Yields on junk bonds are near record lows. But their expected lifespans are shrinking fast, causing some investors to see a surprising amount of value in the lower-rated debt.
The two circumstances are connected.
Since the end of 2018, a global fall in bond yields has pushed investment-grade companies to try to lock in low borrowing costs for as long as possible—increasing the average time until their bonds mature, even as the average interest rates on their debt has declined slightly.
In the speculative-grade world, though, bonds aren’t expected to last as long as in the past. That is because junk-rated bonds, unlike investment-grade bonds, typically can be redeemed, or called, before their maturity date—an option that companies are increasingly likely to take advantage of in order to replace older bonds with new, lower-coupon debt.
These trends can be summed up in a single measurement known as duration.
Much obsessed over by debt investors, duration technically measures how the present value of a bond’s future cash flows—a sum that equals the bond’s market price—is apportioned over time.
Bonds with longer maturities or lower coupons have longer durations because investors need to hold them longer to earn back their original investment. The opposite is true for bonds with shorter maturities or higher coupons.
Over the past two decades, average durations have generally been increasing for investment-grade bonds and shortening for speculative-grade bonds.
That trend has recently accelerated. Since the end of 2018, the average investment-grade bond duration has climbed 13% to 8.02 years, while the average speculative-grade bond duration has dropped 24% to 3.00 years, according to Bloomberg Barclays data.
All else being equal, longer-duration corporate bonds are riskier than shorter-duration bonds because there is more time for their value to be hurt either by rising interest rates or a downturn in a company’s financial performance. As a rule of thumb, a one-percentage-point increase in a bond’s yield also causes a decline in a bond’s price equal to its duration—making prices of long-duration bonds more volatile than those of shorter-duration bonds.
As of Thursday, bonds in the Bloomberg Barclays U.S. high-yield index yielded 5.17% on average, close to the all-time low of 4.83% set in June 2014. But the average duration of the index is also a little more than a year shorter than it was 5 1/2 years ago.
Of course, most speculative-grade bonds still are riskier than investment-grade bonds because there is a greater chance they could default. The question for investors is whether the lower-rated bonds offer enough yield to compensate them for that added risk, while also accounting for factors such as duration.
In a recent report, analysts at Bank of America Corp. noted that the gap in yields between bonds at the bottom rung of investment grade and those at the top rung of speculative grade is narrow by historical standards, but significantly less so when adjusted for the changes in duration.
“The takeaway for investors is that if you are looking for more spread, or more yield,” it might make sense to consider the speculative-grade bonds, said Yuri Seliger, one of the authors of the report.
The average duration of investment-grade bonds has increased as successive companies have refinanced their debt. On Sept. 3, for example, Deere DE -1.13% & Co. sold $500 million of 30-year bonds to help repay $750 million of bonds that were due in October. The new bonds were issued with a 2.875% coupon—well below the 4.375% interest rate of the bonds they replaced. They were also unusual because Deere typically sells bonds with maturities of 10 years or less.
The duration of speculative-grade debt, meanwhile, can shift significantly even without new bonds entering the market.
The duration of Charter Communications Inc. CHTR -1.65% 5.125% unsecured bonds due in 2027 dropped sharply last summer as its price increased from a little under par to around 105 cents on the dollar, according to AdvantageData.
The rising price of the bond, and corresponding falling yield, could push Charter to replace it with a lower-coupon bond as early as 2022 rather than at maturity five years later. As a result, its duration, by one calculation, fell from roughly six years to less than three years.
Some investors caution that the durations of speculative-grade bonds could increase quickly if demand for the debt softens, pushing yields higher and reducing the chances that companies will redeem bonds early.
Still, Michael Collins, a senior portfolio manager at PGIM Fixed Income, said the shortening durations of speculative-grade bonds was one factor supporting his relatively positive view of the asset class.
“If you adjust for that difference in duration, valuation-wise it’s relatively attractive,” he said.
Write to Sam Goldfarb at [email protected]j.com