Viewpoint  |  April 27, 2023

Short Duration Credit – Consensus Should Not Drive Conviction

In times of uncertainty, we believe it makes sense to optimise return potential across a range of possible outcomes, rather than maximise it based on a particular scenario

Capital at risk. The value of investments and the income from them may fall as well as rise and is not guaranteed. Investors may not get back the full amount invested

From today’s starting point, we believe a wide range of economic and investment outcomes is possible for the rest of 2023. Bouts of volatility are likely to punctuate a year in which central banks must balance their fight against inflation with recessionary risks associated with tighter financial and lending conditions.

Anticipation of a traditional rate curve cycle and growing fears of a looming recession have encouraged investors to consider extending duration in their fixed income allocation. Moving out along the rates curve positions investors for greater total returns from a fall in interest rates, should central banks turn to looser monetary policy through the end of 2023 and 2024.

As the success of this strategy is largely dependent on interest rates falling, we feel it is important that investors are aware of other opportunities that may succeed in a broader range of scenarios. There are risks from positioning in longer-dated fixed income as evidenced in 2022. Whilst the range of outcomes suggests returns could be maximised with longer duration, we don’t believe they are optimised from a risk perspective. Investors must remain critical of consensus positioning and what appears to be the obvious next trade.

Starting Yields

Let’s start by looking at the yields available in credit, particularly in investment grade where duration positioning is most prevalent. Inverted rate curves, coupled with upwardly sloping spread curves, combine to give notably flat yield curves in both the US and Europe. This tells us that, should yield curves remain unchanged over the next 12 months, you could generate a similar return from credit across the duration spectrum. Thus, an investment in longer-dated credit needs to be justified by a view that interest rates will move lower over the investment period, driving potential for a greater total return from longer-dated bonds.

Fig. 1 – Investment Grade Yield to Worst by Duration

Source: ICE Data Platform, as of 20th April, 2023. All data in local currency. ICE 1-3 Year US Corporate Index (C1A0), The ICE BofA ML 3-5 Year US Corporate Index (C2A0), ICE BofA 5-7 Year US Corporate Index (C3A0), ICE BofA 7-10 Year US Corporate Index (C4A0), ICE BofA 10+ Year US Corporate Index (C9A0), ICE BofA ML 1-3 Year Euro Corporate Index (ER01), ICE BofA ML 3-5 Year Euro Corporate Index (ER02), ICE BofA 5-7 Year Euro Corporate Index (ER03), ICE BofA 7-10 Year Euro Corporate Index (ER04), ICE BofA 10+ Year Euro Corporate Index (ER09). For illustrative purposes only. Indices used are best representation of the market.

Yield Break-Evens

Given the ongoing upside and downside risks in the economic and monetary policy outlook we must also consider the return outcomes should the consensus interest rate view be wrong. Mixed economic data coupled with changing central bank messaging continue to make the economic and policy outlook unclear. Indeed, a more cautious approach to monetary policy tightening and an extended policy and credit cycle could leave a duration extension trade looking premature.

In this scenario we can consider what yield moves an investor can tolerate at different points on the yield curve before suffering negative returns over a 12-month period. In Figure 2 we present these yield ‘break-evens’ in investment grade markets. These show the approximate changes in yield required to generate a negative return over the coming 12 months.

Fig. 2 – Investment Grade Yield ‘Break-Evens’ by Duration

Source: ICE Data Platform, as of 20th April, 2023. All data in local currency. ICE BofA AAA US Corporate Index (C0A1), The ICE BofA ML 3-5 Year US Corporate Index (C2A0), ICE BofA 5-7 Year US Corporate Index (C3A0), ICE BofA 7-10 Year US Corporate Index (C4A0), ICE BofA 10+ Year US Corporate Index (C9A0), ICE BofA ML 1-3 Year Euro Corporate Index (ER01), ICE BofA ML 3-5 Year Euro Corporate Index (ER02), ICE BofA 5-7 Year Euro Corporate Index (ER03), ICE BofA 7-10 Year Euro Corporate Index (ER04), ICE BofA 10+ Year Euro Corporate Index (ER09). For illustrative purposes only. Indices used are best representation of the market.

Yield ‘break-evens’ are highest in short-dated bonds, with the largest increase in yields required before expected returns turn negative. The further out one invests, the less room there is for error with ‘break-evens’ of just 30 to 80 bps in duration longer than 7 years. This appears modest given that the US 10-year Treasury yield has moved in a 75bp range already this year, and in an almost 95bp range since October 2022.

