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January 2018

Demystifying absolute return fixed income

There are alternatives to traditional bond funds. Investors worried about higher interest rates should consider them.

They might not possess the glamour of stocks, but bonds are pretty much essential for most investors. That’s because they perform several important roles. As they’re interest-bearing loans to governments and companies that are repaid in full on a specific date, bonds have proved a reliable source of income. What is more, they tend to be less volatile than shares and hold up well during economic downturns. So adding them to an investment portfolio can provide much needed stability, particularly when the economic and financial climate is uncertain.

There are, however, signs that bonds could struggle to deliver quite the same degree of protection in future. Thanks to the policies put in place by central banks worldwide to contain the debt crisis in 2008, a growing number of bonds have become very expensive, with many now paying very low levels of income relative to their price. This means that, once central banks hike rates to more normal levels or inflation rises, bonds could suffer a steep decline in value. In other words, what has traditionally been safe could be less so.  

That's not to say bond investments need to be dialled down. Rather, this suggests investors should probably consider changing how they invest in them. One way to continue to secure the traditional benefits bonds provide is through an absolute return fixed income fund. Such funds aim to deliver more stable returns over the different phases of the economic cycle. Typically, they target a specific level of return over a specific time-frame - aiming to beat, for example, inflation or the interest rate on cash savings by a certain amount over a three-year period.
smoother paths: absolute return fixed income funds aim to generate more stable returns than traditional funds

Return trajectories compared, for illustrative purposes only

absolute return approach

Source: Pictet Asset Management

Broadly speaking, absolute return bond funds do three things that mainstream bond funds don’t usually do:

Invest across a broad range of countries, companies and currencies

Absolute return bond funds don’t restrict themselves to one particular category of bond investment. They spread their net far and wide, and seek out the best investments from the widest possible range of countries, companies and currencies. This is a clear logic to this: experience tells us that the more diverse our investments are, the easier it is to navigate the peaks and troughs of economic cycle. 

Controlling risks as a way of achieving returns
Absolute return fixed income funds see return and risk as different sides of the same coin. They therefore attach a high priority to controlling the risks that come with bonds.It's an approach that can help minimise the volatility that investors typically experience from one year to the next.  

Deploy sophisticated investment techniques
Because absolute return bond funds aim to shield investments from the worst effects of a market's ups and downs, they use financial tools that are designed to do just that. These tools – the majority of which are derivatives – have been used by professional investors for years as a way of controlling  or removing unwanted risks when the economy or markets take a turn for the worse.

Because they focus on preserving capital during times of market stress, absolute return fixed income funds can lend much-needed stability to an investment portfolio.

Of course, absolute return fixed income funds aren't appropriate for all investors. They tend to be suitable for those who are willing to sacrifice some gains when markets are rallying as a trade-off for better protection during periods of turbulence. At the same time, it is possible that absolute return bond strategies might not deliver consistently positive returns over shorter time-frames.

Nevertheless, thanks to their many distinctive features, absolute return fixed income funds can lend much-needed stability to an investment portfolio. That's something investors shouldn't ignore.