Tabula insights: is interest rate duration a drag on your Euro high yield allocation?
The attractive yield on high yield corporate bonds often comes with significant interest rate risk. With rate hikes looming, this may be unwelcome. CDS indices like iTraxx Crossover give you credit exposure without direct interest rate risk and are now accessible in ETF format.
Is interest rate duration worth the risk?
Investors typically increase duration to achieve a higher yield. Within the high yield market, where yield is driven by interest rates and credit spreads, you’d expect a higher return from both components when you buy longer maturity bonds.
However, if we look at the interest rate component in isolation, its contribution in recent years has been unimpressive.
Given the expectation of ECB rate hikes towards the end of 2019, it may make sense to minimise this interest rate exposure. It’s not enhancing the yield and will be a drag on bond prices if rates rise.
Longer-term credit spreads are attractive.
Not only are spreads on the credit curve higher than interest rates over the spectrum, but the credit curve is also substantially steeper.
Reduce interest rate duration in passive portfolios.
For passive investors who have a positive view on corporate credit but are concerned about rate rises, there are two common ways to reduce interest rate duration.
An investor can hedge duration risk. However, this comes at a cost and increases the operational burden.
Alternatively, there are ETFs tracking short-term bond indices. These have lower duration (typically around 2y, compared to around 3.5y for a standard ETF) but the investor also misses out on the credit duration in longer-term bonds.
However, there is a third and more efficient option. Taking credit exposure via CDS indices rather than cash bond indices removes direct interest rate duration risk altogether, while maintaining credit duration.