High-yield bonds have had a good run. But with interest rates rising, has the market run out of road? Don’t bet on it. The sector usually motors ahead when rates rise. And when it does decline, it rebounds rapidly.
Unlike many other types of bonds, high-yield bonds aren’t particularly sensitive to rising interest rates. That’s because rates usually rise as the economy expands, which leads to higher corporate profits and increased consumer spending. That’s good news for high-yield issuers and usually leads to lower default rates.
It also helps that the US Federal Reserve is raising rates at a measured pace. During its last tightening campaign, which took two years to complete, US high yield produced annualized returns near 8%.
What explains this performance? Simply this: higher yields eventually lead to higher returns. This goes for all bonds, but it’s especially important in high-yield bonds because the average life of a high-yield bond is just four or five years. Maturities, tenders and calls mean that the typical high-yield portfolio returns roughly 20% of its value every year in cash, allowing investors to reinvest the money in newer—and higher-yielding—bonds.
The End of QE: A New Risk?
Of course, the Fed isn’t just raising rates. It’s also about to begin quantitative easing (QE) in reverse. Over the next several years, it will shrink its massive balance sheet—swelled by its post–financial crisis asset purchases—by more than a trillion dollars. This, along with its rate hikes, will tighten conditions further. And the Fed probably won’t be alone. The European Central Bank may begin tapering its own monthly bond purchases this year and could end them in 2018.
We expect balance-sheet reduction to proceed gradually, and we don’t think it will be disruptive. But this is uncharted territory, and investors are understandably concerned about what it will mean for markets and economic growth. It’s certainly possible that high-yield bonds and other risk assets could hit a rough patch.
High Yield: The Comeback Kid
Thankfully, high-yield sell-offs tend to be short-lived. Those who stay invested tend to recoup their losses quickly. Over the past two decades, high yield has recovered most big drawdowns—losses of more than 5%—in less than a year.
If you’re not a trader with a short time horizon, a brief downturn shouldn’t be a big concern. In fact, it might be an opportunity to acquire assets at attractive prices. During the 2013 taper tantrum, prices on BB-rated bonds fell, and credit spreads—the extra yield offered over comparable government debt—widened. By year-end, they’d more than recouped their losses. Last year, Brexit presented a similar opportunity in high-yield financials (Display).
Generally, we’ve found that the yield you start with when you invest in high yield is a pretty reliable indicator of what you can expect to earn over the next five years. Today’s yield-to-worst for the broad US high-yield market—the lowest likely return you should get barring significant defaults—is nearly 5.5%. For global high yield, it’s 5.1%. With 10-year US Treasury yields hovering around 2.25%, that’s nothing to sneeze at.
Worried About Volatility? Consider Shorter-Duration Bonds
High yield is also inherently less volatile than other risk assets, including equities. As a result, drawdowns tend to be shallower. That’s why the asset class is a good diversifier of investors’ overall equity exposure.
Focusing on short-duration high-yield bonds can limit volatility even further, since these bonds mature sooner than the average high-yield security. This increases portfolio cash flow and lets investors redeploy the proceeds in higher-yielding bonds more quickly.
Keep an Eye on Credit Quality—and Diversify
None of this means that investors should just buy the highest-yielding bonds on offer. For instance, many CCC-rated bonds from companies with fragile finances offer high yields but are likely to be the most vulnerable securities in a rising-rate environment. The outlooks for different sectors vary, too. At this late stage in the credit cycle, it’s more important than ever to conduct careful credit analysis on each and every bond before buying it.
Within high yield, it makes sense to take a global approach. For example, fundamentals in European high yield have improved, and key sectors, including European financials, are not as far along in the credit cycle as their US counterparts.
Investors may also want to diversify by adding other high-income assets such as emerging-market bonds, which benefit from improved economic fundamentals in the developing world and offer high inflation-adjusted yields.
The status quo for bond markets is changing. Central banks are on the verge of reversing quantitative easing, and rates and volatility are likely headed higher. But those who pull out when rates start to rise run the risk of locking in losses and missing the eventual rebound. For income-oriented investors with a long time horizon, that simply isn’t a viable option.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.