With all of the interest rate concerns, we’ve seen several strategies in focus in the leveraged finance space over the past several months.  The most prominent seem to be investing in loans and in short duration high yield.  At first glance, these strategies seem to make sense.  If you are concerned about rising rates, then you will focus on duration, a measure of interest rate sensitivity.  However, as we look at these strategies, we have to wonder if the benefit in duration is worth the sacrificed yield.

First, let’s look at the short duration products.  These mutual funds and ETFs restrict their investment universe to shorter maturity high yield bonds, often with a maturity of less than five years. The largest exchange traded fund in this space is the SPDR Barclays Short Term High Yield Bond Fund (ticker: SJNK), which currently is showing a duration of 2.19 years, a yield to worst of 4.74%, and SEC yield of 4.3%.  Here, you definitely still have some interest rate exposure, though a little over a year less than what we see in the general high yield market.  But is that year worth the sacrificed yield?  In the broader high yield market, there are yields available at hundreds of basis points above this.  And another issue with a blanket focus on near-maturity paper is that we see many of those credits as some of the more over-valued names in the high yield space, trading at large premiums above their call prices.  In this environment, most short maturity paper is expected to be called in the near-term, given the wide open refinancing market, so these bonds tend to trade right around or above the call prices.  This means investors are pricing in par losses upon a call and/or have limited upside (capital gains) potential.

The other strategy we see in spades is investing in leveraged loans.  Yes, there is a duration benefit from investing in loans; though, at face value it is not as immediate as investors seem to think because most loans have LIBOR floors of 1-1.5%. This means that 3-month LIBOR rates need to rise above this 1-1.5% level before we see any benefit, and with 3-month LIBOR at 0.26% (and having been around here for the last year), we’ll need to see a pretty sizable move before there is any benefit.  And again here, you are sacrificing yield for that interest rate benefit.  For instance, PowerShares Senior Loan Portfolio (ticker: BKLN) trades at an SEC yield of just over 4%.   Again, we pose the questions, is the yield sacrificed worth the duration benefit?  Broadly speaking, we don’t think so.  However, on a selective basis, we do like the leverage loan market for the selective investment opportunities it presents, as some companies don’t trade bonds but have loans that are at yields we see as attractive.  It is a way to expand the investment universe; duration is a secondary benefit.

The Fed showed us last week that they will be unpredictable.  While rates were destined to rise off the historic lows we saw earlier this year, and we’ve already seen a swift move, we still struggle to with the case that there is a massive increase still to come given the economic backdrop, and apparently the Fed also agrees the economy continues to languish.  The problem is that you can invest in one of these strategies and sacrifice yield, and then rates don’t do anything much further from here for the next couple years.  Rather than embracing one strategy over another, we feel the focus should be generating yield and income, and building a portfolio accordingly.

The high yield class by its nature is a fairly short duration asset class (especially compared to investment grade and municipals), with bonds generally issued for 5-10 years (and often called well before this).  Additionally, buying at higher yield (due to high coupon levels or buying at discounts in the secondary market) helps serve to reduce duration.  The focus should be on generating return and income with the best investment opportunities available, rather than limiting yourself to loans or short maturity paper.  As we embrace this investment philosophy, we still see a great deal of value in actively managed high yield bonds and often find that by the nature of seeking value via yield and/or capital gains opportunities, sometimes that does include short maturity/duration bonds or leverage loans that are at attractive yields and prices, providing a secondary duration benefit to the portfolio.