Columbia Threadneedle: High yield bonds - focus on maturity over duration

High yield bonds can offer a superior yield to investment grade credit and sovereign bonds such as German bunds and gilts – something that makes them an interesting investment opportunity, even in today’s interest rate environment.

A majority of high yield bonds are “callable”. This means that at predetermined points in time, before they ultimately mature, the issuer can “call” back the bond, repaying the bondholders, typically at a premium. For example, a bond with a maturity of 10 years might be callable after five years. The duration of such a bond is priced to the call date if there is an expectation that the bond will be called at that period in time.

But if interest rates are rising and the bond price falls below its call price, the issuer may choose not to call the bond. In practice, this can lead to an extension of the bond’s duration or interest rate sensitivity just at the wrong time – in a falling bond market, where yields are rising. As a result, the fall in the bond’s price can accelerate.

For this reason, we focus on a bond’s maturity rather than duration when managing risk in the Threadneedle European Short-term High Yield Bond strategy. This removes the unpredictability of duration extension risk, giving this strategy lower interest rate sensitivity than a standard European high yield bond strategy.

Explaining duration extension risk

Callable (or redeemable) bonds give the issuer the right to redeem the bond prior to its scheduled maturity date, effectively shortening the bond’s expected maturity and duration. These bonds benefit issuers in that they give them the option to pay off the debt early and refinance at lower costs if interest rates fall.

So when bond yields are rising, during a sell off, the call dates on callable bonds become less likely to be triggered. In such a scenario, investors who thought they had a bond due to be redeemed at the call date in three years can, for example, suddenly find they are holding a bond that will likely remain in existence until maturity in five years with a corresponding impact on the bond’s price.

This is exactly what happened in the 2022 market sell-off. Callable bonds were not called, which lead to a duration extension just when one least wanted it. For us, focusing on the bond’s maturity date (and not the call date) from the outset made our strategy’s desired risk and performance profile more predictable. This allowed the fund to outperform the market by 180 bps (-4.3% versus -6%), as well as in 2023 during a falling yield market (+10.6% versus +10.3%)1.

In 2023, and more recently in 2024, the call feature has been used by issuers, even at these higher refinancing costs. This is due to a focus on managing their maturity wall in order to prevent maturing debt from becoming current and potentially attracting the wrong kind of market attention.

Avoiding unexpected volatility

In an environment where falling yields are expected, investors are often lulled into a false sense of security, making little distinction between short duration and short maturity. It is only when volatility suddenly picks up, perhaps due to an uncertain environment, and a bond market sell off is possible – causing a callable bond’s duration to sharply extend – that the difference between short maturity and short duration is fully comprehended. By then, it is too late.

High yield may still offer an attractive source of return in today’s environment. But we believe that targeting callable bond maturity rather than duration is the best way to harvest this yield – and avoid any unexpected volatility and yield curve risk.