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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