High Yield Bonds and Interest Rates: Timing Irrelevant
By Heather Rupp, CFA, Director of Communications and Research Analyst for Peritus Asset Management, Sub-Advisor of the AdvisorShares Peritus High Yield ETF (HYLD)
After the strong jobs report on November 6th, it’s looking like the Fed might finally have some data to justify in their minds making their first interest rate increase. With that, the December rate hike is starting to look more and more likely. So it is time to abandon the fixed income market? Not necessarily.
First we want to get back to our take that while the Fed wants to start taking some action, we don’t expect them to be aggressive in their rate hikes. Be it one and done or a few in 2016, we don’t see a huge increase in rates. By all indications, they have wanted to act for months and months, but are just now getting the data support to make the first step happen. While we are seeing a few signs of economic improvement, the reality remains that we are in a no growth world with rates in developed nations around the globe much lower than ours (see our piece “Life in a No Growth World and the Impact on Interest Rates”), there is still a large contingency of underemployed or people that have abandoned looking for a job altogether domestically, and the Fed can talk all they want about the low inflation being “transitory,” but this low commodity and energy price environment appears to be here to stay for the time being.
Fed rate action means that the Federal Funds Rate will increase, but that is merely an interbank lending rate. So while the Fed is impacting the Federal Funds Rate, what really matters for us as investors is the 5- and 10-year Treasury rates. Just what will happen to those more relevant rates? We have seen a recent pop in Treasury rates in anticipation of Fed action, but as we expect the Fed’s actions to be moderate, we also expect that we won’t see a huge spike these Treasury rates for many of the same reason outlined above, and given markets are forward looking, we may have already seen much of the rate impact.
Getting back to the question, is it time to head for the exits on fixed income? There are certain sectors of the fixed income market that are more sensitive to interest rate changes and have a higher duration (as outlined below), such as investment grade and municipals, so it may well be worth investors evaluating those exposures. But the lower duration, higher yielding non-investment grade market has historically fared well in rising rate periods, overall posting strong returns during the annual periods in which we have seen rates rise over the last 30 years (see our piece “Strategies for Investing in a Rising Rate Environment” for further details). We’ve written at length about the subject over the last year, but let’s revisit the main reasons why we believe the high yield market is positioned well in this environment:
Higher coupons and yields in the high yield space help cushion the impact of rising interest rates.
- The higher the starting yield, the less impact we would expect to see from a move in interest rates.
High yield bonds have shorter durations than other asset classes in the fixed income space.
- Duration is a measure of price sensitivity of a bond to changes in interest rates, which incorporates the coupon, maturity date, and certain call features.
- 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, providing the high yield sector with a shorter duration, thus theoretically less interest rate sensitivity versus other fixed income asset classes.1
- Certain asset classes, such as investment grade bonds have high correlation to Treasuries. That means if rates (yields) increase in Treasury bonds, and prices decline, we would theoretically see the same sort of action in investment grade bonds, price declines.
- However, high yield bonds are slightly negatively correlated to Treasuries, so we would expect to theoretically see minimal impact from a move in Treasuries, or even an increase in high yield bond prices.
The price of high yield bonds have historically been much more linked to credit quality than to interest rates.
- Historically rates rise during a strengthening economy, and a stronger economy is generally favorable for corporate credit, as profitability and credit fundamentals often improve.
We actually look forward to a rate increase because that at least removes the uncertainty overhanging the market…and maybe the media can move on to talking about something else. In the scheme of things, we believe that the timing of a rate move is largely irrelevant for high yield investors. The high yield market is offering investors what we believe to be attractive long-term value and tangible yield, which we see as both relevant and necessary for investors no matter where rates go.
1 Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. 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. Barclays Municipal Bond Index covers the long-term, tax-exempt bond market. Data as of 11/6/15 for the various Barclays indexes, source Barclays Capital, and 11/9/15 for the U.S. 5 Year Treasury Note. 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 is a modified adjusted duration for the various Barclays indexes and Bloomberg calculated duration to workout for 5-Year Treasury.
2 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. A153.