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Today I’d like to discuss high-yield-bond strategies and the direction of interest rates. Unlike government bonds and investment-grade corporate bonds, high-yield bonds are influenced greatly by the direction of stock prices and not just interest rates. Yes, they are bonds, and yes, they are influenced by interested rates, but not as directly or as often as many believe.

In the following illustration, stocks are represented by an S&P 500 ETF (SPY), high-yield bonds are represented by a high-yield bond ETF (JNK), and interest rates are represented by the 10-year Treasury yield index (TNX-X). The purpose of this graph is to show that stocks and high-yield bonds frequently move independently from interest rates. From 2011 through 2013, interest rates declined sharply and then rose sharply. During this time, both stocks and high-yield bonds moved higher in price. Again, from early 2016 to early 2018, interest rates moved sharply higher and so did stocks. The reason for this linkage is that interest rates often go up as an economy gains strength. This rising economy is extremely beneficial to stocks even though it is the cause of rising interest rates. During this period from 2016 to 2018, high-yield bonds moved higher for the first 18 months or so and since then have moved sideways in price.

10-year Treasury yield index (TNX-X)

This brings up the second reason for showing this illustration. There are times when high-yield bonds and stocks do not trend in a similar fashion, like in recent months. One of many prior periods to experience this disconnect between stocks and high-yield bonds was in 2013. For much of that year, stocks marched higher but high-yield bonds did not. Eventually, high-yield bonds did move back in sync with stocks and followed them higher into 2014.

High-yield-bond strategies can provide attractive, long-term, low-volatility returns that are closely linked to the direction of stocks. However, high-yield bonds are not always highly correlated to stocks, and they are often not highly correlated with the direction of government bond prices. The return streams of many strategies, including high-yield-bond strategies, are stair-step in appearance, with one to two years of very good performance followed by one to two years of flat performance. Connected over time, the result is quite attractive, but in order to capture the full periods of very good performance, patience must be exerted during the flat periods. Well-designed, strategically diversified portfolios have the potential to weather strategies’ periods of lagging performance—which every successful strategy has from time to time.

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