By Ashish Shah
After the bond market's stumble last quarter, defending against rising rates has moved front and center for many investors. One approach that has been effective over time has been exposure to credit-oriented sectors and strategies. Corporate bonds may provide both insulation and additional opportunities as fixed-income markets head into a new phase. Rising yields don't affect all bond sectors the same way, and these differences can frequently be harnessed to investors' benefit -- notably in high-yield corporate bonds.
High-yield returns typically follow a very different path from those of Treasuries. Treasuries tend to fare poorly when the U.S. economy expands, as investors fret about inflation, Fed tightening, and generally rising rates. High-yield bonds, on the other hand, tend to thrive in the same conditions. That's because a growing economy bolsters issuers' business prospects and credit standing, which causes the extra yield offered by high-yield bonds vs. Treasury bonds -- the yield spread -- to shrink. This works in favor of high-yield prices, helping to counter the impact of rising Treasury yields. Generally, the wider the spread, the lower the sensitivity of a high-yield bond to Treasury-rate movements.
A Strong Showing During Fed Tightening
Historically, the performance of high-yield bonds has been correlated more closely with stocks than with government bonds -- a good thing when rates rise. As the chart below shows, high yield has usually delivered positive returns when the Fed is tightening.
Since 1993, there have been six calendar years (shaded in gray) in which the Fed has raised interest-rate targets. The high-yield market posted positive returns in five of the six periods. And high yield has notched positive returns in 17 of the last 20 years. As for defaults, which are a major concern for investors, our research suggests that defaults should remain at low levels.
Coupon Cushions Volatility
However, investors should be prepared for volatility with high yield; its returns tend to bounce around to a much greater extent than those of other bond sectors -- and there have been speed bumps along the way. Within the last 20 years, U.S. high yield has declined by more than 5% in a calendar year seven times.
The good news is that high yield is also pretty resilient. It recovered all of its losses from each of these episodes in eight months or less, with only one exception. There are a number of reasons for this, but here are two major ones: the compounding power of reinvesting the larger coupon income, and inflows of capital from many active investors who see these downturns as an opportunity to move in at attractive levels.
Shorter Can Be Smoother
Some investors may want exposure to high yield but with less volatility. For them, it might make sense to invest in shorter-duration high-yield bonds. As shown in the chart below, high-yield bonds with one- to five-year maturities have historically captured 92% of the return in high yield (8.1% vs. 8.8%), but with 25% less volatility. And since high-yield bonds are almost always issued with maturities of 10 years and under, there are a lot of short and intermediate issues for investors to pick from. (click to enlarge)
The bottom line is that high-yield bonds have historically fared well in periods of rising interest rates. They've also been a good source of diversification, given their low correlations with other bond sectors. So, when it comes to preparing for rising interest rates, we think investors should give high-yield bonds some credit.
Ashish Shah is Head of Global Credit at AllianceBernstein.
Disclaimer: The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. Past performance of the asset classes discussed in this article does not guarantee future results.