Maximize Your Gain In the Yield and Duration Dance

The income landscape is changing and investors need to consider the embedded risk within their bond holdings to ensure they are situated with the right risk profile for the amount of yield they are receiving.

Unbeknownst to many casual investors that don’t track changes up and down the yield curve, short-term interest rates have been steadily rising since mid-2013, while widely followed yield statistics, such as the 10-year Treasury note yield, have largely traveled sideways.

This has become an important trend since investors who primarily stay within the confines of high quality or government bonds receive substantially more income by staying shorter on the yield curve than just a few years ago.

More specifically, an investor in 2-year Treasury bills received roughly 0.25% in yield in mid-2013.  Now at the end of the Federal Reserve’s zero interest rate policy, owners of 2-year Treasuries receive 0.93% in yield.

From a relative perspective, if the 10-year Treasury Note had risen by the same percentage change, it would be at 4.62% in yield.  Of course, this would significantly stymie the economy, alter the housing landscape, and weigh on corporate profits.

While 0.93% yield for an income investor may not be all that exciting, it has bumped all other similar duration corporate securities higher in-kind.  In fact, relatively conservative income investors can now receive an attractive yield on a short duration diversified investment grade portfolio.

An opportunity we are considering for some of the excess cash in our Strategic Income Portfolio is a holding in the Vanguard Short Term Corporate Bond ETF (VCSH). The fund carries an SEC yield of 2.14% and has over 1,900 individual issues in its diversified portfolio.

Furthermore, it has a very reasonable expense ratio of 0.12% and an effective duration of just 2.8 years.

vcsh

In our opinion, funds such as VCSH make great alternatives to intermediate duration alternatives such as the iShares Investment Grade Corporate Bond ETF (LQD).  Primarily because investors in LQD are only achieving a roughly 50% increase in yield, for almost three times the duration risk.  If you’re not in need of the additional duration to hedge a portfolio of equities or other risk assets, a lower volatility option is simply more enticing.

From a strategy perspective, we will ultimately use a fund such as VCSH to hold until we feel comfortable re-entering our high yield bond exposure.  Rather than tempt fate in U.S.-focused high yield bonds, we have been primarily concentrating our efforts in emerging market debt showing similar yields and lower volatility.

As spreads steadily widen, high yield bonds become more attractive.  Nevertheless, we have also been cautioning investors for months that owning a significant portion of credit related securities during a tightening cycle is ill advised as evidenced by historical price statistics.

High yield bonds have significantly underperformed any other fixed-income asset in 2015.  In our opinion, VCSH will be a great place to hide out in as we wait for stabilization in the high yield sector in the early stages of 2016.

For now, we are awaiting to gauge the markets reaction to the Federal Reserve’s widely expected rate increase to ultimately allocate to a position in VCSH, since short term bonds could exhibit additional volatility after the announcement. However, with a well-timed entry point, VCSH will ultimately be a great place to park shorter term cash.

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The post The Yield and Duration Dance appeared first on FMD Capital Management.

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