Using US short duration bonds to maximise investment returns

  • |
  • 07 mins 34 secs
Michael Memory, Senior Product Specialist, Allianz US Short Duration High Income Fund, discusses what makes this strategy different from other fixed income solutions, what methods are used to preserve capital and why he recommends this strategy to investors.


Allianz Global Investors

Visit for more insights or to contact us for additional information.

Michael Memory: The investment team believes that superior risk adjusted performance, in other words a sharp ratio, is best achieved by mitigating risk, avoiding defaults and protecting principle. Through strict and rigorous credit research, diligent bottom-up issue selection and the application of unique risk management techniques, the investment team can construct a portfolio of highly liquid, high yield securities that are of higher quality and shorter maturity to produce a return profile that is primarily predicated on capital pres ervation, and then secondarily delivering an attractive income and a positive total return.

Core bonds trade at meaningful premiums and with unwanted risk. And then we have the backdrop of the fed beginning to unwind its balance sheet, which could produce additional pressures. Over the last two decades, yields on core bonds have come down meaningfully, and durations have risen concurrently. Today, core bonds yield one to two percent with durations of six to seven years. Look no further than Swiss government bonds that are negative yielding, JGB's, or Japanese government bonds which have no yield, and German bunds which are yielding less than a half percent.

Outside of investment grade, you have European high yield credit that is yielding in line with U.S. investment grade credit, but on a yield to worst basis is offering a rival in that yield of dividends of European equities. On the other hand, U.S. high yield offers a compelling opportunity with yields over six percent, and in line with emerging market's high yield debt.

With regard to core bond solutions, the short duration strategy offers a comparative volatility that's in line with core bonds, but with a much more attractive yield and significantly less interest rate risk. Compared to other short duration high yield managers, there are many different attributes; first and foremost is the team and the construct of the portfolio.

The short duration strategy is managed by a dedicated team. It is not a carve-out of a full high yield strategy, and is not managed by a full high yield market manager. This is important and unique, because a full high yield market manager will construct a portfolio in benchmark relative terms, where they're trying to achieve a level of alpha by taking some additional risk. The short duration team takes a completely different approach, and looks to develop the portfolio from the bottom-up, with the keen eye on protecting principle and preserving capital.

Outside of these differentiators, there are several others, including a concentrated portfolio. We hold names in the range of 60 to 80 issuers. But by limiting our issuer base, we are limiting the volatility that we're introducing the portfolio. By owning more names, we would look like the broader market. We primarily focus on less cyclical industries, where there's less sensitivity to economic cycles, and helps preserve capital and protect downturns in certain market environments. The strategy is also benchmark indifferent, or benchmark agnostic, so we're not looking to introduce risk into the portfolio to maintain a certain level exposure that would be present in a benchmark. And then lastly is the higher credit quality of the portfolio. Today's portfolio has a Ba3-BB minus credit rating, and focuses on the highest quality credits in the high yield space, and very selectively owns CCC issuers.

The investment team is always looking to de-risk the portfolio. They're always going to ask themselves several questions before adding a name. How is this issue we're going to trade in an economic downturn? Can it survive a default cycle? And how much would they stand to lose in either of these cases? There are plenty of investment opportunities in the short end of the high yield market; the controlling the credit risk from the very onset is critical.

Thinking about it from an opportunity set perspective, the investment team is looking to purchase bonds that are trading above par. In other words, they're not reaching for yield by purchasing lower credit qualities. They want to own names with solid fundamentals and healthy balance sheets that trade at a premium, and they want to collect those coupons until the bond either matures, is called, or is tendered.

Lastly, there are two aspects to controlling draw-down; one is credit, the other is relative value. Our strict trading discipline forces us to remove a name from the portfolio on the first signs of credit weakness. With respect to relative value, we want to remove a name that trades from 103 to 107, because we know it can trade right back to 104 just as quickly.

Focusing on higher quality, high yield securities that are highly liquid is critical to managing risk in the high yield marketplace. There are two ways to lose money outside of duration or interest rate risk; one is a poor credit decision, the other is not being able to get out of a security at an attractive price. By investing in high quality, high liquid names, you're mitigating the risk that is associated with a broader high yield market.

In addition, the investment team has a less cyclical bias, which protects the fund in economic downturns in default cycles. Look no further than 2015. The fund avoided owning servicers and exploration of production companies, which was highly exposed in the broader high yield market. The broader high yield market declined 4.6 percent in 2015. The short duration composite returned half a percent over that same time period. Historically, the short duration strategy has delivered a sharp ratio that's two times the broader market, 30 percent of the volatility of the high yield market, and 70 percent return of the high yield market.

Investors need to ask themselves two questions: What happens if rates rise? Core bonds will lose six to seven percent, with a one percent move in interest rates. The other question is, what happens if rates don't rise? Investors will be confronted with depressed global yields, and therefore unable or challenged to meet their total return targets. Adding short duration high income to a fixed income allocation will increase your return, decrease your volatility and increase your sharp ratio. And on a going-forward basis, position your fixed income allocation with a more attractive yield and a lower duration.