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Why absolute return fixed income challenges traditional asset allocation thinking
In his book, Behave, author Robert Sapolsky urges his readers to rid themselves of “categorical thinking”. He uses the visual spectrum to make his point. The distinction between colours is arbitrarily drawn, and each language slices and dices the boundaries differently when they assign words to colours.
Why is this important? As Sapolsky explains, “Show someone two roughly similar colours. If the colour boundary in that person's language happens to fall between the two colours, the person will overestimate the difference between the two. If the colours fall in the same category, the opposite happens.”
So once a categorical boundary exists we start to place far too much importance on something that is, in essence, arbitrary, and you lose sight of the bigger picture. The lessons here for investing are huge.
Characteristics vs labels
When you think about the asset class buckets we have created in the investment industry, they essentially represent the same bias. By drawing lines in the sand between asset classes, and throwing them into categories, we are in danger of losing sight of the broader picture: that the characteristics of assets are what matter to a portfolio, not their labelling.
We can see examples of this when you remove liquidity from your viewing lens, or investment perspective. For example, private and infrastructure debt are fixed income investments that provide stable cashflows, it is just that their illiquid nature make them an ‘alternative’ asset. More conventionally, convertible bonds are a well-known example of an asset that has always straddled the boundary between equities and bonds. All of these assets have characteristics that investors will still desire, and which might be in short supply if we adhere too closely to traditional definitions.
Absolute return fixed income funds create similar challenges in terms of categorisation, with many investors placing them in the alternatives bucket. There are, however, some credible reasons for challenging this view.
Firstly, given the challenging backdrop for bonds, investors could use a helping hand with their fixed income portion of their portfolio. Or put another way, investors need to think differently. Whether we have finally reached the end of the thirty year bond bull market is still up for intellectual debate, but one thing that we can be sure of is that returns on traditional fixed income are unlikely to be as strong as they have been in the past. The characteristics investors have historically sought in bond markets – capital preservation, steady and predictable returns, and diversification from riskier assets – will be challenged in the years ahead.
Furthermore, risk on traditional index-based fixed income is rising. Downside risk management is compromised by such low yields because there is no cushion when prices fall. More importantly, durations – which measure a bond’s sensitivity to changes in interest rates – are increasing as companies and governments issue longer-dated debt. This is not a good thing for investors in a rising rate environment.
Secondly, regardless of the future environment, the need to create well-diversified portfolios (and by definition the component segments of portfolios) is essential. The historical benefits of investing in fixed income as a diversifying, defensive strategy are fading. The negative correlation between bonds and stocks, as demonstrated by data from Bloomberg capturing the US Aggregate Bond Index and the S&P 500 Index, highlights the historical reliability of the diversification benefits. However, more recently we can see that those assets have become positively correlated. Diversification is becoming ever-harder to find.
Lastly, and stepping back from the narrowness of the pure fixed income lens, if investors recognise the importance of having assets within their portfolio that have low or negative correlations to large chunks of the rest of their portfolio, then it makes sense to find some space in their portfolio for assets that offer this, regardless of which bucket they assigned it to.
Diversified sources of return: from two to six
Given the importance of both low correlations and capital preservation, it is key to understand how these characteristics are achieved within absolute return fixed income products.
While more traditional aggregate bond funds, and many absolute return fixed income funds for that matter, rely mainly on managing duration and credit spreads, we seek out additional sources of risk and returns; and it is this diversification that helps keep a portfolio’s overall returns uncorrelated to broader markets. This variation in the sources of risk improves a portfolio’s overall risk/return profile, which is perhaps more important in times of rising interest rates than attempting to maintain returns at any cost. An example of this is our active management of opportunities in bouts of volatility while exploiting inefficiencies, not only in duration and spreads, but also in yield curves, inflation, and foreign exchange markets.
The overriding point here is that our rigidity of thought can often result in us losing sight of the bigger picture. How we define borders and boundaries limits our overall portfolio dynamics and, ultimately, our risk/return profile. If you accept that fixed income markets have shifted irrevocably to an environment in which investors must expect considerably lower returns, then it makes sense to radically alter your thinking to accommodate for this. Removing the ‘alternative’ label from absolute return bond funds might not be a bad place to start.
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