Stew’s Views

May 9, 2022

Short Duration High Yield Funds vs. Loans

Over the past six months, US leveraged loan funds have outperformed short duration high yield funds by a meaningful amount. The key driver of the relative performance was the lack of duration in the loan cohort.  Most leveraged loans are floating rate, and the index which floats is typically 3- or 6-month Libor, which is soon to be converted to the SOFR index.  

As rates have risen across the yield curve over the past year, loans have benefited in two ways: Libor has risen and the all-in rate on the loans have gone up (three-month Libor has moved from 0.13% to 1.35%). Additionally, this floating rate interest rate duration is minimal, and thus the overall impact on the return from the rate rise is quite small.  Thus, investors have been able to capture the attractive all-in yields of loans (currently 3.97% SEC yield for SRLN ETF) without paying a price for owning fixed income in a rising rate environment.

Why Short Duration High Yield Funds

At this point, we think short duration high yield funds offer some compelling advantages over their loan counterparts. First, senior loans, for the most part, are weaker credits than their high yield bond brethren. That isn’t particularly relevant in a booming economy, but as growth downshifts and the fears of recession grow due to Federal Reserve and financial conditions tightening, being “up in credit” has some merit. The share of the loan market that is rated B+ or lower is currently close to 70%, while the share of the high yield bond market that sports that credit rating is 55% (see the chart below from Goldman Sachs). Given the signs of weakening in housing, confidence, and manufacturing, in addition to the recent First Quarter 2022 GDP figure of -1.4%, it might make sense to be in higher rated credits.

Another reason currently supporting short duration high yield bonds over loans is the interest rate environment. “No interest rate duration” was a benefit over the last six months, as the fed funds rate expectations went from pricing one 25 basis point hike in all of 2022 in the fourth quarter of 2021, to ten 25 basis point hikes at the time of this writing. We think owning front end duration is a great investment now, with fed funds priced to peak at close to 3.25% in the later part of 2023. 

Given the downshift in the economy and base rate effects, there is a decent likelihood that inflation will peak soon, and the Federal Reserve will not be able to get rates as high as the market expects. This will benefit short duration high yield funds vs the loans sector, as short duration high yield ETF funds have interest rate durations close to 2 years, and investors can build their own portfolios at that interest rate maturity.  Additionally, investors are now getting paid a meaningful premium to own short duration high yield bonds relative to leveraged loans.  Even with the rise in Libor over the recent past, the 30-day SEC yield of SRLN is currently 3.97%, and for SHYG and SJNK it is 5.95% – a meaningful yield pickup in high yield vs. loans.

Added Expenses for Leveraged Borrowers

Lastly, the rise in Libor and floating rate expense does not come without a cost.  Leveraged borrowers in the high yield market will now face higher interest rate costs—the downside of having floating rate funding. According to Bloomberg, US-domiciled issues will face added annualized interest rate expenses close to $10 billion (see table below).  

Thus, going up in credit, up in yield and avoiding the potential stress of higher interest rate costs make us favor short duration high yield vs their loan counterparts. At YieldX, our fixed income allocation tool helps investors identify these sector allocation opportunities in a portfolio construction context.

about the author

Stewart Russell, Chief Investment Officer

Stewart Russell is Chief Investment Officer. Previously, he was Managing Director, Head of Institutional Solutions and Head of Multi-Asset Portfolios at Barings. Stewart was also a portfolio manager at Moore Capital Management and Partner and Co-Chief Investment Officer at Fischer Francis Trees and Watts, sold to BNP Paribas during his tenure.