Rising Interest Rate Elixir…..High Yield
As I am writing this Tuesday morning, the Federal Reserve is about to embark on its two day meeting to discuss current and future interest rate policy moves. It is widely expected that tomorrow, the last meeting of the year, the Fed will raise the Fed funds rate by a quarter point to .75%. Interestingly enough the bond market has already priced this rate hike into the market as the 10-year has spiked from 1.88% before the election in November to 2.48% as of the close of yesterday. The bond market and investors are looking past this rate hike and will be listening closely to expectations about the pace of rate increases heading into 2017.
No matter what the pace is, investors need to think about protecting their fixed income portfolio from a rise in interest rates. One way to reduce interest rate risk is to own an allocation of high yield bonds. As the chart shows below, in all periods over the last twenty years where interest rates have risen over 100 basis points or more, high yield bonds have outperformed investment grade corporate bonds and treasuries. Not only have they outperfomed their fixed income counterparts in these time periods, but they have produced positive results in all periods.
High yield bonds have a number of characteristics that protect investors from rising interest rates:
· Typically, interest rates rise as the economy is expanding. As the economy expands, this benefits lower quality company debt as default rates decline and credit spreads tighten which creates potential for capital appreciation.
· High yield bonds have a higher coupon or yield than their counterparts and this income differential protects from a rise in interest rates. For example, in today’s environment the 10-year Treasury is yielding 2.47% versus the Bank of America High Yield index yield of 6.22%. As interest rates increase, the current income produced from high yield bonds reduces the potential for a negative return.
· High yield bonds tend to have shorter maturities than Treasury or investment grade corporate bonds. High yield bonds are typically issued with maturities of ten years or less and have call features that shorten the overall duration of the bonds. The shorter duration structure of high yield bonds makes them much less sensitive to interest rate fluctuations.
The Fed will continue to create dislocations and opportunities in the market as it changes the language and pace of rate increases in the coming months. Owning high yield bonds in a risk controlled manner can protect against a rising interest rate environment and from Fed policy changes.
Intended for investment professional use only
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