Talking Heads – Estrategias de renta fija de rentabilidad absoluta

This is an audio transcript of the Talking Heads podcast episode Adding a string to your bow with absolute return fixed income 

Andrew Craig: 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 fixed income investing. I’m Andrew Craig, Co-head of the Investment Insights Centre, and I’m joined today by Jay Mistry, who is a Senior Portfolio Manager in the global aggregate and absolute return bond team in our London office. Welcome, Jay, and thanks for joining me.

Jay Mistry: Thank you very much. It’s great to be here.

AC: The topic today is absolute return fixed income investing. So perhaps the best place to start is if you explain to us what you mean by absolute return fixed income investing. And what about the pros and cons of this approach to investing in bonds?

JM: Absolute return fixed income strategies are basically looking to outperform a cash rate, which is a key difference when you compare that to more traditional fixed income strategies which are looking to outperform a benchmark of bonds. So, for example, if you have a traditional benchmark for bonds and say that benchmark is down by 3% this year because yields have risen, a traditional fixed income product might try and outperform that benchmark by, say, 2%, but this product would still be down by 1% in total return terms. For an absolute return fixed income product, the goal is to try and outperform that cash rate. So, if the cash rate is 5%, if that absolute return fixed income product is trying to outperform the cash rate by 2%, it needs to make a total return of 7%, regardless of how the broader fixed income market is performing.

AC: Today, we’ve got cash rates which are, compared to the recent past, relatively high. Central banks have been fighting inflation; they’ve raised official rates. The European Central Bank has its key rate at 4.25%. The Bank of England base rate is above 5%. The US federal funds rate is still between 5.25 and 5.50%. Those are relatively high cash rates, which I assume makes absolute return fixed income investing particularly attractive, the only risk being that cash rates fall quickly to much lower levels, which would make it less attractive. Is that right?

JM: Absolute return style products are usually shorter in duration in nature, so they’re not going to outperform longer-duration benchmarked fixed income products in a very strong bull market, as you mentioned, where global yields move much lower and risky assets like high-yield bonds outperform. But, in the environment we’re in at the moment, even though we’re quite positive on fixed income, we’re not expecting a large move back towards that pre-COVID era where volatility was compressed by central banks and yields were at rock bottom. We think that fixed income volatility is going to stay elevated, yields will move a bit lower, but there’s going to be even larger differences across different regions, countries and markets. So having an active, flexible approach, absolute return fixed income products still have benefits. And the main kind of positives of this type of product, it’s the ability to generate those positive returns regardless of the market environment and also being able to go not only long fixed income exposure like it would be in a traditional long only fixed income product, but also being able to go short via derivatives. So, for example, in a year like 2022, when yields rose significantly across the globe and risky assets struggled in those long only fixed income benchmark type products, there was nowhere to hide. But by having an allocation to an absolute return product which can go short through derivatives, it means you can look to generate positive total returns even in those types of market backdrops. It gives you diversification which can complement your traditional benchmarked fixed income products.

AC: We are perhaps not in the same environment we were for the 30 years between 1980 and even up to the pre-pandemic period when interest rates fell. And that generated strong returns in terms of capital appreciation that may be behind us. And if that is behind us, then, as you say, an absolute return approach would make a lot of sense.

JM: We’ve had, like you said, a decade or so of interest rates being close to the lower bound. Yields have risen again, and you can now get a decent yield above cash while you can stay in high-quality assets. Yields rising over the last two or three years also means that interest rate volatilities have also risen. And with that we’ve seen more dispersion between different markets, countries, different regions. That presents opportunities within absolute return style fixed income products, especially ones which have relative value strategies being long one region or market, country and short another. Having that flexibility to go short can really help complement those more traditional long duration strategies.

AC: That’s reflected in the fact that conventional benchmarks in, as you say, 2022 had negative returns. They were rescued by the big rally at the end of the year, but otherwise they’d have been underwater again. And even this year we’ve had the stronger inflation numbers in the US, which has made for a rough ride for the conventional benchmarks so far at least. What about your approach to this strategy? How do you manage this type of product as opposed to the conventional long only bond product?

