High-Yield Bonds & The Historical Impact of Rising Interest Rates...

Even at historical low yields of about 7%, high-yield corporate debt stacks up favorably against the S&P 500, which has a dividend yield of less than 2%. That means stocks, which are a lot more volatile than bonds, would need to gain at least +5 percentage points of performance just to keep up with a more predictable 7% yield from high-yield bonds.

Historically, high-yield bonds have not been as sensitive to interest rate increases as investment-grade bonds and treasury bonds.

For example, one of the biggest threats to fixed income right now is that a sudden spike in interest rates — currently at historic low levels — would further wipe out returns. According to an analysis of the biggest interest rate moves over the 20-year period through June 2006, high-yield bonds are remarkably resilient against interest rate volatility.

Between September 1987 and June 2006, there were six separate 12-month periods that saw the yield on the 10-year Treasury climb by between +117 and +222 basis points.

The average total return of high-yield bonds for those same 12-month periods was +5.5%, with just one negative-return period.

In comparison, the average total return for investment-grade corporate bonds over the same periods was a loss of -0.1% ,  including three negative-return periods.

Of the six 12-month periods, the worst performance for high-yield bonds was a decline of -1.57% in 1994, when the Treasury yield climbed by +204 basis points. Over the same period, investment-grade bonds fell by -3.34%.

The best 12-month period for high yield was through May 2004 when the bond category gained +13.23% on a 130-basis-point gain in the Treasury yield. Investment-grade bonds over the same period fell by -0.47%.

One of the main reasons high-yield bonds are able to weather interest rate volatility is the yield “cushion,” according to Sabur Moini, manager of the $1 billion Payden High Income Fund (PYHRX). For example, the current 6.8% average yield on high-yield bonds compares with a 3.8% average yield on investment-grade bonds.

“The bigger yield cushion makes high-yield bonds a lot less interest-rate-sensitive,” Mr. Moini said.

“Typically, low growth, but not in a recession, is the best environment for high-yield bonds,” said Michael Collins, co-manager of the $700 million Prudential Total Return Bond Fund (PDBAX). A little bit of inflation and projected economic growth in the +2% to +2.5% range “is almost the sweet spot for high yield,” he said.