Talking Heads – Flexibility in global bonds with absolute return

BNP Paribas Talking Heads Podcast with James Mcalevey

Andy Craig: Hello and welcome to this week’s BNP Paribas Asset Management Talking Heads podcast. Every week Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing absolute return fixed income investing. I’m Andy Craig, Co-Head of the Investment Insights Centre, and I’m joined today by James Mcalevey, who’s Head of Global Aggregate and Absolute Return in our Global Fixed Income team.

James has managed the team for four years now, and he and his team recently celebrated their Global Bond Absolute Return strategy passing the milestone of €1 billion of assets under management. Welcome, James. Congratulations, and thank you for joining me today.

James Mcalevey: Thank you. Pleasure to be here.

AC: Let’s set the scene to make sure we’re clear about what we’re talking about. [For global bonds] absolute return – in contrast to traditional long-only bond strategies – is managed against a cash benchmark rather than a benchmark that reflects the composition of a particular segment of the bond market.

Secondly, you and your team have freedom of not being constrained to one particular segment of the bond market – [be it] corporate bonds, sovereign bonds, or a particular sector of global bonds. You can invest across the global bond market without constraints, and the aim is to generate positive returns – regardless of what’s happening in the broader market, or whether interest rates are rising or falling, or corporate bond spreads are narrowing or widening.

The objective is to generate positive returns, whatever the overall environment, and your strategy aims to deliver an excess return of 2 to 3% over cash for a low volatility of between 2% and 5%.

So, having established the framework of what you do, it would be good to if you could talk us through where the interest from investors in your strategy is coming from. What’s kind of investors are including an absolute return bond strategy in their fixed income allocation?

James Mcalevey: You’ve articulated the flexibility that these sorts of strategies generally provide. And indeed, they do. They provide a lot of flexibility and, for some, that creates a bit of a headache, as it were, in terms of where to put this type of strategy in their own portfolios.

When I conceived this strategy and joined BNP Paribas Asset Management to establish the process that supports it, I was minded by a couple of things. The first is that we have an incredibly well resourced and very large fixed income footprint here, and it’s really important that we can and do wear our traditional fixed income investor hats to try and find the best bonds, the best markets, the best risk-adjusted return opportunities across the entire depth and breadth of the fixed income platforms. That does sound more traditional, long only in nature, which it is. But there is significant flexibility in terms of where we go and why.

The other point I think is interesting – which is why it probably creates some uncertainty for people in terms of where to put it and how to own it – is this idea of alpha generation that sits alongside it. And by alpha generation in the context of absolute return, we mean long short strategies, market neutral or indeed outright short strategies as you mentioned earlier. And of course, that can bring real benefits.

It means you can and should be able to perform in markets that are not so positive to just long only mindsets. I think that is what truly sets them apart, in terms of where people own them and how they think about using them.

I definitely see an abundance of people willing and happy to put this in their alternatives bucket, which is effectively the defensive part of their allocations.

But perhaps the more interesting [issue] that we’re [discussing] today is the user case [in terms of] people who have sat in money market funds for a number of years now. If we cast our mind back only a year or two, these investors were getting close to 4% in Europe, risk free.

That is no longer the case. That 4% is now roughly 2%. And investors want to get back towards that 4% for a fixed income portfolio allocation, but they want to do it without seven years in duration, and without going all the way down the [corporate credit] risk spectrum.

That obviously has inherent risks attached to it, particularly at this level of spreads, I would argue. But it’s that user case, as a cash surrogate or a cash enhancement where, because we also focus on the capital preservation objective as well as just the upside capture, that I think gives people a lot of comfort that there isn’t a 10% or 20% drawdown on the horizon.

We do everything we can to limit that 12-month drawdown to a number no greater than 2.5%. So [there’s] a clear variety of user cases here and a couple of the most important ones are very different from the way I originally conceived the strategy, but that’s a function circumstance and the environment we face today with cash rates declining again everywhere.

