Kevin’s Corner: One Person’s “Junk Bonds” are Another’s Treasure

With the Federal Reserve getting ever closer to finally increasing interest rates, bond investors have been looking for categories that will offer some measure of protection from the expected decline in bond prices that comes with higher yields on Treasuries.  One asset class that seems to be set up to weather a slow rate of interest rate hikes by the Fed is high yield bonds.

Also known by the unfortunate name of “junk bonds,” high yield bonds are issued by companies that have a below-investment-grade credit rating.  These companies need to pay a higher interest rate on their debt to compensate for the increased risk of default due to their less-than-ideal fiscal strength.  This doesn’t mean that these companies are on their last legs before bankruptcy.  Such well-known firms as Netflix, T-Mobile, and Constellation Brands (owner of Corona Beer, Robert Mondavi Wines and Svedka Vodka) are issuers of high yield debt.

There are several reasons why high yield bonds have traditionally outperformed other fixed income classes in rising rate environments.  For one, the built-in difference between the higher yields these bonds offer and what other bonds pay serves as a buffer to protect them from a modest increase in rates such as the quarter-point increase the Fed is expected to make in the coming months.

The reason behind rising rates is another reason.  The Fed usually increases rates when it feels the economy is strong enough to handle it.  A strengthening economy is good for companies’ balance sheets, meaning it is easier for high yield companies to pay its debt.

In this current environment, rates have been trending lower for so long that high yield issuers have been borrowing at ever lower rates to pay off its existing higher-rate debt early – similar to what many homeowners have done to refinance their mortgages.  This cuts their interest expense and further increases their financial strength.

Let me end with some history, which is not, of course, a reliable indicator of future results, but can provide some evidence of high yield outperformance in the past.  Since 1993 there have been seven periods during which there was a greater-than 100 basis point rise in the 10-year U.S. Treasury yield (For example rates rose from 3.00% to 4.00%).  In each of those periods, high yield bonds have outperformed the Barclays U.S. Aggregate Bond Index as shown in the table below:

There are, of course, risks inherent in high yield bonds and they are susceptible to greater losses than other fixed income categories if things go wrong.  If the economy turns down suddenly and sharply, companies may default on their debt.  When this happens, many people may want to sell their bonds at the same time that buyers disappear and are not willing to pay reasonable prices, creating a liquidity crisis.  However, with these risks in mind, an allocation to high yield debt may offer some protection against rising rates in the year ahead.