With the move we have seen in interest rates (Treasury rates) over the past month and the concerns that this move up will continue, let’s look at the high yield market and how it has traditionally responded to rate moves. Historically speaking, the high yield bond market has performed well in a rising rate environment due to a number of factors.
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 the current yield-to-worst, coupon, and the spread over Treasuries for several fixed income asset classes.1
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 significantly less impact, at about a 17% change in yield. So the higher the starting yield, the less interest rate sensitivity.
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 fixed income asset classes. We’ve profiled some duration comparisons below:2
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 generally 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 generally improve. 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 minimal economic growth, we are still seeing solid fundamentals for corporations and a well below average default outlook for the next couple years:3