Below investment-grade markets to shine as rates rise?

Breakdown of Barclays Agg total returns over time

Source: ICE BofAML U.S. Corporate Index, ICE BofAML U.S. High Yield Index, S&P/LSTA Leveraged Loan Index. Based on rolling 10-year data ended September 24, 2021. Duration measures the sensitivity of a bond’s price to changes in interest rates. Empirical duration uses historical data to calculate the observed change in a bond‘s price given changes in rates. It is calculated regressing weekly change in high yield bond index prices and weekly change in 5-year U.S. Treasury yields.

• Treasury yields have risen sharply since the Fed adopted a more-hawkish tone at its September meeting. Since September 22, the 2-year Treasury yield has risen as much as 6 basis points while the 10-year yield jumped 22 basis points before both moderated a bit.¹
• Amid the rising rate environment, core fixed income returns have suffered. The Barclays Agg returned -0.87% in September, bringing its YTD return down to -1.55%. Over the same time, credit markets have held up relatively well. High yield bonds are flat in September while senior secured loans are up 0.64%. Year to date, they have returned 4.7% and 4.4%, respectively.²
• The divergent paths illustrate the varying degrees of duration risk across fixed income asset classes. (As a reminder, duration measures the sensitivity of a bond’s price to changes in interest rates).
• To this end, the chart compares stated duration to empirical, or observed, duration. Stated duration is based on a preset formula while empirical duration uses historical data to calculate a bond’s sensitivity to changes in interest rates.
• Over the last ten years, the duration of high yield bonds and senior secured loans has been lower than investment grade corporate bonds, as most would expect.² Looking at empirical duration tells a more complete story of their relationship to interest rates. In fact, high yield bond and senior secured loan prices increased approximately 1.4% and 2.6%, respectively, for every 100-basis point increase in interest rates over the last decade.²
• At a time when many investors are looking to reduce or diversify their interest rate risk, below-investment-grade bonds may be particularly attractive against the backdrop of generally stable economic conditions, an uncertain interest rate outlook and expectations for the Fed to begin tapering.