A looming market correction in corporate bond markets may be highly suited to absolute return bond funds, according to Andrew Balls, Pimco’s global fixed income chief investment officer who is forecasting a low return environment over the medium term.
Balls, who is the younger brother of former shadow chancellor Ed Balls, runs a host of fixed income portfolios including the $8bn Pimco GIS Global Bond Hedged fund.
He says there has been prolonged period where beta returns in the market were very attractive, as shown by the fact that yields across nearly all fixed income assets have been driven down by cautious investors and huge amounts of central bank intervention.
Performance of indices over 6yrs
Source: FE Analytics
However, he says that over the medium term beta will not be as successful as it has been and therefore investors will need to focus more on alpha.
“You can do this using traditional benchmark related products because if you have a lower return environment, if we can continue to generate the alpha as a higher share of the total return you can do this using absolute return strategies or income strategies where you have less of a focus on interest rate duration in order to generate returns,” Balls said.
“You can also apply leverage to absolute return strategies, so you have in effect hedge funds and you can go to funds strategies that have lock ups so you are going to be able to garner the risk premiums of illiquid assets.”
However, he says it should depend on investors existing asset allocation.
“If you are doing asset allocation you may want to choose from a range of those products. If you are a retail investor then maybe income products may be a good idea for you. Alpha is going to be even more important in a low return environment.”
Balls says he expects the group, which has seen huge outflows after bond market doyen Bill Gross left last year, will look to “step back” from credit markets at some point in the next three to five years as spreads tighten.
“Corporate credit markets [currently] in terms of valuations look reasonable but they don't look cheap. We have gone from an environment where in the last few years we thought big beta plays – in 2009 and subsequent years – could be very interesting. Today we need to focus much more on the security selection, the bottom up.”
“Valuations look ok but if you see an ongoing reach for yield on the part of investors then we are going to have be prepared to step back from credit markets. It is something we did in 2006 and 2007 and is something we may need to do again if you see an ongoing tightening in terms of credit risk such that you are not getting paid appropriately for liquidity premia.”
“With less liquidity in markets we need to be prepared for periodic bouts of volatility which should be ideally suited to actively managed bond funds.”
According to FE Analytics, corporate bond markets had a rough time in 2006 and 2007 as shown in the graph below in the UK, Europe and the US.
Performance of indices in 2006-2008
Source: FE Analytics
While this was bad for the broader market, Balls says that periods of volatility “can be ok” as they can provide good opportunities for active management.
“We are not going to complain about the prospects for volatility. It underlines the case for active management. [Also] we have had bunds this year, treasuries in October and the ‘Taper Tantrum’ in 2013 - so it is not just credit markets. The combination of less liquidity from the parts of the banks, less balance sheet for trading and a degree of herding on the part of investors means that if people want to change their mind it can be very hard to accomplish this.”
Herding on the part of investors is not surprising it is one way QE works, to try and influence investor behaviour and portfolio rebalancing etc etc. Therefore there is the potential for periods of volatility. If we can be disciplined and run less risk, so we have room to add during periods of market tension then this can provide good opportunities for us over time.”
“We are taking a medium term three to five year view and we are trying to plan ahead. We are overweight broadly defined credit in our portfolios but less so than we were three months ago, six months ago and 12 months ago as we have seen the on-going tightening of spreads.”
He says he is looking to guard against taking on more credit risk and seeing spreads get tighter and tighter as investors continue to hunt to for yield.
“We are not there yet but it is something that we watching very closely. US high yield looks relatively attractive versus investment grade. But if we get back to an environment like in 2006 and 2007 of excessively pressured risk premia we need to be ready to go to negative carry portfolios to own less credit and wait for re-pricing.”
“You can find some parts of the credit market which look attractive based upon the beta, financials for example, but it really is becoming a matter of security selection.”
“One thing we are going to need to be very careful about is to guard against and make sure we get appropriate liquidity premia in credit markets. There has been a lot of issuance and banks have reduced their balance sheets for trading. We must be very careful in terms of making sure we get that sufficient liquidity.”
The £1.2bn Kames Absolute Return Bond is an example of an “alpha not beta strategy”. Managed by Stephen Snowden and Colin Finlayson, it holds holds five FE Crowns.
Since launch it has returned 7.81 per cent, which is unsurprisingly below the average return in the IA Targeted Absolute Return sector but higher than the 2.41 per cent rise in its benchmark of three-month sterling Libor. It also has much lower volatility than the sector average.
Performance of fund vs sector and index since launch
Source: FE Analytics
However, Kames has stopped actively marketing the fund as it is approaching capacity.
Others which feature in this space include Aberdeen Absolute Return Bond, Threadneedle Absolute Return Bond and Henderson Credit Alpha, which is headed-up by Tom Ross and FE Alpha Managers Chris Bullock and Stephen Thariyan.
