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the benefits of absolute return fixed income

October 2019

The trouble with bonds

Why bond investors should consider making an allocation to absolute return fixed income strategies.


Absolute return fixed income: transforming bond portfolios

Bond investors could be forgiven for feeling a little disoriented. In the decade since the US housing market crash, they have had to abandon several of the beliefs they previously held dear. It turns out, for instance, that negatively-yielding bonds are no longer an absurdity.

Thanks to sustained quantitative easing, the volume of fixed income securities trading at negative yields has never fallen below USD6 trillion since 2016. (The figure recently leapt to as high as USD17 trillion).

Also consigned to history is the notion that government bond markets are oases of calm. On one eventful day in May 2018, the yield on Italy’s two-year bond spiked by more than 150 basis points, the sharpest one day sell off in more than 25 years. There was also the US 'flash crash' of October 2015, which saw yields on 10-year Treasuries move up and down by 160 basis points within just 12 minutes. As the US Federal Reserve warns, such episodes will be more frequent in future as passive investing and algorithmic trading gather pace.1

Bond investors face an additional complication. The definition of a diversified bond portfolio has also had to be torn up. That’s because the various fixed income asset classes that make up the global bond market2 have been tracking one another more closely in recent years. The correlation of the returns of US Treasuries, corporate debt and emerging market bonds has been higher in the past three years than in the past 10 (Fig. 1).

Investors can of course accept this new reality. They can simply resign themselves to owning a more volatile portfolio.

But there is an alternative. And it comes in the form of an absolute return fixed income (ARFI) strategy. Untethered from bond benchmarks, and free to deploy advanced risk management techniques, ARFI strategies are designed to deliver returns independent of the fixed income market. 

For these reasons, they can serve as a buffer for - and complement to - a traditional fixed income portfolio. 

moving in lockstep

Correlation of returns vs US Treasuries: investment grade, high yield and emerging market US dollar bonds

ARFI strategy

Source: Bloomberg; data covering period 30.06.2009-31.07.2019 and taken from Bloomberg Barclays US Credit Index, the Bloomberg Barclays US High Yield Index and the Bloomberg Barclays US Dollar Aggregate Emerging Market Bond Index. 

Typically, ARFI funds target a specific level of return over a specific time-frame, expressed as a percentage point gain over a commercial lending rate or inflation.

To the investment managers running the ARFI strategies at Pictet Asset Management, delivering on this goal requires a multi-faceted approach to portfolio construction.

First, the investment universe needs to be broad. Investments should be chosen from the widest possible range of easily-tradeable bonds, currencies and derivatives. This makes it easier to construct a diversified portfolio composed of assets whose returns don’t move in tandem.

Second, more attention should be paid to the structural trends that influence bond returns than cyclical, and more volatile, factors such as economic growth and inflation.

Third, every investment idea must have a corresponding hedge in place to ensure the most favourable trade-off between risk and prospective return.


The essential elements of absolute return fixed income

1. Looking beyond benchmarks

Bond investors often combine passive and long-only active investment strategies in an effort to build diversified portfolios.

Yet these two approaches are not the polar opposites they appear to be. Both expose investors to the shortcomings of capitalisation-weighted benchmarks.

In many cases, there's little to distinguish long-only, actively managed portfolios from their passive counterparts. They are almost equally susceptible to the shifts in the broader market. Sudden moves in interest rate expectations or changes in benchmark composition hurt index-trackers and long-only active portfolios alike. 

Take Greece's sovereign debt crisis. It stung index-oriented investors in two ways. First, bondholders endured losses until Greek securities dropped out of the main euro zone indices. Index-oriented investors then suffered again when they missed out on the subsequent rally. Another example of the flaws of index-tracking is Venezuela. The country's growing footprint in many benchmarks in the lead up to its economic slump hit emerging market investors hard. Such problems occur even more frequently in corporate bond markets. 

