FYI: Copy & Paste 4/19/14: Beverly Goodman Barron's
Regards,
Ted
Investors have been wandering the fixed-income desert in search of yield for more than five years. While that time frame doesn't quite meet Biblical standards for long journeys, it still has taken people into risky territory. For investors in some high-yield bond funds, those risks could present quite a surprise.
High yield has been seen as a safe harbor for years. Default rates are at 1.7%, a five-year low. High-yield bonds are also often seen as immune to interest-rate risk: Rising interest rates typically signal a strengthening economy, which provides a better environment for companies with troublesome credit ratings. Yet, as my colleague Mike Aneiro points out in this issue's Current Yield column ("Managers Junk High-Yield Bonds"), many fund chiefs are dumping their high-yield bonds. Better to get out early than stick around until it's too late, they say. Should investors follow their cue?
Possibly. Investors in low-duration, high-yield bond funds might have taken on more risk than they realize. Duration is a complicated metric that measures a bond's sensitivity to interest-rate risk. Not to be confused with maturity—the point at which a bond comes due—duration is also expressed in years. The shorter a bond's duration (or the shorter a fund's average duration), the less its price will fall as rates rise.
Low-duration high-yield funds have been touted as the best of all worlds in recent years. There are 113 such funds, with $206 billion in assets. More than a quarter of that, $59 billion, has poured in over the past five years, from investors looking for yield, but hoping to minimize interest-rate risk.
But now these funds could have more interest-rate risk and even credit risk than investors realize.
Most high-yield bonds have a maturity of 10 years, but are callable in five. A company will call a bond—pay the debt in full—if it can issue new bonds with a lower coupon; perhaps its credit profile has improved, or interest rates have dropped. It's the corporate equivalent of refinancing your home when mortgage rates drop, or when your credit score improves enough to warrant a lower rate.
But as rates rise, issuers are less likely to call their bonds. And high-yield bonds are generally priced with the assumption that they'll be called. If they're not, and the issuer lets the bonds stay on the market until maturity, their duration increases significantly, making them more sensitive to future interest-rate increases, as well as some other problems, says Matt Conti, who manages the high-yield sleeve of Fidelity Total Bond fund (ticker: FTBFX). "Folks say there's not a lot of interest-rate risk, but anything that causes the market to go down could cause a problem," Conti observes. The benchmark Bank of American Merrill Lynch High Yield Master Index, he points out, currently has a duration of 3½ years, and yields 5%. If priced to maturity, instead of call date, the index's yield increases to 6%, and its duration extends significantly—to five years.
So a longer duration means prices are more likely to fall as rates rise. That's a problem for fund investors on two fronts: First, managers don't typically hold bonds to maturity; they're buying and selling constantly, which means their funds can lose money as prices fall. What's more, as bond prices slide, fund investors usually head to the exits, forcing managers to sell even more bonds at lower and lower prices. Funding redemptions also leaves managers short on cash they could otherwise use to pick up bargains as they materialize, or purchase newer bonds with higher coupons. "It forces a lot of selling at the worst possible time," says Bonnie Baha, manager of the DoubleLine Low Duration Bond fund (DBLSX), which has about 20% of its portfolio in junk bonds.
LONGER DURATION ALSO MEANS more credit risk, so whether you're in a dedicated high-yield fund or a general low-duration fund, look at the average credit quality and make sure the fund isn't overreaching. "A lot of funds stuff with junky, high-yield credits, thinking: 'What can go wrong? Default rates are low,' " Baha says. And while default rates are indeed low, the longer a bond's duration, the more time there is for something to go wrong. Baha looks for high-quality bonds that are teetering on the edge of investment grade; the fund has 26% of its $1.9 billion in assets in BBB-rated bonds, twice the category average.
Another clue that you may be facing a surprise: "If a fund's duration looks extremely low, say, one year, it's likely all bonds are being priced to call," Conti warns. "If rates rise, those durations will likely extend out."
Two good bets for investors focused on high-yield funds with shorter durations: The $14.2 billion BlackRock High Yield Bond (BHYAX), which yields 4.69% and has an average duration of 3½ years, and the $6.4 billion AllianceBernstein High Income (AGDAX), which yields 4.26% and has an average duration of 4¼ years. The latter is a multisector fund, which means that it can—and does—invest in bank loans, emerging-market debt, and other areas; 76% is in high-yield corporate bonds.
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