A jump in interest rates could swamp high yield returns, but a global approach and a focus on short duration can help weather a rising tide.
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Fixed income investors have had ample time to prepare for the inevitable end of accommodative monetary policies from the world’s biggest central banks. That time appears to have arrived: the Federal Reserve is on track for three rate hikes in 2018 and could get more aggressive in future years; the European Central Bank, meanwhile, is expected to call a halt to its asset purchase programme in September, a step seen as a precursor to rates increasing in the euro zone.
Benchmark bond yields have risen accordingly: the yield on 10-year US Treasury notes hit 2.95 per cent in February, a four-year high; also in February, 10-year German Bund yields topped 0.76 per cent, their highest level in over two years.
During the years of falling interest rates, investors soaked up longer-dated bonds in the hunt for yield and drove the overall duration of the bond market to record levels. Now that the trend in rates is changing, fixed income investors have become increasingly concerned about duration risk and are seeking to move out of longer-term positions.
Higher interest rates and the end of central bank easing need not lead to gloom for investors, however. In particular, a global approach to high yield can provide resilience relative to other asset classes in times of rising interest rates.
How will rising rates impact returns?
Investors expect fixed income to struggle generally when the credit cycle turns and interest rates climb. A look at historical returns during previous cycles of rising interest rates shows this is not always true. In fact, global high yield has outperformed other fixed income strategies – and often equities – when rates have risen significantly in the past.
We looked at rising rate cycles since 1990, identifying those periods where the benchmark 10-year US Treasury rate rose by at least a full percentage point (100 basis points or more). In all cases but one, global high yield outperformed other developed market fixed income indexes on a 12-month trailing basis by the time these cycles reached their peaks. Moreover, global high yield also bested the S&P 500 Index in two-thirds of these rising rate cycles.
Exhibit 1: Global fixed income asset class performance during rising interest rate cycles (12-month return at peak of 10-year US Treasury yield increase of 100+ bps)
If the trend in interest rates decisively turns the corner, starting in the US and subsequently around the world, it would not be unprecedented to see global high yield demonstrate resilience relative to other asset classes, whether fixed income or equities. Improving economic performance around the globe would support this trend as well, helping to keep global default rates contained.
Could rising rates expose hidden frailties?
As 2017 came to a close, global default rates were well below their long-term average and trending toward multi-year lows. Defaults are forecasted to continue to decline over the next 12 months, to 1.6 per cent globally according to Moody’s, although default rates may be a bit higher in the US (two per cent) than Europe (one per cent).1 Companies in both regions are riding on the wave of a continuing economic expansion; the cycle may be more advanced in America than in Europe, but the US economy will likely get a boost from the double-shot of fiscal stimulus from the recently approved tax reform and federal government spending packages.
One concern from all of this fiscal stimulus and deficit spending in US is that it will contribute to a spike in inflation and interest rates. What would higher rates mean for defaults? For guidance, we can look at the long-term trend as illustrated in the chart below. High yield defaults (represented by the dark blue line) have followed high yield spreads (the light blue line) with around a six-month lag. Default rates spiked after spreads had widened and conversely declined after spreads had tightened.
Exhibit 2: High yield valuations reflect expected low default rates
With spreads as tight as they have been in the last 30 years, default rates are forecast to continue to fall through the rest of 2018. A surprise spike in rates and the potential widening of high yield spreads would change this forecast, however. High yield investors should therefore put themselves in a stronger position to shield risk through a global strategy as they continue to seek higher total returns.
Is there any value left?
One of the obvious challenges around global high yield at the moment is valuation. The favorable business outlook and a persistent demand for yield have kept high yield spreads tight for much of the past 12 months. This is especially true for European high-yield investors, where rates in the euro-denominated high yield market have matched and sometimes dropped below the benchmark 10-year US Treasury rate. At current levels, it is hard not to argue that high yield is pricey; however, given the forecasts for business conditions and corporate earnings, valuations in the asset class are actually quite fair.
In the European high-yield market, the risk of rising rates is amplified by the eventual wind-down of the European Central Bank’s corporate sector purchase programme (CSPP), the first step of which was taken in January. CSPP only covered investment grade bonds, so why would its tapering affect European high yield? Some investment-grade investors dipped into the upper end of the high yield market (BB-rated) in a desperate scramble for yield. As rates move higher with ECB tapering, many of these investors could be drawn out of the higher quality tranches of European high yield, selling their holdings while rates are rising.
Allocations to various industries and sectors globally could provide these investors with some protection from the risk of rising interest rates as the universe of high yield opportunities is widened. A global approach also offers the flexibility to access different macroeconomic conditions, credit cycles and business risk profiles from regions around the world. US retail presents a good example.
Default rates for US retailers are expected to reach 4.5 per cent in the next 12 months, well above the global forecast of just under two per cent.2 Retailers’ woes are often pinned on the rise of Amazon, but e-commerce is actually expanding in Europe where the forecast default rate for the retail sector is just under two per cent, near the global average.3 The problem in US retail is more specific to the American market, most likely due to an overabundance of physical outlets. Global exposure to high yield can help disperse credit risk in specific regional sectors where defaults may be high and position investors for opportunities where risks are lower and possibly mispriced.
Where’s the high yield sweet spot?
Credit risk may be more crucial in high yield than duration risk, but that doesn’t mean duration is not important. In fact, with the global economy humming along, investors may want to turn their focus to interest rates.
The US may have entered a new cycle of tighter monetary policy, but the Fed seems tenuous about how to go about implementing it. In the last four rate tightening cycles, it hiked rates every two or three months, at nearly every FOMC meeting during those periods (and sometimes in between scheduled meetings). In the present cycle, the rate ratcheting has been more muted, with five increases over 26 months.
The concern among income investors is that the Fed may choose to accelerate the recent pace of rate hikes to ward off a potential spike in inflation. With this concern in mind, investors are looking at shorter duration bonds and bond portfolios, and high yield has benefited from this increased interest. (High yield issues generally have shorter maturities than investment grade issues, so durations for high yield are typically shorter than investment grade.) If inflation does move higher, the Fed will quicken the pace of rate hikes and investors are likely to seek even shorter durations. That would include explicit short-duration strategies in global high yield.
At present, short duration appears to be in the sweet spot relative to the overall high yield market. As of 31 December 2017, duration for short duration global high yield was 1.5 years lower than for global high yield in general, while yields were only 16 basis points lower.4 In other words, short duration global high yields offers nearly half of the sensitivity to interest rate moves without giving up much in terms of yield.
Think globally, act globally
The ability to explore beyond regional borders, into global and high yield bond markets, creates opportunities to seek higher total returns and to better manage risks. But going there requires a strategy for assessing credit risk and a diligent process for analyzing market and company fundamentals. These qualities will become increasingly important for investors to consider now that the path for global interest rates has turned.
1 Moody’s Investor Service, January Default Report, 8 February 2018
2 Moody’s as of 31 January 2018
3 Moody’s, Ibid.
4 Aviva Investors and BRS Aladdin, as of 31 December 2017. The indices used for the characteristics are the Bloomberg Barclays Global High Yield xCMBS xEMG 2% Capped 1-5 Years Maturity Index and the Bloomberg Barclays Global High Yield xCMBS xEMG 2% Capped Index.
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