So at long last we know whether the word “patient” stays or goes: it’s gone and Treasury yields have actually declined as a result. So far this year we have seen rates go from a 2015 low of 1.19% on the 5-year and 1.68% on the 10-year on February 2nd, and then spike a month later at 1.70% and 2.24%, respectively, on March 6th. So an over 50bps move in a month all over the worry about the word “patient” and whether rates will rise as early as June. Only for rates to fall after the statement was released and the key word removed.
At the end of the day, does a rate rise in June versus September versus December really matter all that much? We know that the Fed will be increasing the federal funds rate at some point in the future, as it has sat at a historic low of 0-0.25% for the six years since the financial crisis. It has nowhere to go but up. But markets are forward looking mechanisms so will price in expected interest rates moves ahead of actual moves. So as we sit today, has the market already priced in an interest rate move or could we expect a big spike in rates from here?
An ultimate move in the federal funds rate will not be a surprise to anyone and we don’t expect that once the Fed does begin to take action, they’ll move rapidly in raising rates. If recent history has shown us anything, it is that today’s Fed is cautious and seemingly not wanting to surprise or shock markets. There are also a number of headwinds that we expect to temper a strong move in rates, both by the Fed and in Treasury markets in general, including the strong U.S. dollar, inflation below the 2% target, still mixed domestic economic data, and the rate of U.S. government bonds relative to their counterparts throughout the developed world. For instance, looking at the rate of the U.S. 10-year Treasury relative other 10-year government bond rates, it seems hard to make an argument that buyers won’t be there and ultimately temper rates from spiking.1
So while short term rates will move up once the Fed starts to take action, we don’t expect to see a large and rapid increase on rates on the longer-term bonds, such as the 5-year and 10-year.
With all this speculation and concern about rising rates, what does the mean for financial markets once the Fed starts to take action? Specifically for fixed income, investors often seem to be under the notion that anything “bond” related is highly interest rate sensitive and will take a hit if rates rise. However, looking at the 25-year correlation chart below, we see that is far from the truth.2
Certain asset classes, such as investment grade bonds have a high correlation to Treasuries, thus have much more interest rate sensitivity. That means if rates (yields) increase in Treasury bonds, and prices decline, we would theoretically see the same sort of action in investment grade bonds—price declines. However, as noted above, high yield bonds are slightly negatively correlated to Treasuries, so we would expect to theoretically see minimal impact from a move in Treasuries, or even an increase in high yield bond prices.
Looking at the actual returns for the high yield asset class, in the 15 calendar year periods since 1980 where we saw Treasury yields increase, high yield bonds posted an average return of 13.7% over those annual periods.3 A few other things to keep in mind, high yield bonds have historically been much more linked to credit quality than interest rates. We would expect to see rates rise during stable to improving economic conditions, which we would expect to be favorable to business fundamentals and credit metrics, and thus to high yield investors.
While we don’t expect a rapid increase in rates, if rates do rise, high yield bonds have a good historical track record in this type of environment. Given the low to negative Treasury correlations versus other asset classes, an allocation to high yield bonds may serve to improve a portfolio’s diversification and potentially even lower risk depending on the mix of assets.
1 Data sourced from Bloomberg as of March 24, 2015.
2 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. A153.
3 Data sourced from: Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2008 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 2008, p. 113. “High-Yield Market Monitor,” J.P. Morgan, January 5, 2009, January 5, 2010, January 3, 2011, January 3, 2012, January 2, 2013, and January 2, 2014. 2008-2012 Treasury data sourced from Bloomberg (US Generic Govt 5 Yr), 2013 data from the Federal Reserve website.