February 5, 2020

Top Ranked of 18,323 Indices

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

Short duration BB-B bonds continue to exhibit top ranked risk-return. To illustrate the extent of this anomaly, we’ve compared the ICE BofA BB-B 1-3Y index to every market index within the Morningstar Direct database. We believe this is due to fundamental characteristics of the asset class paired with key market inefficiencies. Neither of which appear to be going away any time soon.

To say that BB-B rated short duration bonds have outperformed would be understatement. Of the 18,323* indices in the Morningstar Direct database, the ICE BofA BB-B 1-3 Year Index has produced a 1st percentile ranked Sharpe ratio across a 3-, 5-, and 10-year basis as of 12/31/19. That immense level of risk-return places the asset class well into anomaly territory, yet few seem to notice. The following analysis breaks down the outperformance, its underlying drivers, and why we think it will continue.


Top Ranked Risk-Return vs Total Index Database

As of 12/31/2019. Source: Morningstar Direct. Indices: US dollar base currency, total return, 18323 total.


Answering 3 key BB-B short duration bond questions. (1) Why have they outperformed, (2) will it continue, and (3) why are they overlooked?

  1. Why have they outperformed? Rating agency and market inefficiencies.
    • Rating Agency Maturity Inefficiencies: Agencies rely on oversimplified rating methods to promote stability and ease of communication, and don’t take maturity into account. A firm with a 2-year bond exhibiting BBB-like risk and a 10-year bond exhibiting CCC-like risk could receive a BB rating on both. The resulting 2-year bond exhibits BBB risk with a BB yield and rating, but is avoided by investment grade bond mandates.
    • Total Return Market Dynamics: Bonds approaching their maturity tend to exhibit less uncertainty/risk, and therefore less yield and potential for capital appreciation. High yield bond mandates, seeking to maintain higher total return, sell short maturity names. This selling pressure helps keep short maturity bond yields at more attractive levels.
  2. Will it continue? Likely yes, inefficiencies magnifying, not reversing.
    • Less Fundamental Research: Bonds are receiving less research coverage amid industry cost-cutting, increasing the potential for maturity inefficiencies.
    • Passives and Largest Firms: Passive strategies and large investment firms rely on large, scalable, and liquid strategies. While excellent for core portfolio assets, they are ineffective at targeting small-scale, less liquid inefficiencies such as BB-B short duration bonds, a mere $143bn asset class which they avoid.
  3. Why are they overlooked? Behavioral finance and a lack of marketability.
    • Behavioral Finance: Investors tend to over-focus on the most and least risky asset classes in a phenomenon called layering, or the division of a behavioral portfolio into mental account buckets. For example, having a downside protection bucket and an upside capture bucket. BB-B short duration bonds fall in the oft-ignored middle area.
    • Lack of Recognition: Little research is produced on the subject as large investment firms and passives ignore the asset class. Its sub-investment grade rating can spook unfamiliar investors, despite exhibiting volatility in line with the BbgBarc US Agg Bond Index.

 

Winning by not losing. A periodic table analysis highlights the outperformance and durability of BB-B short duration bonds versus traditional asset classes. Each asset class exhibits top and bottom performance years, which are notoriously difficult to forecast. BB-B short duration bonds remained above average while avoiding extreme tops/bottoms, resulting in a top ranked risk-return profile.


Periodic Table Analysis – Sharpe Ratio by Asset Class

As of 12/31/2019. Source: Morningstar Direct.


Periodic Table Analysis – Return by Asset Class

As of 12/31/2019. Source: Morningstar Direct.


BB-B short duration bonds have shown a rare mix of durability and return potential across a wide range of environments; bull/bear markets, rising/falling interest rates, widening/tightening spreads, geopolitical events. The bonds have exhibited lower sensitivity to traditional interest rate, credit, and market risks, all of which are highly prevalent in the current environment. This allows for a simpler and far less volatile factor to drive returns: yield.


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

A PDF Version can be found here.

 

 


 


 

The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Under no circumstances should this information be construed as a recommendation or advice. The views expressed herein reflect the professional opinions of the portfolio managers and are subject to change. Penn Capital does not accept any liability for losses either direct or consequential caused by the use of, or reliance upon, this information. These views are subject to change at any time and they do not guarantee future performance of the markets. Investing in the stock market involves gains and losses and may not be suitable for all investors. Investors have the opportunity for losses as well as profits.

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Penn Capital), or any non-investment related content, made reference to directly or indirectly contained within this commentary be suitable for your portfolio or individual situation, or prove successful. Comparisons to indices are inherently unreliable indicators of future performance. The strategies used to generate the performance vary from those used to generate the returns depicted in the benchmarks. Penn Capital makes no representation as to the methodology used to generate the benchmark returns. Portfolio holdings are subject change and may or may not be held by one or more Penn Capital portfolios from time to time. Transactions in such securities may be made which seemingly contradict the references to them for a variety of reasons, including but not limited to, liquidity to meet redemptions or overall portfolio rebalancing.

Sharpe Ratio (Risk-Adjusted Return) is a risk-adjusted return measure calculated using standard deviation and excess return to determine reward versus unit of risk. The higher the Sharpe Ratio, the better the historical risk-adjusted performance. 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 Bloomberg Barclays Global Aggregate Bond Index is a broad-based benchmark that measures the investment grade, US dollar-denominated, global bond market. The S&P/LSTA Leveraged Loan Index tracks the performance of publicly issued, floating rate loans in the US domestic market. The Russell 3000 Index is a capitalization-weighted index of the largest 3000 stocks within US equity market. The MSCI ACWI ex USA Equity Index tracks the performance of international equities excluding US companies. The MSCI Emerging Market Equity Index tracks the performance of emerging market equities. The ICE BofA BB-B Rated 1-3 Year Index is a subset of The ICE BofA High Yield Index, which tracks the performance of non-investment-grade corporate bonds with a remaining term to final maturity between 1 and 3 years and rated BB-B. The ICE BofA High Yield Index tracks the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market. The ICE BofA Municipal Bond Index tracks the performance of municipal bonds issued in the US domestic market. The ICE BofA Treasury Bond Index tracks the performance of US treasury bonds. The ICE BofA Corporate Bond Index tracks the performance of investment grade corporate bonds issued in the US domestic market. The ICE BofA Convertible Bond Index tracks the performance of convertible bonds issued in the US domestic market.