Yield Per Unit Duration: It Turns on How You See It

We look at yield per unit duration across the credit tiers focusing on current levels vs. the end of ZIRP in March 2022.

• We look at the yield per unit duration measure for the credit tiers from early March 2022 before ZIRP ended vs. the current market to see how the whole package of risks frame up in yields/duration from AAA to CCC.

• The IG yield/unit duration metric has risen more than US HY in a market where arguably the cyclical risks are greater, but the yield curve backdrop remains subject to a lot of debate on what form the UST curve shape shifting will take next.

• HY is for now in that zone between past highs and lows which we revisit in this note, but HY is not yet drifting into the rich range seen in other cyclical peaks when recessions were being debated.

In this commentary, we do the simple exercise of framing the yield per unit duration across the credit tiers. We look at the IG and HY index (ICE BofA) and the tiers from AAA to CCC. We reviewed the yields and duration and did the simple math. Our goal is to make a few points that have come up in the past with clients during periods where either spreads or the UST curve (or both) were moving quickly or were vulnerable.  

Like most line items in bond data (yields, spread, duration, relative returns) there are always patterns across expansions/recessions and various credit cycles worth considering. We have used this yield/duration metric in the past for a snapshot of how the relative yields frame up vs. the major items in the basket of risk – credit risk and interest rate risk.

We compare the Friday close (2-17-23) to the pre-ZIRP days of March 1, 2022 before the inflation fight was in high gear as the top priority. What followed was the yield curve going through its painful upward migration and moving the needle on both yields and duration.  Duration adjusted yields for US IG more than doubled while US HY climbed by 1.7x.

The US HY market went from looking cheap vs. IG in March 2022 to more recently drifting in the middle ground vs. the IG market in Feb 2023. Spreads in both US IG and US HY are below long term medians right now, and the market is wrestling with how the long end of the UST curve (10Y, 30Y) could react in the periods ahead as more Fed policy action and inflation trends become clear.

The idea behind the yield per unit duration metric is pretty basic. We often compare the yields of IG bonds vs. HY bonds as a relative return vs. relative risk proxy. We would hear from some clients “What about duration adjusted” so we started doing it.  Since the performance of a bond is tied to both credit risk premiums (and which direction they head) and interest rate risk (duration), both major risk components are in the equation here.  The investor can ask a few questions in looking at these numbers:

• Will the economy stay in hotter mode, leading to more tightening and giving us a fresh dose of pain to duration? That favors US HY.

• Will Fed tightening continue even more than expected on inflation worries into the high 5% or even 6% area? The effects there depend on the HY spread reaction to the Fed and how the long end of UST reacts. We would vote with IG on that one.

• Will the additional tightening and worsening inflation in a stronger economy and shifting inflation expectations moving higher on the long end cause a bear flattener of the UST inverted curve?  That favors leveraged loans and US HY.

• Is the more likely path more like the Fed’s current game plan with a few hikes and a slowdown that rewards duration as the curve moderates and hits credit risk via spread widening and quality spread decompression? That favors IG vs. HY.

• Will the slower growth or demand weakness and weaker employment scenario bring a bull flattener from the front end as the inversion gets scaled back? How will the curve shapeshifting play out in such a scenario? That favors IG in our view, but the HY index duration benefits would not be insignificant in a potential bull steepening if the moves cause a harder landing.

As we have discussed along the path in recent months, we favor US IG over US HY for returns in 2023, but there will be a lot of action and events to react to across the timeline ahead. So far, guidance and earnings season supports a constructive view of the US economy. So do the economic indicators with jobs at the top of the list.

The yield per unit duration metric can be viewed through the lens of some of these questions framing credit risk and spreads vs UST curve moves and duration. Some can also argue the liquidity premium matters (i.e., What is the correct HY securities liquidity premium in yields as you move down the HY tiers?). That liquidity premium exercise is often one of guesswork and weird science assumptions even if one goes through the quantitative dance while saying that all other things remain the same (which they never do).

We will stick with interest rate risk and credit risk items in the basket for this purpose. We recognize that interest rate risk is managed at the portfolio level and the thought process on credit risk often rolls up from the bond issuer level. In the end, this is just a drill and food for thought and another input for the pile.  

HY/IG as a metric sheds some light….

If we can add another metric and just take the ratio of US HY yield per unit duration divided by US IG index yield per unit duration, that one also has some relevance across time. As of Friday, the ratio of HY/IG was 2.6x, down from 3.4x to start March 2022. That 3.4x number in March was more reminiscent of weak periods in the US HY markets such as mid-2009 and Oct 2011 when systemic headlines were ruling the news flow. The interest rate risk factor was working in favor of duration in those days, but the spread volatility was set to support HY in both markets after earlier gapping out. The ratio was highest during credit cycle blowups and lowest during credit market peaks, but the worst of times sometimes took the edge off when monetary support would bring down the long end of the curve as well and reward duration. 

We have looked at more angles on the time series across the cycles for these metrics in prior lives, and the main takeaway was no big surprise.  The median across the decades of volatility and shifting backdrops was around 3x with HY sell-offs mixed depending on the monetary response and how that flowed through into the shape of the curve. A bad market such as Oct 2011 would be in the high 3x range, but the panic of early Feb 2016 hit 4.4x as HY OAS more dramatically spiked and oil was crashing. Redemption fear was in the air given how important E&P and leveraged shale players were in the index. We saw “the low of lows of 1.6x” in the credit peaks of 1997 but low to mid 2 ranges in early 2011 and early 2014 when HY markets were strong. 

Not surprisingly, the winner in outsized moves was during the COVID crisis when the ratio of HY/IG went over 5x by year end with the IG index under 2%. Initially, HY spreads spiked to a 3-23-20 high (1082 bps) and then the curve plunged on Fed actions and flight to quality.  The 4-handle ratio on 3-23-20 looked more like the ratio in Feb 2016 cited earlier when HY spreads had blown out on oil turmoil and some other setbacks.

The vaccine was in the headlines by Nov 9, 2020 while spreads were rallying. The UST index had dropped to 60 bps by the end of 2020. Strange times to the point where you need to double check your notes.

At the end of that fateful year of 2020, a new President was about to start his term with a UST index that was 60 bps away from “free money.” The fact that President Trump had been demanding negative fed funds rates out of “bunds envy” is often lost in the memory banks and political noisemaking. The bunds index stood at negative -60 bps at the Dec 2020 close or 120 bps lower than UST.  What followed is more recent history, but inflation was the result of a laundry list of imbalances and policy actions (or lack of actions early enough) that we have covered in other commentaries.

That post-March 2020 period was a market where interest rate risk and spreads were both rewarded as the fiscal and monetary relief ran up the score in both total returns and excess returns. Excess returns weighed in at a small positive for 2020 after running past -2500 bps of negative excess returns by the end of the peak panic day (3-23-20). Meanwhile, the UST returns for US HY in 2023 ran to almost 550 bps. The IG index saw duration rewarded by over 900 bps. That is a reminder that chaos has always presented the best opportunities in US HY.

So far in 2023, we see very little chaos despite the highest inflation since the Volcker years and the largest land war in Europe since 1945 hitting its 1-year anniversary. There are ample potential chaos scenarios ahead with China and Russia, but that’s not a new topic.