High yield bonds have done well since the end of the global financial crisis, providing positive returns of at least 5% every calendar year since 2009. This performance has largely been driven by an improving economic outlook combined with low (and generally declining) interest rates. As the Federal Reserve cuts back on its attempts to stimulate the economy and gets closer to raising interest rates, are the good times coming to an end for this asset class?
The answer depends on the relationship between interest rates and the performance of high yield bonds, which is more complicated than for investment grade bonds. Like investment grade bonds, high yield bonds are hurt by increases in interest rates since the fixed amount they pay to investors becomes less valuable. But higher interest rates could also be indicative of a stronger economy. Since a large portion of the return that investors get from high yield bonds is compensation for the risk that the borrowing companies could default on their debt, high yield bonds could benefit as a stronger economy reduces this risk.
The risk of default is represented by the difference between the yields on high yield bonds and the yields on treasury bonds. The problem for investors in high yield bonds is that this difference (called the “spread”) is already fairly low by historical standards. Even if the pace of economic growth substantially quickened, it’s unlikely that the spread would fall much further.
The outlook for high yield bonds therefore isn’t symmetrical. As long as the economy continues to grow and interest rates stay relatively low, high yield bonds are likely to continue to offer solid returns. But the potential upside for this asset class is limited by already low spreads, while higher interest rates or a weaker economy create downside risks.