Cast your mind back to June 2014. King Juan Carlos I of Spain abdicates the throne after a 39-year reign. Uruguay’s Luis Suarez is expelled from the FIFA World Cup for biting Italy’s Giorgio Chiellini. The European Central Bank breaks new ground in monetary policy by cutting its deposit rate to a negative level for the first time. The French air traffic controllers strike over budget cuts (some things never change). Meanwhile, the US high yield bond market hits a record low yield of 4.84%.
Any investors who at that point had perfect foresight would have already known that yields would rise to a level of 6.37% by July 2018, and also a spike in defaults in 2016 due to the impact of declining oil prices on the US onshore oil industry. They would have also known that the Federal Reserve would begin a rate hiking cycle in late 2015. People with such foresight may have been tempted to either disinvest from the US high yield bond market, move to underweight, or go outright short. However, such a decision may not have been as profitable as anticipated.
Despite the steady rise in yields, the US high yield bond market delivered a 17.5% cumulative total return from Jun-14 to Jul-18, or 4.04% on an annualised basis. This was greater than both US investment grade corporate bonds (2.65% annualised) and US Treasury bonds (1.54% annualised). A combination of factors helps high yield bonds in a rising yield environment. These are: relatively high coupons; and quite short duration. For any fixed income instrument, the shorter the duration, and the higher the starting yield, the greater the rise in yields that is needed to create a capital loss large enough to wipe out the yield income. With longer duration and lower starting yields, investment grade corporate bonds and government bonds become much more exposed against a backdrop of rising yields.
Looking at today’s market level, with a yield of 6.37%, the US high yield bond market could sustain a rise in yields to 7.92% over the course of the next 12 months without delivering a negative total return to investors. For those readers that are either cautious or bearish about the high yield bond market, the question to ask yourself is not whether you think yields will rise, but whether yields will rise far enough and fast enough to offset the yield income.