April 2022 / FIXED INCOME
High Yield Bonds Could Prove Resilient as Inflation Surges
Shorter durations, higher yields could provide a buffer as rates rise.
- Below investment-grade bonds tend to be more resilient in rising rate environments because of their higher yields and shorter durations.
- High yield bonds have generated positive returns in periods of rising interest rates during the last 15 years.
- However, high yield bonds are not immune to the effects of inflation, so we actively try to manage inflation risk in the strategy.
Inflation and rising rates have left many investors wary of investing in bonds as traditional fixed income asset classes—which have relatively low yields and more sensitivity to interest rate risk—have historically not fared well in this type of climate. However, fixed income strategies that specialize in below investment-grade credit such as high yield bonds and bank loans tend to be more resilient in these environments. This stems, in part, from the higher yields and shorter durations1 of these segments.
Inflation and the Fed
Broad-based supply disruptions stemming from pandemic-related shutdowns and more recently from the Russian invasion of Ukraine have affected everything from transportation to labor to raw materials, which has resulted in higher prices for many goods and services. This, coupled with pent-up demand as economies reopen and consumers are flush with savings and eager to spend after prolonged lockdowns, has brought inflation rates to levels not seen since the early 1980s.
The Federal Reserve has two primary tools for managing inflation—increasing rates and tightening monetary supply by reducing the size of its balance sheet. Keeping inflation near a 2% target and maintaining full employment form the central bank’s mandate. After taking a patient approach throughout most of 2021, the Fed has recently pivoted to a much more hawkish tone, and markets now expect rate increases and balance sheet reductions to occur at a much quicker pace.
Attractive Yield Relative to Duration
(Fig. 1) Yield versus duration
High Yield Bonds Tend to Be Less Affected by Rising Rates
In an environment of rising rates, a shorter duration means less downside risk because money can more quickly be reinvested into newer bonds at higher rates. Meanwhile, higher yields (coupons) provide an added level of income return potential, which can provide a meaningful cushion to help offset any price declines. Additionally, rising rates are typically the product of strong economic growth, and a robust economy tends to boost corporate earnings and revenues. This can make it easier for high yield issuers to service their debt, thereby reducing overall default risk.
As a result, returns of high yield bonds tend to be negatively correlated with U.S. Treasury returns. In fact, over the 15 years ended December 31, 2021, high yield bonds exhibited a -0.3 correlation2 with 10-year Treasuries. A negative correlation means that if U.S. Treasuries are expected to lose value when rates rise, then high yield bonds should actually increase in value.
Looking back at historical periods of rising rates, this has indeed been the case. As Figure 2 shows, there have been six time periods where interest rates rose by 100 basis points3 or more over the last 15 years. High yield bonds produced positive performance results in each of those periods, with an average cumulative return of 9.39% (second only to their close relative, bank loans). It is worth noting that yields today are starting from a lower point than they have in the past; therefore, it may be important for investors to temper expectations for future returns.
High Yield Has Been Resilient in Rising Rates
(Fig. 2) Cumulative high yield returns when 10-year Treasury yield rose more than 100 bps
Taking a deeper look and breaking out these high yield bond returns by credit rating, it is evident that the lower quality tiers within the high yield market have tended to generate the strongest returns in these past rising rate environments. Though our portfolio is well positioned to benefit from this trend given our overweight to the lower quality tiers of the market, we are cognizant of the fact that this will reverse at some point in the credit cycle.
Yet Not Immune to the Effects of Inflation
Though high yield bonds tend to be somewhat insulated from the effects of inflation and rising rates relative to many other fixed income asset classes, they certainly are not immune. There are three primary ways that we seek to manage inflation and interest rate risk in the US High Yield Bond Strategy. First, we have maintained an underweight to BB rated bonds (the highest credit rating rung of the non-investment-grade universe), which tend to have the highest interest rate sensitivity in the high yield market. Second, the strategy typically has meaningful allocations to bank loans, which currently offer similar yield to below investment-grade bonds but with shorter duration given their floating rate coupons. The third way that we manage inflation risk is through sector allocation and security selection, which we discuss further below.
Lower-Rated High Yield Has Outperformed in Rising Rates
(Fig. 3) Returns by credit rating when 10-year Treasury yield rose more than 100 bps
Analyzing the Impact of Inflation on Issuers and Sectors
Inflation has become so rampant and widespread that it is virtually impossible to name an industry or sector that has been untouched by its effects. As part of our bottom-up fundamental credit analysis, we assess the impacts of inflation as we evaluate both current and new investment opportunities. As part of this process, we find ourselves asking questions like:
- Has inflation driven up the cost of key inputs (e.g., raw materials, transportation, labor, etc.) within this sector or for this issuer?
- Are the effects of inflation transitory, or are they likely to be felt over the longer term? Why?
- Does the issuer have the ability to pass higher input costs through to customers via higher prices? To what extent is customer demand for the issuer’s goods or services elastic or inelastic?
- What supply chain issues exist? When and how do we expect those issues to be resolved?
- What net impact will inflation have on the profitability of the issuer’s overall business?
Examining the Impact of Inflation
As we develop answers to these questions, we naturally look to avoid areas of the market where we expect that inflation will serve as a greater headwind and add exposure to parts of the market that we believe will fare better, unless our broader fundamental and relative value analysis of the opportunity directs us otherwise. We show a few recent examples in the Examining the Impact of Inflation section.
Defaults Expected to Stay Low Through 2023
Overall, our outlook for high yield bonds remains constructive. Though credit spreads4 are tight, default rates remain near historic lows as many companies have taken advantage of low rates over the last 12 to 24 months to refinance and extend their debt. With no meaningful waves of maturing bonds on the near-term horizon, we expect defaults to remain low through 2023. Given that credit risk is the primary risk associated with high yield, we believe this backdrop should bode well for the asset class in the near to intermediate term.
Additionally, high yield bonds can offer an attractive risk/reward profile that combines much of the upside potential associated with equities with some of the downside protection and income associated with fixed income. We think this should be a compelling combination in the current environment of low but rising yields and equity valuations that started the year appearing stretched before encountering selling pressure.
Credit Selection to Remain Important Driver of Returns
As an active and concentrated U.S. high yield manager, we do not seek to make big macro calls on the direction of interest rates, nor do we seek to fully hedge out interest rate risk in our portfolio. With that said, we do strive to understand the impact that inflation and rising rates could have on the investment performance that we seek to deliver to clients and to position the portfolio accordingly. In doing this, we rely heavily on proprietary, bottom-up fundamental credit research, which we view as our competitive advantage.
Given the relatively tight credit spreads in the high yield market today, we believe credit selection will be an even more important driver of returns in the year ahead. We anticipate that periods of volatility could provide some windows of opportunity for active investors like ourselves to take advantage of temporary price dislocations in certain areas of the market.
What we’re watching next
Aside from inflation and rising rates, the biggest risk that we see in the market today is a Fed policy mistake, such as hiking too quickly or too slowly or somehow surprising the market, as we enter a tightening cycle. Recent geopolitical tensions involving Russia and Ukraine have added another layer of complexity to markets and for the Fed. At the end of the day, high yield is considered a risk asset and, as such, could continue to experience bouts of volatility throughout the year as markets react to and digest the timing, pace, and scale of Fed communications and actions. We are also keeping a close watch on future maturity walls, which could force companies to refinance their debt at meaningfully higher rates, as well as on risks around the potential for stagflation (the combination of slow growth and high inflation).
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April 2022 / MARKETS & ECONOMY
April 2022 / FIXED INCOME