Why duration is less meaningful for high yield

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

Over the last couple of years, the long-awaited rate increases finally took hold. In anticipation of rate hikes, investors in fixed income continuously evaluated their interest-rate exposure by reviewing their portfolio duration. Investors often view duration as an indicator of how their fixed-income investments may perform in different interest rate scenarios.

10-Year U.S. Treasury yields double in two years

Source: Department of Treasury, as of 6/30/18. Past performance is no guarantee of future results. An investment cannot be made directly into an index.

At the end of July 2016, the 10-year U.S. Treasury yielded 1.46%. Within less than two years, that yield more than doubled to 2.95% by the end of April 2018. Some may simply assume that as a result, they would realize a significant decline in the value of their fixed-income investments over that period. Investment-grade bonds, as measured by the Bloomberg Barclays U.S. Aggregate Bond Index, did lose close to 2% during that period. On the contrary, high-yield corporate bonds and high-yield municipal bonds, as represented by Bloomberg Barclays High Yield Corporate Index and Bloomberg Barclays High Yield Muni Index, respectively, returned 12% and 5%, respectively, over that same time period.

Duration is defined as the approximate change in price of a bond, given a 1% change in interest rates. Bonds are said to have a longer duration when they have greater interest rate sensitivity and conversely, have a shorter duration when they are less exposed to interest rates. Put simply, duration is a measure of interest rate sensitivity in bonds.

However, it is important to view this metric in the appropriate context. The caveat to keep in mind is that duration is less applicable to below investment-grade fixed income, and there are two reasons for this:

  1. Lower-rated bonds are more credit sensitive than interest rate sensitive
  2. The power of the coupon

Credit sensitivity vs. interest rate sensitivity

Interest rates tend to rise during periods of economic expansion. For corporations, a more important driver of high-yield prices is the financial health of the companies issuing the bonds. In a growing economy, many companies will increase their profits, generate more cash, and be better able to service their debt, which would result in less credit risk, real or perceived. Similarly, many high-yield municipal bonds are backed by economically-sensitive project revenues, which can strengthen amid improving economic environments, providing a growing revenue stream from which debt is serviced.

Given that spreads – the difference in yield between a bond and a risk-free bond with the same maturity – are the market’s way of pricing credit risk, they tighten and widen based on investor risk appetite and the perceived creditworthiness of the issuer.

By this rationale, it follows that rising rates coincide with an improving economic environment, which facilitates stronger issuers and lower default risks, leading to tighter spreads, which may offset some or all of the impact of rising Treasury yields.

Figure 2: Spreads can absorb Treasury rate increases

Source: The above is hypothetical and for illustrative purposes only.

However, it is worth noting that when credit spreads are tighter than historical averages, which is now the case, there is less of a cushion and high-yield bonds may not be completely insulated from wider bond market volatility.

The power of the coupon

The total return of a bond in the most basic sense is comprised of price appreciation and coupon income. The coupon component of that total-return equation can be quite significant for non-investment grade bonds. Figure 3 illustrates five rising rate periods and compares the duration expected price return during those periods with the actual price returns. In all five periods, the actual price return is greater than the duration expected price return for both high-yield corporate and high-yield municipal bonds.

Equally important, the relatively large coupons had a compelling impact on total return, which is the difference between the total returns and the actual price returns. Since coupons are a significant portion of total return for high-yield bonds, duration becomes a less useful metric for evaluating risk.

Figure 3: Cumulative performance during rising rate periods: High-yield corporate bonds

Sources: Morningstar Direct and Bloomberg Barclays, 6/30/18. Note: Expected price returns based on interest rate change and duration. Past performance is no guarantee of future results. An investment cannot be made directly into an index.

Figure 4: Cumulative performance during rising rate periods: High-yield municipal bonds

Sources: Morningstar Direct and Bloomberg Barclays, 6/30/18 Note: Expected price returns based on interest rate change and duration. Past performance is no guarantee of future results. An investment cannot be made directly into an index.

Conclusion

The duration of a bond or fixed-income investment portfolio is a frequently referenced risk measure used to predict how bonds may react to interest rate changes. However, high-yield bonds don’t react the same as other bonds to interest rate changes and as such, duration becomes a less useful measure of risk for high yield investors. In fact, contrary to conventional bond wisdom, both high yield corporate and municipal bonds have performed well during periods of rising rates. This can be explained by the idea that rising rates are typically preceded by a strong economy, which sets the stage for a benign credit environment. Credit sensitivity, coupled with large coupons, tend to produce attractive total returns in high-yield bonds when rates rise, despite what an investor may infer from duration statistics.

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. New York Life Investments does not guarantee their accuracy or completeness, nor does New York Life 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.

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.

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.

High yield securities (junk bonds) 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. Diversification does not guarantee profit or protect against loss.

Duration measures interest-rate sensitivity. The longer the duration, the greater the expected volatility as rates change. Fixed Income investing entails credit and interest-rate risks. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall.

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

High yield corporate bonds are represented by the Bloomberg Barclays High Yield Corporate Index.

High yield municipal bonds are represented by the Bloomberg Barclays High Yield Muni Index

Definitions:

3-7 year bonds are public obligations of the U.S. Treasury with a remaining maturity from 3 up to (but not including) 7 years.

Exclusions:

  • Treasury bills are excluded (because of the maturity constraint).
  • Certain special issues, such as flower bonds, targeted investor notes (TINs), and state and local government series (SLGs) bonds are excluded.
  • Coupon issues that have been stripped are reflected in the index based on the underlying coupon issue rather than in stripped form. Thus, STRIPS are excluded from the index because their inclusion would result in double counting. However, for investors with significant holdings of STRIPS, customized benchmarks are available that include STRIPS and a corresponding decreased weighting of coupon issues.
  • As of December 31, 1997, Treasury Inflation-Protection Securities (Tips) have been removed from the Aggregate Index. The Tips index is now a component of the Global Real index group.

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.

High yield corporate bonds are represented by the Bloomberg Barclays High Yield Corporate Index, which measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.

High yield municipal bonds are represented by the Bloomberg Barclays High Yield Municipal Bond Index, an unmanaged index that includes municipal bonds that are non-rated or rated Ba1 or below. They must have an outstanding par value of at least $3 million and be issued as part of a transaction of at least $20 million. The bonds must have a dated-date after December 31, 1990 and must be at least one year from their maturity date.

New York Life Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities are distributed by NYLIFE Distributors LLC, located at 30 Hudson Street, Jersey City, NJ 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 fixed income strategies with a focus on non-investment grade debt. Previously, he worked as a Product Manager for high yield and emerging market debt at Invesco in New York

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