AC: Perhaps you can talk us through your current positioning and give us some colour on the fixed income assets that you like and dislike. Of course you have flexibility and that allows you to generally go overweight or underweight the risk of these assets using derivative strategies, and that means you can potentially benefit from rising or falling markets.

You can protect against downside risk. You can position for a widening or a falling of risk premia on, for example, corporate debt. You have a lot of flexibility and a certain symmetry in terms of how you manage. Could you talk us through the positions you’re currently running and what you particularly like and dislike in fixed income.

JM: Absolutely. To be clear, historically around this sort of strategy, we would’ve been short duration back in 2022, which was a very strong rising rates backdrop for markets. And that enabled us to deliver positive performance [even] in a year like 2022.

But today, we are absolutely not short duration; we are long duration. We can talk about that in a moment, but in terms of where the best risk-adjusted returns are globally, we only allocate capital where we deem we are being adequately compensated for the risks we’re taking. Now, that’s a relatively high bar at times, which might mean that for the majority of the environments we’re not actually fully invested, and we lean on the alpha generation more. And at the moment, we’re not fully invested at all.

Maybe we’re about 50% invested and we can find some things to do that offer really good, credible potential risk-adjusted returns. What we’re not doing at the moment is buying corporate credit. I think some people tend to be surprised by that.

I think they also tend to jump to the conclusion that I might be telegraphing a big recession around the corner, or a big default cycle that’s going to result in meaningfully negative returns for these asset classes. But we’re not. That’s not the view, and not necessarily what we expect.

But with a bar that says “only allocate capital where you’re being adequately rewarded for the risks that you’re taking”, we look at spreads as tight as they are today. In spread terms, not total return terms, often when I look where spreads are trading today, there’s not a lot of protection in there should something go wrong in the future.

We like protection, and we like additional potential gains and income and potential capital returns in terms of spread compression – and none of that exists in the corporate credit landscape today. I know some people are a bit surprised when I tell them that we are not at all interested in corporate credit at this point. But that’s the reason: the bar’s quite high, and the compensation at the moment is very low.

Also, we should remember that there are quite a lot of risks out there on the horizon. I know everything looks hunky dory at the moment, and volatility is low everywhere and risk assets continue their ascendancy to ever higher levels. But when you’re not being compensated, I think you have to draw a firm line in the sand, and that is what we have done with corporate credit of late.

The other reason we’re not actively involved is that we can find other things to do that do look attractive – where spreads are a lot wider and where we believe we’re being adequately compensated for the risks that we’re taking.

At the top of that list is an allocation to US mortgage-backed securities. These are the government-backed agencies of Ginny, Fanny, and Freddie. And these had never really experienced any defaults historically, even through the GFC [Global Financial Crisis] which was a subprime, non-agency issue.

But today, spreads are quite wide versus history. Volatility in fixed income is elevated and this asset class tends to cheapen when volatility is high and tends to become more expensive when it is low. And because we’re [in] a higher fixed income volatility regime today, the opportunities in this asset class look quite high.

The biggest risk for these assets would be one of increased prepayments, where, as bond holders, we end up getting our money back a lot quicker than we generally want. That’s what we call prepayment risk. What we believe at the moment is that the risk of a prepayment weight is incredibly low indeed. So it is a really interesting opportunity.

And spreads in the mortgage market are in the current coupons – the newly issued mortgages, effectively – and yields there are greater than in the US investment grade landscape. Yet these bonds are clearly comfortably several notches up in quality on the credit rating spectrum. So I think that is a nice demonstration that even with a high bar, there are plenty of things we can find that make sense today.

Lastly, [we like] local emerging markets. Latin America in particular, and within Latin America, two countries that stand out to us better than any other – Columbia and Brazil.

We generally like the asset class and we are favourably inclined toward local emerging markets. But when we look under the hood, there are two, maybe even three markets that we think offer very credible opportunities. So you find us invested in [some of] these markets, but definitely all of them.

