If the traditional fixed income indices like the Barclays U.S. Aggregate Index or the IBoxx US Dollar Investment Grade Corporate Bond Index are no longer the ideal fixed income investments for the next cycle, then what exposures should investors consider as alternatives?
Investors may want to look to reposition their fixed income portfolios toward vehicles with the potential for less interest rate risk, less Treasury, MBS, and lower rated general obligation municipal bond exposure and greater corporate bond exposure. These vehicles may include senior secured loans, short-term high yield bonds, short-term investment grade bonds, short-term municipal bonds, floating rate notes and crossover bonds.
SENIOR SECURED LOANS
Why: Senior loans are floating rate bank loans made to below investment grade companies. As such, these investments provide corporate credit exposure with limited interest rate duration. Like high yield bonds, senior loans have the potential to offer an attractive yield, but unlike high yield bonds, senior loans have minimal duration, as they are floating rate instruments whose interest rates reset every three months. In a rising rate environment, investors could potentially benefit from higher interest payments. In addition, since loans are senior in the capital structure they have the priority claim in the event of a default and are potentially less risky than bonds issued from the same company.
How: Since senior loans are a relatively inefficient asset class, investors could potentially benefit from an actively managed investment approach. An actively managed approach allows for the acquisition of loans in the primary market, may identify and sell loans that are likely to be removed from an index due to credit events and can over and underweight individual loans.
SHORT-TERM HIGH YIELD BONDS
Why: For investors looking for the competitive income offered by below-investment grade securities, but wary of interest rate risk in a rising rate environment, short duration high yield bonds may be an attractive option. The 0–5 year maturity window offers half of the interest rate risk of longer maturity bonds with the potential benefit of less performance volatility.
How: While high yield is a market segment with generally low duration, short-term high yield offers a more attractive yield per unit of duration. More specifically, the Barclays U.S. High Yield $350 MM Cash Pay 0–5 Year 2% Capped Index has a modified duration of 2.08 versus 4.34 for the Barclays Very Liquid High Yield Index. As a strategic holding employed to lower overall portfolio duration, short duration high yield can be a valuable complement to longer maturity funds within a portfolio’s high yield allocation.
SHORT-TERM INVESTMENT GRADE BONDS
Why: Shorter duration bonds allow for greater protection in an environment of rising rates and for quicker reinvestment at potentially higher yields. Compared with longer-term bonds, short-duration investment grade bonds may benefit earlier from increased income from the fund’s underlying bonds in a rising rate environment.
How: Moving a portion of a portfolio’s fixed income allocation to shorter duration funds can shorten overall portfolio duration, decreasing sensitivity to the negative effects of rising long-term rates. However, investors may wish to focus on corporate issues and avoid exposure to government-related sectors that are either highly leveraged or low yielding, which can be found in more traditional credit exposures.
SHORT-TERM MUNICIPAL BONDS
Why: Many municipal bonds offer yields that are greater than those on comparable maturity Treasury bonds which is rare as municipal bonds offer tax exempt interest. Investors in higher tax brackets can add a historically attractive yield spread over US Treasury investments.
How: Within the muni market it pays to be selective with exposures, especially when considering the amount of idiosyncratic risks, such as Detroit, MI and Puerto Rico. The Barclays Managed Money Municipal Short Term Index is comprised of 1 to 5-year municipal bonds rated Aa3/AA- or higher by ratings agencies.