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Absolute return – An absolute must in fixed income




Classical fixed income is already a source of ‘return-free risk’ in this post-pandemic economy awash with central bank stimulus. Reflationary expectations have expedited the rise in interest rates and aggravated the challenges faced by traditional fixed income strategies and indices.

In this environment, absolute return strategies are potentially better positioned to deliver fixed income’s core premises of income, diversification and stability.

Absolute return strategies are therefore an absolute must in portfolios aiming to tackle post-pandemic financial markets.

This is an extract from Absolute Return is an Absolute Must

A reflationary challenge

The coordinated central bank response to the COVID-19 crisis has pushed real yields in the developed world into firmly negative territory. While this has prevented a prolonged recession, it has left fixed income investors grappling with an asset class where the coupon has shrunk, while duration risk is higher than ever.

In other words, there remains no income in fixed income. The asset class has become a source of ‘return-free risk.’ Simultaneously, the expectation that this sustained monetary and fiscal stimulus will be the impetus behind a vaccine-led recovery has led to a consensus view that reflation will be pervasive in 2021.

These reflationary forces pose a major challenge for classical fixed income strategies in the near to medium term, with rising inflation potentially aggravating the challenges. Absolute return fixed income strategies are, in my view, particularly well positioned to not just fend off these reflationary pressures, but exploit them to generate portfolio returns.

Conventional fixed income, return-free risk?

In a classic deflationary environment, equities are likely to suffer, while government bonds, even at very low yields, are likely to do well. However, with reflation, economic activity accelerates and the equity risk premium shrinks, and that shrinkage comes at the expense of rising bond yields: If growth is accelerating, why would interest rates remain at recessionary levels?

Indeed, reflationary markets are marked by rising bond yields, and the pullback in 10-year US Treasury yields since the US election points to such an unwind. Central banks, however, have pledged to hold front-end yields low, so the thrust towards increasingly higher bond yields will likely manifest itself via steep yield curves.

Traditional fixed income products, both passive and active, are not well positioned to tackle this projected rise in interest rates. Indeed, as things stand today, fixed income has rarely been riskier, yet yielded less. A 30-year bull run in bond markets has meant that the duration, that is, interest rate risk, of the Bloomberg Barclays Global Aggregate Bond index is its highest ever. In fact, in the 12 years since the Global Financial Crisis, the duration of the index has risen by around 50%, from five years to 7.5 years.

What this means is that if bond yields were to rise by 100bp, bond investors would stand to lose 7.5% of the principal. The US 10-year Treasury yield had already backed up to 1.44% as at the end of February 2021 from a low of just 0.515% last August. It follows that a 100bp rise is not just possible, but that such a rise would be wholly unexceptional.

Exhibit 1 - Duration (interest-rate risk) has reached a multi-year high – chart shows changes in the duration (years) of the Bloomberg Barclays Global Aggregate Bond index, 2008 through 2020

Exhibit 2 - Yield of a multi-sector bond index is at record lows

Little room for price appreciation coupled with low income…

Typically, the income from the spread components of fixed income would counterbalance losses from rising rates. However, low or negative rates, coupled with spreads at historical tights, mean that income from fixed income is also extremely low, and indeed has been negative in real terms (that is, after inflation). In fact, the yield to maturity of the Bloomberg Barclays Global Aggregate Bond index is now below 1%. Compare that to US inflation running at around 1.4%.

Therefore, at current levels, it is increasingly difficult to make ‘buy and hold’ investments in fixed income with the expectation of returns above inflation over the medium term. This fact may have been partially obscured because the increase in capital values – prices – has flattered fixed income total returns. 2020 was a striking example, with the Bloomberg Barclays Global Aggregate Bond index (unhedged in USD), a proxy for fixed income, returning over 9%.

In many cases, investors have also benefited from large secular foreign exchange moves contributing significantly to fixed income portfolios. However, both of these effects are transient. Fixed income as an asset class is delivering very little in the way of income, and with interest rates so low, there is little room for further price appreciation.

A secular bear market for bonds?

The current environment is akin to a ‘Goldilocks’ scenario – economic growth is expected to be strong, yet inflation is well below central banks’ stated targets.

Yet, as noted earlier, rising inflation is a risk to market forecasts in 2021. Add to that the Fed’s new average Inflation targeting framework and apparent commitment to focus on what some are calling the ‘lower leg’ of the K, alluding to the ‘K-shaped recovery’ of a very differently experienced 2020 between those able to work from home, and those furloughed or rendered unemployed, and we could well be headed into a secular bear market for bonds.

In conclusion: Absolute return is an absolute must

Traditional fixed income strategies and indices today are already sources of ‘return-free’ risk. Reflationary expectations and risk of inflation upside may have expedited the bear market for bonds and aggravated the challenges facing traditional fixed income strategies

In this environment, the case for absolute return strategies seems stronger than ever.

Absolute return strategies are doing what traditional fixed income was meant to do, that is:

  • Generating income: The flexible, long/short approach is designed to generate returns in a rising rate environment
  • Increasing diversification: These strategies are derived from fixed income and yet are completely uncorrelated to fixed income and other market betas
  • Providing stability: They involve robust risk management and portfolio construction practices where no one theme, sector, style or strategy dominates

Absolute return strategies are therefore an absolute must in portfolios designed to tackle the post-COVID economy.

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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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