As we start the new year, much of the focus has been on interest rates. We’ve seen the Fed moving up the Fed Funds rate up for the last two years, all the while the 10-year Treasury yield hit the 3% level in early 2014 and has been trending under that ever since. Is 2018 finally the year we see the 10-year Treasury yield move up and sustain that upward momentum and if so, what will that mean for fixed income? While we continue to see constraints to a big spike in Treasury yields, including global rates (relative yields on sovereign debt around the world) and global demographics (an aging global population and continued demand for yield), we have clearly seen the upward trend in yields across the Treasury curve so far this year.
High yield bonds have historically performed well in rising rate environment.1 Yet the gut reaction with rising rates seems to be concerned about anything fixed income related. And for some long duration, low yielding securities (investment grade corporates and municipals as an example), that concern makes sense. If interest rates rise 1% in a year that will certainly matter a lot more for 10-year security that is yielding 3% versus a 5-year security that is yielding 7%. Duration is a measure of interest rate sensitivity incorporating maturities/calls and yields, the higher duration the more theoretical interest rate sensitivity. High yield bonds carry a much lower duration than many other alternatives in the fixed income space. For instance the duration on the investment grade index is 7.56 years while the duration on the high yield index is 4.0 years, indicating a much higher interest rate risk for investment grade debt.2 Within the high yield debt market, our active strategy focuses on maximizing yield relative to risk, and with that, our strategy tends to carry a higher yield than the high yield bond index and we additionally invest in floating rate loans, both of which allow us to target a duration even lower than that of the high yield index.
Keep in mind that the high yield indexes include securities across the ratings spectrum, from what we would call the “quasi-investment grade” BB names all the way to the C bonds. Often higher rated securities have smaller coupons (similar to what you would see in the investment grade world). If this rising rate environment persists, that can change the incentive for companies to refinance or call the low coupon debt early because the interest rates on new debt issuance will have to adjust for higher rates, thus could raise interest costs for these companies. We believe that the prices on many of these securities trading above their call prices may have to adjust to this fact, so that is something for investors to be aware of as they look at the broader indexes.
But it’s also important to keep in mind the reason that interest rates are currently increasing—a stronger economy. Historically rates increase in the face of a stronger economy, and stronger economic activity is undoubtedly a positive for corporate credit, as well as a positive for default rates. Historically, elevated credit and default risk are the biggest negatives for high yield debt. Default rates are expected to remain historically low and economic activity pick up, which creates a favorable credit backdrop for corporate issuers.
So we don’t feel that a higher interest rate environment and increasing treasury yields is the death nail for high yield. Nor do we see any systemic issues on the horizon that pose a massive risk to the downside. Many market prognosticators have been calling for coupon-like returns in high yield for 2018. We don’t disagree, though we may see some blips of volatility along the way just as we saw in 2017, and in each case of volatility in the high yield market last year that was ultimately met with buying. On the index level, spreads are relatively tight compared to historical levels. While there may be some room for further spread compression (price upside) we believe that is much more limited on the index-level, where many bonds are trading at or above their call prices, and as we noted above, if higher rates persist, we may even see some price widening for the very low yielding credits within the index that are trading to call prices. At the same time, we see an environment of improving corporate fundamentals, generally good liquidity and reasonable leverage at the individual company level, and the default rate to continue to trend well below historical averages, and we believe these fundamentals matter and will provide price support for the market.
If we are looking at coupon like returns for the year, the starting coupon is an important consideration. With our focus on yield and finding value, our strategy targets producing a yield that is higher than those offered by the high yield index and many of the index-based products. Additionally, we look for value and with that, our goal is to provide the potential for additional capital gains upside to further support returns. As we look at the year ahead, we believe that an actively managed, value-oriented high yield debt allocation can offer an attractive place to be positioned for yield seeking investors.