The Effect of Rising Interest Rates on Junk Bonds

The downturn in the U.S. economy from 2007-2009 has been felt ever since. In fact, it wasn’t until December 2015 that the Federal Reserve first increased interest rates since the recession. This is perhaps the first inklings that the U.S. economy is truly recovering. As reported by Reuters (2015), after a somewhat lengthy debate about whether or not the economy could handle higher borrowing costs, the U.S. central bank finally raised its benchmark rate range by a quarter percentage point reflecting the new rate of .25 to .50%. Moreover, Janet Yellen, Chair of the Fed states that the current procedures in place to raise rates are “likely to proceed gradually” (Reuters 2015). This would seem to indicate that future rate hikes are eventually coming.

What does this mean for market interest rates? The current low-interest conditions are clearly not gone, and it’s not likely that a high-interest rate market would soon arrive. However, there are indications that there's potential for a medium interest rate market to emerge if the rate hikes. This is becoming more significant due to many of the current challenges investors seeking fixed-income securities face under these conditions. High-yield, or so-called junk bonds, are currently a legitimate opportunity for such investors. Though high-yield bonds clearly require a significant amount of research beforehand due to their higher risk, if investors can perform such due diligence, interesting risk-return trade off opportunities exist.

With this in mind, it is certainly interesting to examine the effect of rising interest rates on higher-yielding bonds.

The General Impact of Rising Interest Rates

According to the SEC, what typically happens when interest rates rise, is that the price of a bond falls. This is true in both high-yield and investment-grade markets. Thus, there is an inherent risk associated with interest rate that is a commonality amongst all bonds — including government issued bonds. When it comes to how vulnerable a particular bond may be to interest rate changes, the most significant features are its coupon rate and maturity.

Maturity: Simply put, the longer a maturity, the more time there will be for potential changes in the interest rate that can negatively impact the bond’s price. So, the longer the maturity, the greater the interest rate risk. Investors compensate for this risk on long-term bonds with higher yields than short-term bonds of similar credit ratings.

Coupon Rate: All others aspects of the bonds being equal, a bond with a lower coupon rate has, in general, a greater sensitivity to fluctuations in market interest rates. Assuming that one bond has a coupon rate of 3% and the other bond has a coupon rate of 6%. In the event that market interest rates do indeed rise, it is the bond with the lower coupon rate of 3% that will see its price fall by a greater total percentage.

Hence, it is highly important to notice that junk bonds are clearly less impacted by increasing interest rates than investment-grade bonds. Moreover, as mentioned above, the remaining term to maturity is a significant factor which should be always taken into account. Cautiousness and profound professional analysis is always advised when choosing to invest in higher-yielding bonds, particularly in a low-interest-rate environment with rising interest rates. In addition to that; however, this particular market situation may open up interesting investment opportunities for junk bonds.

The Increase In Interest Rates May Provide Opportunities

Given that an in-depth professional analysis with appropriate research and financial tools is conducted with regard to each security, investors can benefit from higher-yielding bonds (junk bonds) in times of increasing interest rates. According to Invesco (2015), junk bond investors may profit from the following opportunities.

High-yield bonds, unlike investment grade offerings, typically have both a high coupon and short maturity which means their duration tends to be significantly lower by comparison. Because of this, being aware of the issues and vulnerabilities a specific high-yield bond has in relation to duration risk and volatility due to interest rate changes is an important to potential investors.

When it comes to interest rates, having them go up is not necessarily a bad thing for junk bonds. This is because rises in interest rates tend to indicate the economy as a whole is expanding which indicates strong opportunities for increased profits. This, in turn, means there’s a greater likelihood that businesses offering high-yield bonds will be able to continue to meet their financial obligations. Rising rates can mean a stronger issuer and less risk of default.

Because of the call protection that most junk bonds offer, that is the guarantee to investors that the bond will not be “called” early by the issuer and therefore reduce their debt obligation and the investors continued income from the coupon and eventual maturity, they tend react positively to rising rates. AAA rated companies (or other investment-grade issuers), on the other hand, tend to refinance debt at lower rates before a rise occurs by issuing a call and new bond offering. Call protections prevent this and mean investors benefit from increased security during rising rate periods without fear of the bond suddenly being called prior to the expected maturity date.

The Bottom Line

Without any doubt, interest rate risk should be steadily analyzed and monitored, both on investment-grade as well as higher-yielding bonds. However, it is significant to notice that high-yield bonds (junk bonds) are less impacted by rising rates than investment-grade bonds. Increasing interest rates, particularly in the current low-interest environment, may even provide investment opportunities for junk bonds. However, caution and in-depth professional analysis is always advised when choosing to invest in higher-yielding bonds.

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