After years of yielding close to or even below zero percent, bonds are looking more attractive again – that’s not to say that a traditional fixed income strategy will provide positive returns from here. Instead, we believe an allocation to an absolute return bond strategy can be a good way of diversifying a broad fixed income allocation and maximising its risk-adjusted returns.
What is an absolute return bond strategy?
Traditional long-only strategies, managed against a benchmark reflecting the composition of a segment of the bond market, generally aim to track or outperform this index. They tend to rise or fall as interest rates and the broader bond market move. So, if interest rates rise, these strategies are likely to lose value – sometimes significantly – as they mimic the performance of the index.
By contrast, absolute return strategies are managed against a cash benchmark. They can invest in the broader market without constraints, aiming to generate positive returns regardless of what is happening in the broader market, so regardless of whether interest rates are rising or falling, corporate bond spreads are widening or tightening, etc.
Managers of such strategies have more flexibility than managers of long-only funds: they can typically use a range of financial instruments: developed market government and corporate bonds, emerging market bonds, structured securities such as US agency mortgage-backed securities and currencies.
The absence, in an absolute return bond strategy, of a structural allocation to bonds via a benchmark means there’s no structural allocation to interest rate risk. Absolute return bond strategies typically have zero duration risk as their neutral position and can overweight or underweight duration according to the manager’s market view.
The lack of constraints allows them to take long or short positions through derivatives, which means they can benefit from rising or falling markets, and take out protection against downside risk.
Why invest in absolute return bond strategies?
We believe absolute return bond strategies offer investors a compelling risk-return profile which compares favourably to that of other fixed income assets over the long term. They typically aim to deliver an excess return of 2% to 3% over cash for a volatility of only 2% to 5%.
Instead of investing in a strategy with, for example, only government or corporate bonds, absolute return bond strategies enable investors to obtain exposure to income streams from several fixed income segments within one vehicle.
US agency mortgage-backed securities (MBS) are an excellent example of a sector with global bond markets offering investors potential return streams that are uncorrelated with those of other fixed income sectors. The primary risk with US agency MBS is not credit risk (they benefit from the implicit backing of the US Treasury), but volatility via prepayment risk.
US agency MBS is a large component of the global bond universe: it makes up about 12% of the global bond market and about 23% of the US bond market (source: Bloomberg, June 2025). That size means market liquidity is deep.
As Exhibit 1 shows, current coupon US agency mortgage-backed securities have been offering a pickup in yield relative to US investment-grade credit with lower credit risk. For an absolute return manager, this is potentially an opportunity fulfilling the objective of guiding allocations to those sectors of the bond market where they are adequately rewarded for the risk taken.
Collaboration with specialist teams for the different sectors within global bond markets means an absolute return bond manager has a wide range of tools at their disposal. As a result, the returns of these strategies are generally uncorrelated with those of traditional fixed income strategies, making them a good source of portfolio diversification.
That’s attractive, particularly at a time when the risks of a surge in inflation cannot be dismissed and preserving capital matters.
Why now?
In recent years, we’ve seen a spike in inflation, rapid interest rate hikes by central banks and heightened economic uncertainty. Many investors were caught out when their bond investments, which were supposed to be the ‘safe’ part of their portfolios, suffered significant losses. Rising interest rates caused bond prices – especially those of long-term government and corporate bonds – to fall sharply.
Many central banks are now cutting interest rates, which is good news for traditional bond strategies, but it’s still unclear what comes next:
- Near term, inflation has been proving sticky in many countries. US import tariffs have the potential to cause it to rise sharply again. This has implications for central banks’ interest rate decisions
- Longer term, deglobalisation and high levels of government debt may lead to higher inflation than we have become used to over the last 20 years. If the US were, for example, to run into problems making the fiscal adjustments needed to fund its debt, it could create major and recurrent problems that could unfold in higher interest rates, greater inflation and financial instability.
- The outlook for economic growth has worsened, raising the spectre of more corporate bond defaults and increased market stress
- Geopolitical tensions are high, and it is unclear how this will impact bond markets.
In this kind of unpredictable environment, the flexibility that absolute return bond strategies provide can be a significant benefit. Managers can adopt defensive positioning when they see trouble ahead or quickly increase risk whenever they identify opportunities.
A vital portfolio constituent
By allocating to an absolute return strategy, we believe investors can add a layer of resilience and adaptability that works in complement to traditional long-only bond allocations.
In today’s shifting economic landscape, when the paths of interest rates, inflation and geopolitics are all uncertain, allocating to a dynamic, defensive bond strategy could help protect investors’ wealth, while achieving steady attractive fixed income returns.
So, we believe absolute return fixed income should form a core part of any overall fixed income allocation.
Also read our white paper on the case for absolute return investing in fixed income.
