Add Yield and Manage Extension Risk in Today’s Low Interest Rate Environment
Brian Ellis, CFA, Fixed Income Risk Analyst
Vishal Khanduja, CFA, Fixed Income Portfolio Manager
This December will mark the five-year anniversary of the Federal Open Market Committee's (FOMC's) adoption of its zero-interest rate policy (ZIRP), which has kept short-term interest rates between 0% to 0.25%. As the Fed extends this policy, paltry yields continue to plague fixed-income investors, particularly at the front end of the yield curve. While we expect the Fed to slow the expansion of its unconventional monetary policy tools (like quantitative easing), we think it will be at least 12 to18 months before it increases short-term interest rates.
Four Methods to Pick Up Yield.
Investors seeking to protect themselves from rising interest rates can do so by utilizing short-duration strategies, which are less sensitive to changes in interest rates than longer-duration strategies. However, with the benchmark two-year Treasury recently yielding 0.35%, many look for additional ways to enhance this yield while maintaining a principal protection focus. We suggest four primary ways to enhance yield in a short-duration portfolio:
- Increase portfolio duration, and therefore its sensitivity to the absolute level of interest rates.
- Adjust yield curve positioning by stretching for yield into longer maturities.
- Increase credit exposure, either by lengthening spread duration1 or increasing the allocation to lower-quality assets such as below-investment-grade securities.
- Increase the allocation to negatively convex2 assets, such as structured/securitized assets3 which must compensate investors for the uncertainty inherent in the timing of cash flows.
These four methods are all tried and true, but can increase portfolio volatility and tracking error against a passive benchmark. They can, however, add significant risk-adjusted value in certain market environments when managed conservatively.
The challenges of today's very low interest rates are compounded by lengthening durations—a natural mechanical issue with bonds. This makes further extending duration or curve positioning a difficult proposition. Compared to past market cycles, today, increased price volatility exposure must be taken on to pick up the same amount of yield. On the other hand, credit spreads across many sectors remain above pre-crisis levels, and against a backdrop of a slowly improving economy, remain attractive in our view. Securities with credit risk tend to be less sensitive to changes in interest rates than Treasuries due to their embedded credit spread, which provides a cushion against rising yields.
Our view of under-compensation for duration risk, and our constructive view on credit spreads, formed the basis of Calvert's Thincome campaign (learn more at http://www.thincome.net/). Thincome reflects our view that in the current environment, investors taking incremental credit risk are likely to be better rewarded than those taking incremental duration risk. Our investment strategy across Calvert's fixed-income funds has followed this approach, leading us to favor options three and four above.
What Is Extension Risk?
Extension risk occurs when securities with call or prepayment options delay their expected call dates or prepayment speeds and effectively extend the expected maturity or duration. In rising interest rate environments, extension risk is a critical factor to consider, particularly in shorter duration strategies. While this risk is most often associated with the mortgage-backed securities (MBS) market, it is also common in the asset-backed securities (ABS) market and with corporate and non-corporate securities that have embedded call options.
Securities backed by collateral, such as MBS and ABS, often allow borrowers to pay down, or "prepay," principal faster than scheduled. Prepayments typically rise in declining interest rate environments as borrowers refinance their loans, and fall in rising rate environments as refinancing become less attractive. Therefore, the duration of these securities tends to shorten as interest rates fall, and extend as interest rates rise. This is known as "negative convexity," and explains why these securities typically underperform comparable duration securities in other sectors, such as Treasuries, during periods of high-interest rate volatility.
To a somewhat lesser extent, callable securities can also have extension risk. This is common, for example, in corporate high-yield securities that are callable and trading at a premium. As interest rates rise or credit-spreads widen, the security price may fall below its next call price, causing the security to trade to a further call date or final maturity.
This year's sell-off in bonds that began in the second quarter provides a good example of duration extension across fixed income sectors. From May 1 to July 5 of this year, the benchmark ten-year Treasury yield rose by 111 basis points from 1.63% to 2.74%. Credit spreads also widened. In Chart 1, we illustrate the resulting percentage duration extension between the two dates, by holding the universe constituents constant between the two dates. Not surprisingly, MBS extended the most by 48% and High Yield next at 7%.Commercial- property-backed MBS (CMBS), ABS, investment-grade credit, and Treasuries all shortened, however.
Source: Barclays POINT, CIM Analysis. Barclays U.S.Securitized Index used for MBS, CMBS, and ABS sectors. US HY Index, US Credit Index, US Treasury Index.
Managing Extension Risk.
When managing fixed-income portfolios against passive benchmarks, which typically have positive convexity, there are two primary strategies to limit extension risk. The first and easiest strategy is to limit outright exposure to assets with negative convexity. A second and more complex strategy is called dynamic hedging. This strategy involves consistently hedging the revised duration of the security as it shortens or lengthens. In shorter-duration strategies, successful dynamic hedging can allow portfolios to hold longer duration and more negatively convex assets. However, choosing the exact hedge ratio can be challenging and can prove ineffective during periods of high volatility. Whichever strategy is used, good risk-management systems are critical to successfully managing this risk.
