The Flavors of Absolute Return Fixed Income

July 31, 2017
  

The flexibility of absolute return bond strategies can be appealing to investors concerned about rising rates, but a mindful approach to duration can help to create a portfolio well suited to navigate changing markets.

  

Absolute return fixed income defined

Absolute return fixed income strategies go by a number of different names: absolute return, unconstrained, real return, strategic alpha, opportunistic, strategic income, non-traditional, and even “go-anywhere” fixed income. They are opportunistic in approach and in most cases, can select from a broad array of security types and “go anywhere” within the fixed income market in search of attractive returns.

Regardless of the name, these strategies generally share two common traits:

  1. They strive to deliver positive absolute returns over a specified period regardless of the direction of interest rates.

  2. Unlike traditional fixed income strategies, they are not typically managed against a market-capitalization weighted bond index. Rather, they are often managed against a cash-based benchmark such as 3-month LIBOR, 3-month Treasury bill, or any country’s money market (“risk-free”) rate.

Beyond these two traits, absolute return strategies can vary widely in terms of eligible sectors and security types, alpha objectives, risk parameters, and manager styles. Asset managers, in large part, each have their own concept of “absolute return.”

Unlike traditional long-only fixed income strategies, which underweight positions versus their benchmarks, many absolute return fixed income strategies tactically “short” specific bonds or sectors of the market—often through the use of derivatives—to implement a negative view. These strategies may be levered as a result of their interest rate hedging techniques, but they are not always economically levered. Accordingly, absolute return fixed income can at times have a negative duration (e.g., go “short” interest rates) which can directly benefit investors when interest rates rise.

Flexible duration for rising rates

A primary attraction of absolute return fixed income strategies is their ability to help limit downside risk in a rising interest rate environment. As is illustrated below, during periods of rising rates (from December 2008 to March 2017), absolute return strategies have, on average, posted positive total returns and consistently generated positive excess returns relative to the aggregate bond indices.

Absolute Return Strategies Can Outperform During Periods of Rising Rates

December 2008 to March 2017

PeriodChange in U.S.
Treasury Yield
(bps)
Absolute Return
Category Avg1 (%)
Bloomberg
Barclays U.S.
Aggregate Bond
Index (%)
Outperformance of
Absolute Return vs.
Bloomberg Barclays
U.S. Aggregate Bond
Index (%)
Dec 18, 2008 – Feb 27, 2009+972.0-1.2+3.2
Mar 18, 2009 – Jun 10, 2009+1418.0-0.2+8.2
Oct 7, 2009 – Dec 28, 2009+671.9-0.5+2.4
Feb 5, 2010 – Apr 5, 2010+441.5-0.7+2.2
Oct 8, 2010 – Dec 15, 2010+1140.3-3.1+3.4
Sep 22, 2011 – Oct 27, 2011+670.3-1.7+2.0
Jan 31, 2012 – Mar 19, 2012+581.5-1.2+2.7
Jul 24, 2012 – Sep 14, 2012+471.6-0.7+2.3
Nov 16, 2012 – Jan 30, 2013+441.8-1.0+2.8
May 2, 2013 – Sep 5, 2013+135-2.7-4.9+2.2
Oct 23, 2013 – Dec 31, 2013+550.5-1.1+1.6
Jan 30, 2015 – Mar 6, 2015+571.0-1.9+2.9
Apr 17, 2015 – Jun 10, 2015+63-0.1-2.8+2.7
Jul 5, 2016 – Mar 13, 2017+1253.8-3.7+7.5

Source: Morningstar, Bloomberg, Barclays, and PGIM Fixed Income. Past performance is not a guarantee or a reliable indicator of future results.

1Represents the average return of the Morningstar Non-Traditional Bond Category. The table illustrates the Morningstar Non-Traditional Bond Category average and Bloomberg Barclays US Aggregate Bond Index performance during periods where interest rates rose by 40+ bps from 12/18/2008 through 3/31/2017. Rising interest rate periods as measured by the daily business day movements of the 10-year Treasury bond yield, which is a commonly used reference point for the purposes of tracking the general movement of interest rates for the US fixed income market. The decision to use 40+ bps threshold was done so that an investor could see multiple instances of rate rising periods over the last 5+ years to better assess how Non-Traditional Bond Investments have performed during these types of periods.

Absolute return fixed income portfolios tend to have a low correlation to traditional fixed income, and as a result, during periods of rising government bond yields, an absolute return portfolio with a near zero duration has the potential to post positive returns as the interest rate hedge—created via interest rate futures or swaps—may generate a positive return on a mark-to-market basis.

On the flip side, absolute return strategies may be strongly correlated to risk assets, such as high yield bonds and equities. In other words, a balanced portfolio of stocks and bonds, with a large portion of the bonds invested in absolute return strategies, may be suboptimal. That’s because during “’risk-off” periods both the stocks and absolute return portions of the total portfolio could decline in value.

A strategy that has put some level of constraint around duration can help to create a better diversified portfolio. For one, unexpected drift could heighten interest rate sensitivity precisely at a time when the investor is looking to reduce exposure. Furthermore, strategies with significant negative duration can lead to subpar returns in many scenarios. Secondly, an absolute return strategy with some duration constraints may complement an investor’s overall asset allocation expectations given that interest rate moves are not a primary driver of returns. Conversely, ultra-flexible strategies with wider duration bands can make it difficult to anticipate, or model, how the strategy might contribute—or detract from—an investor’s overall portfolio.

Although the majority of the developed country government bond rally is likely behind us, fixed income can still serve as a source of potential alpha. An absolute return fixed income strategy managed against a cash-based benchmark may be one option for investors seeking to reduce interest rate exposure and generate higher returns than cash. Among the array of absolute return strategies available, a diversified, blended approach that utilizes both top-down and bottom-up investment strategies while constraining duration within a modest, specified band can help to generate a consistent alpha stream while potentially limiting structural interest rate exposure.

To read more about Absolute Return Fixed Income strategies, please read PGIM Fixed Income’s recent Q&A with Senior Investment Officer, Michael Collins, CFA: “The Return of Absolute Return Bond.”




Bloomberg Barclays U.S. Aggregate Bond Index. This index represents securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade, fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

Correlation describes the way two securities move in relation to each other and can take a value anywhere between positive and negative 1. A correlation of +1 means the two securities move in unison, a correlation of zero indicates the two securities do not move together at all, and a correlation of -1 means the two securities move exactly opposite of each other.

Duration is a measure of interest rate sensitivity for bonds.

Alpha measures excess return above a benchmark.

Past performance is no guarantee of future results. Fixed income instruments, which are subject to credit, market, and interest rate risk; Foreign or non-U.S. securities, which are subject to the risks of currency fluctuation and political uncertainty; emerging market risks, which are subject to greater volatility and price declines; interest rate risk, where the value will decline as interest rates rise; derivative risks, which may carry market, credit, and liquidity risks; high yield (“junk”) bonds, which are subject to greater credit and market risks.

Diversification does not assure a profit or protect against loss in declining markets. The views expressed herein are those of PGIM Fixed Income investment professionals at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute investment advice or an offer to sell or a solicitation to buy any securities mentioned herein. This commentary does not purport to provide any legal, tax, or accounting advice.

Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy.

 

0307809-00001-00 Ed. 07/2017