US high yield: Playing the short game

June 7, 2024

With interest rate volatility likely to continue, Bryan Petermann explains how investors can insulate their credit exposure while potentially generating compelling returns via an allocation to short-duration high yield.

The last two years have been volatile for investors, primarily due to the Federal Reserve’s (Fed) rate-hiking programme, which began in March 2022.

This year, markets are still being impacted by rate volatility due to continued economic growth and stubborn inflation that are delaying rate cuts. This has caused longer-duration fixed income assets to underperform their shorter-duration siblings (Figure 1).

What is short duration high yield?

The US$1.3 trillion US high-yield market has a shorter duration (duration to worst – DTW) than US investment-grade (IG) corporates.¹ Several factors influence duration, most notably bond price, coupon, call schedule and maturity.  However, US high yield has produced a shorter duration relative to investment grade by 2.24 to 4.96 years on a consistent basis over the last 10 years (Figure 2).

Short-duration high yield (SDHY) is an even shorter duration subset of the high-yield market. There is no specific definition of short-duration high-yield bonds, but indices typically focus on either a duration range (e.g., 0-3 years)² or a maturity band (e.g., 0-5 years).³

The constituent base of DTW-based indices is inherently more volatile than maturity-based indices, since changes in bond prices can cause bonds to enter or exit the index at every reset. Both indices have experienced an average DTW of 1.68 to 2.27 years over the past 10 years.⁴ 

Duration is not inherently good or bad for bond investors, it is just a measure of how sensitive a bond or portfolio is to changes in interest rates. The shorter the duration, the less sensitive it is to changing interest rates. As SDHY bonds are less sensitive to interest rate fluctuations relative to IG bonds, coupon income and changes in spreads are more important for their total returns.

SDHY bonds can be considered a purer example of credit risk than longer-duration fixed income assets, which are more tied to underlying economic conditions, their impact on government bond yields and the resulting impact on bond prices and total returns.

Smoothing your return profile

At this point in the cycle, it is difficult to reliably predict how interest rates will perform over any near-term timeframe. Fixed income investors are likely to see continued rate volatility, and hence total return volatility, until the direction of interest rates crystallizes. In our view, this provides an opening for SDHY investments for four main reasons:

1. Healthy economic backdrop: The US economy is expanding, and capital markets are open, both of which reduce the potential for unexpected defaults and credit losses across the asset class.⁵
2. Regular-market-duration comparable: SDHY bond yields and spreads are more or less in-line with the full market, with DTW numbers around two years shorter.⁶
3. Value opportunity: SDHY bond dollar prices, meanwhile, remain below par, an unusual situation in a growing economy, providing an opportunity to realise positive convexity⁷ over the near term if bonds are called prior to maturity.⁸
4. Less volatile: Historically, SDHY bonds have proved less volatile than their longer counterparts, meaning investors should see smoother return streams.⁹

References

1.ICE Index Platform, as of 31st March 2024 - broad US high yield index (ICE BofA US High Yield Index (H0A0), had a DTW of 3.55 years, materially shorter than the US corporate index (ICE BofA US Corporate Index (C0A0) at 6.75 years.
2.Example: ICE BofA 0-3 Year DTW US High Yield Constrained Index (HUCS)
3.Example: Markit iBoxx USD Liquid High Yield 0-5 Capped Index (IBXXSHC1)
4.ICE Data Platform and Bloomberg, as of 31st March 2024
5.Bureau of economic analysis, US GDP Q1 2024 at +1.3%, as of May 30th 2024
6.ICE Index Platform, as of 31st May 2024. J1A0 ICE BofA 1-3 year US Cash Pay High Yield Index: YTW 8.59%, STW 356bps, DTW 1.67yrs, H0A0 ICE BofA US High Yield index YTW 8.04%, STW 338bps, DTW 3.57yrs.
7.Convexity is a measure of the relationship between a bond’s price and its yield
8.Source: ICE Index Platform, as of 31st May 2024. J1A0 ICE BofA 1-3 year US Cash Pay High Yield Index price - 93.8.
9.ICE Index Platform, as of 31st May 2024. J1A0 ICE BofA 1-3 year US Cash Pay High Yield Index, H0A0 ICE BofA US High Yield index.

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co. are as of June 2024 and may change without notice.

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Index descriptions

C0A0 - The ICE BofA ML US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.

H0A0 – The ICE BofA ML US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.

ICE BofA 1-3 Year US Cash Pay High Yield Index (J1A0) ICE BofA 1-3 Year US Cash Pay High Yield Index is a subset of ICE BofA US Cash Pay High Yield Index including all securities with a remaining term to final maturity less than 3 years.

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