Why High Yield Wins the Battle of Short Duration Bonds
Offense wins games, defense wins championships. This phrase is used a lot in sports, especially to motivate athletes to play hard on both sides of the ball. There are legendary defenses in football, the golden glove is a coveted award in baseball, and basketball careers have been defined by blocked shots and rebounding. At some point though, you have to score. Michael Jordan showed it’s possible to do both, becoming the first player to win the Defensive Player of the Year Award and the MVP in the same year.
Fixed income investors seem to be subscribing to this defensive minded ethos as the ultrashort category has experienced tremendous inflows. For many investors, given their risk tolerance, investing in short term investment grade bonds is an appropriate choice. The challenge is, how can they play enough offense to meet their income needs while remaining inside the parameters of their risk preferences?
Figure 1: The High Yield Sector Has Attractive Yields When Compared with Other Fixed Income Sectors
YTM of Fixed Income Sectors
Sources: ICE BofAML and Bloomberg Barclays, as of 3/20/19. Core bonds are represented by the Bloomberg Barclays US Aggregate Bond Index; High Yield bonds are represented by the ICE Bank of America Merrill Lynch 1-5 BB-B HY Bond Index, US Corporate Bonds are represented by the ICE Bank of America Merrill Lynch US Corps 1-5 Index; Treasuries are represented by the S&P 500 Index. Chart created by New York Life Investments. Past performance is no guarantee of future results, which will vary. An investment cannot be made in an index.
As illustrated in Figure 1, US high yield has a higher yield than other fixed income sectors.1 High yield corporate bonds have a yield to maturity of almost 375 basis points greater than core bonds. Looking even at shorter duration bonds, the differential is still almost 275 bps between high yield and investment grade. It goes without saying that incremental yield comes with incremental risk. However, it’s important not to look at high yield in isolation, but rather in a portfolio context.
In Figure 2, we use efficient frontier analysis to compare a portfolio consisting of core bonds and short duration high yield, with one made up of core bonds and short-term investment grade corporate bonds. Depending on an investor’s risk tolerance, short duration investment grade corporates may make sense. However, upon a closer look, you will see that for some levels of risks, a portfolio would be optimized by holding short duration high yield instead of short duration investment grade bonds. More specifically, a portfolio made up of 85% core bonds and 15% short duration investment grade corporate bonds underperformed the corresponding core/high yield portfolio (28% short duration high yield) for that level of risk (measured by standard deviation) by 100 bps.
Although one portfolio held high yield and one included investment grade corporate bonds, both portfolios had the same level of risk – and the portfolio with high yield outperformed. Put simply, lower quality bonds increased the risk adjusted returns of the portfolio.
Figure 2: Reducing Duration with High Yield May Be Advantageous for Investors
Efficient Frontier Analysis
Source: Morningstar Direct, March 2010 – February 2019. Core bonds are represented by the Bloomberg Barclays US Aggregate Bond Index; Short Duration HY is represented by the ICE Bank of America Merrill Lynch 1-5 BB-B HY Bond Index, Short Term Corporates represented by the ICE Bank of America Merrill Lynch US Corps 1-5 Index. Chart created by New York Life Investments. Past performance is no guarantee of future results, which will vary. An investment cannot be made in an index.
Intuitively it makes sense to complement a core bond portfolio with short term investment grade bonds to reduce risk and shorten duration. However, investors may be surprised to know that in some cases, they can get to the same level of risk and duration by using short duration high yield instead, which may increase yield and total return potential. Because high yield adds the element of diversification to a core bond portfolio, short duration high yield may be the unexpected competitor who can score points and play defense at the same time.
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.
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.
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.
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 BofA Merrill Lynch US Corporate 1-3 Years Index tracks the performance of US dollar-denominated investment grade debt publicly issued in the US domestic market, including US Treasury, US agency, foreign government, supranational and corporate securities.
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.
The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.
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.
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.