What might rising rates mean for high yield bonds?

Three reasons why high yield has performed well in past rising rate environments

May 25, 2018 | Scott Roberts and Shawn Pope

US interest rates have defied market expectations in recent years, staying historically low despite solid economic growth. But in the last year, and especially the last few months, rates have started to climb. The 2-year Treasury currently yields 2.58% compared to 1.92% at the start of the year and 1.31% a year ago.1 The 10-year Treasury yield has breached 3.0% in recent days, compared to 2.46% at the start of the year and 2.34% a year ago.1 What do these rate moves mean for high yield investors?

High yield has done well during periods of rising rates

High yield bonds performed well in the last rate-hiking cycle in the mid-2000s, and we at Invesco Fixed Income expect similar performance in the current cycle (Figure 1).

Figure 1: High yield vs. equities, leveraged loans, and investment grade bonds

High yield performed well during the rate hikes of the mid-2000s

Looking further back, there have been 17 quarters since 1987 when yields on the 5-year Treasury note rose by 70 basis points or more (Figure 2). In 11 of those quarters, high yield bonds demonstrated positive returns. In the six quarters when high yield bond returns were negative (highlighted in pink), the asset class rebounded the following quarter (highlighted in green). In our view, it is reassuring that high yield bonds have performed positively in past periods of rising rates and in the months afterward.

Figure 2: High yield performance in periods of rising rates

In fact, in the past 35 years, the high yield bond asset class has only experienced negative annual returns in five calendar years (Figure 3).

Figure 3: High yield market historical returns

Why has high yield done well in rising rate environments?

There are three reasons why rising rates by themselves may not be bad for most high yield bonds:

• Normally, rates rise as the economy is expanding. The expanding economy typically generates more profits for most companies and, with increased profits, companies may better service their debt. In this type of environment, we typically see lower or declining default rates and potentially tightening credit spreads.
• High yield bonds may offer call protection. When rates rise, issuers often refinance their debt before rates go higher. If an issuer refinances its debt before maturity, it normally pays a penalty (call price) that varies between 102 and 105. This pre-payment penalty is added to the returns of the high yield bond.
• The duration of high yield bonds is typically lower compared to investment grade bonds due to the comparatively short maturities and high coupons of high yield issues. For example, the Bloomberg Barclays U.S. Corporate High Yield Index has a modified average duration of 3.99 years, compared to 7.24 years for the Bloomberg Barclays U.S. Corporate Investment Grade Index.2

Key takeaway

As high yield investors, we are aware of duration risk and the volatility associated with interest rate movements. We believe that rising rates are not only associated with potentially improving fundamentals among high yield issuers, but also create opportunities for experienced active managers with an understanding of multi-cycle investing and a well-defined credit analysis process.

1 Source: US Department of the Treasury, data as of May 15, 2018, Jan. 2, 2018, and May 15, 2017.
2 Source: Barclays, as of May 21, 2018.

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