The Advantages of High Yield in a Rising Rate Environment

The Advantages of High Yield in a
Rising Rate Environment

Interest rates are poised to rise in the U.S., which can mean tough times for fixed income investors. However, not all bond strategies are alike in how they perform in rising rate environments. In fact, high yield has a record of generating significant returns in periods when rates rise, but high yield is not without other types of risk.

High yield bonds often perform well when rates rise. During the six periods of rising rates over the last 30 years, the high yield market’s median return was 8.1%. In all six periods, high yield returns were positive.

In the immediate aftermath of the 2008 global financial crisis, the BofA Merrill Lynch US High Yield Master II Index fell -33.23% between June 2008 and November 2008. However, that same index notched a 57.5% gain between December 2008 and December 2009. During all six of these rising-rate periods, US 10-year Treasury bonds were negative.

The performance of Treasuries is highly sensitive to changes in interest rates because interest rates and fixed-rate bond prices move in opposite directions. If interest rates go higher, fixed-rate bonds such as Treasuries are bound to go lower. Compared to Treasuries, high yield bond prices are less negatively impacted by increases in interest rates. 

High Yield Bond Advantages When Rates Rise:

  • Shorter maturities than Treasuries or even investment-grade corporates, making them automatically less rate-sensitive.
  • More influenced by the business cycle than by rates. More specifically, periods of higher interest rates typically occur during expansionary economic periods, which creates a positive environment for companies/credit, including increased revenues and earnings, lower defaults and higher liquidity.

While these points make high yield attractive in a rising rate environment, investors need to remember that high yield bonds do carry risk. High yield investors trade rate risk for another type of risk – credit risk.

High Yield Bond Risks:

  • High yield bonds by nature are riskier than investment-grade credit because they have a higher risk of default.
  • Often issued by capital-intensive companies with a lot of debt, or by small companies that are just starting out – two types of companies that may run into problems when paying back their debt.
  • When the economy is booming, the risk of default on these bonds is low because even an indebted or a fledgling company can likely service its debt with few problems. However in a recession, such companies may find paying debts more difficult, leading to default.

High yield investors in 2017 face yet another risk – valuations. Many yield-hungry investors who are wary of interest rate risk have piled into the asset class in recent years. This has led to spreads in high yield well below the long-term median.

In addition, actual yields on “high yield” bonds are not so high these days, as high yield bond prices have been driven up by inflows. The effective yield on the BofA Merrill Lynch US High Yield Master II Index was 5.6% as of July 18 – hardly the double-digit yield investors experienced 10 years ago.

Currently, the U.S. economy seems to be on solid footing, so high yield investors probably do not have too much to worry about. However, high yield may struggle if the economy starts to show signs of weakness. High yield bonds deserve a spot in a well-diversified fixed income portfolio, and their resilience in rising-rate environments is a reason why. Investors should be aware that there is no free lunch in investing, and high yield carries its own unique risks.

 

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