September 24, 2018: High Yield Bonds In A Rising Rate Environment

Sep 25, 2018 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

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High Yield Bonds In A Rising Rate Environment

As fixed income bonds continue weaken, we want to look at how high yield bonds perform in a rising rate environment and see where they can fit in a fixed income portfolio. 

First, let’s look at recent fixed income performance. 

High Yield Bonds Are Positive Year To Date

In addition to short term bonds, high yield bonds are the only asset that has a positive return this year so far: 

As of 09/21/2018

Description Symbol 4 Weeks  13 Weeks 26 Weeks 52 Weeks Trend Score
High Yield JNK 0.39% 1.74% 3.82% 2.09% 1.59%
Treasury Bills SHV 0.13% 0.44% 0.86% 1.41% 0.58%
Short Term Credit IGSB -0.42% 0.33% 0.75% 0.08% 0.13%
Short Term Treasury  SHY -0.2% 0.14% 0.3% -0.13% 0.01%
Intermediate Term Credit IGIB -1.14% 0.43% 0.45% -1.36% -0.39%
US Total Bond BND -0.91% 0.25% 0.25% -1.55% -0.43%
MBS Bond MBB -0.94% 0.01% 0.24% -1.18% -0.43%
Inflation Protected TIP -1.71% -0.82% 0.02% -0.56% -0.64%
Emerging Mkt Bonds PCY 0.0% 2.18% -0.98% -5.65% -0.79%
Intermediate Treasury IEF -1.64% -0.51% -0.53% -3.48% -1.33%
International Treasury BWX -0.07% -0.69% -6.0% -2.05% -1.66%
10-20Year Treasury TLH -2.42% -1.13% -0.93% -4.7% -1.98%
20+ Year Treasury TLT -4.03% -2.18% -1.23% -4.59% -2.65%
International Inflation Protected WIP 0.13% -2.15% -9.06% -5.61% -3.08%

Intermediate treasury, corporate bonds and MBS bonds are all in a negative trend. 

From 360° Market Overview, one can also see that among municipal bond assets, only short term and high yield municipal bonds have positive returns so far.

Do high yield bonds perform well in a rising rate environment?

Before we go on to look at this, let’s first look at a very long term interest rate historical chart: the 3 month Treasury Bill rate that is usually used to represent the interest rate:  

One can see that the interest rate was in a secular rising rate environment from 1934 to 1981 and then it was in a secular declining rate environment from 1981 to 2015 or so. Since then, the rate has started to rise. 

Whether this is the beginning of a long secular rising environment is still subject to debate. However, it does look like that the rate can only go up from here as it is still very low after staying at the bottom (zero) for a couple of years. 

As what we have observed in the recent bond performance, in a rising rate period, almost all bond assets suffer, with the exception of short term (or ultra short term) bonds and/or possibly high yield bonds. 

There are several possible reasons why high yield bonds can stay positive in a rising rate period: 

  • In an expanding economy (for example, the current one at least up to now), many companies are doing well and thus the default rate is declining. Investors are willing to take more risk by chasing higher yields offered by lower quality bonds. This results in a mini-speculation loop that further drives up prices. 
  • Many high yield bonds have short maturity so they are less affected by the rising rate. Furthermore, afraid of further interest rate rising, a company might want to retire (or call) its bond with cash. The prepayment usually carries some penalty that’s paid to bond holders, thus increasing its return. 

Although there has been a claim that high yield bonds usually generate positive returns in a rising rate period, we look at the history and our finding is that this is not always the case. 

 

In the above chart, we use Vanguard High Yield Bond fund VWEHX as the proxy for high yield bonds. Though we can see that in several rising rate periods such as 1982-1983 and 2004-2006 VWEHX returned positively, it did have many negative returns in other rising rate periods (see those circled years). On the other hand, we have to caution that high yield bond market was still in an early stage in 1980s and early 1990s, thus the fund’s struggle in those years might not be very indicative for today’s market environment.

From the above data, we don’t see that including high yield bonds in a relatively conservative fixed income portfolio is a sure bet in a rising rate environment, even though it can probably alleviate some pains if managed properly. Our recommended total return bond fund portfolios (see What We Do -> Brokerage Investors) dynamically select a total return bond fund to invest. These total return bond funds (such as Loomis Sayles Total Return Bond fund LSBRX or PIMCO Income PONAX) are usually adept in getting some exposure in high yield bonds. These portfolios actually already take high yield bonds into account. 

However, it’s interesting to see that including high yield municipal bonds might indeed can help to boost a fixed income portfolio’s return without adding a lot of risk. We will address this subject in a separate newsletter. 

Market Overview

10 year Treasury rate now surpassed its recent high in May this year. Apparently, higher interest rate pressure will start to show up in housing and corporate financing. S&P 500 index again made an all time high last Friday. We are now in a very high valuation and a more hostile interest rate environment. Though US stocks are still showing upward momentum, the likelihood of a sudden correction is also increasing. As always, we call for staying the course while maintaining risk exposure to a level one is comfortable with. 

For more detailed asset trend scores, please refer to 360° Market Overview. 

In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic about U.S. economy in the long term and believe much better investment opportunities will arise in the future. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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