The US high-yield bond market has rallied sharply since its panicked downturn at the start of the COVID-19 pandemic. But now the fear of rising current yields is rampant.
Investors know that bond prices fall when yields rise. So should investors get out of the high yield market to avoid the next rise in yields and only get back in when it’s behind us? We disagree.
When we examine different investor behaviors under different return scenarios, bond math speaks for staying invested.
With bonds, time (invested) is money
Bonds are sensitive to fluctuations in interest rates and investors may initially experience negative returns as yields rise. But here, too, time heals most wounds. Not only do bonds provide current income, but their prices move toward face value until repayment (except in the event of default). That means investors who wait and see can reinvest the capital and coupon income from their portfolio in newer – and higher-yielding – bonds. This can make up for short-term losses and often increases the overall return.
Consider the four scenarios in the figure below. In the first three scenarios – rising returns, stable returns and falling returns – the investor remains in a high-yield portfolio over the entire investment horizon. In the fourth scenario, the investor stays away from the high-yield market when yields rise and then returns after two years.
The results of the four scenarios may seem surprising for two reasons.
First, although they enter the market with a higher initial yield, investors who are left out in the case of rising yields do worse than fully invested market participants in the same scenario with rising yields. This illustrates the power of return and time.
Second, for the fully invested market participant, the rising returns scenario outperforms the falling returns scenario, while stable returns create the best conditions for success. It’s counterintuitive. Investors often want yields to fall, as this creates an additional rise in prices. But the resulting lower returns are detrimental to the portfolio.
Does that mean that investors with high returns should actually bet on increasing returns? Not necessarily.
Timing matters. If yields fall, this should be done as soon as possible before the end of the holding period. In this way, companies will not refinance their bonds with new, lower coupons, which would reduce the return on the portfolio. On the other hand, if returns rise, investors should do so at the beginning of their investment period, as they will then benefit from higher reinvestment returns sooner.
What happens in the event of a “boom in returns”?
The stronger the rise in returns, the stronger the price decline. We believe that US high yield bond market yields would have to rise nearly a full percentage point over the next year for the market to post a negative 12 month return. We wanted to know how such a sharp increase would affect our hypothetical portfolios during our extended holding period. And it turned out it doesn’t make much of a difference (Illustration).
It makes a big difference if you get the timing wrong. Investors should only be left out if they are one hundred percent certain that the “big yield boom” will occur next year. If you are wrong and it takes more time, as in scenario 2, you are left out.
More than most other asset classes, high yield bonds pay well as time goes on. So we don’t think the question is whether yields will rise, but rather whether they will rise sharply and quickly. And because no one can predict it with certainty, investors can also be paid to take part.
Will Smith is Director of US High Yield at AllianceBernstein (AB).
Opinions expressed in this document do not constitute analysis, investment advice or trading recommendations, do not necessarily reflect the views of all of AB’s portfolio management teams, and are subject to change from time to time.
Past performance results do not allow any conclusions to be drawn about the future development of an investment fund or security. The value and return of an investment in funds or securities can go down as well as up. Investors may only get paid less than the invested capital. Currency fluctuations may affect the investment. Please note the regulations for advertising and offering units in InvFG 2011 §128 ff. The information on www.e-fundresearch.com does not represent recommendations for buying, selling or holding securities, funds or other assets. The information on the e-fundresearch.com AG website has been carefully prepared. Nevertheless, there may be inadvertently erroneous representations. Liability or guarantee for the topicality, correctness and completeness of the information provided can therefore not be assumed. The same applies to all other websites to which reference is made via hyperlinks. E-fundresearch.com AG rejects any liability for direct, concrete or other damage that may arise in connection with the offered or other available information. The NewsCenter is a chargeable special form of advertising by e-fundresearch.com AG for asset management companies. Copyright and sole responsibility for the content lies with the asset management company as the user of the NewsCenter special form of advertising. All newscenter notifications are press releases or marketing communications.