A Compelling Approach to Higher Income in a Low-Rate World | Lord Abbett
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Market View

A strategy employing short duration high yield securities has the potential to provide higher income than other fixed-income investments with less interest-rate risk.

Read time: 4 minutes

With the precipitous drop in yields that has occurred this year, the search for income continues to be a challenge.  After reaching a high of 3.25% in late 2018, the yield on the benchmark 10-year U.S. Treasury note declined throughout 2019 before collapsing amid the COVID crisis in 2020 and has been in a fairly narrow range near 0.65% – 0.75% for most of the past six months.1 That has pulled down the yield of the Bloomberg Barclays U.S. Aggregate Bond Index, a common benchmark for core bond portfolios, to less than 1.2% as of September 30, 2020.2 With that low yield as a starting point, core bond allocations offer little in the way of income or opportunity for attractive total return going forward.

To increase yield in fixed income, investors have traditionally turned to two approaches: extending duration or adding credit exposure.  We do not believe extending duration is the right approach in the current environment, as there is very little compensation for taking on that risk.  Previously, we have pointed to the negative term premium3 in bonds as an indication of a lack of risk premium for duration.   Or, one can look at the -0.38% yield on a 30-year U.S. TIPS (Treasury Inflation Protected Security) bond, to see that Treasuries offer negative real yields across the curve.

We do believe, however, that investors might be better compensated for taking on exposure to credit.  As of September 30, the average spread in the ICE BofA U.S. High Yield Index (the high yield index) was approximately 550 basis points (bps) over Treasuries, roughly 50 bps higher than the long-term average.  Meanwhile, the quality of the high yield index is as high as it has ever been.  With issuance heavily weighted toward BB-rated issuers in recent years, paired with a large number of formerly investment grade “fallen angels” entering the high yield index this year, over 55% of the high yield index now consists of BB-rated credits.

Higher Yields, Wider Spreads

Investors interested in the income and total return potential of high yield, but with lower volatility, may want to consider an often-overlooked segment of the market: short duration high yield bonds.

While the yield differential versus investment-grade fixed income is readily apparent, some investors may be surprised to learn that shorter maturity high yield bonds can offer similar yields to their full maturity counterparts.  In fact, as of September 30, the short duration high yield index offered slightly higher yields and spreads than the full maturity index, as illustrated in Figure 1.

 

Figure 1. How Short-Maturity High Yield Stacks Up against Longer-Dated High Yield—and Investment Grade Alternatives
Data as of September 30, 2020

Source: Bloomberg Barclays Indices and ICE Data Indices.  Data as of September 30, 2020. OAS=Option-adjusted spread.  Bps=Basis points. U.S. High Yield=ICE BofA U.S. High Yield Constrained Index. BB-B U.S. High Yield 1-5 Year=ICE BofA U.S. High Yield BB-B 1-5 Year Index. BB-B U.S. High Yield=ICE BofA U.S. High Yield BB-B Index. Corporate 1-5 Year=Bloomberg Barclays 1-5 Year U.S. Corporate Investment Grade Index. 1-5 Year Treasury= Bloomberg Barclays 1-5 Year U.S. Treasury Index. Barclays Aggregate=Bloomberg Barclays U.S. Aggregate Bond Index. IG Corporate BBB=Bloomberg Barclays BBB U.S. Corporate Investment Grade Index. IG Corporate=Bloomberg Barclays U.S. Corporate Investment Grade Index. U.S. Treasury Index=Bloomberg Barclays U.S. Treasury Index.

Past performance is not a reliable indicator or guarantee of future results. The data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

While a shorter duration typically results in lower sensitivity to movements in interest rates, rising rates are generally less of a concern for high yield bonds, which have more credit sensitivity than rate sensitivity.  High yield bonds historically have had negative correlation with U.S. Treasury securities, as movements in rates are typically offset by changes in spreads. 

Historically Higher Income with Lower Volatility

But the lower maturity profile of the asset class has led to lower volatility than the broad high yield market.  As seen in Figure 2, the short duration high yield market historically has delivered over 90% of the return of the broad high yield market with only about 75% of the volatility over the long term. The recent large drop in yields has created more of a tailwind for longer duration assets, and stronger performance for longer duration high yield in recent years. But the opportunity for yield with lower volatility may be an attractive combination in today’s market.

 

Figure 2. Short-Dated High Yield’s Attractive Long-Term Risk/Reward Profile versus Other Credit Sectors
Data for the period December 31, 1996–September 30, 2020

Source: Morningstar.  Data as of September 30, 2020. Volatility is represented by standard deviation, U.S. High Yield=ICE BofA U.S. High Yield Constrained Index. BB-B U.S. High Yield 1-5 Year=ICE BofA U.S. High Yield BB-B 1-5 Year Index. BB-B U.S. High Yield=ICE BofA U.S. High Yield BB-B Index. Emerging Market=JPMorgan EMBI Global Diversified Index. U.S. Bank Loans=Credit Suisse Leveraged Loan Index.

Past performance is not a reliable indicator or guarantee of future results. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

For example, over the long term the short high yield index has a history of participating in the upside of strong credit markets (75% upside capture ratio versus broad high yield index for the period December 31, 1996­–September 30, 2020), with less downside in difficult credit markets (59% downside capture ratio).  Looking more specifically at the five negative calendar year returns of the high yield index dating back to 1997, the short high yield index outperformed the broad high yield market by an average of 322 bps during those years.

