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Treasury yields spiked in advance of the Federal
Reserve Board’s mid-September meeting to decide
whether to raise short-term interest rates. In the
end, the Fed decided to hold off, but the pattern of
U.S. government bonds suffering when interest-rate
worries are running high is a familiar one. Because
the market considers government bonds to be devoid
of credit risk, there aren’t a lot of moving parts;
their prices tend to be a direct reflection of investors’
interest-rate expectations. If investors are operating
under the assumption that there will be new govern-
ment bonds issued with higher yields attached to
them, that has an immediate negative impact on the
prices of already existing bonds with lower yields
attached to them. The opposite is also true: When the
economy shows signs of weakness and investors
are expecting that interest rates could trend down (or
at least remain flat), demand for government bonds—
and in turn their prices—tends to jump the most.
Yet even as long-term Treasuries are widely—and
rightly—called out as the key investments to be
careful of in an interest-rate uptick, other types of
securities have the potential to feel a tremor, too.
As yields have been depressed across the board, valu-
ations have risen, and the duration on the Barclays
Aggregate Index has extended to more than five years,
investors should be aware of the potential for rate-
related volatility in other pockets of their portfolios,
too. Here are some spots to keep an eye on; while
few are expecting rates to begin moving up with a
vengeance, investors may have to put up with some
price fluctuations in the months and years ahead.
Junk Bonds
Investors widely assume that very high-quality corpo-
rate bonds will react negatively to interest-rate
hikes, but junk bonds are often considered to be less
vulnerable. There are a few key reasons for this. First,
lower-quality bonds typically perform well in periods
of economic strength, as investors become more
sanguine about the ability of highly indebted compa-
nies to make good on their obligations; that’s usually
the same time the Fed is considering interest-rate
hikes to head off higher inflation. Additionally, high-
yield bonds are often considered less vulnerable
to rate hikes because their yields are higher in abso-
lute terms, so price declines have a less meaningful
impact on their performance than is the case with
lower-yielding high-quality bonds. A
0
.
25%
change in
short-term rates will likely have a bigger impact on
the price of a bond yielding
2%
than it will on the one
yielding
6%
.
Yet thanks to strong performance, high-yield bonds
don’t have as much of a yield buffer as they once did.
Owing to a fairly steady stream of good news about
the economy, and, perhaps more important, a dearth of
decently yielding alternatives, investors have been
gravitating to high-yield bonds, pushing up their prices
and taking yields down in the process. The average
high-yield fund has gained
6
.
5%
on an annualized
basis over the past five years, the third best of any
taxable-bond category. While the yield differential—
or spread—between high-yield and U.S. Treasuries
spiked to more than
8
percentage points this year, it
has dropped to just
5
percentage points recently.
That means that high-yield bonds are threading a fine
needle. If rates go up, junk bonds might come
under price pressure as investors would prefer to own
higher-quality credits as higher yields come online.
Moreover, senior analyst Eric Jacobson notes that
higher interest rates can create headwinds for highly
leveraged businesses.
“Most high-yield issuance is comparatively short
(that is, new bonds usually issue at
10
years) and is
frequently done under the pretense that it will be
refinanced or retired ahead of time when conditions
favor it. So if rates rise, even if they don’t affect
borrowing costs immediately, the likelihood that they
will increases. That can cause problems for highly
The Usual Suspects Might Not Help
When Rates Rise
Portfolio Matters
|
Christine Benz