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The purpose of this Note is to provide an introduction to the Absolute Fixed Income Strategies (ARFI). This note considers what ARFI are and how they compare to the types of active strategies within traditional fixed income portfolios. The note also considers why investors may consider adding ARFI types of products available to their defensive asset classes (e.g. Fixed Income, Defensive Alternatives), how JANA thinks about ARFI strategies and the classifications of strategy types we consider appropriate.
There is a compelling case for some degree of ARFI type products in investors’ fixed income / defensive alternative portfolios. Investors though need to weigh up a variety of factors when considering which particular product may be the most suitable for their portfolio.
In this article
Summary :The purpose of this Note is to provide an introduction to the Absolute Fixed Income Strategies (ARFI). This note considers what ARFI are and how they compare to the types of active strategies within traditional fixed income portfolios. The note also considers why investors may consider adding ARFI types of products available to their defensive asset classes (e.g. Fixed Income, Defensive Alternatives), how JANA thinks about ARFI strategies and the classifications of strategy types we consider appropriate.
We note that the range of ARFI strategies is quite broad, and the type of strategies appropriate to an asset class will depend on not only the risk/return characteristics sought by the investor but also the other strategies and exposures contained within the asset class and overall portfolio.
In this current environment of historically low interest rates, and potentially a return to a higher volatility environment, ARFI strategies may be well placed to deliver strong absolute returns that are les correlated to traditional market drivers.
Background: Active Positioning within Traditional Fixed IncomeFixed Income managers commonly utilise a variety of active strategies to add value over a benchmark. These benchmark relative portfolios are typically measured against indices such as the Bloomberg AusBond Composite, which represents the Australian fixed income market or the Bloomberg Barclays Global Aggregate index (Global Agg), which includes a broad selection of global investment-grade bonds. These strategies can include sector rotation strategies (such as overweight or underweight individual fixed income sectors or overall allocations to credit), security selection strategies, interest rate duration strategies or interest rate yield curve strategies and currency strategies.
Also utilised by many managers are occasional ‘ex-benchmark’ allocations to sectors or securities outside of the stated benchmarks, though these strategies are commonly limited in some way in order to avoid greatly diluting the risk return characteristics sought by the investor.
Through such ‘active’ positioning strategies, fixed income managers seek to outperform the underlying benchmark by a certain amount, such as return 100bp more than the return of the Global Agg.
However, the overall return to investors from such fixed income portfolios will most often be dominated by the return of the underlying benchmark. And the composition of the benchmark is heavily influenced by which governments and corporate entities issue bonds -subsequently the return of the benchmark will depend on the movement in the underlying interest rates and credit spreads of the components within that benchmark. While the manager can deviate from benchmark positions, active positioning within traditional fixed income is necessarily limited, most often through strict portfolio management guidelines, in order to limit deviations from the benchmark (tracking error) and to ensure the overall asset class risk and return characteristics remain.
What is ‘Absolute Return Fixed Income’?The central tenet of ‘absolute return’ fixed income strategies is to release managers from the confines of the underlying benchmarks, and to construct fixed income portfolios made up solely of ‘active’ fixed income strategies.
In its purest form, Absolute Fixed Income strategies would be completely ‘market neutral’, thereby having no overall ‘beta’ exposure to fixed income interest rate and credit markets, and will thus offer a return profile solely dictated by the manager’s skill. In practice most absolute return managers adopt some degree of ‘long’ credit-based strategies within their strategy set, whether persistent or opportunistic, and hence there will be some degree of correlation to underlying credit markets in many absolute return fixed income products. The credit risk premium (excess return from credit investments above that expected from risk / loss – adjusted returns) is one of the most persistent risk premiums in fixed income markets, and hence is a key active strategy adopted by many fixed income managers, whether benchmark-relative or absolute return.
JANA has thus observed varying degrees of ‘credit market correlation’ within the absolute return space, from low correlation levels of about 20% up to as high as 90% correlation levels. However, there are occasional absolute products which remain truly ‘market neutral’ and offer no correlation to underlying credit markets, and even occasional products with negative correlations to underlying credit markets. Whilst these forms of absolute return products are attractive from a diversification sense, especially for investors with portfolios already heavy in allocations to credit or equities, there has often been other negative characteristics to these products seen over the past 10 years, such as very high volatility and/or poor performance.
