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Written by: Will Smith
High-yield investors should actually root for rates to move higher, rather than lower. And that’s because if rates are moving higher, it means the economy is doing well and companies are generating a lot of earnings, and therefore their credit risk is actually coming down. Which is a really good thing for us as credit investors.
The high-yield market has actually shifted a lot over the last decade. A decade ago, the market was more highly concentrated in the riskiest triple-C names and less concentrated in the most high-quality double-B names. And there’s actually been quite a big migration since that time period, where more than a majority of the high-yield index today is actually double-B-rated and a much smaller percentage is that lowest triple-C rating.
And if you look at the historical returns, high yield actually has very positive returns when rates move higher. On average, they’re about 12%. And if you look back since 1994 of all the instances where rates moved higher, the high yield actually had positive returns in 13 out of those 13 instances.
One of the major reasons why you want to root for higher rates as a high-yield investor is because you can reinvest your cash flow at higher and higher levels of income. So if you have to root for one, you’d root for rates to move up so that it can continue to reinvest that cash at better levels.
Another reason why you want rates to move higher is because as rates move higher, that generally means the economy is doing very well. If the economy is doing well, that means companies are able to generate more and more free cash flow, and the credit risk of lending to them comes down quite a bit. So that dynamic is very, very powerful as rates move higher, and we actually do very well as a credit investor.
So in summary, we think this is a great environment for investors to move into credit risk. First, it gets you out of the potential interest-rate risk as rates move higher, as the Fed tapers bond purchases and potentially raises rates. And then it also moves you into a high income-producing asset class that should do well when rates move higher over time.