Benchmark-unaware investing seems to be a winning philosophy. Kathryn Young explains where bonds stand.
In contrast to traditional benchmark-aware bond funds, a number of offerings are now seeking positive absolute returns irrespective of market performance, in an effort to find solutions for shifting market conditions – in particular, persistently low government bond yields and the ever-present threat of inflation. Some of these have merit and could be used effectively in client portfolios.
Absolute return bond strategies typically exhibit two traits. First, their managers are much more flexible in sector allocation – often moving freely between government and corporate bonds, and cash – and in duration management.
While traditional vehicles keep duration within a range of the benchmark, absolute return bond funds often have extensive freedom to avoid interest rate risk.
The second key trait is substantial exposure to credit-sensitive issues such as corporate bonds. Credit securities are a natural hunting ground, because the credit risk means they offer a meaningful yield advantage over government bonds, and they typically have shorter maturities, which should make them less vulnerable to rising interest rates.
Like most things, these absolute return bond strategies present both advantages and disadvantages that are important to weigh up carefully.
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The upside
The first positive characteristic is capital preservation potential. If interest rates do start to go up, and especially if that rise is sharp, the value of bonds will decline.
This risk is especially acute with interest rates as low as they are now, because any capital declines could more easily wipe out the value of the income.
Because these strategies typically start with lower duration than traditional funds and have more flexibility to shield their portfolios from rising yields, they should be better-equipped to preserve their value.
The credit securities these funds favour offer comparatively high yields, which should translate into high income distributions.
To be attractive, though, the funds must outpace term deposits. They’ve had mixed success at doing so over the past three years, but there are some other important issues to consider.
The funds offer daily liquidity, while investors are tied into a term deposit for a specified period. This is significant, because a large part of the yield offered by the latter is payment for sacrificed liquidity.
Investors are also locked into a given rate, meaning they’ll have to continue to receive a lower yield than the market rate if interest rates rise. The funds can more nimbly take advantage of new, higher yields.
The downside
The first downside is that the absolute return bond funds are relatively untested – many are still comparatively new, and even those with medium- to long-term track records haven’t been tested through a sustained period of rising bond yields.
This makes it difficult to develop conviction that they’ll be able to deliver the capital protection and income they promise when it matters most. Their fees are also generally higher than average, in part because they have yet to achieve considerable scale.
These strategies largely trade interest rate risk for credit risk. The latter implies the possibility of permanent capital losses.
Fund managers generally feel comfortable with substantial corporate bond exposure at present because of the relatively sanguine part of the credit cycle.
But a continued period of low interest rates could trigger a turn in the cycle. And even if default rates remain low, credit risk can be dangerous for its correlation with sharemarkets.
When the market gets risk-averse, it tends to shun credit-sensitive bonds alongside equities.
Finally, these offerings don’t offer the portfolio diversification benefit of duration. Duration can soften the blow of losses from shareholdings, so by avoiding duration, investors also sacrifice that diversification benefit. The decision to avoid or reduce interest rate risk means accepting the risk of missed returns if interest rates fall further from here.
Role in portfolio
The pros and cons mentioned suggest that the usefulness of these absolute return bond strategies in a portfolio may depend largely on the investor’s time horizon. Investors in the accumulation period are likely to be heavily-invested in equities.
They could more easily withstand losses or relative sluggishness in their bond sleeve, and need the diversification duration can provide.
Investors in or nearing the drawdown phase are likely to have more significant fixed interest exposure, making their portfolios very sensitive to interest rate movements.
They’re likely to be living off the income their investments provide, and concerned primarily with preserving wealth. These investors could benefit from having a portion of their defensive allocation in a more flexible defensive strategy.
Any allocation should be part of the defensive sleeve, and it makes sense to source the money from a traditional bond strategy, because those typically have the most interest rate risk.
Even for investors who may have the greatest need for these types of strategies, the cons identified above need to be kept well in mind. It would be wise to maintain some duration exposure as a hedge against credit and sharemarket declines.
Kathryn Young is a fund research analyst at Morningstar.
