23 MAY, 2022
By David Ennett
It is usually assumed that rising interest rates are bad news for bond investors, but then it is also assumed that markets act rationally. In reality, rising interest rates hurt some bonds a lot more than others – and opportunities present themselves for astute investors if the market does not grasp this difference.
Right now, as central banks accelerate the move towards tighter monetary policy and markets respond, high yield bonds – currently offering around 7.5% yield – are looking attractive.
First, the basics. When interest rates rise – or are expected to do so – investors naturally demand a better yield from bonds they already hold. They will otherwise take their money elsewhere. The rate of return is usually fixed when a bond is issued, so the only way to raise the effective yield on existing bonds is if the price at which they are traded falls. This explains why the value of your bond fund may be falling and why bond investors fear tighter monetary policy.
This brings us to the issue of risk. Most high yield bond investors focus primarily on credit risk. They expect to be compensated for taking the chance that a bond issuer defaults. Credit risk varies hugely – on US Treasuries (loans to the US government) it is almost negligible, since no-one expects a default. It is much higher for less creditworthy corporate borrowers.
High yield bonds sit at the latter end of the spectrum. Credit risk is much more significant, because these bonds are issued by companies deemed financially weaker. As much as five percentage points of the return on high yield bonds today is reward for credit risk.
Meanwhile, interest rate risk accounts for a small part of the return on a high yield bond. As a result, rising interest rates are much less of a worry in this part of the market, because increases have a disproportionately minor effect.
‘Duration’ is the market sensitivity a bond has to moves in interest rates. Because they are low-duration assets, high yield bonds offer some protection from expectations of higher interest rates. Another brief explainer may be helpful here.
Remember, a bond is simply a loan. It repays an agreed rate of interest or coupon for an agreed period, at the end of which the loan – or principal – is returned.
Say you have a 10-year bond and a gap opens between what you are committed to receiving and what the market is now offering. The value of that bond will probably fall further than it would for a short duration bond because your relative loss is likely to be sustained for longer.
Four years’ duration is pretty typical in the high yield bond market, but managers can weight their portfolios to go even lower. Our high-yield portfolios have durations of between two and four years currently, so interest rate risk for these is low. Shorter duration has another benefit – we do not have to look so far ahead. We can have greater confidence in the projected cashflows of a business when assessing credit risk over the next 2-3 years than we can for the 8-10-year views required in other parts of the market.
In theory, you should be rewarded more for duration. But yield curves are currently flat. Moving from holding one-to-five-year BB-rated credit in the US dollar market to five-to-10-year credit would result in a pick-up in yield of just 0.3%. So, buying short duration is not costing us.
With interest rate risk less worrying than it might first appear, potential investors in high yield bonds must think about credit risk again. Is it more or less likely that bond issuers will not repay what they owe in today’s market environment?
I would argue that the prospects are encouraging. After all, central banks are raising interest rates because they think the economy is growing so quickly that inflation is a problem. A fast-growing economy means companies’ earnings are increasing, supporting their ability to make debt repayments.
That said, what you own in this environment is incredibly important. This is not a market for the passive investor. In recent years quantitative easing has floated all boats, but this will not be the case going forward. Careful judgements on credit risk are required. We are very underweight the most economically sensitive companies with triple-C ratings. The average annual level of credit loss on BB-rated bonds has historically been around 0.6%. In contrast, CCC-rated bonds have seen average annual credit losses of 8.1%.
Like equity managers, we look for companies that have strong pricing power and which are better positioned to deal with rising costs – including the cost of debt, which becomes important as borrowing comes up for refinancing. We avoid companies with business models predicated on high levels of leverage.
We reduced risk in the fund last summer. Valuations reflected an optimistic news flow, and we wanted some downside protection. Today valuations are much more supportive, pricing in much more aggressive moves from the central banks than we think likely. We feel there is runway for growth to be reduced materially without plunging us into recession.
In an environment where growth and earnings are still strong, you are getting paid a higher premium than you were. For example, BB-rated bonds in the US dollar market with a one-to-five-year maturity yielded 2.5% in October last year. Today that has more than doubled to 6.1% – towards the top of the range seen in the past decade. Across the fixed income team, within our strategic and target return funds, we are increasing exposure to high yield.
This is not a sector that will suit all investors. High-yield bonds are more akin to equities than fixed-income securities, in the sense that their return profile is much more dependent on the underlying performance of the business and the economy. But the returns available currently look extremely attractive. And if you are still worried about drawdowns, look at the performance of global high yield bond funds next to global equities during periods of crisis (figure 1). I would argue that this is an asset class that offers resilience and reward.