Factors affecting total returns
Many factors affect the total returns derived from a bond.
- Higher starting income levels help cushion loss in price due to rising rates.
- A gradual rise in rates may offset the decline in price rather than a sudden rise.
- Wider credit spreads at the start of a rising interest rate period have more potential to offset, as there’s room for tightening when the economy’s improving. This holds true for both high yield and investment-grade bonds.
- A steep upward-sloping yield curve will move towards a normal upward-sloping curve during a period of tightening.
Various asset classes respond differently
Also, the performance of each fixed income asset class can vary substantially from the broad bond market during the rising rate periods. In an improving economy, asset classes with more yield and broader performance drivers, such as high yield corporate bonds and global bonds, have generally performed better than those with less yield and fewer performance drivers such as Treasuries and investment grade corporate bonds. On the other hand, when rates rise at the time of an economic slowdown, asset classes such as high yield corporate bonds and global bonds perform the worst.
Exchange-traded funds (or ETFs) such as iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and SPDR Barclays Capital High Yield Bond ETF (JNK) track the performance of high yield corporate bonds issued by non–investment grade companies in the U.S. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) tracks the performance of 600 highly liquid investment grade corporate bonds of companies such as Verizon Communications Inc. (VZ) and General Electric Company (GE).
In the next part of this series, let’s assess how yields and credit spreads are placed in the face of an expected rise in interest rates.