Why should investors be interested in global absolute return fixed income?

James McAlevey, Head of Global Aggregate and Absolute Return Fixed Income

Why should investors be interested in a global absolute return bond strategy?

We think absolute returns is an interesting proposition now for two reasons: One, capital preservation is important at all points in time. 2022 was a disastrous year for fixed income and absolute return funds generally performed significantly better [than other fixed income funds]. Also, absolute return funds are quite flexible in nature. By being flexible, they remove some of the structural risks that exist when you have static allocations in your portfolio.

Today, the most important and interesting reason is that volatility is back in the [fixed income] asset class. Volatility brings opportunities for us to take advantage of.

At a time of heightened volatility, where do you see the best opportunities for investing in fixed income?

Some of the best opportunities at the moment happened to be in the US structured security space, in particular in the US mortgage passthrough market: AAA-rated securities that are inherently backed by the US government.

It’s not the whole market though. Current coupon securities, those where prepayment risk is highest, where you’re being rewarded for taking on that risk, tend to be relatively sensitive to volatility in markets.

As volatility has risen, the spreads on these assets have widened – to attractive levels. As [yield] curves continue to steepen, and as central banks ease policy gradually in the coming quarters, that is favourable for the performance of US structured securities markets.

There is the additional possibility that in Trump 2.0 world, the regulations for financials will be eased such that it’s easier for banks to carry these [securities] on their balance sheet, hence providing additional demand for them.

How important is diversification when building an absolute return bond strategy?

Diversification is everything when it comes to building a diversified absolute return bond strategy. Construction sits at the heart of all of these processes, but even more so for absolute return fixed income, simply because it is unconstrained in nature. There is no benchmark. The starting point would be a blank piece of paper without any ideas. There’s a multitude of ways to get from A to B depending on the views that you have.

What returns and drawdowns can we expect from this type of diversified strategy?

The returns that we can expect from this sort of strategy range between 2% and 3%. That is a reasonable risk premium for fixed income over the long term if [the premium in] equity markets is 4% to 6%. If we can replicate that through a multi-sector product with lower correlations to the existing marketplace, with less drawdowns, we’re off to an interesting proposition from a capital preservation and drawdown perspective.

These products are designed to perform better than broader fixed income in drawdowns. 2022 is a good example of where we had vast negative returns through a wide complex of different fixed income assets. This universe of product did perform significantly better in that environment.

For us, trying to limit the drawdown in a worst-case scenario to a number no greater than 2.5% on a rolling 12-month window, at the very least offers investors a symmetric return distribution in a world where asset markets can often be asymmetric against them.

How does this strategy differ from more traditional fixed income allocations?

These strategies differ from traditional fixed income products in a sense that they can employ derivatives to use long/short strategies and leverage to help the funds manifest non-directional, relative value, strategies. Those types of strategies help return profiles in a world where you might not be getting much from markets on a long-only capacity. What it does is inject a lower correlation into the wider investment universe, because long/short strategies in particular don’t tend to have as much market directionality attached to them.