Investors have traditionally believed fixed income offers diversification against equities, more reliable income than company dividends and, as a low-risk asset class, capital preservation. However, equity and fixed income returns over the last several decades fail to support these beliefs.
In recent years, when equities have done well, so has fixed income. And while fixed income can rise in value when equities fall, it doesn’t gain enough to compensate for equity losses, especially in a traditional 60/40 portfolio. For example, in 2008, the S&P Equity Index fell 38% while the Barclays Aggregate Bond Index was up 5%, so a 60/40 portfolio was still down 25%.
What investors really want is a hedge for equity risk, which requires a negative correlation with the equity portion of their portfolios. And fixed income doesn’t provide this hedge.
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Income provided by bonds has become much less attractive since interest rates have fallen worldwide over the past three decades. And this income is even lower in real terms, once you take inflation into account.
In the quest for higher yields, many investors have turned to fixed income sectors with higher risk and lower certainty of capital preservation, such as the credit and emerging market sectors. But higher return potential comes with a higher credit risk and the possibility of default.
Since the case for buying bonds is no longer that compelling, investors are seeking new strategies. Enter absolute return fixed income.
How it works
Rather than aiming to outperform a benchmark, absolute return strategies seek to increase value whatever the market backdrop. These strategies share two important characteristics.
1. They give managers the freedom to invest tactically in fixed income markets.
Managers can use a wider range of securities than traditional fixed income, such as mortgages, currencies and asset-backed securities, to exploit opportunities wherever they arise and adapt their positioning as market conditions change.
Absolute return strategies don’t use traditional benchmarks—which mechanically follow market capitalization weights for sectors and individual securities—enabling managers to be much more selective. Absolute return strategies are typically managed against a cash-plus benchmark, such as LIBOR (a benchmark for short-term interest rates) plus a certain number of basis points.
2. They can use derivatives (securities dependent on other underlying securities) to both hedge risk and take active positions. For example, a portfolio can use derivatives to take a short position to profit when interest rates rise and bond prices subsequently fall.
Knowing the risks
Absolute return fixed income portfolios typically focus on preserving capital and aim to provide a steady positive return. Their returns tend to have a low correlation with equities and traditional bond portfolios as they move independently of each other, making them a great diversification tool.
But absolute return can be complex. Following this approach requires making the correct tactical moves as markets change to prevent loss of capital. Investors also need to watch out for volatility. Since the absolute return approach doesn’t use traditional benchmarks, performance outcomes depend on both the total risk in the portfolio and the sources of that risk.
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Pension plans looking for diversification, reliable income and capital preservation may not be satisfied tracking long-only, traditional fixed income benchmarks. Solutions focusing less on traditional benchmarks and targeting absolute returns may benefit these investors.
Ben Steiner is senior portfolio manager, absolute return, with Fischer Francis Trees & Watts, a BNP Paribas investment partner. ben.steiner@fftw.com
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