The world is running low on yield again. $15 trillion of global government debt has negative yields. U.S. bond yields have remained positive, but historically low.

This has left investors scrambling for yield. Per Morningstar and Preqin asset flow data, investors have made a clear decision. Intermediate investment grade, short duration investment grade, and private credit categories remain among the top of the list by a wide margin.

Historically high risks plague each of the 3 chosen asset classes. Investment grade bonds face historically high interest rate risk. Short duration investment grade bonds face sub-2% yields. Private credit faces historically high credit risk. For these reasons, investors should consider diversifying their credit portfolios with an overlooked asset class: short duration BB-B rated bonds.

Credit fundamentals and flows as of 9/30/19​​​
_{As of 9/30/2019. Source: Morningstar Direct, Preqin. Asset Flow Categories: Morningstar Institutional Mutual Funds, Preqin Private Credit.}

Short duration BB-B rated bonds remain overlooked, having not been flooded with recent flows. As result, the bonds exhibit fundamentals in line with historic norms, not at the extremes of more popular asset classes.

An overlooked anomaly, short duration BB-B bonds provided durable income over the last 2 recessions while participating in the upside of ensuing bull markets. The bonds exhibited investment grade-like downside with a speculative grade-like upside, which we believe are ideal characteristics given current market uncertainties.

Last 20-year growth of $100 and performance by asset class

_{As of 9/30/2019. Source: Morningstar Direct. Indices: ICE BofAML BB-B 1-3 Year, ICE BofAML Corporate, ICE BofAML Treasury, BbgBarc Aggregate Bond, BbgBarc Aggregate Bond 1-3 Year, S&P 500.}

The short duration BB-B anomaly exists for 3 reasons and doesn’t appear to be going away anytime soon. We believe the bonds will continue to be overlooked.

1. High Yield Investors Seek Higher Yield: As maturity approaches, bond yields move incrementally lower, deemed less risky by the market. This makes them less attractive to high yield funds, who sell or avoid the lower yielding bonds.
2. Rating Agency Maturity Inefficiencies: rating agencies don’t distinguish between short and long maturity bonds from the same issuer. A short maturity bond may exhibit investment grade risk, yet receive a speculative rating due to the issuer’s longer-term bonds. This typically results in less interest from investors.
3. Large strategies and ETFs can’t scale a $150bn bond market: The larger the AUM, the smaller the investment opportunity. Large strategies can’t target $500mm issues (ICE BofAML BB-B 1-3 Yr Index median issue size) and maintain liquidity, opting instead to avoid or expand the space to 5+ year maturities and CCC ratings.​​​​​​  

BB-B vs Aggregate Short duration return by calendar year

_{As of 9/30/2019. Source: Morningstar Direct. Indices: BbgBarc Aggregate Bond 1-3 Year, ICE BofAML BB-B 1-3 Year.}

Aggregate bond market exhibiting low yield and high interest rate risk
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_{As of 9/30/2019. Source: Bloomberg. Index: BbgBarc Aggregate Bond.}

The result of these industry dynamics is an asset class exhibiting favorable risk-return characteristics, targetable by smaller and disciplined investors. Given the historically high risks of the fixed income market, short duration BB-B rated bonds should be considered within a diversified portfolio.

For more information on the topic, our research can be found here.