The tactical value of absolute return bonds | Insight Investment

Investors used to hold meaningful allocations to absolute return bond strategies, but that doesn't seem to be the case recently. It seems to have fallen off. Why might that be, in your opinion?

I think two key things. One would be behavioral biases that we see from the previous macroeconomic regime, and a second would be perhaps some naivety around diversification within investors' portfolios.

The behavioral biases from the previous regime, we're talking about the 2010s here, an environment where investors were told now is the time for absolute return because yields are low, and this is the exact environment that absolute return will be able to outperform total return on a sustainable basis.

Of course, that's not what happened. Yields were low, but they kept getting lower and lower and lower, and credit spreads also kept compressing through that period, assisted by things like quantitative easing. So actually, beta and total return products continued to perform much better than absolute return. It simply couldn't keep up in that environment.

But also importantly, the correlation between risk assets and risk-free assets was negative through that period, so fixed income and bonds worked well as a diversifier within portfolios. We think the environment is now different. That correlation may change, and investors may need to think much more carefully about how they achieve diversification, and absolute return bond funds are one product that can help achieve that.

So just thinking about today's market environment, how well is beta being rewarded?

You just have to look at your starting point for valuations, and when we're talking to investors and clients, they are concerned about the outlook for beta because valuations are expensive.

Do we think it's a good time to invest in absolute return? Yes, because the four key factors we would argue are, how well is beta rewarded? Not very well, we think. What are your cash rates to give you a running yield before any investment decisions are made? Yield is now available. We don't think we're going back to the low interest rate, low inflation, low yield regime we had before COVID.

Volatility, that's the key ingredient for success for active management and strategies that rely overwhelmingly or 100% on alpha decisions and not beta.

There are a lot of things going on in the world, be it geopolitics, be it inflation back as a risk factor that policymakers need to control, be it fiscal dynamics. We don't think volatility's going anywhere anytime soon. And the shape of yield curves is also important.

Why is that important? Well, owning longer duration bonds, if things like fiscal dynamics continue to put upwards pressure on term premium, upwards pressure on government bond yields, then actually yield curves are not that steep at this point in time, and the path of least resistance may be towards more steepening duration not playing that role in portfolios investors might want it to. And ultimately, therefore, we think those four things combined, we think is a great environment for absolute return.

So just thinking about investors who have a traditional bond allocation or a traditional bond portfolio, what hidden risks are out there that they should watch out for?

The two key risks they need to be conscious of are interest rate duration and credit spread duration and how the outlook for those two things is evolving. What risk-adjusted returns might you expect from each moving forward? Beta, we've mentioned, may not be well rewarded here. Potentially some challenges for interest rate duration as well. So simply projecting the risk-adjusted returns you had over the past 20 years may not be appropriate looking forwards.

And on the more sort of hidden risk side, what should investors be conscious of?

It's what is that really negative environment for fixed income as an asset class here. And if you look at some of the key tail risks, the fiscal dynamics, inflation coming back, potentially with the current conflict, stagflation, these are not traditionally brilliant environments for fixed income.

Cash rates and policy rates may need to rise, and absolute return investing may actually be better rewarded on a risk-adjusted basis than that traditional fixed income approach in this environment.

So can an absolute returns bond strategy therefore help to mitigate these risks, both hidden and aware, that you mentioned before?

If it's run in the right way, absolutely. Because a true absolute return strategy should not have structural exposure to these two key risk factors.

So you should observe cash-like duration on average, but taking both overweight and underweight positions. And similarly, with credit spread exposure, you should see strategies that are willing to go neutral or underweight credit through time, not always overweight beta to help generate returns in their portfolios.

If a strategy does these two things, then it should give you that diversification you're looking for compared to the other asset allocation decisions you're making in your strategy. And this should be particularly beneficial if we are going into an environment where risk-free and risky assets have that positive correlation that we've seen in the past few years.

So let's just zoom in a minute on the current market context. So what does higher energy prices, and subsequently higher interest rates, mean for bond investors?

