Khanchit Khirisutchalual
By Tyler Gile
Short-duration high yield bonds can help investors navigate turbulent market conditions.
Investors are grappling with difficult decisions in the face of rising rates, stubborn inflation and slowing growth. These problems are especially acute for fixed income investors who have a need for reliable income and limited appetite for interest rate risk. In our view, short-duration high yield provides an attractive option given its competitive yield (8.5%) with lower duration risk (2.75 years) as of June 30. The questions for investors are: what are the implications versus other fixed income opportunities and what is the outlook on default risk in the market?
Short-duration bonds capture 85% of the broad market yield but have historically exhibited approximately 35% less volatility. This presents a valuable tool for investors seeking total return opportunities with more consistent downside protection. A reasonable question might be: do the downside protection benefits of lower interest-rate sensitivity come in exchange for lower yield? In our view, short duration currently offers a compelling yield profile relative to the overall high yield market despite having only about half of its maturity. Across the broad universe of fixed income opportunities, short-duration high yield appears to be one of the most efficient ways to optimize the yield-duration trade-off.
Higher yield and spread at the front end of the credit curve is not always a positive sign. It may indicate that default risk is perceived to be higher because an economic slowdown is anticipated over the next year or two. The current high level of inflation and its implications for tighter financial conditions raise the possibility of that outcome. That said, we believe reassurance comes from the marked improvement in credit quality among high yield issuers. The reality today is that the market is among the highest quality in history with over 50% rated BB, a substantial increase from years past. From a sector perspective, energy has been a main contributor to defaults historically; however, the increase in commodity prices has bolstered balance sheets and reduced default probabilities. Finally, we have seen limited highly leveraged transactions, such as mega-LBOs, come to the high yield market. These factors signal that the market is starting from a healthy level in terms of credit quality, which could help moderate defaults going forward.
In summary, we believe short-duration high yield could be an underexplored option for investors seeking attractive income-generating opportunities with reduced volatility.
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