By: Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisory firm of the AdvisorShares Peritus High Yield ETF (NYSEARCA:HYLD)
Over the last month, we have seen the equity markets hit all-time highs, all the while bond investors seem to be indicating there are reasons to be concerned, sending the 10-year Treasury to the lowest yields seen over the past year.1
So who's right? We continue to hear constant chatter and concern in the financial media about rising rates on the horizon, but bond traders don't seem to be indicating that is looming. We ended 2013 with virtually everyone (except us) expecting rates to rise in the year ahead as the long awaited "taper" began, yet so far in 2014 we certainly have not seen any rate pressure materialize as the Fed slowly decreases their asset purchases.
Headwinds for the "rising rate" argument seem to abound. Domestic unemployment and underemployment is still elevated, with much of the job gains being reported coming from temporary and part-time work. Global growth is moderate at best, with cracks starting to re-emerge in Europe, as we saw GDP in the three largest markets, Germany, Italy and France, contract for the second quarter…not to mention the outlook isn't any rosier given the tensions with Russia. And with our 10-year government bond rates at 2.4% versus those of 0.5% in Japan, 0.93% in German, 1.3% in France, and 2.4% in Italy2, our bonds seemingly do look like a good buy. Not to mention the demographic overhangs, with pension plans focused on liability driven investing (NYSE:LDI) and retirees needing income, creating what we see as a sustainable, longer-term demand for fixed income products. It is also important to keep in mind that if and when the Fed starts to raise "rates," we are talking about the Federal Funds Rate which we expect will primarily impact the short end of the yield curve, and much less so those 5-year, 10-year and longer maturities.
But for the sake of argument, let's assume that rates do rise from here. What does that mean for the high yield market? The traditional thought is that as interest rates rise, bond prices fall. But looking at history, the high yield market has defied this widely held notion. Let's examine the four main reasons why high yield bonds have historically performed well during times of rising interest rates.
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 current yields, coupons, and the spread over Treasuries for several fixed income asset classes.3
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 a significantly less impact. So the higher the yield, the less the interest rate sensitive the bond per the duration calculation that we discuss below and the more income is being generated to offset any impact from a bond price response to the interest rate move.
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 asset classes. We've profiled some duration comparisons below:4
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 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 often improve as well. 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 low to moderate economic growth, we are still seeing solid fundamentals for corporations and a well below average default outlook for the next couple of years5:
High yield bonds are negatively correlated with Treasuries. This means that as Treasury prices go down due to yields (interest rates) increasing, 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 fairly low correlation; yet, we see a strong 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 -0.21 and -0.38, respectively, versus a far higher correlation of +0.62 for high-grade bonds.6
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 can help serve to improve portfolio diversification and potentially lower risk depending on the mix of assets. On the flip side, an allocation to investment grade not only provides you a much lower starting yield but can result in significantly more interest rate sensitivity.
In short, while we don't see a spike in rates on the horizon, even if your take is that they will rise, we believe that the general high yield market is positioned well. Within this asset class, we feel the real opportunity for investors is in actively managed portfolios, where managers can avoid overly valued securities and focus on yield generation. For more on the high yield market's historical performance during periods of rising rates and the current strategies in place, and their deficiencies, to address a potential rising rate environment, see our updated piece, "Strategies for Investing in a Rising Rate Environment."
1 Data sourced from Bloomberg and U.S. Treasury, Daily Treasury Yield Curve Rates as of 8/29/14.2 Data sourced from Bloomberg as of 9/2/14.3 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 7/28/14. 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. 4 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 7/28/14. The Modified Adjusted Duration is a measure of interest rate sensitivity based on the yield to maturity date. 5 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. "Credit Strategy Weekly Update," J.P. Morgan North American High Yield and Leveraged Loan Research, June 20, 2014, p. 12. 2014 default rates exclude TXU. 6 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. "2013 High Yield-Annual Review," J.P. Morgan North American High Yield Research, December 23, 2013, p. 296.
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