Income investors have many decisions to make in their allocation process. One of these decisions is where along the yield curve to allocate their marginal capital.

Many investors approach this by using the concept of duration relative to today's yield on offer across the yield curve. Yield represents reward while duration represents risk, which together with a view on the issuer or type of security, can paint an adequate picture of the investment case.

However, this overly simplistic approach ignores a broader understanding of duration as well as concepts like reinvestment and capital gains risk. In this article we review this fuller approach and highlight a number of securities that look attractive at present.

Reviewing Duration

Many investors hold misconceptions about one of the key metrics in fixed-income: duration. Specifically, they view duration as existing on a single-spectrum from low to high. Low duration means low sensitivity to changes in yields and high duration means high sensitivity to changes in yields.

Investors with this view are often surprised when, supposedly low duration assets like bank loans, drop in price along with bonds when yields rise. The reality is that yields are composed of both risk-free rates and credit spreads which means that investors should really consider both credit spread duration and interest rate duration.

The following matrix breaks it down across both of these duration dimensions. As a technical sidenote, there are financial instruments with negative duration such as mortgage servicing rates or MSRs and interest-only CMOs or IOs however these are not typically directly accessible to retail investors, outside of relatively niche funds like (RISR).

Assets with low durations on both counts (i.e. low credit spread duration and low interest rate duration) are cash and short-maturity credit such as, say, corporate bonds maturing in a year or two.

Assets with high credit duration and low interest rate duration are various floating-rate credit assets such as bank loans, securitized assets and floating-rate bonds. These assets can be highly sensitive to changes in credit spreads but much less sensitive to changes in interest rates.

Technically, assets with low credit spread duration and high interest rate duration don't really exist. However, if we focus instead on credit spread sensitivity which is what we are after here then a good example of assets with low credit spread sensitivity and high interest rate duration are Treasuries, Agencies and high-quality bonds like Munis and some corporate bonds. This is because, while credit spread duration can technically be high, credit spread sensitivity can be low for high-quality assets because their credit spreads tend to widen only a bit in a drawdown.

Credit duration for Treasuries and Agencies is undefined rather than low because they don't have any credit risk (Agencies do have an option-adjusted spread over Treasuries however this is due to their negative convexity than anything else). Purists would object for Treasuries and Agencies to be included here but this is one of the rare cases where intuition trumps math. Assets in this quadrant are attractive in a period of relatively high interest rates and tight credit spreads such as the one we are going through now. These assets can be very resilient in a typical macro shock when rates tend to move lower but credit spreads move wider.

Finally, assets with high credit and interest rate duration are corporate bonds with longer-term maturities.

Gauging Risk / Reward

Investors looking to allocate across the duration matrix need to also consider several other factors. These factors include current compensation / yield, reinvestment risk and potential capital gains / losses.

Many investors consider cash or very short-dated assets as the absolutely no-brainer choice in the current market because the Treasury yield curve is inverted as the following chart shows.

It is true that in many cases short-dated exposure can deliver a higher yield than longer-dated exposure. However, apart from current compensation across the yield curve we also need to consider reinvestment risk and potential capital gains / losses.

The downside of very short-dated assets is that their attractive yield can roll off very quickly. Specifically, if the Fed decides to move rates lower swiftly, the high short-term yields on offer will disappear. Investors who locked in today's lower yields for 2-3 years may actually end up generating a higher overall level of yield over that period than investors who stuck with very short-dated assets and then reinvested the proceeds into ever lower yields. And vice-versa, if the Fed leaves rates stable longer than the market thinks, short-dated assets can deliver more yield over the same period than longer-dated ones.

Turning to potential capital gains / losses, shorter-duration assets will be less sensitive to changes in yields than their longer-duration counterparts. If longer-term yields fall, perhaps if inflation moves lower more quickly than anticipated, longer-duration assets will outperform, generating capital gains for investors. And vice-versa, if inflation stalls here or even reverses higher, longer-duration assets will likely deliver capital losses to investors.

In short, all three components need to be taken into account - today's yield, reinvestment risk and potential capital gains / losses.

Some Ideas

Given the combination of an inverted yield curve and very tight credit spreads, short-maturity securities make a lot of sense to us in the current market environment.

These can include term preferreds such as those issued by CEFs such as the CLO CEF Mar-2026 XFLT Series A (XFLT.PR.A) and CLO CEF Dec-2026 Priority Income Fund Series H (PRIF.PR.H), trading at 8.1% and 8.6% yields.

A good example of the resilience of these relatively short-maturity securities can be seen below in a sister CLO CEF preferred OXLCM which is coming due shortly. The stock has not moved a whole lot since 2022, despite considerable volatility in most parts of the income market.

Similarly, short-maturity baby bonds also remain appealing. These include BDC bonds such as the Apr-2026 (OXSQZ) issued by BDX Oxford Square Capital Corp and the May-2027 (HTFC) issued by Horizon Tech Finance. Both of these trade at yields of around 8.3%.

On the ETF side, investors can pick up around 0.3% more yield (portfolio yield-to-worst) by going with the SPDR Bloomberg Short Term High Yield Bond ETF (SJNK) over the longer-duration fund SPDR Bloomberg High Yield Bond ETF (JNK).

CEF investors should have a look at a number of limited duration CEFs which have been overlooked over their loan CEF counterparts which have been all the rage in the last couple of years. This strong demand for floating-rate assets has pushed the average discount of the sector to unusually tight levels. This has left CEFs like the Barings Global Short Duration High Yield Fund (BGH) or the PGIM Short Duration High Yield Opportunities Fund (SDHY) as relative bargains with discounts around double-digit levels and yields of 8.8 and 8.5%, respectively.

Investors can also have a look at a number of term ETFs or ETFs whose portfolios target a certain maturity profile. The yield profile chart below shows that there is typically not much yield to be gained by extending maturity across the yield curve. ETFs like the iShares iBonds 2026 Term High Yield and Income ETF (IBHF) has a higher yield than its longer-maturity counterparts.

Takeaways

Many investors view duration allocation in their portfolios on a single spectrum while also focusing entirely on the current yield on offer. In our view, it makes more sense to think in terms of a duration matrix, incorporating both interest rate and credit spread duration. It also helps to think in terms of reinvestment and capital gain risk in addition to today's yield. This enhanced perspective, in our view, is likely to lead to a more sound investment process.

In our view the two buckets in the duration matrix attractive today are the higher interest rate duration / low credit spread duration and low credit and rate durations as illustrated below. There are a number of securities that can fit in these buckets including shorter-maturity term preferreds and baby bonds, as well as various fund options.