Thomas Ross
A popular image when conveying risk in bonds is the see-saw – the pivoting plank found in children’s playgrounds whereby as one side goes down, the other side goes up. A few decades ago, these were often situated above concrete – children were made of sterner stuff back then, although memories of bruised knees and elbows might attest otherwise. Today, civic planners are kinder and soft sand or rubber normally breaks any fall.
The see-saw is often framed in the discussion of bond prices – as bond yields rise, bond prices fall and vice versa. To understand why, consider that the simple yield on a bond is the level of income expressed as a percentage rate. At its most straightforward, it can be calculated as the annual interest payment (coupon) on the bond divided by the bond’s current price. As interest rates rise, the existing yield on a fixed rate bond (paying the same interest over time) becomes relatively less attractive so the bond price typically falls, causing the yield to rise and become competitive again.
Absorbing the impact
High yield bonds are issued by companies that carry higher credit risk; they are typically issued with a higher coupon to help compensate for the additional risk, hence their name. Credit rating agencies assign scores to borrowers according to their creditworthiness so high yield bonds have a lower credit rating than investment grade corporate bonds. For high yield corporate bonds, the see-saw is also a useful image for two of the key risks that face bonds – interest rate risk (the risk that rising interest rates or bond yields will cause bond prices to fall) and credit risk (the risk that a borrower may fail to meet a repayment to investors). At a time when central bankers are already or considering hiking rates (rising interest rate risk), can improving corporate conditions (declining credit risk) cushion the impact of higher rates?
High yield bonds are typically less sensitive to interest rate changes than investment grade corporate bond and sovereign bond markets. Partly, this is structural; investors have traditionally been less willing to lend to riskier borrowers for longer periods so high yield bonds typically have shorter maturities (the wait to be repaid initial value at maturity). It also reflects the higher yields on high yield bonds, which essentially quickens the pace at which an investor is repaid their investment. Taken together, shorter maturities and higher yields leads to lower average duration (interest rate sensitivity) on high yield bonds (see table).
Duration within fixed income markets
Source: Bloomberg, at 8 February 2021, Indices used, in descending order: ICE BofA Euro High Yield, ICE BofA US High Yield, ICE BofA Euro Corporate, ICE BofA US Treasury, ICE BofA US Corporate, ICE BofA European Union Government. Duration and yields may vary over time.
An effective duration of 3.7 means that if there were to be a change in yield of 1% (100 basis points), then the bond's price would be expected to change by 3.7%. Remember, when bond yields rise, bond prices fall and vice versa, so in a rising rate environment, a lower duration can be advantageous.
High inflation is clearly a concern for central banks and is behind their decisions to raise interest rates but allied to this is evidence of recovering economies that no longer need emergency support. Labour markets are buoyant, earnings are growing, and supply chains are beginning to repair. High yield companies have been tackling their debts and most companies have sufficiently strong earnings to service their debts, even as interest rates rise. Market expectations are that 2022 will be a year of low defaults. This matters because corporate bonds typically yield more than safer government bonds and this additional yield over a government bond is known as the credit spread. This spread can act as a cushion, potentially narrowing and absorbing some of the rise in yields on government bonds when interest rates rise and investors become more optimistic about corporate prospects.
Of course, we are mindful that the high yield market is at the mercy of events. For now, heightened risk aversion due to geopolitics and central bank policy means spread narrowing faces a headwind. Central banks have been caught on the hop by inflation proving more elevated and persistent than they expected, so they are unlikely to soften their tone in the next few months unless there are clear signs of inflation or economic data rolling over. This could make for a rocky few months in markets, albeit creating potential opportunities for active investors.
A cautionary tale
There is no textbook answer to how economies will respond to emerging from a pandemic nor whether central banks are correctly assessing the current inflationary outlook. A potential risk is that if rate rises are too aggressive it could precipitate a recession.
Returning to our opening metaphor, the withdrawal of liquidity does not mean central bankers are about to replace the rubber matting beneath the see-saw with concrete, but investors will need to be more careful. Falls could be more painful as shown by the market volatility in January 2022, both in equities and bonds. For high yield, we take some comfort from the fact that rate rises also indicate growing confidence in the economy’s capacity to stand on its own two feet. Declining credit risk among selected high yield bond issuers we believe could help to offset some of the pressure from rising government bond yields.
Thomas Ross is corporate credit portfolio manager at Janus Henderson Investors.
This article is issued by Jesmond Mizzi Financial Advisors Limited (JMFA) and was prepared by Tom Ross – Corporate Credit Portfolio Manager at Janus Henderson Investors. The contents of the article are the author’s views and should not be construed as advice and may not reflect the other opinions in the organisation. They are for information purposes only and should not be used or construed as investment, legal or tax advice or as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector. Janus Henderson Investors is the source of data unless otherwise indicated. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value. Janus Henderson Investors is the name under which investment products and services are provided by Henderson Management S.A. (reg no. B22848 at 2 Rue de Bitbourg, L-1273, Luxembourg and regulated by the Commission de Surveillance du Secteur Financier); Janus Henderson are trademarks of Janus Henderson Group plc or one of its subsidiaries. © Janus Henderson Group plc.
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