A Natural Hedge Against Rising Rates

While investing in CCC-rated bonds can offer an effective hedge against rising rates, careful analysis of each security is essential

Our clients sometimes ask us how they would benefit from high yield investing in a rising rate environment. To answer that question, we apply insights from market history.

Given that credit spreads, or the premium earned for accepting credit risk, typically decline when rates rise, high yield bonds have traditionally provided a hedge against a rise in interest rates through spread tightening. In addition, these bonds generally have a shorter maturity and a higher coupon than investment grade bonds and, therefore, a much shorter average duration.1 As a result, high yield bonds have performed well in rising rate environments. However, not all high yield bonds are created equal, and a deeper look at the market reveals that some bonds perform better than others.

High yield market data demonstrates that an investment in the lower tier, specifically CCC-rated bonds, can offer a considerable hedge against rising rates relative to an investment in their higher-rated peers. Rising rates typically reflect improved economic conditions, in particular benefitting the creditworthiness of CCC-rated issuers, which are often the most credit sensitive within the high yield market. On the other hand, BB-rated bonds, which do not offer the same credit risk premium as CCC-rated bonds, tend to be more interest rate sensitive as a result of their higher quality, as they are “almost” investment grade in creditworthiness. As a result, their spreads do not tend to tighten as much, and thus do not offset the rise in rates, to the same degree as their lower-rated peers.

Percent of Quarters with Positive Performance when Yields Rise, January 1, 2010 through March 31, 2022

Percent of Quarters with Positive Performance when Yields Rise, January 1, 2010 through March 31, 2022

Source: ICE. Past performance does not guarantee future results. Reflects the percentage of quarters where performance was positive when the 5-year yield increased during a given quarter from January 1, 2010 through March 31, 2022.

However, the CCC-rated segment of the high yield market requires careful analysis of each individual credit to avoid the historical default losses that this cohort experiences most typically at the end of the credit cycle. Given Polen Capital’s expertise in identifying attractive risk-reward investment opportunities in the CCC-rated segment of the high yield market, we believe that we can provide our clients with an additional benefit in the form of a natural interest rate hedge.

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Important Disclosures

1Source: ICE.

5-Year Yield: represents the yield to worst on the ICE BofA Current 5-Year US Treasury Index. The ICE BofA Current 5-Year US Treasury Index is a one-security index comprised of the most recently issued 5-year US Treasury note. The index is rebalanced monthly. In order to qualify for inclusion, a 5-year note must be auctioned on or before the third business day before the last business day of the month and settle before the following calendar month end.

This information is provided for illustrative purposes only. Opinions and views expressed constitute the judgment of Polen Capital as of May 2022 may involve a number of assumptions and estimates which are not guaranteed, and are subject to change without notice or update. Although the information and any opinions or views given have been obtained from or based on sources believed to be reliable, no warranty or representation is made as to their correctness, completeness or accuracy. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice, including any forward-looking estimates or statements which are based on certain expectations and assumptions. The views and strategies described may not be suitable for all clients. This document does not identify all the risks (direct or indirect) or other considerations which might be material to you when entering any financial transaction.

This information should not be construed as a recommendation to purchase, hold or sell any particular security. Holdings are subject to change. There is no assurance that any securities discussed herein will be in the portfolio at the time you review this post or that any securities sold have not been repurchased. The securities discussed do not necessarily represent the entire portfolio. It should not be assumed that any of the securities, transactions or holdings discussed were or will prove to be profitable or that any investment recommendations we make in the future will equal the investment performance of the securities discussed herein. For a complete list of Polen Capital’s past specific recommendations for the last year, please contact [email protected]. Past performance does not guarantee future results and profitable results cannot be guaranteed.