High yield bonds have significantly outperformed higher rated debt in the first seven months of 2023, posting strong positive returns, despite a considerable rise in interest rates and concerns about the health of the banking system earlier this year.
As Senior Principal for Applied Research, Christoph generates insights into market trends with a particular focus on multi-asset class analysis and thematic investing.
While the latter caused an upsurge in risk premia at the beginning of March, credit spreads have since returned to their pre-crisis levels on the back of recovering share prices. Furthermore, the inverse relationship between spreads and risk-free rates indicates that high yield bonds can provide an attractive hedge against further central bank rate hikes.
High yield bonds outperform as tighter credit spreads outweigh higher rates
The left-hand chart in Figure 1 shows year-to-date returns of USD-denominated fixed income ETFs, investing in government (light blue area), investment grade corporate (dark blue line) and high yield (green line) bonds. The chart on the right shows the corresponding yield and spread series, namely the 10-year US Treasury rate and the average risk premia of A3 and B1-rated securities over USD swaps1. The series on the right are plotted against inverted scales to match the directions (and colours) of the corresponding fund returns on the left.
Figure 1: USD Fixed Income ETF Year-to-Date Total Returns
Sources: Axioma Fixed Income Spread Curves, Qontigo, Yahoo! Finance
Since the start of the year, the 10-year Treasury yield has risen by approximately 35 basis points, wiping out most of the government bond ETF’s interest income and resulting in a flat performance year to date. This contrasts with a gross return of around 5% for the portfolio of high yield bonds, which not only benefitted from higher coupon income, but also from tightening credit spreads more than offsetting the rise in risk-free rates. The tighter spreads also supported higher rated corporate securities, albeit to a lesser extent, generating a total gain of about 1.5% over the same period.
Recovering share prices support corporate debt
Figure 2 highlights the close relationships of high yield credit spreads with both share prices in the left-hand chart and central-bank policy expectations on the right. The inverse interaction with the stock market (spreads are once again plotted against an inverted scale) has been very consistent throughout the entire Federal Reserve hiking cycle since September 2021. Especially since the most recent peak in mid-March, BB spreads have tightened more than 100 basis points as the STOXX® USA 900 benchmark gained nearly 20%.
Figure 2: USD credit spreads versus share prices (left) and monetary policy expectations (right)
Sources: Axioma Fixed Income Spread Curves, CME Group, STOXX
The light-blue line in the right-hand chart of Figure 2 represents the expected average effective federal funds rate for December, implied by futures traded on the Chicago Mercantile Exchange. The relationship between monetary policy expectations and credit risk premia has also been mostly inverse over the past two years, though too a much lesser extent than the interaction between spreads and share prices. It has only been since March that the negative correlation has become decidedly stronger. This implies that any indication of further rate hikes from the current central bank target of 5-5.25% could result in even lower risk premia for high yield bonds, thus potentially offsetting any adverse effects from higher risk-free yields.
Inverse rate/spread relationship immunizes high yield against tighter monetary policy
To put this hypothesis to the test, we created two scenarios in Axioma Risk™, where we modelled the potential effects of 0.25% increases in either the federal funds rate or the 10-year Treasury yield on three portfolios of USD-denominated sovereign, investment grade corporate, and high yield bonds2. Figure 3 shows the projected price returns under both scenarios, normalised for a duration of 7 years. It is worth noting that the analysis only measures the instant impact of the rate changes on clean prices; it does not consider coupon income.
Figure 3: Simulated price returns for 0.25% rise in fed fund rates (left) and Treasury yields (right)
Source: Axioma RiskTM
Treasury bonds are likely to experience the biggest negative returns in both scenarios, shedding up to 1.8% for a 25-basis point surge in the 10-year yield. Projected losses for corporate securities are significantly lower, as tightening credit spreads can be expected to offset at least part of the rise in risk-free rates. In the case of further rate hikes from the Federal Reserve, the adverse effect of higher risk-free rates is even projected to be fully immunized by tighter spreads for high yield debt, which would make the latter an attractive hedge in such a scenario. The coupon income should provide an additional buffer, even in the scenario of higher Treasury yields.
High yield bonds can offer better risk-adjusted returns than higher rated debt
At the same time, high yield bonds appear to exhibit similar risk to higher rated debt. For example, the annualised weekly return volatility of the high yield ETF in Figure 1 was 7.3% in the first seven months of 2023, compared with 8.5% for the investment grade fund and 6.5% for the Treasury portfolio. It must be noted, though, that the funds have very different durations. Figure 4 shows predicted risk numbers that were normalised to a 7-year duration, broken down by broad ratings and major factor types. The underlying DTS-based risk model was calibrated on weekly returns over five years with a half-life of one year.
Figure 4: Predicted risk by broad rating and factor type
Source: Axioma RiskTM
At first glance, there appears to be a clear divide between investment grade and high yield in terms of the predominant sources of risk. The returns of AAA to BBB-rated securities appear to be almost entirely driven by interest rates, with very little to no impact from credit spreads. Also, the overall predicted volatility of just under 7% is steady across all four rating bands. This indicates that investors in higher rated debt are primarily concerned about the level of risk-free rates rather than the creditworthiness of the issuing companies.
The picture changes once we cross the threshold into high yield territory. There is still a sizeable risk contribution from interest rates, which remains more or less constant as we slide down the rating scale, while credit risk becomes more dominant. However, the generally inverse relationship between the two risk drivers means that in an environment of rising Treasury yields, tighter spreads are likely to dampen much of the impact, while in times of market turmoil, high yield bonds can still benefit from falling risk-free rates.
An attractive hedge in times of rising interest rates
Based on our risk and scenario analysis in Axioma Risk™, we can conclude that high yield bonds can indeed offer an attractive hedge in times of rising interest rates and tight monetary policy. Due to the strong inverse relationship currently between credit spreads and risk-free rates, overall yields of lower rated securities are likely to be less volatile than those of more secure investments—even in times of market turmoil—due to the added benefit and cushion of the higher coupon income.
1 Rating and tenor of each spread timeseries were chosen to match the average creditworthiness and duration of the corresponding ETF.
2 The transitive stress tests were calibrated on weekly returns from March to July 2023.