E Tightening Impact

It is not just the Bank of England where a minority of policymakers support tightening of credit. At our Fed too the hawks are swooping led by Kansas City Fed Chief Esther George. She has no vote at the main Fed.

Fund managers John P. Calamos and Gary Black of Calamos Investments analyze of the prospects for higher interest rates and how they will affect high yield funds:

We present four scenarios that forecast one-year returns for the U.S. high yield bond market in varying market environments. The scenarios examine changes in default rates, recovery rates, spreads, and Treasury yields to depict forecasted returns for the overall U.S. high yield market. These returns do not represent actual performance, are not guaranteed, and serve only to illustrate possible total returns for changes in the four variables. An investor’s actual performance may differ dramatically from these forecasts depending on many factors.

Scenario 1: The economy expands quicker than expected, leading to lower defaults (1.5%), while recoveries maintain long-term averages (40%). With an improving economy, spreads tighten to +300 in this scenario but are offset by 5-year Treasury rates rising to 2.25% as the taper continues unabated and more talk of the first Fed rate hike intensifies. In this bullish scenario, the high yield market generates a hypothetical total return of 6% over the next 12 months.

Scenario 2: Default rates are in line with Moody’s projections (2.5%) and recovery rates maintain long-term averages (40%). In this scenario, spread tightening of 22 basis points to +350 is offset by 5-year Treasury rates rising by 37 basis points to 2%. This scenario generates a hypothetical return of 4.4% for the next 12 months.

Scenario 3: Defaults and recovery rates are the same as [in] Scenario 2 but 5-year Treasury rates ratchet up to 2.5%, while spreads stay fairly constant and widen by 3 basis points to 375 bps. In this scenario, the carry return more than offsets loss from defaults and interest rate increases to generate a hypothetical return of 1.3%, which would generate positive excess returns over Treasurys with comparable maturities.

Scenario 4: In our worst case scenario, the economy does not expand as expected and default rates tick higher to 3.5% while recovery rates decline to 35%. Spreads widen significantly to 600 basis points and five year Treasury rates rally back to 1.25%. In this scenario, the hypothetical return would be -2.9% .

The combination of stable Treasury yields, moderate economic growth and extremely low volatility continues to be supportive of the high yield asset class. We still expect Treasury yields to migrate higher as the year progresses.

(Thanks to Nicolas Bornozis of capital link, publisher of Closed-end Fund Newsletter, for sharing this paper.) In addition to the Calamos closed-end fund group inputs on the USA, we publish more about other markets today. Plus more from China, Japan, Singapore, Hong Kong, Britain, France, Spain, Switzerland, Finland, The Netherlands, Australia, Israel, Egypt, and Canada.

1 2 3 4
View single page >> |

None

How did you like this article? Let us know so we can better customize your reading experience. Users' ratings are only visible to themselves.

Comments

Leave a comment to automatically be entered into our contest to win a free Echo Show.