Their fervour pushed global bond prices to an average of $106.4 on 14 May this year – the highest since records began – and yields to an all-time low of 4.66 per cent.
Performance of sector and index over 10yrs
Source: FE Analytics
It is a different story now. In June, prices fell to $102.6 as markets were rattled by the US Federal Reserve’s talk of curbing its monthly asset purchases, which have suppressed long-term bond yields since late 2008.
The yield on 10-year US Treasuries rose from 1.63 per cent on 1 May to 2.6 per cent on July 29, according to Bloomberg, and the figure has risen even further more recently. Investors’ fears of volatility and a potential market rout induced by a rise in interest rates made short-duration bonds more appealing.
Duration gauges a bond’s sensitivity to changes in interest rates. Longer-dated bonds are perceived as riskier because they are more likely to be affected by changes in interest rates before maturity.
The appeal of bonds with durations of zero to five years is the prospect of income with less volatility and reduced vulnerability to interest rate rises. This has not been effective lately, though.
Like the yield-seeking behaviour of the past three years, buying short-duration debt is now a crowded trade in Europe and exacts a high opportunity cost. The short-duration component of the Bank of America Merrill Lynch Euro Non-Financial High Yield Constrained Index shows an average price of $104.99 and yield of 2.96 per cent – this is the worst value it has provided in the past five years.
The extra spread offered by 10-year relative to five-year credit illustrates this by proxy. Investors in 10-year credit gain much more incremental spread because the shorter notes are more expensive than they have been since 2008. This shows that short-duration funds are buying the most overpriced part of the high-yield market.
Moreover, the issue of short-supply in the short-duration market is a problem. Only 26 European companies issue high-yield bonds with maturities of less than 2.5 years. Bonds from three of these issuers are distressed, with ratings of CCC or lower, and nine provide a yield of less than 2 per cent – far below the sector average.
Identifying the idiosyncratic risks of high-yield bonds is critical to beating the benchmark and maintaining a diversified portfolio. Is this possible with only 23 viable issuers to choose from?
Call risk is another issue. The maturities of some short-duration bonds were unexpectedly extended when bonds fell below their call prices in June, leaving investors exposed to risks they wanted to avoid.
More than two-thirds of high-yield bonds are callable, enabling companies to refinance by redeeming their debt at a set price in the future. In the first half of 2013, investors pushed many bonds close to or above their call prices in anticipation of payouts. When the recent volatility shook some bonds from their call thresholds, they extended until maturity, leaving investors with losses and unwanted duration risk.
In our view, investors don’t have to buy short-duration bonds to reduce their vulnerability to rising interest rates. Investing outside Europe, and beyond the front of the yield curve, can achieve this.
Worldwide, there are 3,338 bonds trading at several maturity dates, providing far more stockpicking opportunities. It offers the potential to seek better relative-value among securities in the US, Europe and the emerging markets. Diversification is also easier to maintain.
Looking through the capital structures of issuers helps investors cut interest-rate risk while avoiding over-priced securities. Floating-rate loans, whose coupon payments are linked to interest rates, should be considered, and credit default swaps (CDSs) can provide cheaper exposure to bonds at fixed spreads with immunity to interest rate movements.
Investors who buy European short-dated debt are paying peak prices and severely limiting their stockpicking opportunities. Investing globally and throughout the capital structure can curb duration without cutting returns.
Fraser Lundie (pictured) is co-head of credit at Hermes.
He heads up the Hermes Global High Yield Bond fund, which was launched into the UK market in 2010. It has performed very well during the recent soft-patch for bonds, returning 14.77 per cent since November last year, compared with losses of 0.4 per cent from the average IMA Global Bonds fund.
Performance of fund vs sector and index since launch
Source: FE Analytics
The fund has annualised returns of 12.07 per cent over a three year period. It has ongoing charges of 0.76 per cent and is yielding 5.83 per cent.
