JP Morgan AM announced yesterday it is launching a European high yield short duration strategy “for investors who wish to maintain their holdings in fixed income whilst limiting exposure to rising rates and still achieving a reasonable level of income in the current low interest rate environment”, said its head of European distribution Massimo Greco.
Historically, however, high-yield bonds correlate much more strongly with equities than with interest rates. Moreover, US high-yield bonds tend to historically correlate negatively with treasuries.
However, because high-yield bonds are a fixed income asset class, investors are wary: even though they outperformed US equities in November, high-yield bonds saw strong net outflows over the month as investment-grade bond yields rose. While European fund buyers are eager to increase their allocation to US and European equities over the next 12 months, there is relatively little appetite for high-yield bonds: those planning to increase their exposure to high-yield bonds only marginally outnumber those intending to decrease their allocation.
Because interest rates tend to rise when the economy is improving, as is the case now, high-yield spread compression usually compensates for a negative duration effect, says Andrew Wilmont, a European high yield bond portfolio manager at Neuberger Berman.
“Besides, the duration of short-duration high yield funds is only about 1.4 years shorter than that of other high-yield bond funds, which tend to already be quite low in duration,” adds Wilmont. To illustrate that point: the weighted average duration of the BofA Merrill Lynch European Currency Non-Financial High Yield index, a generic European high yield benchmark, is only 0.1 years higher than the equivalent of the AXA IM Europe Short Duration High Yield fund.
“That’s why I think calling these funds ‘short-duration’ is incorrect. They also take less credit risk because they tend to target about one third of the volatility of ‘normal’ high-yield funds. In addition, they tend to own about 50% more securities,” says Wilmont, adding: “As a short-duration manager, you can ill afford a bankruptcy in your portfolio. So you need to spread the risk more.”
That implies short-duration funds often resemble their benchmark closer than other high-yield funds because they have to include more securities. Therefore, an ETF may be an attractive alternative. However, short duration high-yield bond ETFs tracking the European market are not available yet, as far as Expert Investor knows.
In the US, such products have been around for a while though: as the chart above shows, they are indeed somewhat less volatile than other high-yield products, but are still very risky compared to short-duration government or IG corporate bonds.
That’s because credit risk, not interest rates, is the major driver of returns of all high-yield bond funds. If investors believe rates are going to rise, they should consider increasing their allocation to the asset class at the expense of other bonds.