What Does Short Duration Mean for Credit-Sensitive High Yield?
Short Duration High Yield is not a unique asset class, but rather a subset of the overall high-yield market. To represent this segment, we use the Bank of America Merrill Lynch Corp Cash Pay BB-B 1-5 Yr Index, which includes high-yield bonds rated BB or B with remaining maturities of one to five years. Bond math tells us that as bonds get closer to maturity, they become less sensitive to changes in yield. Likewise, higher credit-quality bonds are less likely to default, and therefore, will exhibit smaller price movements than their lower-quality counterparts. Shorter maturities, coupled with relatively higher credit quality result in an asset class that is often characterized by lower volatility – the appeal of short duration high yield. Figure 1 illustrates that short duration high yield has less volatility than high yield, and comparable volatility with investment-grade corporate bonds.
Figure 1: Short Duration High Yield Has Historically Exhibited Toward Lower Volatility
Volatility vs. High Yield and Investment Grade Corporates
Source: MPI, as of 4/30/17. High Yield represented by the Bank of America US High Yield Master II Index, Short Duration High Yield represented by the Bank of America US HY Corp C Pay BB-B 1-5 Yr Index, and Investment-Grade Corporates represented by the Bank of America US Corp Master Index. Diversification cannot ensure a profit or guarantee against a loss. Past performance is no guarantee of future results. Standard deviation measures how widely dispersed a fund’s returns have been over a specified period of time. A high standard deviation indicates that the range is wide, implying greater potential for volatility.
Short Duration High Yield During Rising Rate Environments
A common misconception is that investors should shorten their portfolios’ overall duration during rising rate environments, which may or may not be true. In the case of high-yield bonds, the credit backdrop is more important than Treasury movements. As we discussed in “Duration Not Debunked, Just Practically Applied”, high yield as an asset class is much more credit sensitive than interest-rate sensitive, and as such, the salient driver of high yield prices is the financial health and credit risk of the companies issuing those bonds.
Interest rates tend to rise when the economy is expanding which is when many companies generate profit increases, improving their ability to service debt, and therefore, making their bonds less risky investments. As illustrated in Figure 2, short duration high yield has performed well in rising-rate environments, significantly outperforming US core bonds; however, it has not always performed as well as the broader high-yield asset class with a longer duration. So, with respect to high yield, using short duration high yield does not act as an interest-rate hedge in rising rate environments.
Figure 2: Short Duration High Yield Has Not Always Outperformed the Broader High Yield Market in Rising Rate Environments
Fixed Income during Rising Rate Environments
Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. The periods of rising rates shown above are based on periods of rising 10-year Treasury yields.
Then, What Does Investing in Short Duration Do?
Put simply, short duration high yield is a tempered way of playing the high yield market. Given that credit risk is the primary driver of high yield performance, credit spreads are a larger component of a bond’s yield than the risk-free rate. Spreads over U.S. Treasurys are the market’s way of pricing credit risk and the probability of default, and will tighten or widen, based on investor risk appetite and the perceived creditworthiness of an issuer. It is when there is a risk-off sentiment in the market or bouts of volatility that the shorter maturity and higher credit quality features of short duration high yield benefit investors. Figure 3 shows high yield spreads over the past 15 years and highlights periods of spread widening, and how both high yield and short duration high yield responded. In each of the five periods examined, short duration high yield outperformed high yield in the face of spread widening.
Figure 3: Short Duration High Yield Bests High Yield When Spreads Widen
Source: Bank of America Merrill Lynch, 5/31/2017. Chart created by New York Life Investment Management. High yield is represented by Bank of America Merrill Lynch US HY Master II Index. Short duration is represented by Bank of America Merrill Lynch US HY Corp C Pay BB-B 1-5 Yr Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Figure 4: Short Duration High Yield May Help Offset Negative Equity Returns
High Yield Performance during Negative Equity Market Quarters
Source: Morningstar Direct, 5/31/17. Chart created by New York Life Investment Management LLC. Stocks represented by the S&P 500 Index. High yield is represented by the Bank of America Merrill Lynch US HY Master II Index. Short Duration High Yield is represented by the Bank of America Merrill Lynch US HY Corp C Pay BB-B 1-5 Yr Index.
