While fixed income is full of nuances that impact returns, the predominant risks are interest rate risk and credit risk. Depending on market conditions, investors may scale the level of each respective risk factor as appropriate to their portfolio. Generally speaking, there is an expectation of higher returns for greater risk taking, with the acknowledgment that there is the potential for losses as well.

Despite this year’s unusual high yield market performance (longer duration high quality high yield has outperformed shorter duration lower quality), high yield corporate bonds have relatively higher credit risk, but limited interest rate risk. Because of this credit risk sensitivity, some look at investing in high yield as a binary asset class – either risk-on and invest in high yield, or risk-off and sell out.

However, short duration high yield can be viewed as an “all weather” solution given its lower sensitivity to both interest rate and credit risk. Short duration high yield, as represented by the ICE BofAML 1-5 BB-B Cash Pay High Yield Index, is a subset of the high yield market that consists of bonds with shorter maturities and excludes higher risk CCC-rated bonds. A typical short duration high yield security may be a note issued by a company seven years ago but has three years remaining until maturity.

Like most bonds nearing maturity, bond math dictates that changes in interest rates will have less impact on the price of that bond relative to one with a longer maturity, all else equal. In fact, as shown in Figure 1, over the last 15 years, short duration high yield bonds have outperformed core bonds during rising rate periods. In all six of the periods shown, short duration high yield had positive total returns while core bonds lost value in five of the six periods.

There are two reasons why high yield bonds defy the conventional wisdom that bond prices move opposite from rates: 1) high yield bonds have relatively large coupons that can offset declining prices, and 2) rising treasury yields are indicative of economic growth, which is the result of strong corporate performance and thereby indicates less credit risk. Less credit risk – real or perceived – is priced into bonds in the form of tighter spreads, which can also offset rising treasury yields. As a result, short duration high yield investors need not fear rising rates.

The second argument for deeming short duration high yield as an “all-weather” solution is that the asset class contains less credit risk than the overall high yield market. As we stated earlier, high yield is more credit sensitive than rate sensitive, so the asset class is not immune to adverse credit conditions. That said, short duration high yield has been more resilient than the overall high yield market in periods of spread widening.

In Figure 2, we look at four periods over the last 15 years marked by material spread widening. Although both high yield and short duration high yield had negative total returns during these periods, the resilience of short duration is quite notable. The average drawdown of short duration in these periods was a little over half of the overall market.

Since these bonds have been outstanding for a number of years, analysts have greater insight into the businesses and their financial performance. Additionally, with less than a handful of years until maturity, there is less uncertainty and less risk of unforeseen events than a bond with 10 or 15 years remaining. From a credit risk standpoint, shorter maturities coupled with the exclusion of CCC-rated bonds suggest a higher probability of receiving all interest and principal payments.

Ultimately, investors and their advisors need to marry risk tolerance with investment outlooks to construct optimal portfolios. In the fixed income market, this largely comes down to credit risk and interest rate risk. Given market uncertainties, making short duration high yield a strategic allocation may help investors by reducing the burden of having to make correct economic predictions. Further, we believe its attractive risk profile and appealing results under various market conditions – outperformance relative to core bonds when rates have risen and increased resilience versus high yield when spreads have widened – makes short duration high yield an “all weather” solution for income investing.

1. Short duration high yield is represented by ICE BofAML 1-5 BB-B Cash Pay High Yield Index; Core Bonds is represented by Bloomberg Barclays U.S. Aggregate Bond Index; Rates are 10-year US Treasury Rates.

2. Short duration high yield is represented by ICE BofAML 1-5 BB-B Cash Pay High Yield Index; High Yield is represented by the ICE BofAML U.S. High Yield Index; Spread is represented by ICE BofAML U.S. High Yield OAS Spread.

About Risk

Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.

Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are
also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner, or that negative perception of the issuer’s ability to make such payments may cause the price of that bond to decline. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds.

This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

Definitions

Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.

ICE BofAML 1-5 BB-B Cash Pay High Yield Index tracks the performance of U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market with maturities of 1 to 5 years.

ICE BofAML U.S. High Yield Index tracks the performance of U.S. dollar-denominated below investment grade corporate debt publicly issued in the U.S. domestic market.

“New York Life Investments” is both a service mark, and the common trade name, of the investment advisors affiliated with New York Life Insurance Company. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.

This article originally appeared on ETFTrends.com.