24 Mar 2016

Gaining Yield Through Lightly Managed Short-Duration Credit

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Mark Cernicky, Managing Director for Principal Global Fixed Income discusses the yield benefits of adding lightly managed, short-duration U.S. dollar investment grade credit strategies and how they can benefit investors
by Mark Cernicky, CFA, Managing Director, Senior Product Specialist
In the following paper, Mark Cernicky, senior product specialist for Principal Global Fixed Income, discusses yield benefits of adding lightly managed, short-duration US dollar (USD) investment grade credit strategies and how they can benefit investors.

What Are Lightly Managed Short-Duration USD Investment Grade Credit Strategies? 

Lightly managed short-duration USD investment grade credit strategies invest in U.S. dollar-denominated investment grade credits with maturities that are limited between three to five years. The goal of these strategies is to harvest yield by holding the bonds to maturity. This makes them more attractive to investors who are after yield, rather than total returns. Moreover, these are cash-benchmarked, low-turnover strategies (typically less than 10% per annum), giving them their "lightly managed" moniker. As compared to a more actively managed strategy, where trading will occur to exploit relative value decisions, in a lightly managed strategy turnover occurs primarily for two reasons: credit concerns and replacement of maturing bonds. This is why most of these strategies are concentrated toward the higher end of the targeted maturity window. Finally, lightly managed portfolios can see reduced trading costs, which helps maximize the yield available to investors. 

Why Should Investors Take a Closer Look at These Strategies?

Until recently, investors who needed to manage short-term funding needs were left with two equally insufficient options; increase risk to meet their yield targets or keep risk at comfortable levels and accept lower yield, creating a funding short fall. However since mid-2014, short-duration investment grade yields have dramatically increased. In addition, for non-U.S. dollar investors, as U.S. dollar increased, investors found USD short-duration investment grade credit as an efficient way to benefit from the increasing strength of the U.S. dollar versus such as the Chinese yuan, the Singapore dollar, or the euro. These strategies offer additional attractiveness when considering that additional yield can be earned versus a local yield curve. 

As indicated in Exhibit 1, there is a 1.95% yield pick-up of the U.S. dollar over the euro within the three to five-year investment grade securities. This is a significant yield pick-up for simply taking short-duration exposure to global multi-national companies by buying their bonds in U.S. dollar versus euro, even when adjusting for currency exchange rates. In addition, USD yield curves are steeper than EUR yield curves, therefore an investor has potential to harvest more gain by rolling down the USD yield curve rather than the EUR yield curve. 

How Do Maturity and Credit Quality Affect These Types of Strategies?

Investors can see significant differences along the spectrums of both maturity and credit quality . As Exhibit 2 shows, yield-to-worst  increases as maturity increases, and as credit quality decreases. It is also important to note that there is over a 1.00% increase in yield between A to BBB-rated issues and 0.43% gain by extending the maturity of the investable universe from three to four years. As a result, the sweet spot to invest a large proportion of the portfolio is in BBB-rated bonds. 

What Are Some Common Guidelines for These Types of Strategies?

These strategies are typically set against a cash benchmark. This has an implication for performance measurement, which is typically done on a Sharpe ratio or credit-adjusted yield basis because two portfolios with the same yield can have much different return paths. Typically, the biggest issue with guidelines is the percentage allocated to BBB-rated securities and currency hedging. BBB-rated securities have the highest yield, but are also most likely to be downgraded to high yield, which can result in a forced sell. 

As Exhibit 3 shows, the probability of a BBB-rated issuer falling to high yield is significantly greater, regardless of maturity , than A-rated issuers for the same maturity. But noe that a downgrade to high yield does not imply significant  default risk, as the cumulative three-year default rates for BBB-rated issuers is only 1.1% and increases to 2.2% at the end of five years (Exhibit 4). Also keep in mind that unhedged portfolios can result in realized losses, even if you hold hte bonds to maturity. 












How Do Technical Factors Affect the Market In This Space?

Around 40% of the new-issue investment grade market has maturities of five years of less, with most of the trading occurring in the three-to-five year space. This reduces the ability to source bonds with maturities of less than three years and puts a premium on having access to the new issue market to build portfolios. 

Why Should Investors Buy These Strategies Today?

Low yields outside of the U.S. dollar market are likely to continue. Likewise, the need for yield to fund short-term operating costs has potential to persist for some time. Investors are left with few options, when you consider central bank actions earlier in the year that drove sovereign asset yields negative and the recent decision by the European Central Bank to purchase European corporate debt as part of their quantitative easing program that will further increase the yield differential between U.S. and European investment grade yields. To increase the yield on their fixed income portfolio they can stay on their yield curve and increase rik, which also means increasing the likelihood of suffering capital losses on their short-term funding buckets. Or, they can consider short-duration USD investment grade credit, which offers attractive yields and low volatility. Sometimes, to accomplish your goals, you must think outside of the box, and in this situation, thinking outside the box means thinking outside of your own yield curve. 

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