Over the last 10 years, there have been 11 quarters in which the S&P 500 produced negative returns. Figure 4 shows that in each one of those quarters, short duration high yield outperformed equities. In fact, in eight of those 11 quarters, short duration high yield outperformed the broader high-yield market as well. While the name “short duration” may imply protecting investors from rising risk-free rates, in the case of high yield, short duration is actually a way of investing in below-investment-grade credit, while potentially mitigating credit and equity market sell-offs. Rather than investing in short duration high yield to reduce interest-rate risk, investors should think of short duration high yield as a lower volatility, high-yield investment, a “high yield lite” strategy that may give up some of the upside, while potentially reducing the downside.
Short-duration high-yield corporate bonds are represented by the BofA Merrill Lynch 1-5 Year BB-B U.S. High Yield Corporate Cash Pay Index, which generally tracks the performance of BB-B rated U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market with maturities of 1 to 5 years.
Broad U.S. bond market is represented by the Bloomberg Barclays U.S. Aggregate Bond Index, which is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasurys, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.
Investment-grade corporate bonds are represented by the Bloomberg Barclays U.S. Corporate Investment-Grade Bonds Index, which includes all publicly issued, fixed-rate, non-convertible, investment-grade, dollar-denominated, SEC-registered corporate debt.
High-Yield Corporate Bonds are represented by the BofA Merrill Lynch U.S. High Yield Master II Constrained Index, which is a market value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. Issuers included in the index have maturities of one year or more and have a credit rating lower than BBB-/Baa3, but are not in default. No single issuer may constitute greater than 2% of the Index.
Past performance is no guarantee of future results.
Interest-rate risk is the risk that an investment’s value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any other interest-rate relationship.
Treasury bonds are represented by the Bloomberg Barclays U.S. Treasury Index, which represents the U.S. Treasury component of the U.S. Government Index.
U.S. Government bonds are represented by the Bloomberg Barclays U.S. Government Bond Index, which is the non-securitized component of the U.S. Aggregate Bond Index and was the first macro index launched by Barclays. The U.S. Government/Credit Index includes Treasurys (i.e., public obligations of the U.S. Treasury that have remaining maturities of more than one year), Government-Related issues (i.e., agency, sovereign, supranational, and local authority debt), and Corporates. An investment cannot be made directly in a market index.
High-yield securities carry higher risks and some of the Fund’s investments have speculative characteristics and present a greater risk of loss than higher-quality debt securities. These securities can also be subject to greater price volatility
A bond’s prices are inversely affected by interest rates. The price will go up when interest rates fall and go down as interest rates rise. Bonds are subject to credit risk and interest rate risk.
There is no guarantee that any forecast made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment.
Basis points (BPS) refer to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument.
The BofA Merrill Lynch Euro High Yield Index tracks the performance of Euro denominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets.
The BoA Merrill Lynch EM External Sovereign Index tracks the performance of U.S. dollar emerging markets sovereign debt publicly issued in the U.S. and eurobond markets.
The BoA Merrill Lynch EM Diversified Corporate Index is designed to measure the performance of U.S. dollar-denominated emerging markets corporate senior and secured debt publicly issued in the U.S. domestic and Eurobond markets.
The BoA Merrill Lynch U.S. Cash Pay High Yield BB-B Rated 1-5 Year Index is a subset of the BoA/ML U.S. Cash Pay High Yield Index including all securities with a remaining term to final maturity less than 5 years and rated BB through B inclusive.
The BofA Merrill Lynch U.S. High Yield Master II Constrained Index is a market value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. Issuers included in the index have maturities of one year or more and have a credit rating lower than BBB-/Baa3, but are not in default. No single issuer may constitute greater than 2% of the Index.
The BofA Merrill Lynch U.S. High Yield Master II Index is tracks the performance of U.S. dollar-denominated below investment-grade corporate debt publicly issued in the U.S. domestic market.
The Bloomberg Barclays 10-Year U.S. Treasury Index is a universe of Treasury bonds, and used as a benchmark against the market for long-term maturity fixed-income securities.
The Bloomberg Barclays Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
The Bloomberg Barclays U.S. Corporate High Yield Index is a market-weighted index that includes publicly traded bonds rated below BBB by S&P and Baa by Moody’s.
The Bloomberg Barclays U.S. Corporate Investment Grade Index is a market-weighted index that includes publicly issued US corporate and specified foreign debentures and secured notes that meet the maturity, liquidity and quality requirements.
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
The S&P/LSTA Leveraged Loan Index is a broad index designed to reflect the performance of U.S. dollar facilities in the leveraged loan market.
Risk Premia is the difference between the expected return on a security or portfolio and the “riskless rate of interest” (the certain return on a riskless security).
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
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