High Yield Bonds: Navigating Volatility, Inflation & Rising Rates

1. In what ways are high yield bonds different than equities or investment grade bonds? In terms of portfolio management, what benefits can long-term investors achieve from investing in high yield bonds?

While stock investments offer greater upside return potential, the high yield asset class will typically have lower levels of volatility and drawdowns during market sell-off cycles. While equity markets can be particularly sensitive to growth dynamics, what is more important with high yield investments is a borrower or company’s ability and willingness to pay back its debt obligations.

Relative to investment grade assets, the high yield market typically has higher credit risk associated with it, given you are lending to companies with a lower credit quality profile. This generally results in greater compensation to lenders in the form of higher interest/coupon income. In addition, the interest rate sensitivity (duration) profile for high yield bonds is much lower than with investment grade bonds.

High yield as an asset class has historically offered investors a high level of income with limited interest rate sensitivity and exposure. The large size and well diversified nature of this market can also offer investors a compelling strategic allocation.

2. What are the opportunities and risks in the global high yield bond market in 2022?

2022 has gotten off to a very volatile start, given high inflation, expectations of hawkish central bank activity and, most recently and extensively, the ongoing conflict in Eastern Europe. The human cost of war is extremely concerning.

We would note that in the face of this volatility, the high yield bond markets have sold off considerably on a year-to-date basis, with U.S. Treasury yields higher and credit spreads materially wider. However, periods of volatility may result in market dislocations and outsized moves, providing active, bottom-up managers with an opportunity to generate alpha. We have seen this through multiple market events, from the sovereign debt crisis, to the commodity crisis, to the Covid-19 induced market selloff in 2020.

Given the risks on the horizon—including the potential for further military escalation in Ukraine, disruption to energy and broader commodity markets, elevated inflationary pressures and Covid-19 related disruptions—bottom-up credit analysis and a highly selective approach to risk is key to navigating the current environment.

3. Due to recent inflationary pressure, central banks around the world, including the Fed, are trying to accelerate interest rate normalization. Why should investors pay attention to high yield bonds during the rate hike period?

Shorter-duration fixed income assets, such as high yield bonds, have a lower interest rate sensitivity (duration) profile, which means they can provide more resilient returns during rate-hiking cycles relative to longer-duration government or investment grade corporate bonds.

High yield bond returns have historically been negatively correlated to U.S. Treasury/government bond returns. As a result, even in periods of rapidly rising U.S. Treasury yields/interest rates, high yield returns have only been marginally impacted, while longer-duration asset classes have tended to sell-off more aggressively. Additionally, if periods of rising interest rates are associated with a strong growth and reflationary market environment, that is typically a favorable backdrop for high yield companies.

It is also worth noting that, at a high level, issuers in developed markets look healthy from a fundamental perspective. Many companies have lower leverage and a much higher level of liquidity relative to past periods of rising rates, which should help them absorb higher inflation in the near term. Another factor to consider is that from late 2020 through 2021, new issuance surged across the fixed income universe, as companies built up capital reserves to help weather the pandemic. At the same time, increased refinancing activity pushed out companies’ maturity walls by several years. As such, many of these companies have a positive—albeit unintentional—buffer to get through the inflationary pressures at hand.

4. Expectations for the reopening are building up around the world. Will there be any impact on high yield bonds once economic activities are fully resumed?

While certain disruptions from the pandemic remain, such as supply-chain challenges, labor force participation rates and certain economic activity levels, what is also important to assess is what is being priced into financial markets—as it is the actual outcomes versus market expectations that are likely to cause market prices to move.

Very broadly speaking, the reopening of economies and continued improvement in economic activity indicators should be a favorable backdrop for the high yield asset class, and should continue to support company fundamentals.

5. Market volatility has soared recently due to Russia’s invasion of Ukraine. Is there any advice you would like you give to investors amid this heightened macro volatility?

The current situation in Ukraine is extremely tragic from a humanitarian perspective and very volatile from a global financial market perspective. The situation remains highly fluid, with various military scenarios possible. Further, given the large scale of Russia’s various commodity exports, sanctions by the international community could significantly impact factors such as higher prices/inflation for these products.

Given the current market backdrop and potential for further volatility going forward, active management, versus passive allocations, is as important as ever. An active approach allows managers to be highly deliberate in terms of which parts of the market they have exposure to, and puts them in a position to quickly and efficiently capitalize on inefficient market pricing and outsized market moves. In doing so, it allows managers to capitalize on relative value opportunities as they arise, while also helping in the avoidance of unwanted risks.