JANA’s preference is to focus on unconstrained fixed income strategies which have high probabilities of exhibiting the following characteristics:
• Successful active alpha strategies that represent managers’ ‘best’ fixed income active ideas across widely diversified strategies set within global fixed income markets• Low return correlations versus other asset classes such as equities, credit (investment grade and high yield) and government bonds. The aim being to produce positive returns regardless of the stage of the market cycle• Are not managed against specific indices or benchmarks, but rather against either absolute targets or relative return spreads above Libor• ‘Reasonable’ levels of outright volatility (and therefore attractive risk-adjusted returns).
Underlying return drivers in ARFI:Absolute return fixed income strategies are best deployed across a well-diversified set of sectors, by skilled managers who have demonstrated the ability to deliver sustainable alpha. By identifying anomalies, mispricing and market inefficiencies, skilled managers can deliver positive return profiles through the cycle that should be relatively uncorrelated with traditional market betas.
Many absolute returns strategies are ‘relative value’ in nature, whereby the manager will choose a ‘long’ position in one security (whether that be a credit, interest rate or other type of fixed income exposure) against a ‘short’ position in another. Other absolute return strategies focus on opportunistic ‘long’ positions in fixed income securities or sectors where the manager believes there are high probabilities of favourable price movements.
The active strategies adopted by absolute return mangers are often a blend of systematic (model-based or quantitative-based) and discretionary (qualitative-based and judgement-based) investment approaches. Return generation from these strategies are typically focused on positions within one or more fixed income sectors, such as:
- Developed Market Sovereign Debt (Rates): Strategies can include ‘macro-driven’ (based on fundamental macroeconomic themes), and can be expressed in interest rate, yield curve and currency positions. These are generally ‘relative value’ positions.
- Corporate & Other non-government Debt (Credit): Managers can express positive or negative views on a particular issuer or sector through the use of cash bonds and derivatives. These strategies can be ‘relative value’ or event driven outright long or short positions.
- Structured Assets: Managers specialising in this area invest in agency and non-agency RMBS, at various rating tranche levels, though either long-only positions, or relative value positions (such as long / short coupons through forward agreements) or MBS ‘Basis’ trades utilising forwards and futures products.
- Emerging Market Debt (EMD): Strategies in EMD typically focus on hard currency (often credit) or local currency (often sovereign) debt markets. Positions are typically opportunistically long in nature, though with the development of a deeper credit default swap (CDS) market, relative-value trading has become possible
- Currency: Currency trades are by definition ‘relative value’ in nature. The strategies can either be macroeconomic-based qualitative ones, or quantitative in nature.
- Asset Allocation: These strategies rotation directional (long or short) positions across a variety of different risk premia, such as credit and emerging markets, via products including Credit Default Indices and Swaps
- Volatility: Volatility positions, whether within fixed income or currency products, tend to be directional in nature, and often utilise options / swaptions.
ARFI Returns and AllocationsJANA’s research in this area has focused on absolute return strategies that are reasonably defensive in nature. We have considered a universe of products and managers that can be expected to provide returns in the order of cash +2-5% p.a. by utilising absolute return strategies in a broad range of fixed interest instruments. This includes credit, government bonds, cash, emerging market debt, currency, and asset-backed securities.
As mentioned earlier, these strategies are in theory considered ‘market neutral’ and are reliant on manager skill, though there is diversity amongst the managers and products, with varied levels of correlations to market drivers such as credit. There can also be diversity in the risk characteristics between some products, with some volatility levels higher than investors are seeking outside of their Alternatives or Hedge Fund allocations.
JANA’s preferences for suitable risk characteristics of absolute return fixed income products depend on the role of the product within a client’s portfolio. For example, for an allocation to absolute return fixed income products within a client’s ‘Defensive Alternatives’ portfolio, our preference is that target volatility should be less than the long-term expected volatility of bonds (which is circa 3-6% p.a.), with a low correlation to both equities and bonds. Allocations within a client’s ‘Growth Alternatives’ portfolio would typically target higher levels of volatility.
In aggregate JANA’s preference regarding absolute return fixed income is for lower risk strategies that have minimal or negative correlation to growth assets. Our view is these strategies will grow in relevance for portfolios particularly in the current environment of historically low bond yields (discussed further in the following section of this paper).
Conclusion: JANA considers there to be merit in absolute return fixed income strategies which could be considered as part of the longer-term strategy for de-risking within clients’ portfolios.
Why look at Absolute Return Fixed Income Strategies?Over the past 30 years bond yields around the globe have trended downwards to the point where they are now negative on a real-yield basis in many countries for durations up to 10 years. The following chart clearly shows this trend.
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