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Absolute return in practice: prepared for anything

 
November 2017

Thomas Hansen, Senior Investment Manager

Absolute return fixed income has the flexibility to deliver attractive performance even at a time of rising interest rates.

Predicting the behaviour of markets over the long term is notoriously difficult.  Which is why we don’t try to do it in the Pictet Absolute Return Fixed Income strategy. Instead, our focus is on generating positive returns for our investors regardless of what the market may throw at us. That means we don’t try, for example, to forecast when the 30-year long bond bull market will come to a (potentially abrupt) end, but rather prepare our portfolio for that eventuality.

How does this work in practice?

We weigh probabilities. For instance, we believe that over the next three to five years it’s more likely than not that global interest rates will remain relatively low due to subdued real economic growth and ongoing deleveraging. This, in turn, frames our long-run strategy of investing in long-dated US Treasuries.

However, this view does not preclude the possibility of moderate rate hikes, which could cause significant short-term disruptions in parts of the bond market, potentially negatively affecting returns. Holding Treasuries in isolation would thus be starkly at odds with our risk-focused philosophy, which is to build individual strategies in such a way that the entire portfolio can deliver positive returns irrespective of conditions in the bond market.

In other words, our aim is to deliver gains for our investors not only when markets move up, but also when they move down; simply losing less than a reference index or a competitor’s strategy is not an option for us.

Hungarian rates head lower even as inflation rises
Hungary

Source: Bloomberg, as of 30.10.2017

Of course, risk management is just part of our approach. Building and maintaining a diverse portfolio is also key. Because we don't follow a benchmark, we have the flexibility to invest anywhere in the global fixed income space – across countries and instruments – that we consider attractive.

To reduce the potential risk of rise in interest rates worldwide, we looked for an offsetting position in securities that would gain in value if interest rates increased. 

Interest rate derivatives in central and eastern Europe, and particularly in Hungary, stood out as a relatively inexpensive option given the country's interest rates are, in our view, far too low for an economy that is witnessing rising inflation.

Hungary’s central bank has been cutting interest rates even though output is expanding robustly, wages have increased by more than 13 per cent in the past year and inflationary pressures are elevated by regional standards. Indeed, inflation is now within the site of the central bank's 3 per cent target level, which means the likelihood of a scramble to tighten monetary policy has increased.

Against this backdrop, it is is now cheap to buy those Hungarian fixed income securities whose payouts rise when interest rates head higher. By conducting our purchases via the forward rate market, we have been able to offset the risk of a rise in global bond yields.

While we’re not in the business of trying to time markets, we are mindful that they can shift quickly and sharply. Once the market has turned, it becomes very expensive to buy any kind of protection against yet steeper falls, for example. This is part of the rationale for another one of our recent positions.

flattening spread 

Spread between Markit iTraxx Europe Crossover index and iBoxx European High Yield index, bps

Crossover
Source: JP Morgan, as of 25.10.2017 

European high yield credit looks particularly vulnerable to a negative shift in investor sentiment, with yields hovering around record lows.  In the event of a sustained sell-off and outflows, cash bonds usually underperform their credit default swaps (CDS) - the insurance contracts which bondholders buy to guard against default.

One way to generate returns under such an scenario is via the Markit iTraxx Europe Crossover index, which brings together the CDS of 75 of Europe’s most liquid sub-investment grade companies. The spread between this synthetic index and its cash equivalent, the iBoxx European High Yield index, has normalised to around zero from a peak of 192 basis points in early 2016.

If the bond market does head south, we would expect the cash index to underperform the synthetic one as investors pull money out of high yield bonds and liquidity deteriorates.

Under such a scenario, a short position in the total return swap on the cash index versus the iTraxx CDS index would generate gains.

We believe this ability to invest across fixed income products around the world should benefit our investors. As conditions in the bond market become more complex, a flexible, value-based approach is becoming even more important.