While it is true that absolute return strategies have shown uneven performance following the global financial crisis (GFC), the changing inflation and interest rate landscape could help them generate returns for fixed income investors during a difficult phase for the markets, say Harvey Bradley and Shaun Casey of Insight Investment (1) .
With market volatility increasing and interest rates returning to pre-GFC levels, could it be a good time to invest in absolute return fixed income strategies?
Harvey Bradley, senior manager at Insight, is convinced that this is the case. In his view, absolute return debt strategies – designed to deliver returns consistently across all environments, regardless of whether markets rise, fall or remain within a limited trading range – are well placed to provide opportunities in a new post-pandemic macroeconomic situation.
Bradley believes that the evolving market environment, with higher interest rates, persistent inflation and volatility, presents increasing potential for Active investors with absolute return approaches: «Market dynamics have changed considerably in recent months. At the macroeconomic level, profoundly different economic and financial conditions have emerged than those after the GFC. This change has been driven primarily by the pandemic, but has also been driven by other key factors, including our first inflationary shock in a quarter of a century.
«Against such a background, we believe that the value of absolute return strategies, the diversification they offer and their potential for uncorrelated returns have come to the fore in recent years. We simply think that these strategies can provide positive returns in complicated markets like the current ones,” he adds.
quicksand
While acknowledging that some of these strategies have performed unevenly in the post-GFC low interest rate environment, and that certain products have failed to deliver on their initial promises (2), Bradley argues that the current macroeconomic environment could be more fertile ground for fixed income investors with absolute return approaches.
Uncertainty around the direction of monetary policy has been a key factor in the markets in recent months, continues the manager: initially firm forecasts of cuts in the price of money have given way to greater concern among investors. In August, the Bank of England made a moderate rate cut of 25 basis points (3) (the first since 2020 in the United Kingdom), while the European Central Bank also cut its intervention rate in June. However, the US Federal Reserve remains on standby in the face of disparate economic signals in the United States.
Bradley is also cautious in his interest rate outlook, but anticipates that the higher rate environment will persist, raising the potential attractiveness of absolute return debt strategies.
«Today the markets are still pricing in cuts in the price of money in the next 12 to 18 months, but in our view, rates will generally remain at much higher levels than in the past decade. So why not get some protection in case those cuts don’t materialize? We believe that absolute return strategies are one way to do this, and that they could also provide attractive diversification opportunities,” he explains.
Rate curve
Shaun Casey, Manager at Insight, believes that certain absolute return debt strategies could be driven by a reversal of the slope of the yield curve, a scenario in which longer-term bonds offer lower yields to maturity (IRR) than shorter-term bonds, reflecting investors’ expectation that interest rates will decrease in the future.
He also believes investors could benefit from a strategy that provides exposure to the lthe curve with the highest IRR (effective) while operating in a macroeconomic environment more conducive to generating alpha. «While it is true that IRRs could fall throughout the curve as we enter the next phase of the economic cycle, we do not believe that they will return to levels as low as those of the previous decade. In the short term we still see uncertainty around the moment and the extent to which central banks will cut the price of money,” says the expert.
Another key issue recently has been elevated volatility in the markets, which led to the CBOE VIX index American to shoot itself in August (4) . However, Bradley and Casey believe that the potential threat of volatile markets can be offset by the investment opportunities that can arise due to such ups and downs.
Higher levels of volatility
«We believe that central bank policies are going to be much more volatile than in the last ten years, and there are other important factors to take into account. Globalization, a key trend over the past 30 years, appears to be going into reverse, which has its own economic implications. Furthermore, aspects such as energy transformation, geopolitical developments and technological innovation are likely to keep volatility high, which is excellent news for investment portfolios managed with active approaches,” adds Bradley: “More volatility means more opportunities for managers, and those who know how to make the right decisions could be well placed to add more value to their portfolios.”
Bradley, senior manager of the absolute return strategy at BNY Investments, states that this can offer investors global and diversified exposure to the fixed income segment. By taking both long and short positions, it has the potential to generate positive returns in all phases of the economic cycle: “We do not depend on a narrow investment universe to generate alpha, as we have the flexibility to invest in any debt asset. Our strategy can invest in sovereign debt, investment grade and high yield credit, inflation-linked bonds, emerging market debt, currencies and other asset classes such as asset-backed securities (ABS) and loans. That said, we do not have any strategic bias, which allows us to avoid any underlying asset class that in our opinion does not offer true value,” he concludes.
The value of investments may decline. Investors may not get back the amount invested. The income generated by investments may vary and is not guaranteed.
1. BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA), BNY Mellon Fund Managers Limited (BNYMFM), BNY Mellon Fund Management (Luxembourg) SA (BNY MFML) or affiliated fund operating companies appoint investment managers to undertake activities portfolio management within the framework of contracts relating to products and services concluded between clients and BNYMIM EMEA, BNY MFML or the BNY Mellon funds.
2. FinancialStandard. Absolute-return bond funds fail ambitious returns: Research, May 12, 2023.
3. Professional Pensions. Bank of England cuts interest rates by 25 basis points to 5%, August 1, 2024.
4. Reuters. Wall Street “fear gauge” jumps to three-month high as stocks resume slide, August 1, 2024.
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