Swap duration risk for credit risk: short-duration high-yield bonds
With interest-rate risks rising, short-duration high-yield bonds are becoming highly sought after.
- Short-duration high-yield bonds less sensitive to interest rate and spread changes than longer-dated issues.
- Short-duration high-yield bonds have demonstrated similar performance and better risk-adjusted returns than longer-dated high-yield bonds.
- Short-duration high-yield bonds are an opportunity to swap interest-rate risk for credit risk when defaults are far below their historical average.
- Fund managers pursue different strategies so investors need to be aware of manager’s approach to duration management.
Despite the US Federal Reserve's (Fed) reduction of its monthly bond purchases now being well underway, investors still await the latest announcement from the Fed’s new chairwoman, Janet Yellen, with bated breath. They know that each cut in US monetary support brings the likelihood of an interest rate hike that much closer. This has increased the attraction of high-yield bonds thanks to their superior yields and lower rate sensitivity compared to more highly rated issues. It is also pushing the added benefits of short-duration high-yield bonds firmly into the spotlight.
Indeed, a recent survey of US pension investors found that over a third are now planning to raise their short-duration exposure or their interest-rate hedging1.
Short and Sharpe
In recent years, the short-duration segment of the high-yield market has grown rapidly to account for well over a third of the high-yield universe with US$653 billion2 of bonds in issuance. Its growth partly reflects the increased demand from investors for lower duration exposure.
As well as being less sensitive to interest rate changes than longer-dated issues, short-duration bonds are also less affected by changes in credit spreads (i.e. they have lower spread duration). As a result, they tend to outperform longer-dated issues when rates rise and when spreads widen.
This can be seen from the Sharpe ratios generated by different maturity bands in the high-yield market. The Sharpe ratio is calculated by subtracting the risk-free rate from the rate of return from a portfolio and dividing the result by the standard deviation of the portfolio's returns.
Using 12 years of data to the end of 2013, shows the superior Sharpe ratios – and, consequently, the superior risk-adjusted returns – of high-yield shorter dated bonds. This has made them an attractive option when yields in the wider high-yield market offer relatively meagre compensation for the risk of a rate rise.
At the end of February, the yield to worst (lowest yield on a bond without the issuer defaulting) on the short-duration market stood at 4.1%. Meanwhile, the average duration for this segment of just 2.17 years3. That's significantly less than the 3.81 years for the broader high-yield market4 and barely a third of the duration seen in investment grade indices such as the Barclays Capital Global Aggregate index.
At the end of February, this index offered a yield of just 1.91% but a duration of 6.29 years. With credit quality in the high-yield market still strong and defaults expected to remain far below their long-term average for some time, fixed-income investors have a compelling opportunity to swap interest-rate risk for credit risk.
Default rates have been pushed lower thanks to strengthening profits and de-leveraging and by the high level of new issuance aimed at refinancing. Since 2009, refinancing has accounted for around 60% of annual issuance. This has pushed out debt maturities securing lower cost financing and raising coverage ratios to new highs.
According to the ratings agency Moody’s, the trailing 12-month default rate ended March just 2.3% and is forecast to have only reached 2.6% by March of 2015. This is close to half the long-term average for the market, which sits at 4.8%
From our perspective, short-duration high-yield bonds are a more effective way to manage interest-rate risk than the alternatives. For example, attempting to hedge rate risk by, say, shorting US treasuries, not only presents additional costs but also creates tail risks in the event of a fight to quality. Attempting to hedge treasuries in this way also ignores the fact that the correlation between global high yield bonds and other asset classes depends largely on the spread exhibited by global high-yield bonds over US treasuries. And spreads have already tightened considerably.
Following last year’s strong performance with high-yield bonds delivering eight per cent in dollar terms5, spreads are now so tight that they are now positively correlated to US treasuries and interest rates. They're also negatively correlated to equities – something not seen since 2007.
This was highlighted in January when investors took fright at disappointing Chinese economic data, the Fed’s determination to press ahead with reducing its asset purchases and difficulties in a number of emerging economies.
The S&P 500 index fell 4.5 % and ten-year US treasury yields fell to 2.65% from three %6. With the correlation to treasuries now back in positive territory, high-yield and short-duration, high-yield bonds advanced7.
Even so, if treasury yields were to rise again, short-duration high-yield bonds would still be expected to outperform longer-dated alternatives as was the case in 2013 when US ten-year treasury yields surged to 3.0 from 1.6% in the space of six months. This has given them great appeal at a time when the Fed is actively reducing monetary stimulus.
Beware of imitations
Although there may be few worthwhile alternatives when it comes to lowering portfolio duration, there are a number of caveats to keep in mind with this asset class.
The first is that while the yield on good quality short-duration, high-yield bonds tends to be lower than that of similar quality longer-dated bonds, the average yield on the short-duration segment is greatly influenced by the profusion of distressed issues that it contains. This is because the yield on distressed issues naturally rises as they near maturity. With some distressed short-maturity bonds offering very high yields, this skews the yield higher on the short-duration index.
The second is that high-yield bonds remain among the most idiosyncratic of asset classes. This means that security selection tends to be the most consistent driver of relative performance for experienced managers and suggests that there’s no substitute for genuine fundamental credit analysis.
Investors also need to understand how managers in this space create their portfolio durations and whether it creates so-called ‘extension risk’. This can arise in situations where managers buy bonds that are callable within five years, but which could still have another 30 years until maturity.
Under these circumstances, the bond's duration would be around three years – making it appropriate for some short-duration portfolios – but the remaining maturity of 30 years would introduce extension risk.
This is because if rates were to increase or spreads to widen, pushing down the bond’s price, the bond’s duration would extend in line with that of a 30-year bond and consequently start increasing at exactly the wrong time!
We like to differentiate our approach to this issue by limiting total portfolio duration to three years or less as well as an additional average maturity limit of five years for our portfolio as a whole. In this way, we can create a genuinely short-duration fund without any hidden extension risk.
With the prospect of rising interest rates drawing ever closer, we expect to see a steady increase in demand for short-duration high-yield bonds. Despite the recent rise in lower quality and ‘covenant-lite’ issuance with shorter maturities, overall credit quality in the sector has rarely looked better. Cash flows remain strong and profit margins healthy, meaning companies are cash rich with strong balance sheets and attractive levels of interest coverage.
The strengthening recovery in developed economies also bodes well for the sector as it supports the outlook for a prolonged period of low defaults. Investor demand for new issuance also remains healthy and while spreads may have tightened, we think this should still translate into positive returns of between three and six per cent for the global high-yield market this year, but with naturally less volatility for short-duration bonds than the wider market.