If your starting current yield on the portfolio was 7%, meaning you generate 3.5% of income over that 6mos, then you are looking at a theoretical net gain of 1.35% (3.5% – 2.15%) over the period of rising rates. However, if you can build a portfolio in the high yield bond and loan market investing according to both maximizing yield and considering duration, let’s say you can build a portfolio with a duration of 3 years and a current yield of around 9%. In this case, your theoretical sensitivity to a 100bps movement over 6mos would be a price change of 3%, but you would be generating 4.5% of income over the 6mos, so your net theoretical gain would be 1.5%.
If that 100bps interest rate movement is over a year instead of 6 months, that yield benefit gets even larger, putting you at a theoretical net gain of 4.85% for the hypothetical short duration portfolio versus a theoretical gain of 6.0% for the higher yielding portfolio.
We see this as compelling evidence that investing purely according to a short duration strategy and not factoring in yield is not necessarily the wisest way to approach this environment. At the end of the day, yield matters.
A higher yield can go a long way in making up for relatively small differences in duration. Furthermore, even if rates do rise, it very well can take longer than many expect, making the argument for the higher yielding portfolio versus the purely short duration portfolio even stronger.
1 The duration and price movement relationships are approximates and calculations are provided for illustration only. These calculations assume that credit spreads remain constant and do not factor in any fees or expenses. Actual results may be materially different.