The use of the term duration has successfully been adopted by the high yield investment universe over the past few of years. Why? Because all else being equal, lower duration means lower interest-rate risk. And the number-one concern for fixed income investors over the past several years has been a fear of when interest rates will begin their rise to normal levels. In fixed income, if rates rise, the value of your bonds declines. And the longer your duration, the more pronounced your decline, again with the caveat all else being equal. The common way to explain duration is that it measures the sensitivity of the price of a bond to a change in interest rates and is expressed as a number of years. This is an extremely useful way to compare two fixed income investments where all else is equal. We have noticed that in a reach for yield, investors have invested in short duration high yield as a way to both gain the higher yield available in the high yield market while seemingly reducing risk by having a shorter duration portfolio.
This logic makes sense…until you realize that your return on a fixed income investment is based both on duration and credit risk. This is where the concern lies for high yield issuers. In the high yield market, the issuers have less room for error in case of business downturns and usually try to minimize “trigger” events, which can cause them to default. One of the worst “trigger” events is having a debt mature that you can’t afford to pay off. Therefore, it’s usually advisable for high yield issuers to repay or refinance debt early in order to avoid having to surprise investors by failing to repay a maturity – this would “trigger” a bankruptcy filing. Investment-grade issuers don’t share this type of “trigger” event risk since they are generally assumed to have access to refinancing under almost any market conditions.
Investors that have entered the high yield market with a lack of appreciation for how the normal understanding of duration falls apart in high yield. The fact is that in high yield, the companies with short-duration securities outstanding, based on final maturity, can often be the highest-risk issuers in the market.
So make sure that your “short duration” high yield portfolio is composed of securities that truly are expected to mature or refinance and is not exposed to a trigger event that could end in a default.
There’s actually a dwindling supply of short-duration high yield paper in the market these days as record-low interest rates over an extended period of time have allowed all but companies of the poorest credit quality to extend their debt maturity profiles.
High yield issuers don’t want to have short-duration debt outstanding if they can avoid it. This is why we always look at company fundamentals as the most important aspect of each and every bond or loan in which we invest.
- Borrowing rates for companies have been extremely low in the high yield market for an extended period of time.
- Significant new issuance in the high yield market has allowed these companies to refinance debt with higher fixed interest payments at lower rates.
- Investors need to be cognizant of the amount of credit risk that they are taking in companies that possibly may not be able to refinance their near-term debt.
- Fundamental credit is still the main concern when investing in the high yield asset class, whether it is “short duration” or not.
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