Why a growing contingent of fixed-income investors are eyeing the benefits of the short-duration, high-yield market.

Febuary 2014

What are the main drivers for short-duration, high-yield bonds?

“In recent years short-duration, high-yield debt issuance has grown rapidly and with US$653 billion1 outstanding, it now accounts for well over a third of the high-yield market. The growth of this market segment has been driven partly by issuance in the broader high-yield market in recent years and partly by increased demand from investors lookingwho look for lower duration high-yield exposure.

“Short-duration bonds are naturally less sensitive to interest rate changes than longer-dated issues. They are also less sensitive to 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 by examining the Sharpe ratios generated by different maturity bands in the high-yield market in the 12 years to the end of 2013. These demonstrate that the shorter the period to maturity, the higher the Sharpe ratio2 and the better the risk-adjusted returns. This has made them an attractive option at a time when yields in the wider high-yield market offer reduced compensation for the risk of a rate rise.

“Short-duration yields are close to 7 per cent while the average duration of just over two years is little more than half that of the wider high-yield market3. This presents an attractive opportunity for fixed-income investors to swap interest-rate risk for credit risk at a time when credit quality remains high and defaults are far below their historical average.

“What’s more, we think short-duration high-yield bonds have an important role to play in diversifying fixed-income portfolios by helping to smooth high-yield returns, and we expect to see demand rising as the US Federal Reserve (Fed) continues to withdraw monetary stimulus.”

How has this market segment evolved in recent times?

“One of the key trends we’re communicating to our clients is the recent change in how high-yield bonds are correlated to other asset classes. The extent of this correlation is dictated by the level of spreads over US treasuries, which tightened after delivering 8% to dollar investors last year4. They are currently at a valuation level which means high-yield bonds are positively correlated to treasury markets and interest rates and negatively correlated to equities – something not seen since 2007.

“This was illustrated in January when investors took fright at disappointing Chinese economic data, and the Fed’s determination to press ahead with reducing asset purchases and difficulties in a number of emerging economies. The S&P 500 index fell 3.5% and 10-year US treasury yields moved to 2.65% from 3%5. With the correlation to treasuries now back in positive territory, both high-yield and short-duration, high-yield bonds advanced6.

“But were treasury yields to rise again, short-duration high-yield bonds should outperform longer-dated alternatives as we saw last year when US 10-year treasury yields surged to 3% from 1.6% in the space of six months.”

How should investors approach the issue of benchmarking performance in this sector?

“One of the difficulties facing new investors to the sector is that while the yield on good quality short-duration, high-yield bonds tends to be lower than that of longer-dated bonds of similar quality, the yield on the main Barclays short-duration index is greatly influenced by the profusion of distressed issues that it contains. This is because distressed issues naturally trade down as they near maturity.

“Some of those distressed short-term very high yielding bonds tend to skew the yield higher on the short-duration index.

“As this is not an index that most fixed-income investors would want to own, we think this underlines the importance of taking a bottom-up approach to investment.”

What sort of resource is required to capitalize on this opportunity?

“High-yield bonds are among the most idiosyncratic of asset classes which means there’s no substitute for genuine credit analysis. For us, over the course of a market cycle, security selection is the most consistent driver of relative performance. As a global fixed income manager, we have 23 high-yield analysts based in key locations around the globe. In the US alone, we have eight senior analysts – each with more than a decade of experience –providing comprehensive coverage on at least 40 different companies.

“Our fund managers operate within strict risk parameters. They actively monitor total portfolio risk and once a week challenge our analysts to ‘re-buy’ the portfolio. This is designed to ensure that the original investment thesis for each investment still holds true and enables us to act quickly when it doesn’t.”

How do you differentiate your approach at the portfolio level from others in this sector?

“Apart from the management resources we dedicate to this market, we also tend to differentiate ourselves by how we construct our portfolios and how we manage risk.

“For example, our conservative approach means we have a bias towards double and single B-rated credits and that we typically limit exposure to CCC-rated credits – which we see as five times more likely to default than the wider market – to just 10%.

