Aviva Investors has prepared a research report on absolute return fixed income. The report, called “Building Resilience into Portfolios,” explains that the traditional use of fixed income in a portfolio is quite straightforward. That use generally involves a long position on debt of various sorts (sovereign, corporate, developed or emerging markets), that is relied upon to reap premiums from duration and credit risk. But there are alternative uses of these instruments, and given the “rapid pace of change within fixed-income markets” in recent years they have become more available than ever, with the goal of securing absolute return, “steady positive returns above cash.” These strategies include the exploitation of relative valuation differentials and/or the taking of short positions in order to profit from rising yields. Absolute return funds that avail themselves of new types of FI instrument and more accessible global markets can invest in both directional and non-directional strategies. This, Aviva tells us, normally involves a target return of 2% to 4% above cash “while attempting to limit the risk of drawdowns.” Challenges to the Traditional Use Traditional bond funds, seeking income from duration and credit risk as noted, have historically provided three benefits: income, diversification, and capital preservation. But the report observes that “there are a number of reasons to be skeptical [that] the asset class will continue to fulfill these roles in coming years.” One obvious problem is that the central banks are about to start (in some jurisdictions have started) raising rates, reversing the tailwind that has benefitted the traditional use of FI in recent years. Related: the world’s sovereigns, and many corporations, have in recent years been working to lock in the historically low rates, “”leading to a significant extension in the duration, or interest-rate sensitivity, of most indices.” Alternative investors in FX, though, have the flexibility to avoid such problems. They can “avoid issues, sectors, or sub-categories of assets altogether, as they see fit, investing solely in their highest conviction views.” Taper and Other Tantrums The diversification benefit of traditional FI investing in this field is also lessening. The authors of the paper cite such episodes as the ‘taper tantrum’ of 2013, or the reaction to the surprise of Donald Trump’s election in 2016, or a spike in volatility at the beginning of this year as evidence that even government bonds can no longer be relied upon as diversifiers. Let us supplement the Aviva paper a bit by looking at those events a little more closely. In 2013 the US Federal Reserve announced that it planned to reduce gradually the amount of money it was pouring into the economy, tapering it off rather than ending it cold turkey. Investors drew their money quickly out of the bond market (rapidly, not in tapered fashion!), sending yields sharply upward and giving the financial world the expression “taper tantrum.” The 10 year US Treasury yield gained 1.4% between May and early September 2013. Other sovereign bonds followed suit. The stock market also threw a bit of a panic: the Dow Jones fell 659 points between June 19th and the 24th. Clearly a portfolio that had been long on the stocks indexed by the DJIA would have taken a hit, and a traditional long bond positions on sovereigns wouldn’t have helped matters. The Election and a Conclusion In November 2016 Reuters reported that Trump’s “stunning victory for the White House” had just “wiped out more than $1 trillion across global bond markets worldwide” in a “two-day thumping.” The story contained more such dramatic language. There was a “stampede from bonds” underway, and the 30-year yield had just posted “its biggest weekly increase since January 2009.” On the Thursday after Election Day, the 10-year yield hit 2.11%. Goldman Sachs was forecasting that it was headed to 2.50%. Goldman was right. The yields would get above 2.50% during the presidential transition period. This was a marked development: they had been as low as 1.40% that July. Thus, Aviva suggests some investors will want to go beyond the traditional approach to FI. Although “reasonably high levels of exposure to duration and credit risk will sometimes be appropriate, at others different drivers of performance will be required,” such as yield curve arbitrage, the opportunities offered by inflation-protected products, foreign exchange markets, and capitalization upon (rather than victimization by) such periodic bouts of market vol as mentioned above.
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