(PUB) Investing 2016

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The Usual Suspects Might Not Help When Rates Rise Portfolio Matters | Christine Benz

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

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