 0.26% bond and selling it in RQF 2018 4.72% 2.77% 21.11% 19.38% 3.00% 0.57% 2017 results in a RQG 2019 4.66% 2.86% 25.33% 23.54% 3.07% 0.29% 0.57% increase in RQH 2020 4.48% 2.91% 29.47% 27.62% 3.10% 0.23% annualized return. Rolling Down the Yield Curve

What if interest rates rise? Interest rates do fluctuate, so what is the impact to the strategy if interest rates were to rise dramatically? Below we extend our analysis by examining a scenario in which interest rates increase by 150 bps during the holding period.

Excess Returns with a 150 Bps Increase/Shift in the Yield Curve (at January 31, 2012)

Security Maturity Current Purchased Yield Total Return to Total Return to Ann. Return to Annualized Excess Return from Symbol Year Yield to Maturity Maturity 1 Year Prior 1 Year Prior Buying Longer Duration and (after MER) (after MER) to Maturity to Maturity Selling 1 Year Prior to Maturity 1 Year Bankers Acceptance 2.95% 2.95% 2.95% RQA 2013 4.59% 1.44% 2.90% -0.05% -0.05% -3.00% RQB 2014 4.46% 1.89% 5.79% 2.76% 1.37% -0.07% RQC 2015 3.89% 2.17% 8.95% 5.82% 1.90% 0.01% Even with a 150 Bps RQD 2016 4.15% 2.36% 12.37% 9.15% 2.21% 0.05% shift in the yield curve, RQE 2017 4.17% 2.43% 15.47% 12.16% 2.32% -0.04% the strategy produces RQF 2018 4.72% 2.77% 21.11% 17.64% 2.75% 0.32% virtual break-even, RQG 2019 4.66% 2.86% 25.33% 21.74% 2.85% 0.08% if not positive results. RQH 2020 4.48% 2.91% 29.47% 25.76% 2.91% 0.04%

This table demonstrates the cushion that is provided by the strategy, if interest rates were to increase over the holding period. As summarized, a dramatic shift of 150 Bps in the yield curve continues to generate positive or virtual break-even results. Ultimately, interest rates would have to increase by over 150 bps to eliminate the benefit provided by the strategy. Of course, should interest rates decline, investors would experience a corresponding increase in excess return.

Conclusion Fixed income investors concerned with the possibility of rising interest rates and the related principal loss, but also seeking more generous yields than those provided by short term money market instruments, should consider the strategy of “rolling down the yield curve”. The higher yields provide an element of protection, as it can help offset losses from price declines that result from an increase in interest rates. Ultimately, the strategy provides investors with a potentially higher-yielding strategy to navigate through the current low interest rate environment. The RBC Target Maturity Corporate Bond ETFs provide a simple and easy way to effectively execute this strategy with the additional benefits of enhanced liquidity, diversification and flexibility.

Commissions, management fees and expenses all may be associated with investments in exchange-traded funds. Please read the prospectus before investing. Funds are not guaranteed, their values change frequently and past performance may not be repeated. Fund units are bought and sold at market price on a stock exchange and brokerage commissions will reduce returns. RBC ETFs do not seek to return any predetermined amount at maturity. Index returns do not represent RBC ETF returns. RBC ETFs are managed by RBC Global Asset Management Inc., an indirect wholly-owned subsidiary of Royal Bank of Canada. DEX 2013 Maturity Canadian Corporate Bond Index™, DEX 2014 Maturity Canadian Corporate Bond Index™, DEX 2015 Maturity Canadian Corporate Bond Index™, DEX 2016 Maturity Canadian Corporate Bond Index™, DEX 2017 Maturity Canadian Corporate Bond Index™, DEX 2018 Maturity Canadian Corporate Bond Index™, DEX 2019 Maturity Canadian Corporate Bond Index™ and DEX 2020 Maturity Canadian Corporate Bond Index™ are trademarks of TSX Inc. and have been licensed for use for certain purposes to RBC Global Asset Management Inc. by PC-Bond, a business unit of TSX Inc. The RBC ETFs are not sponsored, endorsed, sold or promoted by PC-Bond, TSX Inc., its affiliates or third party data suppliers and they make no representation, warranty or condition regarding the advisability of investing in the RBC ETFs. This information has been provided by RBC Global Asset Management Inc. (RBC GAM) and is for informational purposes only. It is not intended to provide legal, accounting, tax, investment, financial or other advice and such information should not be relied upon for providing such advice. RBC GAM takes reasonable steps to provide up-to-date, accurate and reliable information, and believes the information to be so when printed. Due to the possibility of human and mechanical error as well as other factors, including but not limited to technical or other inaccuracies or typographical errors or omissions, RBC GAM is not responsible for any errors or omissions contained herein. RBC GAM reserves the right at any time and without notice to change, amend or cease publication of the information.

45192 DI (05/2012)