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Give Me Shelter: What a Rising Rate Environment Might Mean for Credit Markets

With vaccination rates ramping and the economy beginning to emerge from its COVID-induced slowdown, the days of record-low interest rates are likely numbered—which raises questions about the broader fixed income environment. While rising rates could mean conventional fixed income areas are in for a relatively rough ride, they could also provide an interesting environment for high yield and leveraged loans, which have historically fared relatively well as rates rise thanks to some potentially overlooked considerations. 

As investors have rushed to price in their expectations for booming global growth and higher inflation, wild swings in Treasury yields have become commonplace—despite the Fed’s signaling its commitment to accommodative policy for the foreseeable future. Hence benchmark 10-year Treasury yields’ steady march higher, increasing more than 80bps year to date.

So far, conventional fixed income segments like investment-grade credit have borne the brunt of the market move, with the ICE BofA US Corporate Index declining more than 4.5%—wiping out nearly nine months of gains. The move has even been more acute among long bonds, which are down 9% year to date and are on pace for one their worst years ever.

Meanwhile, high yield credit has been relatively insulated from the recent rate swings, with positive returns and relatively little correlation to core credit segments—which isn’t totally surprising given rising rates aren’t necessarily a bad thing for high yield credit. They tend to reflect an improving economic environment in which consumer spending is strong and corporate profits are rising. Because the primary risk with high yield bonds is default risk, a strong economy generally improves corporate fundamentals and issuers’ ability to service debt obligations—particularly for credit-sensitive segments, where the signal provided by rising rates is often more important than the movement in rates itself.

On a more technical level, high yield bonds also tend to hold up due to compositional differences between them and investment grade credit. High yield issuers tend to issue shorter-dated debt that is less sensitive to interest rate changes than high-grade issuers’ debt. And because high yield bonds typically come with higher coupons, they’re able to better absorb price declines caused by higher rates through tighter credit spreads. This difference in interest rate sensitivity shows up in duration: High yield bonds’ average current duration is around 3.7 years, versus 7.9 years for investment grade bonds—just shy of its record high. With the differential near its widest on record, it’s not a big leap to conclude high grade credit will be particularly vulnerable to interest rate shifts, especially now that tight spreads provide less cushion to absorb higher rates.

Duration: High Yield vs Investment Grade Corporate Bonds
Investment grade debt is more susceptible to losses from rising rates

Source: ICE BofA. As of 31 Mar 2020. Based on modified duration. Modified duration is a measure of responsiveness of a bond’s price to changes in interest rates.

History bears this out: There is a clear inverse relationship between credit quality and interest rate sensitivity. During short periods when Treasury yields have increased rapidly, lower-rated credit has been resilient. CCC-rated bond returns in particular have a strong inverse relationship to Treasury yields—likely driven by the idiosyncratic nature of the bonds in the CCC rating bucket, their shorter duration and their reliance on improving economic conditions.  

Returns by Asset Class During Rising Rate Periods
Median 3-month returns when 5-Year Treasury yields have increased more than 50bps

Source: Artisan Partners/ICE BofA/Credit Suisse/Bloomberg. Based on returns for the ICE BofA US High Yield Index (High Yield), ICE BofA US Corporate Index (Investment Grade) and Credit Suisse Leveraged Loan Index (Leveraged Loans) for the period December 31, 1996 to February 28, 2021. Past Performance is not a reliable indicator of future results.

Returns by Credit Quality During Rising Rate Periods
Median 3-month returns when 5-Year Treasury yields have increased more than 50bps

Source: Artisan Partners/ICE BofA/Credit Suisse/Bloomberg. Based on returns for constituents in the ICE BofA US High Yield Index and BBB-rated constituents in the ICE BofA US Corporate Index for the period December 31, 1996 to Feb 28, 2021. Credit ratings typically range for quality from AAA (highest) to D (lowest) and are subject to change. The ratings apply to underlying index constituents. Past Performance is not a reliable indicator of future results.

And finally, leveraged loans are one of the few fixed income segments that directly benefit from higher rates through increased yield. Because of their floating feature, leveraged loans have little interest rate risk, and their prices are unlikely to decline like those of conventional fixed income assets when interest rates rise. Then, too, demand for loans tends to rise with interest rates. Loan yields may be tied to short-term interest rates, but loan prices tend to trade more in line with moves in longer-term Treasury yields. Even though loan coupons remain relatively unchanged with short-term rates still pinned near zero, the asset class has seen more than $8 billion of inflows so far this year, tightening valuations and benefiting returns.