AC: Well, to round off our conversation, let’s take a step back and perhaps you could talk to us about your outlook for bond markets. I know you obviously don’t have a crystal ball, but what do you see as the big trends and factors that are likely to weigh on bond markets through the rest of 2025 and into 2026?

JM: I’m glad you mentioned the crystal ball because you’re right, we don’t have one. Nor does a proposition like this rely on our ability to perfectly predict the future because we are going to be wrong. We don’t quite know yet when, where, how, or why. But I think it’s not lost on anyone that with global policymaking as fluid as it is today, making any forecast on any investment horizon with any certainty is open to fairly regular disappointment. So we don’t have a crystal ball, but that doesn’t mean that we can’t make some reasonably informed statements about what is happening to the asset class.

[There are] statements and belief systems that help instruct the way we either A) like to approach investing or B) think about how we want to construct the portfolio. The most interesting and topical of these today concerns the ongoing gradual but clear trend-like steepening in yield curves globally.

I know there are some markets out there [where yield curves] are steepening more quickly than others, but over the last two to three years, and particularly in the aftermath of Covid, lots of yield curves globally have been steepening gradually. Policy rates have been coming down, which always helps the steepening.

But this whole issue of term premia rebuild has got the market’s attention. Deficit funding within the fixed income market arena is alive and well, and it’s absolutely on investors’ minds. Barely a day or a week goes by where this isn’t a topic for discussion in bond markets, and we saw the extent to which this was relevant in Japan, as the long edge of Japan sold off again with a new prime minister in charge who [appears] more fiscally open-minded.

So these issues are not going away in a hurry. For us, we are operating in a landscape that means fixed income yield curves should be steeper. They’re likely to stay steeper than we’ve been used to in [recent] years, and that’s going to come with increased volatility, too.

The single biggest change that’s taken place in the last few years in fixed income markets is this idea that – I think for the first time in my career – fixed income markets are now standing on their own two feet. They’re now being intermediated by price-sensitive investors only. The central banks have gone, whether it’s direct intervention through QE [quantitative easing] or indirect intervention through global reserve growth through the Noughties.

For the last 20+ years, there has been a firm hand from price-insensitive central banks. And that has gone, dried up. The world looks different now, and fixed income markets are having to digest information, and it is price sensitive investors like us who are ultimately going to become the marginal price makers in these markets.

For me, the punchline of all of this development and evolution is that volatility is back as well. It’s back in a structural way, and I don’t mean heightened extreme levels like we saw in Covid or the GFC, but the compressed levels of volatility we saw around those fixed income asset classes is going to be a thing of the past.

I think that’s a good thing, because we are, after all, active managers. We are looking to benefit from dislocations that accrue in the market. And with more volatility comes more dispersion, more dislocations and alpha opportunities, long short strategies.

So, I think all of these developments and structural changes, play into the hands of those searching for robust, repeatable, active management processes, and in particular, absolute return strategies that can be well placed to take advantage of both long and short positions as that volatility presents itself.

AC: Yes, you have that symmetry, the flexibility to not just position for falling interest rates, but also for rising interest rates or widening credit spreads, which clearly for an active manager, in a market which is driven by price sensitive investors, would seem to be a major advantage.

James, thanks very much for joining me today and talking us through the absolute return bond strategy.

JM: Pleasure to be here. Thank you very much for your time.

AC: That’s it for this week’s episode of Talking Heads. If you’d like to learn more about our investment insights, please reach out to your BNP Paribas Asset Management contact or check out Viewpoint, our website for investment insights, at viewpoint.bnpparibas-am.com.

We recommend subscribing to Talking Heads on your favourite podcast channels such as YouTube or Spotify. You’ll receive your podcast episodes every week, and if you like Talking Heads, please leave us a positive review and a nice rating.

You’ve been listening to the BNP Paribas Asset Management Talking Heads podcast with me, Andy Craig, and James McAlevey, Head of Global Aggregates and Absolute Return in our Global Fixed Income team.

Please do join us again next week. Until then, take care.