How yields, credit spreads, and interest rates are interacting
Assessing the current market situations using three parameters
We’ve discussed what factors impact interest rates, what causes interest rates to go up or down in an economy, what factors affect the total returns you get from your investment in fixed income securities, and how various asset classes respond differently to rises in interest rates. Let’s move on to assessing how, under the current market situations, the yields and credit spreads are placed in the face of an expected rise in interest rates. We’ll discuss three parameters:
- Credit spreads
- Pace of expected interest rate rise
Yields are much lower
A bond’s yield offsets the negative impact of rising rates on bond prices, cushioning total returns. Lower yields at the start of the interest rate rise mean a higher likelihood of a negative total return. However, the pace of increase in rates would help determine the actual impact on total returns from a bond. Long-term Treasuries could be affected the most because of their extremely low yields and longer durations. To understand why investors prefer short-duration exchange-traded funds (or ETFs) in a rising rate environment, read our earlier article Why investors choose short-duration ETFs when interest rates rise.
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Credit spreads are tighter
Credit spread tightening can help offset the negative impact of rising rates and typically occurs as the economy improves. So, lower spreads offer less cushioning. Since the beginning of 2012, when the U.S. economy started recovering from the Great Recession, credit spreads have tightened for most asset classes. High yields have tightened to a greater extent than investment grade credit spreads.
Rise in rates expected to be moderate
As discussed at the recent Federal Open Market Committee (or FOMC) meetings, the Fed wants to maintain low interest rates for some time even after the asset purchases end. The first increase is expected to happen towards the middle of next year. Rates have risen only modestly until now and are expected to rise gradually even after the Fed’s asset purchase program ends.
While changes in interest rates may not prompt long-term investors of safe companies such as Apple Inc. (AAPL) and Exxon Mobil Corporation (XOM) to react, investors holding stocks of highly leveraged companies may want to re-evaluate their holdings. The PowerShares Senior Loan Portfolio Fund (BKLN) is a popular ETF that tracks the S&P/LSTA U.S. Leveraged Loan 100 Index. The Highland/iBoxx Senior Loan ETF (SNLN) and the First Trust Senior Loan ETF (FTSL) are other popular ETFs in the leveraged loans category.
The next part of this series will guide you through how to position your fixed income portfolio for a rising rate environment.