Given the ongoing debate about the imminence of a rate hike in the US, fixed income investors are due to wonder what this would imply for their portfolios.
To start with, I would clarify that the yield for a corporate bond can be theoretically broken down in a component which remunerates for the risks specific to that issuer (i.e. credit risk) and a second one, which will be the yield for the “risk free” investment alternative in that currency.
To be clear, by risk free here I mean an investment with limited credit risk which is in most cases the sovereign. Thus, in the case of USD corporate yields, one would usually presume that they are reflecting the prevailing US government yield, with the extra yield (commonly referred to as spread) varying depending on issuer-specific factors (sector, leverage, outlook etc).
Taking an example, a 10 years USD corporate bonds yielding six per cent is carrying a spread of 3.7 per cent over the benchmark 10 years US government bond which yields about 2.3 per cent.
To go one step further, the question that follows is whether an interest rate hike, which is usually resulting in higher sovereign yields, should drive corporate yields higher. My answer is that this depends on the bond/issuer type and the timing of the hike.
For corporate carrying lower ratings (and higher yields), a rate hike could result in tighter spreads as the change in monetary policy comes with an improving economic outlook; to take the case of the US, Fed is expected to soon increase rates because the economy is faring well and because there is enough confidence that the trend will consolidate.
High yielding companies, which have limited buffers and high leverage, are due to see their credit risk ease in this context. By extension, this would justify narrower spreads over government yields with the end result for corporate yields possibly ranging from tightening (price increases) to a mild increase (which should be offset by the coupon earned).
There could be an opposite reaction in the event that the interest hike is perceived as premature and negative for the growth outlook. However, such risks are low in my view given that the Fed has proven very accommodative has taken a data dependent policy stance.
Indeed, if China fails to arrest the recent volatility in its equity markets and global growth risks rise as a consequence, I expect the Fed to delay the monetary policy tightening as needed.
The 2004 hiking cycle is illustrative for investors in low rated bonds as spreads and yields dropped while Fed increased its rate from one per cent to 2.5 per cent; only after five hikes did the High Yield undergo a correction although this reflected to some degree Argentina’s default and the downgrade to junk of some large issuers (General Motors and Ford).
What is more, at the beginning of the 2004 hiking cycle, USD High Yield spreads were around four per cent, while currently they hover around 4.5 per cent. Yields were more attractive back then, reflecting the higher US Government yields, but this is only because the economy was facing a more bullish outlook.
With demographics, productivity and the global macro environment now seriously challenging the long term prospects, it is hard to imagine that the Fed will anytime soon increase its rate as high as it did back then.
The Fed’s own forecasts see the rate increasing by less than 3 p.p. over the next two years while during 2004-06 the cumulative move was 4.25 p.p.
Consequently, my advice is to carry the historical comparisons in spread terms as the world is now likely undergoing a transition towards lower growth and, hence, lower yields. And while low-rated USD bonds carry low yields by historical standards, the spreads are still attractive, with much lower levels reached in the past.
As regards the implications of a Fed rate hike for higher rated corporates, these are more likely to be negative. This is because such names are less sensitive to the economic cycle and, hence, their gains from a strengthening economy are more limited.
It then follows that there is limited scope for lower spreads in this case. Furthermore, given the lower credit risk of these corporate the spreads are quite low which means that they cannot offset much of the spike in government yields. To put some figures, for the USD Investment Grade universe, the spreads at the moment stand at 1.5 per cent.
Disclaimer: This article was issued by Raluca Filip, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.