Standard Life Investments

Focused Insight

Well Diversified and resilient - Absolute Return Bonds

As an asset class, fixed income continues to be an integral component of investors’ overall portfolio allocation. The past two decades have been a conducive environment for bonds, with a strong bull market and steadily falling yields all being positive for bond returns. Looking ahead, the environment is not as clear as previously, particularly with on-going concerns around rising interest rates and, consequently, a less bond-friendly market environment. To militate against the impact of rising interest rates, many asset managers are looking to expand and broaden their fixed income universe and derive benefit from a wider opportunity set. Such strategies have scope to look beyond traditional benchmark indices and create portfolios that are more closely aligned with an investor’s specific return objectives.

Absolute return bond funds aim to deliver positive returns for investors in all market conditions. They are able to do this by investing in a diverse universe of fixed income investments, so spreading the risk. This is of particular relevance because, in challenging macroeconomic environments, strategies that seek to reduce overall investment risks without unduly sacrificing the returns available play a significant role in dampening portfolio volatility.

The overriding feature of a genuinely diversified absolute return bond approach is access to the entire fixed interest opportunity set. Alongside conventional bond strategies, positions may be established to express specific views on interest rates, inflation, currencies or volatility across a range of global markets and time horizons. This multi-faceted approach affords a high level of diversification when combining these strategies. The result is a high degree of resilience during periods of uncertainty and a low degree of correlation to returns across other asset classes, which makes relevant portfolios less susceptible to fluctuations in market risk sentiment.

Cross market strategies are examples of strategy types that open up the entire fixed income opportunity set, and thereby facilitate the expression of fixed income views between two or more markets. We are currently using cross market positions to take advantage of divergent outlooks for interest rates. An example would be a long position on Australian rates versus an underweight on UK rates. The Australian economy remains supportive of a low interest rate environment as a decline in the mining sector needs to be accommodated by a weaker currency. The UK economy, on the other hand, continues to show signs of a cyclical upswing gathering pace. Furthermore, the pace at which unemployment is falling has created discrepancies between market expectations and forward guidance, leaving scope for interest rates to become unanchored.

Another example of a favoured cross market strategy is being long of European interest rates versus US and Japanese duration. In Europe, there is an increased risk of deflation and concerns over a hesitant central bank response. The Bank of Japan is currently buying 70% of Japanese government bonds (JGBs), but there is a practical limit to this. We also expect wage growth will lead to higher inflation expectations, which is negative for holders of JGBs. The additional short US duration position protects this strategy against a rise in US Treasury yields, as European rates remain highly correlated with US Treasuries.

By having an expanded opportunity set, we are able to express views on different markets that more traditional benchmark-constrained funds cannot. Absolute return bonds offer better diversification and lower correlation to broader market movements, while aiming to deliver positive returns in a rising or falling yield environment.

The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.