Where is the money in bond markets?

With interest rates expected to rise in the US and the UK, investors should brace themselves for extremely lower yields than they have been used to.

“Over the past five years, fixed income has provided investors with significant positive returns. Government bond values have risen as market yields as a whole have fallen. Returns on corporate credits have been even higher as the difference in market yield between corporate bonds and government bonds has fallen to historically low levels. Looking ahead however, prospective returns are likely to be limited by the extremely low level of yields now offered, particularly by government bonds” says Jim Cielinski, Head of Fixed Income at Threadneedle Investments.

“Credit spreads have also declined significantly. Yields are approaching zero in many markets and investors clearly cannot rely on benchmarked ‘long-only’ fixed income strategies to deliver meaningful returns. Moreover, volatility is on the rise. In the second quarter of 2013, emerging market debt suffered significant falls in value and more recently there has been more volatility within the high yield market” Cielinski adds.

Nevertheless, Cielinski believes that there are opportunities to generate meaningful returns in bond markets. “With the right approach and strategy, it is possible to deliver sustainable risk-adjusted returns even in changing market conditions. In our absolute return strategy, we aim to produce a total return of 4.5% above 1-month dollar cash, before fees, over rolling 12-month periods.”

For Jim Cielinski, it is important to be able to generate alpha independent of beta in order to boost returns. Portfolio diversification is also critical. “One of the biggest mistakes that investors can make in fixed income is to rely on one or two large, directional macro calls, as these are notoriously difficult to get right. The cost of getting it wrong can be further amplified by liquidity problems.

The Threadneedle (Lux) Global Opportunities Bond Fund, managed by Jim Cielinski since its launch three years ago, offers an unconstrained, high conviction, flexible investment approach employing a wide variety of strategies with the aim of producing a positive return in all market environments.

The fund can position to take advantage of rising bond yields, falling bond yields, or a convergence/divergence in one country relative to another. The structure of the Fund also means that an asset allocation view can be implemented in a more efficient way than would be possible in a benchmark-relative product. Martin Harvey, deputy manager of the Fund explains: “The flexibility afforded by derivative instruments allows us to take advantage of rising yields or rising credit spreads as and when it is appropriate, a feature that becomes invaluable as yields and spreads decline to low levels. For example, we currently hold a long position in high yield bonds, hedged by a short position in investment grade bonds.”

“Currency is another important source of added value within our macro views, whereby we employ a relative value overlay of positions across a range of currencies in developed and emerging markets. For example, we are currently long the US dollar versus a range of other currencies” adds Harvey. Following the turbulence of mid-2013, the Fund increased exposure to US dollar-denominated EM debt, but has recently reallocated towards local debt of high-quality markets such as Mexico and Colombia.

In FX, the fund combines strategic positions, exploiting long-term valuation anomalies, with tactical positions that take advantage of short-term trends. This year, the strategic element of the portfolio has favoured the US dollar versus commodity currencies such as the Australian and New Zealand dollars. Other positions, such as those in the Japanese yen and British pound, have been employed more tactically.

Although past performance is not a guarantee of future performance, since its launch on 24 August 2011, the fund has delivered an average annual return of 5.54% before fees (in US dollars, as at 30 Sept 2014) [1] delivering on its absolute return objective of generating positive returns in all market conditions and with low volatility of around 3%.

Dominik kremer, Head of Institutional distribution for EMEA and Latin America at Threadneedle Investments says: “Investors remain faced with the challenge of seeking returns within an ultra-low yield environment, without exposing themselves to undue levels of risk. Against this background, investors should consider a flexible absolute return approach such as the Threadneedle (Lux) Global Opportunities Bond fund as a possible solution in challenging fixed income markets. The success of the fund since its launch is in part due to Threadneedle and sister company Columbia Management’s combined 67-strong global fixed income research capabilities and asset allocation perspective advantage. The diverse nature of the fund allows the team to utilise the best ideas in each area.”