Passive and long only bond funds are also susceptible to what is known as asymmetric duration risk. Duration is a metric that approximates the capital loss or gain a bond fund would see in the event of 1 per cent rise or fall in interest rates. The higher a portfolio's duration, the more sensitive it is to interest rate changes. Since 2008, a period marked by steep interest rate cuts and quantitative easing, it has paid to be 'long' duration.

But with official interest rates unlikely to fall as steeply as they have done in recent years, duration will have a much smaller positive effect on a bond portfolio's overall return. In other words, there is an asymmetry in the future direction of interest rates. The probability of rates falling sharply is lower than the probability of them remaining steady or rising.

This highlights why it makes sense to combine index-oriented bond portfolios with others whose returns aren't subject to the influence of fixed income benchmarks. 

A distinguishing feature of ARFI strategies is that they are not overly reliant on any one source of return. They harvest returns from changes in interest rates (duration), issuer creditworthiness (credit premia) and currencies. Investments are sourced from the broadest possible range of tradeable securities. Emerging market bonds and currencies, investment and non-investment grade bonds, and other credit instruments such as credit default swaps are part of the investment mix. 

In diversifying sources of risk and return in this way, ARFI strategies are better able to generate gains across all phases of the economic and financial cycle, which means their inclusion within a fixed income allocation can potentially improve volatility-adjusted returns.

absolute return: uncoupled from the market
ARFI strategy

Source: eVestment Analtyics, data covering period 31.05.2016-31.06.2019; returns for PictetAM Absolute Return Fixed Income strategy in US dollars (unhedged), gross of fees. Returns will be reduced by management fees and other expenses.  *Data for global bond returns taken from Bloomberg Barclays Global Aggregate Index in US dollars (unhedged).

2. Looking beyond the economic cycle

Many bond investors spend a lot of time and effort attempting to forecast future economic conditions. Yet such predictions are rarely accurate. Famously in 2008, not one major economist forecast recession; a year later 49 of the world's biggest economies were in a slump. 

What’s more, each business cycle is invariably different from the one before. Radical changes in the political landscape – such as Brexit and the rise of populism in Europe and the US – can up-end economic models. And then there’s the knotty problem of distinguishing cause from effect in any statistical analysis.

An alternative strategy is to look beyond the business cycle and focus on the long-term structural changes in the economy and markets.

PictetAM's ARFI team has built its portfolio around four long-term trends. 

a. Lower rates for longer.  Global economic growth and productivity has been lacklustre, and developed world governments face an uphill struggle to reduce public debt to levels that can support more fiscal spending. This means real interest rates are likely to remain at unusually low levels for some time. 

b. Stuttering, protracted reform of the euro zone. The financial crisis has highlighted the need for far-reaching reform of the euro zone.  Establishing a common banking union and a fiscal transfer mechanism under which the public debts of euro zone members are pooled and supported is essential. 

Yet given the politically-charged environment in which decisions are taken, it will take time for the region to implement reforms. Europe’s increasingly vocal populist movements are likely to further delay progress, as could the fallout from the UK's decision to leave the European Union. We believe this presents as many opportunities for investors as it does risks.

c. A newly-assertive Japan. Thanks to the radical policies of Prime Minister Shinzo Abe and Bank of Japan governor Haruhiko Kuroda, Japan appears to be slowly moving away from the problems that have plagued it for the past two decade. There is a chance that weak growth, deflation, debt and ineffective government could be consigned to history. 

d. An economic and financial transformation in China. China’s sweeping reforms are yielding early dividends, as its economic focus switches from exports to domestic consumption. Capital market liberalisation and the expansion of the country's local bond market will transform global financial markets, with far-reaching consequences for countries in the developed and emerging world. 

3. Controlling risk at every stage of the investment process

The changes in the economic and political landscape, and their effects on the fixed market, make bond investing more risky. PictetAM's ARFI team has devised a process that seeks to contain such risks at every stage. 

On one level, this involves taking great care to avoid over-exposing a portfolio to any one investment theme, idea or source of return.

