Talking Heads – Making the case for absolute return bonds

Talking Heads podcast recording with Jayesh Mistry

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing absolute return strategies. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Jayesh Mistry, Absolute Return Portfolio Manager. Welcome Jayesh, and thanks for joining me.

Jayesh Mistry: Thanks very much. Great to be here.

DM: Needless to say, we live in interesting times, certainly as well from a fixed income portfolio manager’s point of view. We have tariffs, but then the news on that changes second to second. We have to try to assess the impact of that on growth and inflation. Now we’re adding in everything around the outlook for the US budget deficit negotiations. It’s not only about the US. We see interest rates rising around the world. And then there’s geopolitics. So, in all of this, it’s a safe conclusion that it’s not a really a buy and hold world. You need flexibility and looking for the good opportunities, so it’s not so surprising to talk about absolute return strategies. Could you give us a refresher on what absolute return fixed income is exactly? And how they should think about it in the context of a portfolio?

JM: So, an absolute return fixed income type strategy essentially has no benchmark. We’re just looking to outperform cash over a rolling three-year period. We still invest in fixed income assets, having more of a flexible allocation over time, whereas a benchmark product will have more of a structural allocation to fixed income. Absolute return fixed income products have the ability to go both long and short parts of the fixed income universe rather than having just a long only structural allocation. So, over time, you have smoother, less volatile returns.

DM:I listed at the beginning why it’s such a challenging time for investing more broadly. Volatility has been high after Trump’s election. The challenge is to find the opportunity in that volatility. Can you explain why you see the environment today as good to think about for absolute return strategies?

JM: It’s been a number of years now when market volatility has been high. We’ve seen dispersion between different parts of the fixed income universe. In those types of environments, it makes sense to have a more flexible product, which has less structural allocation to any one asset class or geography or any particular factor. It makes sense to have the ability to flexibly go long and short. Absolute return type strategies [also] have fairly low correlation to traditional fixed income benchmarks. That provides diversification benefits within a broader investment strategy. With cash rates moving higher, we’re seeing an allocation into more absolute return type fixed income products. Within absolute return type strategies, you have a strong focus on capital preservation.

DM: Can you share some of your views with us? What are some of the parts of the market you find interesting?

JM: We came into this year with the view that US growth momentum was slowing, US exceptionalism was probably overpriced in the market, and we weren’t being compensated for owning risky assets. So, we came into the year with a view to be short investment-grade and corporate credit. In terms of where we are today, we’ve moved from a short stance in corporate credit to more of a neutral stance after the volatility we saw in April. We like owning government bonds in the US and the UK, but in shorter-dated maturities rather than the longer end of the curve. We think that the Federal Reserve and the Bank of England will need to lower interest rates more than the market is currently pricing.

We still see a risk case of a stagflationary environment ahead, so we also like owning inflation-protected government bonds in both the US and the UK. We prefer owning bonds in the UK versus Australia and Canada. One market where we like being short is in the front end of Japan. The Bank of Japan still needs to tighten policy rates.

The reason that we prefer owning shorter-dated government bonds in the US and the UK is the fiscal and debt sustainability concerns that we’re seeing play out at the moment. We don’t think these concerns are going away, and so the yield curve will steepen.

In FX markets, we came into the year with a short US dollar position, and we’ve started to see the beginnings of a structural shift out of US dollar assets. However, we have had quite a big move already. The US dollar is about 10% weaker year to date. Even though we think the US dollar will weaken further, we have reduced that short position.

So, overall, we’re defensive, but we like owning government bonds in shorter-dated maturities.

DM: If I could share some of the key points. About absolute return strategies in general, we essentially don’t have a benchmark. You’re trying to outperform cash. That gives you a lot of flexibility. You can go long or short in the markets depending on what your outlook is. And ideally that produces smoother and less volatile returns with a low correlation to other fixed income benchmarks. As far as the market outlook, you like US and UK government bonds, but shorter-dated maturities on the expectation that the central banks are going to need to cut interest rates more than the markets are currently expecting. You’re seeing a structural shift out of the US dollar, but only slowly, so you’re short US dollars. And the risks to all of this you see potentially stagnation, notably in the US. Well, Jayesh, thank you very much for joining me.

JM: Thank you very much.

Daniel Morris: That’s it for this week’s episode of Talking Heads. If you would like more information about our capabilities and absolute return strategies, please reach out to your BNP Paribas Asset Management contact or check out viewpoint, our website for investment insights at Viewpoint dot BNP Paribas am.com. Just before we go, I’d like to mention that the Talking Heads podcast is available on Spotify and on YouTube. For YouTube, visit youtube.com/bnp/playlist and click on Talking Heads. You’ve been listening to the BNP Paribas Asset Management Talking Heads podcast with me, Daniel Morris, and Jayesh Mistry, Absolute Return Portfolio Manager. Please do join me next week. Until then, take care.