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High Yield Bonds in Rising Rate Environments

 

Entering 2021, many market participants were contemplating how high-yield bonds would perform in a rising rate scenario.

That scenario is becoming reality as the economic implications of a unified Democratic government have resulted in a bearish sentiment for rates, reflected by an increase in 10-Year U.S. Treasury yields from 0.91% on 12/31/20 to 1.16% on 02/05/21.

As of this writing, longer duration high-yield bonds have easily digested the recent rate move. In fact, bonds with maturities longer than 7 years have realized outsized spread tightening relative to shorter-term cohorts (see table below). This spread tightening has led to positive returns for high yield overall, with the Barclays U.S. Corporate High Yield Index returning 1.04%, outperforming the investment grade corporate index by 280 basis points (bps).

 

How does the year-to-date performance compare to other periods of rising rates?

Over the past decade, high-yield bonds have exhibited strong relative performance in periods of sharply rising rates, even after adjusting for duration. The Barclays Intermediate U.S. High Yield Index has outperformed the Intermediate Corporate index by an average of 180 bps annually over the last decade. However, if we narrow our view during the period to five instances where 10-Year U.S. Treasury yields rose by more than 75 bps, Intermediate High Yield has outperformed Intermediate Corporates by a staggering 548bps on average, with the former producing only one period (May-Sept 2013) of negative total return.

 

What are the implications for fixed income portfolios?

In addition to the potential for rising rates, fixed income investors are challenged by current valuations with the Barclays U.S. Corporate Investment Grade and U.S. Corporate High Yield indices in the 1st and 4th percentile, respectively, of the historical OAS range over the last 10-years. That said, we believe the case for continued outperformance of high-yield bonds is strong. First, BB and Single-B rated bond spreads are a bit more reasonable than overall index levels would suggest, in the 24th percentile of the 10-year range. Second, the excess spread offered by BB-rated bonds over BBB-rated bonds remains elevated relative to pre-pandemic levels and could compress in favor of BB-rated bonds as the economy recovers. Finally, as noted above, if we are in a rising rate environment historical data would suggest investors favor high-yield bonds. As always caution is warranted with credit selection, but high-yield may well continue to be a source of returns in these challenging markets.

 

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The opinions and views expressed are as of the date published and are subject to change without notice of any kind and may no longer be true after any date indicated. Information presented herein is for discussion and illustrative purposes only and should not be used or construed as financial, legal, or tax advice, and is not a recommendation or an offer or solicitation to buy, sell or hold any security, investment strategy, or market sector. No forecasts can be guaranteed, and the author and Smith Capital Investors assume no duty to and do not undertake to update forward-looking predictions or statements. Forward-looking predictions or statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking predictions or statements.

Any investment or management recommendation in this document is not meant to be impartial investment advice or advice in a fiduciary capacity and is not tailored to the investment needs of any specific individual or category of individuals. Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to changes at any time due to changes in the market or economic conditions. The information presented herein has been developed internally or obtained from sources believed to be reliable; however, neither the author nor Smith Capital Investors guarantees that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio.

Past performance is no guarantee of future results. As with any investment, there is a risk of loss. Investing in a bond market is subject to risks, including market, interest rate, issuer, credit, inflation, default, and liquidity risk. The bond market is volatile. The value of most bonds and bond strategies are impacted by changes in interest rates. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens. High yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.

Please consider the charges, risks, expenses, and investment objectives carefully before investing. Please see a prospectus, or, if available, a summary prospectus containing this and other information. Read it carefully before you invest or send money. Investing involves risk, including the possible loss of principal and fluctuation of value.

All indices are unmanaged. You cannot invest directly in an index. Index or benchmark performance presented in this document does not reflect the deduction of advisory fees, transaction charges, and other expenses, which would reduce performance.

This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission from Smith Capital Investors.

Smith Capital Investors, LLC is a registered investment adviser.

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