Laying Low in a Storm of Equity Volatility and Rising Rates

by: , Director, Product Management, New York Life Investments

Investors have found themselves stuck between a rock and a hard place this year. On one hand, there have been bouts of equity volatility caused by growth and geopolitical concerns. On the other hand, rising rates give pause to investors looking to rotate into fixed income.

As of October 29, the S&P 500 is up a modest 0.32% year to date, after a hard fall from its September record high. After three rate hikes, the 10-year Treasury hit 3.23% in early October, causing U.S. core bonds, as represented by the Bloomberg Barclays US Aggregate Bond Index, to decline 1.99% year to date.

However, if you leave no stone unturned, you just might just find some gold after all. And by gold, I mean junk. And by junk, I mean non-investment grade bonds and floating rate loans. Through October 29, floating rate loans have made a steady climb to a 4.14% total return this year while short duration high yield has returned a relatively respectable 2.42% as shown in Figure 1.

Figure 1: Floating Rate Loans and Short Duration High Yield outperformed other major asset classes year to date

Source: Morningstar as of 10/29/2018.1

The resilience of floating rate loans and short duration high yield amid heightened equity volatility is not unprecedented. On a historical basis, as shown in Figure 2, equities outperformed both bonds and loans during periods of low volatility. Over 180 months, as the month end VIX level increases, that performance dispersion decreases. When equity volatility was high enough, the S&P 500 underperformed both loans and short duration high yield bonds during those months.

In this most recent sell-off, equities may be experiencing more of a risk-off sentiment due to those growth fears which have not caused the same reaction in fixed income investors. By most credit metrics, the financial health of bond and loan issuers is stable and default rates remain below historical averages.

Figure 2: Floating Rate Loans and Short Duration High Yield Proved resilient amid equity volatility

In the months of higher volatility, floating rate loans and short duration high yield outperformed equities.

Source: Bloomberg, Morningstar October 2003 – September 2018.2

What is also observed through a historical lens, is that floating rate loans and short duration high yield outperformed investment grade bonds during periods of rising rates. High yield tended to do well during rising rate environments because 1) it is a short duration asset class, 2) it is more credit sensitive than interest rate sensitive and 3) rates tended to rise when the economy is doing well. Most notably, lower rated bonds and loans have outperformed their higher rated counterparts given that interest rate sensitivity declines with credit quality.

Floating rate loan performance during rising rate periods is a little more straightforward to explain. The stated interest rate floats based on an underlying short-term reference rate, usually LIBOR. The notion that there is an inverse relationship between interest rate and price is predicated upon a fixed coupon, which a floating rate loan does not have. As short-term rates rise, all else equal, floating rate loan investors earn more income. Therefore, regardless of the shape of the yield curve, short term rate increases are beneficial to floating rate loans, and most strategists see a few more rate increases through the end of 2019.

Figure 3: Floating rate loans and short duration high yield outperformed investment grade during rising rates

Gray bars represent periods of rising rates. Table below are cumulative returns over respective periods

A

B

C

D

E

Short Duration High Yield
7.3
Short Duration High Yield
7.2
Floating Rate Loans
43.1
Short Duration High Yield
8.2
Short Duration High Yield
5.7
Floating Rate Loans
4.8
Floating Rate Loans
5.8
Short Duration High Yield
36.3
Floating Rate Loans
6.3
Floating Rate Loans
5.6
Short-Term Corporate Bonds
3.8
Investment Grade Corporates
2.1
Investment Grade Corporates
18.5
Short-Term Corporate Bonds
2.3
Short-Term Corporate Bonds
1.2
Investment Grade Corporates
(0.1)
Short-Term Corporate Bonds
2.1
Short-Term Corporate Bonds
12.8
Investment Grade Corporates
(0.1)
Investment Grade Corporates
0.5
Core Bonds
(0.2)
Core Bonds
2.1
Core Bonds
6.7
Core Bonds
(1.3)
Core Bonds
(0.6)

Source: Morningstar as of 9/30/18.3

In Figure 3, we look at five rising rate periods over the last 20 years, including the current period, and see that floating rate loans and short duration high yield outperformed US core bonds, US investment grade corporates, and US short term investment grade corporates in all five periods.

Volatile equity markets coupled with rising interest rates can understandably make investors uncertain as to how to construct their portfolios. Shorter duration, below investment grade fixed income, namely floating rate loans and short duration high yield, may make sense as a strategic allocation in a portfolio, and even more so as a tactical one given today’s market environment. However, both of these asset classes subject investors to credit risk, so it is particularly important to choose an experienced manager who specializes in fundamental credit analysis and the portfolio construction of floating rate loans and short duration high yield bonds.

