Mark Miller explains why short-duration global high-yield could be a viable option for investors seeking to avoid getting stuck in a fixed-income horror story.
Read this article to understand:
- Why short-duration global high-yield (SDGHY) can provide attractive long-term returns and diversification benefits while exhibiting limited sensitivity to interest-rate rises
- Why improved credit quality has contributed to falling default rates over the past decade
- How a strategic allocation to SDGHY can be an efficient way of investing in the broad global high-yield asset class
Fans of Stranger Things, the smash-hit Netflix horror and homage to the 1980s, will be familiar with the Upside Down, an alternative dimension that exists alongside the human world. Absent the background soundtrack of swirling synthesizers, fixed-income investors may be forgiven for thinking they have also entered an alternative, alien world this year, one vastly different from the environment they have been accustomed to for over a decade.
Against a backdrop of persistently subdued inflation, the prevailing theme in bond markets during these years was “lower-for-longer”. As shown in Figure 1, average bond yields edged downwards across all fixed-income asset classes. For example, global high-yield bond yields fell from eight per cent in 2010 to just four per cent as recently as 2021. It was a similar tale for sovereign bonds and investment-grade credit.
Figure 1: Annual average yields have declined through the past decade
Note: Asset classes are represented by the Bloomberg Global High Yield Corporate, Bloomberg Global Aggregate Corporate, Bloomberg Global Aggregate Treasury, and the Bloomberg Multiverse. Yields are hedged to US$.
Source: Barclays Live. Data as of August 18, 2022
After initially modest interest-rate increases late last year and early in 2022, recent months have seen a flurry of aggressive interest-rate rises by central banks scrambling to squeeze the inflation genie back into the bottle. Bond yields across the fixed-income universe have soared in response, breaking out from the rock-bottom ranges that prevailed since the Global Financial Crisis.
With no immediate end in sight for this hiking cycle — not while inflation remains well above central bank targets in many economies — bond yields seem likely to climb higher from here in the coming months. Whether they can return to lower levels over the medium term depends a great deal on inflation, which has become an economic wildcard. Will the inflationary Demogorgon soon be slain, or will it stalk the global economy for years to come?
If the price shocks of the past year, led by higher energy and commodities costs, become embedded through second-round effects including wage-price spirals, the prolonged period of low bond yields may become a fading memory.
Correlation changes
Interest rates and bond yields are not the only thing on the up. For the first two decades of the century, equities and bond returns were negatively correlated. This relationship has broken down in spectacular fashion this year.
With bond and equity markets sinking in the first half of 2022, correlations between the two major asset classes moved into firmly positive territory, as Figure 2 illustrates. This has upended investor assumptions about the safe haven qualities of bonds during equity market drawdowns, challenged the orthodoxy of the 60/40 balanced portfolio model, and posed tough questions for asset allocators.
Figure 2: Ten-year correlation of returns between equities and fixed income
Source: Bloomberg. Data as of September 30, 2022
The role for short-duration global high-yield
We believe a strategic allocation to short-duration global high-yield (SDGHY) has considerable merits for long-term investors. It may have current appeal for asset allocators reviewing and resetting their portfolios given the changes in the macro and market backdrop.
SDGHY can provide diversification benefits and help investors meet the challenge provided by this reemergence of a positive correlation between equities and bonds. It can also help defensively position portfolios against further interest-rate rises.
As evidenced in Figure 3, SDGHY exhibits a negative correlation with US Treasuries. The three different constituent parts that make up the yield in SDGHY explain this negative correlation:
- The bonds provide exposure to the prevailing risk-free rate
- They offer an attractive credit spread underpinned by high coupons
- The asset class comes with relatively low interest-rate or duration risk — the short-dated nature of the bonds means they are typically more sensitive to corporate earnings and the economic outlook than fluctuations in interest rates. As such, they lack the sensitivity to rising rates of longer-dated bonds
Figure 3: Short-duration global high-yield and its low sensitivity to interest rates
Past performance is not a guide to future performance.
Note: Benchmark (index) performance does not reflect the deduction of transaction costs, management fees, or other costs which would reduce returns. References to market or composite index, benchmarks or other measures of relative performance, over a specified period of time, are provided for your information only and do not imply that a portfolio will achieve similar returns, volatility or other results. An index is unmanaged and the composition of an index may not reflect the manner in which a portfolio is constructed in relation to expected or actual returns, portfolio guidelines, restrictions, sectors, correlations, concentrations, volatility or tracking error targets, all of which may change over time. Indexes are unmanaged, do not reflect fees and expenses and are not available as direct investment.
Source: Bloomberg, April 30, 2001 to September 30, 2022
Declining default risks
The trade-off associated with the higher yields available from global high-yield debt is clearly the greater default risk to which investors are exposed. In our view, this risk is diminishing. Through active management and judicious security selection, we believe investors are often more than adequately compensated for the possibility of defaults.
As explored in more detail by Sunita Kara, global co-head of high yield at Aviva Investors, in a recent article, and as shown in Figure 4, defaults within the global high-yield asset class have been on a downward trend over the long run. Over the past decade, there have been generally shorter and shallower peaks in the default cycle.1
Looking ahead, despite spreads widening since the start of 2022, we expect only a modest and gradual increase in defaults in the current default cycle.
Figure 4: Defaults have moved structurally lower with each cycle
Source: Moody’s. Data as of August 31, 2022
One of the main reasons for our optimism on the outlook for defaults is the improvement in credit quality across the global high-yield universe, as issuers have taken advantage of previous favourable conditions to strengthen balance sheets.
