Since early May Treasury interest rates have shot up over
30% (still when
put in perspective, not that all that much). Bond prices and interest rates have an
inverse relationship, so when interest rates rise bond prices fall.
It’s easy to think about this relationship in a practical
sense, if Bond A is yielding 5% at time 0 and a similar Bond B is yielding 6%
at time 1 then why would anyone own Bond A at the same price they could buy the
higher yielding Bond B? Thus, the price
of Bond A falls.
So given the above it logically follows that recent spike in
interest rates would have led to a fall in bond prices. That indeed happened:
What’s interesting about the above is that high yield bonds
and preferreds, HYG and PFF, also moved down in value. This didn’t happen in late 2012 through March
of this year when Treasury yields also had a 30% rise.
This could be
the start of another shift in the market.
In this instance, high yield bonds and the like may move more with the
change in Treasury interest rates, where in the recent past they moved with
equities:
There are a few takeaways here:
- The spread (difference in yield from high yield bond over a Treasury) may be done contracting for the time being.
- Note: Since I wrote this spreads have moved up, which makes high yield bonds more attractively valued
- If it consolidates into the current range, the spread return (e.g. yields on high yield bonds fall when Treasury yields stay constant or even rise) will no longer be existent.
- Thus, the return from high yield bonds will be a combination of the interest paid on the bonds and change in Treasury interest rates (ipso facto, Treasury yields rise, high yield bonds fall and vice versa).
- The caveat would be that if equity markets fall apart, high yield bonds will probably follow.
- Therefore, if high yield bonds are yielding 6.50% + another 2.50% if Treasuries revert back to 1.60% or so level (a rise from this level resulted in a 2.50% fall in Treasuries) and assuming the spread stays constant means the upside is roughly 9.00%.
- On the flip side, the risk is larger than 9.00% given the correlation to the equity markets, if they fall.
- Further, if Treasury interest rates rise steadily this will also hamper returns, though I don’t think there is substantial downside to high yield bonds in this respect.
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results. Diversification does not guarantee a profit or protect
against a loss. International investing involves special risks, including, but
not limited to, the possibility of substantial volatility due to
currency fluctuation and political uncertainties. The views and
opinions expressed herein are those of the author(s) noted and may or may not
represent the views of Capital Analysts, Inc. or Lincoln Investment. Nothing in the above writing should be taken
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