Short Duration High Yield: A Flower in the Junkyard

by: , Director, Product Management, New York Life Investments

The S&P 500 Index posted a negative return for first quarter of 2018, marking the 12th time in a little over a decade since the financial crisis that this occurred. And, for the 12th time in that time period, the short duration high yield asset class (defined as the ICE BofAML 1-5 BB-B Cash Pay HY Index) outperformed the S&P 500 during the down equity quarter. Further – in nine of those 12 quarters, short duration high yield outperformed the broader high yield market. With the S&P 500 down 76 bps, and the Bloomberg Barclays US Aggregate Index down 146 bps during the first quarter, short duration high yield was up 12 bps.

Short Duration High Yield Performance During Negative Equity Market Quarters

Source: Morningstar, as of 3/31/18. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. Short duration high yield is represented by the ICE BofAML 1-5 Year BB-B US High Yield Index; High Yield is represented by the ICE BofAML US High Yield Index. Index definitions can be found at the end of this blog post.

While some investors may be averse to anything with the phrase “high yield” in the title, they may be surprised to see that short duration high yield has significantly less volatility than investment-grade credit, as well as the broader high yield market across the 1-, 3-, and 5-year time periods. The short duration high yield asset class is a subset of the overall high-yield market and can be categorized as having a shorter duration, as well as a credit quality bias, compared with the overall market. The result is a lower beta version of high yield with less volatility and credit sensitivity. Investment-grade credits have historically been more interest-rate sensitive than non-investment grade, and therefore the shorter maturity nature of the asset class really helped to mitigate that interest rate exposure found in investment-grade corporate bonds.

Short Duration High Yield Volatility vs. Investment-Grade Credit and High Yield

Source: Morningstar, as of 3/31/18. Chart created by NYLIM. Short Duration High Yield is represented by ICE BofAML 1-5Y BB-B Cash Pay HY Index; Investment-Grade Credit is represented by the ICE BofAML US Corporate Index; High Yield is represented by the ICE BofAML US High Yield Index. Index definitions can be found at the end of this blog post. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

So, after establishing that short duration high yield has fairly low volatility, it is time to look at returns. Specifically, is the asset class’ returns commensurate with the level of risk, with respect to the overall market?

The answer is not really. In the chart below, you can see that on a calendar year basis since the financial crisis, short duration high yield’s return as a percent of the overall high yield market was greater than its relative volatility. Last year, short duration high yield returned 72% of the total return of the overall market, with only 60% of the volatility as measured by standard deviation. In 2016, the return and volatility matched at 70%. The prior year, 2015, was an interesting year because it appears that the volatility proportion captured by short duration high yield was greater than the return. Being a down year, this is the preferable scenario for short duration high yield investors.

Proportion of Returns vs. Proportion of Volatility

Source: Morningstar, as of 3/31/18. Chart created by NYLIM. Short Duration High Yield is represented by ICE BofAML 1-5Y BB-B Cash Pay HY Index; High Yield is represented by the ICE BofAML US High Yield Index. Index definitions can be found at the end of this blog post. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. Volatility is measured by standard deviation. Standard deviation is a measure of the dispersion of a set of data from its mean. It is calculated as the square root of variance by determining the variation between each data point relative to the mean. If the data points are further from the mean, there is higher deviation within the data set. In finance, standard deviation is a statistical measurement; when applied to the annual rate of return of an investment, it sheds light on the historical volatility of that investment. The greater the standard deviation of a security, the greater the variance between each price and the mean, indicating a larger price range.

Many investors look to fixed income to potentially generate, as the name suggests, income. When comparing short duration high yield to other fixed-income asset classes, it is apparent, once again, that the asset class punches above its weight. From an interest-rate risk perspective, the asset class provides a very competitive yield, per unit of risk.

