High hopes for high-yield debt

As interest rates rise, junk bonds could be a safe bet for investors

In theory, high-yield bonds should be able to absorb much of an initial rise in interest rates without suffering the same level of price declines as higher-quality bonds.

As a general rule, lower-quality bonds tend to be more correlated to equities than to Treasury bonds.

“In a rising-rate environment, high yield can become a decent relative play as long as the economy stays OK,” said Rick Vollaro, chief investment strategist at Pinnacle Advisory Group Inc.

“If the rates start to go up, it’s usually because economic growth is good,” he said.

In the fixed-income world, a stronger economy is a likely boost for companies that issue high-yield debt because it bodes well for honoring those debt obligations.

[More: Want to short high-yield debt? Here’s an ETF for you]

From a performance perspective, over the first two months of the year, the iShares iBoxx High Yield Corporate Bond ETF (HYG) gained 1.3%, compared with a 6.9% gain by the S&P 500.

Meanwhile, over the same two months, the iShares iBoxx Investment Grade Corporate Bond ETF (LQD), a proxy for investment-grade bonds, declined by 0.2%, which matches the decline of the Barclays U.S. Aggregate Bond Index.

LINKED TO CREDIT QUALITY

In essence, while the highest-quality bonds are more sensitive to interest rates, junk bond risk is linked more to credit quality.

Another part of the distinction is the higher yield on junk bonds, which traditionally is considered to be part of the buffer that makes such bonds less sensitive to interest rate movements.

But these are unprecedented times in the fixed-income world. With rates at historic lows, thanks in part to three rounds of quantitative easing by the Federal Reserve, investors have migrated into lower-quality bonds in search of yield.

“High yield typically tends to be less sensitive than investment-grade bonds when rates move, but right now, everything is so compressed,” said Fran Rodilosso, a portfolio manager of Van Eck Global’s Market Vectors exchange-traded funds.

Ultimately, while high-yield bonds might not be as well-buffered as they have been in years past, they still represent a certain degree of diversity in fixed income.

“Not all bonds are created equal, and all bond prices don’t move one for one with Treasury yields,” said Jim Sarni, managing principal in fixed income at Payden & Rygel.

“There can even be negative correlation between high-yield and Treasury bonds because these are the kinds of companies that are more sensitive to the economic cycle,” he said. “Of course, the key is how gradual the rise in rates will be, because if we came in tomorrow and the 10-year Treasury yield has doubled to 4%, it won’t matter where you were, because you won’t like what you see.”