With a number of data points over the past month, including Friday’s better than expected jobs report, pushing the expectations for a September rate hike higher, concerns about the impact of interest rates on various asset classes is heating up. It is important to keep in mind that if and when “rates” do rise, we are talking about the Federal Funds Rate which we expect will primarily impact the short end of the yield curve, and less so those 5-year to 10-year maturities that relate more to the high yield market. While we aren’t convinced that we will see a big spike in these longer term rates, we have certainly seen much volatility over the past month and a half.
As we have written about on numerous occasions, historically we have seen high yield bonds perform well during periods of rising rates.1 We would attribute this to a number of factors, including the relatively lower duration (a measure of interest rate sensitivity) of the high yield bond market versus other fixed income asset classes2, the higher starting yields this market generally provides, and high yield bonds tend to be more driven by the fundamental backdrop, and rates are usually rising during periods of improved economic times, which bodes well for credit fundamentals.
Not only has high yield historically performed well during periods of rising rates, some expectations we saw for 2015 forecasted rates to rise and high yield bonds to still post what we would view as decent performance. For instance, at the end of 2014, J.P. Morgan published this forecast:3
With our rates team forecasting a 90bp increase in 5-year Treasury yields to 2.60% by YE15, high-yield bond spreads are forecasted to tighten 90bp to end 2015 at T+450bp (absorb 100% of rate increase). A forecasted spread of T+450bp compares to a low for this credit cycle of T+393bp in June (2014), and typical spreads of between 300-400bp in a low default backdrop…And using these targets, our 2015 full-year return forecast for high-yield bonds is 7.0%.
While certainly these are merely projections for the broader high yield market and actual results can always vary, it does go to show that we aren’t the only ones expecting high yield to weather a potential interest rate increase. Spreads for high yield bonds currently sit at 513 bps4, so well above the “typical spreads” they note above for this sort of default backdrop. This compares to spreads of 540 bps when they made this forecast in December 2014.5 So we have seen some spread compression so far this year, but according to them we would still have room to compress further. And then on the 5-year Treasury yield side, even with all of the volatility we have seen over the past couple months in rates, the 5-year yield currently sits at 1.64%, versus closing out 2014 at 1.65%.6
So we certainly don’t see it as a foregone conclusion that all fixed income asset classes, including high yield bonds, will perform poorly if rates do rise this year, as history and expectations for the high yield bond market would indicate otherwise. Other fixed income asset classes have historically been more correlated and sensitive to interest rates, but we haven’t historically seen those same issues in the high yield bond market. We would agree instead that spread compression can occur this year, due to the improved fundamental backdrop that would cause rates to rise, and that, along with the tangible coupon income the high yield bond market provides, could more than offset a potential rate impact.
1 See our writings “Strategies for Investing in a Rising Rate Environment” and “High Yield in a Rising Rate Environment: Duration and Yield” for historical returns data.