High Yield Bond and Rates: Duration and Yield
By Heather Rupp, CFA, Director of Communications and Research Analyst for Peritus Asset Management, Sub-Advisor of the AdvisorShares Peritus High Yield ETF (NYSE Arca: HYLD)
With another Fed meeting on the horizon this week, the topic of rates come into focus. While in just a matter of months markets have seemed to quickly move from the expectation that we’d see a few rate increases this year, to a big drop in Treasury rates and the market participants questioning if given all of the global uncertainties and some weaker domestic economic data if we’ll see even one rate increase in the second half.
While we don’t see that domestic economic data or global conditions support much in the way of rate increases over the coming year, one thing we know over the last several years is that interest rate moves, as reflected by Treasury yields, have been extremely volatile and surprised nearly everyone. We don’t view interest rate risk as a primary risk for high yield investors, though it is a consideration in fixed income investing and one primary way to evaluate interest rate sensitivity in the fixed income asset class is with duration. Duration is a measure of the price change of a fixed-income security in response to a change in interest rates. Per this calculation, rates and prices move in the opposite direction, so an increase in rates would produce a decline in price. Below are the durations and yields for various fixed income asset classes.1
As you can see in the chart above, municipal bonds and the 5-year Treasury carry a duration near 5 years, investment grade bonds have a duration of over 7 years, and high yield bonds offer the lowest duration of 4 years, meaning the high yield asset class carries the lowest sensitivity to interest rates. In other words, all else equal, a given increase in interest rates will hypothetically move the price of investment grade bonds down significantly more than high yield bonds.
The number of years to maturity for the asset is one factor in determining duration, but the starting yield also plays an important role. Municipals offer a yield to worst only slightly over that generated by the 5-year Treasury, both under 2%. The yield to worst on the investment grade index is under 3%, while the broader high yield index offers a yield to worst of twice that, at 6.6%. So not only do high yield bonds offer the lowest duration, they also offer the highest yield. So how does that play into a rising rate environment? Well, it means that high yield bonds are much less interest rate sensitive than these other fixed income alternatives. And while the traditional adage in fixed income is that as interest rates go up, prices on bonds go down, that doesn’t factor in the yield being received which may outweigh the price decline, all else equal. So investors need to consider both yield and duration.
Looking back through history when we have seen rates rise, we have certainly not seen weak returns in the high yield market. For instance, in the 16 years that we have seen Treasury yield increases (rates rise) since 1980, the high yield bond market has posted an average return of 12.4% (or 9.3% if you exclude the massive performance in 2009). This compares to an average return of 4.3% (or 3.4% if you exclude 2009) for investment grade bonds over the same period.2
Intuitively this makes sense because generally rates rise during periods of economic strength, and a strong economy is generally favorable for corporate credit. Historically we have seen the prices of high yield bonds much more linked to credit quality than to interest rates.
We believe that high yield bonds are positioned well for the rate uncertainty ahead. If rates don’t move much for the year, then you have a much higher starting yield for high yield bonds, and if rates do increase (which would likely be on the back of much improved economic data), the high yield asset class has a much lower duration. Furthermore, also including floating rate bank loans in your portfolio can serve to further reduce your duration. For more on interest rates and high yield debt investing, see our piece “Strategies for Investing in a Rising Rate Environment.” Right now we see many attractive opportunities for investment for active managers in the high yield bond and loan space.
1 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). Barclays data as of 7/22/16 and Treasury data as of 7/22/16. Yield to Worst is the lowest, or worst, yield of the yield to various call dates or maturity date. Duration is the change of a fixed income security that will result from a 1% change in interest rate. The duration calculation is based on the yield to worst date, using Macaulay duration for the various Barclays indexes and Bloomberg calculated duration to workout for 5-Year Treasury.
2 High yield and investment grade data sourced from: Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2008 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 2008, p. 113; “High-Yield Market Monitor,” J.P. Morgan, January 4, 2016, p. 15. Treasury data sourced from Bloomberg (US Generic Govt 5 Yr). The J.P. Morgan High Yield bond index is designed to mirror the investible universe of US dollar high-yield corporate debt market, including domestic and international issues. The J.P. Morgan Investment Grade Corporate bond index represents the investment grade US dollar denominated corporate bond market, focusing on bullet maturities paying a non-zero coupon. See https://markets.jpmorgan.com/?#research.na.high_yield.