Absolute return bond funds give managers even greater flexibility to deliver positive returns from bonds in a rising yield environment, according to Paul Brain, manager of the £915m1 Newton Global Dynamic Bond fund.
Record low interest rates and the end of quantitative easing have put significant pressure on bond managers, who are finding it increasingly difficult to find attractive value plays.
Charles Younes, analyst at FE, says that having the maximum degree of flexibility will be the key to making decent returns from bonds in the coming years. “We’re approaching the end of the credit cycle, and it’s becoming harder and harder to make money from bonds. I’d anticipate this to continue,” he said.
“In 2008, government bonds were the place to be, then investment grade credit, then more cyclical securities and finally high yield. Now it’s very difficult to see where the big returns are coming from – only the most flexible bond managers will be able to eke out returns.”
IMA Strategic Bond has been a popular hunting ground for flexible fixed interest portfolios, but Brain (pictured) says that absolute return bond funds are an alternative.
“If you look at a lot of Strategic Bond funds in 2008 and 2013, they were not as flexible as some might have expected,” he said. “A lot of these funds naturally have half an eye on the index.”
“We focus entirely on producing an absolute return – we need to be as flexible as possible to do this, and are not measured against an index. If we don’t like the outlook for a certain area of the market, we don’t own it.”
“This is a go-anywhere fund, though it does have a long bias. We always think there are enough long opportunities, though we can use shorts if we see fit.”
By going ‘short’ on a stock, fund managers are able to make money from falling share prices.
“We have a huge degree of flexibility, with up to 50 per cent in emerging market sovereigns and 50 per cent in high yield. We don’t use much cash – we currently have 4 per cent in true cash – but we do hold a lot of short-dated bonds, which have a better potential for return.”
Brain can hold up to 10 per cent in cash, but can hold 50 per cent in zero-duration T-bills, which are essentially a proxy for cash. His fund can also have negative duration and invest up to 50 per cent in non-sterling denominated currencies. At one point in 2008 it had 45 per cent in other currencies.
Sterling Strategic Bond funds must have at least 80 per cent of their net currency exposure in sterling.
Apart from the added flexibility, Brain says the biggest difference between his strategy and Strategic Bond funds is his greater emphasis on capital protection.
“Our rationale is not to lose money – it’s as simple as that,” he said. “You can’t do it all the time of course, but on a calendar year basis we’ve been successful.”*
“When markets go down, we tend to use derivatives2 to stop the rot. We tend to go sideways and up, which over the longer term means you end up outperforming.”
Newton Global Dynamic Bond has managed to deliver a positive return every year since its launch in 2006.
Source: FE Analytics as at 31 December 2013. Past performance is not a guide to future performance.
The average fund in the IMA Targeted Absolute Return sector lost money in both 2008 and 2011. IMA Strategic Bond coped much better in the latter calendar year but lost a whopping 13.54 per cent in the former.
Brain says Newton Global Dynamic Bond benefited from its overweight to government bonds in 2008 and underweight in credit, and then a gradually higher weighting to the latter in 2009 and 2010.
He upped the fund’s weighting to peripheral Europe last year, which again aided performance, as did stock-specific shorts in the UK and US markets.
Unsurprisingly, the fund looks good from a cumulative return point of view, significantly outperforming its sector average, Libor 1 month +2% benchmark, cash and inflation over three- and five-year periods, and since inception.
Performance of fund, sector and indices over 5yrs
Source: FE Analytics. Past performance is not a guide to future performance.
Brain has underperformed the FTSE All Share over five years, but as the graph above shows, his fund has been significantly less volatile.
As well as gaining a strong track record from a total return point of view, it currently has an attractive yield of just over 3 per cent. Dividends are paid quarterly.
With the consensus suggesting that interest rates are likely to rise in the US within the next 12 months, many are anticipating a significant bear market for bonds as a whole.
Brain thinks it will remain challenging for investors, but doesn’t think a crisis on the scale of 1994 is likely.
“We’ve had stable or declining interest rates and bond yields for many years. We’ve had some small bear markets in between, such as the credit liquidity crisis in 2008 and some of 2007, and for European bonds during the 2011 eurozone crisis, but it’s been a good time to be in bonds,” he said.
“The last time we had an interest rate bear market was in 1994. The market was spooked, with yields rising aggressively between March and October, but much of the losses were recovered within six or seven months.”
“We’ve had a mini bear market over the past year, but I think from here it will be much more gradual and less dramatic than 1994. We have a huge debt burden to deal with, and so economies will not be able to withstand a significant rise in rates.”
Many investors and advisers are intimidated by the complicated nature of absolute return bond funds, but Brain says his product is far easier to understand than may be expected.
“Absolute return bond funds allow you to invest in a lot of different types of areas. In the rest of the absolute return sector, you’ve got long/short and market-neutral funds, which are far more complicated,” he said.
“For us, liquidity and making sure investors understand what we are doing is very important.”
“Overly complicated products don’t always work. Not everything has to feature a credit arbitrage.3 A lot of duration-neutral products collapsed during the loss of liquidity during the financial crisis, which is the trouble with niche areas. They’re fine when liquidity is ok, but can unravel very quickly.”
“We’re much more about keeping it simple. We want to put ourselves in the best position to spot the economic and interest rate cycle across the globe, in a way that is easy to understand, dynamic and nimble.”
“We invest in global government bonds, corporate in high yield and investment grade markets, and we can use shorts and cash when we think the time is right.”
Brain says he expects interest rates to be raised in the first quarter of 2015 in the UK. In spite of this, he has recently put one year’s worth of duration back into the fund, believing that the sell-off in 2013 was overdone.
“We ended the year with 1.6-year duration, and that’s now at 2.6 years,” he explains. “Strategically we think yields will rise, but tactically we are looking to hedge against a wobble in equities.”
This piece has been sponsored by BNY Mellon Investment Management. For a guide to absolute return investing, click here.
1 As at 30th April 2014.
2 Derivatives are a financial product, the value of which is based on something else (like the price of gold or the shares in a specific company); as such it can be used to link to a wide variety of assets or combinations of circumstances. For example, if a fund manager believes the share price of company ABC will fall in value over six months, he can buy a derivative that will pay if it does so. This potentially enables the manager to make money if a share price falls.
3 The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies.
* Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and can fall as well as rise due to stock market and currency movements. When you sell your investment you may get back less than you originally invested.