The Bottom Line
- High yield bonds (i.e., below-investment-grade) tend to behave very differently than “core” sectors of the bond market—an important consideration during periods of rising interest rates.
- As shown above, the Bloomberg Barclays U.S. Corporate High Yield Bond Index produced positive results during 9 of the past 10 periods when the benchmark 10-year U.S. Treasury yield rose by more than 100 basis points.
- In contrast, the Bloomberg Barclays U.S. Aggregate Bond Index—composed of investment-grade Treasuries, government-agency, corporates and securitized (mortgage-backed, asset-backed, commercial mortgage-backed) securities—had negative returns during these periods.
- Looking specifically at the Federal Reserve tightening cycle last decade—a two year period of gradual rate increases that occurred between June 2004 and June 2006—high yield also notably outperformed with a cumulative total return of +16.18% compared with +5.94% for the aggregate index.
- Investors may find the comparison with the 2004-2006 tightening cycle particularly relevant given that the current cycle is expected to play out gradually, barring unforeseen changes in the economic environment.
- Why has high yield fared well when interest rates increased? Primarily because of the higher income—or coupon payment—they offer, which lowers duration or interest rate sensitivity.
- That’s because the higher the coupon, the greater contribution it will likely make to duration—which is the weighted average of all the present values for a bond’s cash flows (both coupon payments and the final payment of principal)—relative to the final principal payment, which (because it comes at the end) has the most interest rate risk.
- Higher yield and lower duration are an attractive combination in today’s environment, given investors’ ongoing interest in attractive income that can stand up to future rate changes.
- Of course, high yield also exposes investors to greater default risk and price volatility, which makes individual security selection—and therefore active management—critical to success.
Sources: Bloomberg and Legg Mason