For fixed income asset classes, investors need to balance a lot of different risks. Managing credit and duration risk is a paramount concern. These two factors are often put aside in the quest for yield and income. But what if there was a way to have your cake and eat it too?
Short-term junk bonds could be the answer.
The best part is that short-term junk is currently providing higher yields than long-dated junk,which features greater default risk. For investors, this could be a once-in-a-lifetime opportunity to boost income potential without taking on much risk to do so.
A Great Set-up
To say the current environment is a bit weird for bonds would be an understatement. The combination of a slowing economy, still-high inflation, and high interest rates has created unique experiences for many fixed income asset classes.
Because of the recession risks, the yield curve remains inverted. Investors have flocked to the safety of bonds. This has driven down yields on longer-dated maturities. However, the Fed has been forced to keep rates high to combat inflation. This has had the effect of boosting yields on short-term bonds and cash.
For high-yield bonds, this has created a particularly interesting equation.
Right now, yields on shorter-term junk bonds are paying more than long-term junk bonds. This chart from AllianceBernstein shows that investors looking at yields for junk bonds maturing in the next five years can score over 8%. However, moving beyond that point, the yields begin to dip as low as 6.5%.
Source: AB.com
More Income With Less Risk
What’s special about this inversion is investors are essentially being paid more to take on less risk.
Short-term bonds are created one of two ways. They can either be bonds issued with short lengths or be longer-term bonds with only a few years or months left before they mature. For Treasuries, there is not a real default risk difference between a three-month T-bill or a 10-year bond. Uncle Sam is good for the money. It’s more about interest rate risk in this scenario.
However, for a company, the longer the timeline, the greater the chance that events can impact cash flows or cause a default. The odds of a firm defaulting over the next year or so is much lower than the odds of defaulting over the next five or ten years.
This fact shows up in data. Looking at defaults in the Bloomberg U.S. Corporate High Yield Index, BB- and B-rated junk defaulted just 0.29% and 1.14%, respectively, over a one-year period. Those default numbers jump to 3.71% and 13.47%, respectively, over five years. There’s more time and more potential for impacts.
Those lower default rates come into play when looking at recessions and downside risk. Looking at every major market decline/event over the last 20 years—the Great Recession, the Pandemic, Debt Ceiling Debates, and even the recent inflationary period—short-term junk bonds have only experienced 63% of the average monthly drawdown of the broader Bloomberg U.S. Corporate High Yield Index. The best part is that they managed to capture more than 88% of the index’s upside. Investors were well protected from losses, while still experiencing the sector’s gains. 1
The inverse is true as well. Like all junk bonds, short-term ones still benefit from a strong economy. If and when the Fed cuts interest rates, the growing economy should boost the ability of junk issuers to keep paying their bills. As a result, prices of short-term junk bonds will increase and once again create a more regular yield curve.
For investors, this means that they can lock in high yields with less risk, reduce their downside losses, and have the potential for capital gains as the economic environment plays out.
Going Short With Your Junk Bonds
Overall, short-term junk bonds can offer the best combination of risk and reward. There’s low default risk, low duration risk, as well as a much higher yield than other forms of risky debt. That could be a win-win-win for income seekers. As such, it may make sense to build out an allocation to short-term junk.
Getting that allocation is best through ETFs or a mutual fund. Thanks to the fact that they trade on the OTC exchanges, bid-ask spreads for junk bonds can be wide. This can cause extra costs and lessen the yield on the bonds. As such, it pays to let a pro do the work. And speaking of those pros, high-yield bonds remain one of the areas that benefits from active management. Credit research can play a big difference in returns.
Short-Term Junk Bond ETFs
These funds were selected based on their allocations to short-term junk bonds. They are sorted by their YTD total returns, which range from 0.4% to 3.3%. They have expense ratios between 0.30% and 0.98% and have assets under management between $27M to $5.54B. They are currently yielding between 3.9% and 7.8%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| FHYS | Federated Hermes Short Duration High Yield ETF | $27M | 3.3% | 6.3% | 0.51% | ETF | No |
| SHYG | iShares 0-5 Year High Yield Corporate Bond ETF | $5.54B | 2.9% | 7% | 0.30% | ETF | No |
| HYS | PIMCO 0-5 Year High Yield Corporate Bond Index ETF | $1.22B | 2.6% | 7.8% | 0.56% | ETF | No |
| IBHG | iShares iBonds 2027 Term High Yield and Income ETF | $96M | 2.4% | 6.8% | 0.35% | ETF | No |
| SJNK | SPDR Bloomberg Short Term High Yield Bond ETF | $4.55B | 2.3% | 7.6% | 0.40% | ETF | No |
| SJB | ProShares Short High Yield | $114M | 0.4% | 3.9% | 0.98% | ETF | No |
Overall, short-term junk bonds can provide investors a great combination of yield and lower risks than other non-investment-grade debt. For portfolios, adding a dose of these bonds can do wonders for income without taking on much more default risk. The time to move into the sector is now.
The Bottom Line
Right now, fixed income investing is a difficult proposition. However, short-term high-yield debt could be the answer to investors’ woes. Featuring high yields, low duration risk, and the potential to outperform if either recession or expansion happens, investors should consider the bond asset class.
1 AllianceBernstein (May 2024). What’s Up with Short-Maturity High-Yield Bonds? Yield.