Higher-quality BB-rated bonds — where average default rates are typically around one per cent —now account for over half of the universe. Meanwhile, the CCC-rated portion — where default rates are typically closer to 17 per cent — has drifted lower to less than one-tenth.2
Higher-quality BB-rated bonds now account for over half of the universe
Part of this improvement in credit quality is a post-pandemic phenomenon. Many issuers were downgraded to high-yield from investment-grade status in the distressed market conditions of the COVID-19 crisis. Around two-thirds of these fallen angels have since reclaimed their investment-grade ratings. However, many fundamentally strong, conservatively managed former investment-grade companies remain in the sub-investment-grade universe. This has swelled the ranks of better-quality high-yield issuers.
Figure 5: Rising stars and fallen angels ($bn)
Source: J.P. Morgan credit research rating distribution. Data as of July 2, 2022
Figure 6: A decade of improving fundamentals
Note: Representing breakdown of Bloomberg Global High Yield.
Source: Bloomberg Data as of September 30, 2022
An efficient approach
While falling default rates benefit SDGHY and broader global high-yield, SDGHY represents the most efficient means of investing in the asset class.
In Figure 7, we split the global high-yield universe into different maturity buckets and compare each bucket’s return profile, volatility and risk-adjusted returns, based on 20-year index returns to September 30, 2022.
SDGHY represents a sweet spot within the broader global high-yield universe
We can see SDGHY — defined here as bonds with under five years’ maturity — represents a sweet spot. An allocation to SDGHY generated almost identical cumulative and annualised returns (293 per cent and 6.6 per cent) to the broad global high-yield universe (292 per cent and 6.6 per cent). But it did so while exhibiting lower volatility (annualised standard deviation of 8.0 per cent versus 9.3 per cent) and a higher Sharpe ratio (0.8 versus 0.7), pointing to superior risk-adjusted returns or efficiency.
Figure 7: The efficiency of SDGHY
Past performance is not a guide to future performance.
Note: The index used is the Bloomberg Global High Yield excCMBS & EMG 2% Capped Index. Benchmark (index) performance does not reflect the deduction of transaction costs, management fees, or other costs which would reduce returns. References to market or composite index, benchmarks or other measures of relative performance, over a specified period of time, are provided for your information only and do not imply that a portfolio will achieve similar returns, volatility or other results. An index is unmanaged and the composition of an index may not reflect the manner in which a portfolio is constructed in relation to expected or actual returns, portfolio guidelines, restrictions, sectors, correlations, concentrations, volatility or tracking error targets, all of which may change over time. Indexes are unmanaged, do not reflect fees and expenses and are not available as direct investment.
Source: Bloomberg, April 30, 2001 to September 30, 2022
The superior showing by SDGHY against the all-maturities universe is down to asymmetries in the market: investors do not benefit from a linear pick-up in yield as they increase duration risk. Investors receive as much compensation for interest-rate risk, often more, for holding shorter-dated than longer-dated bonds.
Bondholders are also exposed to elevated levels of duration risk if marked to market daily
It is worth noting the table shows some ostensibly impressive figures for the much longer-dated ten, 20 and 20+ years buckets. However, these results are somewhat illusory. These buckets largely comprise fallen angels. This part of the market is highly illiquid, with investors typically holding these bonds through to maturity on the expectation the issuers will not default. Bondholders are also exposed to elevated levels of duration risk if marked to market daily.
At the other end of the maturity ladder, the one-to-three years bucket may demonstrate a higher Sharpe ratio than the under five years bucket, but it also suffers from a lack of liquidity and depth.
A high-carry asset class - the power of reinvesting coupons
Income drives the attractive long-term returns of SDGHY— as Figure 8 shows, in some instances more than 100 per cent of the total return of the asset class comes from coupons. With less spread duration risk than an all-maturities strategy, it is the coupon that compensates investors for their credit risk and generates the bulk of total returns.
Structural long-term investors in SDGHY can benefit from the regular reinvestment of these coupons
As a high-carry asset class, the old maxim of time in the market rather than timing the market prevails; structural long-term investors in SDGHY can benefit from the regular reinvestment of these coupons over time rather than making any directional calls on credit spreads.
Of course, if investors are feeling bullish and want to take a more tactical or opportunistic view on the direction of (lower) interest rates and (tighter) credit spreads, they may wish to add beta by additionally allocating to all-maturity global high yield, with its higher duration and spread duration exposure.
Figure 8: SDGHY’s long-term returns are driven by income (per cent)
Note: Coupon return shown with reinvestment. Global Aggregate and SDGHY are represented by the Bloomberg Global Aggregate index and the Bloomberg Global High Yield Corporate Index. Hedged to US$.
Source: Bloomberg. Data as of September 30, 2022
Our approach to SDGHY
Launched in 2012, we believe the Aviva Investors Short-Duration Global High-Yield Bond strategy has proved itself as a credible option for investors seeking exposure to this asset class, based on its:
- Downside consideration – an active approach that recognises the asymmetric nature of the global high-yield market through an emphasis on downside protection, helped by a structural bias to higher-quality (BB and B-rated) issuers
- ESG lens – an investment process that integrates company engagement and considers sustainability risk3
- Global approach – a genuinely global approach that eschews the regional sleeves favoured by many other short-duration high-yield bond strategies. Our European and US-based portfolio managers work closely with our credit and ESG analysts to identify the most attractive issuers and best bonds within capital structures, irrespective of location4
Key takeaways
Short-duration global high-yield is an attractive asset class that offers the potential for:
- Lower interest-rate sensitivity
- Lower correlation to other asset classes
- Lower volatility than longer-dated maturities
- Higher risk-adjusted returns
For these reasons, we believe asset allocators should consider a strategic, long-term allocation to this part of the bond universe. In a fixed-income world that has seemed Upside Down in recent months, this asset class has attributes that should resonate with investors now.