With Rising Rates, Disregard Simplistic Assumptions

Logical fallacies abound in fixed income. Consider rising rates. Investors start with the inverse relationship between bond prices and bond yields. So if yields rise, prices fall. Valid premises, broadly speaking. Then people proceed to a false conclusion: rising interest rates must mean losses. This thinking disregards half of the total return equation: Total Return = Price Change + Income.

Take the Bloomberg Barclays Aggregate U.S. Bond Index, the conventional benchmark for core fixed income portfolios. Since the Agg’s inception in 1976, the 10-year Treasury has staged 18 episodes of yields rising by 100-plus basis points. In eight episodes, the securities comprising the Agg generated enough income to offset price depreciation. Voilà! Positive returns in eight cases of rising rates.

The bond market could be on the cusp of deposing another misconception. While consensus opinion is likely correct that Treasury yields are headed higher, I believe the crowd has misplaced trust in a past safe haven from rising rates. At today’s tight credit spreads, escalating rates could spell trouble for high yield corporate bonds.

Naïve extrapolation from high yield’s past explains people’s complacency over its future. In past rising-rate periods, the sector has typically delivered positive returns – with the bonus of outperforming the two other major corporate fixed income sectors: investment-grade corporate bonds and bank loans.

Since the inception of the Bloomberg Barclays U.S. Corporate High Yield Bond Index, the 10-year Treasury yield has backed up by more than 100 basis points 13 times. In all but one case, the high yield index delivered positive returns and outperformed the Bloomberg Barclays U.S. Corporate Investment Grade Index. 

Bank loans are corporate borrowings, structured and administered by commercial or investment banks. The loans are sold (syndicated) to other banks and institutional investors, including collateralized loan obligations (CLOs) and mutual funds. Bank loans typically are floating rate, paying interest based on a spread over the London Inter Bank Offered Rate (LIBOR). The S&P/LSTA Leveraged Loan Index, the benchmark for this sector, has lived through six periods in which the yield on the 10-year Treasury rose more than 100 basis points. The bank loan benchmark posted positive returns during all of them. High yield corporates still outperformed bank loans in five cases and essentially tied in the sixth.

So why not assume, to paraphrase William Shakespeare, that high yield’s rosy rising-rate past is prologue to a rosy rising-rate future? The game changer is the Federal Reserve.

In response to the credit crisis, in 2009 the Fed embarked on an unprecedented intervention in the markets: massive purchases of Treasuries and Agency mortgage-backed securities, dubbed Quantitative Easing (QE). The effects of QE spread into the corporate credit markets, dropping spreads to record- or near-record tights and thus raising duration (i.e., interest-rate sensitivity). In these conditions, corporate borrowers of course refinanced their debt and pushed out maturities.

QE has given way to QT: Quantitative Tightening. 

Treasury yields have adjusted higher but remain low relative to economic growth, to say nothing of Washington’s imminent demand for more debt financing to fund dramatic growth in the federal deficit. Under DoubleLine’s base-case outlook the 10-year Treasury should yield 6% in three years or so. If you subscribe to a shallower rate trajectory, imagine the 10-year yielding a perfectly feasible 4%. Would investors lend to speculative companies at the same coupon-to-maturity as they did six months ago with the 10-year at 2.2%? Unlikely.

With credit spreads near all-time lows today, the all-in yield on these securities is too small to offset price depreciation under a rise in government yields – even entertaining the hopeful assumption of sustained low default rates and stable, tight spreads.

Where then should investors allocate fixed income portfolios for rising rates? One obvious option is short-term, investment grade paper, held directly or via actively managed short-term bond funds. In the latter case, consider managers who can construct portfolios with attractive dividend yields as well as low duration – without taking much credit risk to get there. 

Also consider floating-rate assets: bank loans, CLOs and floating-rate funds. By definition, floating-rate assets exhibit extremely low duration. Like high yield bonds, bank loans are rated below-investment grade by the credit rating agencies.Loans, however, are senior in the capital structure to traditional debt.

Finally, actively manage the high yield exposure you do have. 

Passive indexation vehicles hold many long-duration bonds of below-investment-grade issuers. These companies could run into refinancing obstacles in less welcoming markets. Managers obviously should underwrite each credit for par payback at maturity. Of course, consider paring exposure to high yieldwhen spreads are tight. At DoubleLine, for example, we hold high yield in core bond portfolios – at below-market neutral weightings. 

And prepare for volatility. On the path to higher rates, the high yield market likely will undergo sell-offs, presenting buying opportunities at much wider spreads than prevail today. The “Taper Tantrum” of 2013 afforded a great opening to capture discounted credits, positioning portfolios for strong returns.More such opportunities lie ahead.

In the meantime, be mindful that the transition to higher interest rates may unfold very differently than in the past. Yogi Berra is a man for our times: “The future ain’t what it used to be.”