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Fixed-Income Insights

As anticipation builds for the Federal Reserve to begin normalizing interest rates in 2015, we examined the performance of U.S. high-yield securities during five prior periods of Fed rate hikes.

 

In Brief

  • U.S. fixed-income returns in 2015 likely will be heavily influenced by the timing of interest-rate hikes by the U.S. Federal Reserve and the speed with which they occur.
  • The recent strength in U.S. high-yield securities, and the complementary weakness in U.S. Treasuries, reflects investor anticipation of Fed tightening. But what happens to the U.S. high-yield sector when the Fed actually raises interest rates?
  • In four of the last five intervals of Fed rate hikes since 1986, the BofA Merrill Lynch High Yield Index outperformed the Barclays U.S. Aggregate Bond Index (a broad barometer of the U.S. fixed-income market). In three of the five periods, the High Yield Index outperformed the two-year U.S. Treasury note.
  • The key takeaway—Right now, the criteria that favor interest-rate hikes by the fed—stronger U.S. economic growth and slightly higher inflation—seem to argue for U.S. high-yield securities. 

 

While investment returns may diverge for many reasons in 2015, including the impact of currency and economic growth differences, U.S. fixed-income returns likely will also be heavily influenced by policy moves from the U.S. Federal Reserve. The timing of Fed interest-rate hikes and the speed with which they occur will influence the relative performance of different fixed-income sectors. The U.S. high-yield sector may be one fixed-income area that can perform relatively well if the Fed begins raising interest rates in June or in December.

As 2015 began, prices of U.S. high-yield securities were more attractively priced than a year earlier. As of January 30, 2015, the BofA Merrill Lynch High Yield Index carried an effective yield of 6.59%, compared with 5.84% at the same point in 2014. The yield spread versus U.S. Treasuries suggests the sector is even more attractive on a relative basis.

The spread versus Treasuries was 543 basis points (bps) on January 30, 2015, more than 100 bps cheaper than the level of 429 bps one year earlier. Concerns surrounding the energy sector are one reason behind lower prices for high-yield securities, but the market also was influenced by an increase in “risk off” behavior by investors.

Concerns about slower global growth, deflation in Europe, and related strength in the U.S. dollar caused some investors to question the pace of U.S. economic growth—and the level of risk in their portfolios. As a result, redemptions of U.S. high-yield funds increased to $28 billion during the second half of 2014.

Shifting Sentiment
However, at the end of January and in the first week of February, evidence of better-than-expected U.S. economic growth began to unfold, and high-yield redemptions were replaced with net inflows, as seen in Chart 1.  

 

Chart 1. Demand for U.S. High-Yield Securities Has Recently Increased
Weekly fund flows ($ in millions)

Source: Lipper.
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.

 

As a result, U.S. high-yield securities improved in price and fell in yield. The shift in investor sentiment, and the resulting improvement in high-yield prices, was related to several indications of economic strength. Fourth-quarter consumer spending was surprisingly strong at 4.3%, according to the Bureau of Economic Analysis. Surveys of purchasing managers in the manufacturing and services sectors showed improved outlooks. Vehicle sales had their best January in nine years. 

Most influential, however, in terms of impact on the market, and potentially, on Fed policy, was the January U.S. employment report released by the Bureau of Economic Analysis. Jobs growth of 257,000 exceeded the economists’ consensus estimate of 230,000, according to Bloomberg. Revisions to November and December data revealed that more than one million jobs were created in the three-month period ended January. The accelerating pace of job creation, which is one pillar supporting the case for interest-rate hikes by the Fed, was supplemented by evidence of a second pillar: wage inflation. The U.S. employment cost index rose to 2.2% in January (year over year), compared with 1.7% in December 2014, according to the Bureau of Labor Statistics. The combination of significant jobs growth and wage inflation over 2% offered the first evidence that would allow the Fed to justify raising interest rates in June. 

By the end of the first week in February, the effective yield on the BofA Merrill Lynch High Yield Index (the High Yield Index) fell 30 bps to 6.29% and the yield spread of the index versus U.S. Treasuries compressed, from 543 bps to 487 bps. There are two insights to be gleaned from these developments: 1) stronger economic activity supports investor interest in high-yield securities and 2) an increased likelihood of Fed rate hikes does not necessarily hurt the U.S. high-yield sector. Even after this recent improvement, yields and spreads in the U.S. high-yield sector still remain more attractive than this time last year.

High Yield and Historical Rate Hikes
This recent strength in high yield and the complementary weakness in Treasuries reflect investor anticipation of Fed tightening, and the economic growth and inflation conditions that would precede it. But what happens to the U.S. high-yield sector when the Fed actually raises interest rates? An examination of the five periods of Fed rate hikes since 1986 lends some insight. As shown in Table 1, in every period but the June 1999 to May 2000 period, the High Yield Index outperformed the Barclays U.S. Aggregate Bond Index, a broad barometer of the U.S. fixed-income market.

 

Table 1. High Yield Has Performed Well, on Average, During Previous Fed Tightening Cycles
Total return by index during indicated periods of Federal Reserve rate hikes

Source: Federal Reserve Bank of New York, Barclays, BofA Merrill Lynch, Citigroup. Two-Year U.S. Treasury= Citi Treasury Benchmark 2-Year Index. Barclays Aggregate=Barclays U.S. Aggregate Bond Index. BofA U.S. HY Index=BofA Merrill Lynch High Yield index.
Past performance is no guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Due to market volatility, the market may not perform in a similar manner in the future.
The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

 

The High Yield Index outperformed even the perceived safety of the two-year U.S. Treasury note in three of these five periods. Combining all five periods, the High Yield Index provided an average return of 3.84%, compared to 1.21% for the Barclays Aggregate Index and 2.42% for the two-year Treasury Index. 

The Fed Factor in 2015
This is no guarantee that high yield will outperform when the Fed’s widely anticipated policy tightening finally takes place. However, the historical returns of the High Yield Index imply economic sensitivity, rather than rate sensitivity, for the asset class, and the importance of the higher yield that accrues over time. If the Fed is able to raise rates as early as June 2015, the economic growth needed to justify Fed action would likely support economically sensitive high yield securities. Furthermore, let’s say that if instead of raising interest rates every month or at every Fed policy meeting, as has happened historically, the U.S. central bank opts for a slower approach, such as hiking the fed funds rate every other meeting. This slower timetable would mean that the higher yield of below investment-grade securities would have more time to accrue and compound, potentially enhancing performance relative to other fixed-income assets. The cautious approach of the current Fed under the leadership of Chairwoman Janet Yellen seems to allow higher yielding securities a better environment to add to performance via yield or income, compared to lower-yielding fixed-income choices.

And if the Fed does not raise rates until December 2015, investors in U.S. high-yield bonds will benefit from the wide yield spread of the sector versus Treasuries for much of the year, again contributing to performance relative to other fixed income sectors. The criteria that favor rate hikes, stronger economic growth and slightly higher inflation, seem to argue for U.S. high-yield securities, regardless of whether those conditions allow the Fed to launch an interest-rate “liftoff” in June or December.

 

What Happens When The Fed Finally Hikes Rates?

How might various investments react after the Federal Reserve starts raising interest rates? In this series, Zane Brown looks at the potential impact on:

▪ High Yield
▪ Bank Loans
▪ Short Duration
▪ Equities

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