Interest in absolute return bond funds is returning after a calamitous experience during the market crash. But the new generation of funds being launched is likely to be very different in structure from those that performed badly as a result of the credit crunch.
Current almost zero short term interest rates look set to continue for some time, whilst the consensus view is that bond yields have only one direction to go now and that is upwards. Both these factors provide a strong stimulus for institutional investors to consider absolute return bond funds. Absolute return bond funds first appeared in the marketplace in 2001, during the period following the collapse of the “dot-com” bubble. Absolute return bond funds encompass a huge range of strategies with very different risks, returns and liquidity profiles, making them difficult to compare with one another. What they did purport to do, was to package many of the techniques used by hedge fund managers, into an institutional framework suitable for institutional investors. The growth of absolute return bond funds looked set to continue at a very high rate until the global credit crash in 2007 and 2008 exposed the underlying flaws in many of the strategies that were the being marketed. Many institutions had invested in so called “cash-enhanced” funds as collateral for swap transactions. But their values collapsed and their liquidity dried up during the crash.
Confusion with cash
A fundamental source of confusion for investors has been that absolute return bond funds have covered a variety of niches across the risk spectrum from what the proponents called “enhanced cash” to products targeting double digit returns with a commensurate volatility. But without an accepted terminology to classify and differentiate the strategies, the experience of the last couple of years has shown that there has often been a considerable mismatch between what investors were expecting and what they were actually getting. This has been exacerbated by the lack of a suitable taxonomy to describe and differentiate between the products on offer. This mismatch between expectations and reality persists today. Whilst absolute return bond products can have many positive attributes, the term encompasses many very different approaches. Their usage needs to be able to marry the characteristics of the strategy to the objectives for the investment.
Ultimately, any attempt to classify absolute return funds is arbitrary, but the broad ranges can be seen in terms of out-performance against a short term cash benchmark such as LIBOR.
- Sub-LIBOR strategies that can truly be described as cash.
- Outperformance in the range 25-50bp, sometimes and possibly erroneously described as enhanced cash.
- The range 2-3% has become very popular for absolute return bond funds, sitting above traditional bond targets of 1-1.5% over a bond benchmark, and the ‘diversified growth’ multi-asset funds that target 4% or higher.
- 4% upwards representing diversified growth funds, targeting equity type returns with lower volatility.
- At the most aggressive end, macro hedge funds targeting 12-15%.
What has become very clear over the past two years is that LIBOR itself is not a risk free rate. So absolute return bond funds targeting anything above LIBOR should be regarded as risk seeking assets rather than some form of enhanced cash.
Where absolute return went wrong
Absolute return bond funds as a class failed miserably during the global financial crash. The underlying cause was of course, credit, and the fact that many strategies turned out to be nothing more than leveraged positions on credit spreads. Many investment managers prided themselves on their large credit research teams built up to manage investments in the large US corporate credit and asset backed securities markets. The advent of absolute return strategies enabled them to transport this expertise onto strategies aimed at beating non-US benchmarks through combinations of swaps and absolute return bond funds. Sophisticated managers realised that they had the building blocks to deliver liability driven investment strategies. They could match the liabilities with swaps, so they just had to generate the floating rate leg tied to LIBOR.
But many absolute return strategies failed disastrously in 2008 and 2009. The most obvious lesson to be learnt from the experience is the mismatch between what investors were expecting in terms of risks, and the actual nature of the portfolios. Clearly, with hindsight, many products were totally unsuitable for the purposes they were being put to. But more significantly, many managers had products that were essentially taking credit spreads which require no manager skill, and could therefore be regarded as beta positions in credit, and effectively claiming fees for alpha. If the credit teams had a 50/50 benchmark government/credit, they would go overweight credit say 70/30 in favour of credit, so it was a credit beta play. Investing in ABS at the time enabled funds to outperform the index benchmarks by moving away from the index universe. But credit spreads are not normally distributed and once in a while, credit spreads blow up!
Understanding the risks is crucial for the future
For institutions, understanding the risks inherent in absolute return funds is critical, as the experience of the crisis has shown. However, this is not so easy in practice, when many funds have opaque strategies and no real benchmarks for risk assessment. The key for understanding and implementing absolute return bond strategies that can survive the sort of turmoil seen in the last two years is managing the downside risk in a crisis.
Christopher Rothery, Fixed Income Portfolio Manager at T. Rowe Price argues that there are three risks that need to be managed. Firstly, market risk, which will remain the most important: “At T. Rowe Price we use VAR but we also have our own risk system where we slice and dice risk in order to better understand how our investments would react at times of market stress.” Secondly counterparty risk which after the Lehman collapse has become a big problem. Fund managers need to be able to trade with high quality counterparties and the number available is going down. Finally, liquidity risk. The credit crash was essentially a crisis of liquidity, not of defaults. A lot of structures and securities were thought to be liquid turned out to be anything but that in a crisis.
Managing downside risk during a crisis of the kind experienced in 2008 invariably means having very controlled or no exposure to credit to ensure liquidity is there when you need it. In particular, in the new generation of absolute return bond products that are appearing, there will be more of a separation between those strategies that use credit and those that do not.
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