We are in a market where demand for yield has resulted in a compression of expected returns from virtually every asset class in fixed income. There are small variations from category to category, but ultimately, the differences between yields across asset classes are small. Similarly, the term structures of yield curves and credit curves across fixed income are relatively flat,1 so even an investor who seeks extra yield by taking on duration is seeing only a small benefit. Put another way, pretty much all fixed income investments come with similar yields in today’s environment.
One area in which this is most notable is in the difference in credit spreads between A-rated corporate debt and BB-rated corporate debt.2 Figure 1 shows that difference over the last 20 years. This chart shows the extra credit spread one would be paid for BB-rated credit risk over what one would be paid for A-rated credit risk. This additional compensation is at its lowest point since mid-2007, just before the start of the decline leading into the 2008 financial crisis. The instinctive reaction of many investors is to conclude that high yield bonds are overvalued relative to investment grade bonds today. But that instinct is incorrect. Figure 2 tells a very different story. This chart shows the historical durations of BB-rated credit and A-rated credit. In fact, the duration of the high yield index has declined over the same 20-year period, while the duration of the investment grade index has increased substantially.
Figure 1: 20-year history of the difference in the option-adjusted credit spreads for the ICE BofA Single-A Corporate Index and the ICE BofA BB US High Yield Index. (Sources: Bloomberg Finance LP, ICE Data Services)
Figure 2: 20-year history of effective duration for the ICE BofA Single-A Corporate Index and the ICE BofA BB US High Yield Index. (Source: Bloomberg Finance LP, ICE Data Services)
This is not to say that there should not be a credit spread difference between A-rated bonds and BB-rated bonds. In 2000, when the durations of the two indices were similar, investors could correctly argue that they were being compensated almost exclusively for taking on additional credit risk (see Figure 3). However, what is clear in the duration data is that the interest rate sensitivity has increased in investment grade fixed income and decreased in high yield fixed income. As a result, some amount of the lower spread difference in 2020 can be explained by a reduction in duration risk offsetting the increase in credit risk.3
Figure 3: Illustration of relative risk tradeoffs between credit and duration within fixed income. The risk profiles of Zeo’s strategies are shown for comparison.
The point we are making is bigger than corporate credit. Our example makes the case that the conventional wisdom of using credit ratings as a sole proxy for fixed income risk, for example, belies a very real countervailing duration risk hidden underneath. But, as we have written before, this type of obfuscation is found throughout fixed income.4 Common shortcuts for evaluating investments are still mired in a myopic and somewhat confused idea that past performance alone, independent of risk and duration, is sufficient despite ubiquitous disclosures to the contrary. Hence, the Agg’s stellar year in 2019 is mistakenly seen by some as a reason to double down on duration risk rather than be wary of it. Ultimately, in a market in which yields and spread differences across asset classes and across durations within each asset class are relatively flat, how does an investor determine relative value between investment options within fixed income?
The short answer is by understanding the risks underneath the hood of each strategy. Within fixed income, most risks boil down to some form of exposure to credit or duration. In our view, it is reasonable in a core fixed income portfolio to take one or the other risk, but not both. Ideally, one would diversify the risks between the two and then further between different credit exposures to minimize the chances that any one risk dominates. Furthermore, when taking on credit risk, which credits get selected are important. To that end, we encourage investors to focus on managers who do deep dives on whatever type of securities they evaluate and are selective about what they include in their portfolios. Otherwise, you may just find yourself adding a third risk, default risk, into your portfolio by mistake at exactly the wrong time.
Lastly, we believe it is especially important to try to identify which strategies consistently deliver on their mandates. There are a host of risk metrics one can use to do so.5 By focusing on consistency, investors can narrow down the almost intractably large list of investment options rather quickly to those who have at least quantitatively shown some risk management skill. From there, there is no substitute for speaking with the portfolio managers themselves and understanding what they do, how they do it and whether you think it is repeatable. And before you know it, you’ve done what most investors fail to do: bring a risk management lens to a portfolio, and just in time.
1The term structure of a curve shows how rates of that curve change over time. A flat term structure means that rates for shorter time frames are similar to rates for longer timeframes
2We use the ICE BofA Single-A US Corporate Index for A-rated credit data and the ICE BofA BB US High Yield Index for the BB-rated credit data.
3Also in Figure 3, readers can see our view of our own strategies relative to this risk tradeoff. Those who have heard us explain where we believe our strategies fit into a fixed income portfolio will recognize that we make the case for diversifying the risk in a traditional fixed income portfolio from duration to credit while maintaining a similar level of overall risk. With the duration of investment grade credit even longer than is typical for a core fixed income portfolio, we would argue the benefits from our strategies are even more pronounced, especially in the current environment where both credit spread risk and interest rate risk loom large over the markets.
4We have in the past called out hidden risks in a variety of fixed income asset classes, including collateralized debt, structured products and business development companies. Ultimately, it’s important that investors understand what mandate they are giving a manager and what risks the manager is taking to deliver on that mandate. A good rule of thumb is this: If it is confusing, it’s probably not worth the risk.
5Among our favorites are rolling 12-month performance (and standard deviation of the same), the ratio of total returns to standard deviation (which we have dubbed the absolute ratio), standard deviation, max drawdown and time between high water marks. We realize this was an unexpectedly quick rundown of interesting risk metrics, and this list isn’t comprehensive. We invite any reader who is interested to reach out for a deeper discussion on how we use these metrics and what insights one can derive from them.
Important Disclosure Information
Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Zeo Capital Advisors, LLC (“Zeo”)), or any non-investment related content, made reference to directly or indirectly in this article will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this article serves as the receipt of, or as a substitute for, personalized investment advice from Zeo. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Zeo is neither a law firm, nor a certified public accounting firm, and no portion of the content should be construed as legal or accounting advice. A copy of Zeo’s current written disclosure Brochure discussing our advisory services and fees is available upon request or at www.zeo.com/disclosures.