Low Duration Means Low Risk? Not Necessarily by Ivan Rudolph-Shabinsky, AllianceBernstein
To protect their portfolios from rising interest rates and volatility, many high-yield investors have headed for short-duration strategies. We think some of the more popular approaches may expose investors to bigger hazards than they realize.
It’s no secret that overall yields on high-yield bonds—and their yield advantage over government bonds—are near historic lows. That means investors receive below-average compensation for the risk they’re taking. And with the US Federal Reserve almost certain to start boosting official interest rates in 2015, the potential for those spreads to widen—and prices to fall—is high.
Still, even at today’s rich valuations, high-yield bonds offer more income than most fixed-income assets, making many bond investors reluctant to pull out of the sector altogether. Often, they choose short-duration funds. Short-duration bond prices are less sensitive to changes in interest rates than longer-duration bonds. Over time, short-duration high-yield bonds have generated returns close to those of the broader high-yield market with less volatility.
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Shortening Duration: Easier Said Than Done
The most straightforward way to shorten—or reduce—duration is to buy bonds with shorter maturity dates. The problem is that there aren’t many actual short-maturity assets available out there. The typical high-yield bond is issued with a 10-year maturity, although many issuers can “call” the bonds much earlier by taking it back and paying the investor a specified price.
To get around this short-maturity shortage, one popular strategy has been to build exposure: buy high-yield bonds of any maturity and combine them with short positions in government bond futures contracts or interest-rate swaps, hedging much of the interest-rate risk. Contrary to popular belief, we think this approach can reduce returns and increase risk, particularly if there’s a broad sell-off in credit assets.
According to Barclays data, the US high-yield market has returned an annualized 7.5% since 1997 with 9.4% annualized volatility. Using interest-rate hedges on a similar portfolio over that period would have cut returns to just 1.8% while boosting volatility to 11.1% (Display).
To be fair, this strategy underperformed largely because interest rates fell, and that lengthy period of low rates may well be ending. Many economists and market strategists expect US rates to climb in the years ahead. If that happens, those hedges would indeed enhance total returns.
Watch Out for the Double-Edged Sword
But here’s one thing that’s worth keeping in mind. Rates are likely to rise, but they may not rise quickly. And the potential for higher volatility could increase the risk of losses. That’s particularly true if the high-yield market were to hit a rough patch, prompting yield spreads to widen.
If there’s a credit selloff, investors tend to rush out of high yield and into government bonds and other higher-quality assets. This would cause government bond yields to fall, and investors could see both sides of their portfolios take a hit: the high-yield bonds would suffer and the interest-rate hedges would lose value as Treasury yields fell.
We think there’s a better approach to build a low-volatility high-yield allocation: buy individual bonds that do have short-term maturities and bonds that are likely to be called in the near future. This effectively shortens duration and provides the attractive return profile we described. We think it’s also important to avoid the riskiest credits. In a credit-sell-off, a short-duration portfolio that sidesteps these potential pitfalls is more likely to outperform the market.
Of course, this approach isn’t risk free. Once rates start to rise, an issuer may decide not to call its bonds when expected. In that scenario, investors would see the duration on their bonds grow at the worst possible time—we call this extension risk. One possible way to reduce this risk is to target bonds trading at prices well above their call prices. It would take a dramatic rate increase to keep the issuer from calling the bond—and we don’t think that’s likely.
Other strategies to reduce extension risk include using credit derivatives to replicate high-yield bonds, as these come without the call option built into most high-yield bonds. All of these approaches require careful security selection. But we think they’re likely to offer more effective protection against rising rates, higher volatility and the possibility of future credit market duress.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Ivan Rudolph-Shabinsky is a Portfolio Manager of Credit at AllianceBernstein Holding LP (NYSE:AB).