Absolute return a potential solution in challenging times

The potential for further upward yield increases, a widening of credit spreads, and eventual base rate hikes has left many fixed income investors assessing the likelihood of being able to achieve a positive total return within their fixed income allocations.

Absolute return fixed income strategies have attracted increased investor attention and may offer one solution in helping investors position their fixed income portfolios for a more challenging bond environment. These strategies may offer a timely option for investors to reduce their overall duration exposures, reduce market directionality within their fixed income allocations and adopt a more capital preservation orientated stance in a rising interest rate environment.

Strategies of this type generally achieve this by following investment mandates that are non-benchmark constrained, allowing managers greater flexibility to implement their fixed income market views at portfolio level without regard to benchmark weightings or composition. Rather than following benchmark relative mandates that seek to generate outperformance of a broad fixed income market benchmark, these strategies typically seek to generate a consistent per annum level of absolute return, alongside other characteristics including reduced volatility in returns, more limited drawdown potential and lower correlation to broader fixed income markets.

Despite these broad commonalities, this emerging segment of the fixed income product landscape does contain several different types of absolute return bond funds and investors should be cognizant of the various differences in exposures and return profiles between strategies. These can be broken down into four broad groups, Libor plus, absolute return/benchmark return, unconstrained fixed income alongside the somewhat different strategic income.

Libor plus strategies are the most conservative available in the sector, seeking a low risk outperformance over cash combined with capital preservation. These strategies typically employ a spread or carry type approach with low risk profile and benchmark target of Libor +2-3 per cent per annum.

Absolute return or benchmark return typically set a higher benchmark return of 3-5 per cent per annum over a one to three year horizon with higher (but still with low) levels of volatility, low correlation to other asset classes and maintain a focus on capital preservation.

Unconstrained fixed income should be considered more aggressive absolute return fixed income strategies, with increased directionality. They are typically broad in remit and focused on unconstrained, tactical fixed income sector allocation with a benchmark return of Libor + 4-6 per cent per annum.

Strategic income products differ from most absolute return fixed income funds, in that these types of funds tend to focus on generation of high current levels of income, and often display a more pronounced bias towards lower credit quality fixed income assets such as high yield, emerging market debt and bank loans. These types of strategies tend to try to provide high current levels of income as a way to avoiding or mitigating the impact of negative market movements.

Measured selection

Given the wide range of investment styles classified as absolute return, and the flexible mandates of these strategies, it is important that investors consider a number of key factors when selecting absolute return managers:

• As return is largely driven by manager skill rather than market or benchmark returns, a track record in the space or demonstrated experience in executing both long and short strategies is important

• Given the flexibility of many mandates the existence of risk management controls and procedures is paramount

• Gross exposure should be noted and any limits that are imposed to manage the portfolio from a risk perspective

• Ucits regulation provides additional protections and peace of mind for investors

The difficulty in selecting a suitable manager is further compounded by the lack of track record for many strategies which could typically be used as a screen for more traditional managers. It is exceptionally difficult to see how strategies have performed across market cycles forcing selection to be based on more qualitative factors.

While investors may face some difficulties in terms of manager selection, absolute return fixed income funds offer a range of potentially attractive investment characteristics. They may offer a timely option for investors to reduce their overall duration exposures, reduce market directionality within their fixed income allocations, and adopt a more capital preservation orientated stance, which is so important in the current rising interest rate environment.

Investors should seek strategies that match their return objectives and risk tolerance. In addition they should be prepared to use more qualitative criteria when selecting managers than they might be used to.   

Gavin Rankin, Emea head of managed investments, Citi Private Bank