Yeah, the current episode is a good test case for your absolute return strategies. Correlations have gone to one, so equity markets, bond markets, other asset classes are either all rising or falling at the same time. And it's fundamentally an inflation shock initially, and that's not good for nominal government bonds, nominal corporate bonds. Why not? Central banks may need to respond to that higher near-term inflation, even if Growth expectations start to falter, and medium-term inflation expectations, an important driver of bond valuations, may also start to edge up.

So in the near term, traditional fixed income, so corporate or aggregate bond funds, they may struggle to perform in this environment. Absolute return strategies should give investors better protection. Why? They shouldn't have that structural interest rate or credit spread duration. They should be able to benefit regardless of the direction of market moves. And even if an active manager makes the wrong active investment decisions, that drawdown should be much smaller than you would observe from traditional fixed income strategies in environments like this.

And if we are going back to a regime that's something more like the 1970s, then investors are going to need to reappraise the approach they take to portfolio construction, risk management, and diversification.

Many managers do absolute return in many different ways. What's your philosophy and what's Insight's philosophy? How do we approach absolute return?

Yeah. So if I was allocating to an absolute return strategy, the most important thing I'd want to understand is what is your manager's philosophy when it comes to this space, because you will see a wide range of approaches.

So how did we come up with our approach?

For us, there's two key things that an absolute return strategy has to do and has to give investors who are looking for diversification.

One, it needs to give you protection when markets are challenging. It's no good just being a sort of lower beta version of traditional fixed income products. For example, periods like March 2026, periods like 2022. When markets are falling, your absolute return funds need to be sustaining capital and ideally giving you a positive return, provided the manager is making the correct active management decisions.

They also need to give you uncorrelated returns through time. Why? Otherwise, you're not getting that diversification, and you're likely just seeing a lower beta version of traditional fixed income, and it won't fulfill that role for investors.

So how do we do that?

We don't take structural interest rate or credit spread duration. The average duration of our product through time has been cash-like.

We don't take structural beta risk, and this is something I would encourage investors to absolutely look at when it comes to absolute return products, because you do see a lot of beta products dressed up as alpha products. We also keep the strategy highly liquid.

Why do we keep it highly liquid? A lot of investors use this to make their cash work harder as a cash replacement vehicle. When markets get challenging, they may need to withdraw liquidity from this strategy to fulfill needs elsewhere.

So what does it mean if we want the product to be liquid? We don't invest in private or liquid securities. We also don't think those asset types are appropriate for an absolute return bond fund, because when markets get distressed, the value of those typically fall more, and you may not be able to transact in them.

That, to us, is not fulfilling that philosophical objective of giving that downside protection. And not having the structural interest rate or credit spread duration, that through time should give us as much diversification as possible from traditional fixed income, where those are the two key risk factors.

Just following on from that, so I want to ask a question that I feel is an important one to get answered. So how should clients and how should those watching be appraising absolute return managers?

Yeah. It's fundamentally linked to that philosophy question. So can a manager evidence to you that they have followed their philosophy through the investment cycle and in different environments? You need to look at, can they perform in different environments? Are they consistent in generating alpha regardless of the macroeconomic environment that we're in, whether it's one that's good for beta, bad for beta, yields are rising or falling, spreads are tightening or contracting? You want to be looking for patterns.

Are they just structurally allocating to credit spread or beta and then trying to hedge or unhedge that with duration? That works very well in some environments, less well in others.

Environments where that correlation is positive, periods like 2022, that's a great test case for absolute return funds. Why? Because that was the worst fixed income market we had in 100 years. But a good absolute return product should have generated you a positive return then because it can benefit from rising yields, it can benefit from spreads widening.

You also want to look at how they've performed through the cycles. You don't want to see a product that's only been launched for four, five, six years. They've not been tested then in different environments.

Ideally, you should be looking for a manager who's been tested through the global financial crisis, Eurozone sovereign debt crisis, COVID, and various geopolitical shocks.

Thank you so much, Harvey, and thanks so much for everybody listening. If you have any questions on anything we've discussed, anything related, please do reach out to your Insight representatives.