Limit Exposure to Extension Risk.
Limiting outright exposure is our primary strategy in all Calvert fixed-income portfolios, which focuses us on the short- and floating-rate ABS and CMBS markets. While we at times recognize relative value opportunities in longer duration and more negatively convex securities, such as residential-property MBS (RMBS), we believe the greater extension risks are inappropriate for the overall risk profile in shorter-duration portfolios. As a result, these assets are not a core part of our portfolio strategy, especially in shorter- duration strategies.
Move Up in Credit Quality and Shorter in WAL.
Prepayment speeds in ABS securities, such as those backed by automobile loan receivables, tend to be less sensitive to changes in interest rates; and instead, sensitive to credit fundamentals. We prefer to invest at the most senior part of the capital structure in these deals for short-duration strategies. For example, within automobile ABS, we currently tend to favor deals backed by subprime collateral, but invest in the senior tranches, which have high credit enhancement and shorter weighted-average lives (WAL). Floating-rate CMBS deals also fit well in our shorter-duration strategies, as extension options to the borrower are mitigated by the floating-rate nature of the security. In addition, many deals have built-in step-up schedules that increase the security's coupon if the borrower exercises an option to extend the underlying loan, helping to mitigate the negative impact from any extension.
Watch High-Yield Price Premiums.
Corporate high-yield securities that are trading at high dollar prices and close to their next call strike price can have extension risk. The potential for this downside is compounded further by the increased cost of extending in duration against steeper high-yield-credit curves, particularly lately. Good risk management techniques and credit analysis can help mitigate this risk, especially on callable securities trading at a premium. Since the prices of high-yield securities are typically driven more by credit fundamentals and less by interest rates, both credit spreads and interest rates need to be considered with premium bonds. For example, we monitor the interest rate sensitivity of higher quality, high-yield securities and hedge out their interest rate risks as appropriate.
Diversify High Yield Exposure with an Allocation to Leveraged Loans.
In addition, as part of our investment theme of garnering yield without adding measurable interest rate risk, we favor an opportunistic allocation to leveraged loans. Loans typically pay coupons in the form of a fixed- credit spread over a floating-interest-rate index, often the London interbank offered rate (LIBOR), and can be repaid in whole or in part at any time by the borrower. Loans do have negative convexity characteristics as credit spreads tighten, contributing to repayment risk. However, the floating-rate feature effectively keeps the interest rate duration very low for loans, often near zero, hence providing a natural hedge against rate-driven volatility and rendering extension risk less of a concern. The early redemption feature of loans, while limiting the price appreciation upside, also helps mitigate the meaningful downside and extension risk that may accompany a high-yield bond trading at a high dollar price to a call date, against a rising interest rate backdrop.
As of August 31, 2013, weightings in the Calvert Ultra-Short Income Fund and Calvert Short Duration Income Fund were as follows:
|Calvert Ultra-Short||Calvert Short Duration|
For additional details about the funds, including the most recent performance, holdings and expense information, visit Thincome.net or view the fund profile for Calvert Ultra-Short Income Fund and Calvert Short Duration Income Fund.
Investment in mutual funds involves risk, including possible loss of principal invested.Bond funds are subject to interest rate risk and credit risk. When interest rates rise, the value of fixed-income securities will generally fall. In addition, the credit quality of fixed-income securities may deteriorate, which could lead to default or bankruptcy of the issuer where the issuer becomes unable to pay its obligations when due. High-yield, high risk bonds, which are rated below investment grade, can involve a substantial risk of loss because they have a greater risk of issuer default and are subject to greater price volatility than investment-grade bonds. The mortgage-backed and asset-backed securities in which the funds invest are subject to risks, such as those described above. In addition, leveraged loans, which are usually more credit sensitive than investment grade securities, may be thinly-traded or illiquid, and are also subject to the risk that the collateral, if any, securing a loan may decline and be insufficient to meet the obligations of the borrower. Each of Calvert Ultra-Short Income Fund and Calvert Short Duration Income Fund are non-diversified and may be more volatile than a diversified mutual fund.
1. Spread duration is a measure of fixed-income portfolio sensitivity to a change in the relative value of the credit-risk securities held compared to duration-matched Treasuries.
2. Convexity measures how far the duration measure is expected to drift from the actual portfolio behavior for larger changes in interest rates.When this effect is expected to be beneficial it is called positive convexity.When it is expected to be detrimental it is called negative convexity. Investors demand additional yield to compensate for negative convexity.
3. Securitized/structured assets are investments that are backed by pools of collateral.Examples of such collateral include residential and commercial mortgages and auto loans.Simple securitizations include widely-held agency-backed MBS.Structured assets are more complex and typically feature several tranches tailored to investor needs.Traditional examples are collateralized mortgage obligations (CMOs) backed by agency MBS.