 

Yield Per Unit of Duration

 Yield to Worst
5.32 6.35   3.12 3.76 2.55
Modified Duration
2.43 4.16   6.08 7.5 6.13

Source: Bloomberg Barclays and ICE. Yield to worst as of 3/31/18. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. US Aggregate is represented by the Bloomberg Barclays US Aggregate Bond Index; U.S. Treasury is represented by the Bloomberg Barclays US Treasury Index; Corporate is represented by the Bloomberg Barclays Corporate Index; Short duration high yield is represented by the ICE BofAML 1-5 Year BB-B US High Yield Index; High Yield is represented by the ICE BofAML US High Yield Index. Index definitions can be found at the end of this blog post.

Increased volatility has found its way into risk assets after the relative calm of 2017, leaving many investors considering how best to position their portfolios for the new environment. During periods of stress, having uncorrelated assets may help achieve more favorable returns and high yield bonds generally have a low correlation to other fixed-income asset classes. The chart below demonstrates the benefits of correlation and diversification through the efficient frontier. Over the last eight years (post financial crisis), by adding short duration high yield to a core bond portfolio, an investor would have achieved greater returns than a core bond portfolio alone, for the same level of risk.

Core Bonds and Short Duration High Yield Portfolio Efficiency

Source: Morningstar, as of 3/31/18. Short Duration High Yield is represented by ICE BofAML 1-5Y BB-B Cash Pay HY Index Core Bonds are represented by Bloomberg Barclays US Aggregate Bond Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. Index definitions can be found at the end of this blog post. Risk is measured by standard deviation.

For investors considering increasing portfolio credit quality through allocations to core bond products, the portfolio may inadvertently end up being overexposed to interest rate sensitive asset classes resulting in an increase in portfolio volatility. Whether you are looking to shorten up the duration of a fixed-income portfolio, reduce exposure to the equity markets, or de-risk your high yield allocation, short duration high yield may serve as an effective portfolio diversifier, as well as a way of increasing portfolio efficiency.

Disclosure

Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.

This material is provided for educational purposes only and should not be construed as investment advice or an offer to sell or the solicitation of offers to buy any security. Opinions expressed herein are current opinions as of the date appearing in this material only.

About Risk

All investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.

Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.

Bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner. 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.

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

Credit ratings agencies, such as Moody’s, Standard & Poor’s, and Fitch Ratings, have letter designations (such as AAA, B, CC) which represent the quality of a bond. Moody’s assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with WR and NR as withdrawn and not rated.

Standard & Poor’s and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, and D.

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

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.

The efficient frontier is the set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal, because they do not provide enough return for the level of risk.

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.

Standard deviation is a measure of the dispersion of a set of data from its mean. It is calculated as the square root of variance by determining the variation between each data point relative to the mean. If the data points are further from the mean, there is higher deviation within the data set. In finance, standard deviation is a statistical measurement; when applied to the annual rate of return of an investment, it sheds light on the historical volatility of that investment. The greater the standard deviation of a security, the greater the variance between each price and the mean, indicating a larger price range. For example, a volatile stock has a high standard deviation, while the deviation of a stable blue-chip stock is usually rather low.

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.

Yield to Worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.

Modified Duration is a formula that expresses the measurable change in the value of a security in response to a change in interest rates.

Index Definitions

ICE BofAML 1-5 Y BB-B Cash Pay HY Index tracks the performance of BB rated U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market with maturities of 1 to 5 years.

ICE BofAML US High Yield Index – The index tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.

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.

The Bloomberg Barclays U.S. Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index.

The S&P 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

For more information about MainStay Funds®, call 800-MAINSTAY (624-6782) for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus or summary prospectus carefully before investing.

MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, New Jersey 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC

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Adam Schrier, CFA, FRM

Director, Product Management, New York Life Investments

Adam Schrier is a Director of Product Management at New York Life Investments, covering taxable fixed income and energy equity strategies. Previously, he worked as a Product Manager for high yield and emerging market debt at Invesco in New York

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