Higher Rates and High-Yield Bonds

Higher Rates and High-Yield Bonds

Fears of a “great rotation” out of fixed income have gripped investors for the past few years as the Federal Reserve moves closer to raising interest rates for the first time in nearly a decade. For anyone who has studied the fixed income market, one of the first things you learn is the inverse relationship between interest rates and bond prices: when interest rates rise, bond prices fall. Does this mean riskier corporate bonds with higher relative interest rates, otherwise known as high-yield bonds, are a bad investment when interest rates are set to increase? Empirical data suggests this isn’t the case. In fact, not only do high-yield bonds currently provide an attractive yield of 7% (as of 9/1/15), they also tend to outperform other fixed income securities when interest rates are rising.
The media has a habit of hanging on every word Janet Yellen says in hopes of pinpointing the exact date the Federal Reserve will begin increasing interest rates. Of course, this date is a moving target because the Fed is “data dependent.” The Fed will not raise rates until they are confident that the economy is strong enough to support a rate hike. In a strong economy, production and consumer spending increase. Both of these things are positive for the high-yield corporate bond market. Since the primary risk associated with high-yield bonds is credit risk, historically the price of high-yield has been positively correlated with economic growth and the business cycle. The Federal Reserve has initiated five tightening cycles in the past three decades (source: federalreserve.gov), and the Barclays U.S. High Yield Index outperformed the Barclays U.S. Aggregate and the Treasury Index in every period but one (1999 rate hike cycle). During these five periods, U.S. high-yield posted an average one-year return of 4.2% (source: Data gathered from Barclays Indices on 8/12/15).
Duration, an approximate measure of a bond’s price sensitivity to changes in interest rates, is a closely followed metric in the fixed income world. Duration measures the time it takes to recover cash flows from the bond you own. The longer the duration, the more sensitive the bond price is to changes in interest rates. High-yield bonds tend to have shorter durations relative to most other fixed income securities, and thus are less sensitive to changes in interest rates. This trait has historically supported high-yield during tightening cycles, which could prove to be important in the second half of 2015 as we move closer to the reality of a rate hike.
Approximately 15% of high-yield issuers are in the oil and gas industry (source: Barclays High Yield Index). This caused the asset class to underperform the broader fixed income market earlier this year as low oil prices took a toll on sentiment. This created an attractive entry point, and Sand Hill chose to re-establish a strategic allocation to high-yield fixed income. At a yield of 7%, valuations remain attractive and currently offer a higher premium above U.S. Treasuries than at the start of past tightening cycles. While corporate fundamentals are mixed depending on the sector, fundamentals have improved since the financial crisis. According to Morgan Stanley, interest coverage ratios, a measure of a company’s ability to make interest payments, are at an all-time high and defaults are still running at around 2% – well below the long-term average of 4.5%.
When valuations are attractive and fundamentals are robust, as they currently are in the high-yield space, Sand Hill seeks to use any interim volatility to our advantage to add value to portfolios. Each tightening cycle is unique, and volatility almost always occurs around major changes in Fed policy. However, the first rate hike does not mark the end of a cycle, and high-yield credit has historically performed well several years into an interest rate cycle.

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Information provided in written articles are for informational purposes only and should not be considered investment advice. There is a risk of loss from investments in securities, including the risk of loss of principal. The information contained herein reflects Sand Hill Global Advisors' (“SHGA”) views as of the date of publication. Such views are subject to change at any time without notice due to changes in market or economic conditions and may not necessarily come to pass. SHGA does not provide tax or legal advice. To the extent that any material herein concerns tax or legal matters, such information is not intended to be solely relied upon nor used for the purpose of making tax and/or legal decisions without first seeking independent advice from a tax and/or legal professional. SHGA has obtained the information provided herein from various third party sources believed to be reliable but such information is not guaranteed. Certain links in this site connect to other websites maintained by third parties over whom SHGA has no control. SHGA makes no representations as to the accuracy or any other aspect of information contained in other Web Sites. Any forward looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. SHGA is not responsible for the consequences of any decisions or actions taken as a result of information provided in this presentation and does not warrant or guarantee the accuracy or completeness of this information. No part of this material may be (i) copied, photocopied, or duplicated in any form, by any means, or (ii) redistributed without the prior written consent of SHGA.


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