It is therefore clear that speculation plays a larger role in the investment thesis in longer-dated credit, and room for error is more limited.

Pull-to-Par and Volatility

On the other hand, simple bond mechanics play a larger and more favourable role in your return potential in short-dated bonds. The average price of bonds in a global short-dated investment grade index was approximately 96 at the end of March 2023, with less than 2 years to maturity on average. These conditions are relatively unusual (Fig. 3). Assuming defaults are avoided, there is a mechanical component of bond investing that will take these bonds back to par over the remainder of their life. This is unlikely to be without volatility and we should not expect a straight-line appreciation, but volatility should be significantly lower than in longer-dated bonds.

Fig. 3 - Average Price of Short-Dated Bonds Over Time

Source: ICE Data Platform, as of 31st March 2023. ICE BofA 1-3 Year Global Corporate Index (G1BC) For illustrative purposes only. Index used is best representation of the market.

Greater Visibility of Repayment

We must at the same time respect that this pull-to-par argument assumes defaults and credit losses are avoided. Indeed, this mechanical element of return would be undermined if the issuer was unable to honour an instrument’s repayment at maturity. However, investors in short-dated bonds also have the benefit of far greater visibility regarding repayment options for short-dated maturities. Analysis can identify cash on balance sheet, free cash flow generation, credit lines or options available in credit and equity markets to ensure repayment at maturity. Furthermore, a portfolio’s higher-quality bias would typically imply more exposure to companies with cash available to repay short-dated debt, simplifying this assessment further.

Summary

In summary, we do not believe that the risk-reward in longer duration credit appears favourable in the current market environment. We acknowledge the appeal of longer-dated investments but continue to prefer the shorter-dated part of the market for its comparable yields, more forgiving ‘break-evens’, and the mechanical element of potential returns that comes from low cash prices and the ‘pull-to-par’ effect.

The merit of this view is further enforced by the potential for an extended market cycle, where we could see market interest rates remaining volatile or even drifting higher as we avoid the immediate crisis that the Silicon Valley Bank and Credit Suisse events encouraged the market to anticipate.

 

 

Risk: Reference to the names of each company mentioned in this communication is merely for explaining the investment strategy and should not be construed as investment advice or investment recommendation of those companies.

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of April 2023 and may change without notice.

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Index Descriptions

C1A0 – ICE 1-3 Year US Corporate Index is a subset of the   the ICE BofA US Corporate Index (C0A0) including all securities with a remaining term to final maturity greater than or equal to 1 year and less than 3 years.

C2A0 – The ICE BofA 3-5 Year US Corporate Index is a subset of the ICE BofA US Corporate Index (C0A0) including all securities with a remaining term to final maturity greater than or equal to 3 years and less than 5 years.

C3A0 - -ICE BofA 5-7 Year US Corporate Index is a subset of ICE BofA US Corporate Index including all securities with a remaining term to final maturity greater than or equal to 5 years and less than 7 years.

C4A0 - ICE BofA 7-10 Year US Corporate Index is a subset of ICE BofA US Corporate Index including all securities with a remaining term to final maturity greater than or equal to 7 years and less than 10 years.

C9A0 - ICE BofA 10+ Year US Corporate Index is a subset of ICE BofA US Corporate Index including all securities with a remaining term to final maturity greater than or equal to 10 years.

ER01 – The ICE BofA 1-3 Year Euro Corporate Index is a subset of ICE BofA ML Euro Corporate Index (ER00) including all securities with a remaining term to maturity less than 3 years.

ER02 - ICE BofA 3-5 Year Euro Corporate Index is a subset of ICE BofA ML Euro Corporate Index (ER00) including all securities with a remaining term to final maturity greater than or equal to 3 years and less than 5 years.

ER03 - ICE BofA 5-7 Year Euro Corporate Index is a subset of ICE BofA Euro Corporate Index including all securities with a remaining term to final maturity greater than or equal to 5 years and less than 7 years.

ER04 - ICE BofA 7-10 Year Euro Corporate Index is a subset of ICE BofA Euro Corporate Index including all securities with a remaining term to final maturity greater than or equal to 7 years and less than 10 years.

ER09 - ICE BofA 10+ Year Euro Corporate Index is a subset of ICE BofA Euro Corporate Index including all securities with a remaining term to final maturity greater than or equal to 10 years.

G1BC - ICE BofA 1-3 Year Global Corporate Index is a subset of ICE BofA Global Corporate Index including all securities with a remaining term to final maturity less than 3 years.

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