As investors assess their interest rate sensitivity for fixed income holdings, they often turn to the duration calculation, a measure of the sensitivity of the price of a fixed-income security to a change in interest rates. Per this hypothetical calculation, rates/yields and prices move in opposite directions, so when interest rates are increasing, that would mean that bond prices are falling, and vice versa in as rates fall.

Yes, per this calculation bond prices would fall as rates rise, but looking back over history, we have actually seen high yield bonds perform well during periods of rising rates. How can this be if bonds are supposed to fall when rates rise? There are a few shortfalls with this hypothetical duration calculation that we believe investors should keep in mind. First and foremost, investors need to take into account the coupon income that these bonds generate over the period of rising rates, which may help cushion any rate move impact and still provide the investor with tangible returns.

Second, interest rates generally rise during periods of an improved economic environment. When economic times are tough, we generally see the world’s central banks easing rates to help stimulate the economy. However, when economies start to improve, this gives these central banks room to start raising rates. Even talk on the Fed’s timing right now is “data dependent,” meaning the stronger economic data has to be there for the Fed to start taking action. And stronger economic activity generally is favorable for corporate profits, credit metrics, and company fundamentals alike. Thus, during these times of rising rates and economic expansion, high yield bonds may also benefit from spread compression, meaning the prices of the bonds may be bid up on the improved fundamentals or investor demand and the spread between the yield offered on these bonds and the comparable yield on the equivalent Treasury decreases. In essence, if spreads were constant that means high yield bond prices were declining/yields increasing in lock step with the rate/yield increases in Treasury bonds, yet if we see spread compression, that could mean that prices are holding firm to moving up to more than offset the Treasury yield move.

Let’s put some numbers to this. First, let’s look back at all of the historical full monthly periods when we have seen 10-year Treasury rates rise by 50bps or more over the preceding three and six months or 100bps over the preceding six months, with data going back to 1986 (when the high yield index data begins).¹

By these historical numbers, the assumption that high yield bonds perform poorly during times of rising rates appears to not be valid. In actuality, we have seen positive returns for this market as 10-year rates move. For instance, during periods when rates have risen 50bps over six months, the high yield bond market has posted a return of 4.5% over that six month period. Even during periods of rapid rate increases, with the 10-year yield increasing 100bps over a six month period, high yield bonds have posted an average return of 2.4%.

Then looking forward at the succeeding six and twelve months, we continue to historically see high yield bonds post positive returns in the periods following these rate moves for the 10-year Treasury:

While the 10-year is a widely quoted rate, if we look at equivalent interest rate moves in full monthly periods for the 5-year Treasury, which is more in-line with the average maturity of the high yield bond market, we see similar results:

Here again, positive returns and spread compression during the three and six month period of rising rates, even during periods where we see the 5-year rise 100bps over a six month period. Additionally, returns for the periods following these rate increases also remain positive:

For instance, we see an average 11% return historically following periods when the 5-year Treasury rose 100bps or more over the preceding six months.

In all of these scenarios, it seems that history clearly indicates that rising rates don’t necessarily spell doom for the high yield bond market. Historical average returns for the high yield bond market have been positive during both periods of rising rates and during the six and twelve months following those rate increases, as this market can benefit from the coupon income generated and the better economic environment that often accompanies rate increases. We believe that instead of shunning the high yield bond market on the assumption that it is bound to fall if Treasury rates continue to increase, investors should instead view the recent weakness in the market as a better entry level to the asset class, as we believe investors may benefit from not only what we view as attractive, tangible coupon income and a potential benefit on improved economic conditions that often go hand in hand with rate increases.

¹ 5-Year and 10-Year Treasury data sourced from Bloomberg for the period 12/31/1985 to 5/31/2015. High Yield market data based on the Credit Suisse High Yield Index for the period 12/31/1985 to 5/31/2015. The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.  Calculations based on month ending yields for 5-year and 10-year Treasuries and tracking the trailing three and six month full month moves in those rates (intra-month moves not accounted for). All months are included in which the previous move in Treasuries was above the indicated threshold, even if there were consecutive months that hit the threshold (time periods were not grouped together). All return and spread data based on month end data and analysis month over month (no intra-month analysis). Spreads used for the Credit Suisse High Yield Index is the spread-to-worst. Averages based on all of the individual monthly periods that meet the indicated thresholds. Past returns and spread moves are not an indication of future results.