June 23, 2004 — While rising interest rates are generally bad news for bond funds, high-yield bond funds may provide opportunities, based on the potential for defaults. As the economy recovers, high-yield defaults tend to fall, benefiting high-yield investors. Since a rebounding economy usually drives interest rates higher but also lowers the rates of high-yield defaults, we reviewed high-yield funds in times of rising interest rates.
We looked at fund performance in two one-year periods of rising rates, 1994 and 1999. In addition, we reviewed these funds over the one-, two- and three-year periods after the year of climbing rates to see if there was any subsequent impact. We also looked at performance for the one-year period through May, when the yield on the 10-year Treasury rose from 3.35% to 4.66%. We reviewed 413 high-yield bond funds, including multiple share classes.
High-yield fund performance in 1994 and the three following years was just the opposite of that in 1999 and the following three years, as shown in Table 1 below. High-yield funds fell in 1994 as rates soared, but as rates dropped sharply in 1995 and remained in a narrower but lower range over the next three years, high-yield funds performed very well. However, they still lagged the Lehman High Yield (US Corporate) Index.
Conversely, in 1999, high-yield funds posted positive returns even as rates surged, and they outperformed the Lehman index. Over the following three years, however, high-yield funds performed poorly and badly trailed the Lehman index, despite a sharp decline in rates. So looking at interest rates wasn’t necessarily the best way to consider investing in high-yield bond funds.