Strong showing, relatively

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The specter of rising interest rates has taken a toll on the bond market in 2013, but demand for high yield bond funds remains elevated as investors continue to look for an alternative to low-yielding Treasuries and volatile stocks. In fact, sales of individual high yield bonds are on pace to surpass 2012’s record. So far this year iShares Boxx High Yield Corporate Bond (HYG), a $15.5 billion ETF,  has climbed nearly 6% in a period where investment grade bond funds, tax-free bond funds and international bond funds have come under pressure and are sitting on losses.

High yield bond funds owe their resilience year-to-date to a low level of interest rate sensitivity.  A study conducted in the mid-2000s attempted to quantify this characteristic and found that only 3% of a high yield bond’s price variation could be explained by interest rates while 24% of price movement was influenced by the direction of equity markets. In other words, high yield bonds actually behave more like stocks than bonds. In May I blogged about a recent Barclays study that looked at periods when 10-year Treasury yields rose 100 basis points or more. Barclays found there had been 13 such times in the past 30 years and that high yield bonds outperformed investment grade bonds 12 times.

I’ve managed a High Yield Bond Portfolio for over 20 years for clients interested in leveraging the high yield bond market’s unique performance characteristics to diversify their portfolios. I move their investments to US Treasuries or cash when high yield bond risk is elevated. Between 1992 and 2012 the program’s returned 8.5% annually compounded, after fees, with only small losses along the way. If you’re interested in trading high yield bonds yourself, check out my newsletter – I supply general buy/sell signals for US high yield bond funds, along with a weekly list of top monitored funds/ETFs based on price momentum.

♦ Please note that my readings will change without notice,  so please don’t buy or sell solely based on anything you read in this blog. ♦

One of these bond markets is not like the other

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Back in 1981, the year I graduated from high school, the yield on 10-year Treasuries topped out at 15.8%. My entire adult life has consisted of a roaring bull market in bonds with steadily falling yields and rising prices. I’m now paying very close attention to what’s happening in the bond market and here’s why: Over the past 223 years of US interest rate history we know that bond bull markets tend to last between 22 and 37 years and the interest rate on the US 10-year Treasury note averages around 6%. The current bull market is now 32 years old and the 10-year note is yielding 1.9%. US bonds seem to be at a generational tipping point. However, a study of past bond cycles also tells us that rates can stay low for years before heading higher. Japan is a good example: In 1996 policymakers cut rates to near-zero and today that country’s interest rates are still under 1% – 17 years later.

I track three categories of US bond funds each market day for my newsletter and managed account program: taxable bonds, municipal bonds and high-yielding bonds. Taking a look at my six-month chart, you can see how taxable bonds [my proxy: iShares Core Total US Bond Market (AGG)] and municipal bonds [my proxy: iShares S&P National AMT-Free Muni Bond (MUB)] are languishing. High yield bond funds [my proxy: iShares iBoxx $ High Yield Corporate Bd (HYG)], however, have climbed nearly 8.5%. That’s quite a divergence.

High yield bonds are performing relatively well now and when the tide turns against the bond market, they should continue to stand-out because unlike traditional bonds, high yield bonds aren’t terribly sensitive to rising interest rates. In fact, they can at times be negatively correlated to rising rates because when interest rates increase, it’s signalling a pickup in economic activity which can be beneficial to the companies who issued the high yield debt. Investment banker Barclays recently published fresh analysis on this subject which confirms that a rising rate environment poses relatively little threat to high yield bonds. Their study showed that high yield bonds avoided negative returns in 12 of 13 periods of rate increases.  In other words, US high yield bonds march to the beat of their own drummer.

For now, my readings: US Bonds – Bearish, US Municipal Bonds – Bearish,  US High Yield Bonds – Bullish.

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Please note that my readings will change without notice,  so please don’t buy or sell solely based on anything you read in this blog.