October 15, 2019

Smart Yield Still Exists

Profile picture for user Peter Duffy
Peter Duffy, CFA
CIO - Credit, Sr. Portfolio Manager

Smart yield still exists. Short duration BB-B corporate bonds are providing high yield, downside protection, and interest rate protection in an ultra-low yielding environment. Yet the bonds remain largely overlooked by the industry.

The world is running low on yield again. $15 trillion of global government debt has negative yields. U.S. bond yields have remained positive, but historically low.

This has left investors scrambling for yield. Per Morningstar and Preqin asset flow data, investors have made a clear decision. Intermediate investment grade, short duration investment grade, and private credit categories remain among the top of the list by a wide margin.

Historically high risks plague each of the 3 chosen asset classes. Investment grade bonds face historically high interest rate risk. Short duration investment grade bonds face sub-2% yields. Private credit faces historically high credit risk. For these reasons, investors should consider diversifying their credit portfolios with an overlooked asset class: short duration BB-B rated bonds.

Credit fundamentals and flows as of 9/30/19

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As of 9/30/2019. Source: Morningstar Direct, Preqin. Asset Flow Categories: Morningstar Institutional Mutual Funds, Preqin Private Credit.

Short duration BB-B rated bonds remain overlooked, having not been flooded with recent flows. As result, the bonds exhibit fundamentals in line with historic norms, not at the extremes of more popular asset classes.

An overlooked anomaly, short duration BB-B bonds provided durable income over the last 2 recessions while participating in the upside of ensuing bull markets. The bonds exhibited investment grade-like downside with a speculative grade-like upside, which we believe are ideal characteristics given current market uncertainties.

Last 20-year growth of $100 and performance by asset class

As of 9/30/2019. Source: Morningstar Direct. Indices: ICE BofAML BB-B 1-3 Year, ICE BofAML Corporate, ICE BofAML Treasury, BbgBarc Aggregate Bond, BbgBarc Aggregate Bond 1-3 Year, S&P 500.

The short duration BB-B anomaly exists for 3 reasons and doesn’t appear to be going away anytime soon. We believe the bonds will continue to be overlooked. 

  1. High Yield Investors Seek Higher Yield: As maturity approaches, bond yields move incrementally lower, deemed less risky by the market. This makes them less attractive to high yield funds, who sell or avoid the lower yielding bonds.
  2. Rating Agency Maturity Inefficiencies: rating agencies don’t distinguish between short and long maturity bonds from the same issuer. A short maturity bond may exhibit investment grade risk, yet receive a speculative rating due to the issuer’s longer-term bonds. This typically results in less interest from investors.
  3. Large strategies and ETFs can’t scale a $150bn bond market: The larger the AUM, the smaller the investment opportunity. Large strategies can’t target $500mm issues (ICE BofAML BB-B 1-3 Yr Index median issue size) and maintain liquidity, opting instead to avoid or expand the space to 5+ year maturities and CCC ratings.​​​​​​  

BB-B vs Aggregate Short duration return by calendar year

As of 9/30/2019. Source: Morningstar Direct. Indices: BbgBarc Aggregate Bond 1-3 Year, ICE BofAML BB-B 1-3 Year.


Aggregate bond market exhibiting low yield and high interest rate risk
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As of 9/30/2019. Source: Bloomberg. Index: BbgBarc Aggregate Bond.

The result of these industry dynamics is an asset class exhibiting favorable risk-return characteristics, targetable by smaller and disciplined investors. Given the historically high risks of the fixed income market, short duration BB-B rated bonds should be considered within a diversified portfolio.

For more information on short duration BB-B bonds, our research can be found here.

A PDF version can be found here.


 



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The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed rate taxable bond market. The ICE BofA Merrill Lynch US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market. The ICE BofA Merrill Lynch 10+ Year Treasury Index is a subset of the ICE BofA Merrill Lynch Treasury Master Index. The index measures the total return performance of U.S. Treasury bonds with an outstanding par that is greater than or equal to $25 million. The maturity range of these securities is greater than ten years. The ICE BofA ML US HY Cash Pay BB-B Rated 1-3 Year Index is a subset of The Bank of America Merrill Lynch US Cash Pay High Yield Index, which tracks the performance of non-investment-grade corporate bonds with a remaining term to final maturity less than three years and rated BB-B. The S&P 500 Index is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy. The Bloomberg Barclays US Aggregate 1-3 Year Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed rate taxable bond market with a remaining term to final maturity of less than three years. Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Standard deviation is a measure of the dispersion of a set of data from its mean.


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