High-Yield Bonds in a Time of Rising Rates
The prices of bonds generally move inversely to interest rates, except when they don’t. High-yield corporate bonds, for example, may defy this expectation under some circumstances.
High-yield bonds are issued by companies with lower credit ratings – typically BB and below. As such, their ability to pay interest and principal on the bonds is more closely tied to the strength of the overall economy, than is generally the case for investment-grade issuers. Investment-grade bonds generally move in relation to the “risk-free” yield – Treasurys. High-yield bonds are sensitive to rates, too, but they tend to have more of a relationship with the “credit spread” or their yields in excess of U.S. Treasury bonds with comparable years to maturity. Because their issuers benefit from a strong economy – when improved cash flow and profitability make it easier to service debt – prices can be stable or even go up during periods of rising interest rates, if their credit spreads narrow.
High-yield bonds have other potential benefits as well. The maturities are often shorter – 10 years or less – which can help dampen volatility, and they may include some form of call protection, meaning the issuer can’t refinance them if rates go down. By their nature, they provide some buffer against rising rates, particularly for those who choose to reinvest the income. If the price of the bond moves down, the interest is reinvested at the lower price point – with the higher level of return from the coupon. In this scenario, the investor is essentially using dollar-cost averaging to invest at lower prices with higher yields. And, most high-yield ETFs pay interest on a monthly basis.
Correlation with the S&P 500
Given their equity-like risk profile, it’s no surprise that high-yield bonds are actually far more closely correlated to the S&P 500 than to 10-year U.S. Treasury bonds. For the 10-year period ending December 31, 2016, the Merrill Lynch US High Yield Index had a correlation of .73 vs. the S&P 500 as compared to a correlation of 0.19 vs. the change in the yield on the 10-year U.S. Treasury bond. For the 20-year period also ending December 31, 2016, the correlations are .62 and 0.15, respectively.
High-Yield Correlation with the S&P 500 Index
Source: Bloomberg, as of 12/31/16.
It’s increasingly looking like the decades-long bull market in bonds is coming to a close. At a minimum, the Federal Reserve seems determined to keep ratcheting up the Fed Funds Rate, with two more bumps anticipated for this year. Assuming those increases are driven by an improving economy, high-yield bonds may prove resilient.
All investments are subject to risk and will fluctuate in value. Alternative investments are speculative, entail substantial risk, and are not suitable for all clients. Alternative investments are intended for experienced and sophisticated investors who are willing to bear the high economic risks of the investment. Investments in absolute return strategies are not intended to outperform stocks and bonds during strong market rallies. Hedge funds and hedge fund of funds can be highly volatile, carry substantial fees, and involve complex tax structures. Investments in these types of funds involve a high degree of risk, including loss of entire capital. Treasurys are backed by the full faith and credit of the Federal government as to the time payment of principal and interest.
The Merrill Lynch US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.
The Standard & Poor’s 500, often abbreviated as the S&P 500, or just “the S&P”, is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.
Correlation is a statistic that measures the degree to which two securities move in relation to each other.
Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation.
Credit spread is the difference in yield between a U.S. Treasury bond and a debt security with the same maturity but of lesser quality.
Risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.
The information and opinions contained herein are for general information use only. IndexIQ does not guarantee their accuracy or completeness, nor does IndexIQ assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are as of the date of this report, are subject to change without notice. Past performance is no guarantee of future results.
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