ETF Trends
ETF Trends

It was hard to ignore the call in the fixed income space for “short duration” investing over the last couple years. Duration is a measure of interest rate sensitivity (the percentage change in the price of a bond for a 100 basis point move in rates), so the lower the duration the theoretically less sensitive those bonds are to interest rate movements.

Lower duration bonds would not eliminate the interest rate impact, just lessen it. We see this as a good strategy broadly speaking if you are talking the high yield asset class versus the investment grade asset class, with the high yield market naturally having a much lower duration due to its higher starting yields and generally shorter maturities. However, we believe this strategy is lacking when it is used to parse out the high yield space itself, investing in only the lower duration names within the high yield category, irrespective of other considerations.

This gets back to the concept of yield. In a box, this sounds like a good strategy, but you need to factor in the starting yield on the portfolio to mathematically assess if practically speaking this is the right strategy. If you were to invest according to a “short duration” strategy in the high yield debt market, let’s hypothetically say you could achieve a portfolio with a duration of 2.0 years, so a 100 bps change in rates over 6mos would mean that the price of your portfolio would theoretically decline by 2.0%. If your starting current yield on the portfolio was 6.5%, meaning you theoretically generate 3.25% of income over that 6mos, then you are looking at a theoretical net gain of 1.25% (3.25% – 2.0%) 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 2.5 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 2.5%, but you would be theoretically generating 4.5% of income over the 6mos, so your net theoretical gain would be 2.0%. 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 4.5% for the hypothetical short duration portfolio versus a theoretical gain of 6.5% for the higher yielding portfolio.1

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