Institutional investors are increasingly looking into absolute-return fixed income strategies because of the expected continued rise in US interest rates and the heightened market volatility seen in the first few months of 2018, say some industry insiders.

At BNP Paribas Asset Management alone, the absolute-return fixed income asset base of Asian institutional investor clients increased by around $500 million in the first quarter of 2018. 

That matches the entire increase recorded in 2017 when the total reached $2 billion, Alex Johnson, head of multi-strategy fixed income absolute return for BNP Paribas Asset Management, said.

It's not an isolated event either. Janet Li, wealth business leader for Asia at consultancy firm Mercer, notes increased interest in absolute-return fixed income strategies across a range of Asian institutional investor clients, now markets have turned more jumpy and risks are deemed to be rising.

“Absolute-return fixed income provides them with the needed downside protection, and can act as a diversifier in their portfolio, while also adding sources of alpha and reducing inherent interest rate, country, sector, or credit spread risk,” Li told AsianInvestor.

Broadly speaking, absolute-return fixed income strategies are not measured against traditional fixed income benchmarks. Instead, they aim to generate returns that are uncorrelated from the market environment. Managers will typically take both long and short positions in a variety of global fixed income opportunities, including government bonds, credit, currencies, and emerging markets.
 
When markets are doing well, investors want those highly correlated returns, Johnson told AsianInvestor. But less so when market conditions get a bit more testy.

With global markets experiencing a manic correction in early February, the US Federal Reserve raising its rates three times in 2017 and tipped to do so another three/four times in 2018, and yardstick long-term bond yields climbing too, Asian institutional investors are increasingly being drawn to the risk-adjusted returns promised by absolute-return fixed income strategies, he said.

As such, the improving trend seen in the first quarter looks well placed to continue into the second quarter. 

“We’ve been talking about the risk of rising rates for a while, but with the US 10-year [Treasury bond yield] having breached 3% in April, that made real to many investors what was previously a more academic concern,” Johnson said.

Coupled with the jump in market volatility, that is understandably spurring some investors into rethinking their approach. The CBOE Volatility Index, which measures the expected range of movement in the S&P 500 index, surged to around 37% in early February, after averaging 11.1% in 2017. Since February 5, the index has averaged 19.6%.

INSURERS AND PENSION FUNDS

Interest in absolute-return fixed income strategies appears particularly pronounced among insurance companies because of their regulatory requirement to hold fixed income.

They don’t get to say they don’t want fixed income in their portfolio as allocations to fixed income are required to diversify the portfolio, generate a cash return, and provide stability in the portfolio, Johnson said. “What they don’t want is the beta of fixed income, but they still want the de-correlation, they still want the income, and they still want the drawdown management that a fixed income allocation will provide, and absolute return aims to deliver that.”

Insurance companies need to have yields that can meet their policy liabilities, and they, along with sovereign wealth funds, are trying to see how they can get more alpha from their fixed income exposures, Li said.

“For both segments of clients, I expect to see more and continuous demand in absolute-return fixed income,” she said.

Pension funds may also have a preference towards absolute-return fixed income strategies in their asset allocation mix for the purposes of generating cash flow to pay retirees, Johnson said.

Korea’s Public Officials Benefits Association (Poba) uses an absolute-return strategy across its fixed income investments, and they have been steadily increasing their allocations towards fixed income in the last three years, Jang Dong-hun, Poba’s chief investment officer, told AsianInvestor.

In 2017, Poba’s fixed income allocation increased by 1.7 percentage points to 8.3% and the current allocation has risen by another 2.7 percentage points to around 11%, Jang said.

The Hong Kong Housing Society also said they were looking for a manager for an unconstrained bond strategy to reduce portfolio volatility in August 2017.

RETURNS EXPECTATIONS

Institutional investors in Asia are expecting returns in the low-single digits when it comes to public markets allocations, Li said. “For investments that include government, corporate, emerging market bonds, use of different currencies and derivatives together, probably the typical return will be 2-4% per annum.”

However, if private markets are taken into account, including illiquid credit exposures, the expected return would increase to 5% to 8% over the prevailing cash rate, typically the 3-month London inter-bank offered rate, Li said.

For 2018, Poba expects returns in the 5% to 6% range across their structured note, CLO, and private debt fund investments, Jang said.

BNP Paribas is targeting returns of around cash plus 3% to cash plus 3.5%, Johnson said.

Being short duration in a rising rate environment is a clear opportunity, he said, and they also prefer high yield exposure in broad baskets of derivatives, as opposed to illiquid single names. Emerging markets are also favoured, he said, due to central banks continued removal of policy accommodations in an environment of continued global economic growth.