A bond allocation is like a railroad. Credit is the locomotive that generates high returns, duration the track that keeps the train in line. Take the track away and you risk running your portfolio into the ditch. That’s why duration-hedged credit strategies are dangerous.
Few things worry bond investors more than rising interest rates. We get it. When interest rates rise, bond prices fall. So it’s not hard to see why a strategy that lets investors keep their bonds and the income they produce while losing the duration, or exposure to interest-rate changes, would seem like the perfect solution.
It isn’t. You may do a little better when interest rates go up. But you’ll do a lot worse when they go down.
Gain a Little, Lose a Lot
For example, a duration-hedged credit approach may outperform when the credit cycle is in its late stages and interest rates are rising but growth remains strong. This is as close as it gets to a Goldilocks scenario for credit assets, and if it sounds familiar, that’s because it’s where we are today.
But this strategy will do a lot worse when the cycle ends and higher rates start to slow growth. We think we’re getting closer to that point. Slower growth and higher rates can lead to higher debt defaults and large credit asset drawdowns. In a slowing-growth, falling-rate environment, it’s portfolio duration that outperforms and provides a cushion against credit-related losses.
Consider what would have happened during the 2008 global financial crisis. The broad US high-yield market, which is predominately sensitive to credit risk, was down 26% that year. That’s bad enough. But if you had eliminated the duration that high-yield bonds carry, your losses would have exceeded 34%. In 2011, the year of the European debt crisis, the US high-yield bond market returned 5%. Duration-hedged high yield? It was down 2.6% (Display 1).
What’s more, hedging out duration exposure often involves making leveraged bets in the interest-rate futures market. That can supercharge a strategy’s risk. To avoid disaster, a duration-hedged investor would have to be able to time perfectly the movement in interest rates and know when higher rates would finally start to slow growth. She might get it right once. But not even the most seasoned professional could pull that off on a regular basis.