Fixed income investors are looking for ways to prepare their portfolios for rising interest rates.
While bond prices generally fall when rates rise, history shows that high-yield bonds have typically held up well in rising rate environments.
Since 1987, there have been 16 quarters in which 5-year Treasury yields rose by at least 70 basis points. During 10 of those quarters, high-yield bonds delivered positive returns. During the other six quarters (in bold below), high-yield bond returns were negative - but, they rebounded into positive territory the following quarter.
Why do high-yield bonds perform well in rising rate environments? We see three reasons:
- Rates generally rise when the economy is expanding, which means companies tend to have increasing earnings and can better service their debt.
- When rates are expected to rise, companies try to take advantage of lower rates and refinance before they increase. If a company refinances its debt before maturity, it is normally required to pay a pre-payment penalty, or call premium, that is added to the total return of the high-yield bond.
- The duration of high-yield bonds is typically much lower than that of investment grade bonds due to their relatively short maturity and high coupon. Lower duration generally makes a bond less sensitive to interest rate increases.
There are many ways to get exposure to high-yield bonds, including passive index strategies and actively managed funds. Today, we believe investors are better served by an active strategy that is grounded in fundamental research. Why? Interest rates are low and return opportunities are compressed. And shifting economic data can trigger volatility and open up pockets of opportunity for nimble investors. In short, we're in a bond-pickers' market, where discriminating bond selection is critical to performance. Active managers have the flexibility to seek value in different parts of the high-yield market and to find mispriced securities.
Junk bonds involve a greater risk of default or price changes due to changes in the credit quality of the issuer. The values of junk bonds fluctuate more than those of high-quality bonds in response to company, political, regulatory or economic developments. Values of junk bonds can decline significantly over short periods of time.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise; conversely, bond prices generally rise as interest rates fall. Specific bonds differ in their sensitivity to changes in interest rates depending on their individual characteristics, including duration.
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All data provided by Invesco unless otherwise noted.
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Additional disclosure: The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. The opinions expressed are those of the author(s), are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.