On another, it means ensuring investment strategies are expressed in a way that offers the most efficient trade-off between risk and return. Scenario-based portfolio construction is critical to meeting these goals.

a. Diversification by source of return. Investing across a broad range of developed and emerging fixed income asset classes gives investors access to a number of potential sources of return. Pictet AM's ARFI strategy aims to secure returns from three main sources: interest rates, credit premia and currency.  We recognise that each of these is also a potential source of risk, and ensure the portfolio’s risk budget is equally distributed across all three.

b. Diversification by investment theme and risk scenario. If one investment theme does not play out as anticipated, it is important that the portfolio is sufficiently diversified to be able to deliver on its investment objectives. With this in mind, the team makes sure that all its investment ideas are evenly represented in the portfolio. Neither does the team favour one economic forecast over another. Rather, it seeks to balance one scenario against another. This distinguishes PictetAM's approach from those of strategic bond funds or active benchmark-oriented portfolios. The former tend to concentrate investments in high-conviction ideas, while the latter do not usually venture far beyond the boundaries of their reference index. 

c. Efficient implementation of investment ideas. 

By embracing a broad investment universe, our portfolio managers give themselves options. Often, they find they're able to express a particular investment view in several ways.

This means they can compare alternatives, and choose the most efficient. For instance, there are many investments that could perform well if interest rates remain low, as the team envisage. 

These include long positions in corporate bonds and emerging market (EM) dollar denominated debt.  The choice boils down to value and prospective return.

But there's also a risk-mitigation element to the process. The team also seeks out an offsetting investment to contain any unwanted volatility.

The aim to here is to protect the portfolio should the team's thesis fail to play out as expected. It is an insurance policy. 

For example, our managers' positive medium-term view on China is reflected in an allocation to US dollar EM debt. However, the team's scenario analysis shows this could be a volatile investment. Such bonds could fall in value by more than 10 per cent in the event of a global economic slowdown. 

Because of this risk, the team combined the US dollar EM debt investment with short positions in developing world currencies. (Because EM currencies tend to depreciate whenever the economy stalls, a short position would generate gains in such a scenario).

The risk-mitigation strategy proved its worth. When EM US dollar debt fell sharply at the end of 2016 due to the anti-trade rhetoric from the then President-elect Donald Trump, the portfolio's short currency investments helped preserve capital. 


A more balanced bond portfolio

Bonds have historically provided investors with steady capital returns and reliable streams of income. Yet the structural trends unfolding in the fixed income market have changed this dynamic. Not only are a large proportion of government and corporate bonds offering negative yields, but the fixed income asset classes that make up the market are more in sync with one another than they have been for decades. 

Investors looking to build and maintain diversified portfolios should consequently modify their approach. By allocating some capital to strategies that aim to deliver attractive returns irrespective of market conditions, investors have the opportunity to build more resilient fixed income portfolios.

it's all about correlation

Correlation of returns: selected fixed income asset classes and Pictet AM's absolute return fixed income strategy 

ARFI strategy

Source: Bloomberg, Pictet Asset Management; Data covering period 31.08-2012-30.08.2019. Returns for Pictet ARFI reference portfolio are expressed gross of fees and in US dollars (unhedged) and they encompass actively managed portfolios that follow an investment strategy that aims to generate annual returns of 3-5% over a 3 to 5-year investment horizon. No benchmark is associated with this reference portfolio. Returns will be reduced by management fees and other expenses. Index data are expressed in US dollar and are taken from the following: Bloomberg Barclays Global Bonds Aggregate Index (hedged and unhedged), Bloomberg Barclays US Aggregate Index, Bloomberg Barclays US Credit Index, Bloomberg Barclays Global High Yield Index, Bloomberg Barclays Emerging Market US Dollar Aggregate Index, Bloomberg Barclays Emerging Market Local Currency Index, Bloomberg Barclays Euro Corporates Index (hedged).