A Flexible Approach for Navigating the Current Fixed Interest Outlook.
A fundamental shift is underway for global bonds. The sector has delivered a slightly negative return for the calendar year to date*, and the medium term outlook is looking subdued with bonds facing a number of headwinds.
That said, traditional global bonds still have a role to play in a diversified portfolio, so we recommend keeping some exposure in place. Over the long term we still expect them to provide income, albeit at much lower levels, and to help defend against weakening economic conditions and deflationary environments.
If you are considering reducing your exposure to traditional global bonds, then an option is to invest in a related asset class that doesn’t have the same risk exposure, such as Absolute Return Bond (ARB) strategies.
ARB strategies are a means of pursuing active management within fixed interest in a flexible manner and with a defined focus on downside protection. This means that the appointed fund manager is trying to generate positive returns in most market environments. A typical return target is 2-4% pa above the prevailing cash rate; however, as mentioned, a primary objective will also be the preservation of capital. Given these attributes, we believe ARB strategies best fit within an investor’s defensive portfolio - often serving as a good complement and diversifier to traditional bonds, whilst also providing a compelling alternative to cash.
ARB strategies invest in a variety of global fixed income assets, often in a dynamic manner. Portfolios might include government and corporate bonds, as well as currencies, and many will use derivatives extensively to generate short exposures as well as long. Despite this level of flexibility, it is important to remember that ARB strategies are not hedge funds in disguise - leverage is not typically used and the risk profile is more akin to traditional fixed income.
As the universe of ARB managers has grown, we have identified a number of different approaches including:
- Low Volatility Income – where the core of the portfolio is made up of high quality, short dated, credit securities which provide a natural incremental return stream,
- Directional allocating to the most attractive bond sectors or currencies over a short- to medium term timeframe, and
- Relative Value – finding relative value trades which aim to exploit more idiosyncratic opportunities which are not affected by market beta.
The key benefits of adding ARB strategies to a portfolio include:
- Reduce interest rate risk – as the strategies are benchmark-agnostic, managers are not tied to the rising duration risk in fixed income benchmarks.
- Useful diversifier - in general, they have relatively low correlations versus other asset classes.
- Liquid - they are a useful portfolio construction tool given their liquid nature, and we believe they provide a good “dry powder” alternative to cash.
Whilst there are clear benefits to adding ARB strategies to a portfolio, it is important to be aware of some key considerations when making an allocation. Investors investing in ARB strategies are swapping market risk (i.e. beta) for manager risk (i.e. alpha), and so manager selection is key to the success of the strategy. Further, as discussed earlier, there are three key approaches or styles used by managers to generate returns. There are pros and cons for each approach and some approaches work better in certain market environments. It is therefore beneficial to create a portfolio of ARB strategies which blends and provides exposure to a variety of approaches.
To conclude, bond yields have been on a broadly decreasing trend for over 30 years, which can be attributed to a decline in inflation and the aging demographics of developed countries. More recently, in the 10 years since the GFC, we have witnessed one of the most unconventional and drawn-out cycles in history. However, given the low level of prevailing yields, a repeat of these extraordinary returns is very unlikely. At the very least, the potential distribution of bond returns from this point appears to be more skewed to the downside.
In the face of these challenges, investors can look to expand their portfolio toolkit by using less traditional methods of attaining fixed interest exposure, such as via ARB strategies.
*Bloomberg Barclay Global Aggregate Index hedged to NZD to 30 October 2018
Robert Kavanagh is a Portfolio Manager at Mercer Investments, based in Auckland. Sue Wang is a Senior Fixed Income Specialist at Mercer Investments, based in Sydney. Together they advise New Zealand investment clients on their investment policies, portfolio structures and fund manager selection.
This article does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.