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Absolute Return Bonds Guide

Conclusion

In summary, an absolute return bond fund is able to achieve a broad range of investment strategies. The manager can adopt directional and relative value strategies to exploit expected movements in interest rates, credit markets and currencies. Moreover, the manager is able to implement these strategies through the use of derivatives, as well as direct physical investment in securities, such as government bonds. Indeed, derivatives can often provide a more precise way to express investment views.
A final word of caution
Managers of absolute return bond funds will use a range of techniques to achieve the required returns. Some do so through very active management of the assets of the fund. Others use derivatives entirely. The use of derivatives involves complexities over and above those of traditional funds and consequently requires fund managers with a greater skill set. In short, managers of these new, complex funds need to know exactly what they are doing. This means that before recommending any fund targeting absolute return, you should ask for concrete proof that the fund managers:
  • Have a detailed risk management and control process in place and can illustrate that they are able to carry out this process, so as to manage the funds effectively and safely
  • Have a sophisticated fund accounting system to price the derivative instruments on a daily basis and to value the fund
  • Can prove that they have experience of short/long management
  • Are able easily to explain what they are doing with the derivatives they are using
Glossary
Absolute Return Fund
A fund that targets positive investment returns rather than investment returns that are compared to the performance of market indices. Counterparty Risk
The risk that the other party to a contract will default on their obligations.
ETF
An exchange-traded fund is designed to replicate the return on a specific index. Essentially the ETF trades as a security tracking the performance of an index and just like an index fund it comprises a basket of securities. Ownership of an ETF offers the diversification benefits of an index fund as well as the ability to sell short. As with an individual security, the price of an ETF will vary throughout the trading day.
Gearing
Derivative instruments are said to be 'geared' in that only a proportion of their total market exposure has to be paid to open a position. In the futures market, this proportion is referred to as 'margin' and in the options market it is known as the 'premium'.
Going short, shorting or short selling
This describes the sale of a security that the seller does not own. The seller borrows that security to sell it on. However, the seller is committed to eventually buy back that security at a later stage. The aim of such a technique is to benefit from an expected decline in the price of the security.
Gross exposure
This is a measure of how much capital is being deployed by the fund in the markets. This measure is derived by adding a portfolio's long and short positions together. It is different from the net exposure. Money market futures positions can be excluded when calculating the gross exposure.
Leverage
For an absolute return bond fund, leverage can be achieved through the use of derivatives such as futures and options. Leverage is calculated by dividing the Fund's gross global exposure (in excess of its Net Asset Value) by the Fund's current NAV.
Long-Only strategy
This strategy does not eliminate or control the exposure to underlying market movements.
Long/Short
An absolute return bond fund can use this strategy to invest in bond markets by combining long positions with short positions to reduce, but not necessarily eliminate, the exposure to the market. These strategies are therefore somewhat directional and their returns typically exhibit some correlation with the underlying markets.
For an absolute return bond fund, the manager would be able to take long and short positions in areas such as government bonds, currencies and interest rate futures. By definition, a currency trade is always a long/short trade.
The Manager can therefore use this strategy to exploit the relative pricing differentials between two different markets and not necessarily as a means of reducing the level of risk.
Net exposure
This is a measure of how much capital is exposed to market movements. This measure is derived by adding a portfolio's long positions and subtracting a portfolio's short positions.
Stop-Loss measures
Stop-loss limits can be set at a security level, with a view to limiting trading losses. This entails the automatic sale of a security when it reaches a specific price. Stop-loss measures can also be instigated at a strategy level for positions that form part of larger well-defined strategies that in normal circumstances would all be traded together.
Strike price
This is the specified price at which an options contract may be exercised. It is also known as the exercise price.
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