In a perfect world, a diversified portfolio would have asset classes that are uncorrelated, allowing an investor to maximize return while minimizing risk. As every high yield portfolio manager has probably told you, high yield bonds have had low correlations with other asset classes, and they can offer attractive risk-adjusted returns. This low level of correlation has allowed investors to benefit from allocating to high yield bonds. According to Barclays, monthly high yield bond-return correlations have been negative versus U.S. Treasurys over the past twenty years. Obviously, that correlation statistic includes a time period of declining Treasury rates.
So what have correlations done during the most recent increase in rates?
Despite what feels like a 1.00 (perfectly positive) correlation to rates, high yield bond daily-return correlations to the Barclays U.S. Treasury 5-7 Year Index since May 1 are elevated, but still remain relatively low, only 0.20 (unless otherwise noted, all performance information is as of August 27, 2013). Although total returns during this time period were negative, -4.75% for the Barclays U.S Treasurys 5-7 Year Index and -2.50% for the Barclays High Yield 2% Issuer Capped Index, high yield performed “better” than Treasurys.
The low correlation and relative outperformance is due to the large coupon present in the high yield asset class. This coupon return helped to soften the negative return caused by the swift move in Treasury rates. Keep in mind, coupon return has carried the Barclays U.S. High Yield 2% Issuer Capped Index to a positive return of 2.31% year to date, despite a negative price (capital appreciation) return.
Digging a little deeper, the yield on U.S. Treasury 5- to 7-year maturities and the yield on the Barclays High Yield 2% Issuer Capped Index have moved nearly in lock step since May 1, widening by 101 basis points and 113 basis points respectively.
What happens if Treasury yields widen by another 100 basis points over the next twelve months?
Utilizing the assumptions in the table below:
|Spread Change, bps||
|Treasury Change, bps||
|Expected Current Yield||
|Implied Total Return||
Using our model, the high yield market still shows an implied positive return of 2.0% even in the unlikely event that Treasury yields widen another 100 basis points. The 7.2% “coupon” on the asset class helps to insulate investors from rate moves, hence the low correlation.
Rate worries over the Fed’s potential tapering of its quantitative easing program have been compounded in the high yield asset class by volatile asset-class flows in ETFs and mutual funds as investors worry about future returns. We feel as though this fear is overdone. Further, we feel that clarity from the Fed in September, by itself, will alleviate market concerns about an immediate and significant rise in rates.
The recent rise in rates symbolizes economic growth. High yield companies have significant operating leverage because of the level of debt on their balance sheets. Economic growth is fundamentally beneficial for companies, especially companies that find themselves classified as high yield because of their inherent operating leverage. Economic growth will ultimately lead to spread tightening, which will also help offset a rise in rates (in addition to the coupon highlighted above). In fact, looking at 13 different periods of sharp Treasury rate increases since 1996, only once have high yield spreads not tightened. That period started May 1 of 2013. We don’t expect this trend to continue.
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