Last year, the fixed-income markets saw considerable volatility as participants debated whether quantitative easing was about to end — this was answered in December as the Fed began its tapering program. At the time of writing, U.S. growth dynamics remain favorable and with greater visibility on fiscal policy, there is risk that U.S. growth could surprise on the upside.
However one thing remains clear: QE will only end if the economy is growing. If growth is less than expected, there will be no tapering and we will see the continuation of demand for high-yielding assets. However, if growth surprises to the upside and tapering does happen, markets will focus on how high yield behaves in a rising rate environment. The good news is that in a rising rate environment, high yield usually outperforms other fixed-income asset classes as long as there is economic growth and default rates remain subdued.
While short-term interest rates are expected to remain low, any signs of growth are likely to be accompanied by a steepening yield curve and the 10-year Treasury returning to 3.5% if not higher. So the question would be: How would that affect high yield? In fact, high-yield returns are usually negatively correlated to Treasury returns, as are equity returns. The biggest driver of high-yield returns is real gross domestic product growth.
The reason for this is that high-yield companies, especially those lower down the rating scale, need economic growth to grow into their capital structures. In some cases, economic growth can lead to strength in the equity markets and this increases the prospects of initial public offerings for private companies and also gives management of investment-grade companies an incentive to buy smaller companies that are often high yield. This is the reason high yield also has one of the highest correlations to equities within fixed income. Unsurprisingly, positive expectations for GDP growth would support the asset class.