Absolute return bond funds

This relatively new offering from fund managers offers a new choice to income seeking investors with new risks attached.

Summary: Absolute return bond funds can help fill the need for income as cash and term deposit rates are low. These funds are benchmark unaware and can hold a wider range of fixed income assets than benchmark aware bond funds. Absolute return bond funds try to avoid the risk of capital loss through using a wide range of assets and strategies.

Key take-out: Returns have been relatively weak compared to traditional bond funds, but liquidity is higher than for term deposits.

Key beneficiaries: General investors. Category: Investment bonds.

In our recent Eureka Report piece on fixed income ETFs (Are bond ETFs for you?, February 11) we showed how these have generated excellent returns over the last couple of years. This has been driven in large part by falling interest rates, which push up the value of older bonds which pay a higher coupon than more recent issues.

We noted that this trend should continue for at least the near to perhaps medium term, as the Australian interest rate trend remains on a downward slope. That won’t last forever, and holders of traditional “benchmark aware” bond funds or ETFs which track those indices need to be cautious in the timing of these investments. This is the space in which the relatively unknown phenomenon of “absolute return” bond funds can play a role – to help fill the need for income in the low return cash and TD market, with the hope for some immunity against the inevitable rise in interest rates.

There are several absolute return bond funds available to Australian investors, many of which have a reasonably long track record for consistent returns. The table below shows returns across this sector, with the data typically taking account of manager fees but not including tax costs. Data has been sourced from individual fund managers, and further information is available from each product issuer.

Fund

Inception Date

1 year return (%pa)

3 year return (%pa)

Return since inception (%pa)

Australian Unity Altius Bond

Jan 2011

5.59

5.64

6.22

Australian Unity Altius Strategic Fixed Interest

October 2005

5.34

4.44

5.61

Alliance Bernstein Dynamic Global Fixed Income

June 2014

N/A

N/A

4.13

Colonial First State Enhanced Yield

February 2005

2.94

4.97

5.67*

Kapstream Absolute Return Income

May 2007

4.72

5.67

5.88

Perennial Tactical Income

June 2009

6.5

5.0

5.6

PIMCO EQT Australia Focus

February 2009

5.66

5.26

5.96

PM Capital Enhanced Yield

March 2002

3.2

5.0

6.5

*Five year return. Table does not include funds launched in 2015.

Seeking to avoid the traditional bond fund risk of capital loss by being benchmark unaware

Benchmark aware bond funds and ETFs hold bonds in accordance with set rules (with the active fund trying to outperform that benchmark but with the majority of its holdings still pegged to the benchmark). These benchmarks track the weight of bonds issued in the market and apart from the typical rule that they must sell bonds which have less than one year till maturity, they are forced to hold long dated bonds which can be extremely sensitive to rising interest rates.

The risk of capital loss in this environment is real, and as we discussed in our review of fixed income ETFs, if you’re in the camp that fears a crash in the bond market, that means you probably aren’t willing to invest in traditional bond funds or ETFs.

In contrast, absolute return bond funds are benchmark unaware and can hold a wider range of fixed income assets, with whatever maturity the manager deems suitable. This often means they venture into the corporate bond market as well as holding shorter dated bonds which are less susceptible to capital volatility when rates move.

The industry defines these strategies as using flexible “sector allocation” and “duration management,” which really means that the fund can invest based on analysis of the value of a bond irrespective of its weighting in the benchmark. By being able to move between lower risk cash and government bonds, and higher risk corporate bonds, the fund can exploit pricing anomalies, where investments are perceived to be under- or over-priced based on their fundamentals.

This is where the game becomes interesting – as the value of a specific investment is often based on a subjective assessment of factors such as industry and sectoral trends, company specific financial performance, market sentiment and simple movements of supply and demand. Clearly these factors are susceptible to manager skill and so looking for an absolute return bond fund with a long term track record is an important consideration.

Added to these ingredients, absolute return bond funds typically also use long/short trading strategies (where differences in the relative value of bonds is exploited) as well as derivatives.

Good funds will disclose the make-up of their portfolio and the range of trading strategies they use – but at the end of the day, investors are clearly reliant on the skill of the manager in implementing often short-term strategies with complex systems behind them.

Think of it like this – absolute return bond funds try to avoid the risk of capital loss in a rising interest rate environment by investing in a wide range of assets and strategies: hopefully that approach works, but it creates its own set of risks of capital loss in the process.

So, why bother?

The primary goal of these funds is to preserve the investors’ capital against the risk of rising interest rates. This will eventually happen and can do so quickly as and when inflation takes hold. While that might be a long way off (at least in Australia), markets have a habit of surprising us!

The trade-off is that returns for the majority of funds in this style have been relatively weak compared to traditional bond funds over the last few years, with the added risk arising from complexity verging on the “black box” style of fund that disappointed in the GFC.

Perhaps the most relevant comparison is to consider how well these funds fare when measured against term deposits – and it’s here that the flexibility offered by the daily liquidity of these funds is a real boost. After all, the usual rationale for a TD is that the yield over cash deposits is compensation for being locked into the TD for its term. TD’s also come with fixed rates, whereas the flexibility of the actively managed fund can allow the manager to move to higher rate instruments as these become available.

So an absolute return bond fund that pays at or above TD rates but with the benefit of daily liquidity could be an interesting part of the overall investment portfolio, especially for retirees needing good levels of regular income.

What about the “black box” problem, that is, the risk you may suffer losses because of unforeseen tactics used by the bond fund manager?

Although there are a few absolute return bond funds with relatively long track records, many have been launched in the last year or two and are untested. Fees are higher than simple bond funds or ETFs, and the opportunity for outperformance compared to traditional bond funds or ETFs comes at the risk of capital volatility through exposure to riskier corporate bonds and credit derivatives.

On the whole, the problem with complex strategies based on quantitative models, is that these models tend to work when markets behave as they have done during previous periods. We are clearly still in uncharted territory as global markets react to the unwinding of US QE.

One of the golden rules of investing is not to do so unless you can understand what the investment is about. Many of the broken investments from the GFC were in complex products that weren’t transparent – or even if they were, used quantitative-based models that were unable to be understood by investors (and many advisers).

At the same time, the accepted rationale for any DIY investor using a managed fund is where the fund provides access to investments or strategies that aren’t available to the direct investor.

Clearly the absolute return bond funds considered here tick that box. Underpinned by the rationale that a fund in this category that has demonstrated a long term capacity to match or exceed returns offered by term deposits, but with the daily liquidity that TD’s don’t have, could be considered for a portion of the fixed income portfolio. In any event, as an alternative or as a supplement to the potentially riskier “long only” bond funds – prone as they may be to sharp falls in capital value as rates rise or if bond markets falter – absolute return bond funds should be visited as an interesting concept by inquiring investors.


Dr Tony Rumble provides asset consulting services to financial product providers and educational services to BetaShares Capital Limited, an ETF provider. The author does not receive any pecuniary benefit from the products reviewed. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.