A timely fixed income solution
The case for European high yield short duration bonds1
Rohan Duggal, Lisa Tomasi
Why short duration?
Aggressive central bank rate hikes have contributed to an inverted yield curve whereby yields on shorter-dated bond investments exceed those on longerdated fixed income securities.
Short duration bonds have less price sensitivity than longer dated bonds to a given move in yields. All other things being equal, this makes their returns less volatile (Exhibit 1).
Flows into short duration fixed income assets have been strong, given the combination of higher carry (i.e. higher yield levels) and lower mark-to-market volatility versus longer dated bonds.
Exhibit 1: EHY and EHY SD – Total Return
Why European high yield short duration?
European high yield short duration (EHY SD) compares well to the full duration EHY market – The EHY SD2 yield to worst (YTW)3 is 7.02% (436 basis points Option Adjusted Spread) with 1.3 years of duration versus regular duration EHY4 6.72% YTW (409 basis points Option Adjusted Spread) with 3.1 years of duration.
In other words, European HY investors can halve their sensitivity to changes in yields while only giving up 27 basis points (bps) of carry by moving into the short duration part of the market. (Exhibit 2 and 3).
Exhibit 2: Yield to Worst & Effective Duration for Euro fixed income asset classes
Exhibit 3: EHY and EHY SD: OAS* difference (bps) – since December 2012
EHY SD is historically cheap – All-in-yields are attractive with the current EHY SD Yield to Worst, currently in the 97th percentile of its historical daily yields over the past 10 years.
Break-evens are attractive – The combination of high yields and short duration translates into attractive break-evens.5 This means that investors could tolerate a 524bps move higher in short duration yields before their annualised carry is negated. (Exhibit 4).
Exhibit 4: Increase in yields required to negate current annualized yields
Low cash prices provide buffer against downside exposure – The average cash price for European high yield short duration bonds is 93.35 versus a 10-yr average of 102.35. This discount to par provides an enhanced buffer against downside exposure to potential credit losses.
The opportunity set is growing – The investment universe, which is currently at ~EUR 125bn, can potentially grow to ~EUR 155bn by the end of 2024,6 as higher yields reduce the incentive of issuers to call their debt early.
Key risks to bear in mind
The shorter duration subset of the overall EHY market is smaller and less diversified than the broader universe.
There is generally more refinancing risk associated with shorter dated maturities.
During periods of severe financial market stress, such as that seen in March 2020, short duration spreads can widen more than the broader market.
Why J.P. Morgan Asset Management?
Our JPMorgan Funds - Europe High Yield Short Duration Bond Fund is ranked 5-stars by Morningstar7 and is ranked No. 1 out of all Morningstar-rated (and categorised) “EUR High Yield” funds, for the past 12 months.8
The fund has been in existence since 2017 and is managed by a highly experienced team led by Peter Aspbury, the head of our European High Yield strategies, along with co-portfolio manager Russell Taylor and five dedicated European high yield research analysts.
The portfolio managers have been with J.P. Morgan Asset Management since 2010 and have an average experience of 24 years in the EHY market.
The investment style is a fundamental-based active approach, with an up-in-quality bias.
With the continued prospect of underlying rates curves remaining inverted and broad European high yield spread curves flat, we believe EHY SD provides an appealing alternative to higher duration credit markets.
In our view, short duration sub-investment grade bonds still manage to provide a relatively high yield compared to other fixed income asset classes, but with lower interest rate risk and therefore a lower correlation to moves in government bond yields.
Overlaying active management to avoid potential defaults can add significant excess returns above the benchmark.
EHY SD really does look like a timely fixed income solution for bond investors for the remainder of the year.