With the low interest rate policy fostered by the central banks s in developed economies investors face a real struggle trying to generate adequate income. They must look beyond sovereigns and other “safe havens” but understand that doing so brings with it additional risks. Before venturing too far out along the risk spectrum, investors need to take a step back and consider the trade-off between the potential gains and these risks. We believe that one area worth looking at is the U.S. short-term high yield.
Historically, the short-end of the U.S. high yield market has produced better risk-adjusted return than the broad high yield market. One of the reasons the Sharpe ratio is comparatively high is because of the historically lower volatility of short-term high yield. In this context, “short” means maturities of up to five years.
In addition, by investing in the shorter end of the yield curve, investors can reduce the sensitivity of their portfolio to higher interest rates. This is particularly relevant with US dollar denominated debt, if as expected the Fed begins raising interest rates later this year. In that scenario, short-term bonds should not react as severely to the news as longer-dated bonds. For instance, the Bank of America Merrill Lynch 0-5 Year US High Yield Constrained Index has a duration of 2.4 while the Markit iBoxx USD Liquid High Yield Capped is 3.7. As a rule, the lower the duration, the less sensitivity to rate movements.
The high yield space is very large and quite diverse,. Even at the shorter end, there are nearly 900 names. This is why it is important to have the investment expertise and research capacity to be able to focus on the stronger companies while trying to avoid those that are at risk of a credit downgrade or, worse, a default. This can be achieved either by taking an active approach to security selection, by tracking a common index, or by using a screening mechanism to filter out the weaker, high default candidate, from the portfolio.
Assuming that buying bonds individually is not a viable option for investors, this leaves them with two viable choices: Exchange Traded Funds (“ETFs”) or mutual funds. Either investment vehicle would suffice for most investors, but the choice will often come down to whatever factor is most important to the particular investor, whether that is total costs, the level of transparency or ease of trading.
Interestingly, we conducted a Europe-wide survey of private bankers, wealth managers, asset managers and institutional investors at the end of 2014. We found out from this survey that the investors we interviewed in Israel were among the highest users of ETFs, with 86% saying they currently use them, while only 22% said they were using traditional mutual funds. Two-thirds of respondents said they have used ETFs to access high yield bonds. The amount of investors who said they expected to use even more ETFs over the next 12 months was also very high, at 78%.
It is also interesting to note that some fixed income ETFs have tighter bid-ask spreads than the underlying basket of bonds. This may be partially as a result of the experience of the market-makers in pricing the ETF, or it could be a factor of the size of the ETF. While this is not always the case, the instances when it is apparent could provide a cheaper opportunity for investors to gain exposure – by investing in the ETF rather than all the bonds separately.
In addition, there are now distributing and accumulating shares of some short-term high yield ETFs. Accumulating shares could be attractive to investors who want to potentially improve their risk-adjusted returns, but do not want to take the income from the investment. There are also some ETFs with the currency hedged, which again could be attractive to certain investors, such as those who do not want the currency risk.
Investors who thought they did not have much chance to get a reasonable level of income from a bond portfolio, unless they took on excessive risks, may be surprised to learn that it is possible. At Source, we have seen plenty of interest from investors, and we believe this trend could continue, especially given the US interest rate outlook.
Historical risk/return profile - short versus broad duration US HY bond index
Source: As of 31 March 2015 since Apr 2012. Source: Bloomberg, Markit website. Past performance is not a reliable indicator of future returns.