So how can an investor use sector rotation during a rising rate period? By rotating some assets out of fixed income sectors that tend to underperform in this kind of environment and into sectors that tend to benefit. Typically during rising rate environments, the Fed is raising the federal funds rate in response to high growth or inflationary pressures. Positive economic growth means credit conditions improve leading to a tightening (improvement) in credit spreads. Credit spreads are the incremental yield an investor demands to hold a risky asset over a similar duration risk-free bond. So while Treasury rates are increasing, tightening credit spreads can lead to stronger performance from credit investments such as corporate and high yield bonds.
Market Realist – The graph above compares the yields of ten-year U.S. Treasuries (IEF) with the yields of high yield corporate bonds (HYG)(JNK) since October 2004. Before the financial crisis, the spread between the two was low, as the economy was doing well. In fact, the ten-year low of ~250 basis points was hit in December 2004 when the economy was doing well. This happens because the chance of high yield bond issuers defaulting decreases. However, at the peak of the crisis, the spread was as high as 1,814 basis points! This is due to the heightened possibility of issuers defaulting.