Duration – Does it pay to shorten duration in the high-yield asset class?

As I have been traveling the country the past several months meeting with advisors, both independent and at the wirehouses, the talk and strategy has been to move their corporate fixed income allocations to shorter duration corporate debt and floating rate loan strategies.  Is this the right strategy?

If you have/had an investment grade allocation, the answer is yes. Investment grade has never made much sense as these bonds have higher durations, small coupons and little to no covenants that protect the bondholders from the company adding debt on the capital structure ahead of them.  The latter is what we call event risk.  However, if you have a high-yield allocation, we think the strategy should be to look to active management from passive, rather than to simply shorten duration.

One problem with passive or index strategies is that you can’t sell appreciated debt and buy the lower priced debt, nor can you choose which industry/company you want to loan your money.  In regards to active management, you can sell those appreciated securities and then invest in debt that has adjusted/widened with the rise in Treasury yields.  If you pick the right companies, they often refinance their debt around the time of their first call dates, thus the securities often rise to these call prices as this time nears.

As per duration itself, high yield is naturally a short duration product as new issues tend to come to market with higher coupons and shorter maturities than many other fixed income asset classes.  Passive or index-based investments tend to have longer durations because the newly issued securities are added to the index shortly after coming to market and in some cases, these vehicles have mandates that restrict them from holding bonds with less than a year left to maturity; whereas an active manager can choose the length of maturity it wants to target.  The active manager can also sell appreciated assets, thus shortening the perceived duration.  From what we have seen in the short duration products currently offered, they have a slightly shorter duration (1 year or so) but give up a great deal of yield to do so.

Lastly, when you talk about active management, you need to make sure you know what you are getting.  I met with an advisory firm last week and we were talking through the holdings and strategies of the actively managed mutual funds.  When we looked through the portfolio, it contained non-dividend paying equities as well as foreign country debt.  Is foreign country debt, like Spain, Ireland, Greece and Italy, really high yield?  I guess if you compare it to the U.S., it is.  My argument was the fact that you can’t analyze or project a real financial model for a foreign country, so it really is nothing more than speculation.  Is 6 – 7% a big enough yield for this risk, especially when you can stay right here in the U.S. and get better yields?  The U.S. high yield bond market is approximately $1.5T in size and the loan market is about equal to that.  If as an active manager you can’t find 60 – 80 names to invest in here, then you are not doing your work or you have just become too big to produce true high yield.

We feel the ultimate goal with your high yield allocation should be a truly actively managed portfolio that focuses on generating yield/income to you as an investor, as we don’t feel the sacrifice in yield is justified with the “shorter duration” products in a broader asset class that  already has a short duration.

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