The long-awaited rise in Treasury rates finally appears at hand. From January through September of this year, 10-year Treasury rates had quietly backed up about 40 basis points (bps), but the additional 30-plus bps rise since September has been more abrupt and initiated a new round of debates and interpretations regarding its rise. We have seen multiple head fakes over the past few years, but it appears an inflection point has been reached in the domestic economy with GDP breaching 4%, labor markets tightening to levels not seen in nearly 50 years and corporate revenue and earnings growing materially. Other factors may be contributing to higher rates, however, such as looming Treasury supply and expectations for the end of quantitative easing by the European Central Bank.
Fixed income returns have been negative all year, with the exception of high yield and certain floating-rate asset classes. Within high yield, lower quality credit has outperformed high quality; as is typical in a rising rate environment driven by broad-based growth. Two ways to potentially mitigate interest rate risk in dedicated high yield strategies include adding floating-rate loans and high coupon, short/intermediate maturities into the portfolio. Both offer coupon cushion should rates continue to rise, while adding a manageable amount of credit risk. While I remain constructive on credit given business fundamentals and low expected default rates, I am wary of reaching too much given current valuations.
Key Takeaway
When it comes to cushioning the pain from higher rates in high yield portfolios, my current preference is for high coupon shorter maturity bonds, as opposed to floating-rate leveraged loans. This is due to the fact that floating-rate leveraged loans have relatively tight spreads, limited covenant protection and the potential for more challenging liquidity over the next few years given the rapid increase in market size. Relatively short maturity high coupon paper in issuers that, in my estimation, have adequate refinancing options in any market environment represent a good way to balance portfolio duration.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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