Talking Heads – Absolute return fixed income in an uncertain world

This is an edited audio transcript of the Talking Heads episode Opportunity for absolute return strategies in volatility

Daniel Morris: Hello and welcome to the 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 strategies. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by James McAlevey, Head of Global Aggregate and Absolute Return. Welcome, James, and thanks for joining me.

James McAlevey: Pleasure to be here, Daniel.

DM: James, if we think about how fixed income has evolved over the last couple of decades, for a long time it was kind of easy. Interest rates just seemed to go down structurally for a long time. Then with the Global Financial Crisis, we entered negative interest rates. And here we are in a whole new world with at a minimum heightened volatility and more uncertainty about what the future is going to look like. As we think about absolute return strategies as perhaps a good way to manage that environment, how does a portfolio manager of an absolute return strategy go about harvesting returns in fixed income?

JM: We look to invest in markets that are attractive, that had good carry and income characteristics, that have generally lower durations than wider fixed income products do and therefore have less market sensitivity attached to them. There are always opportunities around to help us deliver return levels matching the cash interest rate plus 2/2%. The continued abundance of excessive risk premium or tailwinds seem to be more or less in in the rearview mirror. But fixed income absolute return funds can actually take advantage of the volatility that you have highlighted. With volatility come opportunities. We can actually employ long/short strategies, what we call relative value investing. And the great thing about more volatility is that there’s generally more dispersion. And with dispersion comes excellent opportunities for buying a market A versus market B or buying the short end of the curve versus the long end of the curve. These are all really rich opportunity sets for enhancing returns. And that is a really important component of absolute return strategies that shouldn’t be overlooked.

DM: James, you’ve talked about how you go about investing for an absolute return strategy. Simple question then: why should investors be interested in absolute return and maybe elaborate on how it differs from a more traditional fixed income allocation?

JM: Starting with the differences, products like this aim to do a better job of preserving capital in turbulent times than conventional long only products will. They also tend to have enhanced diversification. Both of those characteristics have significant benefits over and above pure traditional long only types of categories. With 2022 fresh in our minds, we know how volatile the fixed income markets were and how bleak the return profiles were. There wasn’t one fixed income asset class that year that managed to deliver excess returns versus cash.

However, lots of absolute return funds can and indeed did deliver positive returns versus a cash rate in that environment. So clearly, they are more agnostic to the backdrop that we’re dealing with, and they can and should be able to deliver returns in any environment. This enhanced diversification issue needs discussing too, because given the way these products are generally managed, their correlation to a wider fixed income universe tends to be relatively low. And of course, as portfolio managers, we know that when we put assets in our portfolios that have low correlations, our overall risk-adjusted returns tend to go up.

DM: So, two differentiated and valuable additional benefits that absolute return can bring to the table.

Let’s get to the opportunities you see today. We all appreciate that the perspective has changed since early November. Fixed income markets reflect that. When you look at the landscape, where do you see the best opportunities?

JM: First of all, markets that we like, assets that we want to buy, cash we want to invest in, there are a few. We tend to steer clear of credit at the moment simply because we think spreads are relatively tight and there are risks on the horizon. I just don’t think as an investor that has a wide remit that we are being adequately compensated in that asset class for the risks that we’re assuming.

But there are places we do like. We like the local emerging market complex for different reasons. Firstly, yields tend to be higher than the cash rate, so you can get a pickup to cash rates from investing in those markets. Yield curves are positively sloped, which as in investors in fixed income, is a nice and attractive feature. We also think that many of the emerging market central banks can actually cut rates quite aggressively this year because they’ve really dealt with their inflation problems post-Covid pretty quickly by hiking rates sooner than the developed markets did. So, two really good reasons why we think the emerging markets can perform relatively well. And the Trump policies are having less of an issue for the emerging market asset classes today than they did the first time Trump won the election. While there are concerns afoot for that asset class, they’re very investable and those risks are heavily discounted already.

The other assets that we like are US mortgages, particularly the current coupon pass-throughs, the Fannie Mae, Freddie Mac, Ginnie Mae bonds that are either implicitly or explicitly backed by the US government. What we like is that they offer a yield pickup, an enhanced return profile and income over and above US corporate bonds, yet they are of a better credit quality. Going up the credit quality spectrum and picking up a yield in the process is a very nice way of approaching investments for an absolute return product today.

We should also highlight [that] more volatility is a more interesting backdrop. I’m very thankful and excited by the landscape in fixed income today because there are lots of relative value or market neutral strategies available. Volatility does bring dispersion and dispersion does bring opportunities for these types of products that can engage in long/short strategies and that is something we like doing a lot of in the current climate.

DM: I’m encouraged, James, that if you’re looking at US mortgages and the implicit guarantee of the US government that indicates you have faith in the outlook for the US as an institution and its ability to pay its debt. If we think more broadly about the key points that you shared with us and why absolute return makes sense in this environment, we’re dealing with more volatility. If we think about the markets that you find attractive today, you discussed local emerging market debt and, as I mentioned, US mortgages. Well, James, thank you very much for joining me.

JM: Pleasure to be here, Daniel.