What are the breakeven scenarios for the next 12 months?
Short term US dollar interest rates continue their march higher. 3-Month USD LIBOR recently hit 1.61%, fuelled by the Fed’s 25 basis point hike on December 13th, a level last seen in late 2008. With further rate hikes on the horizon in the US and a potentially more hawkish European Central Bank, is 2018 the year when floating rate high yield meaningfully outperforms its fixed rate cousin?
The short answer is: “probably yes” for a EUR investor and a somewhat unsatisfying “maybe” for a USD investor.
Looking at a simple scenario analysis for 1 year total returns, I take two theoretical USD portfolios (one of high yield floating rate notes and the other high yield fixed rate bonds), both priced with a spread of 250bps to normalise the relative impact to returns, and flex the total return of each portfolio to take into account three rate hikes from the Fed (the current market consensus view) and a change in yield curve (i.e. a move that would mean an interest rate duration related capital gain or loss for the fixed rate portfolio).
It should be noted, however, that I have not considered the relative impact of a move in credit spreads or default rates, which is another very important driver of returns for high yield. I would expect floating rate high yield to outperform fixed rate high yield in a spread-widening sell-off or if we saw higher default rates (floating rate bonds tend to have less spread duration and are more heavily skewed to senior secured instruments), and vice versa. The numbers below do not take this into account.
The results above show that the market would need to see a moderate move higher in US treasury yields before floating rate high yield outperforms fixed rate high yield. In fact, the breakeven level is 34bps in this case. Some hikes are already reflected in the steepness of the US treasury curve at the front end, so investors are already to some extent compensated for the fact that the Fed is maintaining its hawkish stance. Floating rate high yield would be better placed to outperform if we saw more than three hikes or if a subsequently more hawkish stance was priced into the fixed rate market. The perception that floating rate bonds outperform when interest rates are rising in not always true.
USD – (three hikes and steeper/flatter yield curve)
|Change in yield (bps)||-75||-50||-25||0||25||50||75|
|FRN HY 1yr total return||4.42%||4.42%||4.42%||4.42%||4.42%||4.42%||4.42%|
|Fixed HY 1yr total return||8.73%||7.75%||6.76%||5.77%||4.78%||3.80%||2.81%|
How about EUR based investors? Below is the same exercise, but I assume no change to EURIBOR at -0.39% (i.e. no hikes from the ECB), but flex the yield curve as before.
EUR – (no hikes and steeper/flatter yield curve)
|Change in Yield (bps)||-75||-50||-25||0||25||50||75|
What is interesting here is that the flat government bond curve works against fixed rate investors. European government bond yields would have to sell off by only 8bps before floating rate high yield outperforms. Any marginal repricing of ECB intentions to a more hawkish scenario, therefore, would mean investors are much better off in floating rate bonds, not because they benefit from higher coupons as interest rates rise, but rather because they have almost zero sensitivity to moves in the government bond markets.