1. Short Duration High Yield is represented by the ICE BofAML 1-5 Year BB-B Cash Pay High Yield Index; US Investment Grade Corporates are represented by the ICE BofAML U.S. Corporate IndexS&P 500: An unmanaged index of large-cap stocks commonly used as a measure of U.S. stock market performance. Floating-Rate Loans: S&P / LSTA Leveraged Loan Index, an unmanaged index of the institutional leveraged loan market. U.S. High Yield Corporate: ICE BofAML US High Yield Index, an unmanaged index of below-investment grade U.S. corporate bonds. Global Aggregate (ex-U.S.) Bonds: Bloomberg Barclays Global Aggregate Ex -U.S. Index, a broad-based measure of global Investment grade fixed-rate debt investments, excluding USD-denominated debt. E merging Markets Corporate Bonds: JPMorgan Corp. EM Bond Index (CEMBI) Broad Diversified, an unmanaged index of USD-denominated emerging market corporate bonds. U.S. Investment Grade Corporate Bonds. Emerging Markets Sovereign Bonds: JPMorgan Emerging Markets Bond Index (EMBI) Global Diversified, an unmanaged index of USD-denominated bonds with maturities of more than one year issued by emerging markets governments.

2. Short duration HY Short Duration High Yield is represented by the ICE BofAML 1-5 Year BB-B Cash Pay High Yield Index. Floating rate S&P / LSTA Leveraged Loan Index. VIX The VIX Index is an up-to-the-minute market estimate of expected volatility that is calculated by using the midpoints of real-time S&P 500® Index (SPX) option bid/ask quotes. More specifically, the VIX Index is intended to provide an instantaneous measure of how much the market “thinks” the S&P 500 Index will fluctuate in the 30 days following each tick of the VIX Index. No one person or committee determines the level of the VIX Index. Rather, the VIX Index reflects an equilibrium price for risk as reflected in the prices of SPX options, which rise, and fall based on the flow of orders from traders around the world. Past performance is not indicative of future results. It is not possible to invest directly into an index. Index definitions can be found at the end of this report.

3. Short Duration High Yield is represented by the ICE BofAML 1-5 Year BB-B Cash Pay High Yield Index; Core Bonds is represented by the Bloomberg Barclays U.S. Aggregate Bond Index; Bank Loans are represented by the S&P/LSTA Leveraged Loan Index; Investment Grade Corporates are represented by the ICE BofAML U.S. Corporate Index; and Short Term Corporate Bonds are represented by the ICE BofAML 1-3 Year U.S. Corporate Index. The periods of rising rates shown above are based on periods of rising 10-year Treasury yields. Performance for periods greater than a year has been annualized. Period A: 11/1/98-1/31/00, Period B: 7/1/03-6/30/06, Period C: 1/1/09-4/30/10, Period D: 8/1/12-9/30/13, and Period E: 8/1/16-9/30/18. Past performance is not indicative of future results. It is not possible to invest directly into an index. Index definitions can be found at the end of this report.

Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. New York Life Investments does not guarantee their accuracy or completeness, nor does New York Life Investments 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 subject to change without notice and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized.

Neither New York Life Investment Management LLC, nor its affiliates or representatives provide tax, legal or accounting advice. Please contact your own professionals.

About Risk

All investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.

Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results

Floating rate funds are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, borrower industry concentration, and limited liquidity. Securities that are liquid at the time of purchase may subsequently become illiquid due to events relating to the issuer of the securities, market events, economic conditions or investor perceptions. As a result, an investor could pay more than the market value when buying Fund shares or receive less than the market value when selling Fund shares.

High yield securities (junk bonds) have speculative characteristics and present a greater risk of loss than higher quality debt securities. These securities can also be subject to greater price volatility. Diversification does not guarantee profit or protect against loss.

Duration measures interest-rate sensitivity. The longer the duration, the greater the expected volatility as rates change. Fixed Income investing entails credit and interest-rate risks. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall.

High yield corporate bonds are represented by the Bloomberg Barclays High Yield Corporate Index, which measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.

High yield municipal bonds are represented by the Bloomberg Barclays High Yield Municipal Bond Index, an unmanaged index that includes municipal bonds that are non-rated or rated Ba1 or below. They must have an outstanding par value of at least $3 million and be issued as part of a transaction of at least $20 million. The bonds must have a dated-date after December 31, 1990 and must be at least one year from their maturity date.

Index Definitions

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.

The Bloomberg Barclays Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.

Bloomberg Barclays 1-5 Year U.S. Treasury Index – The index includes all publicly issued, U.S. Treasury securities that have a remaining maturity of greater than or equal to 1 year and less than 5 years, are rated investment grade, and have $250 million or more of outstanding face value.

The CBOE Volatility Index (VIX Index) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

ICE BofAML 1-5 Y BB-B Cash Pay HY Index tracks the performance of BB rated U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market with maturities of 1 to 5 years.

ICE BofAML US High Yield Index – The index tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.

The S&P 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The S&P/LSTA Leveraged Loan Index is a broad index designed to reflect the performance of U.S. dollar facilities in the leveraged loan market.

Consider the Fund’s investment objectives, risks, and charges and expenses carefully before investing. The prospectus and the statement of additional information include this and other relevant information about the Fund and are available by visiting nylinvestments.com/etfs or calling 888-474-7725. Read the prospectus carefully before investing.

New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, located at 51 Madison Avenue, New York, New York 10010, provides investment advisory products and services. IndexIQ® is the indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs, and NYLIFE Distributors LLC is a distributor of the ETFs. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Adam Schrier, CFA, FRM

Director, Product Management, New York Life Investments

Adam Schrier is a Director of Product Management at New York Life Investments, covering fixed income strategies with a focus on non-investment grade debt. Previously, he worked as a Product Manager for high yield and emerging market debt at Invesco in New York

Full Bio

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