Investing in a diversified portfolio of limited duration, mid-grade credit provides an attractive alternative to traditional limited-duration strategies in a rising interest rate environment. We define mid-grade credit as corporate bonds and floating rate leveraged loans rated from B- to BBB+ by S&P and B3 to Baa1 by Moody’s. The mid-grade portion of the corporate bond and bank loan market generally avoids exposure to the most volatile and distressed sectors of the credit market. Limited duration refers to securities falling within a duration band of 0.5 years and 4.5 years, equivalent to a maturity range of nine months to five years.
A portfolio of short-maturity, mid-grade credit offers certain advantages compared to other limited-duration fixed income investments. Such advantages include higher coupons for relatively attractive income generation, floating-rate coupons and limited duration to help reduce the impact of rising interest rates on total return, and low correlations to 10-year Treasuries to help improve risk-adjusted performance.
MAXIMIZING YIELD IN A LIMITED-DURATION PORTFOLIO
A diversified portfolio of short-duration, mid-grade credit can generate relatively high levels of current income versus alternative limited-duration strategies while offering a level of principal preservation during periods of volatile or increasing interest rates. Figure 1 compares the yields of seven 1‒3 year maturity indexes. The bars on the left side of the graph show the yields of three conventional US fixed income indexes: a 1–3 year Treasury index, a 1‒3 year agency index, and a 1‒3 year broad market index. The bars on the right side of the graph show the yields of four indexes constituting the mid-grade portion of the credit market.
From Figure 1 it can be seen that short-maturity, mid-grade securities offer far more yield than conventional short-maturity fixed income alternatives. The yields on the 1‒3 year B-rated high yield bond index and the BB-B rated leveraged loan index provide more than three times the yield of the 1‒3 year broad fixed income market index. The yield premium offered by mid-grade corporate bonds combined with the floating-rate component of leveraged loans will likely dampen the negative effect of rising interest rates on total return.
Source: Merrill Lynch 1-3 Year indices. Credit Suisse Loan Index. Data as of June 30, 2017.
LOW CORRELATIONS HAVE PROVIDED SUPERIOR PORTFOLIO DIVERSIFICATION
The mid-grade sectors of the corporate market may also offer superior diversification benefits to a fixed income portfolio. Figure 2 shows the correlations of traditional and mid-grade bond indexes relative to the 10-year Treasury over the past decade. Whereas the broad market Bloomberg Barclays US Aggregate Index is 86% correlated to movements in the 10-year Treasury rate and the Bloomberg Barclays US 1‒3 Year Government/Credit Index is 59% correlated, limited-duration, mid-grade securities have demonstrated low-to-negative correlations to 10-year Treasury yields.
Relative to the 10-year Treasury, the -0.16 correlation of the ML 1-3 Year BB Corporate Index, the -0.20 ML 1‒3 Year B Corporate Index, and the 0.14 correlation of the ML 1–3 BBB Corporate Index imply that these rating cohorts move in a low to nearly uncorrelated fashion to interest rates. The negative correlation of -0.44 for the Credit Suisse Leveraged Loan Index suggests that this market segment moves in a somewhat opposite direction to rate movements.
In summary, a well-structured portfolio of limited duration, mid-grade securities can provide a level of protection from rising interest rates along with an attractive income stream. The portfolio’s reduced duration relative to broad market indices, greater income cushion provided by the BB-B rating cohort, and interest-rate hedging provided by floating-rate bank loans may serve to dampen the effects of rising interest rates on performance. The favorable income-and-correlation profile of this market segment positions it as a compelling diversifier to a broad market fixed income portfolio.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.