28 Sep Risk-Reward Tradeoff in HG Corp
Reinhart Partners Corporate Only Objective
Reinhart Partners Corporate Only portfolio is designed for investors who desire the extra yield available in corporates over a more broad market strategy including Treasury and Agency securities without taking excessive credit risk. To achieve this objective, Reinhart Partners invests in a portfolio of high quality, investment grade corporate securities, severely underweighting the BBB sector of the corporate universe.
How much does BBB underweight cost?
Underweighting BBB securities accomplishes the goal of reducing credit risk, but at a cost. BBB securities typically yield more than higher quality bonds. Chart 1 shows the effect that relative weighting differences (left scale) have on portfolio yield (right scale). As can be seen, the portfolio maintains an underweight to each BBB sector, and each underweight corresponds with a reduction in portfolio yield. For example, the Reinhart portfolio holds a 3% position in BBB industrials while the benchmark contains 35%, a relative underweight of 32%. This underweight results in a 40 basis point reduction is portfolio yield. Obviously, some of the reduction in yield due to BBB underweights is offset by overweights in higher quality securities. However, the end result of building a portfolio with high credit quality is approximately a 20 basis point reduction in total portfolio yield.
What about security selection?
A second important consideration when building a high quality portfolio is security selection within each sector/quality allocation. As can be seen in Chart 2, bonds held in the Reinhart portfolio have a lower average spread (and correspondingly higher credit quality) than bonds in the benchmark. Similar to the underweighting of BBB securities, this focus on high quality issuers provides protection from shocks to the corporate sector, but comes at a cost. Currently, the emphasis on quality within each sector/quality bucket reduces portfolio yield by around 22 basis points.
The Reinhart Partners Corporate Only portfolio realizes its objective of providing yields in excess of similar strategies which include Treasury and Agency bonds while still providing the protection achieved by investing in high quality.