Generally speaking, bonds with low coupons and long maturities, like Treasury bonds, are more susceptible to interest rate changes. Meanwhile, bonds with higher coupons and shorter maturities, such as high yield bonds, have lower durations or are less sensitive to interest rate movements.
Figure 1 compares the performance between a low-duration manager, a high-duration manager and a high-yield index. As you can see, during the 40-year period when yields were on a consistent down trend, the high-duration manager outperformed by a wide margin. When Treasury yields started their ascent in August, however, the higher duration manager faltered while the low-duration manager outperformed.
Figure 1: Source: Zephyr; Long Duration SMA vs. Low Duration SMA
As you can see in Figure 1, low duration bonds are not going to overwhelm you with eye-popping total returns, but their steady performance and low standard deviation make them more attractive on a risk-adjusted basis (Sharpe ratio) compared with long duration and high yield bonds.
Below are some of the top separately managed accounts found in the PSN SMA database with durations between one and three years and superior three-year risk-adjusted returns (Figure 2).
Figure 2: Sources: Zephyr, PSN database; data: three years as of 2/2021
Despite concerns that higher yields will hurt lower-quality bonds as borrowing costs for these lower-rated companies increase, the benefits of the strong economy and solid financial conditions should offset the higher costs.
In addition to high-yield bonds, look to bank loans and floating-rate bonds, which are a hedge against rising interest rates. Figure 3 displays some of the top high-yield and floating-rate bond SMAs that are found within the PSN SMA database with durations of less than five years and superior three-year risk-adjusted returns.
Figure 3: Source Zephyr, PSN database; data: three years as of 2/2021
Lastly, if your clients are not dependent on investment income and are comfortable with more exposure to equities, you may want to consider increasing their allocation to equities — particularly sectors and styles that benefit from higher yields and greater economic expansion like financials, cyclicals and small-caps.
After decades of relying on total returns with low risk from high-quality bonds, financial advisors are now faced with replacing the stellar total returns, solid income and diversification benefits that have anchored client portfolios for years with alternatives that reduce interest rate risk but bring their own obstacles.
Ryan Nauman is a market strategist at Zephyr. His market analysis and commentaries are available at financialintelligence.informa.com.