Short Duration High Yield: A Flower in the Junkyard Revisited
Last year, we published “Short Duration High Yield: A Flower in the Junkyard” to highlight short duration high yield’s resiliency in the face of volatility and provide interesting perspectives on a lesser known asset class. Since then, risk assets experienced bouts of volatility culminating in a synchronized plummet in the fourth quarter of 2018, and then a subsequent recovery in Q1 of 2019 predicated upon the easing of the same fears which drove the prior quarter’s unease.
With that backdrop, we are revisiting the idea that short duration high yield is a flower in the junkyard.
The fourth quarter of 2018 marked the 13th time dating back to the financial crisis in which the S&P 500 was down for the quarter and for the 13th time, the short duration high yield asset class outperformed equities. In 10 of those 13 quarters, short duration high yield outperformed traditional high yield as shown in Figure 1. In the three quarters in which traditional high yield bested short duration high yield, both asset classes generated positive returns despite negative equity returns.
Figure 1. Resiliency During Equity Declines
Source: Morningstar 3/31/19.1 Past performance is no guarantee of future results, which will vary. It is not possible to invest in an index.
The short duration high yield asset class is not a unique asset class, but rather a subset of the overall high yield market. It is characterized by its shorter maturities in addition to a quality bias as compared with the overall market. These distinctions result in a lower beta variant of high yield with less volatility and credit sensitivity than traditional high yield. By investing in bonds that are closer to maturity and have higher credit quality, the asset class is less likely to experience the same fluctuations as longer duration traditional high yield. Keep in mind, this works in both directions – with less volatility on the downside comes less upside volatility.
One way to get a sense of the upside potential is by looking at the upside and downside capture of short duration high yield versus other risk asset classes. In Figure 2, the higher the plot is on the Y-axis, the more short duration high yield participates in the upside of that asset class and the further left the plot is on the X-axis, the less it participates in its downside.
For example, the core bonds plot has an up capture ratio of 80% and a down capture of -20%, indicating that short duration high yield has both favorable up capture and down capture ratios versus core bonds. In fact, the negative down capture means that even when the core bonds decline in value, short duration high yield has generated positive returns. You will notice that short duration high yield has exhibited higher up capture ratios than down capture ratios for each respective asset class. This asymmetric return profile is likely appealing to investors looking to earn attractive levels of income but mindful of capital preservation.
Figure 2: Asymmetric Return Profile vs. Other Risk Assets
Source: Morningstar as of 3/31/2019.2 Past performance is no guarantee of future results, which will vary. It is not possible to invest in an index.
While some investors may be averse to the phrase “high yield” in the name, they may be surprised to see that short duration high yield has less volatility than investment grade corporate bonds as well as traditional high yield as shown in Figure 3. While the comparison to traditional high yield delivers the expected and somewhat obvious outcome, the results with respect to investment-grade corporate bonds are a little more surprising. Investment grade bonds tend to be more interest rate sensitive than non-investment grade, and therefore the shorter maturity mitigates that interest rate exposure found in investment grade corporate bonds.
Figure 3. Less Volatility than Investment Grade Corporate Bonds
Source: Morningstar 3/31/19.3 Past performance is not indicative of future results. An investment cannot be made directly into an index.
Investors may also be surprised to learn that adding short duration high yield bonds to a core bond portfolio can decrease the overall risk. Reducing risk through lower quality bonds sounds counter-intuitive, however Figure 4 demonstrates the benefits of correlation and diversification through efficient frontier analysis. Over the last 20 years, by adding short duration high yield to a core bond portfolio, the portfolio would have produced greater returns than a core bond portfolio alone, with the same level of risk measured by standard deviation.
Figure 4. Increasing Portfolio Efficiency through Short Duration High Yield
Source: Morningstar. Data as of 4/1/1999 – 3/31/2019.4 Past performance is not indicative of future results. An investment cannot be made directly into an index.
While there is a strong case for investing in short duration high yield for its lower volatility and attractive up/down capture potential, many investors look to fixed income for income generation purposes. When comparing short duration high yield to other fixed income asset classes, it is apparent that once again the asset class punches above its weight as shown in Figure 5. From an interest rate risk perspective, the asset class provides a very competitive yield per unit of risk.
Figure 5. Attractive Yield per Unit of Duration Relative to Other Fixed Income Sectors
Source: Morningstar 3/31/19. Past performance is not indicative of future results. An investment cannot be made directly into an index.
For investors looking to shorten the duration of a fixed income portfolio, reduce exposure to equity markets, or allocate to a lower beta high yield alternative, short duration high yield may be a compelling solution. Short duration high yield has historically exhibited favorable up/down capture ratios to other risk assets as well as served as an effective portfolio diversifier.
1. Short duration high yield represented by the ICE BofAML 1-5 BB-B U.S. High Yield Index. Stocks represented by the S&P 500 Index. High Yield represented by the ICE BofAML U.S. High Yield Index.
2. All up capture and down capture ratios are of 4/1/1999 – 3/31/2019. Core Bonds is represented by Bloomberg Barclays U.S. Aggregate Bond Index. Short duration high yield represented by the ICE BofAML 1-5 BB-B U.S. High Yield Index. Stocks represented by the S&P 500 Index. High Yield represented by the ICE BofAML U.S. High Yield Index. Bank Loans represented by the S&P/LSTA Index.
3. Short duration high yield represented by the ICE BofAML 1-5 BB-B U.S. High Yield Index. IG Corporates represented by the Bloomberg Barclays U.S. Corporate Bond Index. High Yield represented by the ICE BofAML U.S. High Yield Index. Volatility is measured by standard deviation.
4. Short duration high yield represented by the ICE BofAML 1-5 BB-B U.S. High Yield Index. Core bonds represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Risk is measured by standard deviation.
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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 High Yieldbrid 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.
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.
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.
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