Domestic Fixed Income | June 2012
BB-rated and B-rated short-term high yield continues to offer opportunities for compelling risk-adjusted returnsBy Tom Price, CFA; Kevin Maas, CFA; and Michael Schueller, CFA—Portfolio Managers, Wells Fargo Advantage Short-Term High Yield Bond Fund
During the fall of 2011, we noted that the trade-off in credit markets caused by European sovereign debt fears had pushed yields on short-maturity BB- and B-rated bonds higher and that the potential risk-adjusted income was attractive compared with many alternatives. This assessment proved accurate as the BB-rated and B-rated short-maturity segment of the high-yield market rallied during the first four months of 2012, even outperforming longer-maturity investment-grade corporate bonds.
This performance is a continuation of a longer-term trend in which the short-term high-yield bond segment (as measured by the BofA Merrill Lynch 0-5 Year BB-B U.S. High Yield Constrained Index) has outperformed longer-maturity investment-grade corporate bonds (as measured by the Barclays U.S. Corporate Investment Grade Index) over the last five years on an annualized basis. Despite this trend of outperformance, we believe high-quality short-term high-yield bonds, while not as cheap as they were in the fourth quarter of 2011, still offer attractive income and relatively low expected volatility compared with alternative asset classes that investors commonly consider.
Short-term high yield has generated competitive returns with relatively low volatilityTable 1 illustrates that the returns of the short-term high-yield index have been competitive with longer-maturity asset classes of both investment-grade and high-yield credit quality with lower volatility than high yield as measured by standard deviation. This is highlighted by the short-term high-yield category’s strong Sharpe ratio, which measures the return provided for the volatility experienced. Investment-grade corporate bonds have been less volatile, but at the cost of a lower return and with much greater exposure to the potential of rising Treasury yields due to a substantially longer duration. High-yield bonds have provided better returns, but at a much higher volatility due to their exposure to lower-quality credit with longer maturities. Notably, short-term high-yield has significantly outperformed high-yield loans on an annualized basis over the last five years and has done so with much less volatility.
Thus, investors in the short-term high-yield space have earned competitive returns compared with investment-grade and high-yield alternatives in recent years while minimizing volatility, particularly relative to the much more volatile longer-maturity segments of the high-yield market.
Today, with Treasury yields anchored near record lows and likely to stay there given the Federal Reserve Board’s announced intent to keep the federal funds rate low into 2014, the extra yield available in short-term BB-rated and B-rated bonds relative to Treasuries remains generous. For example, as of April 30, 2012, the yield-to-maturity of the BofA Merrill Lynch 0-5 Year BB-B U.S. High Yield Constrained Index was 6.23%, yet this index had a duration of just 2.1 years. By comparison, the yield-to-maturity of the Barclays U.S. Corporate Investment Grade Index was 3.29% with an effective duration of 6.9 years—significantly higher interest-rate risk (measured by effective duration) with 294 basis points (100 basis points equals 1.00%) less of yield compensation than the short-term high-yield index. While high-yield bonds have offered higher potential yield than short-term high yield, they also leave investors exposed to lower credit quality and longer duration than short-term high yield.
Concluding observationsWe believe the short-term high-yield market continues to offer compelling risk-adjusted returns for investors. Yields in the short-term high-yield market remain significantly higher than U.S. Treasury yields and much of the investment-grade bond market, but with less exposure to changes in interest rates. Compared with high-yield bonds and loans, the shorter-maturity profile and generally higher credit quality of the short-term high-yield market has helped reduce price adjustments from negative shifts in credit spreads. In our view, investors who are looking for more income than offered in the Treasury and investment-grade markets but who are wanting to minimize duration risk and avoid exposure to the more volatile parts of high yield should consider investing in the short-term high-yield market.
Bond fund values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. In general, when interest rates rise, bond fund values fall and investors may lose principal value. High-yield securities have a greater risk of default and tend to be more volatile than higher-rated debt securities. The use of derivatives may reduce returns and/or increase volatility. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to foreign investment risk. Consult the fund’s prospectus for additional information on these and other risks.