Bond investors could be forgiven for feeling a little disoriented. After a decade of ultra-low rates and negative yields, inflation is suddenly on the rise.
Uncertainty abounds – over the pace of monetary tightening in different countries, the persistence or otherwise of inflationary pressures, and the evolution of the Covid-19 pandemic.
The notion that government bond markets are oases of calm has consequently been consigned to history. Lockdowns eased after new vaccines offered an exit from the pandemic and the resumption of economic growth. But the ‘return to normal’ unexpectedly led to much higher inflation (hitting 30-year highs in the US, for instance) and higher interest rates. Central bankers tried to balance their inflation-fighting credibility with assurances that policy would remain supportive. Yet bond market volatility spiked, with the MOVE index setting 20-month highs. In just three months, the yield on benchmark 10-year US Treasuries swung from a low of 1.17 per cent in August to a high of 1.70 per cent in October before trending down and then up again. While repayment of principal and interest are still assured, gone are the days of one-directional trading in government bonds.
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 unconstrained, 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.
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 buffer in place to ensure the most favourable trade-off between risk and prospective return, particularly when developments don’t unfold as planned.
1. Looking beyond 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. As recent experience shows, sudden moves in interest rate expectations or significant changes in benchmark composition hurt index-trackers and long-only active portfolios alike.
Take the current situation in Turkey. Conventional wisdom dictates that sustained increases in inflation warrants tighter monetary policy. In Turkey’s case, intervention by the country’s president not only led to interest rate cuts instead of hikes, but also to a complete change of the central bank’s monetary policy committee when its members disagreed with him.
Similarly, the inclusion of China in the FTSE WGBI in October 2021 forced investors to buy Chinese government bonds merely to stay neutral to their reference benchmarks, regardless of their views on the country. Because they are unconstrained and not tied to an index, ARFI strategies can avoid such risks.
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 tradable securities globally. 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.
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. In late 2019, for example, economists were forecasting a respectable 2.7 per cent growth for the following year. Then the pandemic hit, countries locked down and, in the end, global GDP contracted by 3.4 per cent in 2020. Of course, no one could have predicted Covid, though, but forecasts continue to be proved wrong, not least by the extent of the supply bottlenecks and the resulting inflation pressures.
Even stripping out extreme events, such as the pandemic, each business cycle is invariably different from the one before. Radical changes in the political landscape – like 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 three long-term trends:
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 the 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:
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. 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 inflation pressures prove transient and stagflation is avoided. To this end, we see potential in the intermediate part of the curve (5 and 10 year maturities) in the US and in Germany, and also have exposure to peripheral Europe.
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, central banks in some countries – such as the UK and Poland – may have more of a credibility issue when it comes to bringing inflation under control. The risk can be mitigated through taking short positions on their currencies or bonds.
3. Stress testing and risk oversight
Diversification of positioning is critical to controlling risk in the portfolio, while monitoring the correlations of portfolio investments is key to maintaining that diversification. The team not only stress tests the portfolio’s performance under different one-off shock scenarios, but also on an on-going basis across the alpha sources, investment themes and risk scenarios. This continuous monitoring is key to controlling risk.
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 still offering very low or negative yields, but as market liquidity has diminished over the years, the fixed income asset classes that make up the market are more in sync with one another than they have been historically.
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.
This marketing material is issued by Pictet Asset Management (Europe) S.A.. It is neither directed to, nor intended for distribution or use by, any person or entity who is a citizen or resident of, or domiciled or located in, any locality, state, country or jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation. The latest version of the fund‘s prospectus, Pre-Contractual Template (PCT) when applicable, Key Investor Information Document (KIID), annual and semi-annual reports must be read before investing. They are available free of charge in English on www.assetmanagement.pictet or in paper copy at Pictet Asset Management (Europe) S.A., 15 avenue J.F. Kennedy, L-1855 Luxembourg, or at the office of the fund local agent, distributor or centralizing agent if any. The KIID is also available in the local language of each country where the compartment is registered. The prospectus, the PCT when applicable, and the annual and semi-annual reports may also be available in other languages, please refer to the website for other available languages. Only the latest version of these documents may be relied upon as the basis for investment decisions.
The summary of investor rights (in English and in the different languages of our website) is available here and at www.assetmanagement.pictet under the heading "Resources", at the bottom of the page.
The list of countries where the fund is registered can be obtained at all times from Pictet Asset Management (Europe) S.A., which may decide to terminate the arrangements made for the marketing of the fund or compartments of the fund in any given country.
The information and data presented in this document are not to be considered as an offer or solicitation to buy, sell or subscribe to any securities or financial instruments or services.
Information, opinions and estimates contained in this document reflect a judgment at the original date of publication and are subject to change without notice. Pictet Asset Management (Europe) S.A. has not taken any steps to ensure that the securities referred to in this document are suitable for any particular investor and this document is not to be relied upon in substitution for the exercise of independent judgment. Tax treatment depends on the individual circumstances of each investor and may be subject to change in the future. Before making any investment decision, investors are recommended to ascertain if this investment is suitable for them in light of their financial knowledge and experience, investment goals and financial situation, or to obtain specific advice from an industry professional.
The value and income of any of the securities or financial instruments mentioned in this document may fall as well as rise and, as a consequence, investors may receive back less than originally invested.
The investment guidelines are internal guidelines which are subject to change at any time and without any notice within the limits of the fund's prospectus.
The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a specific security is not a recommendation to buy or sell that security. Effective allocations are subject to change and may have changed since the date of the marketing material.
Past performance is not a guarantee or a reliable indicator of future performance. Performance data does not include the commissions and fees charged at the time of subscribing for or redeeming shares.
Any index data referenced herein remains the property of the Data Vendor. Data Vendor Disclaimers are available on assetmanagement.pictet in the “Resources” section of the footer.
This document is a marketing communication issued by Pictet Asset Management and is not in scope for any MiFID II/MiFIR requirements specifically related to investment research. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any products or services offered or distributed by Pictet Asset Management.
Pictet AM has not acquired any rights or license to reproduce the trademarks, logos or images set out in this document except that it holds the rights to use any entity of the Pictet group trademarks. For illustrative purposes only.