Navigating the Storm: A Deep Dive into the Rocky Debut of Short-Term Junk Bond Funds
The Tough Journey of a Short-Term Junk Bond Fund in a Challenging Climate
Every week, we’ll profile a high yield investment fund that typically offers an annualized distribution of 6% or more. With the S&P 500 yielding less than 2%, many investors find it difficult to achieve the portfolio income necessary to meet their needs and goals. This report is designed to help address those concerns.
The bond market has been a wild ride for nearly a year and a half now. The Fed’s aggressive rate hiking cycle effectively neutered Treasuries’ ability to act as a risk-off asset and sent long bonds to their worst calendar year performance ever. Even in 2023, when the Fed is likely to be entering the final phase of its monetary tightening program, Treasuries have still been volatile and yet to consistently behave as the safe haven they’ve historically been. On the plus side, yields are much more attractive today than they have been in years and are giving investors a true income option for their portfolios once again.
The corporate bond side, especially junk bonds, has been more interesting. They’re traditionally considered riskier than Treasuries, but they actually held up better during the bond bear. Credit spreads are still very low and investors have yet to really price in any credit risk, but that doesn’t mean they shouldn’t consider positioning themselves cautiously heading into what looks like a broader economic contraction later this year. The PGIM Short Duration High Yield Opportunities Fund (SDHY) mixes a comparatively decent credit quality profile with more modest duration risk and a diversified mix of exposures. It will still be vulnerable to a credit cycle downturn, but it could be a nice middle ground for income seekers looking to capture a high yield without overexposing themselves to downside risk.
Fund Background
SDHY seeks to provide total return through a combination of current income and capital appreciation by investing primarily in below investment‐grade fixed income instruments. It aims to maintain a weighted average portfolio duration of three years or less and a weighted average maturity of five years or less. It also employs a modest use of leverage in order to enhance yield and total return potential.
SDHY is a relatively new addition to the PGIM lineup, having only launched a little more than two years ago. It has roughly $420 million in assets, which isn’t a terribly large number comparing it to the rest of the CEF universe, but it’s enough to remain liquid for investment. The 23% leverage overlay is right within the range I prefer to see, making it high enough to deliver on its goal while not being so high that it becomes overly costly and risks being ineffective. The 1.75% total expense ratio isn’t terribly attractive, but it’s kind of the cost of doing business in the leveraged junk bond space.
While SDHY looks to remain below the 5-year maturity/3-year duration ceiling, it actually comes in well below both limits.
The maturity spectrum is split fairly evenly across the 1-5 year range, which provides a nice bit of diversification across exposures. The limited duration could be the big advantage here. High yield bonds and Treasuries have been highly correlated over the past couple years, but that’s likely to decouple in a deeper recession. When credit risk gets priced in, junk bond prices are likely to correct, perhaps significantly. Duration, of course, is a measure of interest rate risk, not credit risk, so it may provide limited benefit, but the idea of sticking on the short end of the rate risk curve is still likely the better choice.
While many junk bond CEFs are willing to delve pretty deep into low credit qualities to maximize yield, SDHY does a bit of a better job of managing risks.
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