As Treasury yields surge, high-yield maturities shorten

Fri Feb 8, 2013 12:20pm EST

Feb 8 (IFR) - The recent rise in Treasury yields has led to a surge of interest in shorter-dated debt in the high-yield market, as investors look to protect themselves from duration risk.

In the past couple of weeks, a variety of issuers have responded by pricing five- or six-year bonds with call dates of around two years or three years, at which point the company is allowed to redeem the bonds at a specified call price.

These shorter-maturity notes compare with the more typical high-yield maturities of eight-year non-call four, or 10-year non-call five.

"Issuers are playing to the appetite of the market, and that is not for longer-dated fixed income securities at these extremely low yields," said Dan Heckman, senior fixed income strategist at US Bank Wealth Management.

The average yield-to-worst hit 5.61%, its lowest point ever, on January 24, but has since widened to 6.01% as the market has reacted to rising Treasury yields.

Buy-side participants have been refocusing their strategy in both the secondary and primary markets to adapt to the changing climate.

"Investors need to be careful and dance around the higher risk areas of the market from a credit and duration perspective," said Heckman.

"It doesn't take much of an uptick in default rates for high-yield to be affected. It's a very touchy time in the bond market. We would be shortening duration here and taking a little bit of a breather until we see a better buying opportunity."

SHORT AND GETTING SHORTER

The shorter tenor made up almost half the deal flow last week. Of the 38 tranches priced across the globe, 17 had five-year to 6.5-year maturities.

That included US dollar deals for NCL Corporation, Talos Production, Permian Holdings, Nord Anglia Education, Global A&T Electronics and Beazer Homes.

This week, Canadian waste management company Tervita Corp priced a Canadian/US dollar split currency offering that will mature in 5.75-years, callable in 2.75 years.

Cantor Commercial Real Estate priced a US$250m five-year non-call two senior unsecured offering. Alliance Grain Traders came with a five-year C$125m private placement offering, priced yesterday, with the call structure revised to three years instead of two.

No surprise either, that short-duration bond funds are also growing in popularity. These funds have an average maturity of around two to 2.5 years.

Ultra-short bond funds, with average maturities of less than a year, are also available. These typically offer higher yields than money market instruments with less price volatility than a typical short-term fund.

David Sherman, founder of Cohanzick Management, manages the RiverPark Short Term High Yield fund, which has an average maturity of less than six months. The fund targets investors seeking a very limited interest-rate risk. It has generated a 4% annual return since its inception in September 2010.

Sherman expects that if interest rates go up gradually, high yield will perform better than other areas of fixed income.

"Even though junk-bond yields are at historic lows, the spread over central bank manipulated Treasuries is reasonable and should provide some cushion in a rising rate environment."

Still, investing in this area it is not entirely without risk.

"If you don't manage it appropriately, there is a lot of risk being involved in a short-duration fund," said a short-duration fund manager. "You can't just say short duration is a flight to safety. The flight to safety is picking the right bonds."

Of particular concern is the risk of a default scenario. Assuming an appropriate yield curve, a shorter-term bond would typically trade at a much higher dollar price compared to a longer-term bond in the same complex. In a recovery, this means that there is far more downside for the short-term paper.

"If you pick the wrong bonds, you are going to get destroyed," said the fund manager.

With the Fed keeping rates so low, the yield curve for high-yield is a lot steeper than usual and so high-quality, short-duration high-yield paper comes with a lower yield.

"It may not be as attractive as it used to be from a yield standpoint but you have considerably less Treasury risk, which is compelling for investors in this environment," said Michael Anderson, chief high-yield bond strategist at Citigroup.

One banker said he has seen a spike in interest for new five-year issues among short-term investors because of the current tight secondary spreads.

"Some of this short-term debt, which includes yield-to-call paper, is hard to find or get at a reasonable price, so short-term managers are finding value in the primary market.

"With these shorter maturity new issues, we're seeing a whole different buyer base," he said.

While five-year paper has spiked in recent week, the average maturity of the high-yield market has shown a steady decline since the credit crisis as the overall appetite for risk faded.

Sherman of Cohanzick said this suggests that the performance of short-term high-yield funds should be more correlated with the overall high-yield market than in the past.

According to the BofA Merrill US high-yield index, the average maturity in the high-yield market has dropped from a decade high of 8.5 years in late 2005 to the current average of 6.5 years. When adjusted for bonds trading to the yield-to-worst call date, the average maturity drops to 5.25 years.

Ultimately, though, bankers don't expect the five-year non-call two deal to become standard.

"In markets that are constructive and good, issuers always want to go longer," said the high-yield banker. "If the Treasury environment got worse, you might see more of these short-term deals, but if things calm down, the credit environment is fairly strong and issuers will keep on going with the eight-year and 10-year deals."

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