High yield’s little brother

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

Given the unusually strong performance of both equity and fixed income markets year to date, it only makes sense that investors are revisiting their portfolio allocations. Where is it best to take gains and reallocate risk? Does my fixed income portfolio have the optimal mix of interest rate and credit risk?

We are here with a potential solution – high yield bonds. Not the broad high yield market, but rather the lesser-known segment made up of shorter maturities with slightly higher credit quality: short duration high yield. We like to think of it as “high yield’s little brother.” By excluding the lowest rated portion of the high yield market and including bonds that are closer to maturity, short duration high yield exhibits considerably lower volatility than the overall high yield market. In fact, as shown in Figure 1, short duration high yield has even demonstrated less risk than investment grade corporate bonds.

Figure 1: Short duration high yield has less volatility than investment grade corporate bonds

Source: Morningstar, as of 8/31/2019.1 Volatility is measured by standard deviation. Past performance is no guarantee of future results, which will vary. It is not possible to invest in an index.

While we believe a strategic allocation to high yield may be beneficial due to its low duration, high coupon, and diversification benefits, there are those who use spreads as a barometer to gauge the merits of the asset class. So, when it comes to spreads, at what levels does short duration high yield outperform core bonds? In Figure 2, we compare median 1 year forward returns of short duration and the Bloomberg Barclays U.S. Aggregate Bond Index, segmented by beginning spread level. Except for a few pre-financial crisis months when we saw spreads below 300 bps, short duration high yield outperformed the Agg regardless of spreads. Even more so, the median 1-year outperformance for the 15-year period is almost 200 bps.

Figure 2: Short duration high yield has historically outperformed the Agg

Source: Morningstar, ICE Indices, and Bloomberg Barclays, as of 8/31/2019.2 Returns represent the median 1-year forward return over the last 15 years; 1-year forward returns take into account the 1-year return following the referenced start date. Past performance is no guarantee of future results, which will vary. It is not possible to invest in an index.

It’s clear that short duration has performed well without excessive risk when compared to IG corporate bonds and core fixed income. Let’s now turn to another member of the below investment grade family, bank loans. Due to a confluence of reasons, not the least of which is Fed rate cuts, the bank loan asset class has experienced massive outflows. Short duration may represent an ideal landing spot for investors seeking an attractive level of income potential without having to extend duration. Interestingly, over the last 15 years, short duration high yield has provided all of the upside of bank loans with considerably less downside. Figure 3 shows this asymmetric return profile of short duration, which generated 102% of the up capture and only 68% of the downside. Put more definitively, a short duration high yield investor got all of the upside of bank loans with 30% less downside.

Figure 3: All of the up and less of the down versus bank loans over 15 years

Source: Morningstar, as of 8/31/19.3 Past performance is no guarantee of future results, which will vary. It is not possible to invest in an index.

The crux of the “little brother” descriptor is this: short duration high yield consists of bonds closer to maturity and therefore, has less volatility. This has resulted in a smoother ride than that of the broader high yield market. In other words, while the good times won’t be as good, short duration historically held up better when spreads widened, making it a more resilient option. Figure 4 demonstrates this by showing how short duration high yield has performed versus regular high yield as spreads move. During quarters when spreads tightened, the median high yield return was greater than short duration high yield, as expected. Conversely, in quarters marked by spread widening, short duration held up better.

But, in high yield, the adage, “what goes up must come down” applies. When spreads widen significantly, they tend to do so rapidly and do not stay near their peak for long. Subsequent tightening also often leads to range bound spreads which explains the quarterly excess return of high yield relative to short duration over the 15-year period. Therefore, over longer time periods, high yield has a greater expected return than short duration high yield. However, for investors looking for less volatile income generation, short duration high yield may be the best approach.

Figure 4: A smoother ride

Source: Morningstar and ICE BofAML U.S. High Yield Index, as of 8/31/19.4 Past performance is no guarantee of future results, which will vary. It is not possible to invest in an index.

In an undoubtedly challenging interest rate environment where stocks and bonds continue to post outsized gains, the need for an alternative is increasing. As proven, short duration high yield compares favorably to other fixed income asset classes in terms of historical returns and volatility. We believe high yield’s little brother can solve for the questions plaguing investors given its compelling risk/reward profile. One way to access this segment of the high yield market is with MainStay MacKay Short Duration High Yield Fund (MDHIX)*.

*Click on the fund name for the most current fund page, which includes, the prospectus, investment objectives, performance, risk, and other important information. Returns represent past performance which is no guarantee of future results. Current performance may be lower or higher. Investment return and principal value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. Visit nylinvestments.com/funds and for the most recent month-end performance.

1. Short Duration High Yield is represented by the ICE BofAML 1-5 BB-B Cash Pay High Yield Index; High Yield is represented by the ICE BofAML U.S. High Yield Index; IG Corporates is represented by the ICE BofAML U.S. Corporate Index.
2. Short Duration High Yield is represented by the ICE BofAML 1-5 BB-B Cash Pay High Yield Index; Core Bonds is represented by the Bloomberg Barclays U.S. Aggregate Bond Index.
3. All up capture and down capture ratios are of 9/1/04 – 8/31/19. Short Duration High Yield is represented by the ICE BofAML 1-5 BB-B Cash Pay High Yield Index; Bank Loans is represented by the S&P/LSTA Index.
4. Short Duration High Yield is represented by the ICE BofAML 1-5 BB-B Cash Pay High Yield Index; High Yield is represented by the ICE BofAML U.S. High Yield Index.

About Risk

Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.

Before considering an investment in the Fund, you should understand that you could lose money.

The Fund is not a money market fund and does not attempt to maintain a stable NAV. The Fund’s net asset value per share will fluctuate. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets.

Floating rate loans are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, borrower industry concentration, and limited liquidity. Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and are more vulnerable to changes in the economy. The Fund may invest in derivatives, which may increase the volatility of the Fund’s NAV. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner, or that negative perception of the issuer’s ability to make such payments may cause the price of that bond to decline.

Diversification does not eliminate the risk of experiencing investment losses.

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 taken 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.

For more information about MainStay Funds®, call 800-624-6782 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.

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.

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

ICE BofAML U.S. Corporate Index tracks the performance of U.S. dollar-denominated investment grade corporate debt publicly issued in the U.S. domestic market.

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

S&P/LSTA Leveraged Loan Index is a broad index designed to reflect the performance of U.S. dollar facilities in the leveraged loan market.

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 both a service mark, and the common trade name, of the investment advisors affiliated with New York Life Insurance Company. The MainStay Funds® are managed by New York Life Investment Management LLC and distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company. 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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