May 2014

FIXED INCOME: Time for A change

Weather mapFear over yields is fuelling an interest in absolute return bond funds, finds Nicholas Pratt. The next few months could be crucial for this relatively immature asset class. Absolute return bond funds are designed to produce attractive and medium-term returns in changing market conditions. Given some of the concerns among bond investors – a high yield bubble, underwhelming yields in traditional, index-linked bonds and an inevitable rise in interest rates – it is no surprise that absolute returns are now being talked up. These funds, which invest in a diverse range of fixed income asset classes and rely on the use of derivatives to provide flexibility, have been around for more than ten years, ever since Ucits III clarified its rules on the use of derivatives in 2004. Absolute return equity funds made their name in the wake of the 2008 market crash but for their bond equivalents, the rise has come in the last two to three years. There has been no similar crash in the bond market but the promise of more attractive returns and the relatively low volatility of bonds within the absolute return world has seen much more investor interest in absolute return bond funds. Currently the biggest driver in their demand is the fear over yields. The rationale among fixed income investors is that yields will have to rise so they are looking to absolute return bond funds to protect their capital, manage the downside and add some value on top. “If the fear over yields is the only reason they are buying absolute return bond funds, that is not healthy for the asset class,” says Colin Finlayson, co-manager of the Absolute Return Bond Fund at Kames Capital, a UK-based investment manager with £53 billion (€64 billion) of assets under management. “They should be buying them for diversification and for their low volatility.” DYNAMIC ALLOCATIONS
In order to achieve the diversification, the allocations in absolute return bond funds tend to be dynamic, says Finlayson, adding the Kames fund aims for as low a correlation as possible with market dynamics so that market directional views can be avoided. “We are trying to put together pairs of assets. It is the relative performance of assets rather than the sector itself.” Diversification is also a primary goal at Switzerland-based GAM says Daniel Sheard, investment manager and responsible for GAM’s absolute return funds. The challenge of achieving consistent returns within a highly diversified portfolio means that it is essential to try and identify the environment you are operating in, says Sheard. “The key point is that investors need to be confident in allowing managers the flexibility to generate returns.” The use of derivatives is essential in absolute return funds as a way to minimise the downside, says Martin Tschunko, fund manager at Switzerland-based Harcourt Investment Consulting, a wholly owned subsidiary of Vontobel. “Since the financial crisis, derivatives have undergone an overhaul and with the introduction of central clearing and two-way margining, everything is in place to make them more secure financial instruments.” The way that absolute return bond funds are managed has also evolved, says Tschunko. “There is still a big range of investment outcomes and there are some structural differences. We unbundle the risk factors in a bond fund – credit, duration, liquidity and foreign – and trade them separately. We had a chance to make money last year. If you had a more traditional absolute return bond fund that forced you to take a long-only cash position, that would have lost you money. So we built a product in line with the current environment.” TAPER TEST
Positive returns since 2012 have helped to add credibility to absolute return bond funds but not all of them have performed that well, says James Carver, fund manager of the SWIP Absolute Return Bond fund, which is now part of Aberdeen Asset Management. “We tell investors to do their due diligence and ensure that managers are trying to do what an absolute return bond fund should do, which is to make positive returns in all market conditions – both a strengthening and weakening fixed income environment.”   One of the challenges facing absolute return bond funds is that not all of them have a track record to speak of. Furthermore, the fixed income market has been relatively benign in the last three years, so the absolute return bond funds have not had a chance to prove that they can make returns in more volatile market conditions, says Carver. “There have not been many periods in the last three years where, for example, corporate bond funds would not have done well. One exception was in May 2013 and the Federal Reserve’s ‘taper tantrum’. So investors would be well advised to look at the fund’s performance during that period when there was a change in market conditions.” Investors also need to make sure they know what they are buying, says Carver. “Many of them do different things. Some are return focused, others are focused on the risk/return trade off. It is not just about the volatility index. We invest in all assets but other absolute return bond funds are very specific and only invest in EM [emerging market] debt or government debt or credit.” There is also a wide variation in the promised performance targets and also the risks that are associated, says Kames’s Finlayson. “Generally investors will think these are low risk funds that will hold their value in times of stress but the funds with much more challenging performance targets will have to take more risk and that means being more market-directional and exposed to changes in market conditions. It makes them much more like strategic bond funds. “There is a lot of room for different types but investors need to understand that with greater returns come greater risks.” Given their relative immaturity and their primary function as a diversification tool, absolute return bond funds are still likely to be a small portion of investors’ portfolios, says Chris Higham, credit portfolio manager at Aviva Investors. “We are a long way from investors having 100% of their portfolios in absolute return bond funds but it will be interesting to see how they perform over a period of time.” Consequently, the next year could well be a crucial time for absolute return bond funds to be well placed to prove themselves. MULTI-BONDS?
One alternative to absolute return bond funds is the multi-bond fund. “The idea is to provide a reasonable return with relatively low risk,” says Hans van Zwol, senior investment manager at ING Investment Management, talking about his offering. Van Zwol also says that at present bond flows are still supportive to high yield products and sentiment is positive. But he is concerned about whether the market may start to turn and so, for a multi-bond fund, the idea is to have as much flexibility as possible, he says. That said, there is perhaps more flexibility with an absolute return bond fund. There is an underlying benchmark in the ING multi-bond, which make a negative duration difficult to achieve, says Van Zwol.
“For an absolute return bond fund it is easier to profit from rising interest rates than with a multi-bond. “There is a longer-term horizon. There is always a balance with multi-bonds, they tend to be less volatile.” By way of comparison, some investors may look to the record of absolute return equity funds – an asset class that has been around longer but has not performed as well as many expected. The absolute return sector has returned 3.57% over the last three years, according to Morningstar. Some investors may question whether the same will happen in fixed income. But while it is important that the absolute return bond funds get off to a healthy start in line with investors’ expectations, disappointing performance will not be the death knell for these funds, says Higham. “As we have seen with other sectors, one or two years of poor returns will not signal the end of the asset class, it will just take longer for it to become popular.” Institutional investors have not yet fully embraced the absolute return bond fund sector, in part due to the fact that they do not guarantee a return in the same way that holding a government bond to maturity does but instead aim for a targeted return, albeit a more attractive one. However, says Aberdeen’s Carver, institutional investors are putting more research into absolute return bond funds and their consultants are proposing them as viable funds for long-term returns. “I see the growth of absolute return bond funds as being continuous and long-term,” says Carver. ©2014 funds europe

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