Persistent Anomaly? High Yields on Short Bonds

03 October 2023

3 min read

Will Smith, CFA| Director—US High Yield

Robert Schwartz| Portfolio Manager—High Yield

With yield curves still inverted, a short-dated high-yield strategy continues to make sense for return-seeking investors with a defensive mindset.

The US and some European yield curves have been inverted for some time now. Of course, that can’t last forever. Ultimately, inflation should fall enough to allow central banks to lower short-term rates. In the meantime, continued yield-curve inversion translates to continued investing opportunities at the short end of the high-yield market, in our view (Display).

Shorter-Duration High-Yield Bonds Offer Higher Yields than Their Longer Counterparts

One- to two- year bonds yielded 1.5% more than 10+ year bonds as of August 31, 2023.

For illustrative purposes only. Current and historical analyses do not guarantee future results.
As of August 31, 2023
Source: Bloomberg Global High Yield Corporate Index and AB

Short-Dated High-Yield Valuations Still Look Attractive

US and euro high-yield spreads have tightened this year (by about 93 bps and 19 bps respectively), driving bond prices higher. Even so, for return-seeking investors, shorter-dated high-yield bonds still look attractive, with yields at their highest levels in a decade and starting prices still very low by historical standards (Display).

Short-Duration High Yield at One of the Most Attractive Points in Last 20 Years

Bloomberg Global High Yield Corporate 1–5 Year Index: Starting Annual Price and Yield

These bond prices were lowest in the 2009 Global Financial Crisis (GFC), but 2023 is their second lowest-priced year in 20.

Historical and current analyses do not guarantee future results.
Price and yield for market is represented by the Bloomberg Global High Yield Corporate 1–5 Year Index.
As of December 31, 2002 for years 2004 through 2022. For 2023, yellow dots indicate positions as of December 31, 2022 and as of August 31, 2023.
Source: Bloomberg and AB

That’s because years of low interest rates allowed companies to issue bonds with rock-bottom coupons, and these securities now trade at big discounts to par because of subsequent rate hikes.

As a result, we think potential credit-market scenarios are the most favorable they’ve been in a long time. Deep discounts to par help cushion returns on the downside and provide greater upside if the issuer experiences a positive credit event. And as starting yields have proved to be reliable indicators of future returns over the next three to five years, we think short-duration high-yield bonds may currently offer worthwhile prospective returns at current prices.

Higher-Quality Shorter-Dated Bonds Can Help Mitigate Downside Risks

Focusing on high-quality, short-duration bonds helps mitigate two big risks: sensitivity to interest rates, and the impact of defaults that result from an economic slowdown. Higher-quality issuers have stronger fundamentals and so are more resilient to economic setbacks, including rate rises. Bonds with short lives leave less time for defaults to strike. They also benefit from the “the pull to par” as prices rise toward par at maturity, which will likely create capital appreciation irrespective of fluctuations in interest rates or the economy.

Of course, with global economies slowing, credit fundamentals are sure to weaken from current levels, and defaults and downgrades are likely to pick up. But we think that’s mostly priced into markets for those industries and credits that are on weak footing. For the better-placed issuers, credit fundamentals are starting from a position of strength.

The result is a larger margin of safety to cushion investors from the impact of high rates or prospectively lower growth. A high-quality, short-duration high-yield credit strategy should provide even better downside mitigation if prospects for economies darken further.

Higher-Quality Short-Dated Bonds May Improve Risk/Return Balance

For defensively minded bond investors, we find there’s a yet another advantage over time. Opting for a higher credit-quality, short-duration high-yield strategy can materially reduce volatility compared with the broader high-yield market, in exchange for only a modest reduction in yield (Display).

High-Quality Short-Dated High-Yield Bonds Have Offered Attractive Yields

Average Yields in US Dollars over Different Timescales (Percent)

Over one, three, five and ten-year periods these bonds have yielded about 0.8% less than the global high-yield market.

Current and historical analyses do not guarantee future results.
Indices used are Bloomberg Global High Yield Corporate Index, hedged to US dollars, and US 10-Year Treasury Bond Yield.
As of August 31, 2023
Source: Bloomberg and AB

In fact, over the 20 years ending August 31, 2023, BB- and B-rated high-yield bonds between one and five years to maturity captured more than 88% of the broader high-yield market return, while experiencing approximately 63% of the average monthly drawdown. Consequently, they have provided better risk-adjusted returns than their longer-dated (five- to 10-year) high-yield counterparts.

But they have really come into their own during periods of extreme market stress. At these times, higher-quality, short-duration high yield has exhibited much lower downside capture than both the global and US high-yield markets (Display).

Higher-Quality Short-Duration High Yield Captured Less Downside When Spreads Widened

Cumulative Return when US High-Yield Spreads Widened 50 Basis Points or More (Percent)

In major crises including the GFC these bonds’ prices fell significantly less sharply than US and global high-yield markets.

Past performance does not guarantee future results.
Periods when US high-yield spreads widened 50 b.p. or more. US corporate high-yield returns and spreads are represented by Bloomberg US Corporate High Yield Index; global high-yield hedged returns are represented by Bloomberg Global High Yield Corporate hedged to USD Index; and higher-quality short-duration high-yield returns are represented by Bloomberg Global High Yield Ba/B 1–5 Year Index hedged USD.
As of August 31, 2023
Source: Bloomberg and AB

While the near- to medium-term future seems uncertain and is likely to be volatile, we think credit investors could be handsomely rewarded, particularly in short-duration high-yield corporate bonds. Investors who sit on the sidelines may be disappointed if they don’t lock in today’s elevated yields.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

About the Authors

Will Smith, CFA

Will Smith is a Senior Vice President and Director of US High Yield Credit. He is also a member of the High Income, Global High Yield, Limited Duration High Income, Short Duration High Yield and European High Yield portfolio-management teams. Smith designed and is one of the lead portfolio managers for AB’s Multi-Sector Credit Strategy, which invests across investment-grade and high-yield credit sectors globally. He leads the monthly High Yield portfolio-construction meeting, and is a member of the Credit Research Review Committee, which determines investment policy for the firm’s credit-related portfolios. Smith has authored several papers and blogs on high-yield investing, including one on the importance of using a probability-based framework to build better portfolios. He joined AB in 2012, and spent 2014 in London as part of the European High Yield portfolio-management team. Smith started his career with UBS Investment Bank, working as an analyst with the Credit Risk team and then later on the Fixed Income sales and trading desk. He holds a BA in economics from Boston College and is a CFA charterholder. Location: Nashville

Robert Schwartz

Robert Schwartz is a Senior Vice President and Portfolio Manager for High Yield. Previously, he was an AB Corporate Credit Research analyst, covering specialty finance, automotive, aerospace/defense and industrial companies. Prior to joining the firm in 2012, Schwartz analyzed the same industries as a senior credit analyst at Citadel Investment Group and Bell Point Capital Management. Before beginning his investing career in 2005, he was a project leader with Boston Consulting Group, where he advised industrial and financial companies on corporate strategy. Schwartz started his career as an automotive engineer working in Detroit, where he was awarded two patents. He holds a BS in mechanical engineering (summa cum laude) from the University of Michigan and an MBA (with high distinction) from the University of Michigan’s Stephen M. Ross School of Business. Location: Nashville