Inflation is the bond market's worst enemy
Inflation was notable by its absence in the wake of the financial crisis. Global central banks cut interest rates and pumped excess liquidity into the system via quantitative easing in a desperate attempt to stoke an inflationary fire. This exercise appeared futile, until the combination of Brexit, the Covid pandemic and the Ukraine war sparked the embers of what has now become an inflationary inferno. Supply chain disruption and domestic onshoring (of defence and energy), combined with tight labour markets, has seen global interest rates skyrocket as global central banks try to douse the flames with a disinflationary hose.
This rise in interest rates has resulted in capital deterioration within investor portfolios as historically low bond yields were insufficient to offset the magnitude of the drawdown experienced as yields rose. There was almost no shelter as government, inflation-linked and corporate bonds all suffered a similar fate. Only money market funds provided an element of safe haven, although allocations to this asset class were limited due to the very low yields on offer.
Absolute return funds should have been the key benefactor in a rising rate environment: theoretically, these funds are non-correlated with market beta and are free to deliver a positive absolute return whatever the macroeconomic conditions. However, many investors found that this was not the case and a number of funds in this sector have experienced returns that echoed those of a bond fund. This is not the first time this has happened and over the years these outcomes have given the sector a bad name. However, is this the fault of the sector and the available products or perhaps the mindset of the managers who manage these strategies?
How should an Absolute Return Government bond fund be structured and managed?
Many managers think about Absolute Return in a long-only context. What do I mean by this? The manager constructs a portfolio of bonds that they believe will outperform a cash benchmark over time. The problem with this approach is that it embeds significant interest rate risk and or credit risk into the portfolio and therefore, the absolute return of the portfolio is most likely determined purely by the direction of interest rates or credit spreads. If an investor wants exposure to rate moves or credit spreads, then they should just buy a plain vanilla government or corporate bond fund.
In our opinion an absolute return strategy should focus on providing an excess return over and above a cash rate in all market conditions. To achieve this the manager must keep interest rate and credit risk to a minimum and focus on delivering outperformance from a range of non-correlated diversified market neutral strategies.
This post is funded by Royal London Asset Management
This is a financial promotion and is not investment advice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.