Impact of Higher Interest Rates on High Yield Bonds

August 21, 2015 | Christopher Caparelli, CFA, Partner

Under the Fed’s zero interest rate policy, high yield bonds have enjoyed a terrific run of performance. For the five-year period ending June 30, 2014, the Barclays U.S. Corporate High Yield index produced an impressive annualized return of 14.0% per year. However, returns in this more speculative portion of the bond market have been disappointing since last summer, when the high yield spread over Treasuries reached a multi-decade low of 221 basis points. The index fell 0.4% in the twelve months ending June 30, 2015, and has continued to show weakness, falling another 1.9% through the middle of August.

This week’s chart examines the past relationship between high yield spreads and rate tightening cycles.¹  Although there certainly isn’t a perfect correlation, tightening activity by the Fed has often caused high yield spreads to widen, significantly impacting total return potential. It is no secret that low and stable interest rates are good for speculative companies that are active in the debt markets. While a rake hike doesn’t spell impending doom for the entire high yield universe, some of the more speculative borrowers who have become accustomed to borrowing at ultra-low rates could be in trouble, particularly if the Fed embarks on a prolonged period of successive rate hikes. As we prepare for the first Fed rate hike — likely later this fall — it will be important to pay close attention to high yield exposure within investment portfolios as well as manager positioning within the high yield space.

¹ Most recent rate tightening lines refer to the end of QE 1 and 2 and the start of the Fed’s tapering