Laying Low in a Storm of Equity Volatility and Rising Rates

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by Iris

Investors have found themselves stuck between a rock and a hard place this year. On one hand, there have been bouts of equity volatility caused by growth and geopolitical concerns. On the other hand, rising rates give pause to investors looking to rotate into fixed income.

As of October 29, the S&P 500 is up a modest 0.32% year to date, after a hard fall from its September record high. After three rate hikes, the 10-year Treasury hit 3.23% in early October, causing U.S. core bonds, as represented by the Bloomberg Barclays US Aggregate Bond Index, to decline 1.99% year to date.

However, if you leave no stone unturned, you might just find some gold after all. And by gold, I mean junk. And by junk, I mean non-investment grade bonds and floating rate loans. Through October 29, floating rate loans have made a steady climb to a 4.14% total return this year while short duration high yield has returned a relatively respectable 2.42% as shown in Figure 1.

Figure 1: Floating Rate Loans and Short Duration High Yield outperformed other major asset classes year to date

Source: Morningstar as of 10/29/2018.1

The resilience of floating rate loans and short duration high yield amid heightened equity volatility is not unprecedented. On a historical basis, as shown in Figure 2, equities outperformed both bonds and loans during periods of low volatility. Over 180 months, as the month end VIX level increases, that performance dispersion decreases. When equity volatility was high enough, the S&P 500 underperformed both loans and short duration high yield bonds during those months.

In this most recent sell-off, equities may be experiencing more of a risk-off sentiment due to those growth fears which have not caused the same reaction in fixed income investors. By most credit metrics, the financial health of bond and loan issuers is stable and default rates remain below historical averages.

Figure 2: Floating Rate Loans and Short Duration High Yield Proved resilient amid equity volatility

In the months of higher volatility, floating rate loans and short duration high yield outperformed equities.

Source: Bloomberg, Morningstar October 2003 – September 2018.2

What is also observed through a historical lens, is that floating rate loans and short duration high yield outperformed investment grade bonds during periods of rising rates. High yield tended to do well during rising rate environments because 1) it is a short duration asset class, 2) it is more credit sensitive than interest rate sensitive and 3) rates tended to rise when the economy is doing well. Most notably, lower rated bonds and loans have outperformed their higher rated counterparts given that interest rate sensitivity declines with credit quality.

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Floating rate loan performance during rising rate periods is a little more straightforward to explain. The stated interest rate floats based on an underlying short-term reference rate, usually LIBOR. The notion that there is an inverse relationship between interest rate and price is predicated upon a fixed coupon, which a floating rate loan does not have. As short-term rates rise, all else equal, floating rate loan investors earn more income. Therefore, regardless of the shape of the yield curve, short term rate increases are beneficial to floating rate loans, and most strategists see a few more rate increases through the end of 2019.

Figure 3: Floating rate loans and short duration high yield outperformed investment grade during rising rates

Gray bars represent periods of rising rates. Table below are cumulative returns over respective periods

A

B

C

D

E

Short Duration High Yield
7.3
Short Duration High Yield
7.2
Floating Rate Loans
43.1
Short Duration High Yield
8.2
Short Duration High Yield
5.7
Floating Rate Loans
4.8
Floating Rate Loans
5.8
Short Duration High Yield
36.3
Floating Rate Loans
6.3
Floating Rate Loans
5.6
Short-Term Corporate Bonds
3.8
Investment Grade Corporates
2.1
Investment Grade Corporates
18.5
Short-Term Corporate Bonds
2.3
Short-Term Corporate Bonds
1.2
Investment Grade Corporates
(0.1)
Short-Term Corporate Bonds
2.1
Short-Term Corporate Bonds
12.8
Investment Grade Corporates
(0.1)
Investment Grade Corporates
0.5
Core Bonds
(0.2)
Core Bonds
2.1
Core Bonds
6.7
Core Bonds
(1.3)
Core Bonds
(0.6)

Source: Morningstar as of 9/30/18.3

In Figure 3, we look at five rising rate periods over the last 20 years, including the current period, and see that floating rate loans and short duration high yield outperformed US core bonds, US investment grade corporates, and US short term investment grade corporates in all five periods.

Volatile equity markets coupled with rising interest rates can understandably make investors uncertain as to how to construct their portfolios. Shorter duration, below investment grade fixed income, namely floating rate loans and short duration high yield, may make sense as a strategic allocation in a portfolio, and even more so as a tactical one given today’s market environment. However, both of these asset classes subject investors to credit risk, so it is particularly important to choose an experienced manager who specializes in fundamental credit analysis and the portfolio construction of floating rate loans and short duration high yield bonds.

Written by: Adam Scarier

Link to original article.

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