“We also have strict rules around the allocation of industry sectors in the portfolio, individual issuer concentrations and issue size. We also try to keep portfolio turnover relatively low as transaction costs can eat into returns – especially at a time of low yields. Unlike some rival managers, as well as imposing a limit on total portfolio duration of three years or less, we additionally impose an average maturity limit of five years for the portfolio as a whole.

“This prevents us from holding any bonds that are callable within five years but which could still have another 30 years until maturity. In this example, the duration of this sort of bond would be around three years – making it appropriate for some short-duration portfolios – but the remaining maturity of 30 years would introduce what’s called ‘extension risk’.

“For example, 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. This means that duration would increase at exactly the wrong time! By imposing both a three-year average duration limit and a five-year average maturity limit for the portfolio we can create a genuinely short-duration fund without any hidden extension risk.”

How are corporate issuers making use of this market and what does this say about the outlook for new issuance?

"The last four years have seen record levels of new issuance in the high-yield market with almost two-thirds of this due to refinancing. Within this, issuance in the short-duration segment has also risen, which reflects fund managers’ growing reticence towards holding longer-duration bonds.

“This has helped to create a seller’s market for short-duration bonds. Strong fundamentals such as low default rates are allowing companies to refinance at a lower cost of capital. And with interest rates potentially increasing in the medium term, we expect to see this trend continue.

“Although refinancing activity is now starting to decline after several very busy years, new issuance remains healthy with more companies issuing debt to fund share buy-backs or special dividends.”

Can you explain some of the sector biases that have resulted from our bottom-up approach?

“Our approach to the high-yield universe has always been predicated on our fundamental bottom-up research and this holds true for our short-duration portfolios. We eschew the market index in order to avoid it dictating how we construct our portfolios. If there are industries that we think look vulnerable, we avoid them altogether.

“As a result, our short-duration fund is notably underweight in banking and other financial sectors where we see a higher level of risk. We much prefer the opportunities on offer in consumer sectors and areas such as technology, energy and utilities and, as a result, our portfolios are markedly overweight in such sectors.

“Our conservative philosophy means we only purchase bonds where we’re comfortable with a lower probability of default and the potential severity of loss given the capital structure. In this way, we can limit any capital losses for our clients.”

What’s your current outlook for the sector?

“The global high-yield bond market continues to be supported by low default rates and strengthening economic activity in North America and Europe. Companies have rarely been as cash-rich and profit margins remain healthy. Balance sheets and interest coverage are also strong.

“Although spreads have tightened, we think this should translate into positive returns of between three and five per cent this year but with less volatility for short-duration bonds than the wider high-yield market. Although we don’t expect to see the same magnitude of returns as last year, we expect increasing attention from duration-conscious investors in 2014.

“In terms of risks, we’ve been highlighting the concerns presented by the trend towards lower quality and ‘covenant-lite’ issuance with shorter periods until they become callable, for some time. We continue to monitor this carefully, especially given current high valuations. The recent volatility in emerging markets and signs of weakness in China also require scrutiny, as does the pace at which US monetary accommodation is withdrawn.”

 

 

1. Source: Barclays Global High Yield excluding xCMBS xEMG 2% Capped 1-5 Years Maturity Index as at 31 December 2013

2. Source: Barclays Global High Yield excluding xCMBS xEMG 2% Capped Index based on US dollar hedged returns from 30 April 2001 to 31 December 2013

3. Source: Barclays Global High Yield excluding xCMBS xEMG 2% Capped 1-5 Years Maturity Index as at 31 December 2013

4. Source: Barclays Global High Yield excluding xCMBS xEMG 2% Capped Index one-year return to 31 December 2013 

5. Source: Bloomberg 

6. Source: Bloomberg. Net of fees one-month return as at 31 January 2014 for: Barclays Capital Global High Yield ex-CMBS&EMG 2 per cent Capped Index USD hedged 0.72 per cent; Barclays Global High Yield Bond excl-CMBS & EMG 2% Cap 1-5 years Index USD hedged indices 0.56 per cent

 

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