Bonds and Rates
Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD), analyzes interest rate risk.
Right now the topic de jour in the fixed income space is interest rate risk. The traditional thought is that as interest rates rise, bond prices fall. But looking at history, the high yield market has defied this widely held notion. Let’s examine the four main reasons why high yield bonds have historically performed well during times of rising interest rates.1
1) Higher coupons and yields in the high yield space help cushion the impact of rising interest rates. High yield bonds, as the name would suggest, have traditionally offered among the highest coupons/yields of various fixed income instruments. The following chart depicts yields, coupons, and the spread over Treasuries for several fixed income asset classes.2
The higher the yield the less the interest rate sensitive the bond, per the duration calculation that we discuss below, and the more income is being generated to offset any impact from a bond price response to interest rate moves.
2) High yield bonds have shorter durations than other asset classes in the fixed income space. Duration is a measure of sensitivity to changes in interest rates that incorporates the coupon, maturity date, and call features of a bond. The fact that high yield bonds are typically issued with five to ten year maturities and are generally callable after the first few years, as well as offer higher coupons, provides the high yield sector with a shorter duration, thus less interest rate sensitivity, versus other asset classes. We’ve profiled some duration comparisons below:3
3) The prices of high yield bonds have historically been much more linked to credit quality than to interest rates. Historically, interest rates are increasing during a strengthening economy and a strong economy is generally favorable for corporate credit and equities alike. Due to the nature of the high yield bond market, the major risk on the minds of investors is default risk (not interest rate risk), causing them to be much more concerned with the company’s fundamentals and credit quality than interest rates. When the economy is expanding, profitability, financial strength, and credit metrics often improve as well. So a stronger economy would undoubtedly be a positive from a credit perspective and would indicate lower default rates (on top of an already very benign default environment), meaning improved prospects for the high yield market.
4) High yield bonds are negatively correlated with Treasuries. This means that as Treasury prices go down due to yields (interest rates) increasing, high yield would theoretically experience the opposite change (increase) in pricing. Additionally, while high yield is still positively correlated to investment grade, it is a fairly low correlation; yet, we see a strong correlation between investment grade and Treasuries. As a recent J.P. Morgan report explained, “Over the past 15 years, high-yield bonds and loans exhibit correlations to movements in the 10-year Treasury bond of -0.2 and -0.4, respectively, versus a far higher correlation of +0.6 for high-grade bonds.” Looking over just the last five years, we see a similar takeaway.4
Given these low or negative Treasury correlations versus other asset classes, especially the more interest rate sensitive asset classes such as investment grade, it appears that an allocation to high yield bonds can help serve to improve portfolio diversification and potentially lower risk.
In short, whether your take is that rates rise or not, we believe that the general high yield market is positioned well. Within this asset class, we feel the real opportunity for investors is in actively managed portfolios, where managers can avoid overly valued securities and focus on yield generation.
1 See our piece, “Strategies for Investing in a Rising Rate Environment” for data on historical performance of the high yield market in periods of rising rates.
2 Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). U.S. 5 Year Treasury Note is the on-the-run Treasury (source Bloomberg). Barclays Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital). Barclays Municipal Bond Index covers the long-term, tax-exempt bond market (source Barclays Capital). All data as of 12/19/13. The yield to worst is the lowest potential yield that can be received on a bond, without the issuer actually defaulting, and includes the various prepayment options such as call or sinking fund. The spread is the spread to worst based on the yield to worst less the yield on Treasuries. The coupon is the annual interest rate on a bond.
3 Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). U.S. 5 Year Treasury Note is the on-the-run Treasury (source Bloomberg). Barclays Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital). Barclays Municipal Bond Index covers the long-term, tax-exempt bond market (source Barclays Capital). All data as of 12/19/13. The Modified Adjusted Duration is a measure of interest rate sensitivity based on the Yield to Maturity date.
4 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2013 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 23, 2013, p. 112, 97.