The Crossroads Of Duration And Credit Quality

by: Michael Fabian

Never have I witnessed a more polarizing subject than the direction of interest rates among investors. It's become an epidemic that has even spilled over into casual conversations I have with clients, friends, or family, since almost everyone has a dog in this race. What is most startling to me is the amount of conviction investors have for their hypothesis being proven true. If there is one thing I've learned in my investing career it's that belief in only one possible directional outcome is a dangerous thing. Legitimate persuasive arguments can be made for both rising or falling rates, however, that doesn't always tell the whole story. The velocity, momentum, and depth of the change can go a long way in helping you make real world portfolio management decisions. The strategy of fixed income investing we employ for the clients of our firm is one that is centered on balance. Simply put, a portfolio with a long duration subjects you to way more sensitivity to interest rates than the coupons could hope to make up for. Conversely, too much credit risk hitches your portfolio directly to the cyclical economic wagon, whereby a recession could have a devastating impact on your total return. I believe the correct answer lies in the convergence of these two unique risks to leverage the benefits and weaknesses of each.

The ongoing evaluation of the fixed income sleeve of our portfolios starts by zeroing in on the exact exposure to duration and credit quality. A successful bond portfolio hinges on the right mix of securities that intermingle well in an inflationary or deflationary market environment. My ultimate goal is to forge a portfolio that is low in volatility but also produces a respectable income stream. As an example, I would look to pair a higher quality, higher duration ETF like the PIMCO Total Return Bond Fund (NYSEARCA:BOND) with a fund that has lower duration, and lower credit quality like the PIMCO 0-5YR High Yield Corporate Bond Fund (NYSEARCA:HYS). In the table below, a simple measure of a fund's credit quality is analyzing the percentage of the holdings that are above investment grade, or S&P BBB and higher. (Please keep in mind securities that are not rated are left out of this simple calculation).

Fund Effective Duration % Invst. Grade SEC Yield
Bond 4.51 Years 73.32% 2.36%
HYS 1.88 Years 10.13% 3.52%
Click to enlarge

Typical interest rate and market cycles would pin the principle movement of these two funds against each other, since high yield bonds are more apt to perform well in an inflationary environment, the same type of environment where equities perform well in. Whereas, the total return fund holds higher quality treasuries and agency securities that respond well to falling rates, or a deflationary environment.

The beauty of this type of management is that you can overweight or underweight each respective fund as you overlay your directional bias on interest rates. As time moves forward and risks change, you can actively shift your portfolio's bias from one end of the spectrum or the other to sidestep the inherent volatility associated with each risk. As an added benefit, the funds will often work in concert with each other during times where the stock and bond markets are buoyant. Since this is just one example of pairing two relatively low duration funds together, other more aggressive examples might look like:

  • iShares 20+ Year Treasury ETF (NYSEARCA:TLT) and the iShares High Yield Corporate Bond ETF (NYSEARCA:HYG).
  • iShares 10+ Yr Credit Bond ETF (NYSEARCA:CLY) and the iShares Global High Yield Corporate Bond ETF (BATS:GHYG).

Based your individual goals, sizing your fixed income sleeve will have a profound impact on your exposure to the bond market and in turn your performance. Other key factors I didn't discuss in this article such as the relative value of bonds or spread to treasuries should be considered. The Achilles' heel to any bond strategy is a large swift rise in interest rates, in which all bonds will lose value. As with any investment thesis, understanding the risks and developing a plan is a great start to a successful outcome.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Clients of Fabian Capital Management own certain securities listed in this article.