Managing rising rates through short dated high yield

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This is a sponsored article from BNY Mellon.

SUMMARY

We believe that the following strategies will be important to enable investors to protect themselves against rising interest rates:

  • A global approach, rather than a regional bias
  • Focus on short-dated and callable securities, where fundamental analysis supports the belief that there is a strong incentive for management to refinance
  • Underweight longer maturity issues, especially those where there is a low incentive for refinancing. In addition, in the current rate environment, coupon rates can have an important impact on price volatility
  • Underweight BB bonds versus B bonds

THE CURRENT CYCLE IS NOT A TRADITIONAL ONE

In 2017, the global economy experienced a broad upswing, buoying sentiment and leading to a decline in spare capacity in most economies. Even so, this current cycle continues to be quite different from many historical examples. In a more traditional cycle, as spare capacity declines, inflation accelerates and central banks are forced to tighten monetary policy in order to contain inflation. In the current cycle, inflation has not been a significant concern, allowing central banks to maintain an unprecedented level of stimulus. Even now, with spare capacity having rapidly declined, inflation continues to be elusive. Developed market inflation forecasts for 2019 have barely moved, despite a significant change in growth forecasts for both 2018 and 2019 (see Figure 1).

Figure 1: Consensus forecast for developed market growth and inflation

Source: Bloomberg. Data as at 28 February 2018

For investors in corporate bonds, the combination of stronger growth, still moderate inflation, and only gradually rising inflation has created a positive backdrop for corporate earnings, which have grown strongly. This has underpinned credit ratings, especially in high yield. Default rates have declined globally; in Europe default rates are now at historically very low levels and are not expected to rise significantly over the next two years.

Rising interest rate sensitivity

Returns in the high yield market are traditionally driven by (1) spreads and default rates and (2) movements in interest rates. Traditionally, the first factor has dominated returns, but the sensitivity of the high yield market to interest rate movements has now increased. European issuers, especially BB rated issuers, have used the period of low yields and strong demand to extend their maturity profiles (see Figure 4). This has added duration risk for investors following mainstream benchmarks. The coupons on these new issues have been low, with several securities issued with coupons in the 2-3% range. For these low coupon securities, assuming there is no dramatic change in company fundamentals, interest rate risk would be expected to be a significant driver of future returns.

Figure 2: Change in duration, Bloomberg Barclays high yield index from end 2014

Source: Bloomberg, Barclays. Data as at 28 February 2018.

ANALYSING RISING INTEREST RATE SCENARIOS

Using the Bloomberg Barclays High Yield indices as a model, we can calculate the expected total returns under various scenarios for changes in yields (see Figure 5). In this analysis, we assume no change in spreads or defaults, so the return from the index comes solely from the movement in prices resulting from changing yields and income.

Figure 3: 12 month total returns under various yield change scenarios

Source: Bloomberg. Data as at 28 February 2018.

By undertaking this analysis, it becomes clear that yields are sufficiently high in high yield to absorb the negative price impact of a broad-based rise in bond yields under most scenarios up to a 100 bps rise in yields. If there was a 100 bps rise in European bond yields, the European index would generate a negative return over a one year period, primarily as a result of the increase in duration in that index over recent years. For investors with exposure to government bonds, however, there is far less yield protection and greater duration risk.

CONCLUSION

Irrespective of interest rate moves, an approach to high yield investing which combines a focus on short dated opportunities, a global approach to investing, and rigorous credit analysis should deliver superior returns over time. The rise in duration of European indices leaves passive investors with a greater exposure to interest rate risk, just as yields are starting to rise. In this environment, we believe investors need to have the flexibility to actively manage duration risk in high yield.

Ultimately, although rising yields could impact returns, the income available from high yield debt is sufficient to absorb quite significant price declines, especially relative to government or investment grade bonds, so long as the economic environment remains supportive.

IMPORTANT INFORMATION
RISK DISCLOSURES

Past performance is not indicative of future results. Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations.

  • The performance results shown, whether net or gross of investment management fees, reflect the reinvestment of dividends and/or income and other earnings. Any gross of fees performance does not include fees and charges and these can have a material detrimental effect on the performance of an investment.
  • Any target performance aims are not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for the returns to be significantly different than expected.
  • Portfolio holdings are subject to change, for information only and are not investment recommendations.

IIFM DISCLOSURE
This document is a financial promotion and is not investment advice. Unless otherwise attributed the views and opinions expressed are those of Insight Investment at the time of publication and are subject to change. This document is only directed at investors resident in jurisdictions where our funds are registered. It is not an offer or invitation to persons outside of those jurisdictions. Insight Investment reserves the right to reject any applications from outside of such jurisdictions. Insight does not provide tax or legal advice to its clients and all investors are strongly urged to seek professional advice regarding any potential strategy or investment. Issued by Insight Investment Funds Management Limited. Registered office 160 Queen Victoria Street, London EC4V 4LA. Registered in England and Wales. Registered number 1835691. Authorised and regulated by the Financial Conduct Authority. FCA Firm reference number 122259.

© 2018 Insight Investment. All rights reserved.

This is a sponsored article from BNY Mellon.

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