Risk and Portfolio Construction: Rising interest
In short, we do believe switching a portion of conventional bonds into some form of absolute return strategy can improve outcomes; however investors need to be mindful of the risks introduced and ensure sufficient focus is placed on retaining a robust strategic asset allocation and achieving value for money. To shed light on this we explore market forces, product development trends and how investors can take advantage of the current investment landscape.
The 30-year bull market in bonds is over. The light green line in figure 1 shows the sustained and precipitous fall in 10 year US Treasury bond yields that created this golden period for traditional bonds. Yields are now far more likely to rise than fall. For interest rates, it is even clearer, with official rates across the developed world still largely anchored at zero.
The overwhelming consensus in the market is that rates and yields will rise (the red line in figure 1 shows the market’s current expectation for future cash rates) and as such total returns from traditional bond investments are likely to be lower than they have been previously and potentially negative over certain periods.
This has important implications for the sort of bond products asset managers are launching. Indeed, in response to the current market predicament, the asset management industry’s product development machine has gone into over-drive. The last few years have seen a huge number and variety of bond products launched seeking to exploit or protect against the seemingly inevitable rise of bond yields.
This new rash of products includes funds that are variously labelled: absolute return bond funds, unconstrained bond funds, strategic bond funds and numerous other strategies. The nomenclature and often quite subtle differences are unhelpful and confusing to investors. It can complicate the assessment and selection of different strategies and funds.
There is considerable breadth to the range of product and strategy types that fall under the general ‘absolute return’ title. In truth, each investment strategy is manager-specific and consequently often difficult to bucket; many products use the same title yet follow totally different processes. Figure 2 attempts to characterise strategies based on their neutral position and mandate flexibility in interest rate and credit risk, with the investment discretion signified by the length of arrows.
While the subtleties of the different strategies need to be carefully understood and assessed, of greater importance are the key differences of absolute return versus traditional bond investments. These include:
• A lower neutral interest rate duration position.
• A broader range of interest rate duration and credit risk flexibility.
• Slightly greater discretion to access ‘plus’ sectors such as emerging market debt, high yield bonds and leveraged loans.
• A focus on absolute volatility rather than tracking error relative to a benchmark.
• Typically greater complexity and sophistication in terms of strategies and instruments utilised.
We have no prejudice that any of these absolute return strategies are good or bad in themselves. All are worthy of consideration as a way of gaining certain risk exposures and improving the robustness of a broad portfolio; indeed our analysis suggests that an allocation to absolute return can improve investment efficiency without reducing returns.
Having said that, we do not subscribe to the view that investors should contemplate replacing all conventional bond investments with absolute return. An investor’s asset allocation should incorporate a broader range of inputs in its derivation than just shorter-term performance vulnerabilities, including the robustness across different macroeconomic regimes, the balance of structural and tactical risk exposures, the degree of active management, governance and others factors.
For example, while absolute return may represent a superior solution in an environment of higher economic growth and higher inflation (and rising interest rates), it may prove less effective in different macroeconomic regimes – and successfully predicting the prevailing future macroeconomic regime is a far from trivial exercise.
Through this broader lens we observe a number of key factors that lead us to believe that a modest, but material, allocation from the capital currently in the conventional bonds might be appropriate for certain investors.
Before pursuing absolute return, we recommend investors examine the belief set behind its attraction, in particular the reliance on manager skill (and the associated higher investment management fees). The efficacy of an allocation to absolute return is inextricably linked to manager skill. While the greater investment flexibility afforded to absolute return managers provides greater scope to protect against a rising interest rate environment, success is not guaranteed.
Superior performance will only be achieved if the selected managers are able correctly to forecast future market conditions and position accordingly. Furthermore, identifying and selecting skilled managers is a challenging and competitive task, and typically high and poorly structured investment management fees represent a significant drag on performance. However, we do believe there are skilled absolute return managers worth considering, where the increased complexity and governance associated with introducing a new strategy is worth it.
Chris Redmond is global head of bond research at Towers Watson.