Absolute-return lens put on bonds

The looming reality that interest rates must eventually rise — depressing bond prices — is pushing more U.K. pension funds to take a look at their fixed-income portfolios from an absolute-return stance.

“Interest rates are so low; they can't go down much further,” said Dominic Pegler, managing director in BlackRock Inc.'s fixed-income group based in London. “That being the case, why would you want to hold bonds with a high degree of sensitivity to any increase in interest rates? Immediately, absolute-return bond strategies would come to mind.”

Designed to perform whether interest rates are rising or falling, absolute-return bond strategies are attracting investors such as pension funds, endowments and insurance companies. For pension plans, many of which are underfunded, the need to achieve higher returns from bonds has become more urgent, sources said. Diversification is another main draw.

“The U.K. is leading the way,” said Mr. Pegler. BlackRock officials declined to provide total absolute-return assets under management, but said recent institutional mandates in the strategy have ranged from £50 million to £300 million.

Daniel Phillipson, senior vice president and product manager for alternatives for Pacific Investment Management Co. based in Munich, added, “We're talking to clients, particularly in the U.K., almost on a daily basis about these types of strategies.” PIMCO's assets under management in absolute-return bonds increased about 55% to $17.9 billion globally in the year ended Dec. 31.

Consultants and managers see less interest from continental Europe and the U.S. However, they expect more institutions worldwide to consider absolute-return bond strategies as returns in traditional active bond portfolios wane. In March, for example, PIMCO Managing Director William H. Gross said in a radio interview that “bonds have seen their best days” as real interest rates have been edging higher.

U.K. pension funds were early adopters of liability-driven investing strategies, and absolute-return bond strategies are an extension of that approach.

“There's a need to balance the trade-off between the risk relative to liabilities and returns relative to liabilities,” said Tony Broccardo, chief investment officer of the £16 billion ($24 billion) Barclays Bank PLC U.K. Retirement Fund based in London. “The way we solved that issue” is by attempting to realize a higher return potential for bonds as well as efficient hedging of interest and inflation risks.

To obtain better risk-adjusted performance from its fixed-income portfolio, Barclays executives applied the absolute-return philosophy to a meaningful portion of its standalone fixed-income portfolios and its global tactical asset allocation portfolios. Unlike traditional active bond strategies that are benchmarked to an index, absolute-return strategies employ a more dynamic asset allocation framework using a broader set of fixed-income investments that might include high-yield and emerging market debt.

“I would not be surprised if flexible bond-based alternative strategies can increasingly add significant value during what will likely be a very uncertain macro-economic backdrop to pension fund returns,” Mr. Broccardo said. “There are plenty of opportunities.”

A specific breakdown of the fund's exposure to absolute-return bond strategies was not available. But overall, about 25% is invested in global equity, 25% in global alternative, 20% in credit and the remainder in LDI strategies as of the year-end 2009. The fund's absolute-return strategy is a complement to its LDI approach.

In comparison, at the end of 2006, the fund was largely invested in “a very traditional bonds and equities portfolio with a large home-country bias.”

Absolute-return bond strategies were around for years before the financial crisis hit, according to several consultants. But after Lehman Brothers Holdings Inc. went belly up in 2008, a lot of absolute-return bond products sustained negative returns because of the high credit risks embedded in them. While some recovered, others closed because of unsustainable outflows.

“We've seen a bounce-back in 2009,” said Margaret Frost, senior consultant and global head of bond manager research at Towers Watson & Co. based in London. The firm is conducting more searches so far this year compared with the same period last year, she said, but specific numbers were not available by press time.

“It's not a trickle, but it's not a flood either,” she said. “These (strategies) still need to prove themselves — that they can do the job of protecting the downside. In 2007-2008, a lot of products didn't do that.”

Stephen Birch, head of manager research at consulting firm Hymans Robertson LLP, Glasgow, Scotland, said clients have given the strategy a second chance as performance improved among managers who survived through the crisis. However, officials are also more wary of the risk assumptions embedded in absolute bond strategies. About half of all bond-related searches have been in absolute return strategies over the past year, averaging about £100 million per mandate, he added.

“At the moment, absolute-return managers are probably in a sweet spot. Things are looking rosy,” Mr. Birch said. “But the test will be whether managers can protect clients through next blow-up. That's when they will really prove themselves.”

The strategies range widely from relatively conservative portfolios in which active returns are gained over and above what is essentially a money market strategy, to long/short mandates that use leverage to add risk, and therefore, more potential for returns. And it's not just the fixed-income houses that are gaining business; traditional equity managers such as State Street Global Advisors also have introduced absolute-return bond strategies.

Philip Barleggs, vice president and fixed-income product engineer at SSgA based in London, said the firm's absolute-return bond strategy targets a return about two percentage points above the London interbank offered rate using a mixture of fixed-income securities, derivatives and bond or money market futures. SSgA is considering launching a separate higher-risk strategy that might include emerging market debt. Overall, the firm manages about $28 billion in active bonds. The relatively new absolute return bond strategies comprise less than 2% of the total active bond assets.

Diversification is another reason that absolute-return products may prove more attractive in an environment in which fixed income returns may become more volatile.

“At certain points in time, certain investment opportunities will offer better value than others in the market,” said Robert Michele, global chief investment officer for fixed income at J.P. Morgan Asset Management in London, adding that absolute-return strategies are designed to guard the bond portfolio against an unstable macroeconomic outlook by diversifying risks.

For example, officials at the £1.9 billion Norfolk County Council Pension Fund, Norwich, England, began shifting about half of the bond portfolio's assets into an absolute-return strategy in the third quarter of 2009. Goldman Sachs Asset Management now manages a £70 million long/short diversified fixed-income portfolio for the Norfolk fund targeting one percentage point over LIBOR net of fees. M&G Investments manages a £100 million mandate for the fund that is “a tactical position in investment-grade credit” strategy, said Alex Younger, pension fund accountant.