Why Credit Investors Need to Manage Duration More Creatively

Many credit investors pay little attention to duration, seeing themselves primarily as bottom‑up investors who specialize in sector and security selection. However, duration has become a major driver of credit total returns over the past decade, making it increasingly difficult to ignore. Managing duration is likely to be a key source of performance for credit investors in the future—giving those who are skilled in it a major potential advantage.

Yet predicting what that future will look like is complicated by the fact that we may be entering a different regime in which the playbook of the past decade no longer works. The 40‑year bull market for bonds, and tailwind for credit returns, is likely exhausted. The massive expansion of the central bank balance sheets in response to the coronavirus pandemic, which have directly and indirectly benefited corporate borrowers and investors, will probably peak this year. Managing duration exposure in the period ahead is going to demand new—and creative—approaches from investors.

The fixed income market has evolved considerably since the global financial crisis (GFC). Vast injections of central bank liquidity have driven down bond yields and encouraged corporate issuers and investors to extend out the curve—bonds of more than 10 years’ maturity now compose more than 28% of the Bloomberg Barclays Global Aggregate Corporate Index (as of December 31, 2020). The average credit investor now holds significantly more duration than in 2009: The duration of the index has increased by around two years, or around 1.4 times, since then.

And while credit strategies have performed very well over that time, much of that performance has been effectively “engineered” by central banks supressing sovereign bond yields. Changes in underlying risk‑free rates—the duration impact—have accounted for the majority of the returns of U.S. and European investment‑grade debt and emerging market (EM) hard currency bonds over the past 10 years and have contributed significantly to the returns of U.S. high yield strategies using index returns as a proxy (Figure 1).

The Post‑Pandemic Recovery May Pave the Way for Inflation

The strong influence of duration on credit returns has not been a problem while yields were trending lower. However, with most of the major central banks at their lower bound on interest rates, the downtrend in yields is probably at its end. Indeed, the market has already started to price a return to more normal conditions as vaccination programs ramp up and fiscal stimulus takes the reins from monetary policy. As the lifting of restrictions enables economies to bounce back quickly, anticipation is building about central bank rate hikes and the cessation—or slowing down—of asset purchase programs, posing an eventual risk for credit investors.

Real yields (the yields on Treasury Inflation Protected Securities, or TIPS) which exclude anticipated inflation, may not normally be followed closely by credit investors. However, we believe the direction of real yields is critical for total credit returns because they provide a window on future monetary conditions. Long‑term real yields are determined by structural economic factors such as the pace of productivity growth and demographics, and deviations from the long‑term level are driven by monetary policy. While nominal yields have recently bounced from all‑time lows with expectations for higher inflation, real yields have remained near all‑time lows as the Federal Reserve has maintained a consistently dovish outlook for monetary policy.

Many investors are worried about a repeat of 2013, when market panic over the prospect of the U.S. Federal Reserve tightening policy triggered the “taper tantrum” as government bonds and risk assets sold off dramatically, causing large losses for credit investors (the Bloomberg Barclays Global IG Corporate USD Hedged Index declined 5% in less than two months). Although we believe there is no immediate prospect of rate hikes, and therefore that a repeat of the taper tantrum is unlikely, the enormous amount of monetary stimulus injected into the global economy since the coronavirus swept the world will have to be reduced at some point. Tighter monetary policy, when it comes, should push up real yields closer to the long‑run average rate, which we estimate is currently in the range of 0.0–0.5% (at the end of May, the yield on 10‑year Treasury Inflation‑Protected Securities (TIPS) was -0.86%).

Typically, monetary policy and credit total returns are negatively correlated. Tighter monetary policy typically reduces the attractiveness of credit assets in several ways, such as reducing liquidity, improving the relative returns of risk‑free assets (e.g., U.S. treasuries) versus risky assets, and increasing the cost of corporate borrowing. While corporates can usually absorb higher interest rates driven by higher inflation, higher real yields may squeeze profitability. Figure 2 shows that, over the past 13 years, tighter monetary policy and higher real yields have been associated with poor credit returns, and vice versa.

An increase in real yields is not the only risk to credit investors. Central banks are concerned about a premature withdrawal of monetary stimulus, preferring instead to maintain easy liquidity conditions until the economic recovery is well advanced. The risk from this approach is higher expected inflation and interest rate volatility. So even if the Fed stays dovish and the market does not price a significant tightening of policy in the next few years, the long end of the Treasury curve should steepen in order to price in a greater term premium that captures inflation and Fed policy uncertainty. At present, in spite of very high current inflation, the market is forecasting that longer term inflation will be only slight above the Fed’s 2% target. If the recent price gains do not cool, it will cause a headache for bond investors.

As interest rates fell over the past 40 years, corporate investors were rewarded by the decline in the risk‑free rate plus the additional credit spread. Holding corporate debt has often helped to mitigate the impact of periodic sovereign yield spikes as credit duration was lower and spreads were able to compress, cushioning the blow from rising risk‑free rates and demonstrating a negative correlation. However, in times when market stress coincides with significant Treasury yield moves, the correlation may flip to positive as the market’s rates concerns translate into credit concerns (Figure 3).

The correlation has been mean‑reverting, but what if inflation persists and gives rise to additional uncertainty over the Fed’s policy reaction? Could the correlation remain near zero where it is today, or possibly move into positive territory? This is not our current base case, but it is a risk to be aware of, particularly with regards to portfolio construction. Furthermore, we believe the diversification impact of corporate debt has diminished over the past decade as U.S. and European investment‑grade indices have become more sensitive to interest rate rises (Figure 4). In my view, the current combination of very low sovereign yields (greater interest rate risk), tight credit spreads (less cushion), and less diversification benefits puts credit bondholders in a vulnerable position. This suggests a need for greater duration flexibility.