High Yield in a Rising Rate Environment: Yield, Duration, Correlation, and Economic Factors
By Heather Rupp, CFA, Director of Research for Peritus Asset Management, Sub-Advisor of the AdvisorShares Peritus High Yield ETF (NYSE Arca: HYLD)
With the move we have seen in interest rates (Treasury rates) over the past month and the concerns that this move up will continue, let’s look at the high yield market and how it has traditionally responded to rate moves. Historically speaking, the high yield bond market has performed well in a rising rate environment due to a number of factors.
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, corresponding to higher perceived risk. The following chart depicts the current yield-to-worst, coupon, and the spread over Treasuries for several fixed income asset classes.1
Let’s think about this intuitively for a minute. If you own a bond with a yield of 3% and interest rates move up 1% that would obviously have a meaningful impact, as we are talking about a move equivalent to 33% of your total yield. However, if you instead have a starting yield of 6.0% on a bond and interest rates move that same 1%, you are looking at significantly less impact, at about a 17% change in yield. So the higher the starting yield, the less interest rate sensitivity.
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, typically provides the high yield sector with a shorter duration, thus theoretically less interest rate sensitivity, versus other fixed income asset classes. We’ve profiled some duration comparisons below:2
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 generally 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 generally improve. So a stronger economy would undoubtedly be a positive from a credit perspective and would indicate lower default rates, meaning likely improved prospects for the high yield market.
Even in today’s environment of minimal economic growth, we are still seeing solid fundamentals for corporations and a well below average default outlook for the next couple years:3
High yield bonds are negatively correlated with Treasuries. This means that as Treasury prices fall as interest rates increase, 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 low correlation; yet, we see a stronger correlation between investment grade and Treasuries. As noted below, over the past 15 years, high-yield bonds and loans exhibit correlations to the 10-year Treasury bond of -0.25 and -0.38, respectively, versus a far higher correlation of +0.55 for high-grade bonds.4
Given these low or negative Treasury correlations versus other asset classes, especially the more interest rate sensitive asset classes such as investment grade, an allocation to high yield bonds may help improve portfolio diversification and potentially lower risk depending on the mix of assets.
For more on how the high yield bond market has historically performed during periods of rate increases and various strategies for investing during periods of rising rates, see our piece “Strategies for Investing in a Rising Rate Environment.”
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). All data as of 5/15/15. 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 comparable maturity Treasuries. The coupon is the annual interest rate on a bond.
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 5/15/15. The Modified Adjusted Duration provided is a measure of interest rate sensitivity based on the yield to maturity date.
3 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. 14. 2014 default rates exclude TXU.
4 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 29, 2014, p. 298.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. Information on this website is for informational purposes only. As with all investments, investing in high yield corporate bonds and loans and other fixed income, equity, and fund securities involves various risk and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.