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 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. This article was written by Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisory firm of the AdvisorShares Peritus High Yield ETF (HYLD).