As rates rise, are defaults a concern?
We're not concerned about rising interest rates leading to higher defaults, and I'll explain two ways. First, from the top down, then the bottom up. From the top down, interest rates typically rise when the economy is expanding and profits are growing. In these bullish environments you typically get the credit spread tightening. Spread tightening can absorb and offset much of the negative impact that rising interest rates have on fixed income securities. From the bottom up, I need to first explain how high yield companies are typically financed. Usually there's two debt components. The first is secured loans, also known as leverage loans and they're a floating rate. The second component are unsecured bonds, also known as high yield bonds and they're fixed rate. On the bonds side, these fixed rate high yield bonds are typically issued with seven to ten year maturities and over the past couple years, most companies have taken advantage of the strong credit markets and refinanced their bonds, locking in these low rates for many, many years. On the loan side, there will be some impact because loans are floating rate, but many companies have protected themselves by synthetically converting a portion of their floating rate loans into fixed rate loans by doing floating-to-fixed swaps, effectively locking in low rates for a number of years. And the last point I'll make is that the balance sheets of most high-yield companies are very manageable. So if a company was concerned about rising interest rates, they could use their free cashflow to pay down debt and reduce their interest expense.
Views are as of 3/15/2018 and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices. High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risks, and may be more volatile than investment grade securities. Federated Investment Management Company 18-73701 (3/18)