Leaving aside the apocalyptic prophesies of a populist political movement sweeping through Europe and dismantling the Eurozone, there is one word that enters all of our conversations with fixed income investors. This ‘D’ word is not the Donald, but duration, i.e. the sensitivity of price to a change in yield. With rates still hovering near record lows, corporate bond investors increasingly desire the reward from credit spreads without the risk of an upward move in sovereign yields.
If you can tolerate the higher credit risk, sub-investment grade corporates generally meet these requirements. In fact, duration has historically provided a useful albeit imperfect hedge for credit investors as rates tend to rally when credit and equities sell off. Furthermore, for most of the past decade (or three) interest rate exposure within junk bond portfolios has made a meaningfully positive contribution to high yield total returns. Nonetheless, with European yields at or near record lows and speculative grade spreads at the tighter end of historical ranges, a growing chorus of investors would prefer to minimize their exposure to duration even if it means reducing their positive carry.
Floating rate high yield assets such as leveraged loans or FRNs (floating rate notes) can provide savers with a high spread and an interest rate hedge. The problem for European fund investors is that due to their illiquid nature, the UCITS regime severely restricts the presence of loans in retail funds. As for FRNs, they remain too small a part of the European high yield bond market with which to construct a sufficiently diversified portfolio. However, a combination of FRNs and shorter dated fixed rate European high yield bonds (typically with three years or less until maturity) can be used to construct a diverse portfolio with both positive carry and low interest rate sensitivity. Our own recently launched fund has joined the ranks of these European short-duration high yield strategies.
Despite a current yield-to-worst of our European short duration high yield benchmark of just 1.3% (BofA ML Q936 EHY SD Index as of 27 Feb 2017), the appeal of European short-duration high yield strategies has been evident in fund flow data. Since the start of last year €3.2bn, or 116% of total net European high yield fund flows, has gone into the short duration part of the market.
Before wading in, investors need to be aware that lower duration also means that any positive returns derived from either rates or credit spreads will be capped relative to the full high yield market. Furthermore, if default rates do rise, the thinner spreads of shorter maturity bonds will provide less compensation ceteris paribus for default-related losses. Nevertheless, given the backdrop of low default rates and incredibly low interest rates, many investors’ aversion to rate risk is greater than their aversion to credit risk. They have therefore allocated to short duration high yield funds. After you compare the current trade-off between yield, credit quality and duration across the wider spectrum of European fixed income, you can hardly blame them.