JM: A key thing that we focus on is capital preservation. So, this doesn’t mean no losses, it just means that there’s a lot of focus on the portfolio construction element of our process to try and ensure a smoother or less volatile path of returns and manage any drawdown. We can use these long and short strategies and a range of derivatives and run a diversified, active strategy trying to find trades which we think are asymmetric in nature. So, with that kind of mindset, we run strategies that are around cash plus 2.5% as a return target. We think that’s quite a good return target for this type of strategy. It still means that you get quite strong total returns over a business cycle, but without having too much volatility along the way. For example, government bonds, investment-grade corporates, high-yield corporates –nearly every year at least one of those asset classes produces a positive total return, and often the differences can be pretty largen those asset classes. So, if you have an active, absolute return approach, you can find opportunities for positive total returns.

AC: You have a vast investment universe because [in] the global bond markets there are ‘s numerous segments – that is a source of diversification. So, you’re seeking to choose the most attractive segments within that broad universe. It’s giving you another string to your bow. Let’s talk about your view on markets. Towards the end of May, we’ve had a big change in terms of what’s anticipated for official interest rates from the US Federal Reserve and to a certain extent in Europe too. How do you see markets and where do you see opportunities?

JM: Over the past year or so, US 10year Treasury yields have traded between 4% and 5%. At the moment, we’re near the middle of that range. And as you mentioned, inflation has printed stickier than expected, mostly in the US. That’s pushed back the timing and the scale of interest rate cuts. We think that growth is moderating in some markets more than others. Unemployment has been rising from low levels, but overall global growth is still okay at the moment and the US has really been the outperformer over the past year, but we’re starting to see signs of that outperformance waning and also signs of stabilisation outside of the US. Inflation has been trending lower. But there has been stickiness in services inflation across several markets, but we do think that inflation will continue to trend lower as we move into the second half of the year. The real focus at the moment for the market is on monetary policy, especially so in the US. The market pricing for monetary policy has been moving a lot this year. There is scope for slightly more interest rate cuts to be priced in, but that does vary across different regions and countries. For example, the growth and inflation dynamics between Australia are very different to the likes of Canada or Sweden, where the Riksbank has already started to cut rates. And then in places like Japan, after decades of deflation, we’ve seen inflation and wage growth picking up and the Bank of Japan moving towards a tighter policy. All of that put together should mean that yields outside of the likes of Japan move lower, especially shorter-dated yields. And the yield curve should begin to normalise, which should also lead to the US dollar reversing some of its recent strength. We always like to consider different risk cases to our views as well. For example, something that’s been playing on the market’s mind has been the risk of inflation staying stickier. There are other risks on the horizon as well such as the labour market deteriorating faster than we expect, which leads to more cuts being priced into the front end of the curve. There’s also political risk with the US presidential elections later this year. All of these risks shape some of the strategies and hedges that we that we use within our absolute return strategies.

AC: How do you translate that into a strategy to harvest returns in the global bond market?

JM: Within our strategies, we’ve started adding duration. From a directional perspective, we’re mainly focusing on markets where we think that the central banks will have to ease policy quicker than the market’s pricing. We’ve also been focusing on relative value type rate strategies. We like being long duration in the front end of the curve in markets like the UK, Canada, Sweden and against being short in other markets like Australia and Japan. We also like holding yield curve steepeners across different developed markets. We’ve allocated risk towards themes within corporate credit markets. We don’t see an imminent catalyst for spreads to widen, but we do think that valuations are rich at the moment. We think that US breakeven inflation looks quite attractive at these levels versus Europe. Absolute return type strategies can benefit from taking a directional view on where we think interest rates are going to go, but also taking advantage of the differences that we see between different countries and regions and markets by being long certain markets and being short others against them.

AC: Jay, thank you.

JM: It was a pleasure.