Schroders: Absolute return - thinking differently about bond funds

Bonds are still essential, but investors may not be aware of the risks

Bonds are still an essential part of building a diversified portfolio. As investors come to rely on their investments to meet liabilities, bonds often play an increasingly significant role in protecting capital and generating a predictable income stream. This traditional approach to portfolio construction remains true today. However, while bonds still have a crucial part to play, today’s macroeconomic environment means that using only traditional bond funds may expose investors to more risk than they are aware of.
Throughout the summer of 2015, headlines in financial media were focused on the Greek debt crisis and steep falls in the Chinese equity market. These stories did cause volatility to rise in bond markets, but from a structural point of view, neither is currently expected to pose a serious threat to market stability. For bond investors, the most prominent threat is posed by an otherwise positive development: the global economic recovery. In particular, the economic recovery in the US is likely to drive a profound change in the accommodative monetary policy environment that has supported bond markets since 2008.

The story so far...

In response to the global financial crisis, the Federal Reserve (Fed) – central bank to the world’s largest economy – dropped its headline interest rate to almost zero. In addition, the Fed also eased monetary policy in a way never seen before; introducing a series of massive quantitative easing (QE) packages that injected a total of $4.5 trillion into the US bond market. Treasury yields during that time fell to all-time lows, and as a number of major central banks enacted similar asset purchase programmes, many other bond markets followed suit.

Compared to when these measures were introduced, the US economy now looks very different. The pace of QE was reduced during 2014, with no additional purchases made from October of that year. Since May 2015 the Fed has made it clear that the headline interest rate should be expected to rise during 2015. Given that low rates and rising liquidity were so supportive of bond markets to the start of 2015, it stands to reason that the opposite will be true. Rising rates are bad for bonds, and this makes life particularly tough for conventional bond funds.

Thinking differently about bond exposure

Conventional bond funds will often be tied to a benchmark. The manager of a conventional fund can adjust the amount of participation the fund has in market moves; known as ‘beta’. Unfortunately, while this type of bond fund might successfully perform better than its benchmark, it will always move in the same direction. If the market falls, investors in the fund will – to a greater or lesser extent – lose out.

For an absolute return bond fund this is not the case. The fund may use a broad index in order to monitor portfolio volatility or performance, but equally it may use none at all. In either case, the aim is to generate an absolute return by investing in the manager’s best ideas, irrespective of an underlying benchmark. The wider array of investment strategies available allows an absolute return manager to allocate - or mitigate - risk in a far more tailored way. Most importantly, an absolute return bond fund can also alter ‘duration’ positioning to a greater extent than a conventional bond fund.

Duration is the way bond fund managers quantify their portfolio exposure to interest rates. The duration level - measured in years - helps determine how much of the fund’s value is exposed to a rise or fall in interest rates. The more duration you hold when rates are rising, the more money you lose.
Without a benchmark, an absolute return bond fund has the ability not just to hold less duration than an index - as with conventional funds - but can be ‘short’ duration in specific areas. This is where investors not only insulate themselves from a rate hike, but can profit from it.  An absolute return bond manager can sell exposure to interest rates, to profit from a fall in bond prices when rates are increased.

Volatility isn't going away

Bond markets throughout 2014 and into the start of 2015 outperformed even the most optimistic of expectations. With very low interest rates and high levels of liquidity still being introduced by some major central banks, bond values crept up consistently. Corporate bond yield spreads – the amount of return offered by corporate bonds over government bonds – also narrowed as investors hunted for returns. Bond issuers have continued to bring a high level of new bonds to the market, seeking to secure low rates before rates are hiked. Meanwhile, investors have begun to reduce duration levels for the same reason. As we have discussed, this trend of falling yields and tightening corporate spreads increasingly looks to have run its course.

From here, we anticipate that volatility will become more pronounced and periods of market volatility more frequent. The bond market has expanded enormously since the financial crisis, whilst changes in regulation have reduced its liquidity. Add to that the central bank involvement in markets, and it is easy to see that there are likely to be periodic pinch points; phases of stress caused by liquidity problems in the secondary market. Concurrently, the trend level of global productivity and economic growth is set to slow, because of the ‘top-heavy’ nature of its demographic distribution. More people, all living longer, need to be supported in retirement while not contributing to economic growth. This means that rates will rise, but probably by not as much as in previous rate hike cycles. Absolute return funds could position themselves to capitalise on these periods of volatility.

During rising bond markets, an absolute return bond fund could generate positive returns, whilst the complete flexibility to adjust market and duration exposure means these strategies could protect investor capital when markets are falling.