The inclusion of bonds in a portfolio is typically meant to generate income and add some level of predictability to investment returns. With continued rate volatility since 2020, bonds have been anything but predictable. We believe short-duration, high yield bonds may help add back some predictability to fixed income portfolios.
Our research shows that over the past 20 years, there is a strong correlation (93%) between the initial yield of this asset class and five-year forward returns. The yield-to-maturity of a bond is the expected annualized return of that bond if held until maturity. For example, a 10-year U.S. Treasury bond is expected to achieve an annualized rate of return of approximately 4.5% upon maturity (based on 5/31/2024 yield-to-maturity and assuming cash flows are reinvested at the same rate). The challenge is that there can be a lot of price movement and volatility during those 10 years. However, a short-duration, high yield portfolio is comprised of bonds with relatively short maturities, meaning there is less price sensitivity to changes in rates. Given the relationship between medium-term returns and starting yields, a 7.2% yield-to-worst* suggests an attractive entry point.
Initial yield is highly correlated to five-year forward returns
Source: Source: FactSet 04/30/04 − 05/31/24. Short-Duration High Yield represented by ICE BofA High Yield 1-5 BB-B Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Since the financial crisis, the asset class’s yield to worst has been greater than or equal to 7%, at the start of five calendar years. In all five years, the index returned greater than 10%, as shown below.
On the other hand, there have only been two down years during that same period. In the most recent down year, 2022, the index was down 5.5%, which was less than half that of the Bloomberg Agg. At the start of that year, the yield of the index was 3.5% versus the current yield, (as of May 31st ) of 7.2%. A higher starting yield may better mitigate market volatility than a lower one. Also, the current (as of May 31st), average price is 96.2, considerably lower than the 104.6 price at the onset of 2022. The lower dollar price is a more favorable starting point given “pull to par,” or the propensity for bond prices to accrete to par over time. Also, since short-duration high yield has a relatively short average maturity, that pull to par happens more quickly than longer-duration asset classes.
Yields greater than 7% have led to double-digit returns
Source: FactSet, 2010-2023. Short-Duration High Yield represented by ICE BofA High Yield 1-5 BB-B Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. Starting yield is the yield to worst
While a yield to maturity is an annualized return over a period, actual returns within the period can vary. This is why starting yields greater than 7% for short-duration high yield have led to returns greater than 10% in the subsequent year. When the yield curve is upward sloping, like the front end of the BB high yield curve shown below, bonds “roll down the curve” as time passes. This means that after one year, a bond with a three-year maturity now has a two-year maturity. For hypothetical purposes, using the BB yield curve below (assuming a 6% average coupon), a bond with three years until maturity has a 6.9% yield-to-maturity. If nothing happens — the yield curve remains the same — after one year, the bond will have returned 7.3%. Factoring in active management, bond managers can select bonds more likely to see spread compression, or if yields fall more broadly, returns can be further amplified. The opposite is true as well.
Rolling down the curve has the potential to enhance return
Source: FactSet, 5/30/2024, ICE BofA High Yield Cash Pay B Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
It is also important to mention, this isn’t a strategy that only makes sense at certain yield levels, but rather one that serves a purpose in a portfolio. It can be considered an “all-weather” high yield solution and hold a strategic place in a fixed-income portfolio. The asset class has the potential to generate relatively high levels of income while adding diversification, as it has a fairly low correlation to longer-duration, high-grade strategies. Notably, over the past ten years, short-duration high yield has not only outperformed core bonds, investment-grade corporates and U.S. Treasuries, but it has also produced greater risk-adjusted returns, as well.
A strategic solution with strong risk-adjusted returns
Source: Morningstar, 5/30/2014 – 5/30/2024. Short-Duration High Yield represented by ICE BofA High Yield 1-5 BB-B Index. EM Debt represented by JP Morgan EMBI Global Diversified. U.S. Corporates represented by Bloomberg US Corp Bond Index. Core bonds represented by Bloomberg U.S. Aggregate. U.S. Treasuries represented by Bloomberg U.S. Treasury. It is not possible to invest directly in an index. Past performance does not guarantee future results. There may have been other time periods where the short duration high yield index did not out-perform.
Fixed income has had its challenges over the last few years, particularly due to Treasury yield volatility and this higher-for-longer environment. As we continue to put one of the worst bond years in history behind us, many investors are rethinking their fixed-income allocations. For those seeking to generate attractive levels of income with more predictability, short-duration high yield may be the perfect solution.
*Yield-to-worst is a more conservative measure than yield-to-maturity as it takes into account call features.
About Risk
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
Investing in below-investment-grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. High yield securities (junk bonds) have speculative characteristics and present a greater risk of loss than higher-quality debt securities. These securities can also be subject to greater price volatility.
Bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
Opinions expressed herein are current opinions as of the date appearing in this material only. Investing involves risk, including possible loss of principal. Asset allocation and diversification may not protect against market risk, loss of principal or volatility of returns. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors, and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits.
This material represents an assessment of the market environment as of a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular. This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision. The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
Definitions
The ICE BofA 1-5 Y BB-B Cash Pay HY Index tracks the performance of BB-B rated U.S. dollar-denominated, corporate bonds publicly issued in the U.S. domestic market with maturities of one to five years.
The ICE BofA U.S. Corporate 1-5 Year U.S. Corporate Index is a subset of ICE BofA U.S. Corporate Index including all securities with a remaining term to final maturity less than five years.
JP Morgan EMBI Global Diversified Index tracks the traded market for U.S. dollar-denominated Brady bonds, Eurobonds, traded loans and local market debt instruments issued by sovereign and quasi-sovereign entities.
The Bloomberg U.S. Corporate Index measures the investment-grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers.
The Bloomberg U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate, taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities and commercial mortgage-backed securities.
The Bloomberg U.S. Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index.
Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. Duration is a measure of sensitivity of a bond's or fixed-income portfolio's price to changes in interest rates.
Standard Deviation measures how widely dispersed a fund’s returns have been over a specified period of time. A high standard deviation indicates that the range is wide, implying greater potential for volatility.
Sharpe Ratio compares the return of an investment with its risk. It's a mathematical expression that divides a portfolio's excess returns by a measure of its volatility to assess risk-adjusted performance.
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