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Fixed-Income Insights

Should interest rates rise significantly from current levels, history suggests that high-yield bonds could outperform higher-rated fixed-income securities. 

 

In Brief

  • Investors remain concerned that if yield spreads of high-yield securities versus U.S. Treasuries widen back to normal, then high-yield bonds might fall in price even more than higher-rated bonds.
  • But history suggests that yield spreads have narrowed as interest rates have risen, not widened. Further, longer-term studies have found an extremely low correlation between representative high-yield and U.S. Treasury indexes.  
  • Further, high-yield bonds outperformed Treasuries in terms of relative yield changes in each of the last seven periods of rising interest rates.
  • The key takeaway: Should interest rates rise significantly from their current levels, any price declines in high-yield bonds could be more than offset by the larger income stream they offer, potentially allowing them to outperform higher credit-quality securities on a total return basis.

 

The Federal Reserve’s tapering of bond purchases and the prospect of increases in the fed funds rate in 2015 have investors fearful of the prospect of associated price declines in fixed-income securities, especially among longer-term, higher credit-quality bonds. High-yield bonds can offer higher yield to offset some of this risk, but concern remains that if yield spreads versus U.S. Treasury securities widen back to normal, high-yield bonds might fall in price even more than higher-rated bonds.

Those worries may be misplaced. A thorough analysis reveals that high yield has performed surprisingly well even when spreads have returned to normal, but more important, history suggests that yield spreads have narrowed as interest rates have risen, not widened. Although there is no guarantee high-yield bonds will perform in a similar manner under similar conditions in the future, such behavior from high-yield bonds implies some protection from the full impact of rising Treasury rates, and may reinforce investors’ decisions about whether to include high-yield bonds as a tactic to address the impact of rising interest rates on bond portfolios.

It should not be too surprising, then, to find that historically high-yield spreads relative to Treasuries have compressed as interest rates have risen. If interest rates rise, a frequent cause may be stronger economic growth—a phenomenon that favors the economic health of high-yield companies, potentially reducing default risk. The combination of the higher interest income provided by high-yield bonds, along with the perception of reduced default risk, could attract investor interest to the asset class, supporting prices in the process. 

Also, as yields rise and prices on higher credit-quality securities such as Treasuries fall, investors may seek higher-coupon securities that may cushion the impact of rising rates. Investor behavior, then, can also help support prices in the high-yield sector at the same time that prices may be falling among lower-yielding, higher credit-quality securities.

Low Correlation
The fact that high-yield securities may perform differently from or even opposite to more highly rated bonds or Treasury securities is well documented. Longer-term studies of close to 25 years have found correlation of less than 0.06 between the Barclays U.S. High Yield Index and the Barclays U.S. Treasury Index,1 and even a negative correlation of -0.01 between the BofA Merrill Lynch High Yield Master II Index and an index of seven- to 10-year Treasury securities, according to Advent Capital Management.2  In terms of the specific behavior of high-yield spreads during periods of rising interest rates, Chart 1 is instructive. 

 

Chart 1. High-Yield Spreads versus Treasuries Historically Have Narrowed During Periods of Rising Interest Rates
Yield spread of the Credit Suisse High Yield Index versus Treasuries, April 30, 1988-April 30, 2014

Source: Credit Suisse. Yield spreads represented by the Credit Suisse High Yield Index.
Past performance is no guarantee of future results.
It is important to note that the high-yield market may not perform in a similar manner under similar conditions in the future. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

The chart illustrates the yield spread, since April 1988, between high-yield bonds and underlying Treasury securities. During this time, there have been seven instances in which the yield on the 10-year Treasury note has risen at least 100 basis points within a 16-month period. Those seven periods of rising interest rates are represented by the shaded areas beneath the yield spread. Note that in every period of rising interest rates depicted in the chart, the high-yield spread (highlighted in gold) has declined. This compression in the yield spread suggests that in such a rising interest-rate environment, high-yield bonds not only have offered higher income than underlying Treasuries but also better price performance.

Table 1 extends this analysis. Each of the seven rising interest-rate environments is described by the rise in the 10-year Treasury yield during that time. The comparable movement of high-yield securities is listed for each rising-rate environment. Not only did high-yield bonds decline less in yield than the market for 10-year Treasuries for the first four periods, but beginning in December 2008, the yield on high-yield bonds actually declined during the next three rising interest-rate environments, suggesting an absolute price rise during those three periods when 10-year Treasury prices fell. Even in those four periods of rising rates listed in which high yield also rose, it rose on average 47%, or less than half the increase of Treasury yields. This historical yield behavior on the part of high-yield bonds would be welcome in a rising interest-rate environment, and is even more appealing when accompanied by the higher income stream of high-yield bonds.

 

Table 1. High-Yield Has Outperformed Treasuries in Past Periods of Rising Interest Rates
Yields on the Credit Suisse High Yield Index and the 10-year U.S. U.S. Treasury note during the last seven periods of rising interest rates

Source: Credit Suisse and Bloomberg.
*High yield declined in yield (rose in price) as Treasury yields rose (declined in price).
Past performance is no guarantee of future results.
It is important to note that the high-yield market may not perform in a similar manner under similar conditions in the future. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Investment Implications
Rising interest rates should be concerning to fixed-income investors. And investors purchasing high-yield securities at below-average spreads relative to Treasuries should remain cautious. But history suggests that in the past seven rising interest-rate environments, high-yield investors also have not had to worry about widening high-yield spreads.  In fact, spreads have tended to narrow. In the future, if spreads don’t narrow but remain steady, high yield will be impaired by rising rates. But a larger income stream could still allow high-yield to outperform higher credit-quality securities on a total return basis.

 

1 Frank K. Reilly, David J. Wright and James A. Gentry, “Historic Changes in the High Yield Bond Market,” Journal of Applied Corporate Finance (Summer 2009).
2High Yield Bonds in a Low Rate World, June 2013, Advent Capital Management, LLC.

 

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ABOUT THE AUTHOR

RELATED FUND
The Fund seeks to deliver current income and the opportunity for capital appreciation by investing primarily in high yield corporate bonds.
RELATED FUND
The Fund seeks to deliver high current income and long-term growth of capital by investing primarily in a variety of fixed income securities and select equity-related securities.

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