Avoiding Unintended Risks in Short Duration High Yield
“How do they not see it? It’s so obvious!” we often scream incredulously at our TVs, tablets and books when we are in disbelief that our protagonists fail to recognize that the culprit is right in front of their faces. While looking into every lead from all different angles, they are oblivious to the clues and signs that they will in hindsight, acknowledge should not have been missed.
Similarly, for investors trying to understand the risks and factors that may impact their portfolios, there are an increasing number of tools that can be used to quantify these risks so that objectives and risk tolerance levels can be managed appropriately. Investors can stress test their portfolios and optimize allocations for various scenarios. This is all great – it is important for investors to be thoughtful about risk management, however, sometimes the biggest risks may be staring us in the face.
We like to think of short duration high yield as a “high yield lite” asset class – a lower volatility alternative to traditional high yield which participates in less of the upside but also gives up less on the downside. In figure 1 we look at the credit ratings of three high yield indices. The Bloomberg Barclays US High Yield 350mm 0-5 years Index which is tracked by a popular passive investment vehicle, has almost 20% in CCC and below exposure, including non-rated. This is a greater allocation to lower quality bonds than the overall market!1 Shortening a portfolio’s duration may not have the intended implications if it means increasing exposure to the lowest rated segment of the market.
Figure 1: Short Duration Index Without Credit Constraints Has Greater CCC-Exposure Than Market
Source: Bloomberg, as of 12/31/18. Past performance is not indicative of future results. An investment cannot be made in an index.
Given what we said earlier about investing in short duration high yield for a lower beta high yield, the credit quality allocation seems a bit counterintuitive. Also included in the chart is the ICE BofAML 1-5 year BB-B US High Yield Index which excludes CCCs. (the figure shows a modest allocation to CCCs due to the Bloomberg Composite Rating methodology). We believe the credit quality constraint is appropriate given the goal of generating a high yield, with less volatility than the overall market. Additionally, using a passive approach to a portfolio with such a high degree of credit risk doesn’t seem advisable. Rather, selecting a highly skilled manager with expertise in credit analysis may be preferable for portfolios with exposure to lower rated credits.
Let’s now turn to the scoreboard. In figure 2, we show the 5-year cumulative performance as of 12/31/18 of four short duration high yield indices. Surprisingly, the index that is constrained to BB-rated bonds was the leading performer, followed by the index constrained to BB and B-rated bonds. The two indices without credit constraints underperformed, albeit modestly. What is most striking, however, is not where we ended up but how much better the quality constrained benchmarks held up during the energy crisis.
Figure 2: 5-Year Cumulative Performance of Short Duration High Yield Indices
Source: 12/31/18 Bloomberg. Past performance is not indicative of future results. An investment cannot be made in an index.
What is equally important as absolute returns, is risk adjusted returns. Over the same 5-year period, the constrained indices had higher Sharpe ratios than the non-quality constrained indices as well as the market benchmark as shown in figure 3. This means for a unit of risk as measured by volatility, the higher quality indices generated higher returns.
Figure 3: Quality Constrained Indices Had Better Risk Adjusted Returns Over 5 Years
Source: Bloomberg 12/31/18. Past performance is not indicative of future results. An investment cannot be made in an index.
Just as people have different preferences for what shows they stream, they likely have different reasons for selecting high yield products, and more specifically, short duration high yield products. In fact, those short duration indices with significant CCC exposure outperformed the higher quality indices in January, as high yield bounced back from a difficult fourth quarter. The point isn’t to focus on short term performance but rather to be aware of an investment’s risk profile and composition, so that it performs as expected. Investors who invest in lower quality short duration high yield looking to reduce risk, may unknowingly be increasing credit risk and finding themselves thinking “I should have known, it was right in front of me” at some point in the future.
1. As represented by the ICE BofaML US High Yield index
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
Credit Ratings: AAA credit ratings apply to the underlying debt securities and are rated by an independent rating agency, such as Standard & Poor’s (S&P), Moody’s, and/or Fitch. S&P rates borrowers on a scale from AAA to D. AAA through BBB represent investment grade, while BB through D represent non-investment grade. Moody’s rates borrowers on a scale from Aaa through C. Aaa through Baa3 represent investment grade, while Ba1 through C represent non-investment grade. Fitch rates borrowers on a scale from AAA through D. AAA through BBB represent investment grade, while BB through D represent non-investment grade.
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.
Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Subtracting the risk-free rate from the mean return allows an investor to better isolate the profits associated with risk-taking activities.
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.
Bloomberg Barclays US High Yield 350mn Cash Pay 0-5 Yr 2% Capped Bond Index 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 the indices’ EM country definition, are excluded.
BoA/ML 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 five years and rated BB through B inclusive.
ICE BofAML U.S. High Yield Index tracks the performance of below investment grade, but not in default, US dollar denominated corporate bonds publicly issued in the US domestic market, and includes issues with a credit rating of BBB or below, as rated by Moody’s and S&P.
The ICE BofAML BB-B U.S. High Yield Constrained Index contains all securities in the ICE BofAML U.S. High Yield Index rated BB+ through B- by S&P (or equivalent as rated by Moody’s or Fitch), but caps issuer exposure at 2%. Index constituents are capitalization-weighted, based on their current amount outstanding, provided the total allocation to an individual issuer does not exceed 2%.
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.
Markit iBoxx USD Liquid High Yield 0-5 Capped Index is designed to reflect the performance of USD denominated short duration high yield corporate debt. The index offers exposure to liquid high yield corporate bonds maturing between 0 and 5 years. The index is rebalanced on a monthly basis and only bonds with a minimum face value of $350 million per bond are included in the index. The index is weighted by market value, with a 3% cap on each issuer and a 10% cap for 144A bonds without registration rights or with registration period greater than one year.
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.
New York Life Investments is a 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, New York 10010, provides investment advisory products and services. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.