Extension risk in the high-yield market, measured as difference between the duration to worst and duration to maturity, is at highest recorded level – and the coronavirus could trigger that extension.
Credit markets performed strongly in 2019, with global high yield returning nearly 15%. Widespread economic uncertainty soured appetite for growth assets and interest rates hit all-time lows, creating a positive technical backdrop for credit – emphasised by the stock of negative-yielding fixed-income assets hitting a record high of $17tn during the year.
Given this performance, many bonds have rallied to trade to their next call date rather than maturity. Securities that were previously analysed in the context of seven-to-10 years to maturity are now seen as having one-to-three years to call, therefore reducing the duration of the market and dampening volatility (see figure 1).
Figure 1. At the limit: extension risk in the high-yield market
Source: Hermes Credit, ICE Bond Indices as at January 2020.
This is exacerbated by several other factors: first, the record-low interest-rate environment has suppressed coupons; second, the large number of rising stars in recent years reduced the volume of longer dated bonds and non-callable bonds; third, non-call periods have generally shortened in the past few decades.
What can credit investors do? Focusing on the more liquid sections of the market, an intensely active approach combining top-down and bottom-up views is an appropriate course of action, in our view.
This relays important lessons. Unconstrained top-down allocation allows investors to avoid areas of the market with acute problems, like European high yield at the moment, in favour of others, like the US and emerging markets. Second, heightened extension risk currently makes security selection extremely important, and investors should be mindful of misleadingly low volatility when sizing positions.
Such considerations should come naturally to active credit investors. How deeply they are investigated is a question of conviction.