Some investors may have concerns about greater refinancing risks in shorter maturity high yield bonds, as the inability to pay off or refinance near-term maturities could trigger defaults.  But issuers have been very active in taking care of upcoming maturities through refinancing.  Based on data from JP Morgan, of the $350 billion in new issue U.S. high yield supply through the first nine months of 2020, $230 billion has been used to refinance existing debt, already surpassing the calendar year record for refinancing supply.  The access to capital markets has allowed issuers to shore up their balance sheets and push out maturities, leaving little outstanding debt that needs to be rolled over in the near term. This is one of the factors that has led many analysts to reduce their forecasts for defaults versus what had been predicted just a few months ago.

Finding Opportunities in Short Duration High Yield

A shorter maturity profile should offer more clarity on an issuer’s credit standing; that is, there is much more uncertainty surrounding what the company and industry dynamics may look like over a five- or 10-year horizon relative to what may occur over the next year or two. But when investing in high yield, rigorous credit research is key to understanding individual issuers’ businesses and the industries in which they compete.  We believe in-depth analysis of a company’s liquidity position, cash flow, leverage, and interest coverage, among other metrics, and how they may change under base case, worst case and stress case scenarios is vital to determine the credit worthiness of a company and its ability to meet future debt obligations.

While short maturity high yield offers many potential benefits, strategies that focus on this segment of the market are not too common.  Less than 10% of the assets in the eVestment U.S. High Yield Bond category and the Morningstar U.S. High Yield Bond Category are in strategies dedicated to the short duration high yield space.  That may create some inefficiencies, as most managers are focused on outperforming a full duration index.  Less demand from a smaller natural buyer base may lead to enhanced opportunities for active managers seeking to enhance yield and mitigate interest-rate risk for investors.

 

1U.S. Treasury market data from Bloomberg.
2Index data, where applicable, are from ICE Data Indices or Bloomberg Barclays Indices.
2Term premium is a measure of the risk of holding longer-term bonds versus shorter-maturity securities.

 

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As interest rates rise, the prices of debt securities tend to fall. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Lower-rated bonds carry greater risks than higher-rated bonds. The principal risks associated with bank loans are credit quality, market liquidity, default risk, and price volatility. While bank loans are secured by collateral and considered senior in the capital structure, the issuing companies are often rated below investment grade and may carry higher risk of default. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer maturity of a security, the greater the effect a change in interest rates is likely to have on its price. No investing strategy can overcome all market volatility or guarantee future results.

Neither diversification nor asset allocation can guarantee a profit or protect against loss in declining markets.

There is no guarantee that the floating-rate loan market will perform in a similar manner under similar conditions in the future.

The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize, or that actual returns or results will not be materially different from those described above.

Any examples provided are for informational purposes only and are not intended to be reflective of actual results.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

A basis point is one one-hundredth of a percentage point.

A bond yield is the amount of return an investor will realize on a bond. Though several types of bond yields can be calculated, nominal yield is the most common. This is calculated by dividing the amount of interest paid by the face value.

Correlation is a statistical measure that describes the strength of relationship between two variables. It can vary from 1.0 to -1.0.

Downside capture: The downside capture ratio measures a manager’s performance in down markets relative to a particular benchmark. A down market is one in which the market’s quarterly (or monthly) return is less than zero. For example, a ratio of 50% means that the portfolio’s value fell half as much as its benchmark index during down markets.

Duration is an approximate measure of a bond's price sensitivity to changes in interest rates. 

Fallen angels refers to bonds that have been downgraded from investment grade to speculative grade status.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.

risk premium is the return in excess of the risk-free rate of return an investment is expected to yield;

Standard deviation measures the dispersion of data from the mean. Applied to a rate of return, standard deviation is an indication of an investment’s volatility. 

TIPS (Treasury Inflation-Protected Securities) are U.S. Treasury securities indexed to inflation in order to protect investors from the negative effects of inflation.

The Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.

The Bloomberg Barclays U.S. Corporate Investment Grade Index is the Corporate component of the Bloomberg Barclays U.S. Credit Index. The U.S. Credit Index is defined as publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. The index includes both corporate and non-corporate sectors. Bonds must be an investment grade credit security and have at least $250 million par amount outstanding.  The Bloomberg Barclays 1-5 Year U.S. Corporate Investment Grade Index and Bloomberg Barclays BBB  U.S. Corporate Investment Grade Index are maturity- and ratings-specific subsets of the Corporate Index.

The Bloomberg Barclays U.S. Treasury Index is the U.S. Treasury component of the Bloomberg Barclays U.S. Government Index, which is a market value-weighted index composed of all publicly issued, nonconvertible, domestic debt of the U.S. government or any agency thereof, quasi-federal corporations, or corporate debt guaranteed by the U.S. government. The U.S. Treasury index includes public obligations of the U.S. Treasury with a remaining maturity of one year or more. The Bloomberg Barclays 1-5 U.S. Treasury Index is a maturity-specific subset of the U.S. Treasury index.

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated, leveraged-loan market.

The ICE BofA U.S. High Yield Constrained Index tracks the performance of U.S. dollar denominated, below-investment- grade, corporate debt publicly issued in the U.S. domestic market. The ICE BofA U.S. High Yield BB-B 1-5 Year Index and the ICE BofA U.S. High Yield BB-B Index are maturity- and ratings-specific subsets of this index.

ICE BofA Index Information:
Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofA INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofA INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD, ABBETT & CO. LLC., OR ANY OF ITS PRODUCTS OR SERVICES.

The J.P. Morgan Emerging Markets Bond Global Diversified Index is a uniquely-weighted version of the J.P. Morgan Emerging Markets Bond Index Global ("EMBI Global"). The EMBI Global Diversified index limits the weights of those index countries with larger debt stocks by only including specified portions of these countries’ eligible current face amounts of debt outstanding. The countries covered in the EMBI Global Diversified are identical to those covered by the EMBI Global.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action, as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product, or service may be appropriate for your circumstances.

The opinions in this Market View are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research, or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

 

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