ETF Trends
ETF Trends

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 (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

2014.9.10_chart 2

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 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.

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