A pending US interest-rate hike and worries about inflation may have persuaded investors to start avoiding bonds. We think that’s a mistake, especially when it comes to high yield, a sector that often thrives when rates rise.
Bonds, of course, are highly sensitive to interest-rate movements—when rates rise, prices fall. And rising rates can certainly create short-term volatility. We’ve seen our share of it in the past few weeks.
The volatility—and the anxiety bond investors are feeling—increased after Donald Trump won the US presidential election and markets began betting his policies would trigger a jump in inflation. This scenario could convince the Federal Reserve to follow an interest-rate hike in December with several more in 2017.
But remember, interest rates have been low for decades and inflation in developed economies all but evaporated in the years after the global financial crisis. Investors have grown accustomed to this situation. The reaction to tighter Fed policy and possible reflation in financial markets, including high yield and other credit markets, isn’t a big surprise.
The good news is that the backup we’ve seen in bond yields is largely self-correcting; higher yields eventually lead to higher returns. That’s because as bonds mature, their prices drift back toward par. Investors who sit tight will soon be able to reinvest the principal from maturing, called or tendered securities and the coupon income that their portfolios pay in newer—and higher-yielding—bonds.
LOOKING PAST VOLATILITY
It’s also important to remember that in high yield sell-offs tend to be short-lived. Over the past two decades, high yield has recovered most big drawdowns—losses of more than 5%—in less than a year.
US high-yield bonds also have a strong track record during periods of Fed tightening (Display). This is partly because high yield isn’t closely correlated with interest rates. Rather, the bonds are strongly linked to the business results and fundamentals of the companies they represent. When the Fed raises rates because the economy is strengthening, that tends to bode well for many high-yield issuers.
SHORTER DURATION, HIGHER CASH FLOW
So how can investors maximize growth in a rising-rate environment? By seeking out bonds that generate a high amount of income. The more cash flow your portfolio can deliver, the more you’ll benefit.
In our view, a short-duration high-yield strategy can offer a particularly good opportunity to take advantage of rising rates; the quicker the bonds mature, the faster investors can put the proceeds to work in higher-yielding securities.