Is interest rate duration worth the risk?
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.
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. Comparing yields on 3y and 5y German government bonds from 2008 to 2018. As you would expect, 5y yields have typically exceeded 3y yields. However, since late 2015, yields on even 5y bonds have been negative.
Given the expectation of ECB rate hikes towards the end of 2019, we believe 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.
Adding credit volatility premia to a bond portfolio »