Duration Targeting: No Magic for High-Yield Investors

Over time, the annualized return of a duration-targeting, investment-grade corporate bond portfolio will nearly match its initial yield. A high-yield bond portfolio’s performance is not similarly predictable. Furthermore, the difference between the high-yield universe’s initial yield and annualized return has a sharply negative bias. The absence of benefits from duration targeting has a bearing on valuation of the high-yield asset class and helps explain the instability in its investor base.A duration-targeting portfolio maintains an approximately constant duration by selling bonds as they approach maturity and replacing them with longer-dated issues. Over a determinable period, a duration-targeting investment-grade bond portfolio will reliably produce an annualized return very close to its initial yield. If interest rates rise, the portfolio’s market value falls and thus its total return declines. As these events occur, however, the reinvestment rate increases. Given sufficient time, reinvesting at the higher-than-initial rate offsets the loss in market value, leaving a net return equal to the initial yield. Conversely, if interest rates fall, the resulting gain in market value is eventually offset by a lower reinvestment rate. The convergence of initial yield and total return represents a valuable benefit in the form of predictability.Martin L. Leibowitz, Anthony Bova, and Stanley Kogelman mathematically demonstrated that initial yield and total return converge after the number of years that equals twice the duration minus 1 (2d – 1). They referred to this point in time as the bond’s effective maturity. The authors confirmed that convergence occurred in practice by examining historical returns on the Barclays US Aggregate Government/Credit Index.In our study, a similar analysis using The BofA Merrill Lynch US High Yield Index did not reveal a convergence of any practical value to investors. On the basis of historical experience, a portfolio manager who, on 31 December 2012, held a portfolio similar to the US High Yield Index with a yield-to-worst of 6.11% and monthly rebalancing might realize an annualized return of anywhere from –2.31% to 6.68% over the succeeding five years.The explanation of high yield’s less pronounced return convergence lies in its greater price volatility. During our study’s observation period, prices on the investment-grade index at the end of five years ranged from 102.20 to 110.86. The comparable range for the high-yield index was 61.15 to 104.35. It is more difficult for a change in the reinvestment rate to compensate for price swings over a 43.20-point range than for price swings over an 8.66-point range.Excess returns (the difference between initial yield and annualized total return) on the high-yield index were not only too wide to represent a useful level of predictability but were also heavily skewed to the negative. This bias was observed despite the declining trend of interest rates during the observation period, which gave investment-grade excess returns a positive bias. The difference was attributable to high-yield bonds’ higher default losses and the high-yield index’s greater concentration in callable bonds.Our study’s findings have two important implications for investors. First, a value comparison of investment-grade and high-yield bonds should attribute a portion of high yield’s total return premium to the absence of predictable performance in a duration-targeting high-yield portfolio. Second, the negative bias in high-yield excess returns helps explain the chronically destabilizing mix of investors in high-yield bonds. If high-yield investors could reliably earn a multi-year return close to their beginning yield, more long-term players would probably be attracted to that asset class. Because they cannot do so, however, high-yield prices are more heavily influenced by short-term traders seeking to catch interim highs and lows—and are thus more volatile—than they would be if duration targeting worked the same magic in high yield as it does in investment grade.